Paying Executives for Short-Term Performance Hurts Shareholders

The background to the brouhaha is that WaMu was particularly outspoken in declaring "pay for performance" to be its watchword. "In determining compensation," the board said in the 2006 proxy statement, a significant portion of each officer's and senior executive's total compensation should be "dependent on Company performance and creation of long-term shareholder value."

During the early years of the great mortgage boom, WaMu's stock did perform. From the end of 1999 to 2003, the shares surged from $17 to $40. Then as investors sensed that its potential was peaking — you can get homeowners to refinance only so many times — the stock flattened out.

So WaMu, under the leadership of its longtime chief executive, Kerry Killinger, started writing mortgages for customers previously not considered creditworthy. These are known as subprime. A lot of folks couldn't afford the interest rate WaMu needed to offset the risk of default, so WaMu offered them "teaser" loans, with a low rate of interest for a year or two and then — whammo — a big hike. The game worked when home values were rising. Mortgage holders could refinance and take out a new teaser loan, and WaMu would collect another round of fees. Stoked by the profits from this enterprise, Killinger reaped a gaudy pay package in 2006, of $14 million.

Perhaps the money went to his head. At the end of 2006, Killinger wrote to shareholders that WaMu was positioned to deliver "stronger operating performance" in 2007. By then WaMu had $20 billion in subprime loans on its books. Delinquency rates on such loans were rising. And as WaMu noted, many borrowers were keenly dependent on home-price appreciation, and "appreciation levels may not continue." Indeed, the housing market was cooling fast. In 2007, as waves of subprime mortgages defaulted, WaMu's strategy blew up. The bank recorded a $1.87 billion loss in the fourth quarter and added a crushing $3.5 billion to its reserve for bad loans in the first quarter of 2008.

The losses checked the executives' pay formulas, and in 2007 Killinger earned a paltry $5.3 million. But he and his lieutenants did not want to risk being stiffed again. Thus the board decided not to "count" writeoffs from soured mortgages in determining what to pay Killinger and 100 other top executives in 2008.

In corporate America such lack of accountability is rife. The biggest problem with executive compensation is that executives get rewarded for performance over too short intervals. Thus a CEO will clean up one year, tread water the next, clean up again the following year. Over the long term, even if shareholders do not reap any sustained gains, the CEO will get rich. Ask Oracle's Larry Ellison. His stock is still down over the eight years of this century, yet Ellison keeps raking it in. Last year he "earned" $61 million. Such executives in effect cash in on their "hit" years while paying no penalty for their "out" years.

This problem is potentially acute in banking because of the way earnings are accounted for. When a bank issues a loan, it books a profit based on the difference between the interest rate it charges and its expected cost of funds. But of course, the bank doesn't really "earn" the money until the customer pays it back. So banks are always recording "hits" now on the expectation that they have accurately forecast the number of "outs" — i.e., loan losses.

Killinger & Co. went a step further and proclaimed — even when the outs were visible on the scoreboard — that they wouldn't count. After shareholders raised a storm, the company seemed to retract its "hits only" policy. At the spring annual meeting, Killinger said company brass would be held accountable for specific "credit-related targets," though he was sketchy on the details.

A shareholder protested, "I think your bonuses should be taken back for the last couple of years." Killinger shrugged it off, saying even Fed Chairman Ben Bernanke did not anticipate the subprime fiasco. But plenty of other people did. And by the time Killinger raked in his $14 million, the crisis was in the making.

As that shareholder was painfully aware, all WaMu's stock-price gains of the past 10 years have been lost. Yet over that period Killinger has received nearly $100 million in total compensation, according to the Corporate Library. He has been paid for hits aplenty; meanwhile, the shareholders are left with the disastrous effects of his strikeouts. WaMu's mortgage business is in ruins. It has abandoned subprime lending and sharply reduced home-equity loans. It has cut the dividend to a penny a share and seriously diluted the stock by raising new capital on the cheap.

So here's a suggestion. If they really want to motivate the brass, let Killinger and the company's other senior officers be paid in defaulted subprime loans. That ought to focus their minds on the job ahead, which is trying to recover some value from these turkeys. The way to keep executives from taking foolish risks is to penalize them for their bad judgment.

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