Why CEO pay fed the mortgage mess

By Michael Brush

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.

"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.

• Video: The highest-paid CEOs

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.

Continued: Pay for risk

Wachovia acknowledges that buying Golden West near the peak of the housing boom was bad timing, but it thinks the purchase of Golden West will pay off in the long run.

"We purchased a solid company, and as the market begins to turn we feel we will be very well-positioned," a Wachovia spokesman says. The option ARM portfolio that Wachovia picked up through Golden West is also performing above industry averages, the spokesman says.

Meanwhile, executives at Wall Street investment banks such as Citigroup (C, news, msgs), Bear Stearns and Merrill Lynch all reaped big annual bonus rewards in part for repackaging subprime loans into risky debt instruments that spread the damage around the globe.

Pay for risk

Problem No. 2: Bonus pay was linked to measures that encouraged execs to take on excess risk.

At virtually all of the major culprits in the subprime mess, including Countrywide, Wachovia, Washington Mutual, Merrill Lynch, Citigroup and Bear Stearns, executive bonuses were directly linked to increases in return on equity, or ROE, which measures net income growth against stockholder equity.

Because one quick way to boost ROE is to assume more debt to increase growth, tying bonus pay to ROE encouraged execs to take on higher levels of risky debt linked to subprime loans.

For example, to keep up with competitors during the housing bubble, Washington Mutual shifted its loan mix away from standard fixed-rate mortgages toward riskier subprime and/or adjustable-rate mortgages that presented "much greater risk of default," says William Patterson, CtW Investment Group's executive director.

This helped prop up Washington Mutual stock in 2006 so that chief Killinger could realize $15 million by cashing out options and collect total pay that year of $24 million, according to The Corporate Library. But the next year, problems related to subprime loans hit the stock, costing shareholders $28 billion in a 71% stock price decline that "wiped out all of the shareholder value created since 2000," Patterson says.

Guaranteed windfalls

Problem No. 3: Boards offered execs huge guaranteed retirement pay and golden parachutes, regardless of how they performed.

Execs knew they could collect big severance and retirement pay even if their companies flamed out as they left. So they had little incentive to avoid getting their banks in trouble. For example:

• Even though former Merrill Lynch CEO Stanley O'Neal oversaw Merrill's involvement in the subprime mess, he got more than $160 million in stock and retirement benefits when he left the bank in October. That's because it's Merrill Lynch policy to give employees, if they have worked there long enough, all of their restricted stock and unvested options from prior years. But much of the money was from stock awards granted during the six years O'Neal was CEO. Did he really deserve the money? Merrill Lynch stock lagged the S&P 500 Index ($INX) during this period, and shareholders lost 41% last year alone. In fairness, before he left Merrill Lynch, the company's policy also required O'Neal to keep 60% of the stock he was given, so he felt some pain along with shareholders.

• Former Citigroup chief Charles Prince pocketed $40 million when he left the company last year, including a discretionary bonus of $10.4 million and more than $28 million in unvested stock and options that vested immediately, according to the AFL-CIO. As with Merrill, he got the stock and options automatically because he had worked at Citigroup long enough, almost 30 years. Shareholders haven't done so well, at least recently. They lost 2.5% a year while the S&P 500 was posting average annual gains of 12% during Prince's tenure as CEO from 2003 to 2007. Shareholders lost 45% last year alone.

• Countrywide's Mozilo will collect $23.7 million in pension benefits and $20.6 million in deferred compensation when he leaves the company, according to The Corporate Library, despite the mess he helped create.

• If Washington Mutual were to get bought out like Bear Stearns or Countrywide, its chief, Killinger, would get a golden parachute worth more than $22 million, according to the AFL-CIO.

Money, it's a gas

Mistake No. 4: The sheer size of the pay packages granted by boards created a hazard.

If you dangle huge potential rewards in front of someone, they are more likely to do dumb things in order to take a swing at the piñata.

Bear Stearns, for example, created a bonus pool for execs worth $165 million in 2006. The only restraint -- other than that the company had to meet minimal targets for things such as annual sales and earnings growth --- was that no single exec could get more than 30% of the pot.

With that kind of temptation, it should be little surprise that then-Bear Stearns chief Cayne led his bank into the subprime morass. Doing so helped him get $33.8 million in pay in 2006 alone, including a cash bonus of $17 million.

• Video: The highest-paid CEOs

Cayne paid dearly along with shareholders when Bear Stearns blew up, because he owned a lot of stock. But he managed to keep enough dough to pay cash for a $25.8 million luxury condo recently on New York's Fifth Avenue.

Likewise, CEOs at Countrywide, Merrill Lynch, Citigroup, Wachovia and Washington Mutual all reaped annual pay of $20 million to $40 million during the go-go days of the housing boom. Because of the way their pay plans were structured, they knew all along that they could keep it no matter what happened.

Continued: What shareholders can do

What shareholders can do

If these kinds of stories tick you off and you want to make a difference, vote shares of stock you own in ways that bring about stronger boards. If you don't own stocks, make sure your mutual funds do this. Many shareholders don't bother to vote.

Activists have placed a variety of measures on ballots that allow shareholders a voice on executive pay and promote independent boards:

• "Say on pay" proposals give shareholders a vote on executive pay packages.

• Other proposals do things such as adjust board elections so that all members are voted on at once, which makes it easier to oust a bad board.

• Some votes even go so far as to suggest companies vest stock options only after enough time has passed to see whether management decisions really pay off.

These votes are generally nonbinding, but they send a message.

It also pays to follow news reports on efforts by activists to oust board members. CtW Investment Group, for example, this year successfully challenged Washington Mutual board member Mary Pugh. As the chairwoman of the bank's finance committee, part of her job was to monitor Washington Mutual's exposure to subprime risks.

CtW asserted in an open campaign against Pugh that her role might have been compromised by the fact that her company, Pugh Capital Management, managed a significant amount of money for Washington Mutual. Washington Mutual recently accepted Pugh's resignation after she did poorly in a shareholder vote.

Once independent boards are in place, they need to link pay to meaningful measures of growth, says Eleanor Bloxham, an executive-pay expert at The Value Alliance and the author of "Economic Value Management: Applications and Techniques."

• Video: The highest-paid CEOs

They also need to deploy pay packages that hold back a portion of bonus pay until it's clear that executives have created lasting value. Without strong boards looking out for shareholders, it's not clear this will happen.

"A lot of executives don't like this because it really does hold them accountable," Bloxham says.

At the time of publication, Michael Brush did not own or control shares of any company mentioned in this column.