Career Journal

If you want to learn more about peoples' characters, put them in a situation where they have (or think they have) a lot of power and observe what they do. Few will resist using that power inappropriately if they feel that no one is going to hold them accountable.

One reason that few challenge those in power is because most people are more comfortable doing the wrong thing on command than challenging authority. For example, researchers have demonstrated how compliant most people are when someone in apparent authority whom they have just met (such as a person in a lab coat holding a clipboard) tells them to do something that's obviously wrong.

In one famous experiment, a lab-coated experimenter commands people to send ever-increasing electrical shocks into test "subjects" who give incorrect answers to questions . . . past the point where the shocks could be lethal and while watching those being shocked writhe in agony and listening to them beg for mercy.

Almost everyone who hears the commands to shock just follows the orders. (Fortunately, no shocks are actually being received by the test "subjects" who are actors simulating the effects of electrical shock.)

Let's take this observation about how power reveals character into the workplace. Who is going to say "no" to the boss? Hardly anyone will. As a result, bosses who don't control themselves are going to act irresponsibly, especially when they can feather their own nests in the process.

Let's consider a business example. The recent collapse of U.S. house prices has been tied in part to huge numbers of foreclosures on homes where lenders and mortgage brokers qualified borrowers for mortgages that they could not afford.

According to the principle of unconstrained people with power doing what they want, how might these inappropriate mortgage approvals have occurred?

Let's assume that a lender offered a new type of mortgage designed to help people with low incomes to buy a home. To do that, the cash outlays need to be low.

The mortgage contract might require little or no down payment, roll closing costs into the mortgage total, and eliminate paying back principal for several years. In fact, the agreement might even let borrowers add the short-term cost of interest to principal rather than paying it as incurred.

Beyond that, let's set the initial mortgage interest rate well under the current market rate . . . perhaps by as many as 6 percentage points below the rate during the time when principal and interest do have to be paid in cash.

That looks great in the beginning, doesn't it? If money was tight for someone, why not agree to such a mortgage?

But it won't look so great when the payments rise by several hundred percent, will it?

How should a lender or mortgage broker analyze whether the low-income borrower should receive such a low-cost mortgage or not?

At one extreme, you might look primarily at the most the mortgage payments and property taxes might cost a borrower during the most expensive part of the repayment period.

At the other extreme, you might look instead only at the amount the mortgage and property taxes would cost a borrower in the near-term when the interest rate is artificially low and not being paid back to the lender while no principal is being repaid either.

Clearly, the safer answer (and the correct one) is to look primarily at the highest-cost period to see if the borrower has enough income to qualify for a mortgage. But that's the opposite of what many mortgage originators did in the last few years before the housing price bubble burst in the United States.

What went wrong? Experts point to many contributing factors, but the common thread connecting most of those factors is that mortgage originators were well paid to issue these loans even if there was little or no chance that borrowers could ultimately repay them. And no one was second-guessing the lenders and mortgage brokers for their mistakes.

With an opportunity to make a buck today and no apparent risk of losing a buck tomorrow, the mortgage brokers and originators sought as much money as they could for themselves and made lots of very bad mortgage loans leading to the home foreclosures.

How could they get away with that? The counterparties who worked with the originators to create the mortgages weren't paying any attention either to whether the borrowers could repay the loans. Why? They also were paid to do as many deals as possible, whether or not the loans were ever repaid.

You could simulate a similar set of incentives by continually dropping stacks of hundred-dollar bills belonging to others while ignoring that the owners were losing money whenever someone picked up the money.

Why would the owners allow that circumstance? They didn't realize that they had been cheated for many years, being assured by other parties that the money would be returned with interest. In addition, the legal authorities paid no attention to the inappropriate conduct.

By contrast, mortgage issuances were originally designed to follow a process during which many people checked on one another so that apparent errors would be challenged before lending decisions were made. As a result, loans were almost always repaid by borrowers or, in the alternative, the properties were sold for more than enough money to satisfy the outstanding loans.

How was repayment usually obtained by lenders? First, the borrower would pay a large amount of money (often in the range of 20 percent) toward the purchase price. If the value of the property later went down by 20 percent (the maximum downward price risk in most housing markets prior to 2007-9), the property was still worth the initial value of the mortgage.

Second, part of each monthly payment went to repay some principal (the balance of the note) and the interest. As a result, the percentage of the original value represented by the mortgage balance was always going down. The lender's position was getting safer and safer, even if house prices didn't go up.

Third, lenders used to originate their own loans. When that happened, they knew the local conditions for how risky the price levels were and how likely the borrowers were to lose part of their income.

To compensate when those risks rose, lenders would require a larger down payment, limit the size of mortgages by requiring more income be available to pay for the mortgage and property taxes, and more quickly begin working borrowers whose economic circumstances worsened.

How did we get from this workable model to what happened recently? You can point to many steps along the way, but clearly one of the important ones was Congress deciding that it wanted to create more home ownership. With each additional nudge from the government to lend to more poor people, the process gradually went from good to wretched.

Imagine that you are someone faced with such a situation as a mortgage originator. What would your lending practices be?

Only you can know that answer, but I think you will find it interesting to consider the observations of Jerry Gensel, a veteran of the consumer-finance and mortgage-banking industries, who earned an MBA in leadership from Rushmore University while the bad loans were being made:

"The complete disregard for quality relative to compliance, credit, and the future repayment of loans destroyed the industry. It was obvious that very few decision-makers in the industry cared that borrowers would be unable to make their payments when the rates were reset.

"There were billions of dollars in loans granted where the debt-to-income ratio was calculated based on the one percent start rate instead of the seven and one half percent fully-indexed rate.

"Many of those borrowers did not have the income to make payments on the higher rate. Their loan amount was usually near five hundred thousand when they could only afford to make payments on a loan half that size with a realistic interest rate.

"In addition, the loan carried a negative amortization feature because the borrower did not pay anything toward the balance. This means that in addition to the payment being too high compared to income, their balance increased by up to fifteen percent.

"This is why every aspect of quality is so important in business. A business that does not constantly examine its quality plan will most likely cease to exist sooner than it might imagine.

"According to Crosby, many companies ignore the concept of quality management much of the time. These companies spend more time evaluating areas unrelated to quality, and they do not work on loan fraud and the prevention of imprudent lending. Quality suffers, and only becomes an important process when problems inevitably arise."

Mr. Gensel also observed, based on his studies, that while most people pay lip service to quality improvement for key business processes, leaders usually don't have the experience to know how to map the current process, to research the best practices for improving the process, and to test the quality of their solutions.

In addition, he noticed that most leaders are short-sighted concerning how much they can trust themselves and their subordinates to do the right thing in the absence of sound business processes that encourage responsible decision-making by giving some people incentives to challenge bad decisions and planned actions before they go into effect.

Most people imagine that all an effective leader has to do is point to the right goal and ask everyone to charge off in that direction. That view is short-sighted and can lead to the kind of mess that occurred in the U.S. home mortgage market.

Leaders need to learn more about the characters of their people and themselves and design ways to apply the best qualities of those characters while minimizing the harm of the worst qualities.

Are you prepared to do that by improving the quality of your important processes?

About the Author:

Donald W. Mitchell is a professor at Rushmore University, an online school, who often advises MBA candidates who wish to become more successful business leaders. For more information about ways to engage in fruitful lifelong learning at Rushmore to increase your effectiveness and improve your career, visit http://www.rushmore.edu

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