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Wed

07

Jan

2009

Orangutans Hate Changes in Their Cages
Wednesday, 07 January 2009 06:56
by Stephen P. Pizzo

If Barack Obama's economic team wants to make changes in how American businesses do business, there are two relatively simple changes that, if made, could change everything. I'm no economist, but I do understand accidents waiting to happen when I see them. And, I think now that even the most committed free-marketeers would agree that accidents have happened under the current scheme of things. And those accidents have happened before -- and happened and happened again. Obviously something has to change. While there will be furious opposition to the two changes I write about here, keep in mind that one definition of “crazy” is doing the same thing over and over and each time expecting a different outcome. But those who will oppose these two changes are crazy alright, crazy like foxes. Because they've benefited mightily under the rules as they are. Even when they cost others billions, they do fine, thank you very much. If we want to be in the same fix we're in now a decade down the road, or likely a worse one, then don't make these changes. Just add a few more federal regulators to the beat, who will, as they have in the past, be quickly marginalized by heavyweight corporate lawyers. And let the games begin anew. Or enact these two fundamental changes:

Change No. 1: Stop letting the foxes hire the chicken coup guards.


One of the mysteries I and my coauthors of Inside Job sought to answer was just how so many savings and loans could have been looted into insolvency right under the noses of their own “independent” accounting firms. The answer became almost immediately obvious.

Under current rules governing federally-insured financial institutions and publicly traded companies, each submit an independent audit each fiscal year. Such audits are conducted by accounting firms like Pricewaterhouse-Coopers LLP, Deloitte & Touche, Ernst & Young LLP and such. These are independent companies, the idea being that they have no dog in the fight and will produce an objective report on these company's true financial condition.

But the law then defeats its purpose by requiring companies and financial institutions pick the accounting firm they want, and pay them like any other subcontractor. The larger the institution to be audited, the larger the paycheck for the accounting firms. Also these auditing companies also offer a host of other for-fee services to companies, from financial consulting to human services. The audit job is a foot in what could be leveraged into a lot of other fees unassociated with that firm's audit functions.

Lincoln Savings crook, Charles Keating, was famous for offering lucrative jobs to auditors or their spouses once their audit is completed.

Getting the picture?

I could go on for pages with tales like that. But here's my point. There's a very simple fix to this obvious flaw, and here it is:

Rather than having companies hire their own auditors, they should instead be required to purchase audit insurance from companies formed to provide just that kind of coverage.

This audit insurance would protect shareholders and taxpayers in the event that an audit misses insider fraud or overly risky investments, Madoffishness etc, that later creates significant loses. The cost of these audit insurance policies would be priced like any other insurance product, based on the risks being insured. Right there companies would have a new incentive to keep risk under control as it would lower the cost of their policy.

It's all about incentives in business. Create incentives to do the right thing because it saves or makes money, and they'll do the right thing. Create incentives to do the wrong things because that makes money, and they'll do the wrong thing. Audit insurance creates the incentive to do the right things – keep risks under control. Duh.

The second flaw audit insurance would solve is the most obvious one – companies would no longer hire and pay their own auditors. Instead the insurance company sure as hell would. Insurance companies would not write a policy for tens of millions, may hundreds of millions of dollars for an unknown entity filled with unknown risks. These insurance companies would either have their own in-house accountants comb the books of those seeking a policy or they would hire one of the established accounting firms. But this way those independent accounting firms would now have a completely different set of incentives. Rather than trying their best not to alienate their corporate client, they would be anxious not to let down their new client, the audit insurance companies. The last thing one of these giant accounting firms would want is to give a company a clean bill of health only to have it fail months later costing their new client, the audit insurance company, a bundle.

Got it? Simple. Easy. So, duh. Double duh.

Change No.2: Bonding home loans


The Economist had a good piece this week on the Danes way of funding, originating and securing home loans. And it completely does away with the kind of “mortgage securitization” that has now spread so much misery and damage across the US and world economy.

Under the Danish model when a bank makes a home loan it must create and sell a bond of the same face value, same duration and same terms. That bond, secured by the property, is sold and the money provided to fund the purchase of the home.

Now, why is this different and why is this better than Wall Street securitization? The Economist explains:

“The Danish system has two characteristics that change it almost completely. The first is that the issuers of mortgage bonds remain responsible for making payments on them. This avoids a flaw that was so painfully exposed in America’s mortgage market: lax lending is encouraged when the link is broken between those who sell mortgages and those who bear the risk of default.

The second feature of the Danish system is that mortgage-holders can also buy the bonds in the market and use them to redeem their mortgages. This is useful if a rise in interest rates (or a fall in house prices) causes mortgage-backed bonds to trade at a discount. Redeeming their bonds allows homeowners to reduce the amount they owe. In America, for instance, mortgage-backed securities have fallen far below their fundamental value in thinly traded markets, partly because the people who would benefit most from buying them have no mechanism to do so.

“Everybody can buy that bond at a discount except that one guy who is most involved with the loan, the homeowner,” says Alan Boyce, a mortgage expert who has worked with George Soros, an investor and philanthropist, on promoting the Danish model in emerging markets. In Denmark, by contrast, a fall in the value of mortgage bonds usually encourages homeowners to snap them up to redeem their own mortgages, as is happening now.” (Full article here)

As with the change the conditions that govern corporate audits, switching to home loan bonds would change the incentives. Moral hazards abound under both schemes right now, which is why we are in them mess we're in. Whenever the care and feeding of other people's money is involved one has to make damn sure that those caring for that money do not have any incentive to cut corners, fudge inconvenient facts and then sell steaming turds to investors lulled into complacency by the stamp of approval of some compromised accounting firm.

There. Now was that so hard? alt

We've just begun repairing the damage done by the current rules governing how firms are audited, how mortgages are funded, made and sold on Wall Street. Those repairs are being made, as they were in past disasters like this, which the application of hundreds of billions of taxpayer dollars, being handed out to banks and other financial institutions that failed following and/or manipulating current rules. More often than not the rules they have played under are rules these industries themselves lobbied for, paid for, and got. Now we're paying for them. And we'll pay and pay and pay for them again, unless those rules are changed.

I understand the odds of getting anything like these two proposals passed range from slim to none. I recall a meeting I had with Senate Banking staffers back in 1991. At the time Congress was debating whether or not to repeal the Glass-Steagal Act, passed in the wake of the Great Depression barring federally insured banks from co-mingling their operations with Wall Street investment banks. The staffers listened to my arguments then one of the senior staffers spoke up.

“Listen Steve, banking industry is contributing mightily to get this legislation through. Now, just who do you suggest would contribute to defeat it.”

She wasn't trying to shake me down. She was simply schooling me on the facts of life that govern most of what happens in that town.

But really now, would it be too much to ask the politicians in charge of the leading capitalist nation on earth, to implement laws that walk that walk. Key to achieving that is first creating rules that allow the marketplace to really operate as Adam Smith envisioned – with incentives... but the right kind of incentives.

And the only way to do that is to make damn sure that risk... risk ... risk... is always, always, always, part and parcel of every business transaction on both sides of that transaction. And to insure that that risk is always, always always, aimed straight between the eyes of the party(s) responsible for every single decision that involves the care and feeding of other people's money ... particularly taxpayer money.

But I understand, it won't be easy to change the way business is done in America. As the old Simon & Garfunkel lyrics go:

Orangutans are skeptical
Of changes in their cages,
And the zookeeper is very fond of rum.
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