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THE EXECUTIVE COMPENSATION CONTROVERSY: 24 MAY 2010A TRANSATLANTIC ANALYSIS(and median) Black-Scholes value of €22 million (and €7.1 million). By year-end 2008,only 18% of the CEO options were in the money, the average value had fallen by 95% toonly €1.2 million, and the median value had fallen by 98% to only €156,100. The dramaticdeclines are much steeper than observed in banks not receiving government funds, or forUSA firms outside of the banking sector.4.5. If Not Banking Bonuses, What Caused the Financial Crisis?The precise causes of the global financial crisis will be debated for decades (just as theprecise causes of the 1930s depression are still being debated), and it is beyond both thescope of this report and of our abilities to provide a detailed account here. 141 However, theevolving consensus suggests that the risk-taking contributing to the crisis reflected acombination of factors (at least in the USA) having nothing (or little) to do with the bankingbonus culture, including social policies on home ownership, loose monetary policies, “TooBig to Fail” guarantees, and poorly implemented financial innovations such as exoticmortgages, securitization, and collateralized debt obligations.The USA housing crisis, for example, can be traced not to banking bonuses but toprogressive government tax and social policies stretching back to the 1970s. 142 With respectto tax policies, the USA (along with the Netherlands, Sweden, and Switzerland) are the onlydeveloped countries allowing deductions for mortgage interest for personal taxes. Recentsocial policies to expand homeownership can be traced to the passage of the Home MortgageDisclosure Act (HDMA) in 1975, which required mortgage lenders to provide detailedinformation on mortgage applications. In 1977, when these new data suggested that somebanks were providing loans only in low-risk suburbs rather than intercity areas, thegovernment passed the Community Reinvestment Act that required banks to offer loansthroughout all the areas in which they operated. In 1991, the HDMA was expanded to allowcomparisons of loan rejection rates by race. In 1992, the Federal Reserve Bank of Bostonpublished the results of a study based on these new data showing that minorities were more141 A sampling of the emerging surveys include Brunnermeier (2009); Taylor (2009); Kling (2009); Boyd, etal. (2009); and Kashyap, et al. (2008). For evidence on the role of corporate governance mechanisms (beyondexecutive compensation) during the crisis, see Erkens, et al. (2010) and Beltratti and Stulz (2009).142 Much of the information in this paragraph is based on Liebowitz (2009), who observes that governmentintrusion in the USA housing market actually began following the housing collapse in the 1930s. In 1934, forexample, the USA government created the Federal Housing Administration (FHA), which guaranteedmortgages against default (thus protecting banks from risk), and also created Fannie Mae to purchase FHAmortgages.-113-
THE EXECUTIVE COMPENSATION CONTROVERSY: 24 MAY 2010A TRANSATLANTIC ANALYSISlikely than whites to be denied mortgages after purportedly controlling for a variety of factorsproxying for creditworthiness.The Boston Fed study – which has by now been largely discredited (Liebowitz (2009))– was a lighting rod for government intervention to loosen lending standards and makehousing available to a broader set of the population. Congress passed a bill mandating thatFannie Mae and Freddie Mac (the government supported entities that purchased mortgages)increase their acquisitions of loans made to lower-income borrowers. The Boston Fed issueda follow-up report titled, “Closing the Gap: A Guide to Equal Opportunity Lending,”suggesting that traditional measures of creditworthiness where discriminatory and should belargely ignored when cultivating business from minority customers. The report helpedfacilitate creative underwriting standards and spurred the popularity of adjustable ratemortgages (or ARMs, where borrowers could be qualified based on artificially low initial“teaser” rates even when their income was not sufficient to repay the mortgages at marketrates). The popularity of ARMs grew in the early 2000s, as the Federal Reserve maintainedinterest rates significantly below historical experience (Taylor (2009)). While the Fed’sshort-term rates are not highly correlated with rates on 30-year fixed-rate mortgages, they arehighly correlated with initial teaser rates on ARMs, and thus sparked more demand forARM-financed housing.The increase in home ownership caused by a loosening of underwriting standards wasin turn associated with an unparalleled appreciation in housing prices. Default rates wereunusually low, since borrowers who could not afford to repay their mortgages couldrefinance (taking money out to fund future mortgage payments) or sell their house at a profit.Mortgage lenders were happy to continue lending under the lax standards, since evenforeclosures would not be costly for the lenders as long as prices kept appreciating. Thus, asdiscussed above, mortgage lenders such as Washington Mutual provided rewards focused onthe quantity of loans written rather than on their quality.Financial innovation also led mortgage lenders to pay less attention to the creditworthinessof the borrowers. In particularly, mortgages were increasingly pooled togetherand sold as mortgaged-back securities. While such “securitization” can provide for efficientex post risk allocation, it creates ex ante “moral hazard” problems since the loan officer willcare only about the quantitative measures of creditworthiness required for securitization, andwill ignore important qualitative aspects that would be considered important if the bank were-114-
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