He could destroy us

You will seldom hear a more vocal defender of capitalism than myself. I tend to be for allowing the market to find its own way, and keeping the government as far away from commerce as possible.

Capitalism works on a few simple principles, which I'm sure I hardly need to recount to AI readers. But the most critical and most fundamental principle is that of incentives. Capitalism assumes that human beings react to incentives. If a system is devised which incentivizes people to work toward socially beneficial goals, then people will naturally perform socially beneficial activities. Hence why people strive to invent new products, devise new production processes, discover new medicines, etc. The dream of striking it rich compels people to pursue all sorts of positive achievements, and mankind has certainly benefited from these pursuits.

In some corners, however, the modern incarnation of Smith's capitalism has become divorced from its core principles. Take Countrywide CEO Angelo Mozilo. He founded the company in 1969 and grew it into one of the largest mortgage underwriters in the U.S. For his success, Mozilo has certainly been well-rewarded over the years.

Today, of course, Countrywide is in serious danger of bankruptcy. The mortgage business is going through a historically difficult period, and if it weren't for a recently announced merger with Bank of America, Countrywide's future as a going concern would be very much in doubt. We could debate the degree to which Mozilo is personally responsible for Countrywide's sudden collapse. But what cannot be denied is that under Mozilo's leadership, Countrywide has destroyed shareholder value over the last 10 years.

And yet Mozilo looks to walk away with a gigantic pay day. According to Bloomberg News, Mozilo could walk away with as much as $84 million assuming the merger goes through. There are some circumstances in which the number could be lower, or even zero. Regardless, the mere possibility that Mozilo would enjoy such a payout creates a perverse incentive.

In any free market system, there will be failures. The dream of riches has to have a downside. With the potential for great success must also come the potential for great failure. Without a penalty for failure, economic agents would be incentivized to take inordinate risks. In private companies, this risk is naturally managed. Small business owners normally must put up their own capital, or borrow against existing assets, such as their homes. Obviously an entrepreneur believes in his new business idea if s/he is willing to mortgage his home and life savings to fund it. Whether the business winds up succeeding or not, the incentives are for the entrepreneur to create value.

Mozilo may have been an entrepreneur once upon a time, but today he's the CEO of a very large public corporation. He knew his company had a large servicing portfolio which would have value to a larger financial institution, regardless of how the rest of his business was performing. He had a long standing relationship with Bank of America, and indeed was supposedly discussing a merger late in 2006. Mozilo could rationally conclude that he'd be able to sell Countrywide, whether to Bank of America or some other institution, in the event Countrywide ran into serious trouble.

With this in mind, what were Mozilo's incentives in recent years? Countrywide's shares had been languishing in the upper 30's for most of 2005, 2006 and early 2007. No doubt Mozilo's personal stock and stock options were not gaining much during this period. Let's be particularly cynical and suppose that Mozilo saw that sub-prime lending had gotten out of hand, and many bad loans were being made. If he was motivated primarily by personal wealth accumulation, then he was probably wise to just keep making those bad loans. After all, the only way Countrywide's share price was going to rise, and create wealth for Mozilo himself, was for the company to grow EPS. In order to do that, they had to keep making loans. Pulling back and tightening credit standards would only slow revenue.

So if Mozilo wanted to grow his personal wealth by pushing the share price higher in the short-term, he would do well to bet heavily on good times. All the while knowing that if it all went to hell, he would just sell the company and collect his exit pay.

Now, we don't actually know what Angelo Mozilo thought about the housing market in 2005 or 2006. We know what he said publicly, but we'll never know what he really believed in his own mind. Perhaps his motivations were noble, and he was merely wrong about the lending business. Even if that's true, the fact that his incentives were otherwise is a serious problem for modern capitalism.

I don't know what the solution is here. Perhaps it is nothing more than having investors put more pressure on compensation committees to create better incentives. Maybe it means that more businesses should stay private. But the problem of perverse incentives is the biggest single problem facing capitalism today. The sub-prime mess will come and go. This is a bigger problem.