The House of Cards, Jean-Baptiste-Siméon Chardin, 1736–7
You remember what has gone before. I posted some text called, “My Worst Prediction Ever: Corporate Leisure Time,” and before you knew it, I was claiming that the recent fad for paying top corporate personnel mostly by huge bonuses rather than by straight, if large, salaries is what caused the world financial melt-down of 2008.
“Oh,” you say, “what nonsense! How could so simple a bookkeeping device have such catastrophic effects?”
Well, like this. Let’s say that the board of directors of the XYZ corporation calls you in and says, “Mr. Phan, we like the cut of your jib, so we’re going to offer you the job as our CEO. Since you don’t have an impressive work history, the salary we can offer you is only $37.50 a week. Now, we know that’s not much. But we’re willing to pay for results.
“So here’s what we’ll do. XYZ’s stock hasn’t been doing well in the market lately. It’s been running at about $18 a share on the Big Board. We’d like to see it at around $30. We will give you a year to get it done, and we don’t care how you do it, but if 365 days from today, XYZ is at that higher figure, we’ll give you a $2 million bonus.”
So what would you say to that? I think I know what you would say. I think you would say, “Yes, sir!” And I think you would say it with great speed, so the nice XYZ man wouldn’t have time to change his mind. After all (you might calculate) there was a chance that you could just stumble into some new business opportunities that would actually make the company gain that much in a year.
And — this, you promise yourself you might try but only as a very last resort — you might go to dealing in those “derivatives” that nobody seemed to understand but some people seemed to be making an awful lot of money on.
What are these “derivatives”? There are two that caused most of the trouble, and they are called “sub-prime mortgages” and “credit-default swaps.” The sub-prime mortgage is easy enough to understand. “Sub” means below and “prime” in this case means “a good investment.”
So what happened is that some banker (call him the “predatory lender” or just “thief”) had gone to nice old Mrs. Whitehead, who had lived in the shotgun flat behind the AME church since Lyndon Johnson was in the White House, and made her an offer she couldn’t refuse. “Sign this mortgage paper,” he said, “and I’ll give you forty thousand dollars. Here’s a pen.”
Now Mrs. Whitehead is not a fool. The first question she asks him is how in the world she can make the payments called for on a monthly income that is derived mostly from Social Security, plus what few bucks remain of what Mr. Whitehead left when he passed. But she’s not a CPA, either. Thief shows her in black-and-white that her house cost $10,000 when she and the Mr. bought it, has been gaining value ever since.
Were the payments on a $40,000 mortgage too onerous? No problem. Before you know it the house will become worth $60,000 or more. So you refinance at the new value, pay off the old mortgage, and walk away with a few thousand more of spending money, and ain’t America grand?
That system worked well as long as house prices kept going up … but not one day longer.
Then the system came cascading down. Real estate prices stopped rising, maybe dipped a little. Mrs. Whitehead couldn’t pay her mortgage any more. Thief’s bank foreclosed and poor Mrs. Whitehead was out on the street.
Did Thief know that was going to happen when he sold her that first mortgage?
Of course he did. He just didn’t care. His pay wasn’t based on how reliably the customers paid off their mortgages, it was based only on how many mortgages he sold.
That’s when I might lose you. “Hey,” you say, “hold on a minute. If that’s the way these people run their bank, aren’t they going to wind up with a vault full of worthless paper?”
I pat you on the head. “Exactly, my son. They do.” Of course, they could foreclose the mortgage — say the one on poor Mrs. Whitehead’s shotgun flat. But what would they do with the house once they had taken it over? If they want to get actual money, they have to sell it. But in today’s market, all they could get for it is say, $35,0000, while the amount due on the mortgage — the amount they’ve been carrying on their books as an asset — is now at, say, $50,000. So every mortgage foreclosure that they handle in that traditional way shows up on the books as a thumping great cash loss for the bank, and there are millions and millions of them.
You think that over for a moment, then you sigh. “Beats me,” you say. “I don’t see any way out for the bank. They should have seen this coming and avoided it, maybe by being a little less unethical in the way the loans took place. But they didn’t, and now only a miracle can save them.”
I have been patting your head again, this time quite hard. “Clever child!” I cry. “That’s what did it for them, at least for the moment. A miracle! Have you ever heard of transubstantiation?”
Bruce Cohen (SpeakerToManagers) says:
It’s actually quite a bit more corrupt than that. Say I’m Mr. CEO, and I can get a $2 million bonus for increasing corporate profits 10%. But it turns out that half of the board of directors are personal friends or colleagues of mine, so I tell them that I’d really like to stay with the company and help them get rich, but I’ve heard about a larger company that may need a new CEO soon, and that I’m thinking I’d like to apply there. But being an old friend I don’t want to leave them in the lurch, so I’d be willing to stay if they give me $10 million if I’m still with the company at the end of the year. They like me and want to keep me, so they agree. Now I don’t need to care what happens to corporate profits, or whether I do a good job; I can just go golfing and vacationing, and get $10 million dollars just for not quitting.
What’s worse even than that is that, since I don’t have to care if the company does well, I can use my powers over the operation of the company to manipulate the stock, and get rich betting on it, even if what I do hurts corporate profits.
April 4, 2009, 3:26 pmStefan Jones says:
I agree with everything here, but a minor correction:
A sub-prime mortgage is not a derivative. There’s nothing complicated about it . . . it’s just a egregiously irresponsible financial “product.” Bad for the borrower and for the lender.
The connection with derivatives: For a small, responsibly run bank, a sub-prime loan would be unthinkable. But dishonestly rated bundles of bad loans, insured by derivative-based financial instruments, allowed mortgage salesmen to go crazy.
There’s a benefit to backing agencies like “Freddie” and “Fannie,” but they have to be run as a service, not a business.
April 5, 2009, 12:27 amMarc Novak (observer) says:
Re: Cascading effects of reckless companies
It seems that a particularly effective method for focusing the minds of “the powers at be” within corporate organisations is personal liability. Having seen this in action over the years the word “focus” is actually an understatement. When there’s a legal requirement to rollout legislative change with personal accountability attached, “all consuming obsession” is probably more accurate.
I think it would be nice to see this method extended into business areas/models that have the potential to adversely impact financial events outside of an organisation, specifically in the industries noted in the blog text. Thankfully I don’t believe it’s currently possible to insure against personal liability within the corporate world.
April 5, 2009, 8:01 amJeff says:
<a href=\"http://jeffcrook.blogspot.com/2009/03/collapse-of-mayan-civilization.html\">The Collapse of the Mayan Civilization Revealed</a>
<i>Therefore, the priests began lending money to the farmers so they could farm more land and buy more assurances of rain. Some farmers discovered that by placing themselves into massive debt to the priests, they could produce enough milk, fiber and korn to become incredibly wealthy themselves, which allowed them to pay extra money to the priests to short the other farmers their portions of rain, destroying their farms and driving them out of business. Thus land became cheap. Then the farmers discovered that they could sell their own version of assurances back to the priests, with the guarantee that if in fact it didn\’t rain, contrary to what the priests had assured, they would pay the priests a guaranteed portion of their crop with which to offset the losses on the priest\’s assurances.</i>
April 6, 2009, 8:33 amPyrtolin says:
Everything you’ve said here is true, but it misses the other side of the story in some cases.
Take that first case. After all that is done and the Board has shown the door to the people responsible for digging them into a hole, they’re still in a hole and need someone to fill it. Now, they track down a fellow with considerable talents to fix the problem and are faced with a dilemma- they’re hiring him to fill a hole. Once that hole is full, he’s out of a job. What’s more, if he happens to get a better offer when the hole is close to full, there’s a good chance that, being somewhat rational about his long term interests, he may well walk away and take his knowledge of what still needs to be done with him.
In this case it makes a lot of sense to say. “We’re going to pay you enough to get by while you work, but if you stay the whole term and finish the job properly, we’ll make it worth your while.”
There’s a fine line between the two, and most of it lies in how concrete the goals are and who is dependent on the other for support. It’s good insurance against loss, but about as good for wish fulfillment as any of the classic wish-granters.
April 7, 2009, 12:23 pmTina Black says:
Actually, some crafty debtors have taken to demanding to see the note that gives the foreclosing group’s proof that they actually own the loan. Sometimes this shuts down foreclosure for quite awhile, and for the lucky winners it shuts it down for good.
April 18, 2009, 11:15 pm