JURIST Contributing Editor Nancy Rapoport of the William S. Boyd School of Law, University of Nevada Las Vegas, says that the current financial crisis reflects a failure on the part of lawmakers and regulators to learn some of the key lessons of the Enron collapse several years ago....
n 2002, after Enron had collapsed, Congress scrambled to enact the Sarbanes-Oxley Act in an attempt to shore up market confidence and remove the incentives for future corporate disasters on the scale of Enron, WorldCom, and similar fiascos. Now, it's six years later and we're in an even worse mess. Why? There are a couple of reasons for our current situation: First, you can't separate risk from responsibility without suffering serious adverse consequences. Second, imposing regulations without controlling the improper incentives is a futile activity. Whenever you separate risk from responsibility, you get catastrophic results.
If we had to pick the theme of the current crisis, it would be that separating the risk of a deal from the deal's potential rewards (if the deal works) or from its adverse consequences (if it fails) leads the dealmakers to take on much more risk than they would if they had to keep those deals on their own books. Consider the components of this particular crisis: First, the government asked lenders to make loans to people who were normally passed over for mortgages at good market rates. (Great idea; but, as we know, the road to hell is paved with good intentions.) Then these subprime mortgages were packaged into securities that were then sold, with less-than-accurate ratings, to third-party entities. Those sub-prime mortgages were based on the theory that people who couldn't qualify for "normal" mortgages with "normal" downpayments or sufficient income would somehow be able to afford an adjustable-rate mortgage that would adjust way above the their true ability to repay. Then we added in a wholly unregulated derivatives market based in part on those poorly conceived securities. Finally, we mixed in the expectation that some combination of market information and regulation would prevent companies from the risks of dramatic undercapitalization. That's the recipe for today's crisisâand we're not just eating crow now.
Enron's downfall was described as a house of cards, but our current house of cards is a mansion in comparison: one built on a sandbar, awaiting the first ripple of economic downturn before collapsing in on itself.
And the group that least suffers the consequences of stunningly bad decisions? That would be the CEOs who manage to lose their companies while retaining the benefits of their golden parachutes. We taxpayers are going to be on the hook for billions, and the failed CEOs are still going to be millionaires. Even the failed Congressional bailout provided that CEOs who seek a governmental handout would still be eligible for a salary of "no more than" $500,000. Did we learn nothing from the Enron crisis?
Well, apparently we didn't. But here's what we should have learned:
- Rushing into regulation without paying attention to the incentives that the regulation provides is just window-dressing.
Just as it did during Enron's fiasco, Congress is rushing to fix the problem out of genuine fear that the failure to do something will lead to the next Great Depression. This current crisis appears far worse than the crisis that Enron and the other corporate scandals of the early 2000s, and time is at a premium. But the actual underlying causes of the crisis are not going to be easy to fix with an omnibus solution. How is Congress to strike the right balance between encouraging innovation to capitalize a company (the smart new ideas) and preventing companies from fully divorcing risk from responsibility (the dumb ideas)? If Congress over-regulates, the economy will lose the ability to move forward after the crisis passes. If Congress under-regulates, we're right back to where we started (or worse).
An example? Giving Treasury unfettered, unappealable discretion to fix the crisisâthankfully, a proposal that everyone has already shouted downâis the same "no risk" idea that got us into trouble in the first place. That type of regulation would create a frightening precedent for handling future crises, even though we might have faith in the two personalities (Bernanke and Paulson) who are urging us to trust them to find the right solution.
On the other hand, one of the proposals bubbling up that actually might create incentives for proper behavior is the one that dramatically reduces CEO pay for those companies that make use of the bailout. If a chief executive wants to keep his lucrative pay package, then he should make the choices that will keep his company in the black. Fail to do that, and the executive shouldn't reap big benefits from failure.
- Don't underestimate greed as a motivator.
Ponzi schemes (which look a lot like many of the deals that have already cratered) have been with us for millennia (even before Ponzi was born). Our best hope is not to eliminate greed from the market. Such an option is just like the old joke about the economist who is stranded on an island with a can of food and no opener. To open the can, the economist will just "assume a can opener." That ideaâthat we can assume the impossibleâwill starve our economy just as it starves the economist in the joke. We can't pretend that greed (or, more nicely put, the drive to make profits in an economy) is going to go away during the crisis. Congress needs to ask itself what unintended consequences are going to come from the bailout, given that companies are going to do everything they legally can to find work-arounds to the regulation.
- Humans are hard-pressed to learn from their mistakes.
Why didn't we learn from Enron? Enron was the very definition of greed run amokâof deals that didn't make financial sense and large-scale cover-ups of the failures of those deals to work. We didn't learn from Enron because even the smartest of people have an enormous capacity to fool themselves. Deal-makers who view themselves as the "smartest guys in the room" are not going to be deterred from making fraudulent deals by the threat of criminal sanctions, because they're not going to believe that they could get caught. Even well-intentioned people who think that they're following the law can talk themselves into going forward with a foolish deal because no one else working on the deal is willing to be the one person pointing out that the emperor has no clothes. Desperate people who need to make their budgets will commit to deals that cross the line because of cognitive dissonanceâthe inability to reconcile one's belief that he or she is a good person with the understanding that he or she is doing something really, really awful. A combination of groupthink and cognitive dissonance contributed to Enron's demise, and that combination is likely to do us in here as well, if we're not careful.
Risk must be linked to responsibility, and incentives will always dictate performance. Without a clear understanding of those two principles, no bailout can possibly save us from ourselves.Nancy B. Rapoport is the Gordon & Silver, Ltd. Professor of Law at the William S. Boyd School of Law, University of Nevada, Las Vegas.