Executive Compensation at Fannie Mae: A Case Study of Perverse Incentives, Nonperformance Pay, and Camouflage
Bebchuk, Lucian A., Fried, Jesse M., Journal of Corporation Law
In December 2004, the board of the Federal National Mortgage Association (Fannie Mae), a financial company of great importance in the U.S. economy, asked CEO Franklin Raines and CFO Timothy Howard to step down. The departure of the two executives followed a determination by the SEC that Fannie Mae had inflated its earnings over the last several years. The company will be required to restate its earnings by at least $10 billion, which would wipe out a large portion of the company's total reported profits from 2001 to 2003. The departures of the two executives were classified as "retirements," and Fannie Mae revealed in an SEC filing the terms of the generous retirement packages with which they were leaving.1
This paper is a case study of Fannie Mac's executive compensation arrangements during the period from 2000 to 2004. We consider the compensation paid to the executives while they served, as well as their retirement packages. We identify and analyze four problems with Fannie Mac's executive pay arrangements:
(1) Perverse Incentives: Fannie Mac's compensation arrangements richly rewarded its executives for reporting higher earnings without requiring them to return the compensation if the earnings turned out to be misstated, thus providing incentives to inflate earnings.
(2) Soft Landing: Fannie Mae's arrangements provided a soft and generous landing to executives who were pushed out by the board for failure; expectation of such an outcome adversely affects ex ante incentives.
(3) Pay Decoupled from Performance: Most of the executives' retirement payouts were totally unrelated to firm performance, thus greatly increasing the fraction of their total compensation that was decoupled from the managers' own contributions to firm value.
(4) Camouflage: Fannie Mae obscured rather than made transparent the total values of the executives' retirement packages.
We do not know, nor do we want to speculate, whether the dilution and perversion of incentives produced by Fannie Mae's compensation arrangements in fact affected the executives' decision-making about accounting or anything else prior to their departures. Raines and Howard may have acted throughout their service with the utmost dedication to Fannie Mae and its shareholders. Our claim is merely that Fannie Mac's pay arrangements, which are typical of pay arrangements given to public company executives, did not strengthen the managers' incentives to enhance shareholder value but rather weakened and distorted them. As we discuss below, there is empirical evidence that, in the aggregate, pay arrangements at public companies have influenced executives to inflate earnings.
We also should stress at the outset that, even though Fannie Mae's story has received significant attention due to the prominence of the company and its CEO, the importance of this case for our purposes is that it reflects current practices rather than presenting an exceptional aberration. As we document in a recently published book,2 the types of problems found at Fannie Mae have long been endemic among public firms.
To begin, firms often base bonuses and other forms of incentive compensation on earnings figures that can be manipulated, and commonly give managers broad freedom to choose when they sell shares. Thus, the structure of both equity and non-equity compensation provides executives with incentives to inflate short-term earnings at the expense of long-term shareholder value. In addition, executive pay arrangements commonly provide soft landings-even when executives are pushed out by the board for failure. The generous treatment of managers who have performed poorly weakens their incentives, thereby imposing costs on shareholders both ex ante and ex post. Directors also often alleviate their personal discomfort, at shareholders' expense, by authorizing large gratuitous benefits beyond those to which executives are contractually entitled.
Furthermore, after executives leave-whether as a result of retirement, resignation, or being forced out-they often receive substantial retirement payouts that are unrelated to firm performance, greatly increasing the fraction of total compensation that is performance-decoupled. …