NCPA - National Center for Policy Analysis

INCENTIVES ASKEW?

April 28, 2005

The government should restrict aggressive risk-taking by government-sponsored enterprises (GSEs), such as housing financers Fannie Mae and Freddie Mac, say economists William Emmons and Gregory Sierra.

Financial economists have long supported the practice of tying CEO pay to performance, since CEOs and other executives respond to incentives; indeed many publicly-traded companies do so successfully.

In 1992, however, Congress mandated "pay for performance" measures for GSEs, which affected the executive pay arrangements for executives of Fannie Mae and Freddie Mac. This is a bad idea for many reasons, say Emmons and Sierra:

  • Although Fannie and Freddie are quasi-private and publicly traded, they are still backed by tax dollars; excessive risk by executives in order to boost shareholder earnings might put taxpayers at risk.
  • Fannie and Freddie are highly leveraged (meaning large amount of assets per dollar of equity), which should decrease the need for pay-for-performance incentives.
  • Companies with opportunities for growth rightly tie pay for performance, but Fannie Fae's and Freddie Mac's growth has decelerated for some time; thus, GSEs should de-emphasize pay for performance.
  • Additionally, the larger a firm, the more expensive it becomes to provide CEOs with a meaningful equity stake in the company; GSEs market capitalizations are large enough that executive performance pay is not necessary.

Whether or not Congress decides to completely privatize Fannie or Freddie or move toward stricter oversight similar to the banking industry, Congress must remove incentives for GSE executives to maximize shareholder returns at the expense of taxpayers, say Emmons and Sierra.

Source: William R. Emmons and Gregory E. Sierra, ?Incentives Askew?? Regulation, Winter 2004-2005, Cato Institute.

For text:

http://www.cato.org/pubs/regulation/regv27n4/v27n4-2.pdf

 

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