Don’t Blame Loan Officers for Poor Loan Performance

The Obama Administration thinks loan officer pay should be tied to the quality of their loans. From the Wall Street Journal:

The Obama administration has begun serious talks about how it can change compensation practices across the financial-services industry, including at companies that did not receive federal bailout money, according to people familiar with the matter…Among ideas being discussed are Fed rules that would curb banks' ability to pay employees in a way that would threaten the "safety and soundness" of the bank -- such as paying loan officers for the volume of business they do, not the quality.

This idea reflects a fundamental misunderstanding of how loan origination works. Loan officers do not approve their own loans; there is always some kind of credit approval structure with people other than the originator signing off. I’m not saying that system doesn’t break down (for example, see my post, “Why Did WAMU Abandon Underwriting Standards?”). However, if a lender does a lot of bad loans, it means senior management made bad decisions and/or looked the other way.

VoxEU addresses the issue in their article, “Bonus Incensed”:

Until the 1970s, the predominant institutional form for risk taking in financial institutions specialising in speculative trading was partnerships, with partners’ unlimited liability a central element.

Employees were entitled to bonuses, but entirely at the discretion of the partnership. Employee traders producing significant profits were very well paid; those generating losses did not get bonuses, were often dismissed, and even blacklisted. The partners had a highly developed sense of risk and their asymmetric exposure to it, in no small part because failure could also mean personal bankruptcy.

Partnerships have disappeared over time, and the predominant institutional structure in the financial industry is now the limited liability corporation. This transformation is a key reason for the emergence of the bonus culture, because it substantially reduces the incentive of senior management to monitor risk taking. Any financial institution engaged in speculated trading faces the inherent danger of individual traders taking so much risk that it threatens the firm. It is the role of the senior management to prevent that.

Their solution:

Financial institutions should adapt elements of partnership structures to the limited liability financial institutions of today. Senior management (the partners of old) need to have a substantial part of their compensation deferred over a long period of time, with the amount of compensation directly related to the long run fortunes of the firm. Any senior manager in an institution receiving public assistance should lose all of their deferred compensation. By contrast, the supervisors should not mandate deferral of trader bonuses or regulate junior employee compensation. This provides management with an incentive to check for gaming.

When I’ve been in a credit position, I’ve always been impressed with how effectively experienced loan officers triage their loan applicants. Spending time on a loan application which is not going to be approved is a waste of time, and good loan officers can’t afford to waste time. In my experience, applications for bad loans are almost invariably taken by inexperienced loan officers who don’t know a good loan from a bad one and/or who are desperate to establish a client base. Changing their compensation structure is not going to solve that problem – you need good credit people willing to say no to bad deals and senior management willing to back them up.

To the extent bad loans are originated, the problem lies with the lender’s credit people and senior management, not the loan officer.

Keep the Bonuses, Change the Criteria

Thomas Gehrig and Lukas Menkhoff at VOX survey the research on bonuses and suggest we keep them, with some changes. An excerpt:

In fact, banks themselves are trying to correct their internal incentive schemes in order to re-adjust incentives on longer horizons. They seem to largely agree that, prior to the crisis, their systems may have been excessively short-sighted, and they are now trying to base rewards on more sustainable performance criteria such as average growth rates and volumes across longer sampling periods.

My suggestion (posted here) is measuring shareholder equity over a five year period.

A Modest Proposal to Reform Management Compensation

Nassim Nicholas Taleb has a post on incentive compensation in Financial Times which describes the problem with the typical bonus plan. Here’s an excerpt:

Take two bankers. The first is conservative. He produces one annual dollar of sound returns, with no risk of blow-up. The second looks no less conservative, but makes $2 by making complicated transactions that make a steady income, but are bound to blow up on occasion, losing everything made and more. So while the first banker might end up out of business, under competitive strains, the second is going to do a lot better for himself. Why? Because banking is not about true risks but perceived volatility of returns: you earn a stream of steady bonuses for seven or eight years, then when the losses take place, you are not asked to disburse anything. You might even start again, after blaming a “systemic crisis” or a “black swan” for your losses. As you do not disgorge previous compensation, the incentive is to engage in trades that explode rarely, after a period of steady gains.

Taleb’s solution is radical:

We trust military and homeland security people with our lives, yet they do not get a bonus. They get promotions, the honour of a job well done and the disincentive of shame if they fail. Roman soldiers signed a sacramentum accepting punishment in the event of failure. This is prompting me to call for the nationalisation of the utility part of banking as the only solution in which society does not grant individuals free options to look after its risks.

I like the military analogy, but I think Taleb goes further than needed in eliminating bonuses entirely, and I think he doesn’t go far enough when he limits the proposal only to banking. Here is what I propose for all managers of public companies (or private ones which rely on public support, for example, a privately held bank).

1) Your base pay is limited to it’s military equivalent:

2) The rest of your compensation is in the form of whatever bonus your company thinks is appropriate – no mandated limits or performance criteria. However, the bonus must be paid in cash, and it gets paid into a federal trust fund.

3) After five years, the trustees compare the shareholder equity for the year the bonus was paid with current shareholder equity. If equity is the same or has increased, the bonus is paid. If shareholder equity has declined the bonus is forfeited and used to offset costs of administering the trust and then for some good purpose (education, or unemployment benefit funding). You don’t have to stay at the company to get the bonus.

This approach will cause managers to be thinking about values five years out, which should be a long enough horizon to avoid the problem Taleb describes. It also encourages managers to control employees engaging in risky actions (e.g., traders), and to move on if they think the company is taking excessive risks.

There are plenty of potential objections, but I think the most serious one is that some risk taking often produces real long term rewards, and this approach will dampen productive risk taking in public companies. That’s true, but I think it’s mitigated by the fact that private companies and partnerships will still be around to take big risks, and to provide opportunities for those who can’t wait five years for their reward.

Executive Compensation and Market Share

I’ve previously argued the decision by Fannie and Freddie to stray from conforming conventional loans was attributable to their CEOs' desire to earn their pay by maintaining market share. Bloomberg, reporting on testimony by Dan Mudd, Fannie’s former CEO, before the House Oversight and Government Reform Committee:

A June 27, 2005, internal presentation by Fannie shows the company at a “strategic crossroad” to either “stay the course” or “meet the market” by increasing risk and entering the subprime market. In staying the course, Fannie noted that it would continue to lose market share, and generate lower revenue and profits. In meeting the market, the document shows that Fannie identified the subprime market as a source of growth. “The choice was presented relatively starkly in order to identify what the key issues were,” Mudd said in response to a question from Representative John Tierney, 57, a Massachusetts Democrat.

I see this as a compensation issue – you can’t reasonably expect executives being paid eight figure annual compensation to take actions (or refrain from actions) which will result in loss of market share.

More on Banker Compensation

Compensation is a hot topic these days. From The Big Picture:

One of the maddening features of the financial crisis has been Wall Street’s constant insistence that without its mind-boggling compensation, talent will go elsewhere. On the face of it, this seems an empty threat from a group of hysterical prima donnas who don’t want to have to suffer the consequences for their actions. We focus a lot on pay for the top few at a public company (my, how that term has a new ring to it after the bailout) because public companies disclose the pay of those at the top.

Felix Salmon is ready to take the plunge:

Andrew Ross Sorkin is worried about what happens if you don't pay bankers enough money:

The trick, of course, is to dole out enough rewards to keep executives working, and working hard, but not to dole out too much...
Citigroup and other firms need to find ways to keep and attract talented people who can make smart decisions, without lavishing pay on them or rewarding them for shoddy performance...
Mr. Pandit and others -- to the extent you believe they are the right leaders of Citigroup -- or whoever takes their roles are unlikely to hang around if they're not amply paid.
The risk, Mr. Johnson said, is that if we taxpayers don't offer the possibility of a payday, we won't get the performance. "If you were in senior management and you knew you'd never get paid, you're not going to work as hard or you'll leave," he said. "It's actually worse if they stay. If you have a bunch of demoralized people hanging around, it will kill you."

I say, let's take the risk, and see what happens. I've now reached the point at which I simply don't believe people when they say that lower pay for bankers will result in worse performance -- especially since it looks very much as though it was higher pay for bankers which was at least partly responsible for much of the present crisis. Let's bring down pay, a lot, and see whether performance really falls.

Angry Bear provides a link to a history of the legislative efforts to limit executive compensation (the short story – meaningful restrictions were not passed).

Finally, Richard Epstein touches on the topic in a very interesting podcast on Happiness, Inequality, and Envy. Epstein believes the reason the wealthy are not measurably happier than others is that they have undertaken jobs whose conditions make them unhappy in exchange for high compensation. Pity the poor investment bankers who have to work 18 hour days and fly to Europe at a moment’s notice to close deals – where would the world be without them? We don’t envy them, because we understand the highly compensated bear a heavy burden. As Epstein notes, nurses don’t envy doctors, but the idea of people not pulling their weight makes us crazy.

I don’t think Epstein has it quite right; I’m with Felix on this one. I had one of those jobs. The work was challenging and felt important, and the people I worked with were interesting. Of course, the hours were long and travel gets old, but nice hotels and five figure closing dinners go a long way towards easing that pain. Is it really necessary to pay mid six figures and up to find good people to make that kind of sacrifice? I think not.

Epstein is right about the “pulling your weight” part. That is precisely why Robert Rubin disclaiming any responsibility for Citigroup’s problems makes people crazy.

 

 

Internalizing, Externalizing, and Compensation

There’s a great post at Naked Capitalism skewering Robert Rubin for his unwillingness to take responsibility for his role in Citigroup’s troubles. Rubin is an externalizer – bad things happened as a result of external forces and other people beyond his control (the opposite is an internalizer, who, when bad things happen, attribute the cause to themselves).

As Yves points out, it’s a little hard to justify paying someone $115M if, when things go badly, they claim they couldn’t have influenced events.

Big Bonuses Don’t Equal Big Performance

In an earlier post I argued that the enormous compensation paid to the CEOs of big banks was a motivator to maintain market share at all costs. Along the same lines, here’s a link to a study which found the size of a bonus doesn’t correlate positively with performance.

Big Banks and Big Compensation

Felix Salmon has a post Against Big, Public Banks:

There's a strong case to be made that banks, like law firms, should be boring and conservative and reasonably small and mutually-owned. That's one of the thing which worries me most about TARP and the $140 billion tax break being used to encourage huge banks to get even bigger still. The fact that all those huge banks are publicly-listed and therefore prone to taking excessive risks only makes matters worse.

I think the "prone to taking excessive risks" part ties in to my previous post about the huge compensation received by management at the big banks. These huge pay packages can only be justified by company performance, and giving up market share to avoid risk is not viewed as good performance until it's too late.

Fox Guarding the Henhouse? Bear Stearns Risk Manager Now at the Federal Reserve

Carol Baum has an opinion piece on the Bloomberg site about the New York Fed decision to hire Michael Alix, who was former chief risk officer at Bear Stearns at the time of its collapse. This story is interesting in itself, but it also provides an update on the status of a number of others associated with financial fiascoes, all of whom appear to have landed on their feet. Hopefully this is survivorship bias at work. I would like to believe for every scoundrel who lives happily ever after there are ten scoundrels toiling as clerks at Walmart whose stories won't make the paper.

Actually, as a former chief credit officer (for a much, much smaller organization than Bear Stearns, just $12B in income property loans), I have some sympathy for Mr. Alix. Although he had the chief risk officer job since just 2006, Alix was an 11 year employee at Bear and he had to be aware of the high wire the company was walking. But, if you were him, what would you do with that knowledge?

I think an apt analogy is the classic WWII movie scene in which there's a bunch of guys in a foxhole, and the enemy throws a hand grenade into the hole. Some credit officers in that situation see their role as saying something like, "Excuse me, but an object that looks like a hand grenade is now in our foxhole, and if it is a hand grenade and it explodes we could be injured or killed. But it might not be a hand grenade, and if it is it might not explode, and even if it does explode we might survive." Under this approach the credit officer has done his duty, tried to mitigate risk within the system, and he and his compatriots are probably dead.

Another approach is for the credit officer to yell "Grenade!" and, if no one reacts, throw himself on it. This would be the equivalent of telling your coworkers they're screwing up, and if they don't stop, calling up your regulator to shut the place down. Like throwing yourself on a grenade, this involves some personal risk and a great deal of courage. Here's a link to the fascinating story of a former coworker of mine who took that route at Indymac.

A third route is to shout "Grenade!" and, if no one reacts, exit the foxhole as quickly as possible. I think most people would say this is the course of action Mr. Alix should have taken, and before 2001 I think I would have agreed without thinking much about it. When I took my first big credit job (1997), I viewed myself as a circuit breaker. If the company I worked for overloaded, I would trip, and while I knew I was probably done with that company I thought I could go to another company who needed a circuit breaker. When the 2001 recession started and it made sense to turn deals down, it dawned on me that finding a replacement position during a recession might not be all that simple. The times when an assertive credit person is most likely to find his or her services no longer needed are the times they are least likely to find a new job. My response to this realization was to stockpile food in the basement and prepare for a long period of underemployment if necessary (thankfully, it wasn't), but another understandable approach would be for the credit person to step back and not make waves.

Compensation enters into this balancing act, but not in the obvious way. The standard view is that a credit person sells their soul to keep the big bucks rolling in, and I am sure that happens. However, the converse is also true; if you're not financially independent doing the right thing can be a hardship. This is especially true if others are dependent on you. Economists would like to believe you can structure compensation to incentivize people to do the right thing. I don't think that's possible with credit officers; in the end it's a character issue, not an economic one.

So, I have sympathy for Mr. Alix; he was in a difficult situation facing difficult issues. But, he should not have been hired by the Fed, as any economist knows. A basic tenet of principal-agent theory is that the threat of termination of the relationship is one of the ways to keep an agent from acting against the interests of the principal. If a credit person knows association with a major financial disaster will terminate his or her credit career, he or she is more likely to do the right thing. The hiring of Mr. Alix by a regulator to be a regulator is the most effective action I can think of to undermine that principle.

Kerry Killinger, Daniel Mudd, and Richard Syron are not Stupid, Greedy, or Crooks

An article in today's Seattle Times says "Washington Mutual suffered an ugly death, leaving thousands without jobs, homeowners facing foreclosure, a civic crater in Seattle and a 100 year old institution flushed away by miscalculation and greed...Shareholders are also appalled by what they see as incompetence, and worse, by executives in their failure to protect the company...The Ontario Teachers Pension Plan Board of Canada, a major shareholder, has filed a securities class action complaint against Washington Mutual and some officers, including former Chief Executive Officer Kerry Killinger." Daniel Mudd, former CEO of Fannie Mae, and Richard Syron, former CEO of Freddie Mac, have been similarly lambasted (see, for example, His Name is Mudd) and the subject of calls for criminal investigations.

First, let me make clear that I don't know these men; they actually could be stupid, greedy and crooks. But, I think that's unlikely; my guess is they're probably really smart guys, and as honest and ethical as the rest of us (here are a couple of interesting posts arguing the elite really are elite, and the difficulty of assessing the ability of those at levels above our own). I think there is a much simpler explanation for the decisions which blew up their companies:

They tried to earn what they were being paid.

It's admirable, of course, to earn what you're given -if they didn't try to do that, they would be justly criticized. In 2007 Mr. Killinger's compensation was $14,364,883, Mr. Mudd's was $14,231,650, and Mr. Syron's was $14,497,981. What should they have done in 2008 to earn that money?

Lenders compete on price (interest rates, fees, processing costs), execution (speed and certainty of delivery of the promised transaction), and terms (leverage, documentation, covenants). By all accounts, all three companies were very competitive on price and execution. That leaves terms. As long as there are lenders willing to lend more aggressively (higher LTV loans, lower income ratios, less documentation, fewer reserves and covenants) conservative lenders will lose market share. You do not get paid $14M to lose market share.

In the old days (1970's and '80s), savings and loans were called 3-6-3 businesses; pay depositors 3% interest, extend mortgages at 6%, hit the golf course by 3PM. WAMU, Fannie, and Freddie were all stable, well run companies that could have made a good return making/buying secure loans, and their CEOs could have been on the golf course by 3. But, that would not be worth $14M. So, they tried to earn it by competing for riskier business, and they failed.