The Subprime Mess: Incntives That Help

THE SUBPRIME MESS: INCENTIVES THAT HELP

Jim Shoe

SEMINAR MANAGEMENT CONTROL SYSTEMS

INTRODUCTION

The subprime crisis can be described as a series of events with the so-called

�savings glut’ as Ben Bernanke described as a starting point. Low interest rates and

rising house prices created an opportunity for financial innovation. Credit quality

mattered little because if a buyer couldn’t make the payment, the lender would repossess

the house and sell it quickly in a hot market. When rates started to climb, lenders began

to increase the volume of exotic loans to keep buyers coming. When repossessed houses

couldn’t sell so easily, the credit quality of buyers did matter. The result was a subprime

crisis.

OBJECTIVES

The objective was to examine the management of financial services industry and

determine the role incentives play in its success and failure. Specifically, we determined

whether key management personnel used proper incentives to:

a) Control risk (credit and reputation).

b) Create the right corporate culture.

c) Customize the compensation system.

BACKGROUND

Incentives are usually tied to performance. They can be long term or short term.

“Short-term incentives usually are very specific performance standards. Long-term

incentives are intended to focus employee efforts on multiyear results.”

Collateralized debt obligations (CDOs) are mortgages bundled into a pool and

securities sold against it. Securities sold by the mortgage pools were further bundled and

claims against them were sold. “Rating agencies went along certifying senior tranches

with the highest credit rating, even though they had little sense of their default

properties.” Due to the вЂ?savings glut’, these instruments were purchased by foreign

countries, pension funds and insurance companies looking for a good return on little risk.

So they thought.

RESULTS

Condition (1a). CDOs suffered from information risk. Because they were backed by

mortgages and the housing market became illiquid, information on the quality of those

mortgages became more important. Ratings were now less reliable.

Condition (1b). Some banks are already beginning to feel the cost of a tarnished

reputation. Using sound judgment and oversight is the responsibility of everyone in

financial services and it should start at the top. The industry should be experts at

managing risk.

Condition (1c). The compensation system needs to be utilized to reduce risk. This starts

with hiring the right people. “Level of pay and pay system characteristics influence a job

candidate’s decision to join a firm, but this shouldn’t be to surprising.” Recent

acquisitions to the chief risk officer (CRO) role at financial services are happening. “Both

National City and Citigroup tapped new CROs from internal ranks (Dale Roskom and

Jorge A. Bermudez, respectively) following mortgage-loss write- downs in the fourth

quarter.”

Cause. This condition occurred because incentives for a successful risk management

process have been placed incorrectly. At AmSouth which was recently acquired by

Regions Financial, the incentive plan for commercial loan officers rewards them based on

profitability of new business. “The officers have to generate a certain level of new

business before they qualify for incentives.” A risk management and control process is

essential to a successful company. This represents a real challenge for the financial

services industry. A lot of change and innovation has occurred. The fraction of financial

assets held by risk-transferring institutions such as mutual funds, pension funds and

various unit trusts has increased relative to those held in risk-absorbing institutions such

as commercial banks and other depositories . Managers are seeing less return on bearing

the risk of these loans.

The corporate culture at these firms needs