House Committee Holds Hearing on Compensation in the Financial Industry

Today, the House Committee on Financial Services held a hearing on compensation in the financial services industry. Testifying before the Committee were:

•  
  
  
  
  • Lucian Bebchuk, Professor of Law, Economics and Finance and Director of the Program on Corporate Governance at the Harvard Law School
  
  
  • Nell Minow, Editor and Co-Founder, The Corporate Library
  
  
  • Joseph Stiglitz, University Professor of Economics, Columbia Business School
  
  
  
  

In a heated exchange between Chairman Barney Frank (D-MA) and
Ranking Member Spencer Bacchus (R-AL), Rep. Bacchus said that he was
disappointed by the Committee’s refusal to allow Edward DeMarco, Acting
Director of the Federal Housing Finance Agency (FHFA, formerly the
Office of Federal Housing Enterprise Oversight), to testify, as a
minority party witness, before the Committee, to respond to questions
regarding the December 24 announcement
regarding bonus decisions at the Federal National Mortgage Association
(Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie
Mac). Chairman Frank replied that this hearing concerned private sector
entities, and Fannie Mae and Freddie Mac were effectively public sector
entities, which would be dealt with in a later hearing in February. He
also indicated that “the committee will be recommending abolishing
Fannie Mae and Freddie Mac in their current form and coming up with a
whole new system of housing finance.”

Mr. Bebchuk began his
testimony by reviewing the incentives for risk-taking in standard
compensation arrangements. Executives, he stated, are rewarded for
short-term results even when those results were subsequently reversed.
As a result, executives are incented to pursue goals which may provide
short-term successes even if those successes later result in a crisis
to the firm. He reviewed the compensation structures of firms that
later failed, specifically Bear Stearns and Lehman Brothers,
and found that the top-five executive teams at these firms cashed out
large amounts of performance-based compensation during the 2000-2008
time period, and that this bonus compensation was not “clawed back”
when the firms collapsed. He estimated that the top executive teams of
Bear Stearns and Lehman Brothers derived cash flows of about $1.4
billion and $1.0 billion, respectively, from cash bonuses and equity
sales during the 2000-2008 time period.

Equity compensation,
Mr. Bebchuck argued, should be linked to performance; however, it is
desirable to separate the time that equity-based compensation can be
cashed out from the time that it vests, and suggested five years was a
reasonable period of time to “block” cashing out of equity incentives.
Executives should also be limited to cashing out in any given year only
a specified fraction of the portfolio of equity incentives held, for
example, no more than 20%.

Mr. Bebchuk then suggested the following design features for a model compensation program:

•  
  
  
  
  • Equity awards should be made on pre-specified dates and not discretionary
  
  
  • Terms and amount of post-hiring equity awards should not be based on the grant-date stock price
  
  
  • Cash outs from restricted stock or options should be tied to the average price of stock over a reasonably long period of time
  
  
  • Executives should not be permitted to use financial instruments to “hedge” against the equity-based awards they receive
  
  
  
  

Ms. Minow began with a comparison of the $1.5 billion loan guarantee
given to Chrysler in 1979 and federal intervention in the current
financial crisis. Lee Iacocca, then-CEO of Chrysler, received a $1 per
year salary and escalated stock options that would be valueless absent
a substantial increase in the stock price. She contrasted that
arrangement with compensation in the current crisis, in which
management teams have limited downside exposure and are receiving
compensation that is effectively funded with federal funds. She
reviewed a series of financial institutions in which equity awards were
granted to executives at historically low prices in the late summer and
fall of 2008. She termed such grants “mega-grants” and noted that each
stock had risen in value, resulting in considerable profits to
executives.

Ms. Minow suggested the following features for a model compensation program:

•  
  
  
  
  • Indexing options and stock grants to specific performance goals
  
  
  • “Clawbacks” of bonuses to ensure any adjustments in financial reports would result in an adjustment of the bonuses
  
  
  • Incentive compensation based on more than one performance metric
  
  
  • Incentive compensation measuring performance over at least a year or more
  
  
  • Long-term performance-based compensation comprising the majority of total compensation
  
  
  
  

Mr. Stiglitz began by noting the enormous presence of the financial
industry as a percentage of corporate profits, stating that it garnered
over 40% of all corporate profits in the years before the crisis. He
accused the financial industry of badly managing risk and misallocating
capital to the point of a collapse of the economy’s payments mechanism.
He acknowledged that some parts of the financial system, for example,
venture-capital firms, performed admirably and even served as a check
on the poor performance of other firms. He noted that the capital
allocated to asset backed securities could have been used to finance
new investment that would have increased the longer-term productivity
of the economy; however, in his view this misallocation resulted in
venture-capital firms scaling back their investments, resulting in the
dynamic parts of the U.S. economy being without necessary capital.

Mr.
Stiglitz noted that the losses created by the recent financial crisis
were greater than the cumulative profits in the four years preceding
the crisis, and therefore from a long-term perspective, the profits
(and consequently the performance of the top executive teams) were
negative. He also noted the “negative externalities,” or the broader
impacts, of the financial crisis on other sectors of the economy and on
homeowners, retirees, workers and taxpayers.

Mr. Stiglitz
emphasized the link between incentives and executive compensation. The
prevailing compensation structure in the financial industry created
incentives to engage in excessive risk taking and leverage, and
distorted executives’ behavior by encouraging deceptive accounting and
financial models with poor assumptions that were not rigorously
questioned. He argued that these flawed incentives not only encouraged
short-sighted behavior and poor quality of the financial products
created, but also distorted accounting standards and misallocated
capital. Finally, he noted that the compensation system did not even
achieve its goal of “pay for performance,” since pay was high not only
when performance was good but also when it was poor.