FEATURE | SUMMER 2010 EFFECT

An Ethical Downturn?

by Michael Lotti

When things go wrong, we look for someone to blame. So we think there must have been some kind of unethical behavior behind the economic crisis that began in September 2008. And if we can identify it, shouldn’t we be able to do something about it?

No one disputes that many mortgage brokers used fraud and deceptive practices to convince people to sign up for loans they couldn’t afford. Many also used false documentation to convince banks to fund people who weren’t creditworthy. A lack of due diligence kept the likely-to-default mortgages moving up the financial food chain, resulting in investment portfolios stuffed with mortgage-backed securities that seemed safe but were, in fact, poised to lose considerable value if the housing market tumbled.

But according to Ian Maitland, professor of management at the University of Minnesota, there was not much unethical behavior beyond that. “There was no way anyone could have confidently predicted such a drastic downturn in the housing market,” he states. While acknowledging that Nouriel Roubini, professor of economic and international business at New York University, accurately forecasted the burst of the housing bubble nearly two years before it actually happened, he also notes that “other forecasters predicted housing prices would level off, decline slightly, or continue to go up.” Moreover, these predictions were backed by sophisticated computer models that were based on reams of data from the housing market in the twentieth century. “So there was no cover-up as with Enron and WorldCom—just a faulty assumption that wasn’t known to be faulty,” concludes Maitland. “There is no way to know, when you’re in the middle of it, whether a boom is a sustainable boom or just a bubble.”

Maitland, however, is in the minority.

Stephen B. Young is especially critical of the large Wall Street investment banks. As the global executive director of the Caux Round Table, a nonprofit organization that promotes principled decision making in free markets, he is quick to identify careless—and thus risky—business practices. “These firms consciously took on huge levels of leverage. A 35:1 debt-to-asset ration was common, and 50:1 was not unknown. This put all of their investors at risk,” he says. “And because this is the world of credit and finance, they were putting the whole economy at risk. It doesn’t matter what business model you’re dealing with—some levels of debt are simply unacceptable.”

Larry Rittenberg, a professor of accounting and information systems at the University of Wisconsin, thinks the Wall Street firms are accountable for their lack of knowledge. “If I sell you a car that has no brakes and I know it has no brakes, shame on me. If I sell you a car with no brakes and I don’t know that, then shame on me still, for I should know.” Rittenberg also thinks insurance companies like AIG had an obligation to manage their risk more carefully. “What kind of Las Vegas bookie takes bets on only one side of a gamble?” he asks. “They take in enough from both sides to cover themselves no matter what happens. AIG, on the other hand, hedged all its bets on a sustained housing market. The word for that is irresponsible.”

The whole situation shows Urton Anderson, chair and professor of accounting at the University of Texas at Austin, that “we still don’t do corporate governance very well.” He notes that Sarbanes-Oxley led to significant reform of accounting standards after the Enron and WorldCom debacles, but nothing was on the books about super-high leverage or risky securities. So at every level of the Wall Street firms, he says, managers simply didn’t check on the work of their underlings—or if they did, it was to ensure profits were still being generated, not to ensure everyone was carefully weighing the risk of the investments.

Young agrees. The boards of these firms “failed in their primary task: to govern the institution with independent judgment so it would have long-term viability,” he says. “They didn’t hold anyone accountable for anything except profit and share price.”

Young, Rittenberg, and Anderson all think compensation schemes throughout the system were ethically suspect. “The incentive structures created an unethical culture,” says Anderson. “Mortgage brokers and bond sellers got paid according to the volume of business they did, not the quality of that business.”

No one, in other words, was ever paid or rewarded for being diligent. Charles Gasparino, author of The Sellout (HarperCollins, 2009), is especially critical of the ratings companies that routinely gave “AAA” ratings to shaky mortgage-backed securities. They obviously did not carefully look into the contents of the securities, and worse, they operated with an unethical conflict of interest: they were “paid by the municipalities, the corporations … and the investment bankers doing the deals they were rating” and thus could hardly be expected to deliver unbiased assessments.

Will there be a next time?

Can anything be done to shore up ethical thinking and practice in the financial world and thereby prevent another crisis? Unfortunately, all options seem limited.

Business ethics programs at the undergraduate and MBA level are important, but they can only do so much. Rittenberg, Maitland, and Anderson are all proud to teach in programs that require business ethics courses. “If a business ethics course is an elective,” states Maitland, “the people who really need it won’t sign up.” But all three professors warn against betting on education as a reliable tool for ethical reform. The most any teacher or academic program can do, they say, is help students become better thinkers about ethical issues. They can’t make students actually be ethical, and that, in the end, is what counts.

As for legislative remedies, “don’t hold your breath,” says Young. “Our current political leaders are a bunch of munchkins when it comes to this stuff. No one wants to take a risk and propose something that doesn’t fit the status quo.”

Anderson comes to the same conclusion from a different angle. The issues of compensation, regulation, and disclosure rules are extremely complicated, he says, which makes them difficult to address with the blunt force of a law.

Young also thinks legislation can’t address the larger shortcomings behind the failure of Wall Street. “The ethical lapses of the big Wall Street investment banks mirror those of the larger society: an abdication of responsibility and long-term thinking in favor of short-term gratification,” he says. What we need, he argues, is something like the post-Sputnik response in the late 1950s. “At that time, leaders in the scientific, political, and business communities came together and accelerated an agenda to improve math and science education throughout the country,” he says. Likewise, leaders in education, business, and politics need to embrace an agenda to teach people how to evaluate situations with more ethical rigor. He hopes the Caux Round Table can help accelerate such a process via seminars, conferences, workshops and, increasingly, training courses brought directly into specific corporations. But he also knows that many more people and organizations will have to be proactive before significant, culture-wide changes are made.

According to Urton Anderson, compliance officers can do a lot to maintain a legally and ethically sound corporation. Such a person generally reports directly to a corporate board about whether the company is meeting all of its legal obligations and whatever other ethical standards the board has imposed.

Roy Snell, CEO of the Society of Corporate Compliance and Ethics, goes further and thinks that a compliance officer is an absolute must in a business that wants to improve and maintain an ethical culture. “I get frustrated when I hear people say that if a corporate culture is ethical, it will be legally compliant as well,” he says. “The fact is that unless you have a compliance officer with authority to look into everyone’s work, errors due to mistakes, incompetence, and unethical behavior are bound to creep in.” But compliance officers are expensive, he notes, and lots of corporate boards think a compliance officer is a signal to employees that they aren’t trusted.

A natural solution

So if education, law, and corporate compliance efforts won’t get the desired results, what will?

Perhaps the surest way to deal with the ethical problems behind the current crisis is to let capitalism take its natural course. When lots of people lose lots of money in a short amount of time, corporate awareness and practices are bound to evolve. “Enron and WorldCom woke a lot of people up to ethical problems in accounting,” says Maitland, “and this crisis will wake people up to the issues surrounding mortgages, trading, and a host of other things.”

A recent special section of The Economist (February 11, 2010) highlighted several changes taking place throughout the financial industry: boards establishing new capital requirements for their institutions, CEOs appointing scrupulous risk managers, technology departments significantly revising (and in some cases abandoning) the computer-generated models that failed to highlight the danger of certain securities, and all kinds of managers developing compensation structures that build in long-term accountability and performance. Notably, none of these things are taking place to comply with a new law; the survival and profit motives, it seems, are sufficient.

Even with more attention on corporate ethics, it’s hard to imagine there won’t ever be another crisis. Because the world changes, Maitland argues, new problems aren’t identified simply because they’re different from all previous problems. Furthermore, the problems that led to the panic of 2008 demonstrate that “people are not likely to be cautious and questioning in good times, which is exactly when they most need to be that way.”

So what is the big ethical lesson of this downturn? In some ways, it may be very simple. There are plenty of banks and other financial institutions that remained reasonably cautious and stuck solidly to their business principles. Today, they are the businesses leading the industries—and probably the economy—to safer ground.

With some diligence, you can find prudent and ethical companies to invest in or do business with. But keep your eyes open. If Maitland is right, another economic bubble will form, and it will be the sharp ethical eyes, and those who trust them, who will be best protected when the bubble bursts.