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 ‘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... [continues]

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