The Failure of Social Enterprise

Fannie Mae and Freddie Mac have failed. Over the weekend they were taken over by the federal government. While this in no way discredits the concept of for-profit firms having social missions, the fact that these unique “social enterprises” have failed cannot be ignored by the philanthrocapitalist set.

From today’s Wall Street Jounrnal:

An unanswered question in the takeover of Fannie Mae and Freddie Mac is what happens to the social goals mandated for the agencies by Congress — which include boosting homeownership and funding apartment construction for low- and moderate-income families…

…Regulators say efforts to meet the social goals will continue as Fannie and Freddie operate under government conservatorship…

But the details of how these goals will be met and how Fannie and Freddie will balance their social goals with the need to shore up their finances remain to be worked out…

…The future of Fannie and Freddie’s social mission is at the heart of a debate brewing in Congress over the fate of the two companies. Democrats invoke the goals in defending the companies against critics.

But some Republicans say the two companies should be privatized and their social mandates ended. “There is no validity in taking a for-profit private company and forcing a nonprofit social mission on it,” says Texas Rep. Jeb Hensarling…

…The companies have a mixed record when it comes to meeting social goals through residential mortgage business. Fannie and Freddie helped boost homeownership by moving away from “one-size fits all” underwriting. For instance, they began allowing first-time home buyers to make down payments of as little as 3% and borrowers to count court-ordered child support payments as income, notes Michael Shea, executive director of Acorn Housing Inc., a nonprofit that focuses on homeownership.

But Mr. Shea and others say the companies have sometimes let their drive for profit get in the way of responsible lending. As they lost market share to subprime lenders and others making risky loans, Fannie and Freddie responded by increasing their exposure to riskier mortgages, both through their traditional guarantee business and the purchase of residential mortgage-backed securities backed by subprime mortgages and Alt-A loans, a category that includes mortgages made to borrowers who don’t fully document their income and assets. Some of the loans underlying the bonds counted toward the companies’ housing goals. Such investments have played a key role in the companies’ financial troubles.

It seems that at the end of the day, these for-profit companies put their profit motive ahead of their social mission. Is it reasonable to expect anything else from a for-profit company? I’m a big believer in aligning incentives. The movement to create B Corporations is a good step to creating for-profit companies with social missions in a way that better aligns incentives. But in the meantime, I think the failure of Fannie Mae is exhibit #1 for anti-philanthrocapitalists. However, it is an interesting footnote that much of the criticism of philanthrocapitalism come from people whose political beliefs have in the past aligned them in support of Fannie Mae (whose political support has generally come from political liberals). Personally I think it is important that philanthropy recognize philanthropic tools (such as for-profit mission driven enterprises) as simply tools and not something that we come to view as integral to our philanthropic philosophy.

(Nothing in this post should be considered investment advice. At the time of publication my firm, Ensemble Capital Management, held no positions in Fannie Mae or Freddie Mac.)

27 Comments

  1. Jeff Trexler says:

    This article was for me a justification for continuing to subscribe to the paper WSJ; don’t know that I would have caught it this morning otherwise!

    I had a much different reaction to the bit about the “drive for profit.” That seemed to me to be a post hoc denial of the more fundamental and problematic commitment to a social mission. At the time, the loans seemed justifiable because they were doing good; without that reasoning it’s likely that the riskiest loans would not have been made.

    From a cog-sci perspective, there’s an innate resistance to seeing one’s own transcendent values as the root of harmful acts. To make that connection would call the entire enterprise into question, not just for philanthro-capitalists but for all forms of doing good.

    In this instance, it would entail acknowledging that the norm of home ownership for all is not universally valid, an assertion that would be both politically dangerous and, for many in the U.S., a blasphemy against the American dream.

  2. Thanks for the comment Jeff. There’s a number of valid ways to examine this issue, so don’t assume that I am deeply committed to a certain frame on this one. And do recognize that I’m positioning the failure as a great talking point for the anti-philanthrocapitalists rather than saying my own view is that social enterprise has failed.

    However, I don’t think that the decision to move into risky loans was, at the time, a decision driven by social mission. It was almost certainly a reaction to profit driven shareholders who were watching for-profit competition making more money by engaging in risky lending.

    When Fannie Mae was created (in the late 1930’s) it was created as a dual purpose entity driven to produce profits for shareholders while at the same time following a social mission to increase the availability of home loans (and thus drive up home ownership). I think it is rather undeniable that it was a search for profit during a speculative frenzy that unraveled Fannie Mae rather than the pursuit of their social mission.

  3. Jeff Trexler says:

    One thing that helps illuminate the mindset during the bubble is the mission-based manifesto that Fannie Mae chairman Frankline Delano Raines called The Five Principles of Fannie Mae.

    Number one was that Fannie Mae was “an instrument of national policy” through which “Congress reaffirmed its long-standing beliefs in home ownership.” A hallmarks of this public “mission” was Fannie Mae’s success in pulling “housing capital into underserved communities . . . where it wouldn’t have gone on its own.”

    The fifth and summary principle solidified the connection: “Fannie Mae grows as the American dream grows.” For Raines, a projected increase in the U.S. population called for an equivalent increase in new home ownership–a one-to-one statistical correspondence that, Raines reasoned, justified Fannie Mae’s belief that the housing market was “set for another strong year and another strong decade.”

    The quotes above were from 2004. Of course other folks’ mileage may differ, but it seems at least worth noting that in official statements Fannie Mae’s leadership framed profit-making through subprime loans as a public purpose.

  4. Yes, but I’m not suggesting they didn’t believe in their public purpose. The social mission was a front and center attribute of the organization. But in the end, the fact that they were also a profit seeking company seems to have led them astray. In the case of Freddie Mac, media reports are saying that they went so far as to overstate their financial health. That would be nonsensical from a purely profit driven standpoint.

    Remember, I think the blurring of the lines between nonprofits and for-profits is a good thing because it opens up new opportunities. But the social enterprise crowd can’t let an event of this magnitude pass by without learning some lessons.

  5. foundationwriter says:

    And what are the lessons? Making more money available in poor communities is clearly a laudable goal, as is increasing home ownership. Saddling people with debt they can’t afford is not. It suggests that the folks in charge completely disregarded the agencies’ public purpose.

  6. I think the lessons are that when you charge a firm with both a social mission and a profit motivation, the profit motivation will always win. However, entities like L3C’s and B Corp’s are seeking to address this.

    Plenty of other evidence shows that you need to incentivize people in ways to encourage the activity you want to see. Encouraging them to maximize profits while telling them to also serve a public purpose isn’t going to work. But that does not mean that for-profit firms cannot produce social good.

  7. Barbara Saunders says:

    The flaw I see in the “mission-driven” vs. “profit-driven” labels is that a moral hazard exists for a mission-driven organization to perpetuate the very problem(s) it was created to solve if the underlying money engine works no other way. The possibility also exists for an organization to invent work to justify funding after it has actually succeeded in solving its original problem.

    An example from a friend: She works with an agency that pioneered a practice that has since become mainstreamed, taken up by organizations who are closer to the consitutents, have more money, and have access to better qualified staff than the pioneer has or can have. What is the value, she argues, of continuing to allocate resources to that organization?

  8. That’s a good point Barbara. I was focused on the way that for-profit companies would always honor their profit seeking motive in crunch time, but mission driven organizations have the same issue. Hopefully a board without a financial interest in the existence of the nonprofit would prevent it from taking actions that perpetuated the nonprofit if it didn’t help the mission. But I can certainly see how paid staff would have an incentive to keep the organization running even if it meant not solving the problem.

    However, in an impact oriented world, I wonder if a nonprofit that actually performed so well that they were not needed anymore would be seen as such a valuable entity that they would have little trouble finding funding for a new mission?

  9. Barbara Saunders says:

    Shannon, You’re right. The organization might be well positioned to capitalize on its success. Same problem may exist for at least some of the staff, though, if they strongly identify with “the cause” and can’t detach into a larger or changed picture.

  10. Jeff Mowatt says:

    Quite a surprise, finding this promoted on the B Corps website to discover that social enterprise is to blame for the collapse of an economic paradigm.

    Social enterprise, the form I participate in, isn’t at all forced socialisation. To suggest this seems somehow disingenuous.

    The SE model, pitched at Clinton’s re-election committee seems to have quite a lot in common with this form of social enterprise, it’s optional, serving the community as stakeholders and up to the shareholders to decide to what extent the social investment goes.

    There has to be a viable and sustainable business to start with, otherwise it might be perceived as what we in the UK call a quango, a quasi autonomous non governmental organisation, which is not in any kind of free market competition for it’s services.

  11. Jeff Mowatt says:

    Reading back, I should clarify – a lot in common with B corporations.

  12. I don’t disagree with you Jeff. However, I admit I wasn’t entirely clear about my opinion in this post.
    In the post I wrote, “[The failure of Fannie and Freddie] in no way discredits the concept of for-profit firms having social missions”. I was pointing out that “anti-philanthrocapitalists” would use the failure as “evidence” that social enterprise won’t work. I was trying to point out the ways this event would effect the overall debate, not state that I thought the failure discredited anything.

  13. Jeff Mowatt says:

    Thanks for clarifying Sean. I don’t know whether you followed the blog discussion on Creative Capitalism a month or so ago, but there was a pretty strong showing of an anti-philanthrocapitalist gathering, if ever there was one.

    I’d wanted to discuss the application of similar ideas, which brought microfinance to Russia nearly a decade ago, but the group was far too exclusive. One contributor, I think Clive Crook, commented later in the FT, which again, was rather selective in the comments accepted for publication.

    I read ideas bring re-branded, re-dismissed, but seemingly little hope of reaching MDGs by 2015.

    Jeff

  14. Allan Shore says:

    There is no way that any kind of metrics or even philosphical justifications can be used yet to judge the effectiveness of socially responsible enterprises. In no small part because the value, potentials and true-to-the-heart realities of what the social (nonprofit) sector can bring to the table are hardly well reflected in the few models we have to look at. The nonprofit sector’s voice is just now beginning to be heard so we don’t yet know what truly responsible enterprises will look like in the future. I worry a good deal that failures of all kinds will be used to set back the progress we have made; and I encourage everyone to use the bad we see as a stronger justification for turning to their caring partners to ask whether we’re really playing this game correctly. Only then, after a time of experimentation, can we decide if we have done justice to the model we’re looking for. Some 20 years ago I helped develop one of the first significant business ventures for a nonprofit agency in California, and only now is it really getting to the point where we can see its positives begin to shine. So have patience and don’t fall into the trap of assuming that corporate structures that are forced to bend with a prevailing wind are actual ships on an the right course of a new adventure of opportunity! Our sailing journey has yet to take us very far from the old-world harbor.

    Allan

  15. Jeff Mowatt says:

    I can wholeheartedly agree with what you say Alan. I tuned into what Gordon Brown was saying earlier this year in his “Business Call for Action” and was struck by two things. His script used the same arguments as a call for “social business” a decade earlier but the new message was for business to “showcase” actions targetting the MDGs.

    I’m in the rather unusual position of a small business owner supplying much larger corporations and have now doubt that while corporations showcase at the board level, the majority will be doing their best to delay paying their suppliers on time. This may well enhance the corporate image, but in these times of difficulty in particular they threaten the existence of many a small business and those it employs.

    In 1957 John Spedan Lewis claimed that the (then) present state of affairs was a perversion of capitalism, when there were millionaires while there were still slums, my bet would be on him turning in his grave at what he might observe today.

    In terms of social business and it’s performance metrics, Peter Burgess of the Transparency and Accountability network has made a brave start.

    Jeff

  16. Dear Sean,
    You’ve raised a fundamental problem with the incentives that is well worth the discussion.

    Robert Reich, in Supercapitalsim, makes a compelling argument that CSR is doomed to fail. Corporations are expected to make profits. The responsibility is to increase shareholder value. The good ones take a long term view. The less good ones take a short term view to pop the stock price. But in either case, there is no real incentive for the corporations, as opposed to the people in the corporations to act in any other way.

    My opinion is that non profits have an even more complicated problem. With no outcome measure, mission become obfuscated with proximate incentives for the directors, board and the people who work there.

    The focus on fund raising is just one example of time away from task. The educational institutions that are hedge funds or money machines from student revenues are other exmaple.

    IMHO, B corps are a very, very promising approach. The key element is the writing into the articles of incorporation. Well done. And very good luck.

  17. Jeff Mowatt says:

    Michael, I agree entirely with the idea of a modified set of articles. it may be interest to discover that the idea appeared in a paper delivered to President Clinton’s re-election committee in 1996, for a an inclusive people-centered economic paradigm.

    “The P-CED concept is to create new businesses that do things differently from their inception, and perhaps modify existing businesses that want to do it. This business model entails doing exactly the same things by which any business is set up and conducted in the free-market system of economics. The only difference is this: that at least fifty percent of profits go to stimulate a given local economy, instead of going to private hands. In effect, the business would operate in much the same manner as a non-profit organization. The only restrictions are the normal terms and conditions of free-enterprise. If a corporation wants to donate a portion of profits to its local community, it can do so, be it one percent, five percent, or even fifty percent. There is no one to protest or dictate otherwise, except a board of directors and stockholders. This is not a small consideration, since most boards and stockholders would object. But, if an arrangement has been made with said stockholders and directors such that this direction of profits is entirely the point, then no one will object. The corporate charter can require that these monies be directed into community development funds, such as a permanent, irrevocable trust fund. The trust fund, in turn, would be under the oversight of a board of directors made up of employees and community leaders. ”

    From there, it led to leveraging a development initiative and microfinance bank in Russia, yeilding 10,000 new businesses in the city of Tomsk.

    In this regard, it succeeded as a bottom up approach where the preceding Harvard (HIID) Initiative in the Defense Enterprise Fund had floundered.

    I took over the core operating revenue generation function in 2004, applying the P-CED model to a small software business. In October 2006 we delivered the ‘Marshall Plan’ for Ukraine as a blueprint for microeconomic development and social enterprise. To-date it has prompted from the US, the creation of the East Europe Foundation with Ukraine adopting 3 key recommendations as policy in childcare reform.

    The original paper about digital and economic inclusion was published on the web, free to use as an idea virus in 1997.

    http://www.p-ced.com/about/history/

    The rest is described on the same site.

    Jeff

  18. Jeff
    I spent a little time on your website and find the argument and the model compelling.

    An FY, 2 questions and a comment:
    FYI,
    I blog in the commercial printing world with a focus on biz development and education. As you can imagine the waves of creative destruction are swallowing many printing companies. There is a muted discussion about new “business models” that is in fact a discussion about how to get more customers.

    Question 1:
    Is there any experience you can share of going small businesses up to $5 million gross, facing the destruction of their business models and moving towards the P-CED approach.

    Question 2:
    How does P-CED relate to G corps. On first reading they seem very similar. Is it merely an organizational difference or are there significant differences in concepts?

    Comment:
    I was especially intrigued by the notion of P-CED’s instead of American non profits. It has long been my belief that the no tax paying status of many non profits has been a shield behind which the incentives are truly dysfunctional.

  19. Oops. I meant to say B Corps in Question 2.

  20. Jeff Mowatt says:

    Hi Michael,

    None that I know of as business as such. The Tomsk Initiative was to raise &6 million ‘investment’ to service a city of 600,000 with a microcredit bank. We’ve never been more than a small business ourselves.

    B Corps sounds very much like the profit for purpose model of P-CED, they may differ in the ‘manifesto’ I hadn’t read about them until a few weeks ago. A similar concept of what’s know here in the UK as a Community Interest Company (CIC) was made available here as a form of incorporation within UK company law in 2005.

    With regard to our overall focus on digital and economic inclusion, it also seems to have much in common with creative capitalism.

    Speaking from my interpretation, which I hope corresponds with our founder’s I saw the power of the P-CED model in being able to seed similar businesses and support like minded others by means of procuring them as suppliers and serving them as customers.

    In practice,I find there’s a disconnect between what today’s CSR delivers and my imagined self-propelling social economy because of brand consciousness, with corporations tending to be unwilling to engage with other than that which they can derive publicity.

    A P-CED model is more than rendering profit to charity, it’s about investing in the needs of the community and there’s another advocate, totally unconnected to us with a People-Centered Model of Business (PC-MOB) which illustrates rather well how these connections can be made:

    http://www.triplebottomline.com.pk/response.asp?id=1&sub_id=7

    This as someone else put it rather succinctly recently is not a question of what we’re doing, but what we’re being.

    Jeff

  21. Jeff

    Thank you. I will look through the links to I learn more.

    Im my humble opinion, I think the time that was not quite right in 1997 may be coming to pass. As American/Global financial institutions are being reinvented it seems that the next step here in the States will be GM and big Auto. From everything I’m hearing Obama’s team is preparing a “structured bankruptcy.”

    The movement from a consumer society to a producer society has, I think, finally begun in earnest. As we know that last thing to change are the institutions that are supported by conventional wisdom and proximate incentives. With Obama’s election, I think our political system has begun that process.

    Meanwhile, America has to create millions of jobs soon. The irony might be that the innovations at the periphery will come home to the metropole. It is only small,local businesses, like printers among others, that create jobs. Global corporations eliminate jobs.

    For whatever it’s worth, I think non profit organizations are going to be under alot of pressure in the coming years. As are small businesses. It will be interesting to see what emerges from the tensions.

    I can imagine non profits looking at some form of B corp or P-ECD as an alternative as the political heat is turned up. This may turn out to be the next big thing for non profit fundraising.

  22. Jeff Mowatt says:

    That’s true enough Michael, 1997 wasn’t a year that too many were thinking about poverty and work. Winter of 2003/4 and a man blogging from a library while living in a tent may have prompted John Edwards to launch the Center of Poverty Work and Opportunity.

    Right now, however something rather spontaneous has erupted among readers of Daily Kos, as so far hundreds have gathered with a view to collaborate on income generation. That tent dweller is there, in the thick of it.

    http://kossacksnetworking.ning.com

    Jeff

  23. It’s too bad that Edwards got himself into such trouble. The work he was doing with College for All was very interesting and seemed to be on the road to fixing the problem.

    I have to believe that someone else, someplace else is doing similar work. If you or anyone happens to know about such work, it would be great to hear about it.

    If the tent dweller had anything to do with that, he should be very proud.

  24. Jeff Mowatt says:

    Michael, Returning here to answer your question because I’ve found someone what seems to be similar work (to P-CED) it comes from an organisation called ATCA Open and the Philanthropic Trinity which to my astonishment is engaging with the Skoll Centre for Social Entrepreneurship at Oxford. I’ve been networking on Skoll’s Social Edge relating our work for about 5 years and this as far as I know has never been mentioned there. Meanwhile my tent dweller, whose life is still exceedingly frugal gets an acknowledgment this week for his speaking out about corruption and neglect.

    http://www.btbetterworld.com/pg/giving_young_people_a_voice/seen_and_heard_awards/casestudies/Speak_out.ikml

    it’s a sharp contrast with the lifestyle of the philanthropic and academic elite.

  25. Jeff-

    Thank you for keeping this discussion in mind. I look forward to following your leads.

    Meanwhile, I am living the life of the semi-retired. Just the good luck of having got out of the game just before the roof caved.

    As for the elites, either academic, philanthropic, business or poltical, I think they are going to have a bit of time coming up. Elites in the auto economy were built on superior information. My expectations is that elites in the Google-Mart economy are going to be based on excellence.

    I think we are in for an interesting ride.

  26. Jeff Mowatt says:

    Something new today Michael and all, as feedback arrives from Davos. This item comes from a lunch for the elite, on the subject of Ukraine.

    As I’ve indicated before, nowhere has the point about reforming the model of capitalism been made more than in Ukraine where for the last 5 years, our profit has been directed to deliver the ‘Marshall Plan’

    So here’s Richard Branson to echo the point to the VIPs assembled.

    http://pinchukfund.org/en/news/archive/2009/01/29/986.html

    This might be endorsement, for being the change and all.