1. Failed Governance and Perverse Compensation Caused the Current Crises William K. Black Associate Professor of Economics and Law University of Missouri – Kansas City Governance of the Modern Firm Universiteit Utrecht December 12, 2008

2. An unusual U.S. perspective Staff leader of successful reregulation of S&L industry in face of political opposition Heterodox law & econ. scholar White-collar criminologist: elite fraud & corruption Expert for the regulator in its case against Fannie Mae’s former senior leaders

3. U.S. Governance: abject failure Most elite & sophisticated firms In a law & econ. paradise Plus: governance reforms (SOX), advanced governance research, & an info./modeling revolution In “the great moderation” Produced a catastrophe

4. But it’s worse than that An “epidemic” of mortgage fraud Virtually no corp. heroes Virtually no corp. leadership – except to corp. socialist trough and for accounting fraud Virtually no elite accountability – no “poster child” in prison Triumphalism vs. Gresham’s

5. Fraud epidemic facts FBI warned of it in 2004 Corp’s aided it: continued to gut underwriting, controls & spread MBA’s priority: stop reg., not fraud FBI took advice from the perps Nonprime fraud incidence: >40% 80% of frauds induced by lender Invest. banks: 34 referrals (03-07)

6. Every day: new scandals Madoff’s “giant Ponzi scheme” Results: “Too good to be true” Madoff morals: give $300 M in bonuses at end to ensure clients suffer total loss Steven Gordon pleads guilty to crude mortgage fraud. AUSA: "You would think there would be more due diligence."

7. Governance implications No one did any underwriting – at >7 levels at multiple firms Controls suborned deliberately to hide the massive fraud Has to be done systematically, can’t be hidden from BOD Requires firing, intimidating or suborning your personnel Expertise = never using expertise

8. Looting the firm w/o going to jail Bad loans, huge leverage & rapid growth optimize accounting fraud & maximize comp. CEO can’t send a memo. urging that strategy But he can send that message: through comp. Gresham’s dynamic sends it to rival firms, extending bubbles

9. Ask the experts how it’s done Don't just say: "If you hit this revenue number, your bonus is going to be this." It sets up an incentive that's overwhelming. You wave enough money in front of people, and good people will do bad things. Franklin Raines: CEO, Fannie Mae

10. Do as I say, not as I do “ By now every one of you must have 6.46 [EPS] branded in your brains. You must be able to say it in your sleep, you must be able to recite it forwards and backwards, you must have a raging fire in your belly that burns away all doubts, you must live, breath and dream 6.46, you must be obsessed on 6.46…. After all, thanks to Frank, we all have a lot of money riding on it…. We must do this with a fiery determination, not on some days, not on most days but day in and day out, give it your best, not 50%, not 75%, not 100%, but 150%.”

11. The anti-canary “ Remember, Frank has given us an opportunity to earn not just our salaries, benefits, raises, ESPP, but substantially over and above if we make 6.46. So it is our moral obligation to give well above our 100% and if we do this, we would have made tangible contributions to Frank’s goals.” (Mr. Rajappa, head of Fannie’s internal audit.)

12. Rival concepts of the problem Law & economics: government and overly cautious CEOs Governance scholars: weak governance and excessive risk Contradictory. U.S. policy an incoherent blend of both Neither addressed the acute problem explained above

13. Law & econ. praxis caused the crisis, governance didn’t stop it Governance scholars’ good ideas missed the acute problem Law & econ. praxis optimized the “criminogenic environment” Neither identified the real problem Risk isn’t the issue or the problem Fraudulent CEOs (1) make sure BODs don’t govern & (2) hate good government ideas

27. Can’t govern a control fraud Because the ideas are useful control frauds won’t use them Formal compliance is an illusion Their “tone at the top” – enriching those creating the most fake income – aids fraud Remove corrupt CEOs from office Use prisons to govern them