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.
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
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
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
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.