Risky Business or Fraud?

The accounting scandals that brought Enron down, creating a crisis of confidence among investors that resulted in Sarbanes-Oxley, may pale in comparison to the fallout from the government's bailout of financial companies.

The Federal Bureau of Investigation (FBI) has launched preliminary probes into Fannie Mae, Freddie Mac, Lehman Brothers Holdings Inc., and American International Group Inc., to determine whether fraud at top levels of the organizations caused some of their problems. But determining the difference between risky business practices and fraud could be tough. According to The Wall Street Journal, prosecuting wealthy bankers who helped to inflate the mortgage bubble will be a tough call because the financial vehicles involved are so complex. A more likely outcome of the investigations will be more retail-level fraud cases similar to the ones already brought against brokers, real estate agents, and buyers who provided false information on mortgage applications. In short, it's unlikely that a Charles Keating (who went to prison in the savings and loan crisis) will emerge, but some Fannie Mae executives are already being called on the carpet for sweetheart mortgage deals. The Journal reported that Countrywide Financial Corp. made "large, previously undisclosed home loans" to Fannie Mae executives including former Vice Chairman Jamie Gorelick and former CEO Franklin Raines.

Investors, however, don't need a Keatingesque poster child to recognize Enron-like ethical problems and lapses in leadership in the firms at the heart of the bailout. Main Street already has a pretty low opinion of Wall Street.

Wharton professors trace the problems back to the 1980s, when businesses started aligning executive incentives with shareholder interests at the expense of managing in the best interests of the company overall. Wharton professor of management Peter Cappelli says that too many managers choose not to lead, believing that if they hire smart people and provide huge financial incentives for individual results, management of the firm will take care of itself. He adds that, particularly in investment banking, managers are harsh and ineffective, creating a culture where lots of bonus money based on individual performance covers up all the problems. Read more about this "moral hazard" here.