Context:
The reported cost of the Obama Administration’s cash payments made to Government Sponsored Enterprises (GSEs) Fannie Mae and Freddie Mac was $130 billion (Cover). This number has been a well-publicized figure signaling the corruption of these two mortgage giants. In fact, enormous sums of money often become the public symbol for corruption when corporate fraud is committed. By the same token, Fannie Mae’s $9 billion of overstated earnings from 2001-2003 also became a strong representation for the executive deception that was committed during this time period (Harvard Law School Case). However, the reasons for the fraud itself are often overlooked. While we can’t be certain that executive compensation practices contributed to this fraud, it undoubtedly did not strengthen the idea of producing firm value for the benefit of shareholders.
Fannie Mae was created in the midst of the Great Depression (1938) to buy mortgages from lenders so that money would be freed up for other borrowers (Pickert). Although Fannie started off with just $1 billion to purchase mortgages, the organization was extremely effective and shaped American home ownership for a new class of people that once were not considered creditworthy. Essentially, low to middle income buyers were able to receive credit and become homeowners due to the success of Fannie Mae. It is important to note that Fannie Mae was established with an amazing social mission in mind: to help American homeowners realize their dreams. It could be argued that the company’s leaders have lost sight of this mission as the company has grown and progressed.
In 1954, Fannie Mae became a “mixed ownership” corporation, meaning that the company was then partly owned by private stockholders (“Fannie Mae History”). However, the company grew at an astounding rate. Fannie Mae continued to buy and sell both Federal Housing Administration (FHA) mortgages, as well as Department of Veteran’s Affairs (VA) mortgages. FHA and VA mortgages were both backed by the government, meaning Fannie Mae was still very much tied to the U.S. Government and was the largest buyer in the market as well. Yet, rates increased and the cost of borrowing a sufficient amount of money to purchase mortgages became very high; this caused a slight dip in Fannie Mae’s profits in the late 1960’s. Thus, the company’s level of success became coupled with U.S. interest rates.
Fannie Mae made the transition from mixed ownership to becoming a private corporation in 1968. This alteration in company ownership was due to a combination of a strain on the U.S. national budget and the company’s recent poor performance. The Housing and Urban Development Act split the company up into two different organizations: the new Fannie Mae, which would focus on secondary market mortgages, and the Government National Mortgage Association (GNMA), which focused on the FHA and VA mortgages described earlier. Fannie Mae’s past is not free from turmoil at the top of the organization. Interestingly, President Richard Nixon dismissed Fannie Mae President Raymond Lapin; Lapin tried to contest this decision with the courts, as he believed that the decision was political and that Nixon had no “cause” (“Fannie Mae History”). Still, no courts ruled in favor of Lapin. A critical adjustment had to be made by Fannie Mae, as the company was now buying conventional mortgages that weren’t backed by the government. Fannie Mae met this challenge and was rather stable in the 1970’s. However, interest rates began to rise in 1979 and continued through parts of the 80’s. Fannie Mae began looking for ways to become less vulnerable to changes in interest rates. One such way was to begin selling mortgage-backed securities (MBS). These securities offered a degree of liquidity that the traditional mortgages of Fannie Mae lacked. By 1988, the company sold over $140 billion in MBS (“Fannie Mae History”). Fannie Mae reached its most profitable level in the 80’s due to this effective product differentiation. The company even was added to the Standard and Poor’s 500 stock index (“History of Fannie Mae”). Fannie Mae had become a very reliable company because of its ability to constantly re-position itself in the market.
In 1991, Fannie Mae underwent a leadership change and implemented the “Opening Doors to Affordable Housing” Initiative. This turned into a great success, as Fannie Mae produced $10 billion in purchases for low- and moderate-income and special needs housing (“Fannie Mae History”). Due to the success of the initiative, Fannie Mae also launched its “Trillion Dollar Commitment,” which pledged $1 trillion in housing finance for low- and moderate-income families. The company was simply on a roll in the 1990’s and reported its 10th consecutive year of record earnings in 1996 (“History of Fannie Mae”). It seems as though that the public opinion of Fannie Mae must have been pretty favorable, as the company was profitable, but appeared to be helping a number of people realize their dreams of becoming homeowners.
Franklin Raines was hired as Fannie Mae’s CEO in 1999. The company soon changed its mission statement to:
“Our Mission is to tear down barriers, lower costs, and increase the opportunities for home ownership and affordable rental housing for all Americans. Because having a safe place to call home strengthens families, communities, and our nation as a whole” (“History of Fannie Mae”).
We can tell that Fannie Mae was focused on maintaining a strong public opinion, as they clearly wanted to be thought of as a company that was focused on making home ownership a possibility for everyone in the United States. However, we know that Franklin Raines and CFO Timothy Howard were both asked to step down in 2004 because of the inflation of earnings from 2001 to 2003. Yet, it was odd that Raines, Howard, and the others involved in the inflated earnings scandal would feel the need to inflate earnings in the first place. Fannie Mae had been achieving record growth in the late 90’s. With economic recession and the outbreak of war in the early 2000’s, it would seem as though the public would have been forgiving if Fannie Mae had released the fact that its earnings dipped. Raines also appeared to be extremely focused on creating shareholder wealth. Right when he took the CEO position, he claimed that, “The future is so bright that I am willing to set as a goal that our EPS will double over the next five years” (McClean). From an outsider’s perspective it looked as though Fannie Mae had a great structural balance of focusing on helping people become homeowners, but also driving financial growth for the company. Yet, when the market didn’t do as well in the early 2000’s as Raines anticipated, there was an added pressure placed on him due to his earlier ambitions of doubling EPS. Thus, Raines’ own financial aspirations may have gotten in the way of what was really best for the company. However, Raines’ financial goals were not the sole contributor to Fannie Mae’s fraud. Fannie Mae simply had too much power given to it by the U.S. Government. The Office of Federal Housing Enterprise Oversight (OFHEO) was a government organization that was supposed to monitor Fannie Mae and Freddie Mac; yet, the organization was understaffed and weak (McClean). In fact, OFHEO actually even came out just days before the 2004 scandal and said that GSEs were “accurate and reliable” in their controls. Clearly, they were not. Executive compensation issues were likely a large contributing factor to these issues.

Executive Compensation Structure Complexities:
The executive compensation structure at Fannie Mae during 2000-2003 was very complicated. In the annual proxy statements that Fannie Mae had to file with the SEC, a “summary compensation table” showed the compensation of the top-five executives in four main categories: (1) salary, (2) annual bonus, (3) option/restricted stock grants, and (4) long-term incentive plan (LTIP) payouts (Harvard Law School Case). Simply looking at the amounts given to Raines in each category says a lot about the executive compensation at Fannie Mae, which was very dependent upon earnings and offered many retirement benefits. First, a bonus was given to Raines each year. The case study said that the executives’ yearly bonus was tied to a particular earnings goal for that year. This is a problematic situation because of the fact that the people who are reporting the earnings are the ones who are receiving millions of dollars in bonuses for these same earnings. It is obvious to point out that this offers executives with a direct incentive to inflate earnings, as their pay is so dependent upon this performance measure. Yet, Fannie Mae’s Board of Directors did not try to recover any of the bonuses given to executives on the basis that earnings would need to be restated. This is hard to fathom, as the company essentially encouraged its employees to lie about their own performance. If a mid-level manager received a bonus for implementing a new statistical approach to acquire more clients and the company found out it was stolen from a different employee, it is hard to believe that the company would not at least rescind said bonus. Second, the LTIP payouts also accounted for a large portion of total executive compensation. However, the name “long-term incentive plan” is extremely deceiving due to the fact that 50% of the shares awarded to executives were given because of prior years’ earnings. This is yet another way in which the executive compensation structure of Fannie Mae was flawed; there was clearly too much weight placed on earnings. Tying compensation to earnings is not a bad idea. Conversely, it is a bad idea to tie earnings and pay when the person who is receiving the money/compensation is someone who has the potential to change these earnings. Another aspect of the executive compensation structure was the “Earnings Per Share Challenge Option Grants.” This allowed options to become vested and exercisable depending on the EPS level. Of course, EPS was over-inflated and executives were able to immediately exercise their options and receive large payouts. Overall, the EPS Challenge, the LTIP payouts, and the bonuses given to executives were not tied to long-term shareholder value. The ultimate goal for any public company like Fannie Mae should be to increase shareholder value; thus, it is detrimental to tie executive compensation with short-term stock returns and yearly earnings figures that can be manipulated. Executive employment contracts were another major element of the executive compensation structure at Fannie Mae. The contracts at Fannie Mae contributed to “soft landings” for CEO Raines and CFO Howard. These contracts specified that the two executives could only be terminated “for cause” due to a felony conviction, a fraud that discredits and is incurable to the company, the engagement of material conflict, failure to perform material duties and failure to cure a material breach of contract. “For cause” clauses are often used so that an executive is protected from being fired for petty, personal reasons (Zweig). This contract was beneficial to the executives because of the narrow definition of what constitutes “for cause” termination. Also, the Board of Directors amended the agreement shortly before Raines was fired to allow him to avoid “for cause” termination charges. This was certainly a form of a “gratuitous goodbye” benefit and seems like an unfair executive benefit from the perspective of a regular shareholder. The executive compensation structure at Fannie Mae also included a number of retirement benefits that were given to the fired executives. Fannie Mae circumvented the Congress ruling that prevents firms from deducting more than $1 million annually of nonperformance compensation. Raines ended up receiving benefits worth a few million dollars of nonperformance pay for each year he was the CEO. Raines’ retirement package consisted of: immediate option vesting worth around $7 million, retirement payments worth around $25 million, tax-free buildup on deferred compensation, medical coverage, and life insurance worth at least $1 million each (Harvard Law School Case).
It is interesting that a majority of the value in these retirement benefits were not linked to performance. This could contribute to a complacent attitude and decreased performance if the individual receiving these automatic benefits isn’t highly motivated to achieve earnings targets in an ethical manner. Due to the fact that over 50% of the Fannie Mae yearly executive compensation was dependent on earnings, it is surprising that none of the retirement benefits were predicated on annual earnings. Generally, employees will want retirement benefits to be safe and secure, as they depend on these benefits later in life. Yet, it is contradictory for Fannie Mae to compensate their executives so well through earnings incentives and to just give millions of dollars to executives in retirement benefits.
Fannie Mae’s compensation structure was unquestionably complex and difficult to understand. The company did not go to great lengths to make the true value of executive retirement packages available to investors; instead, the company reported the minimum amount of each form of compensation on its SEC filings. At the time, the amount of information that Fannie Mae presented was legal. One thing that Fannie Mae did disclose was the $8.7 million in the deferred compensation account of Franklin Raines. The reason Fannie recorded this amount was that it is a cost to the company to let Raines have a tax-free buildup of deferred compensation. Nevertheless, Fannie Mae made it difficult for investors and others to determine the annuity value of the retirements, the medical coverage, and the life insurance values. It would be especially hard for someone to calculate these numbers the closer you get to the present date. In order to combat some of these problems with the camouflage of executive compensation, there has been an increased level of regulation. For example, the Dodd Frank Wall Street Reform and Consumer Protection Act requires a company report detailed descriptions of executive golden parachutes and a disclosure of the ratio of the median compensation for all employees compared with the CEO (Falink).

Defining the Issue:
Fannie Mae’s executive compensation contributed to a number of problems for the organization as a whole. One of the largest consequences of the executive structure was that it led to incentives to inflate earnings; in turn, this had a negative impact on long-term shareholder value. Due to the fact that the annual bonus, LTIP plan and the stock options were all somewhat dependent upon short-term earnings, there was an incentive for Raines and other people high up in the organization to commit fraud. The people that were hurt most by the artificial inflation of short-term earnings were shareholders. In 2006, after the fraud had begun to settle down, SEC Chairman Christopher Cox said that they would “determine their focus to individuals, including Raines and Howard” (Day). Cox also came out and said: “Fraudulent financial reporting cheats investors of their savings.” The executive compensation structure at Fannie Mae was too alluring for its corporate officials to not take advantage of the situation and commit the fraud. However, the people that were really affected by their decision were innocent shareholders who saw the value of their stocks instantly diminish when the scandal came out.
Ultimately, the executive compensation did not only hurt Fannie Mae as an entire organization, but it also hurt the executives who were lured into the fraud. CEO Franklin Raines, CFO Timothy Howard, and Controller Leanne Spencer paid nearly $31.4 million over their roles in the 2004 scandal (NY Times). Raines was also forced to give up stock options valued at around $15.6 million. Fannie Mae also suffered from bad press and many lawsuits. For example, Ohio Attorney General Jim Petro accused Fannie of securities fraud and claimed that the deception “could cost shareholders billions of dollars” (Dunn).
Besides the failure to perform, the executive compensation structure of Fannie Mae also had the consequence of creating “soft landings.” These soft landings undoubtedly caused an incentive problem, as the executives had a sense of entitlement knowing that there would be plenty to fall back on if they were caught in this accounting scandal. They knew that they didn’t have to perform well to receive great retirement benefits and ended up taking the easy way of “improving” the company by simply cooking the books. In class, we also discussed the idea that the soft landings, which were allowed by Fannie Mae’s executive compensation structure, also contradicted and weakened the power of Sarbanes Oxley. Section 304 of the Sarbanes Oxley Act “requires executives engaged in accounting-related ‘misconduct’ to return to the firm bonuses or other incentive or equity-based compensation within 12 months of a misleading financial statement” (Harvard Law School Case). Instead of requiring a payback, Fannie Mae made it even easier for the executives by changing the “for cause” termination provisions in the executive compensation contract.
Another aspect of the compensation structure that was problematic was that the Fannie Mae Board of Directors seemed to be far too complacent with whatever the executives wanted. This was likely due to the fact that there was too much crossover between the executive compensation committee, the board of directors, and the executive team. This created the consequence of a certain “you scratch my back, I’ll scratch yours” attitude that became too prevalent in the company. Ultimately, this attitude became so predominant that Fannie Mae’s board eliminated a pension penalty under a “for cause” termination stipulation that allowed Raines to keep $6 million of what should have been investor money (Harvard Law School Case).
One of the most interesting aspects of Fannie Mae’s executive compensation was its clear strategy to pay its executives a very large amount of money to its executives. It is hard to benchmark the amount of money Raines received; yet, a study showed that in 2004 the average pay for a CEO was around $11.8 million (Heritage Institute). This means that Fannie Mae clearly took a “lead the market” executive compensation strategy. Thus, Fannie Mae was looking to attract and retain sufficient executives and had the ability to be really selective in who they chose in the first place. There were likely a number of driving market forces behind this decision. First, the economy was not doing well in the early 2000’s and Fannie Mae had likely under-performed in comparison to the stretch in the 1990’s when revenues had grown for 10 consecutive years until 1996. Second, the fact that Fannie Mae is a government-sponsored enterprise means that it has the support of the U.S. Government. This support might allow the company to take on added risks that it might not take if the organization didn’t have government backing. As we mentioned in class, it would be interesting to see how Fannie Mae paid its top management and other employees. This would show whether or not there would be a “spillover” effect within the organization. As a whole, government and public institutions tend to pay employees with a lot of benefits.
Warren Buffet has said, “Too often, executive compensation in the U.S. is ridiculously out of line with performance.” In the case of Fannie Mae, executive compensation, specifically in the form of performance and retirement benefits, was way out of line with performance. However, the unique part of this situation is that it did not appear as though performance was bad because of the accounting fraud. It certainly appeared as though Raines was earning his keep with the company’s reported earnings. In reality, his greed and the selfishness of other executives were setting up the company for future failure.
Another fundamental portion of the Fannie Mae executive compensation strategy that was significant, and often is overlooked, was the action of the board of directors. It seemed as though the behavior of the Fannie Mae Board of Directors was just as big of a reason for the fraud as the conduct of the Fannie Mae executives. This is because the board seemed to tend to the executive team whenever it looked to be in hot water. For example, Fannie Mae’s board made a series of changes to Raines’ employment agreement right as the government began investigating the accounting problems. While this shows an impressive, unwavering commitment of the board to the executive team, it also appears that the board was simply fulfilling promises for the executives.
The board of directors can play a big part in the strategic direction of a company. In this case, the board acted rather unethically by constantly taking action that was best for the executives. Instead, the board’s job should be to look to maximize shareholder value. The shareholders are the ultimate group of people affected by these decisions. Truthfully, the Fannie Mae Board of Directors probably cost the shareholders between $5 and $10 million by allowing the executives to leave without “for cause” termination (Harvard Law School Case). There is a clear chain of events that can explain this deterioration of shareholder value in this case. The compensation structure that the board created provided executives with soft landings; sequentially, this caused a reduction in the difference in financial payoff when the firm does well and when it does poorly. This difference is what the shareholders attempt to create with their money. By not respecting this, the board is not doing its job in maximizing shareholder value.
One of the most influential laws involved in Fannie Mae’s executive compensation was the Sarbanes Oxley Act. Specifically, Section 304 of the act requires executives to pay back bonus compensation when “misconduct” occurred to create this compensation in the first place. However, the Fannie Mae Board of Directors provided Raines and Howard with a soft landing that weakened the incentive effect of Sarbanes Oxley. One piece of noteworthy information about Section 304 is that the SEC is the only regulator that can enforce it (Bondi, Rockwood). This means that other groups, such as shareholders, have little to no say when it comes to forcing a company to comply with this regulation.
Luckily, the SEC has begun to enforce Section 304 in a more aggressive manner in recent years. Until 2009, the SEC only enforced Section 304 when it was found that the executive in question was directly involved with the “misconduct.” However, due to situations like Fannie Mae where the board covered for the executives by not firing them “for cause,” the SEC is now pursuing action even when the executive has not been found to be responsible for the misreported earnings. As an example, the SEC decided to bring a stand-alone Section 304 action against the former CEO of CSK Auto Corporation, Maynard Jenkins (Bondi, Rockwood). In this particular case, the courts ruled in the SEC’s favor, setting the strong precedent that executives may be punished for misreported earnings no matter their level of involvement.
Another law relevant to this case was Section 162(m) of the Internal Revenue Code. Under this clause, companies are denied a tax deduction for compensation in excess of $1 million per year paid to defined executive officers unless the compensation satisfies certain criteria. Fannie Mae got by this regulation due to the fact that Section 162(m) does not address payments made to executives after they retire. Remarkably, there are also a number of other ways to get by this clause. One criterion that would allow for more than $1 million in deductions is that the compensation committee must consist of two or more “outside directors” (Greco). Thus, it seems as though the U.S. Government is not looking to heavily enforce Section 162(m) of the Internal Revenue Code.

Alternatives For Fannie Mae: Fannie Mae could have used a number of alternative executive compensation strategies. First of all, Fannie Mae could have tried to describe its executive compensation in more detail for the benefit of shareholders. More transparency would have made the executive compensation program less confusing. If executives are willing to share their compensation with the public, there is more potential for a trusting relationship with employees and other company stakeholders. Overall, executives should be wary of how they are perceived throughout their company, as most people don’t want to work for a company where people at the top receive ridiculous amounts of money when the company has told them that they have to cut things such as employee health care benefits. One of the concepts we discussed in class was employee equity, which is the perceived fairness of what a person does and what they receive. Deceitful executive compensation can lead to decreased equity; this is something that Fannie Mae should have eliminated from its executive compensation structure.
In fact, Fannie Mae has since improved the way it shares executive compensation to the public. Looking at the current Fannie Mae Annual 10-K Report, it is easy to see that the current CEO Timothy Mayopoulos received $500,000 in base salary and $1,358,500 in deferred salary. Yet, the company discloses even more information. Fannie Mae now describes the different types of benefits that employees are all eligible for. It even discusses what would happen if an executive were terminated and goes into great depths about the design of its compensation committee.
The Fannie Mae executive compensation structure was based off a performance system where much of the executives’ money was tied to the company’s earnings. However, the problem with this system was that the executives had the power to manipulate the earnings. Thus, the ultimate goal would be to find a way to tie earnings to long-term earnings so that executives would be satisfied with making decisions to promote the long-term financial health of the company. Since measures like yearly reported numbers on the income statement affect the EPS and ROI calculations, it would be best to find an alternative way to compensate executives with performance indicators.
One such alternative would be to lengthen the time before executives can cash in their shares and options. The short vesting periods that Raines’ stock had was a disadvantage to the company’s long-term health, as one of the reasons Raines and other executives misreported earnings was to see higher profits from vested stock. It would be impossible to determine an appropriate waiting period length for all companies, as different companies have diverse product pipelines. For example, it may take a pharmaceutical company seven years before it reaps profits from a particular product. Fannie Mae would have to determine a waiting period that would fit with the trends in the housing market. Fannie Mae allowed its executives the power of immediately vesting their stock. Yet, it is imperative that the vesting period for this stock be longer and have stipulations that doesn’t allow an executive to instantaneously receive the benefits from short-term changes in stock price. In summary, short vesting periods like Fannie Mae’s can be a contributing factor to unethical behavior from executives who don’t see incentives to maintain long-term financial success. Another alternative to the Fannie Mae executive compensation structure would be to force executives to hold an even level of stock (or even a higher level of stock) after a price decline. Often, executives’ incentive accounts will be rebalanced after a price decline to include less stock and more deferred cash (Edmans). In general, companies should try to keep the balance of stock offered to executives consistent. This prevents executives from adding stock to their portfolio of total compensation and then inflating short-term earnings to influence this stock price. Also, forcing executives to maintain a constant level of stock (even after a price decline) will hopefully become a motivating force for executives to increase earnings in the right way.
One recommendation for Fannie Mae, or any other company looking to revamp its executive compensation, would be to begin to pay executives in more creative ways. Precisely, the company could look to pay executives through debt instead of equity. Oftentimes, debtholders suffer from decisions made by executives who are looking to benefit shareholders. Due to the fact that debtholders must be paid back before equityholders when liquidation occurs, shareholders may support taking on risks that debtholders would not support. This is because a shareholder’s value may be wiped out anyway with a risky move, but it also could increase more than a debtholder’s value could increase. Thus, giving executives compensation based on debt would be a way to decrease risky behavior. This could have been extremely helpful in Fannie Mae’s situation, as the executives didn’t see any downside risk in inflating the company’s earnings and stock price valuation.
Defined benefit plans are used when “employees are promised a pension amount based on age and service” (Mathis and Jackson). These plans, along with deferred compensation, are already used frequently in practice. They have equal priority with unsecured creditors when it comes to bankruptcy (Edmans). This allows for CEO’s to take an interest in what debtholders’ want. Another way that Fannie could tie executive compensation to debt would be through the price of the company’s bonds. American International Group (AIG) used this type of system in 2010 by tying 80% of an executive’s performance pay to the price of its bonds (Edmans). Alternatively, Fannie Mae could even just give actual long-term bonds to executives; this may incentivize long-term firm performance.
Another recommendation for Fannie Mae and other companies would be to revamp their compensation committees. A compensation committee is usually a “subgroup of the board of directors that is composed of directors who aren’t part of the firm” (Mathis and Jackson). There wasn’t much of a mention of a committee in the case, but the Fannie Mae Board of Directors clearly had a large say in the way the executives were compensated. The members of the committee should not include any corporate-level officers within the organization; instead, it should consist of outsiders and even external consultants to help benchmark executive pay with other large financial institutions.
Today, Fannie Mae has a full executive compensation committee that is referenced a number of times in its annual report. This committee works to ensure fair practices and to make sure that the company is not paying too much to executives and diluting shareholder wealth. An independent consulting firm called FW Cook and McLagan helped Fannie Mae with its most recent decision on how much to pay new CEO Timothy Mayopoulos (Annual Report). In fact, the committee uses a number of different competitors as benchmarks for industry executive compensation, including Allstate, Freddie Mac, Metlife, and Prudential Financial. This has helped the company avoid paying too much to executives, as Fannie Mae is looking to stay in the middle of the market when it comes to executive compensation.
Overall, Fannie Mae and other companies who have had problems with executive compensation need to get creative in the way they link pay to performance. While it is hard to develop true measures of long-term success, this is what needs to be done to help prevent an environment that would be more apt to fraud. Also, one way to attack this problem head on is to start with the people that are making the decisions: the executive compensation committee. Improving these two aspects of executive compensation is a great start to creating a more ethical workplace.

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