Naked Economics by Wheelan, Charles (best books to read .TXT) 📗

likely to engage in accounting fraud and more likely to default on their debt.11

Meanwhile, CEOs (with or without options) have their own monitoring headaches. Investment banks like Lehman Brothers and Bear Stearns were literally destroyed by employees who took huge risks at the firm’s expense. This is a crucial link in the chain of causality for the financial crisis; Wall Street is where a bad problem became disastrous. Banks across the country could afford to feed the real estate bubble with reckless loans because they could quickly bundle these loans together, or “securitize” them, and sell them off to investors. (A bank takes your mortgage, bundles it together with my mortgage and lots of others, and then sells the package off to some party willing to pay cash now in exchange for a future stream of income—our monthly mortgage payments.) This is not inherently a bad thing when done responsibly; the bank gets its capital back right away, which can then be used to make new loans. However, if you take the word “responsibly” out of that sentence, it does become a bad thing.

Simon Johnson, former chief economist for the International Monetary Fund, wrote an excellent postmortem of the financial crisis for The Atlantic in 2009. He notes, “Major commercial and investment banks—and the hedge funds that ran alongside them—were the big beneficiaries of the twin housing and equity-market bubbles of this decade, their profits fed by an ever-increasing volume of transactions founded on a relatively small base of actual physical assets. Each time a loan was sold, packaged, securitized, and resold, banks took their transaction fees, and the hedge funds buying those securities reaped ever-larger fees as their holdings grew.”12

Each transaction carries some embedded risk. The problem is that the bankers making huge commissions on the buying and selling of what would later become known as “toxic assets” do not bear the full risk of those products; their firms do. Heads they win, tails the firm loses. In the case of Lehman Brothers, that’s a pretty accurate description of what happened. Yes, the Lehman employees lost their jobs, but those most responsible for the collapse of the firm don’t have to give back the huge bonuses they made in the good years.

One other culpable party deserves mention, and again misaligned incentives was a key problem. The credit rating agencies—Standard & Poor’s, Moody’s, and others—are supposed to be the independent authorities that evaluate the risk of these newfangled products. Many of the “toxic assets” now at the heart of the financial meltdown were given stellar credit ratings. Part of this was pure incompetence. It didn’t help, however, that the credit rating agencies are paid by the firms selling the bonds or securities being rated. That’s a little like a used car salesman paying an appraiser to stand around the lot and provide helpful advice to customers. “Hey Bob, why don’t you come over here and tell the customer whether he is getting a good deal or not.” How useful do you think that would be?

These corporate incentive problems remain unresolved as far as I can tell, both for senior executives in public companies and for other employees taking risks with their firm’s capital. There is a fundamental tension that is tough to resolve. On the one hand, firms need to reward innovation, risk, insight, hard work, and so on. These are good things for the firm, and employees who do them well should be paid handsomely—even astronomically in some cases. On the other hand, the employees doing fancy things (like designing new financial products) will always have more information about what they are really up to than their superiors will; and their superiors will have more information than the shareholders. The challenge is to reward good outcomes without creating incentives for employees to game the system in ways that damage the company in the long run.

One need not be a corporate titan to deal with principal-agent problems. There are plenty of situations in which we must hire someone whose incentives are similar but not identical to our own—and the distinction between “similar” and “identical” can make all the difference. Take real estate agents, a particular breed of scoundrel who purport to have your best interest at stake but may not, regardless of whether you are buying or selling a property. Let’s look at the buy side first. The agent graciously shows you lots of houses and eventually you find one that is just right. So far, so good. Now it is time to bargain with the seller over the purchase price, often with your agent as your chief adviser. Yet your real estate agent will be paid a percentage of the eventual purchase price. The more you are willing to pay, the more your agent makes and the less time the whole process will take.

There are problems on the sell side, too, though they are more subtle. The better price you get for your house, the more money your agent will make. That is a good thing. But the incentives are still not perfectly aligned. Suppose you are selling a house in the $300,000 range. Your agent can list the house for $280,000 and sell it in about twenty minutes. Or she could list it for $320,000 and wait for a buyer who really loves the place. The benefit to you of pricing the house high is huge: $40,000. Your real estate agent may see things differently. Listing high would mean many weeks of showing the house, holding open houses, and baking cookies to make the place smell good. Lots of work, in other words. Assuming a 3 percent commission, your agent can make $8,400 for doing virtually nothing or $9,600 for doing many weeks of work. Which would you choose? On the buy side or the sell side, your agent’s most powerful incentive is to get a deal done, whether it is at a price favorable to you or not.

Economics teaches us how to get the incentives right. As