White Paper No. 44 – The Financial Crisis and the Collapse of Ethical Behavior
by Gregory Curtis, Chairman of Greycourt & Co., Inc.

Please note that this presentation is intended to provide interested persons with an insight on the capital markets and is not intended to promote any manager or firm, nor does it intend to advertise their performance. All opinions expressed are those of Greycourt & Co., Inc. The information in this report is not intended to address the needs of any particular investor.

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Most assessments of the financial crisis that began in August of 2007 identify as the source of the problem such issues as poor risk controls, too much leverage, and an almost willful blindness to the bubble-like conditions in the housing market. Well, maybe. These issues were certainly the proximate causes of the crisis we find ourselves in, and if only one or two firms had drunk the Kool-Aid – a Drexel
Burnham, let’s say, or a Long Term Capital Management – we could buy the usual nostrums as the full story.

But we suspect that the financial firms and their executives aren’t quite so collectively stupid as this explanation would imply. We think there was something else going on, something that allowed intelligent people to persist in unintelligent behavior. In our view, poor risk controls, massive leverage, and the blind eye were really symptoms of a much worse disease: the root cause of the crisis was the gradual but ultimately complete collapse of ethical behavior across the financial industry. Once the financial industry came unmoored from its ethical base, financial firms were free to behave in ways that were in their – and especially their top executives’ – short-term interest without any concern about
the longer term impact on the industry’s customers, on the broader American economy, or even on the firms’ own employees.

By a collapse of ethical behavior we mean exactly what we say – that the actions of many, if not most, of the large American financial firms (and of the many foreign firms that succumbed to the “American disease”) would strike an ordinary person as unethical – repulsive and scurrilous. But we also mean something more specific to the long-term viability of the financial industry, namely, the disappearance of any sense of fiduciary responsibility to the ultimate client.1 Integrity and a sense of responsibility to the industry’s customers are at the core of what a financial industry must be all about; otherwise, it’s just a big Ponzi scheme.

An Unsavory Rehash of Recent Ethical Failures

Painful as it is, let’s take a quick look at some of the moral and ethical failures of the financial industry, focusing on those that led directly to the current financial crisis.

Ethical failures in subprime lending

Back in the day, people obtained their mortgages from their local banker, whom they likely knew personally. The banker held the mortgage paper on his balance sheet, and hence cared very much whether the paper was good. That was inefficient, of course, so matters began to evolve rapidly. By the 21st Century the system worked like this:

* Mortgage brokers developed to find borrowers. Since these brokers were paid on quantity (“How many mortgages did you bring me today?”), not quality (“How many good mortgages did you bring me today?”), and since they weren’t carrying the paper on their own balance sheets, far too many of the brokers cared not at all whether the borrowers were engaging in thoughtful transactions or were being set up for heartbreak and penury. Once a mortgage was approved, the broker got paid and would never see the borrower again. To say that very large numbers of mortgage brokers behaved abominably is merely to state the obvious.

* Banks approved the mortgages after (maybe) reviewing the applications, but the banks had no intention of holding onto the paper. Instead, they needed to build leverage into their balance sheets, which meant getting this paper off the balance sheet as quickly as possible.2 (The paper was sold into mortgage pools that were in turn sold to unsuspecting investors.) Underwriting standards declined and eventually disappeared altogether. Did the banks care whether their shoddy practices resulted in lending money to people who couldn’t possibly pay it back? Did the banks care what was likely to happen to the ultimate investors in this paper? Not likely. In fact, commercial banks scrambled to acquire subprime lending banks so they could get ever more deeply into this seedy game.

* Because banks wanted to leverage their balance sheets (re-using their lending capacity over and over again), a market developed for pooled mortgages. Fannie Mae and Freddie Mac and the various megabanks and investment banks put these pools together and then sold them on to investors. Did the financial firms care about the quality of the paper they were selling, or the possible harm to investors who bought it? No, this was a volume operation: the more pooled vehicles the firms could form and the more they could reduce their costs (i.e., no actual checking on the quality of the paper), the higher the profits. What about the consequences for the end investors, many of whom were loyal, long-term clients
of the financial firms?

* And what about the rating agencies, the last line of defense between a scamming industry and the ultimate investors? Turns out that conflicts of interest were so rife in the industry that at least one state attorney general is investigating the “symbiotic relationship” between the agencies and the banks and investment banks whose securities they were supposedly rating objectively.3 Were the ratings agencies in the pockets of the financial firms, essentially selling their ratings to the highest bidder?

After a few years of this, is it any wonder that the subprime business blew up, destroying investor capital, wreaking havoc with the lives of over-leveraged borrowers, and destroying confidence in the institutions, individuals, and regulatory agencies that not only allowed all this to happen, but in many cases actively cheered it on?

Ethical failures among the subprime lending banks

We think it likely that there is a special circle in hell reserved for subprime lending banks like Countrywide Financial, which were at the epicenter of the subprime collapse, and at the epicenter of the ethical collapse. Looking back, it’s clear that the main raison d’être of the subprime banks was to sell mortgage loans to people who couldn’t afford them. Screaming ads were created to dupe people into applying for these mortgages, and new, highly misleading mortgage products were developed (teaser rates, Alt-A, etc.) to ramp up volume. Mortgage brokers were paid big fees to lure a steady stream of suckers into the scheme. There was a time when this would have been seen for what it was: predatory
lending.

Strangely enough, prior to Countrywide et al., there had been a long and reasonably distinguished history of subprime lending in the US. But here is the interesting point: prior to Countrywide, lenders to less-than-prime borrowers employed more intensive underwriting, not less intensive underwriting, before making their loans. Loans to less credit-worthy borrowers require more careful background checks, more complex structuring, different legal, collateral and repayment conditions, and so on. Countrywide and others substituted volume for hard work, giving the entire subprime lending industry a
bad name.

We single out Countrywide both because of the scale of its subprime lending activities and, especially, because of the egregious conduct of its CEO, Anthony Mozilo. Mozilo didn’t build his huge personal fortune because he was smarter or harder-working or more creative than other financial executives, nor even because he was luckier than others. He built it on predatory lending and by buying influence in high places. We described the predatory lending activities of Countrywide above, so let’s turn to the sordid business of currying favor. It is now clear that Countrywide attempted to suborn the support of key politicians, regulators, and other influential figures via a secret internal program (headed by loan
officer Robert Feinburg, now a whistleblower) that offered below-market terms on mortgages to individuals Countrywide wanted to curry favor with. This VIP-loan underwriting unit handled mortgage applications from what was known inside Countrywide as “Friends of Anthony,” that is, important figures Mozilo wanted to have in his pocket. The known list of “bribees” is still growing, but so far it includes US Senators,4 former Cabinet officers,5 Fannie Mae CEOs,6 judges,7 and many others.8

Continued here

Category: Bailouts, BP Cafe, Credit, Markets

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

17 Responses to “The Financial Crisis and the Collapse of Ethical Behavior”

  1. blackbox says:

    Perp walk time!

  2. michael m. says:

    This is an excellent summary.
    I think the most devastating part comes towards the end, where the author asks why ethical failures spread so widely. He believes that from his experience, financial people are not more greedy than other professionals he knows, but that their circumstances changed – e.g., the loss of broker commissions, envy of hedge funds, and so on.
    In other words, the ultimate cause -which the writer does not remark on – is that circumstance bends humans’ ethical standards very easily because people in general are not really very ethical: they are easily bent by greed, envy of others, and so on. In searching for causes, the writer doesn’t go to the level of this last cause, which is the worst of all: We don’t have a species to write home about. History and anthropology tell us nothing else.
    I teach psychology at a major university. The students generally think, in line with the tenets of our society, that people are basically good. When one asks them why, if children are naturally good, people end up not behaving so well, they say it is because of temptations, or bad models. In other words, goodness means you are all right as long as nothing tempts you, or no one shows you you can do well by not being good. They have lost all track of the traditional notion that goodness means an ability to resist temptation, not just that you’re o.k. as long as there’s no reason not to be.

    None of this seems very promising.

  3. David Merkel says:

    good article, Barry, thanks for posting it.

  4. dwkunkel says:

    Articles like this are what set “The Big Picture” apart from the crowd. Thanks!

  5. Francois says:

    Two very striking conclusions result from this excellent article:
    1) Despite everything wrong and disgusting banks did, politicians and “Friends of Bankers” a.k.a. Bernanke, Geithner, and Paulson gave them billions and billions in bailout money with what amount to “You don’t tell,’cause we won’t ask” policy.

    2) Compare this royal treatment toward the Moneymakers with the one reserved for the Automakers. There is something sanctimonious and hypocritical in this difference of treatment, no? Guess the FIRE sector is more adept at showering the politicians with campaign money.

    Have we sunk so low that this is all it takes to do business in the US? A good lobbying program that divert the necessary amount of money to DC?

    If so, it is no wonder we are in such deep doodoo.

  6. Chuck Ponzi says:

    Ponzi Scheme.

    Whocoodanode?

  7. RonN says:

    Barry,

    Thanks for posting this – the traditional business media (WSJ, CNBC, etc) don’t have the guts or the motivation to “tell it like it is”. They are part of the scheme.

    I’ve been a CEO and dealt with many “bankers” through the years. When former and current financial CEO’s and BOD members say they didn’t understand the “financial engineered” products and risks, I say “no way”. They are all sharp enough to fully understand. It was greed and poor ethics and they are hiding behind a flimsy alibi.

    Further, when the pol’s talk about more regulation as the solution, it’s just setting the smart bankers up to find a new way around them, and they will even before the legislation is signed. A solution requires prosecution and punishment for many of the current actors (management and BOD’s) to serve as a future deterrent, and it requires taxpayers and stockholders to demand better accountability and more reasonable executive compensation (less outrageous amounts and ties to long term shareholder value). Carl Icahn is right about the need for more shareholder rights and improved BOD’s. Under the current situation, common shareholders are not owners in the companies, they are just speculators playing a vegas like game while the “house” calls the shots and is the big winner.

  8. Moss says:

    The unethical behavior became institutionalized to the point where it became rewarded. The system is clearly broken. I wonder if humans have lost the ability to govern themselves within the existing confines of the system.

  9. Jojo99 says:

    It isn’t just the Wall Street that is short on ethics, it is humankind. As long as the standard of success in this world is how much more you have than your neighbor/worker (i.e status, money, material goods, etc.), then ethics will take a backseat as we attempt to achieve more than the other person, to be recognized as a relative success.

    Pressure to achieve, to be better than those around you starts early in childhood by parents and is institutionally reinforced in school, by peers and via TV shows and advertising. As we grow older, the pressure only intensifies. The ever growing number of unemployed can only make this pressure worse in this dog eats cat world. An old adage says that “What goes around, comes around”, yet I have encountered many people who have treated others poorly, acted out of greed and so forth but have never paid a price for their behavior.

    A couple of recent related news stories:
    ————————-
    Survey: Student cheating common in high schools
    Sunday, November 30, 2008 | 10:25 PM

    A new survey has found high levels of stealing and cheating among American high school students.

    An ethics organization called the Josephson Institute surveyed nearly 30,000 students from 100 schools across the country.

    The survey found that 30 percent of high school students have stolen from a store in the past year.

    Sixty-four percent said they had cheated on a test. Some of those students admitted to cheating multiple times.

    Link
    ——————————–
    WSJ
    NOVEMBER 24, 2008
    UBS Clients Seek Amnesty on U.S. Taxes

    Wealthy clients of Swiss bank UBS AG are coming forward to make amends with tax authorities, a sign U.S. efforts to battle offshore tax evasion and dent Switzerland’s bank secrecy are having the desired effect.

    Moved to take action after a former UBS private banker was indicted and spilled valuable secrets, the UBS clients are hiring tax lawyers and pursuing amnesty through an Internal Revenue Service voluntary disclosure program. The program allows U.S. citizens to avoid criminal prosecution if they acknowledge evasion and agree to pay taxes and penalties.

    The clients’ actions are a boon for the IRS, which lacks …

    Link

  10. Neil C Denver says:

    Talking about ‘ethical standards’, Alt-A loans do not require income verification. These loans are widely known in the industry as ‘tax cheat’ loans.

    I tried and tried to get my Senator who sits on the Bank and Finance Committee to send the names of these persons to the IRS. If the reported income on the tax return is less than the amount stated on the mortgage applicaion, those people should be seriously investigated.

  11. jreev says:

    This may seem out of left field, but I could never stand President Clinton. It seemed pretty obvious that he was sleazy, manipulative and operated under the belief that the ends justify the means. People were generally happy with him (not everyone, I know) because the economy and markets were very good, but I couldn’t get rid of the feeling his slickness (a relative to unethical) while people had some fun with it, was a horrible example for the country. I’m not saying people were so virtuous before by any means, but when leaders are so obviously flawed in this way it can’t be good.

  12. Jojo99 says:

    So jreev, so you’re the point you are trying to make is that you liked Bush better because he was someone you thought you could enjoy a beer with? [roflol]

  13. jreev says:

    Hi Jojo99. Bush has been horrible and he ain’t my type for a beer either. You certainly could make the case he is sleazy but not in a way like Clinton where it seemed like many took pride in his sleaziness. He just set a very bad example. FDR said “the depression was the result of a lack of honor from men in high places.”

  14. az2007 says:

    Hi,

    If you dump the rules and regulations aimed at protecting the system [1] then ANYTHING can happen…as the last few months will testify.

    References:

    1. http://www.mail.com/layoutengine.aspx?page=Article.aspx&articlepath=APNews\General-Business\20081201\Meltdown-Ignored-Warnings.xml&cat=money&subcat=business&pageid=2

  15. az2007 says:

    Hi,

    I can’t help feeling putting the rules and regulations back into place is a little like “closing the stable door after the horse has bolted”…perhaps more drastic action is needed to save the global economy…something like…interest-free banking.

    Interest-Free banking is a strange beast…few people really understand it. However there’s very little to understand, just three rules:

    1. Rental-Mortgages: For homes purchases, every house has a market value AND and rental value (which is annually reviewed). The bank purchases a maximum of 85%, the mortgagee funding the rest. After that the mortgagee pays 85% of the rent. So a house worth $100,000 with a rental value of $8000/year, the Bank procures $85,000 with the rest paid for the by the mortgagee. The mortgagee then pays $8000*85%/12 = $567 per month rent.

    2. Shared-Risk Investment. Instead of securing bank loans to fund investments, investors invest at least 15% into an investment, the bank investing the rest, with profit/loss shared out at the level reflecting investment. Deposit and other savers accounts would similarly have to be replaced with Shared-Risk Investment Accounts

    3. Inter-Bank borrowing…well either:
    a. they borrow at zero percent interest
    b. they accept if they can’t afford to finance themselves, they’ll just have to stop operating and pack up the business

    and that’s it! And no, this isn’t something I’ve cudgeled up…its the basis of…Islamic Finance and Banking, though I fear to use the word ‘Islamic’ knowing full-well how those mass-murdering Texan thugs in the White-House have twisted it out of shape in order to justify their own agenda. Though having brought up the issue of the Texan-Thugs, I have an interesting theory as follow:

    After the collapse of the Cold War, no-one wanted US Military Hardware and Software anymore, resulting in a collapse of the Southern Industries (at one point Banks didn’t even care about the interest on the loans used by the afftected Southern Companies…they just wanted their loans back). So these Southerners thought and thought, and eventually came up with a ‘brilliant idea’. Since:

    1. They hated Islam with a vengeance (classic Islamaphobes)
    2. Many Muslim Lands had Natural Resources (eg oil) they could use to get out of financial turmoil and rebuild the Southern Economies

    why not manufacture a ‘War on Terror’ to justify smashing Muslim Lands and stealing their natural wealth (under the guise of ‘hunting down the terrorists’)? I would also argue that MOST wars over the past 3000 years have occured because the aggressing-nation couldn’t afford to pay the interest on loans they had secured, so ‘looked abroad’ for alternative sources of income. I would equally argue that the major beneficieries of Islamically-unlawful industries eg Pornography, Prostitution, Alcohol etc etc are People and Institutes looking for ‘guaranteed income’ to fund their interest-based loans.

    Oh and whilst I’m still on the subject of Islam, I fully support amputating the right hand of thiefs…people like:

    1. those b*stards at Enron who had wealth but just wanted more and more
    2. I suspect the people who supported the removal of the rules and regulations that ultimately lead to the Banking Crash (and the meltdown shouldn’t be underestimated [1]) knew exactly what they were doing and the consequences…but they did it anyway because they also wanted more and more wealth…

    though I would prefer public crucifixion for both sets of b*stards

    References:

    1. http://www.newsweek.com/id/172647/page/1

  16. az2007 says:

    Hi,

    In fact I can’t help feeling the Banking and Finance Industry has been playing ‘loose, hard and fast’ because of all this guaranteed income (as a result of interest-based loans), since even if they suffer losses, they’ve always got more guaranteed interest-income coming through.

    Once this curse [of interest-based loans and guaranteed income] has been completely abolished, God-Willing we should see a more mature global Banking and Finance system that takes MANAGED risk, with rules and regulations, exit-strategies etc etc in place BEFORE they start trading

  17. AFIPER says:

    Thank you Mr. Curtis for your very accurate paper.

    Concerning credit rating agencies I would like to provide a testimony from holders of defaulted sovereign bonds whose issuers inexplicably remain rated “investment grade”.

    Although credit rating agencies (CRAs) are only one of the flawed links in the chain leading from unpaid mortgages to credit crunch and worldwide market turmoil, their role proves essential because they are supposed to be the gate-keepers in whose opinions market participants and individual investors must ultimately be able to place their trust.

    If there is only one issue to be fixed it is the issue of trust; that is what new regulation on both sides of the Atlantic is about and that is where it is failing miserably.

    How will trust in the gate-keepers ever be restored if while claiming to have resolved the conflicts of interests embedded in their business models and rating processes the CRAs remain in denial of the massive and notorious unresolved defaults of sovereign issuers whom they continue to rate “investment grade” in the face of their own self-imposed methodologies which claim to place willingness to pay first and foremost among their rating criteria?

    The Russian Federation’s “investment grade” ratings wilfully ignore:

    • Russia’s proven absence of willingness to pay.
    • The falsity of the accounts of the Russian Federation which do not mention – therefore conceal – the rights of hundreds of thousands of private bondholders, which remain valid as per three consecutive findings of France’s highest administrative court the Conseil d’Etat in 2003 and 2004.
    • Litigation risk on claims conservatively estimated to be worth well in excess of €100 billion.

    Until the existence of holders of defaulted bonds issued by “investment grade” rated sovereigns is acknowledged and they are satisfied, credit ratings will remain openly tainted with conflict of interest issues.

    CRAs are supposed to protect investors, yet investors are the one category of interested – yet neglected – parties whose relevant, precise and verifiable input, such as proof of an unresolved default, can be ignored by the CRAs, who are under no obligation to justify such decisions.

    That is why two European groups of defaulted bondholders, including our own AFIPER, officially petitioned the European Parliament in June of this year. And that is why a third one has wrote to G20 participants and 200 Members of the European Parilament one month ago.

    The case of the Russian Federation is not unique. I know that a similar situation exists where American holders of defaulted Chinese bonds are concerned and I believe they have been very active in both Houses in Washington, with a view to obtaining formal recognition of the default of the People’s Republic of China.

    Resolving these matters will not bring an end to the credit crunch; but trust will not be restored until CRAs stop rating notorious defaults as investment grade.

    Eric SANITAS,
    President of Afiper-Association fédérative internationale des porteurs d’emprunts russes.
    http://www.afiper.org