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Orangutans Hate Changes in Their Cages

By       Message Stephen Pizzo     Permalink
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If Barack Obama's economic team wants to make changes in how American businesses do business, there are two relatively simple changes that, if made, could change everything.

I'm no economist, but  I do understand accidents waiting to happen when I see them. And, I think now that even the most committed free-marketeers would agree that accidents have happened under the current scheme of things. And those accidents have happened before -- and happened and happened again. Obviously something has to change.

While there will be furious opposition to the two changes I write about here, keep in mind that one definition of “crazy” is doing the same thing over and over and each time expecting a different outcome. But those who will oppose these two changes are crazy alright, crazy like foxes. Because they've benefited mightily under the rules as they are. Even when they cost others billions, they do fine, thank you very much.

If we want to be in the same fix we're in now a decade down the road, or likely a worse one, then don't make these changes. Just add a few more federal regulators to the beat, who will, as they have in the past, be quickly marginalized by heavyweight corporate lawyers. And let the games begin anew.

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Or enact these two fundamental changes:

Change No. 1: Stop letting the foxes hire the chicken coup guards.

One of the mysteries I and my coauthors of Inside Job sought to answer was just how so many savings and loans could have been looted into insolvency right under the noses of their own “independent” accounting firms. The answer became almost immediately obvious.

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Under current rules governing federally-insured financial institutions and publicly traded companies, each submit an independent audit each fiscal year. Such audits are conducted by accounting firms like  Pricewaterhouse-Coopers LLP, Deloitte & Touche, Ernst & Young LLP and such. These are independent companies, the idea being that they have no dog in the fight and will produce an objective report on these company's true financial condition.

But the law then defeats its purpose by requiring companies and financial institutions pick the accounting firm they want, and pay them like any other subcontractor. The larger the institution to be audited, the larger the paycheck for the accounting firms. Also these auditing companies also offer a host of other for-fee services to companies, from financial consulting to human services. The audit job is a foot in what could be leveraged into a lot of other fees unassociated with that firm's audit functions.
 
Lincoln Savings crook, Charles Keating, was famous for offering lucrative jobs to auditors or their spouses once their audit is completed.

Getting the picture?

I could go on for pages with tales like that. But here's my point. There's a very simple fix to this obvious flaw, and here it is:

Rather than having companies hire their own auditors, they should instead be required to purchase audit insurance from companies formed to provide just that kind of coverage.

This audit insurance would protect shareholders and taxpayers in the event that an audit misses insider fraud or overly risky investments, Madoffishness  etc, that later creates significant loses. The cost of these audit insurance policies would be priced like any other insurance product, based on the risks being insured. Right there companies would have a new incentive to keep risk under control as it would lower the cost of their policy.

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It's all about incentives in business. Create incentives to do the right thing because it saves or makes money, and they'll do the right thing. Create incentives to do the wrong things because that makes money, and they'll do the wrong thing. Audit insurance creates the incentive to do the right things – keep risks under control. Duh.

The second flaw audit insurance would solve is the most obvious one –  companies would no longer hire and pay their own auditors. Instead the insurance company sure as hell would. Insurance companies would not write a policy for tens of millions, may hundreds of millions of dollars for an  unknown entity filled with unknown risks. These insurance companies would either have their own in-house accountants comb the books of those seeking a policy or they would  hire one of the established accounting firms. But this way those independent accounting firms would now have a completely different set of incentives. Rather than trying their best not to alienate their corporate client, they would be anxious not to let down their new client, the audit insurance companies. The last thing one of these giant accounting firms would want is to give a company a clean bill of health only to have it fail months later costing their new client, the audit insurance company, a bundle.

Got it? Simple. Easy. So, duh. Double duh.

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Stephen Pizzo has been published everywhere from The New York Times to Mother Jones magazine. His book, Inside Job: The Looting of America's Savings and Loans, was nominated for a (more...)
 

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