In today's New York Times, Paul Krugman offers an explanation for the cause of the mortgage meltdown. While I think he comes close to the mark, he misses an important point: bankers will respond to incentives.
I would love to have the talent that warrants the platform Krugman has -- to opine on economic and political matters on the pages of the New York Times. Krugman uses that platform to suggest that the reason for the bad mortgage loans is that bankers "haven't been forced to give back any of the huge paychecks they received before the folly of their decisions became apparent."
My view differs from Krugman's. There is no way bankers will give back their paychecks after they've negotiated their contracts just because Krugman wants them to. In my view, the real issue is that bankers are like any other person and they will respond to incentives. If their pay was linked to both the costs and benefits of the loans they made, then they would care about the risk that the loan might not be repaid.
But since bankers are paid only for the benefits of the loans they originate, they have a big incentive to originate as many loans as they possibly can -- regardless of whether they go bad or not.
As I've said many times before, one way to make bankers care about the quality of their loans is to put their pay in an escrow account. They can keep getting their enormous bonuses as they do now. But instead of getting the entire sum, the money would remain in escrow.
Each year that went by in which the loans they originated remained below a typical loss ratio, they would get a pro-rata share of that bonus. And after 10 years they'd get the whole thing.
On the other hand, if the loans went bad, the money in their escrow account would go to paying off the bank's shareholders for the losses they incurred due to the banker's poor decisions.
If bankers had been paid that way over the last several years, I would be willing to guarantee that the mortgage market would not be melting down right now.
If I could have written Krugman's op-ed piece today, that's what I would have said.
Peter Cohan is President of Peter S. Cohan & Associates, a management consulting and venture capital firm. He also teaches management at Babson College and edits The Cohan Letter.
Once again, OPEC has killed the goose that lays the golden egg
Closing Bell: Markets bounce after yesterday's sell-off; BA, F, GE, DOW all up, GS down 
Where have all the consumers gone?
Reader Comments (Page 1 of 1)
11-23-2007 @ 5:19PM
Jill Schottenstein said...
WILL THE GAO REQUEST A NATION-WIDE AUDIT OF ALL BANKS, AUDITING FIRMS, HEDGE FUNDS, INSTITUTIONAL HOLDERS, AND PUBLIC COMPANIES?
(JP'S AUDITER IS PRICEWATERHOUSECOOPERS)
PERHAPS SINCE THE SEC JUST HIRED A NEW ACCOUTANT PRICEWATERHOUSECOOPERS SHOULD GO FIRST?
PERHAPS AUDITING THE JUDGES SALARIES STARTING WITH GEORGE BUNDY SMITH IS A GOOD IDEA? ISN'T THE GOAL TO ELIMINATE COURT CORRUPTION AND KEEP THE BEST INTEREST OF THE CHILDREN?
Press Release: "Wayne Carnall Named Chief Accountant in Division of Corporation Finance;" 2007-239; Nov. 20, 2007
"Mr. Carnall has been a partner at PricewaterhouseCoopers since 1997. As a member of the National Professional Services Group, he worked with a number of large international clients and developed firm SEC reporting policies and practices for foreign private issuers. From 1991 to 1997, Mr. Carnall served in a number of positions of increasing responsibility in the Division of Corporation Finance including Associate Director for Accounting Operations. "
11-24-2007 @ 1:51PM
franz said...
Sales and Marketing Productivity by Chet Holmes
Two furniture stores open up in a town on nearly the same day. One is totally tactical and the other is very strategic. If you go in to look at couches in store one the salesperson tries to sell you a couch. Tactical. Over a four-year period, this store grows at about ten percent per year, mostly driven by the increasing costs of furniture.
In store two, of course they try to sell you a couch, but the management constantly trains the salespeople to sell the store. “First time in our store? Well, let me tell you about it.” And while the salesperson is on their way to the couches, they pitch the heck out of that store. They tell you about the history, the owner’s devotion to service, why they have lower prices than their competitors, how well trained they are on furniture construction and how that benefits you as the consumer.
The purpose of this buyer education is to create brand loyalty. Over time, this store builds a large and loyal following of customers who automatically come to them first when they are interested in any type of furniture. When you shop for furniture, you probably go to various stores with little or no brand loyalty. Or you may see a sale in the newspaper and go because of the sale. But if you had a relationship with a store that stood behind their product like no other and could thoroughly explain the differences in furniture quality (and there’s quite a bit to know) and even offered expertise in decorating, you might have an affinity, a loyalty, a preference for that particular store. When you needed furniture, you would go there first because of the relationship that they purposefully built with you. Over a four-year period the tactical store remained a one-store location and the strategic store opened six locations.
People will even pay more if they perceive there is a greater value or a deeper reason for buying from one provider over another. I cannot tell you how many times I’ve helped companies step up out of the commoditizing world in which they live by being more strategic. In a moment I’ll have you do an exercise that will really pound this idea home. Let’s do a little more set up so you get as much as possible out of the exercise to follow.
Here’s a question I want you to answer: When your buyer looks to purchase your type of product or service how much of an expert are they? When I ask this question in front of a large audience, everyone pretty much admits that in any given purchasing situation, the average buyer is not much of an expert. For example you are probably not much of an expert at all about carpet cleaning, are you? If most of your buyers are not experts at what to look for in your product or service, this opens a gaping strategic opportunity for the brilliant strategist to capitalize on.
I call this the science of setting the market’s buying criteria. Basically it means that every
buyer can be taught how to be a better buyer of your type of product or service. Using the
carpet cleaning example, the buyer calls in with loose or little buying criteria at all. The
salesperson then resets that buying criteria by educating that consumer about the EPA
studies on the importance of clean carpets to the quality of the air and life in your home.
You can do this for your company with profound results.
Chet Holmes has worked with over 60 of the Fortune 500 companies as America’s top marketing executive, trainer, and strategic consultant. Chet is the author of the best selling book, The Ultimate Sales Machine (#1 business book on Amazon, #1 Sales and Marketing book on Amazon, and also on NY Times best seller list). Chet has identified and developed the 12 core competencies that are proven to provide the main structure of truly great companies and he has developed more than fifty proprietary methods to implement them. To learn more about how to double the sales of your company, go to www.howtodoublesales.com
11-23-2007 @ 5:33PM
Luke said...
After reading Krugman's piece, I'm not sure the two of you are that far off. Sounds like you both see the same problem, and you have slightly different ideas on how to deal with that problem.
11-23-2007 @ 5:40PM
Janeg said...
The NewsVisual article on Freddie Mac http://www.newsvisual.com/newsvisual/2007/11/knowledge-map-s.html talks about the company’s plan to issue $5 billion in preferred stock in order to raise capital the company requires to offset its huge losses in the subprime market.
11-23-2007 @ 5:59PM
ken jacobson said...
sounds like another fox watching another henhouse.sorry about that, but that seems to be the way our country is heading.
11-23-2007 @ 6:17PM
Jill Schottenstein said...
"Why should ousted CEOs get to walk away with millions? Fortune's Allan Sloan takes a look."
By Allan Sloan, Fortune senior editor-at-large
November 13 2007
"Even if you flame out on Wall Street, you still get to keep the money. That's one of the lessons we learn from the fall of Chuck Prince and Stan O'Neal, who have bitten the dust because Citigroup and Merrill Lynch had to take billions in losses on securities that were overvalued on their books."
"Those write-offs will soon be followed by layoffs of a lot of people, some of whom may get retraining money or a buck of two of extra severance, if they're lucky. But the CEOs get to walk away with a bundle, and board members get to keep their highly paid part-time jobs. Sure, they'll lose some face, but they'll still be able to send the kids to college and keep the fancy house, and they will never have to rely on Social Security to retire."
"Wayne Carnall Named Chief Accountant in Division of Corporation Finance;" 2007-239; Nov. 20, 2007"
"Mr. Carnall has been a partner at PricewaterhouseCoopers since 1997.
As a member of the National Professional Services Group, he worked with a number of large international clients and developed firm SEC
reporting policies and practices for foreign private issuers. "
"Columbus, Ohio (June 15, 2006) - In a joint statement issued today, M/I Homes, Inc. (NYSE:MHO) and Steven Schottenstein announced that, after 27 years with the Company, Steven Schottenstein, Chief Operating Officer of M/I Homes, has resigned to pursue other interests. He will remain on the Company’s Board of Directors and continue to serve as Vice Chair of the Board."
"Robert H. Schottenstein, Chairman of the Board, Chief Executive Officer and President stated, “Steven has been a key member of senior management of M/I Homes for more than 27 years..."
"FIRST JUDICIAL DISTRICT INDEPENDENT JUDICIAL ELECTION QUALIFICATION COMMISSION ANNOUNCES QUALIFIED CANDIDATES.
"HONROABLE GEORGE BUNDY SMITH CHAIR FOR THE FIST JUDICIAL DISTRICT"
"IN FEBRUARY 2007, CHIEF JUSTICE JUDITH KAYE AND THEN CHIEF JUSTICE ADMINISTRATIVE JUDGE JONATHAN LIPPMAN ANNOUNCE THE MEMBERS OF THE INDEPENDENT JUDICIAL ELECTION QUALIFICATION COMMISSION FOR THE 12 JUDICIAL DISTRICTS IN NEW YORK STATE. THE STATEWIDE SCREENING PROCESS WAS APPROVED BY THE NEW YORK STATE COURT OF APPEALS
SCHOTTENSTEIN V SCHOTTENSTEIN FIRST DEPT. JILL SCHOTTENSTEIN V GEORGE BUNDY SMITH. IS THERE A CONFLICT OF INTEREST? WHY IS GEORGE BUNDY SMITH ADVOCATING AGAINST THE CHIEF JUSTICE JUDITH KAYE COMMISSION? WHY ISN'T HE HELD ACCOUNTABLE FOR HIS ACTIONS?
September 13, 2007, 12:22 pm
Former Judge Sues Governor on Behalf of Current Judges
"With this decision, this Court supports a public policy that says a man should never take on a parental role unless he wants to be unconditionally responsible for the child's financial support," Judge Bundy Smith wrote."
WHY DID STEVEN BUY JUDGE BUNDY TO FIGHT AGAINST PAYING FOR CHILD SUPPORT? IS HE AFRAID TO FILE THE CORRECT TAX RETURNS AND FEDERAL PAPERWORK?
On August 6, 2007 George Bundy Smith signed a brief submitted for Respondent Steven Schottenstein. On that day he swore on his 14 years as an experienced Judge,lawyer for the lawfirm of Chadbourne & Parke LLP. his entire career as a Judge of the highest court of the states.
He had a relationship with the chief Justice the Hon. Chief Justice Judith Kaye, of the States highest court.
It could be questioned why George Bundy Smith took this case was it for political gain or just the paycheck?
It cannot be questioned that he broke the rules of the First Appellate Dept. when he approached the esteemed panel of Judges including none other the Head Judge Jonathan Lippman to speak to the Judges in his own language.
He did so unquestionably to sway and distort the outcome of a young girls life that now suffers from SLE LUPUS.
The total improper behavior and appearance of impropriety that existed when George Bundy Smith walked to the podium and introduced pro hac vice attorney Barry Wolinetz, had the same affect as the speech that Chief Justice Judith Kaye gave the day of December 13, 2005. There is no mistake he had MOTIVE, INTENT, and acted to PREJUDICE my case!
The Hon Hiliary Rodham Clinton US Senator from NY was the evenings keynote speaker, the Hon, Judith S. Kaye, Chief Judge of the State of the NY received the William Nelson Cromwell Award for her unselfish service to profession and community.”
THERE ARE NOW 19 BANKS ASSOCIATED WITH THIS POSSIBLE ENRON SITUATION...
MI just filed a new 10 Q, they deleted their Accounting firm Deloitte and failed to enter the 4 million in derivities. In other words they are cheating the public shareholders. They did the same thing in 2005 in a S-4 when they merged and bought Shamrock Homes.. AS far as the stock going up, its being manipulated for appearances only. The insiders, directors are using funds to move the volume. They have never audited any books since 1986, and my guess is neither has their bookrunner JP Chase…look it up don’t take my word for it!
11-23-2007 @ 8:37PM
slevine7267 said...
Let the chips fall they may . . without tax payer bail outs.
11-23-2007 @ 8:39PM
slevine7267 said...
I have a friend whose income is less than $1000 a month on disability . . who has 15 credit cards and can't make the minimum payments. Whose fault is it?
Sheep who borrow money to play the casino in Vegas and lose . . TOUGH!
Banks that leant the money should suffer and not be bailed out. But they will . . just to keep the game going. America is built on credit.
No Misplced compassion for irresponsibly.
11-24-2007 @ 9:21AM
Brent said...
Talent? Paul Krugman? Get real. This ass shows his economic ignorance with every sentence. He neither understands the US economy nor can he explain the issues and problems that develop therein. But that's true for every Socialist, even those who have conned the NY Times into giving them credibility and paper space. But then again, the liberal Times has a pretty sorry understanding of this economy as well. Oh, and Mr. Krugman, how about returning the publisher's advance for your latest worthless book. Now, THAT makes sense.
Brent HUffman
Charlotte
11-24-2007 @ 10:02AM
Carol said...
that is a ridiculous comment. One issue has nothing to do with the other. Geez
11-24-2007 @ 10:11AM
william lindblad said...
When there is dissatisfaction, there will be an abundance of blame.
Cause is still evasive, but it would appear to be a combination of events rather than a singular. The most popular is the issuance of the balloon and arm style notes that will continue to re-set at higher levels and to this end we blame the banks and mortgage houses. Second is people living beyond their means. Third speculators. While these are surely correct, there is more. The more is the dangerous part as it went completely un-noticed and the chain of events that are driving up energy and food will soon bring this to the forefront. The default ratio of Fannie and Freddie provide the clue. These agencies do not engage in voodoo lending. They always have a fair amount of default, but they issue fixed rate. The buyers in this area are the first timers and low income. They are also the first to get laid off. What has gone un -noticed is that we have had years of systematic down sizing and layoffs. These people found other work, not always comparable, and slowly went into default. Now, if it hit the HUD market we can expect it to spill into the conventional market as well. Further slow-down in the economy will effect those that are living in homes as homes, have little desire to move and are current on their notes. That is, until they are next on the lay off list.
The real culprit is that the middle class is being slowly erroded and the disparity between top and bottom has been on the increase. The economic management has been essentially run by an oligarc concerned with their own well being.
11-25-2007 @ 6:13AM
Mike D said...
I like'd Krugman's idea.
As a former insurance agent who operated on the basis of an escrow account I can verify that this system works: Write good business, get paid well. Write inferior business, suffer a lame paycheck.
As an insurance agent, if you go out and write bad business (people who can't afford to pay), it will drop off the books and your commission will be charged back against your escrow account. The company gets your commission back, you find out that writing bad business ultimately pays you nothing, so you figure it out and start writing clients who can afford to pay their bills.
Or you fail and get out of the business as you ought to, because you're too dishonest to represent a client's financial picture accurately, or too dumb to figure out that writing bad business is bad business for the company that pays your commissions! It's that simple.
In the case of an insurance agent the escrow builds and depletes over a course of weeks, as you write several new customers a week, and those customers pay their premiums over a period of months. In the insurance business it only takes a few months' experience period before a customer proves whether they can afford, or whether they really want, the coverage that's been sold to them.
Under Krugman's proposal, the account builds over a longer period of time, i.e. you have a greater "experience period" of time for the loans you write to prove to be good or bad, as all mortgage customers want the product that's been sold them, i.e. money (a refi) or the house they're living in. In Krugman's proposal, there is a 10-year experience period which gives ample time for a CEO's underwriting standards to prove themselves profitable or unprofitable.
It's simple folks. Let the folks who enjoy the benefits of these commissions suffer the adversities of the pieces of business they write if they're bad pieces of business.
Enforce this type of policy, and you won't have the problem we now face; huge books of bad business that are falling like flies. Case closed!