Slabbed takes the Regulatory Challenge Part 3: Incompetent is as incompetent does. Tim Geithner and Peter Principle.

The Peter Principle is the principle that “In a Hierarchy Every Employee Tends to Rise to His Level of Incompetence.” It was formulated by Dr. Laurence J. Peter and Raymond Hull in their 1969 book The Peter Principle, a humorous treatise which also introduced the “salutary science of Hierarchiology”, “inadvertently founded” by Peter. It holds that in a hierarchy, members are promoted so long as they work competently. Sooner or later they are promoted to a position at which they are no longer competent (their “level of incompetence”), and there they remain, being unable to earn further promotions. This principle can be modeled and has theoretical validity.[1] Peter’s Corollary states that “in time, every post tends to be occupied by an employee who is incompetent to carry out his duties” and adds that “work is accomplished by those employees who have not yet reached their level of incompetence”.

The Peter Principle is a special case of a ubiquitous observation: anything that works will be used in progressively more challenging applications until it fails. This is “The Generalized Peter Principle.” It was observed by Dr. William R. Corcoran in his work on Corrective Action Programs at nuclear power plants. He observed it applied to hardware, e.g., vacuum cleaners as aspirators, and administrative devices such as the “Safety Evaluations” used for managing change. There is much temptation to use what has worked before, even when it may exceed its effective scope. Dr. Peter observed this about humans.

In an organizational structure, the Peter Principle’s practical application allows assessment of the potential of an employee for a promotion based on performance in the current job; i.e., members of a hierarchical organization eventually are promoted to their highest level of competence, after which further promotion raises them to incompetence. That level is the employee’s “level of incompetence” where the employee has no chance of further promotion, thus reaching his career’s ceiling in an organization.

In part 2 of Slabbed takes the regulatory challenge I introduced the concept of behavioral economics to the overall concept of financial regulation, specifically public choice theory the tenants of which I generally adhere:

Public choice in economic theory is the use of modern economic tools to study problems that are traditionally in the province of political science. From the perspective of political science, it may be seen as the subset of positive political theory which deals with subjects in which material interests are assumed to predominate.

In particular, it studies the behavior of politicians and government officials as mostly self-interested agents and their interactions in the social system either as such or under alternative constitutional rules. These can be represented a number of ways, including standard constrained utility maximization, game theory, or decision theory. Public choice analysis has roots in positive analysis (“what is”) but is often used for normative purposes (“what ought to be”), to identify a problem or suggest how a system could be improved by changes in constitutional rules.[1] Another related field is social choice theory.

So with an understanding going in the players have their own self-interest as paramount let’s examine some recent developments involving our crooked treasury secretary Tim Geithner and Lehman Brothers in the months leading up to its implosion. Lets begin at Naked Capitalism:

Quite a few observers, including this blogger, have been stunned and frustrated at the refusal to investigate what was almost certain accounting fraud at Lehman. Despite the bankruptcy administrator’s effort to blame the gaping hole in Lehman’s balance sheet on its disorderly collapse, the idea that the firm, which was by its own accounts solvent, would suddenly spring a roughly $130+ billion hole in its $660 balance sheet, is simply implausible on its face. Indeed, it was such common knowledge in the Lehman flailing about period that Lehman’s accounts were sus that Hank Paulson’s recent book mentions repeatedly that Lehman’s valuations were phony as if it were no big deal.

Well, it is folks, as a newly-released examiner’s report by Anton Valukas in connection with the Lehman bankruptcy makes clear. The unraveling isn’t merely implicating Fuld and his recent succession of CFOs, or its accounting firm, Ernst & Young, as might be expected. It also emerges that the NY Fed, and thus Timothy Geithner, were at a minimum massively derelict in the performance of their duties, and may well be culpable in aiding and abetting Lehman in accounting fraud and Sarbox violations.

Geithner’s name keep popping up here at Slabbed. Our longer term readers no doubt remember Kid Geithner and his role as waterboy helping Greenspan, Larry Summers and Robert Rubin railroad Brooksley Born out of the Clinton administration because she dared to propose that derivatives should be regulated. When I think of Rubin and Geithner I think of Goldman Sachs mainly but the level of involvement of the New York Fed coming on the heels of the Fed’s complicity in helping AIG mislead investors is stunning. I’ve come to view Mr Geithner as the Peter Principle personified in his ascension to the post of Treasury Secretary. President Obama does his administration a  disservice every day this joke of a man is allowed to man the helm at Treasury as we continue:

So what transpired? The SEC (which in all fairness, has never had much expertise in credit markets, this is a major regulatory problem) handed assessing Lehman over to the Fed, which bent over backwards to give it a clean bill of health:

After March 2008 when the SEC and FRBNY began onsite daily monitoring of Lehman, the SEC deferred to the FRBNY to devise more rigorous stress‐testing scenarios to test Lehman’s ability to withstand a run or potential run on the bank.5753 The FRBNY developed two new stress scenarios: “Bear Stearns” and “Bear Stearns Light.”5754 Lehman failed both tests.5755 The FRBNY then developed a new set of assumptions for an additional round of stress tests, which Lehman also failed.5756 However, Lehman ran stress tests of its own, modeled on similar assumptions, and passed.5757 It does not appear that any agency required any action of Lehman in response to the results of the stress testing.

Yves here. So get this: the stress tests were a sham. Only one outcome was permissible: that Lehman pass. So after the Fed was unable to come up with an objective-looking stress test that Lehman could satisfy, they permitted Lehman to devise a test with low enough standards to give itself a clean bill of health.

The fact Lehman’s accounting did not add up was hardly a secret at the time, far from it in fact. As we’ve found time and again in the making of the financial crisis the messenger would be demonized or shunned in this case the messenger being David Einhorn, president of Greenlight Capital later turned author, who shorted Allied Capital years before it became fashionable:

When I speak of investors I am including hedge fund managers. An author on Investopedia defined hedge funds as “lightly regulated, private investment funds that use unconventional investment strategies and tax shelters in an attempt to make extraordinary returns in any market…these factors have given them a secretive and shady aura in the financial community.” Forbes has called us “The Sleaziest Show on Earth.” Basically, according to some in the media, elected officials, government regulators and individuals, hedge funds are really gambling operations amounting to ticking time bombs with secret plans to destroy the galaxy. Good thing they don’t say what they really think. In truth, hedge fund managers at their core are simply investors.

The SEC seems much more interested in whether investors share analysis, particularly critical analysis, of public filings rather than whether management teams made accurate public filings in the first place. The SEC seems more interested in whether investors discuss investments among themselves on private phone calls than in whether management teams make truthful statements on public conference calls. The SEC seems more likely to bring a case against an individual investor over a small crime than it is to prosecute a large corporation that fudges its numbers for years on end and pays out management bonuses in the millions based upon inflated accomplishments.

Hedge funds short stocks and those that short stocks wear the black hats in the investing world for better or worse.  Our more financially oriented readers will no doubt remember it was Shorty that briefly drew the blame for the pricing implosion in the financial services sector of the stock market back in the fall of 2008. That meme was pure bullshit designed to distract the nation from what had really happened, specifically the decisions by the NY Fed to pump big time cash into AIG to the benefit of Goldman Sachs.

Now back to Naked Capitalism, a financial blog which lived all those events real-time. Yves bottom lines this real well:

So why should we trust ANY government designed stress test, particularly when the same permissive grader, Timothy Geithner, was the moving force behind the ones dreamed up last year, which have been widely decried by banking experts, including Bill Black, Chris Whalen, and Josh Rosner? We linked to a simple analysis by Mike Konczal that demonstrates that for the biggest four banks alone, merely on their second mortgage portfolios, the stress tests of 2009 were too permissive to the tune of at least $150 billion.

Lehman type accounting, in other words, is being institutionalized, with the active support from senior government officials.

It is time for Geithner to go. He is not fit to serve as Treasury secretary.

The Wall Street Journal has exhaustive coverage of this scandal as E&Y are brought back to the scene of the crime, those dreaded accounting questions  are asked (people actually make a living answering these arcane questions), when money is involved why lying isn’t really lying or fraud despite investors being fleeced and finally why regulators should have pulled their heads outta their asses and listened to Shorty as Greenlight Capital’s bet against both Lehman and Allied Capital Corp is profiled.

There are good reasons why the new regulatory agency belongs at neither the Fed or Treasury but that is another post.

sop (h/t Russell)