March 19 (Bloomberg) -- For KB Home, 2007 was a disastrous year.

Revenue dropped to $6.4 billion from $9.4 billion. Diluted earnings per share plummeted to negative $12.04 from positive $5.82 the year before. Total shareholder return for the fiscal year ended Nov. 30, 2007, was negative 58 percent compared with a positive 7.7 percent return on the Standard & Poor's 500 Index.

So what did KB Home's compensation committee give Chief Executive Officer Jeffrey Mezger in addition to his $1 million salary, which was an increase from the $569,000 he earned in 2006 when he was chief operating officer?

A $6 million bonus. Free shares worth $2 million at grant. Stock options the company estimated were worth $12.4 million at grant. A target opportunity under a third long-term incentive program of $2 million more.

Add in a few other odds and ends, including an increase in pension at present value of $389,000 and miscellaneous compensation of $973,000, and you have a pay package for fiscal 2007 of $24.8 million.

Of all the gifts to the 52-year-old Mezger, who has been CEO since November 2006, the most troubling for me is the $6 million bonus.

KB Home's compensation committee justified its action with numerous reasons, though none have anything to do with that stupefying total return of negative 58 percent. There were, however, some good things on that list, including:

-- The generation of $1.2 billion cash from operations.

-- Reduction of debt of $759 million.

-- Reduction of the ratio of debt to total capital to 31 percent from 43 percent.

Discretionary Bonus

Then there were these reasons for his pay increase: The hiring of a new head of human resources, and reducing the workforce by 39 percent.

Huh? Mezger was rewarded for an appointment and for overseeing the dirty work of firing staff?

What made all this so risible was that Mezger had been eligible for a formulaic bonus of as much as $17.5 million based on KB Home's pretax, pre-incentive profit. Had there been no floor to this bonus, Mezger would have been writing a big check back to the shareholders, since there was a pretax, pre- incentive loss.

But that didn't stop the compensation committee. It turned right around and awarded him a $6 million bonus using its discretion. If you want your man to be overpaid, you really don't have to let some silly little formula stop you.

Piling On

The compensation committee also piled on long-term incentives. Mezger got what the committee thought he should have received if there hadn't been a ``review'' in 2006. That's a euphemism for options backdating, which cost Mezger's predecessor, Bruce Karatz, his job on Nov. 11, 2006. The committee also gave Mezger his 2008 long-term incentive package in 2007.

The committee was advised by Semler, Brossy Consulting Group LLC, an executive compensation consulting firm in Los Angeles, where KB Home is based.

Mezger also got the opportunity to receive as many as 81,000 shares free predicated on KB Home's three-year total return compared with a roster of other homebuilders.

Based on KB Home's total return for the period Nov. 30, 2006, through the close on March 17, KB Home outperformed all but five of the 12 homebuilders in its peer group (which includes KB Home itself). Were that performance to keep up, Mezger would receive clear title to approximately 59,000 shares currently worth $1.2 million.

Some Portfolio

Think of Mezger's beautifully diversified portfolio. If KB Home's stock rises, he stands to make millions from his options and free shares. If it falls at a lesser rate than KB Home's homebuilding peers, which is exactly what has happened so far, Mezger also gets millions. Those 59,000 shares he is on the way to earning are based on a negative total return of almost 60 percent. And his free shares will be worth something, too.

If the stock goes up, shareholders and Mezger win. If it goes down, so long as it doesn't hit zero, shareholders lose but Mezger still wins. Even if the stock doesn't move, Mezger could still make millions from his free and performance shares.

KB Home's compensation committee should be forced to read every word of the proxy statement filed on March 7 by its competitor, Miami-based Lennar Corp.

That company also did terribly in 2007. Total return for the fiscal year ended Nov. 30, 2007, was negative 69 percent, with the company's diluted EPS swinging to negative $12.31 from positive $3.69.

Way to Go

CEO Stuart Miller received the same $1 million salary as Mezger. He was also offered the chance to earn 200,000 shares free, which were worth $10 million at their grant, provided certain goals were accomplished. They weren't, and Miller lost the shares. So Miller made just $1 million in 2007 (as well as $131,000 in miscellaneous compensation).

Now that's the way compensation should be done.

KB Home has a history of treating CEOs nicely. Former chief Bruce Karatz was so wildly overpaid that I once suggested he change his first name from Bruce to 24 -- as in 24 carats.

I have found that compensation committees that approve obscene pay levels for one CEO often produce the same obscene pay levels for succeeding CEOs. Chalk it up to institutional memory.

What KB Home should do is fire the compensation committee and bring in new directors who don't have an institutional memory for lavish pay packages that float free of performance.

(Graef Crystal is a columnist for Bloomberg News. The opinions expressed are his own.

To contact the writer of this column: Graef Crystal in Santa Rosa, CA at graefc@bloomberg.net.

Last Updated: March 19, 2008 00:01 EDT