Incentives Askew? Fannie Mae and Freddie Mac's Executive Pay Arrangements May Be Inappropriate
Emmons, William R., Sierra, Gregory E., Regulation
FINANCIAL ECONOMISTS HAVE LONG advocated tying top executives' pay to the performance of their firms. Michael Jensen and Kevin Murphy summarize the results of years of intensive academic study of the managerial agency problem in a 1990 Harvard Business Review article, "CEO Incentives: It's Not How Much You Pay, But How." Jensen and Murphy emphasize that CEOs respond to incentives, and executive compensation is first and foremost an incentive system. If shareholders want executives to act as if they own the firm, executive compensation should vary with firm value. In practice, that means that top executives' pay and personal wealth should be tied explicitly and substantially to the stock price or some accounting-based metric that might bear on the stock price over time.
Stock- and option-based executive compensation swept across the corporate landscape both in the United States and abroad during the 1990s as corporate boards attempted to align the interests of managers with those of shareholders. Fannie Mae and Freddie Mac, the privatized, publicly traded, housing government-sponsored enterprises (GSEs), were no exceptions. Indeed, congressional reform legislation in 1992 mandated "pay for performance" as a substantial component of GSE executives' total compensation.
The original advocates of pay for performance expected that firms easily could induce executives to create shareholder value by providing heavily stock- and option-based compensation packages. Those expectations may have been too optimistic. What financial economists call "high-powered incentive" structures sometimes create new distortions that can be as harmful as the managerial agency problem they seek to eliminate. As Jensen, Murphy, and Eric Wruck note in a 2004 working paper, "While executive compensation can be a powerful tool for reducing the agency conflicts between managers and the firm, compensation can also be a substantial source of agency costs if it is not managed properly."
Flawed executive compensation plans may have caused or exacerbated many of the recent corporate governance scandals. The consequences of improperly managed executive compensation arrangements extend beyond the executives themselves, to the firm's shareholders, employees, and other stakeholder groups. When the firms involved are government-sponsored enterprises that have grown so large that they pose systemic risks to the financial system, the consequences of improper executive incentives are amplified. The critique of Fannie Mae's corporate governance delivered in September 2004 by the Office of Federal Housing Enterprise Oversight (OFHEO) echoed the point revealed in Freddie Mac's governance crisis of June 2003: Executive incentives were poorly aligned not only with stakeholder groups but potentially also with shareholders' long-run interests.
This article describes the misaligned incentives in the executive compensation schemes at Fannie Mae and Freddie Mac. We argue that the problem at the stockholder-owned housing GSEs potentially is worse than it is in the average S&P 100 firm because the GSEs are different in terms of their financial structure, the flexibility of their business models and financial-reporting systems to respond to executive incentives, and the range of stakeholder groups that have legitimate interests in their governance. Yet, executive compensation plans at the GSEs are composed of a large stock- and earnings-based component that is benchmarked to financial institutions that are different from Fannie and Freddie. More appropriate and targeted performance goals--such as limiting interest rate risk and meeting affordable housing goals--also are part of GSE executive compensation plans, but they make up a much smaller component of bonus awards.
The design of executive compensation is central to the governance of the GSEs. In our view, the relationship between executive compensation arrangements at the GSEs and their alleged earnings management abuses has not received adequate attention in the discussion of possible GSE reforms. …