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If you're wondering how otherwise extremely bright people at the top of our country's best banks led us into the subprime mess, here's a simple answer:
There was too much money in it for them to resist.
We hear all the time that companies have to pay top execs tens of millions of dollars a year to "attract the top talent."
But dangling huge payouts in front of bank CEOs in exchange for short-term bursts of growth brought just the opposite: the worst performance by some of the best-paid execs in decades, taking a big toll on homeowners and bogging down the whole economy.
- Countrywide Financial (CFC, news, msgs) chief Angelo Mozilo cashed out $400 million in stock options from 2003 to 2007. In 2007 and 2008, the company's stock fell to multiyear lows, and the lender may soon disappear.
- Washington Mutual (WM, news, msgs) chief Kerry Killinger took home $24 million in 2006. A crash that started in 2007 as subprime-related problems surfaced has wiped out all shareholder gains since 2000.
- The head of Merrill Lynch (MER, news, msgs) got $160 million upon his retirement last year; the head of Citigroup (C, news, msgs) collected $40 million. This happened in the same period both stocks plunged more than 40%.
- And former Bear Stearns (BSC, news, msgs) CEO James Cayne got $39 million in bonus pay alone for 2004-06. He left in January of this year, just before his bank had to be bailed out with help from the Federal Reserve to avert a disaster that might have brought down much of the U.S. financial system.
Despite all the problems they helped create, these execs get to keep that loot. For that, blame lousy boards of directors for poorly designed pay plans that encouraged Wall Street's elite to take too much risk on the subprime mortgages that have caused so many problems. Here are four ways the boards erred:
Too much, too soon
Mistake No. 1: Boards awarded too much bonus pay too fast in exchange for fleeting achievements, such as raising revenue or earnings growth in a single year.This tempted execs to create a lot of fireworks in the near term without regard for how sustainable growth really was. After all, they got no reward for building lasting shareholder value. They could take the money right away and run, which is exactly what many did.
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"Their bonuses and long-term incentives were largely tied to earnings targets," says Alexandra Higgins, a researcher at The Corporate Library, which tracks pay and corporate-governance issues. "Those earnings targets were directly linked to loan production."
So execs created as many mortgage loans as possible -- to heck with the consequences down the road -- in what The Corporate Library's Nell Minow describes as an "après moi le déluge" (after me the deluge) dynamic.
Home-mortgage lender Countrywide stands out as Exhibit A. Mozilo's huge stock-option grants vested quickly -- in equal slices over just three years. And a big chunk of bonus pay came in the form of cash paid immediately. His board offered no reward for creating lasting value.
Mozilo and his fellow execs had every incentive to stoke the subprime machine as hard as they could to rev up earnings and drive the stock higher. By 2004, Countrywide had become the largest U.S. mortgage lender, in part by lowering lending standards and pushing exotic mortgages that allowed borrowers to qualify for bigger loans.
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Countrywide's performance responded, allowing Mozilo to exploit a compensation package that rewarded him for short-term gains. In 2006, Mozilo pocketed a $20.4 million cash bonus because earnings had advanced 4.6% to $4.30 a share. His total compensation that year was $102 million, if you include other kinds of pay and profits on options. Between 2004 and 2007, Mozilo cashed out options worth $414 million.
That's money Mozilo doesn't have to give back, even though Countrywide's fall has cost shareholders 88% losses since the start of 2007.
"Countrywide is probably the worst example," says Daniel Pedrotty, a corporate governance expert at the AFL-CIO's Office of Investment. But you see the same scenario across the financial sector.
At Wachovia (WB, news, msgs), for example, execs were richly rewarded for short-term earnings growth -- even through acquisitions. By 2006, this enticed them to buy Golden West, a California bank that was knee-deep in option adjustable-rate mortgages, known as ARMs.
ARMs can help borrowers because their interest rates are held artificially low for an initial time frame. But they are riskier, too: Homeowners eventually need to refinance or face much higher payments, but many people have found they can't refinance because home values are falling and loans are now harder to get.
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