We have a hearing today on Compensation in the Financial Industry at 10:00, for which you can find the prepared testimony at this link.
Standard compensation arrangements in publicly traded firms have rewarded executives for short-term results even when these results were subsequently reversed. Such arrangements have provided executives with excessive incentives to focus on short-term results. This problem, first highlighted in a book and accompanying articles that Jesse Fried and I published five years ago,2 has become widely recognized in the aftermath of the financial crisis. In financial firms, where risk-taking decisions are especially important, rewards for short-term results provide executives with incentives to improve such results even at the risk of an implosion later on.
Bah.
Nobody wants to talk about the true issue - massive, pernicious and institutionalized fraud among financial firms.
Let me be clear - how much compensation is paid to the employees of a firm is a matter strictly between the owners of that firm and its employees. In a corporate environment this means that the shareholders are, ultimately, the boss when it comes to executive compensation.
We do need reform of shareholder rights. Specifically, we must put in place the right for shareholders to explicitly veto executive pay packages - not as an "advisory" or "non-binding" vote but rather as a legally binding option.
But this would not have prevented the financial crisis in any form or fashion, because when a firm is reporting 20%, 30% or 50% earnings increases for years at a time the people responsible for that in the executive suite will have no problem convincing shareholders to hand over the loot - nor should they!
No, the problem is that the alleged "profits" from which these payments were made never really existed.
There is a generalized problem with accrual accounting that is difficult to resolve - you can "book profits" that never actually materialize, and then you either re-state the financial statements later (or in some cases never!) yet that "booked profit" never actually materializes.
This sort of BS is still going on. For example, Wells Fargo has somewhere in the neighborhood of $2 trillion in off-balance sheet exposures. They claim they don't have to consolidate this (even under FAS 166/167) based on the fact that this is mostly "conforming" mortgages and thus are "money good."
Well, if they're "money good" why not consolidate them? Why not reserve honestly against whatever the actual payment characteristics are of these loans and the securities backed by them? Why not come right out, be honest and let everyone see what's going on?
Likewise in the early part of this mess - spring of 2007 - I outlined that Washington Mutual was paying dividends out of "capitalized interest" - that is, negative amortization that the accounting rules cause you to book as "earnings" - even though you received no actual money yet. Accrual accounting says that when the value of an asset (in this case the principal balance of a mortgage) goes up you get to count that but the fact remains that the actual money does not (yet) exist in your checking account and thus paying dividends out of not-yet-received funds is only safe if there is reason to believe you will receive those funds in reasonably short order. This act should have brought immediate regulatory action down upon the executives of Washington Mutual. It did not and, in the fullness of time the firm failed - exactly as and why I predicted it would.
Likewise when investment banks and others bought "protection" from AIG it allowed them to hold "assets" on their books without regard to their payment performance deterioration because they were allegedly "protected" against a reasonably-foreseeable default (either incipient or in some cases actually in progress!)
The problem wasn't the purchase of the insurance - it was that the entity that sold it had no money to pay the claims and the buyer knew or should have known this because they purchased that protection below the expressed price of the risk in the original transaction. That the price was below the risk-adjusted cost is axiomatic - but for that the yield of such a security plus its protection would have been below the risk-free rate of return and thus it would have been unmarketable!
Again this act should have brought immediate regulatory response, at minimum, of a demand to disregard the so-called "protection" in the computation of balance sheet assets, liabilities and reserves. But it did not - not by the auditors, not by the regulators, and not by The Department of Justice or SEC.
Why not?
Is it really any different to claim that you have made a bunch of money by trading when you really did not (as is the case in Madoff's Ponzi Scheme) or that you have created value as a consequence of your "assets" when in point of fact you are marking the value of those assets where they are only as a consequence of "insurance" you bought from a market participant below the risk-adjusted cost of providing it and both you and he either know (or would if you bothered to look!) that he won't be able to pay if and when it becomes necessary?
Now let's look inside these "securities." Pull the prospectus for any of the securitizations that contain ALT-A loans from the 2005-2007 vintage. Look through it and see if you can find a statement in any of them disclosing that the FBI had warned of massive, pernicious mortgage fraud in 2004 and that in 2006 and 2007 there were both HUD and private credit agency warnings that as few as one in ten borrowers incomes were accurately represented.
You can't. Fannie's prospectuses are readily available from that time frame (here's one such prospectus) and there is no disclosure in their paperwork. I have looked at many private-label RMBS prospectuses as well and have yet to find anything approaching an appropriate disclosure of these known facts.
This is not about "excessive risk taking" or any such thing. It is and always has been about the intentional understatement of risks so as to be able to sell trash to bagholders while claiming it is all "money good."
Look, I can show great "earnings" if I take a dog's used food and put it in a box, then claim the box is full of gold and sell it onward. This charade can and will continue until someone who buys one of these boxes opens it and discovers what's inside, at which point the "market" for such boxes will instantaneously collapse.
This is the gist of the problem folks and until we focus our eye on the ball and bring sanction upon those who sold used dog food as "money good" securities (in all forms) we not only will not address what caused the bubble and meltdown we will have failed to prevent it from happening again in the coming months and years.
We need no new laws or "regulations" - we need only to enforce existing laws against fraudulent conduct up and down the line.
To date there has been zero attention paid to this by regulators, law enforcement including The FBI and Department of Justice, or Congress.
I argue that this blindness is willful and that all the noise and fury over "executive compensation" is nothing other than an intentional act of misdirection designed to distract the citizens of this nation who have been repeatedly screwed blind by these financial shenanigans.
