Dylan Rati­gan, MSNBC’s finan­cial expert, has writ­ten a book about how mar­kets have become per­verse.  It is an inter­est­ing exam­ple of how strange “com­pe­ti­tion” has become.  One odd­ity pre­sented itself on the cover of the pack­age in which the book arrived.  The cover pro­claimed “Simon & Schus­ter: A CBS Com­pany.”  The author works for NBC.  Only in America!

I was con­cerned by the title (“Greedy Bas­tards”).  I think that greed is unlikely to have changed greatly over the last quar­ter cen­tury in which the U.S. has suf­fered three recur­rent, inten­si­fy­ing finan­cial crises.  I don’t call peo­ple bas­tards, even the self-made ones, because my mother reacted poorly to Speaker Wright refer­ring 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, but per­verse incen­tives.  When CEOs have incen­tives adverse to the pub­lic and their cus­tomers they tend to act on those incen­tives and harm the pub­lic and their cus­tomers.  This obser­va­tion is one of those obvi­ous but essen­tial points so often over­looked.  A CEOs’ prin­ci­pal func­tion is cre­at­ing, mon­i­tor­ing, and adjust­ing the corporation’s incen­tive struc­tures.  There is a mas­sive busi­ness lit­er­a­ture on this func­tion and CEOs uni­formly believe that incen­tive struc­tures for offi­cers and employ­ees are crit­i­cal in shap­ing their behavior.

There is only one (disin­gen­u­ous) excep­tion to this rule – when offi­cers and employ­ees act crim­i­nally because the CEO has cre­ated per­verse incen­tive struc­tures.  Sud­denly, the CEO is shocked that his offi­cers and employ­ees acted crim­i­nally in response to the CEO’s incen­tive struc­tures that encour­age crim­i­nal con­duct.  Rati­gan focuses on pre­cisely this excep­tion.  Any­one that has had the mis­for­tune to lis­ten to com­pul­sory busi­ness ethics train­ing by his or her employer will have learned that the key is the “tone at the top” set by the CEO.  True, but that always ends the dis­cus­sion.  No employee is going to be trained by his employer as to what to do when the tone at the top set by the CEO is pro-fraud.

As Rati­gan demon­strates, our most élite finan­cial CEOs typ­i­cally cre­ated and main­tained grotesquely per­verse incen­tive struc­tures that 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 of under­stand­ing that the loan offi­cers and bro­kers’ com­pen­sa­tion depends on vol­ume and yield – not qual­ity – the result will be catastrophic?

Is there any CEO of a lender inca­pable of under­stand­ing that if the loan bro­kers’ fees depend as well on the reported debt-to-income and loan-to-value ratios and the bro­ker is per­mit­ted to make liar’s loans the result will be that the bro­kers will engage in endemic, severe infla­tion of the bor­row­ers’ incomes and their homes’ appraised val­ues?  Is there any reader that doubts that the CEOs intended to pro­duce pre­cisely what their per­verse incen­tives were cer­tain to pro­duce?  A CEO can­not send a memo to 50,000 loan bro­kers instruct­ing them to inflate appraisals and use liar’s loans to inflate the bor­row­ers incomes’ but he can, and does, send the same mes­sage through his com­pen­sa­tion sys­tem.  None of these per­verse incen­tives pro­duces an unex­pected result.

Rati­gan gets right two of the three essen­tials to under­stand why we suf­fer recur­rent, inten­si­fy­ing finan­cial crises.  First, cheat­ing has become the dom­i­nant strat­egy in finance.  Sec­ond, cheat­ing is dom­i­nant because finance CEOs cre­ate such intensely per­verse incen­tives that fraud becomes endemic.  The Busi­ness Round­table (the largest100 U.S. cor­po­ra­tions), had to react to the Enron era frauds.  It chose as its spokesper­son a CEO who embod­ied the best of Amer­i­can big busi­ness.  This was the response he gave to Busi­ness Week when their reporter asked why 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.” It sets up an incen­tive that’s over­whelm­ing. You wave enough money in front of peo­ple, and good peo­ple will do bad things.”

How did the CEO know about the “over­whelm­ing” effect of cre­at­ing incen­tives so per­verse that they would rou­tinely cause “good peo­ple [to] do bad things”?  He knew because he directed and admin­is­tered such a per­verse com­pen­sa­tion sys­tem.  An SEC com­plaint would soon iden­tify that com­pen­sa­tion sys­tem as dri­ving account­ing con­trol fraud at his firm.  His name was Franklin Raines, CEO of Fan­nie Mae.

Rati­gan can add to the effec­tive­ness of his expla­na­tion by adding a descrip­tion of the third essen­tial dri­ving our per­verse incen­tives.  Account­ing con­trol fraud, as crim­i­nol­o­gists, econ­o­mists, and (com­pe­tent) finan­cial reg­u­la­tors rec­og­nize is a “sure thing”.  See George Akerlof and Paul Romer, “Loot­ing: the Eco­nomic Under­world of Bank­ruptcy for Profit” (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 the con­trol­ling offi­cers, and causes cat­a­strophic losses.

It is tri­fecta of guar­an­teed results that causes CEOs to adopt the per­verse incen­tives they know will cause their offi­cers and employ­ees to fol­low the fraud recipe.  It is the three “de’s” – dereg­u­la­tion, desu­per­vi­sion, and de facto decrim­i­nal­iza­tion that allow the CEOs to put these per­verse incen­tives in place with impunity and pro­duce the crim­ino­genic envi­ron­ments 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

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