Managerial Myopia and the Mortgage Meltdown

Adam C. Kolasinski is Associate Professor of Finance at Texas A&M University Mays Business School. This post is based on a recent article, forthcoming in the Journal of Finance Economics, by Professor Kolasinski and Nan Yang, Assistant Professor of Finance at Hong Kong Polytechnic University.

In a new study forthcoming in the Journal of Finance Economics, we present evidence that financial firm CEOs’ incentives for short-term focus played an important role in the subprime crisis of 2007-2009. Prominent policy makers and opinion leaders have asserted that incentives for managerial myopia were important drivers of the crisis. For example, the Financial Crisis Inquiry Commission Report of 2011 asserts the following:

Compensation systems… too often rewarded the quick deal, the short-term gain—without proper consideration of long-term consequences… This was the case up and down the line—from the corporate boardroom to the mortgage broker (p. xix).

While this assertion may have seemed intuitive to the Commissioners, their report provides only anecdotal evidence to support it. Furthermore, till now, evidence that short-termism played a major role in the crisis has proven elusive to scholars who examined the question (c.f., Erel, Nadauld and Stulz, 2014 and Fahlenbrach and Stulz, 2011). Hence, though our findings are intuitive, they provide strong evidence supporting what, till now, has been a disputed proposition supported by little more than anecdotes.

To construct our measure of incentives for short-term focus, we collect data on how long financial sector CEOs were contractually obligated to wait in order to cash out of their stock and options holdings as of the end of fiscal 2006, roughly the peak of the pre-crisis subprime boom. Since CEOs almost always have multiple holdings, each with a different minimum holding period, we use as our measure the weighted average and label it “equity duration.” [1]

The logic behind equity duration, first developed by Gopalan, Milbourn, Song and Thakor (2014), is that CEOs who can cash out earlier will have stronger incentives to engage in value-destroying activities that happen to increase earnings or cash flows in the short run. Activities resulting in high short-term cash flows but with initially hidden negative long-term consequences can temporarily inflate the stock price. A short equity duration, in turn, allows the CEO to cash out more of his holdings before the negative consequences are revealed. Validating our measure of short-term incentives, we confirm that CEOs with short equity durations cashed out significantly more of their holdings during the 18 months prior to the crisis than did CEOs with long durations. In contrast, the previously cited studies on short-term incentives and the crisis use a different measure: the ratio of the CEO’s bonus to salary. Bonuses, however, are small relative to the typical financial CEOs’ total holdings in the firm (less than 2% for most firms in our sample), so it is unsurprising these studies failed to find the bonus ratio had an effect.

The origination and securitization of subprime mortgages during the mid-aughts are precisely the sort of activities theory suggests would be encouraged by short CEO equity durations. These activities generated high fee income during the boom, but they required firms to take on large exposures to subprime defaults, which would only be realized later. Furthermore, recent research suggests that important information indicative of high future subprime default rates, to which top financial firm CEOs were privy, was hidden from securities market participants during the boom. Griffin and Maturana (2016) find evidence that financial firms, on a massive scale, deliberately misrepresented in their public filings the following information about the subprime mortgages they originated and securitized: the value of the underlying property, its owner-occupancy status, whether the borrower’s income was documented, and second lien information. Piskoski, Witkin and Seru (2015) find that prices of subprime mortgage-backed securities did not fully reflect the high probability of future default implied by the information hidden from investors as a result of the aforementioned misrepresentation. Thus while firms active in subprime mortgage origination and securitization were enjoying high fee income during boom, they were simultaneously destroying shareholder value by taking on large exposures to subprime assets that were overvalued due to the misrepresentation of information. They were also destroying value by exposing their firms to legal liabilities for the said misrepresentation. Since the misrepresentation temporarily hid the value destruction from equity markets, however, CEOs with short equity durations could benefit by cashing out before it was revealed. Hence theory predicts short equity durations should be associated with higher firm exposure to subprime assets and future legal settlements for fraudulent misrepresentation.

Sure enough, our empirical analysis reveals that that firms with shorter CEO equity durations as of 2006 had significantly more subprime exposure during the 2007-2009 crisis. In addition, shorter durations are associated with larger firm payouts in subprime fraud-related lawsuits settled over the 2010-2016 period. Finally, firms with short CEO equity durations had better risk-adjusted stock returns during 2006, when subprime activities were at their most profitable, but significantly worse returns during the crisis. Financial firms with short CEO durations were also more likely to fail during the crisis. We conclude CEO incentives to trade short-term gain for long-term pain were indeed at the root of the crisis.

Finally, we point out that myopic value-destroying behavior is distinct from “excessive” risk taking, and our evidence suggests the former was a more important factor in the crisis. In addition to equity duration, our specifications include the CEO’s “vega.” The standard measure of CEO incentives for risk-taking in the corporate governance literature, vega is defined as the sensitivity of the dollar value of the CEO’s holdings in the firm to changes in the firm’s equity volatility. While some prior studies find higher financial firm CEO vega and similar measures for risk-taking are associated with greater firm risk-taking, [2] we find vega has no detectable effect on in-crisis performance or probability of failure when equity duration is controlled for. We conclude reform efforts geared toward reducing financial firm CEO risk-taking incentives might be better directed toward improving incentives to create long-term value.

The complete article is available for download here.


Boyallian, P., Ruiz-Verdú, P., 2015. CEO risk-taking incentives and bank failure during the 2007-2010 financial crisis. Unpublished working paper available at SSRN:

Cerasi, V., Oliviero, T., 2015. CEO compensation, regulation, and risk in banks: Theory and evidence from the financial crisis. International Journal of Central Banking 11, 241–297.

DeYoung, R., Peng, E. Y., Yan, M., 2013. Executive compensation and business policy choices at us commercial banks. Journal of Financial and Quantitative Analysis 48, 165– 196.

Erel, I., Nadauld, T., Stulz, R. M., 2014. Why did holdings of highly rated securitization tranches differ so much across banks? Review of Financial Studies 27, 404–453

Fahlenbrach, R., Stulz, R. M., 2011. Bank CEO incentives and the credit crisis. Journal of Financial Economics 99, 11–26.

Gopalan, R., Milbourn, T., Song, F., Thakor, A. V., 2014. Duration of executive compensation. The Journal of Finance 69, 2777–2817.

Griffin, J. M., Maturana, G., 2016. Who facilitated misreporting in securitized loans? Review of Financial Studies 29, 384–419.

Piskorski, T., Seru, A., Witkin, J., 2015. Asset quality misrepresentation by financial intermediaries: evidence from the RMBS market. The Journal of Finance 70, 2635–2678.


1In our main results, we use the sensitivity of the dollar value of each holding to a 1% change in stock price as the weight, but our results are qualitatively unchanged if we use just the dollar value of each holding as the weight.(go back)

2Boyallian and Ruiz-Verdú (2015), Cerasi and Oliviero (2015), DeYoung, Peng, and Yan (2013)(go back)

Both comments and trackbacks are currently closed.