The Executive Compensation Controversy - Fondazione Rodolfo ...

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THE EXECUTIVE COMPENSATION CONTROVERSY: 24 MAY 2010A TRANSATLANTIC ANALYSISrelation implicit in stock options, providing rewards for stock-price appreciation above theexercise price, but no penalties (below zero) for stock-price depreciation below the exerciseprice. Executives with options close to expiration that are out of the money have strongincentives to gamble with shareholder money; executives with options that are well in themoney have fewer such incentives.The second way that incentive compensation can create incentives for risk taking isthrough performance measurement. For example, in the years leading up to its dramaticcollapse and acquisition by JPMorgan Chase at fire-sale prices, Washington Mutual excelledat providing loans and home mortgages to individuals with risky credit profiles. 138 WaMumortgage brokers were rewarded for writing loans with little or no verification of theborrowers assets or income, and received especially high commissions when selling moreprofitableadjustable-rate (as opposed to fixed-rate) mortgages. After launching the “Powerof Yes” campaign in January 2003, the revenue from the bank’s home-lending unit grewfrom $700 million to almost $2 billion in less than a year, and its adjustable-rate loans grewfrom 25% of WaMu’s new home loans in 2003 to over 70% by 2006. Most of WaMuoriginatedloans were packaged and sold to Wall Street; WaMu routinely pressuredappraisers to generate inflated property values so that these packaged loans would appear lessrisky. Nonetheless, the value of bad loans on WaMu’s books grew from $4.2 billion in mid-2007 to over $11.5 billion in mid-2008. Regulators seized the bank in September 2008,selling its assets to JPMorgan for $1.9 billion – a year before WaMu’s market capitalizationhad exceeded $30 billion.The basic incentive problem at WaMu was a culture and reward system that paidpeople to write loans rather than to write “good loans” – that is, loans with a decent chance ofactually being paid back. In the end, WaMu got what it paid for. Similar scenarios werebeing played out at Countrywide Finance, Wachovia, and scores of smaller lenders whocollectively were not overly concerned about default risk as long as home prices keptincreasing and as long as they could keep packaging and selling their loans to Wall Street.But, home prices could not continue to increase when prices were being artificially bid up byborrowers who could not realistically qualify for or repay their loans. The record number offoreclosures in 2008, and the associated crash in home values, helped send the U.S. economy(and ultimately the global economy) into a tailspin.138 The information in this paragraph is based on Goodman and Morgenson, “By Saying Yes, WaMu BuiltEmpire on Shaky Loans,” New York Times (December 27, 2008).-103-
THE EXECUTIVE COMPENSATION CONTROVERSY: 24 MAY 2010A TRANSATLANTIC ANALYSISIn the current anti-banker environment, it has become fashionable to characterize planssuch as those at Washington Mutual as promoting excessive risk taking. But, the problemswith paying loan officers on the quantity rather than the quality of loans is conceptuallyidentical to the well-known problem or paying a piece-rate worker based on the quantityrather than the quality of output, or the well-known problem of paying executives (orinvestment bankers) based on short-term rather than long-term results. Put simply, these areperformance-measurement problems, not risk-taking problems, and characterizing them asthe latter leads to impressions that the problems are somehow unique or more important inthe banking sector, when in fact they are universal.Before describing how compensation plans can be improved to mitigate problems withboth asymmetries and performance measurement problems, it is worth noting that thechallenge historically has been in providing incentives for executives to take enough risk, nottoo much risk. As discussed in Section 2.2.2, executives are typically risk averse andundiversified with respect to their own companies’ stock-price performance. On the otherhand, shareholders are relatively diversified, placing smaller bets on a larger number ofcompanies. As a result, executives will inherently be “too conservative” and want to takefewer risks than desired by shareholders. Indeed, stock options (or other plans with convexpayouts) have long been advocated as ways to mitigate the effects of executive risk aversionby giving managers incentives to adopt rather than avoid risky projects (see, for example,Hirshleifer and Suh (1992)). Similarly, there is a long history of attempts to documentempirically a relation between convexities and actual risk-taking incentive, and the resultshave been relatively modest. 139To show how poorly designed pay-performance relations can cause a host of problems(including excessive risk taking), consider the typical executive cash compensation (salaryand bonus) schedule illustrated in Figure 4.1. As depicted, no bonuses are paid untilperformance reaches X 1 , at which point the executive receives a sizeable bonus (e.g. half ofhis target bonus). Bonuses continue to increase with performance until X 2 , at which pointbonuses are “capped” regardless of subsequent increases in performance.139 DeFusco, et al. (1990) find some evidence that stock-price volatility increases, and traded bond pricesdecrease, after the approval of executive stock option plans. Similarly, Agrawal and Mandelker (1987) find someevidence that managers of firms whose return volatility is increased by an acquisition have higher optioncompensation than managers whose volatility declined-104-
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