By William K. Black
(Cross-posted from Benzinga)
Dylan Ratigan, MSNBC’s financial expert, has writtena book about how markets have become perverse. It is an interesting example of how strange “competition” hasbecome. One oddity presented itself onthe cover of the package in which the book arrived. The cover proclaimed “Simon & Schuster: ACBS Company.” The author works forNBC. Only in America!
I was concerned by the title (“Greedy Bastards”). I thinkthat greed is unlikely to have changed greatly over the last quarter century inwhich the U.S. has suffered three recurrent, intensifying financialcrises. I don’t call people bastards,even the self-made ones, because my mother reacted poorly to Speaker Wrightreferring to me as the “red-headed SOB.” Ratigan’s view on these points turns out to be similar to mine. He argues that the issue is not greed, butperverse incentives. When CEOs haveincentives adverse to the public and their customers they tend to act on thoseincentives and harm the public and their customers. This observation is one of those obvious butessential points so often overlooked. ACEOs’ principal function is creating, monitoring, and adjusting thecorporation’s incentive structures. There is a massive business literature on this function and CEOsuniformly believe that incentive structures for officers and employees arecritical in shaping their behavior.
There is only one (disingenuous) exception to thisrule – when officers and employees act criminally because the CEO has createdperverse incentive structures. Suddenly,the CEO is shocked that his officers and employees acted criminally in responseto the CEO’s incentive structures that encourage criminal conduct. Ratigan focuses on precisely thisexception. Anyone that has had themisfortune to listen to compulsory business ethics training by his or heremployer will have learned that the key is the “tone at the top” set by theCEO. True, but that always ends the discussion. No employee is going to be trained by hisemployer as to what to do when the tone at the top set by the CEO is pro-fraud.
As Ratigan demonstrates, our most elite financialCEOs typically created and maintained grotesquely perverse incentive structuresthat encouraged their officers and employees as well as “independent”professionals to act criminally in a manner that harmed customers, the public,and shareholders – but made the controlling officers wealthy. Is there any CEO of a lender incapable ofunderstanding that the loan officers and brokers’ compensation depends onvolume and yield – not quality – the result will be catastrophic? Is there any CEO of a lender incapable ofunderstanding that if the loan brokers’ fees depend as well on the reported debt-to-income andloan-to-value ratios and the broker is permitted to make liar’s loans theresult will be that the brokers will engage in endemic, severe inflation of theborrowers’ incomes and their homes’ appraised values? Is there any reader that doubts that the CEOsintended to produce precisely what their perverse incentives were certain toproduce? A CEO cannot send a memo to50,000 loan brokers instructing them to inflate appraisals and use liar’s loansto inflate the borrowers incomes’ but he can, and does, send the same messagethrough his compensation system. None ofthese perverse incentives produces an unexpected result.
Ratigan gets right two of the three essentials tounderstand why we suffer recurrent, intensifying financial crises. First, cheating has become the dominantstrategy in finance. Second, cheating isdominant because finance CEOs create such intensely perverse incentives thatfraud becomes endemic. The BusinessRoundtable (the largest100 U.S. corporations), had to react to the Enron erafrauds. It chose as its spokesperson aCEO who embodied the best of American big business. This was the response he gave to Business Week when their reporter askedwhy so many top corporations engaged in accounting control fraud:
“Don’t just say:”If you hit this revenue number, your bonus is going to be this.” Itsets up an incentive that’s overwhelming. You wave enough money in front ofpeople, and good people will do bad things.”
How did the CEO know about the “overwhelming” effectof creating incentives so perverse that they would routinely cause “good people[to] do bad things”? He knew because hedirected and administered such a perverse compensation system. An SEC complaint would soon identify thatcompensation system as driving accounting control fraud at his firm. His name was Franklin Raines, CEO of FannieMae.
Ratigan can add tothe effectiveness of his explanation by adding a description of the thirdessential driving our perverse incentives. Accounting control fraud, as criminologists, economists, and (competent)financial regulators recognize is a “sure thing”. See GeorgeAkerlof and Paul Romer, “Looting: the Economic Underworld of Bankruptcy forProfit” (1993). It produces guaranteed,record (albeit fictional) short-term reported profits if one follows the fraud“recipe” for a lender, which produces guaranteed, extreme compensation for thecontrolling officers, and causes catastrophic losses. It is trifecta of guaranteed results that causesCEOs to adopt the perverse incentives they know will cause their officers andemployees to follow the fraud recipe. Itis the three “de’s” – deregulation, desupervision, and de facto decriminalization that allow the CEOs to put theseperverse incentives in place with impunity and produce the criminogenicenvironments that drive our recurrent, intensifying financial crises.
Bill Black is the author of The Best Way to Rob a Bank is to Own One and an associate professor of economics and law at the University of Missouri-Kansas City. He spent years working on regulatory policy and fraud prevention as Executive Director of the Institute for Fraud Prevention, Litigation Director of the Federal Home Loan Bank Board and Deputy Director of the National Commission on Financial Institution Reform, Recovery and Enforcement, among other positions.
Bill writes a column for Benzinga every Monday. His other academic articles, congressional testimony, and musings about the financial crisis can be found at his Social Science Research Network author page and at the blog New Economic Perspectives.
Follow him on Twitter: @WilliamKBlack