Question

Excessive executive compensation in the financial services industry ranks high among examples of failed corporate governance. Corporate government at the government-sponsored mortgage giants Fannie Mae and Freddie Mac were particularly weak. The politically appointed board at both enterprises failed to understand the risks of sub-prime loan strategies being employed, did not adequately monitor the decisions of the CEO, did not exercise effective oversight of the accounting principles being employed (which led to inflated earnings), and approved executive compensation systems that allowed management to manipulate earnings to receive lucrative performance bonuses. The audit and compensation committees at Fannie Mae were particularly ineffective in protecting shareholder interest., with the audit committee allowing the company’s financial officers to audit report prepared under their direction and used to determine performance bonuses. Fannie Mae’s audit committee also was aware of management’s use of questionable accounting practices that reduced losses and recorded one-time gains to achieve financial targets linked to bonuses. In addition, the audit committee failed to investigate formal charges of accounting improprieties filed by a manager in the Office of the Controller.

Fannie Mae’s compensation committee was equally ineffective. The committee allowed the company’s CEO, Franklin Raines to select the consultant employed to design the mortgage firm’s executive compensation plan and agreed to a tiered bonus plan that would permit Raines and other senior managers to receive maximum bonus without great difficulty. The compensation plan allowed Raines to earn performance-based bonuses of $52 million and a total compensation of $90 million between 1999 and 2004. Raines was forced to resign in November 2004 when the Office of Federal Housing Enterprise Oversight found that Fannie Mae’s executives had fraudulently inflated earnings to receive bonuses linked to financial performance. Securities and Exchange Commission investigators also found evidence of improper accounting at Fannie Mae and required the company to restate its earnings between 2002 to 2004 by $6.3 billion.

Poor governance at Freddie Mac allowed its CEO and senior management to manipulate its financial data to receive performance-based compensation as well. Freddie Mac’s CEO Richard Syron received 2007 compensation of $19.8 million while the mortgage company’s share price declined from a high of $70 in 2005 to $25 at year end 2007. During Syron’s tenure as CEO, the company became embroiled in a multibillion-dollar accounting scandal, and Syron’s personally disregarded internal reports dating to 2004 that cautioned of an impending financial crisis at the company. Forewarnings within Freddie Mac and by Federal Regulators and outside industry observers proved to be correct, with loan underwriting policies at Freddie Mac and Fannie Mae leading to combined losses at the two firms in 2008 of more than $100 billion. The price of Freddie Mac’s shares had fallen to below $1 by the time of Syron’s resignation in September 2008.

Both organisations were placed into a conservatorship under the direction of the U.S. Government in September 2008 and were provided bailout funds of more than $160 billion by early 2011. The U.S. Federal Housing Finance Agency estimated that the bailout of Fannie Mae and Freddie Mac would potentially reach $200 billion to $300 billion by 2013.

Sources: Chris Isidore, “Fannie, Freddie Bailout: $153 Billion…and counting,” CNNMoney, February 11, 2011;” Adding up the government’s Total Bailout Tab, “ New York Times Online, February 4, 2009; Eric Dash, “Fannie Mae to restate results by $6.3 Billion because of Accounting,” New York Times Online, www.nytimes.com, December 7, 2006; Annys Shin, “Fannie Mae sets executive salaries,” Washington Post, February 9,2006,p.D4; and Scott DeCarlo, Eric Weiss, Mark Jickling, and James R.Cristie, Fannie Mae and Freddie Mac: Scandal in U.S. Housing (Nova Publishers,2006), pp. 266-286.

QUESTION 1

A) Fannie Mae and Freddie Mac are two examples of poor execution of corporate governance in mortgage financial institutions. Identify and discuss the corporate governance issues in this case study.

Answer 1

Fannie Mae and Freddie Mac are the two examples of poor execution of corporate governance in mortage financial institutions.

Here, in this case study the excessive execution compensation in the financial industry  leads to poor execution of corporate governance. Fannie Mae and Freddie

1. Audit committee:

- audit committee of both the company failed to understand the risk of sub prime loan strategies.

- did not exercise effective oversight of the accounting principles which lead to inflated earnings.

- over authority allowed to management that lead to manipulate earnings to receive lucrative performance bonuses.

- failed to protect the shareholde's interest

- audit committee failed to investigate formal charges of accounting improprieties.

2. Compensation committee:

- compensation committee of both the enterprises will be equally ineffective.

- fradulently inflated earnings to receive bonuses detoriates the financial performance.

- improper accounting practice in the enterprises

- poor governance lead to manipulate the financial data to receive performance based compensation which leads to fall in mortage company's share price , then the companys recieve underwriting of loans due to the price fall in mortage company's share price which leads to big losses for both the enterprise.