Statement of Edward J. DeMarco, Acting Director
Federal Housing Finance Agency
Before the U.S. House of Representatives Committee on Financial Services
February 25, 2010
Thank you. Chairman Frank, Ranking Member Bachus, and members of the Committee, you have asked me to address recent actions taken by the Federal Housing Finance Agency (FHFA) in which we have had to make determinations concerning executive compensation at our regulated entities. This has been a particularly important topic for us for two reasons. First, the Housing and Economic Recovery Act of 2008 (HERA), which created FHFA, also expanded our compensation-related authorities beyond those of our predecessor agencies. Second, just 5 ½ weeks after HERA was enacted, FHFA placed Fannie Mae and Freddie Mac (the Enterprises) into conservatorship, with Treasury using new authorities in that law to provide a financial backstop. Compensating the executives in these conservatorships has raised numerous issues, many of them similar to those arising at other federally-assisted institutions, but some unique to the Enterprises. Our principal goal in these decisions was to provide sufficient compensation to achieve the goals of the conservatorships while avoiding excessive compensation and minimizing taxpayer costs.
Initial Conservatorship Decisions
During FHFA’s intense preparations for placing the Enterprises into conservatorship, we received some valuable insights from discussions we had with the Federal Deposit Insurance Corporation (FDIC). The FDIC’s experience in bank failure resolutions, including conservatorships, supported our view that achieving the goals of conservatorship depended on retaining capable and knowledgeable staff at the Enterprises. At the same time we sought to no longer employ those executives most responsible for the conditions leading to our action. As a part of our planning process, we hired Hay Group, a well respected executive compensation consultant, to help us design a plan to encourage the best employees to stay, while not rewarding poor performance.
In placing the Enterprises into conservatorship, our foremost concern was that their troubled condition was leading them to withdraw their services from housing finance markets at a time when they were greatly needed. Their combined market share in 2008 was more than double what it had been two years earlier, as most other participants went out of business or sought to avoid new risk exposure to the mortgage market. For the sake of our country’s economy and especially its housing sector, it was essential that the Enterprises continue to bring liquidity, stability, and affordability to the secondary mortgage market. Furthermore, the Enterprises’ enormous size, including $5.4 trillion of mortgage credit risk, and taxpayer exposure to that risk in the face of rapidly deteriorating housing markets, made it imperative that the Enterprises strengthen their management in the areas of risk control and loss mitigation. In addition, it was and remains imperative that the Enterprises attract and retain the particular and specialized skills needed to manage these activities.
To address these concerns, FHFA discussed our retention approach in some detail with both new Chief Executive Officers (CEOs) on the day before their new jobs officially began. As former FHFA Director Lockhart reported to this Committee later that month, both CEOs agreed with our view of the importance of such a plan, and over the next few weeks worked with us, Treasury, and Hay Group to customize plans for their respective institutions. Director Lockhart justified the resulting plans in a letter to Chairman Frank, which is attached. Payments under the plans were virtually the only non-salary compensation for Enterprise employees for the 2008 performance year, as no bonuses were paid for that year at either Enterprise.
At the inception of the conservatorships, we also announced that the incumbent CEOs would be leaving after a brief transition period. They received no severance payments. In prohibiting such payments, we relied in large part on the golden parachute provisions in HERA. In addition, because most of their remuneration had been in the form of Enterprise stock, roughly two-thirds of their previously reported pay during their tenures as CEOs vanished with the collapse in the market prices of their shares. The golden parachute provisions were also helpful in other cases, as ultimately, five of the six Fannie Mae executives that were highest paid before the conservatorships and all of the top four Freddie Mac executives left in one fashion or another, but none of them received severance or other golden parachute payments. They also saw a substantial reduction in the value of their past compensation due to the collapse in their company’s stock price. While I know all the attention today is on executive pay, I’d like to add that many of the more than 11,000 rank and file employees at the Enterprises also had large portions of their life savings in Enterprise stock and suffered accordingly.
New Compensation Structures
FHFA’s development of a new compensation structure for senior Enterprise executives for 2009 and beyond was delayed, first by our appointment of new boards of directors at the Enterprises, with new compensation committees, then by the departure of the CEOs hired at the start of the conservatorships. Additionally, FHFA had agreed, under the Senior Preferred Stock Purchase Agreements that provide financial support to the Enterprises, to consult with Treasury about new compensation arrangements with executive officers at the Enterprises. We wanted to consider fully the approach being developed at the Treasury for institutions receiving exceptional assistance from the Troubled Assets Relief Program (TARP). After Kenneth Feinberg was appointed Special Master for TARP Executive Compensation, Treasury asked us to consult with him, and we began to discuss how we could adapt the approach he was developing for TARP institutions to the Enterprises. I must say that I found those discussions productive and constructive, and I want to thank the Special Master for his thoughtfulness on these issues.
In making that adaptation, a major consideration was that compensating Enterprise executives with company stock would be ineffective because of the questionable value of such stock. Further, large grants of low-priced stock could provide substantial incentives for executives to seek and take large risks. Accordingly, all components of executive compensation at the Enterprises are in cash.
Another consideration is the uncertain future of the Enterprises as continuing entities, which is in the hands of Congress and beyond the control of Enterprise executives. It is generally best to focus management’s incentives toward its institution’s performance over the long-run rather than just the near-term. In the case of the Enterprises, that is nearly impossible. Therefore, compensation for current work will not depend on results beyond 2011. To encourage talent to stay put, FHFA made deferred payments generally dependent on an executive’s continued employment at the Enterprise and corporate performance until the date of payment.
FHFA also looked to existing practice elsewhere to determine the appropriate levels of total target compensation for the most senior positions. We considered data from consultants to both Enterprises, data received earlier from our own consultant, and the reported plans of TARP-assisted firms. It was important to set pay at levels sufficient to compete for quality talent because the Enterprises had many key vacancies to fill, potential departures to avoid, and pay has been a significant issue in some cases. That need must be balanced by our efforts to keep the cost to taxpayers as low as we possibly can.
FHFA settled on a target of $6 million a year for each CEO, $3.5 million for the Chief Financial Officers (CFOs), and less than $3 million for Executive Vice Presidents and below. I know $6 million is a considerable sum of money. But that amount rolls back Enterprise CEO pay to pre-2000 levels. It is less than half of target pay for Enterprise CEOs before the conservatorships. For all executive officers, Fannie Mae and Freddie Mac have reduced target pay by an average of 40 percent.
The basic compensation structure for senior executives at both Enterprises, as at institutions receiving exceptional TARP assistance, comprises three elements: base salary, a performance-based incentive opportunity, and deferred salary. Salary scales have been sharply reduced from pre-conservatorship levels at both Enterprises. Going forward, as at the TARP-assisted firms, salaries will generally be capped at $500,000 with a few exceptions. Before the conservatorships, the two Enterprises had 16 officers earning salaries higher than that amount, now there are only five.
As at TARP-assisted firms, target incentive pay for the Enterprises is limited to a third of overall compensation. Payment is based on Enterprise performance, as measured by scorecards developed by each Enterprise subject to FHFA approval, and individual performance. In reviewing scorecards, we are particularly sensitive to ensuring that executives are not given incentives to take inappropriate risks. Our special examinations of accounting failures at each Enterprise in 2003-2006 revealed that badly-constructed compensation incentives contributed significantly to excessive focus on near-term earnings reports to the serious detriment of the Enterprises.
Accordingly, FHFA has required a much broader focus that emphasizes remediation of operational and risk management weaknesses, loss mitigation, and mission achievement. For 2009, I have approved for each Enterprise funding of incentive payment pools at 90 percent of aggregate targets. Both Enterprises made substantial progress in loss mitigation and risk management, while meeting the challenges of implementing Treasury’s Making Home Affordable Programs. However, the boards of both Enterprises, with my encouragement, recognized that those successes needed to be tempered by consideration of the sizable contributions of taxpayers needed to offset Enterprise losses, which occurred despite the generally strong efforts of the executives.
The remaining portion of compensation is deferred salary, which is paid with a one year lag to executives still working for their Enterprises at that time. Any exceptions will require FHFA approval, in consultation with the Treasury. Starting with payments made in 2011, the amounts will be adjusted up or down, based on each Enterprise’s performance on its 2010 scorecard. Further details are available in the Enterprises 8-Ks, which were issued late last year in Fannie Mae’s 10-K and in Freddie Mac’s 10-K/A to be issued shortly.
These new structures are designed to align pay with taxpayer interests. They also adopt and in some respects expand on reforms advanced by the Special Master for firms receiving exceptional TARP assistance.
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In 2010, no executive officers will receive perquisites exceeding $25,000 without FHFA approval, in consultation with the Treasury.
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No retirement plans for executive officers will be continued that use more generous formulas for such officers than plans for lower ranking employees.
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No expense reimbursements to executives will provide so-called "tax gross-ups" that reimburse executives not only for the expenses they paid, but also for the taxes they must pay on the reimbursements themselves.
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Deferred salary and incentive pay for all executive officers will be subject to clawbacks by the Enterprises in the event of gross misconduct, gross negligence, conviction of a felony, or erroneous performance metrics.
Except for our use in certain instances of HERA’s golden parachute authorities, these actions have relied principally on our conservatorship powers. We have also taken advantage of new authorities in a limited number of cases involving the hiring or departure of Federal Home Loan Bank (FHLBank) executives, and we have issued a new proposed rule broadly implementing our responsibility to prohibit excessive compensation at both the Enterprises and the FHLBanks. We expect to issue a final rule in the next few months. We have not had occasion to use new authority to withhold compensation or to recapture previous payments under some circumstances, but we may find them valuable in the future. The broad authority provided in section 1117 of HERA to approve, disapprove, or modify the compensation of executive officers at regulated institutions has expired. It was not necessary to use this power with regard to the Enterprises because they are in conservatorship, and we did not determine a need to take such action with respect to any FHLBank.
In my judgment, we have achieved the right balance between enough compensation to acquire and retain quality management, while preventing compensation from exceeding appropriate bounds.
Lessons Learned from the Enterprises’ Conservatorship Operations
Before closing, I would like to briefly review a few lessons we have learned about compensation for institutions operating in conservatorship. Some of these lessons may be relevant for Congressional consideration of future resolution authorities.
If the resolution of a failed institution requires maintaining ongoing business operations for a period of time, compensation and retention will be key concerns. For example, as I explained in my recent letter to the Committee’s leadership, at the inception of the conservatorships FHFA made clear that the Enterprises would continue to be responsible for normal business activities and day-to-day operations. To that end, we reconstituted the boards of directors of each Enterprise and appointed new CEOs. As with other private companies, the boards and CEOs must follow the laws and regulations governing financial disclosure, including requirements of the Securities and Exchange Commission. Like other corporate executives, the Enterprises’ officers have a legal responsibility to use sound and prudent business judgment in their stewardship of the companies. These are large, complex businesses managing $5.4 trillion of risk exposure. The most efficient way to effectively protect taxpayers in this situation is to place management of normal business activities and day-to-day operations in the hands of qualified and experienced senior executives and boards of directors. I became acutely aware of the challenges of competing in the market for top executives, when Freddie Mac went a year or more without a Chief Operating Officer and a permanent CFO; it also operated for months with an interim CEO.
As Congress considers resolution regimes for potential future situations involving systemically important institutions, in some circumstances maintaining human capital will likely be important to an orderly resolution, and to accomplish that goal, whatever agencies are in charge of resolutions will have to pay sufficient compensations. This is especially important in a situation where the future of the firm in question is uncertain. It is particularly challenging to attract and retain executives that don’t have the normal sort of control over outcomes. In the case of the Enterprises, the executive management teams may do a great job in meeting the goals of conservatorship but the future of the companies rests with Congress, not with them.
Summary
The directors and senior executives tied to the financial collapse at each Enterprise are no longer with the companies. The senior executives who remain as well as those that were recently hired are essential to the Enterprises fulfilling the important goals of the conservatorships. As FHFA has stated since the outset of the conservatorships, it is critical to retain existing staff, including many senior managers, and critical to attract new executive management to fill the vacancies. The challenge of meeting this goal with companies in conservatorship is immense. The Enterprises operate with an uncertain future that will be the source of much public debate. As conservator, I believe it is critical to protect the taxpayer interests in the Enterprises by ensuring that each company has experienced, qualified people managing the day-to-day business operations in the midst of this uncertainty. Any other approach puts at risk the management of more than $5 trillion in mortgage holdings and guarantees that are supported by taxpayers through the Treasury Senior Preferred Stock Purchase Agreements.
Thank you and I’ll be happy to answer your questions.
Letter to Barney Frank on Employee Retention Programs – March 20, 2009
Contacts:
Corinne Russell (202) 649-3032 / Stefanie Johnson (202) 649-3030