Brief flashback: In the early 1980s, Bob Beck joined Bank of America as the head of human resources. The B of A was suffering from a lot of bad loans made to countries in Latin America. The source of the problem was soon clear to Bob: Loan officers were compensated on the volume of loans they made — the more loans, the higher their compensation. They would take the money and, in some cases, leave the bank before the loans went bad. But in any event, their rewards were not contingent on making loans that would actually be repaid, just on the volume of loans they originated.
Fast forward to the present and we can see the same factors at work creating the present financial debacle in the mortgage market. A colleague’s wife works for Fannie Mae — the large mortgage company that is a government-sponsored entity now in a form of conservatorship with the government backstopping the company. Fannie Mae, during the time it got into trouble by underwriting mortgages that would likely default and — believe it or not, even up this very moment — rewards people on the basis of the volume of loans they underwrite. Just the other day this person complained that she had “wasted” three hours reviewing loans that she had to turn down. The time was wasted because no loans were made, and thus no progress was made on the path to earning bonuses. Of course, taxpayers, now implicitly on the hook for Fannie’s problems, might take a different view and think that hours spent reviewing loans that shouldn’t be made was time very well spent.
It’s not just financial institutions that have reward systems that cause financial debacles. While I was writing a case on Fresh Choice, the salad buffet restaurant chain that went into bankruptcy, the CEO told me he was trying to clean up the mess created by a real estate executive who had signed lots of leases in geographically dispersed locations, many of which made no economic sense. The real estate executive, by that time gone from the company, had been compensated based on the number of leases/locations signed up. So he had done what any rational person would do—signed as many deals as he could. Others would have to clean up the financial disaster that ensued from having restaurants in the wrong places.
There are many, many instances of financial incentives driving behavior that then causes organizations major problems. This fact raises the question of why no one ever seems to learn anything—which explains why the current situation with home mortgages looks remarkably like the case of making bad loans to countries that couldn’t repay them about 25 years ago and a little like the savings and loan mess of the late 1980s.
I can point to three key reasons why collectively we seem to learn nothing from past mistakes:
- Lack of focus on understanding failure. Go to a leading business school and find me the business historians. Good luck. Or, for that matter, the cases on failure. We find history boring and are much more interested in successes—witness all the media attention to Google—than on learning from mistakes.
- Over-reliance on compensation as a management tool. Most people suffer from an “extrinsic incentives bias”—the belief that others are motivated by money even if we know we are not. For instance, Kaplan, the test preparation company, gave a survey to some people taking the LSAT. While only 12% of those responding said they were interested in law school for the money, these same people thought that 60% of their fellow test-takers were. Coupled with the large compensation consulting industry and a belief held with almost religious fervor that properly designed incentive schemes are necessary to get the right behavior, most organizations overemphasize pay as an element in their management system.
- Omnipresent managerial hubris. Finally, there is the amazing resilience of managerial hubris—pride. Although executives obviously know many instances of how poorly designed reward systems produced behavior that caused other companies problems, they cling to the belief that such things won’t happen in their organizations because—they are smarter! Wrong again.
There’s an old saying in investigative reporting—follow the money. Turns out that’s a pretty good clue to understanding lots about organizations and the troubles they encounter. While pundits expound endlessly on how the current financial mess arose, the answers are, in virtually every case, quite simple. People did what they were paid to do—make (bad) loans, take excessive risks, package and resell worthless paper, leverage up the balance sheet, and so forth. Unless we get better at the seemingly simple task of predicting what reward systems are actually going to do, and unless we get smarter about designing rewards that don’t produce destructive behavior, the current bad news will just get recycled in the future. That’s because we don’t seem to learn anything from experience.
