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Leadership lapses fuel Wall Street's fall

(chinadaily.com.cn)
Updated: 2008-10-23 19:11

Donaldson has helped companies develop a system in which a trusted senior executive is designated as a sounding board for employees who don't want to put their careers at risk with a public campaign, but are concerned about broad-based unethical behavior. Many firms have ombudsmen, but they are usually lower down in the corporate hierarchy. He suggests that companies should designate a senior manager to be open to these types of conversations in order to assess and protect against potentially damaging reputational risk.

US businesses need to be aware of what a tribe in New Guinea called "mokita," or the truth that everybody knows but agrees not to speak about, Donaldson advises. "When it came to subprime and many of the other problems that have tripped up Fannie and Freddie and so many others, there was mokita."

Moral hazard

Eric Orts, a Wharton professor of legal studies and business ethics, worries about the so-called "moral hazard" created when financial services companies get a government bailout to stave off widespread economic disaster. Such rescues may contribute to weak leadership, because "markets for efficient organizations work only when they are allowed to correct and punish mistakes and mismanagement. ... Some of the current examples of very large government bailouts are setting bad precedents for the future."

He concedes some bailouts may be necessary to prevent a broad collapse of the financial system, but the need to take such extreme measures is a clear indication that a regulatory overhaul is necessary to reduce the long-term economic risk to taxpayers.

Donaldson suggests better regulation is only one solution. "Unfortunately, regulation typically lags behind awareness in an industry," he says, predicting that the unregulated hedge fund industry may pose the next big challenge to the economic system. "We're maybe one or two big hedge fund failures away from Congress stepping in with regulations."

However, the Sarbanes-Oxley legislation passed in the wake of massive accounting scandals has not solved those problems entirely and has introduced new challenges. "The solutions lie with the hedge fund industry policing its own house." How would that happen? "It means asking the questions people in polite conversation don't want to ask," says Donaldson.

The combined public and private missions of the Federal National Mortgage Association and the Federal Home Loan Mortgage Corp. may have contributed to special leadership problems at those companies.

"A quasi-public private organization, such as Fannie Mae or Freddie Mac, has difficulties in terms of playing a dual role (of) enhancing the ability of private individuals to gain mortgage financing to purchase their own homes ... and maximizing shareholder value in a highly competitive environment," says Orts.

Meanwhile, pressure within the mortgage industry intensified the disconnect between the dual roles within both Fannie and Freddie. "Mortgage securitization seems to have been allowed to spiral out of control with insufficient regulatory oversight. Pressure to increase profits at Fannie Mae and Freddie Mac led to excessive financial risk-taking rather than prudent banking."

In retrospect, he adds, regulatory efforts to encourage competition between Fannie Mae and Freddie Mac were misguided because they intensified the pressure on entities that were not completely free-market vehicles. Leaders either did not understand or were unable to balance the goals of a "public-private hybrid" Orts notes. "It might be more sensible to have a clear division between 'public' and 'private' organizations in order for them to focus on a clear mission."

Donaldson points out that Fannie Mae and Freddie Mac spent more than $150 million on lobbyists over the past decade, illustrating another leadership problem stemming from the organizations' structures. "That's wholly inappropriate for a government agency and yet, given the way the business model was set up, lobbying had to be an attractive option for the leaders -- though perhaps not to that extent," he says.

Gary Gordon, who follows Fannie Mae for Portales Partners, an independent equity research firm in New York, says the leadership failures at Fannie and Freddie were aggravated by the recent housing price bubble that has led to problems across the financial services sector.

While asset bubbles are common, from tulips to Internet stocks, the housing bubble was even more difficult to prick because the price inflation benefited so many Americans across the income spectrum. "I'm not sure you can come up with a system that could fix it," he says. "You would have to create a system where some human being would blow the whistle as everyone else is benefiting."

Moshe Orenbuch, a Credit Suisse analyst who follows the mortgage industry, says Fannie and Freddie came under the same pressures that led private mortgage firms and companies in other industries to restate income related to derivatives. Fannie and Freddie continued to write loans after the credit markets seized up in 2007 in order to fulfill their public mission, leaving them with a greater share of the market and more problem loans. "If you take market share without tightening criteria, you effectively loosen," notes Orenbuch.

In recent years, regulators did raise questions about management at the government-sponsored housing lenders. In 2006, the Office of Federal Housing Enterprise Oversight (OFHEO), which monitors the financial health of Fannie Mae and Freddie Mac, released a report describing an arrogant and unethical culture at Fannie Mae where employees manipulated earnings to generate higher bonuses for executives between 1998 and 2004.

"Our examination found an environment where the ends justified the means. Senior management manipulated accounting; reaped maximum, undeserved bonuses; and prevented the rest of the world from knowing. They co-opted their internal auditors. They stonewalled OFHEO," said James Lockhart, the director of OFHEO when the report was released.

Companies can get into dire straits when they ignore early signals of problems like those at Fannie Mae and Freddie Mac, says Robert Mittelstaedt, a former Wharton dean who now leads the W. P. Carey School of Business at Arizona State University. "These warnings kept popping up. At some point in time there had to be somebody somewhere in these organizations that said, 'This just doesn't feel right.' It's a common mistake."

Reproduced with permission from Knowledge@Wharton, http://knowledgeatwharton.com.cn. Trustees of the University of Pennsylvania. All rights reserved.

 

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