The Subprime Mortgage Scandal - What Really Happened

As in the wake of Enron, there's now a lot of discussion about the collapsing subprime mortgage market as we all try to determine just what went wrong and who (if anybody) defrauded who, when. First, there was a change in the law that allowed loans to be treated (and traded) far more freely, as if they were securities.

Unfortunately, the ultimate purchasers of the loans (such as hedge funds) didn't stop to analyse how the legal changes in the resale market had suddenly removed any incentive for the initial "lenders" (who were now really more like scouts than investors) to vet homebuyers. Largely, although not exclusively, the large investment institutions who were hurt when the music stop "fooled themselves." Or rather their hirelings profited (in the short term at least) from self-deception or a lack of "fiduciary curiosity", to coin a term - while the firms who paid these bozos their bonuses lost an far bigger pile of money.

What's most interesting is the parallel between the functionaries who ultimately stuck their investment firms with these loans and the similar functionaries in accounting and stock-sales firms who fully cooperated with Enron frauds with similarly disastrous results (See the film "The Smartest Guys in the Room.") Again and again, decade after decade, now; the big money seems to be in making "Dutch Book" between the interests of large financial institutions, and that of their higher-level managerial staff, who turn out to be very willing to betray the long-term interests of their employers. Bonus structures focused on the short-term obviously exacerbate those differences (conflicts of interest!), which are already extremely problematic for ordinary stockholders.

In support of this view, many of the biggest losers were hedge funds, and note this quote :

"...the top 25 hedge fund managers combined appear to have earned more than all 500 S&P 500 CEOs combined (both realized and estimated)."

(originally from Steve Kaplan and Joshua Rauh, http://www.nber.org/papers/w13270)

Who can doubt that bonuses for short-term "performance" were a big part of those "earnings?"

It may be that enough evidence is in now in to suggest that with few exceptions, bonuses for management that exceed a small fraction of their wage are an irresistible encouragement to fraud, particularly if the crimes first originate outside that company and give the illusion of allowing theft without ultimate responsibility. It isn't possible to plug every mousehole, that is, to remove every possible fraudulent scheme; so dangling huge carrots in front of executives that most will only be able to reach if they tell themselves and their bosses a few convenient (but eventually very costly) lies is a very bad idea - unless you've just gotten your management degree and want to improve your lifestyle, of course.

The take home lesson for investors, institutional or individual, is to find out the bonus structure before you buy stock in a firm. If it is high enough to heavily reward theft or fraud, invest elsewhere. Originally published by the same author at http://www.completeconfusion.com

The author's hobby site is BestPaperAirplanes.com a free site with original paper aircraft designs to build and fly.

PhotoperiodEffect.com has information concerning new scientific discoveries in chronobiology and the connection between too much light, too little darkness, and our health.

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