On many issues of public concern, from food safety to the financial crisis, legislators and commentators alike line up on one side or the other: Either these failures prove the free market doesn’t work and more government regulation is required, or our regulatory structure doesn’t work and more free enterprise is required. Both positions ignore a common thread — the failure of "guardian structures" to do their jobs properly. The question is why.
It may not be obvious what unites the shipping of salmonella-laced peanut products, the issuance of mortgages without property value adequate to back them up and the sale of dubious securities. Yet oddly enough, all three problems are explained by the same private-sector failure played out in three different industries: that of third-party monitors to aggressively safeguard the public interest.
The Peanut Corporation of America, for example, was audited for food safety by AIB International, formerly the American Institute of Baking. Its job was to provide an assurance to food manufacturers that they could buy with confidence. Yet inspectors from the Food and Drug Administration found mold on the ceilings and walls, large holes where vermin could enter, and cockroaches — both dead and alive.
How could AIB miss such obvious problems? Maybe in the same way appraisers used by mortgage companies missed the wildly excessive valuations they assigned to homes: They had another agenda.
The appraisal of my own condominium for refinancing at the crest of the mortgage boom is illustrative. When the appraiser arrived I made my pitch, pointing out enhancements that could boost his valuation. Armed with print outs of every sale in the building for the previous year, I was prepared to make my case. It was all superfluous. The appraiser simply looked around and asked, "What value do you need?" I told him and that is what I got.
Of course, mortgage appraising is a penny-ante business as opposed to the business of the big financial ratings agencies — Moody’s, Standard & Poor’s, Duff & Phelps and Fitch. The whole subprime crisis would have been impossible if these firms had waved a red flag by rating the securitization of these assets poorly or refusing to rate them on the grounds there was not enough historical data.
What caused these completely separate individuals and entities operating in different fields to be too lax in the execution of their responsibilities?
There is a common flaw in the way all of them interact with their industries: They are financially dependent on people and organizations that want to see the transactions completed.
If the property appraiser didn’t deliver for the mortgage company, other appraisers could be hired. If AIB International was an obstacle to commerce, the buyer could specify a different auditor, or the Peanut Corporation of America could unilaterally switch.
And what about the rating of Wall Street paper? In a hearing in October 2008 by the House Committee on Oversight and Government Reform, one damning e-mail by a Moody’s representative explained what she was told by Mabel Yu of Vanguard, a large mutual fund company: "It feels like there’s a big party out there. The agencies are giving issuers every benefit of the doubt," and "I feel that if Moody’s doesn’t give the rating, the issuer can simply go elsewhere and get it somewhere else."
Yu was correct. Allowing an audit, appraisal or rating to be given by someone who is dependent on the parties involved in the transaction is an inherent conflict of interest. That is why all three widely divergent fields suffered.
The only solution is to strengthen the guardian structures in our commercial systems.
The basic need is to require that no "guardianship" function have any financial interest in the completion of transactions. The decisions the guardians make must in no way increase or decrease their opportunities for business in the future. In effect these professional tasks need to operate under a series of guilds of qualified food safety auditors, property appraisers or financial rating analysts.
The auditors, appraisers or rating analysts have nothing to lose but their reputations. They can’t get more or less business because they cut anyone some slack. Fixing this flaw is the very first step in saving capitalism.
Much as society depends on mediating structures such as churches, schools and charities to smooth the rough edges of government and business, so commerce depends on guardians to stand at crucial points in transactions and, sometimes, yell halt. Ensuring there is no financial conflict of interest that might cause the guardians to stay silent is the crucial task ahead.
Jim Prevor is the founder and editor-in-chief of Phoenix Media Network, Inc. a business-to-business media company specializing in the food industry. He regularly writes on food safety and other issues at PerishablePundit.com.ibune.com.