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Failed Governance and Perverse Compensation
Caused the Current Crises
William K. Black
Associate Professor of Economics and Law
University of Missouri – Kansas City
Governance of the Modern Firm
Universiteit Utrecht
December 12, 2008
An unusual U.S. perspective
Staff leader of successful reregulation of S&L industry in face of political opposition
Heterodox law & econ. scholar
White-collar criminologist: elite fraud & corruption
Expert for the regulator in its case against Fannie Mae’s former senior leaders
U.S. Governance: abject failure
Most elite & sophisticated firms
In a law & econ. paradise
Plus: governance reforms (SOX),
advanced governance research, &
an info./modeling revolution
In “the great moderation”
Produced a catastrophe
But it’s worse than that
An “epidemic” of mortgage fraud
Virtually no corp. heroes
Virtually no corp. leadership – except to corp. socialist trough and for accounting fraud
Virtually no elite accountability – no “poster child” in prison
Triumphalism vs. Gresham’s
Fraud epidemic facts
FBI warned of it in 2004
Corp’s aided it: continued to gut underwriting, controls & spread
MBA’s priority: stop reg., not fraud
FBI took advice from the perps
Nonprime fraud incidence: >40%
80% of frauds induced by lender
Invest. banks: 34 referrals (03-07)
Every day: new scandals
Madoff’s “giant Ponzi scheme”
Results: “Too good to be true”
Madoff morals: give $300 M in bonuses at end to ensure clients suffer total loss
Steven Gordon pleads guilty to crude mortgage fraud. AUSA: "You would think there would be more due diligence."
Governance implicationsNo one did any underwriting – at
>7 levels at multiple firms
Controls suborned deliberately to hide the massive fraud
Has to be done systematically, can’t be hidden from BOD
Requires firing, intimidating or suborning your personnel
Expertise = never using expertise
Looting the firm w/o going to jail
Bad loans, huge leverage & rapid growth optimize accounting fraud & maximize comp.
CEO can’t send a memo. urging that strategy
But he can send that message: through comp.
Gresham’s dynamic sends it to rival firms, extending bubbles
Ask the experts how it’s done
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.
Franklin Raines: CEO, Fannie Mae
Do as I say, not as I do
“By now every one of you must have 6.46 [EPS] branded in your brains. You must be able to say it in your sleep, you must be able to recite it forwards and backwards, you must have a raging fire in your belly that burns away all doubts, you must live, breath and dream 6.46, you must be obsessed on 6.46…. After all, thanks to Frank, we all have a lot of money riding on it…. We must do this with a fiery determination, not on some days, not on most days but day in and day out, give it your best, not 50%, not 75%, not 100%, but 150%.”
The anti-canary
“Remember, Frank has given us an opportunity to earn not just our salaries, benefits, raises, ESPP, but substantially over and above if we make 6.46. So it is our moral obligation to give well above our 100% and if we do this, we would have made tangible contributions to Frank’s goals.” (Mr. Rajappa, head of Fannie’s internal audit.)
Rival concepts of the problem
Law & economics: government and overly cautious CEOs
Governance scholars: weak governance and excessive risk
Contradictory. U.S. policy an incoherent blend of both
Neither addressed the acute problem explained above
Law & econ. praxis caused the crisis, governance didn’t
stop it Governance scholars’ good ideas
missed the acute problem
Law & econ. praxis optimized the “criminogenic environment”
Neither identified the real problem
Risk isn’t the issue or the problem
Fraudulent CEOs (1) make sure BODs don’t govern & (2) hate good government ideas
Law & economics: praxis
1. Deregulation & desupervision
2. Performance pay to align CEO/shareholder interests
3. Private market discipline & reputation trump incentives
4. Reduce fiduciary duties; criminal/civil liability
“Control fraud” is the problem
1. The person that controls the firm uses it as a “weapon”
2. Apparent legitimacy & power
3. Accounting is a financial firm’s “weapon of choice”
4. Causes more financial losses than all other forms of property crime combined
Only the CEO can:
1. Suborn “controls” into allies
2. Convert firm assets to own use via normal corp. means
3. Optimize the firm for fraud
4. Change the external environment to aid fraud
Optimizing Accounting Fraud
1. Assets w/o clear mkt. values
2. Risk is not the key
3. Loan to the worst borrowers
4. Bad underwriting is good
5. Cover up defaults & book new income via refinancing
6. Grow rapidly & lever – Ponzi
7. Trivial loss reserves
Control fraud epidemics
1. Occur when there is a strongly “criminogenic environment”
2. Extend & hyper-inflate bubbles
3. Create Gresham’s dynamic due to modern compensation
4. Overwhelm law enforcement
5. Suborn & degrade controls
6. Deceit erodes trust: can cause systemic risk: mkts. fail
Recent epidemics1. S&Ls: fraud “invariably” at the
“typical large failure”
2. Treadway found control fraud in 80% of SEC cases
3. Russian privatization
4. E. Europe “tunneling”
5. Enron, WorldCom, et al.
6. Washington consensus: L. Am.
7. Non-prime mortgage fraud
Why is it getting worse?
1. Hindsight is rarely “20:20”
2. Conservative resistance is understandable
3. Control fraud epidemics are a fundamental, existential threat to everything they hold dear
4. Denial and reinterpretation: the government as villain
The challenge to conservatives
1. Epidemics falsify the core theories of modern finance
2. Epidemics make econometric studies perverse
3. Conservative praxis optimizes criminogenic environments
4. Regulation becomes essential to block Gresham’s dynamic
5. Their patrons & heroes: frauds
The challenge to theory
1. Finance rests on efficient mkts. & efficient contracts
2. Easterbrook & Fischel: don’t even need rules vs. fraud
3. Core of corporate law theory
4. Fraud epidemics are impossible: falsify theories
5. If it’s bad criminology, it’s bad economics
Perverse econometric studies
1. The worst practices optimize accounting fraud
2. Econometrics uses earnings or share price = “performance”
3. Accounting fraud produces record earnings & share prices
4. Econometrics, during an epidemic, must laud the worst practices that produce disaster
Farblondget
1. Greenspan & Fischel re Keating’s Lincoln Savings
2. Benston lauds financial cyanide: 0 for 32
3. Enron & Fastow’s awards
4. Praise for CEO super comp.
5. Greenspan & neo-classical economic praise for exploding rate ARMs
Praxis1. Deregulation decriminalizes control
fraud and creates opaque, or worse, falsely transparent markets
2. Comp. suborns controls, intensifies CEOs’ conflicts and optimizes the conversion of corporate funds
3. Private players don’t discipline control fraud – they aid it
4. Weaker sanctions & fiduciary duties encourage control fraud
Denial (and worse)1. Fischel’s text on his theories ignores
their failures when he used them
2. Asserts critics of one control fraud (Milken) were anti-Semites and communists & lauds “Keating Five” pressuring regulators on behalf of the worst S&L fraud as a “model”
3. Mankiw (1993): “it would be irrational for operators of the savings and loans not to loot.”
Can’t govern a control fraud
Because the ideas are useful control frauds won’t use them
Formal compliance is an illusion
Their “tone at the top” – enriching those creating the most fake income – aids fraud
Remove corrupt CEOs from office
Use prisons to govern them