Credit Crunch, Character Crisis

The global financial markets' August upheavals have generated endless commentaries on the reasons for their liquidity problems. The identified culprits range from American subprime mortgage-lenders, to securities-rating agencies, to central banks.

Characteristic of these analyses is a tendency to study the crisis in strictly economic terms. Phrases such as "overexposure to high-risk investments," "suspension of withdrawals from funds invested in illiquid credit securities," and "margin-calls forcing hedge funds to liquidate good assets" dominate the discussion.

All these and other expressions have real meaning and accurately describe elements at work in the economic storm that reduced the value of Goldman Sachs' leading global equity fund by over 30 percent within a week.

Unfortunately the language of these commentaries sometimes distracts our attention from the human dimension involved.

Like other elements of the market, financial businesses do not consist of faceless entities, anonymous group-dynamics, or even "the gnomes of Zurich" (as anti-Semites and conspiracy theorists imagine). Real human beings, actions, and choices are at the heart of the world's bourses: that is, real people who create wealth, respond to incentives, make honest mistakes, and sometimes behave irresponsibly.

With so many people's economic well-being now partly determined by decisions of those working in financial industries, sound moral character in their employees and directors should be a premium asset sought by any bank or financial company.

An example of character's importance is the failure of many securities-rating agencies to identify the growth of defaults in subprime mortgages as an emerging problem. One reason for this failure lies in their apparent acquiescence in conflict of interest situations.

Since 1995, asset-based securities that used American subprime mortgages as collateral have been purchased by individuals and institutional investors. These securities were in turn consolidated into collateralized-debt obligations (CDOs) and collateralized-loan obligations (CLOs). The risks associated with different CDOs and CLOs are assessed by securities-ratings agencies. This is one of their most profitable activities.

 As The Economist recently observed, many financial institutions (knowing that ratings help determine the value of CDOs and CLOs) began approaching rating agencies some years ago to ask their advice on how to structure CDOs and CLOs in order to maximize their value.

At that point, ratings agencies' moral antennae should have begun quivering. It is very difficult to provide objective assessment of risks associated with particular securities when you have helped structure the very same securities. This, however, did not deter some ratings agencies from involving themselves in CDO/CLO structuring.

Thus it is little wonder that when the subprime mortgage market on which many CDOs/CLOs were built began imploding, some ratings agencies were slow to concede something was wrong — this would have raised the very questions now being asked about their objectivity.

This is not to suggest that rating agencies were somehow engaged in sordid financial swindles. The point is that when ratings agencies were asked by banks to become involved in structuring CDOs/CLOs, they should have said, "No. That would compromise our capacity to objectively assess the risks associated with your securities. Our objectivity is our greatest asset. It can lend value to your assets. But only if our assessments remain objective and detached."

The fact some ratings agencies did otherwise suggests failures of judgment and character on their part.

A longer-term problem is that this failure may facilitate calls for more financial regulation, much as the Sarbanes-Oxley Act was a response to America's 2000-2001 corporate scandals. The evidence is growing that Sarbanes-Oxley has proved extremely costly for business. Even Sarbanes-Oxley's authors now concede many of its provisions were badly drafted.

According to a University of Pittsburgh study, Sarbanes-Oxley's discouragement of prudent risk-taking and its generation of additional compliance-costs have contributed to many firms listing themselves in the City of London rather than Wall Street. This has also been facilitated by Britain's Financial Services Authority's shift away from Sarbanes-Oxley-like procedural approaches to financial regulation, towards principles-based regulation which focuses on (a) the behavior reasonably expected from financial practitioners and (b) good outcomes.

In the end, however, no amount of regulation — heavy or light — can substitute for the type of character-formation that is supposed to occur in families, schools, churches, and synagogues.

These are the institutions (rather than ethics-auditors and business-ethics courses) which The Wealth of Nations' author, Adam Smith, identified as primarily responsible for helping people develop what he called the "moral sense" that causes us to know instinctively when particular courses of action are imprudent or simply wrong — regardless of whether we are Wall Street bankers or humble actuaries working at securities-rating agencies.

Perhaps the recent financial turmoil will remind us that sound financial sectors rely more than we think upon sound moral cultures.

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  • Guest

    Great article.  I am amazed at what we call business.  It also calls me to see that the little things I do have a moral aspect I may not be aware of.  I will work to get be fair and square in my life.

    GK – God is good!

  • Guest

    In the formerly Eastern block countries the people were demanding over and over again, give us communism (socialism) with a human face. The response over and over again was tanks but thanks. Free society hardly even knows enough to ask for an ethical mind behind the human face that we already have. As the former crumbled so will free society. A moral compass is the only thing that keeps us properly oriented, even in beautiful country. In order to obtain a loan the banks used to apply the rule of the 4 "C's" – character, credit, collateral and I can't think of the 4th, (maybe it was just these three). In any case how does this compare with today's :"bad credit? no problem!" It's already compensated by unethical, shark interest rates.

  • Guest

    Dr. Gregg's article is right on the mark. When individuals transacting business replace due diligence with faith in government or industry regulation, they are headed for trouble. Caveat emptor still applies.

    Dr. Gregg's mention of CDO's and CLO's is worth noting. The buyer's of these instruments disregarded a time honored principle when they allowed the seller of a credit obligation to determent its value, instead of an independent rating agency, and they paid for it.

    As my Business Law professor used to say, "They have been tried and found wanting."

    All of us in business must try to be good judges of character, and character has to count in our evaluations of who to do business with.