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In 2010, Richard Fuld, the former CEO of Lehman Brothers, told a congressional committee that he had "absolutely no recollection whatsoever of hearing anything" about Repo 105 at the time of the transactions. Lehman's demise, he claimed, was caused by "uncontrollable market forces" and the U.S. government's unwillingness to rescue the firm. Of course, Henry Paulson, the U.S. Treasury Secretary in 2008, had tried in vain to get Fuld to accept a buyer offering a reasonable price; Fuld had been holding out for more in spite of the financial condition of Lehman. It is stunning that a man who had been allowed to reach such a pristine and lofty office in the business world would not even permit himself to acknowledge any contributory role in the downfall of the organization he had run. Such an attitude alone seems worthy of a prison sentence (and the return of his salary and bonuses); how he and his "team" had manipulated the books to make the bank look wealthier than it was would seem to make such a sentence inevitable.

However, as of March 15, 2011, no high-profile executives involved in the finacial crisis of 2008 had been successfully prosecuted. In Feburary of the same year, for example, a federal criminal investigation of former Countrywide Financial Corp. Chief Executive Angelo Mozilo had been, according to The New York Times, "closed without charges." Regarding "the battered real-estate portfolio and an accounting move known as Repo 105," the paper reported that SEC officials were growing more worried in the early months of 2011 that "they could lose a court battle if they bring civil charges that allege Lehman investors were duped by company executives. The key stumbling block: The accounting move, while controversial, isn't necessarily illegal." This is an extremely important point, for it means that FASB, the non-profit quasi-regulatory body that promulgates generally accepted accounting principles (GAAP) in the United States, is too permissive--too accommodating of how executives of publicly-held corporations want to value assets and liabilities.

Punctum saliens, the means by which accounting standards are determined is too susceptible to influence from CPA firms and their clients, the public corporations being audited.  The structural conflict of interest existing between the "independent" auditors and their clients is magnified to the extent that either of the two parties have inordinate influence on FASB.  Even if a government agency such as the SEC were to set the regulations, there would still be the risk that the accounting firms and/or public corporations could gain leverage over the regulators, in what is called regulatory capture. The root problem behind both allowing the conflict of interest and being too accommodating in terms of GAAP is that Americans, and thus the values in American culture, are too conducive to business--meaning not sufficiently realistic concerning the possibility of greed and any resulting harm. An examination of why the Lehman executives could manipulate their books unfairly and yet legally points to this proclivity manifested through a too-flawed and friendly accounting regulatory system.

The New York Times reports that in March of the same year in which Richard Fuld testified before Congress to disavow any responsibility in the failure of the bank he had run, "the Repo 105 transactions were condemned by court-appointed examiner Anton R. Valukas, who said in a report that they enabled Lehman to 'paint a misleading picture of its financial condition.' . . . In the transactions, Lehman swapped fixed-income assets for cash shortly before the securities firm reported quarterly results, promising to buy back the securities later. The cash was used to pay down the company's debts. Emails sent by executives at the company referred to Repo 105 as a 'drug' and 'basically window dressing.'" Valukas concluded there were "colorable," or credible, legal claims against Ernst & Young, Fuld and former Lehman finance chiefs Ian Lowitt, Erin Callan and Christopher O'Meara. Indeed, when he was the Attorney General of New York, Andrew Cuomo criticized the Repo 105 transactions as a "house-of-cards business model, designed to hide billions in liabilities in the years before Lehman collapsed."  The implication is that Fuld and his subordinate managers had committed fraud.

Even so, Ernst & Young "had concluded that the accounting in the Repo 105 transactions was acceptable."  In a statement, Ernst & Young "said," we stand "behind our work on the Lehman audit and our opinion that Lehman's financial statements were fairly stated in accordance with the U.S. accounting standards that existed at the time." (italics added) Fairness, in other words, depends solely on whether the books of a company are in line with the accounting standards, rather than on whether the values recorded on the books reflect the values of the underlying assets and liabilities. In terms of the repos at Lehman, The New York Times reports that SEC officials generally concluded that "the transactions were consistent with accounting standards." Successfully prosecuting former Lehman execcutives for making misleading statements about the bank's financial condition is an uphill battle, according to the paper, because the executives relied on legal and accounting opinions. Furthermore, in his report, Valukas wrote that he didn't find "sufficient evidence to support a colorable claim for breach of fiduciary duty in connection with any of Lehman's valuations." Also, SEC officials were not "convinced that Lehman shareholders suffered material harm, since executives were trading one type of highly liquid asset for another." However, the apparently lower debt levels might have influenced existing and potential investors in their decision-making regarding their level of exposure from investing in Lehman. In other words, their risk was being deliberately understated by Lehman's management. Even if particular investors were not actually harmed, showing an apparent lower risk than would be the case without the repos (and cost valuations on the real estate investments) was not in the investors' interest. Moreover, it just isn't fair, even if it is legal because it is allowed by GAAP. The problem, in other words, extends from Fuld and his sycophants at Lehman to the FASB.

The wrench in the works with my thesis is the fact that there are indeed different ways in which an asset or liability can be valued fairly. There are different viable assumptions, for example, regarding whether an asset should be valued at cost or market. Each assumption has a downside. Showing a real estate investment at cost, for instance, has the downside that the market-value of the asset, if significantly lower, is not shown. That is, the transactions-value of the asset at the time is ignored. Even if the firm intends to hold the asset, the lower market value would determine what the firm could do with that asset in covering for any needed debt payments. On the other hand, if market values fluctuate substantially, changes in an asset's value may not make much difference to the underlying value of the asset, and thus to the firm, especially if the firm intends to hold the asset long term.  To the extent that speculators can artificially push up or short an asset's market price, the latter does not reflect the underlying, or fundamental, value of the asset or even the real supply and demand (e.g., oil price hikes in the wake of the Libyan disruptions in 2011). Unfortunately, the companies being regulated and the accounting firms they hire can use such authentic debates to open GAAP up wider than a sloppy whore so they can have their way with her in order to look better than they are. That such selfishness, deceitfulness and greed can be accommodated by GAAP, and thus the FASB, and ultimately the American electorates, is the real problem, and unfortunately there is not an easy solution because the basic problem lies in values and assumptions held by a population.

As useful as flexibility is in accommodating different assumptions and plans regarding assets and liabilities, the refusal of FASB to fortify its sanctioned accounting methods with conditions so investors are not misled--a refusal that I contend is from inordinate influence from the regulated and their public accountants--means that managers running publicly-held companies like Lehman Brothers are enabled to do practically-speaking whatever they want to show the public (and the owners) only the asset values and debt levels that they want. Allowing only cost to value real estate, for instance, could be conditioned not on whether the firm intends to hold the asset (a subjective matter that a manager could manipulate and even falsify), but rather on the extent of difference in percentage terms between the market value and cost. An accounting breed of relativism unchecked allows for and enables greed. Lest we want to succumb to such decadence, fairly stated ought not be tied to conforms to GAAP if the latter is too tolerant. The regulated will always prefer relativism in regulation.  Even if GAAP is tightened, fairly stated ought not to be determined solely in terms of those standards. Additionally, CPA firms ought to be on the look out for fraud or misleading practices even if they are allowed by the FASB's standards.  The latter are means rather than ends in themselves. According to Kant, beings of a rational nature must be treated as ends in themselves (as well as means). GAAP are not rational beings.

Beyond changes in GAAP and what CPA firms are charged to look at, the friendliness of the FASB to the business world, or at the very least the extent of the organization's accommodation, should convince the American people and government officials that more government regulatory involvement is warranted. While some government regulators could come from industry to contribute their technical knowledge, they should be checked by superiors who have a healthy skepticism of business and a salient regard, or value, for the public interest. Ultimately, it is up to the American people, operating through our elected officials and the related governmental agencies, to stand up to the temptation to have regulation esssentially by the regulatees. However, this requires esteeming values that are sufficiently realistic concerning the role that greed and selfishness can play in those of us who run the world of business. Power as well as money can be intoxicating, especially in high doses. Lest the value of economic liberty blind us to this subterranean all-too-human propensity, we as a society could pay more attention to the societal blind spot of structural or institutional conflicts of interest implicit in the very design of some of our most important regulatory systems.
Source: http://online.wsj.com/article/SB10001424052748703597804576194871565429108.html

Click to add a Comment or Question (or View Posted Comments) on business ethics at Lehman Brothers.


On greed, see related essay, "Godliness and Greed": http://thewordenreport.blogspot.com/2011/02/godliness-greed-how-effective-is.html

On Lehman's corporate governance, see: http://thewordenreport.blogspot.com/2011/02/godliness-greed-how-effective-is.html

While watching Lord of the Rings on TBS in 2010, I noticed that the network was posting not only its logo on the bottom right of the screen, but also advertising for its programming on the bottom left. Also, “more movie, less commercials” was written to accompany the logo. What really got to me during the movie was when pictures advertising a television show were shown. They took up almost an eighth of the screen and thus could not but distract the viewer from watching the movie. I decided I would not watch movies on networks that compromise or prostitute their own programing in order to sell themselves while "in progress." It is like sitting down at a restaurant and having the waitor sell me on other dishes while I am trying to enjoy the one that I'm eating. “I just want to enjoy this fine meal, thank you,” any discerning customer would be wont to say. Once at Starbucks, the customer in front of me at the register was paying $25 for a variety of products.  As I was thinking that the store had made a good sale, the clerk tried to sell the customer on a certain food item for the next visit--as if the present sale was not enough.  The same propensity wherein nothing is ever enough is evinced by the television networks that can't seem to restrain themselves from adding more and more self-promotions onto the screen during their own programming.  These networks are playing off the mitigated nature of the additions being incremental, and thus not objectionable to the average viewer. 

It is simply bad business to interfere with a customer’s enjoyment of a product by trying to promote the business or another product. The over-reaching has the bad smell of self-indulgence knowingly at others’ expense. It is impossible to enjoy a movie while animated characters run around the bottom of the screen to get the viewers' attention. The perpetrators ought to be regarded as children wherein if we give them an inch, they will indeed take a mile. Sadly, too many of us allow ourselves to be strung along the slippery slope--perhaps some viewers don't even notice the incremental intrusions. The smell of the network managers' over-reaching ought to be emetic, but perhaps the stench is so ubiquitous that we as a soceity are innoculated against even smelling it.  One can hope that one day, we shall wake up to the decadence and "smell the coffee." Perhaps only the loss of a significant viewership would mean that the sordid managers will be out of their jobs–unable to earn their high salaries for trying to manipulate us in new subterfuges. That, ladies and gentlemen, would be justice and a more salubrious society.  In the meantime, American television will increasingly come to reflect the lowest common denominator in the viewership because that is where the numbers are. In fact, perhaps it could be said that this nature of television reflects the values that are taking hold in American society.

Do we as a society value mutual respect and self-restraint, or are we too tolerant of selfishness and manipulatory behavior? Do we not value strength, but instead enable weakness? Are the stars of reality shows famous for fifteen minutes because they evince our society's actual values?  In other words, have we become a self-absorbed, petty people without realizing it?  If so, the television networks may simply be us taking advantage because it is condoned.

In 2010, Eric Jackson, an activist investor and hedge fund manager, averred that Goldman’s board was too cozy and too lacking in financial know-how to diligently oversee top management. He claimed the board was packed with honchos who led companies that had paid large fees to Goldman. Jackson pointed to Indian steel magnate Lakshmi Mittal and former Fannie Mae chief James Johnson as cases in point. The problem with these choices, Jackson said, is that “these people seem to be favorably disposed to senior management’s way of thinking,” and are therefore unlikely to act as a check on CEO Lloyd Blankfein and his team. Colin Barr of Fortune argued that the bank’s system of corporate governance was behind the times. He pointed out that Lloyd Blankfein continued to serve as chairman and CEO, even as the trend in recent years had been toward independent board leadership.

After all, one of a board's main functions is to oversee and evaluate the CEO as well as the other top executives. The duality of chairman/CEO is the epitome of a structural or institutional conflict of interest; a CEO who is also chair of the group whose job it is to evaluate the CEO is presuming to evaluate him or herself, in effect. The sheer existence of such an obvious conflict of interest can be viewed as presumptuous. Furthermore, the arrangement itself is an incentive to engage in duplicitous subterfuge. A board of directors is by definition independent of the management because the board’s function is to oversee it.  Overseeing and being cozy are like oil and water.  A “trend” away from conflating the two minimizes the decadence in the problem.  Instead, corporate governance ought to require independence.

When Armstrong was chair/CEO of ATT, I asked him whether giving up the chairmanship wouldn't enable his board to better evaluate him as there would not be the suspicion of a conflict of interest. He replied as though he were president of the United States, saying "the buck stops here."  He went on to say that he had to have complete control or he could not rightly be blamed if his strategy (which was broadband at the time) didn't work.  If his board said no to part of his strategy, it would not be fair to blame him for the failure of his entire strategy. Of course, he could have presented his strategy to his board and if it objected to part of it, the resultant strategy, it could be agreed, would not be considered to be his; he would be evaluated on how well he implimented it. The notion that any sort of check on power renders the power compromised or impotent ignores the basic difference between a board and a management. Managers work within broad strategic guidelines that are set as a matter of policy by a board, and managerial implimentation can indeed be evaluated without compromising it.  In effect, Armstrong wanted to go beyond managing to the property-rights goal-level of owning.  That he was overreaching is all the more reason why an independent board would have been a valuble commodity for ATT.

To be sure, it is difficult to counter the influence that a management has on account of its position vis a vis the company and its board. As a starting point, people having former ties to the management, or even hand picked by the CEO, ought to be barred from serving as directors. It should go without saying that a CEO ought to be barred from serving as the chair of the board.  Conflating these two roles is tantamount to suggesting that a CEO can (and should) oversee himself, which is nonsensical. For there simply to be a mere trend away from this duality essentially “normalizes” that which ought to be approached as an oxymoron--a contradiction in terms. That such a phenomenon would be allowed to exist at all points to the power that CEO's have to define social reality for society. Such power is very dangerous, especially if left unchecked even in the name of "the buck stops here."

Source: http://money.cnn.com/2010/04/20/news/companies/goldman.board.fortune/index.htm

For years, banks and other issuers have paid rating agencies to rate their securities. This is a bit like restaurants paying food critics to write on their food.  In the wake of the SEC’s charge that  people at Goldman Sachs built the Abacus investment to fall apart so a hedge fund manager, John A. Paulson, could bet against it, the Senate’s Permanent Subcommittee on Investigations questioned representatives from Moody’s and Standard & Poor’s about how they rate risky securities. Carl M. Levin, the Michigan Democrat who heads the Senate panel, said in a statement: “A conveyor belt of high-risk securities, backed by toxic mortgages, got AAA ratings that turned out not to be worth the paper they were printed on.” Throughout the testimony, the institutional conflict of interest was salient whereby credit-rating agencies put market-share considerations foremost in rating securities presented by the banks that are paying the agencies. Someone at one bank, J. P. Morgan, went so far as to communicate to one of the agencies that the agency’s ratings should reflect market-share considerations.  Essentially, the bank was reminding the agency that the bank was a client. To be fair, the agency replied that such considerations are not part of the ratings process.  However, the testimony before the committee suggested that the reality has often been quite otherwise. The upper managements of the agencies in particular regularly pressure their ratings analysts to rate in such a way that the agency’s market share does not suffer.  In other words, the message is: “Rate so we don’t lose any clients.”

In fact, the agencies even shared their models with the banks.  As a result, the banks could game the models so the securities would get high ratings.  To be sure, there was also fraud involved, such as making it seem like the mortgages in a CDO came from different servicers or different regions of the US.  Some bankers relabeled parts of collateralized debt obligations in two ways so they would not be recognized by the computer models as being the same. Others were also able to get more favorable ratings by adding a small amount of commercial real estate loans to a mix of home loans, thus making the entire pool appear safer. “If you dug into it, if you had the time, you would see errors that magically favored the banker,” said one former ratings executive.  The assymetry was no accident, for there is an underlying structural conflict of interest at the core of the ratings system. The actual clients–the general public that relies on the ratings–are not the parties paying the agencies.  Also, the agencies get more when their ratings are higher because more of the underlying securities are sold.   To demand that an agency be independent of the “client” paying it is to place the agency in a structural or institutional conflict of interest that cannot be effectively remedied by simplying subjecting the agency to higher regulatory standards. Worse still, often times the underlying structure is ignored.

Although not made transparent in the Senate hearing, I want to point to the assumption that the agencies would be able to handle their conflict of interest, even in the face of rising pressure for profits as increasing attention was directed to their stock prices. There seems to be a belief in American society that businesses can rise to the occasion when a structural conflict of interest is involved.  In other words, we tend to mitigate the force of such ethical dilemmas, essentially assuming that human nature can be relied upon to surmount them.  Even in the committee testimony, former employees from the rating agencies suggested that common regulatory standards for rating, similar to the FASB standards in accounting, would suffice. This is actually a rather poor choice of comparison, for the public accounting profession is rife with its own conflict of interest that has thus far been shoved under the rug.  One need only look to Arthur Andersen in giving the go-ahead to Enron’s use of “unrelated” partnerships to hide debt or to Arthur Young knowing of the Repo 105s at Goldman Sachs to question whether using regulatory standards goes far enough.

Institutional conflicts of interest are not solved by common regulatory standards because they too can be gamed. The incentives have not been changed, so we can expect the pent-up water to eventually make its way through the muddy dams we construct.  In both public accounting and securities rating, the “independent” assessors cannot be paid by the institutions whose books or products are being assessed.  The unwarranted assumption that turning these functions over the government is the only alternative adds to the easy decision that simply creating or tweeking regulatory standards must suffice.

As an alternative to having the government rate securities, the financial industry as a whole could be required to contribute to a pool that would fund the rating agencies. The SEC would assess the agencies periodically and decide how much each would receive.  Essentially, the government would be the umpire rather than perform the rating function itself.  As long as the banks do not capture the SEC (which is another problem in need of a solution), they would not be able to pressure the rating agencies.  It might be suggested that industry self-regulation could work. That is, the banks altogether would assess the rating agencies.  However, this alternative would simply allow the banks to collude to pressure the agencies.  We ought not replace the government with one of the teams in performing the role of umpire.

It is unlikely that Congress will go beyond mandating stricter disclosure statements and allowing plaintiffs to sue the agencies. Within the fecklessness of Congress in extracting the structural conflicts of interest from the rating function is a fear that tampering with it might risk the salubrity of the credit markets.   Under this logic, riding the ratings function of a structural bias would somehow compromise the function because the public might get a true look at the lack of credit-worthiness of some of the securities currently deemed credit-worthy. An illusion is thought better, or more expedient, than a solid economy. Besides the dubiousness of such reasoning, there is the argument more generally that we can’t afford to tamper with our financial system as long as it is still at risk.  However, before assuming power, Barak Obama argued that the only time when real change can happen is during a crisis–while the forces of the status quo are temporarily marginalized.   So it would seem that we are in a catch 22–or, more accurately, we have put ourselves in one.   In actuality, riding our financial system of institutional conflicts of interest would strengthen rather than risk our economy.
I suspect that the true reason why neither the ratings nor the public accounting structural conflicts of interest have been removed goes beyond our collective ignorance of the nature of an institutional conflict of interest.  As Dick Durbin said after the  banking industry scuttled foreclosure reform, “the banking industry owns Congress.”  Apparently it owns the credit-rating agencies too, as well as the public accounting firms. The wolves are paying the guards of the chicken coop.  Regulating the pay does not go far enough; we need to address the question of the payor.  Until we do so, we are bound to keep scratching our heads as chickens continue to come up missing.

Sources:
http://www.nytimes.com/2010/04/24/business/24rating.html?hp=&adxnnl=1&adxnnlx=1272117625-MtgpixNdFNobkGOTVoD0NA ; http://www.nytimes.com/2009/12/08/business/08ratings.html?_r=1&ref=business

After watching hours of the US House Government Affairs committee on Investigations’ hearing on Goldman Sachs,  I concluded--totally contrary to the disavowals by the Goldman managers who testified--that there was indeed a conflict of interest between Goldman’s proprietary and market-making functions.  By proprietary, I mean a bank trading on its own books beyond simply being the counter-party in its market-making transactions. In their testimony, Goldman managers presumed that all of the bank’s proprietary transactions are part of its market-making role. However, I contend that the bank has been both a market-maker and a player in those markets, and furthermore that the latter function has affected the former in ways that are intended to benefit the bank. That is to say, Goldman Sachs’ financial interest has been put before that of its customers. In some cases, Goldman’s employees refused clients’ requests for shorts related to the housing market so Goldman’s own profits in shorting the market  could be preserved. Sen. Susan Collins (R-ME) said, “There is something unseemly about Goldman betting against the housing market as it is selling housing-related products to its customers.” Sen. Conrad, a more conservative Republican, echoed this sentiment.  The fact that Republicans on the subcommittee joined with Democrats rather than joined in Goldman’s paradigm points to a major disconnect between Wall Street “speak” and the discourse of the general public.  In other words, the financial managers and the politicians were largely talking past each other.  Even so, the two “worlds” can be translated into a common language that nonetheless finds Goldman culpable, while acknowledging some of the managers’ points.  In what follows, I discuss a number of the points raised in the hearing to bear out my contentions here.

Broker dealers do not have a legal fiduciary obligation to their clients in the US. This, Sen. Collins argued, is the root cause of the conflict of interest at Goldman (i.e., pitching toxic investments to its clients while betting against them).  Goldman bankers view their obligation being to be market makers.  A duty to serve the clients or act in their best interest?   Goldman’s managers tended to affirm the former because where the bank is making markets, similarly to an exchange, it is not in an advising capacity. According to one of the managers, market-makers do not have an obligation to tell clients of the market-maker’s position in the market.  The manager contended that how Goldman is positioned may not affect how the instrument performs.  So long as clients understand what they are investing it, the position of the market-maker is not relevant to the client.

Paulson (of the hedge fund, Paulson & Co) had a role in picking the securities in the Abacus CDO. The rating agency said that if the rating analyst had known this, the rating would have been far different.  Torre, the manager at Goldman who oversaw the deal, claimed in testimony that he had told ACA (the major long buyer) that Paulson was going short, but in a memo from ACA afterward refers to Paulson going long. Paulson was involved in the selection of the securities, according to Torre, though ACA left off more than half of the securities that Paulson had recommended. Even so, Paulson was in the room as the securities were being selected, and he had selected the criteria of their removal. Goldman employees did not indicate in the Abacus CDO that Paulson, whose intent it was to short, had been involved in the selection of the securities (which were subprime mortgages from 2006—presumably the stated-income-only variety).

In replying to Sen. Levin’s questions regarding whether it is correct that Goldman made money on its net short position in 2007, two of the Goldman managers replied, “I didn’t write that.” A third replied, “I can only comment on what I did.” Although such non-answers could have been directed by lawyers or the answers could be due to the difference in general paradigms between Wall Street and the general public, I submit that the managers’ underlying attitude is particularly troubling because it involves some cognitive warping.  Because Chairman Levin (D-MI) was not asking  whether they wrote the Goldman document he was referring to, the reply “I didn’t write it” simply doesn’t apply.  At the very least, the managers were adding assumptions into Levin’s question that simply were not there. My question is this: what, cognitively or affectively speaking, would prompt such “value-added addendums”? After a similar answer to one of his questions, Sen. Colburn (R-OK) replied, “Mr Burnbaum, you didn’t hear what I said.”  Similarly frustrated after a question, Sen. Levin gave up with the witness, saying, “I think you’ve not answered the question as best you can.” At one point, Sen. Colburn asked Mr. Burnbaum whether he had any knowledge of whether his firm had a short position on an issue, he replied that he didn’t take the position.  “I don’t speak for the firm; I speak only for my position.” But Sen. Colburn didn’t ask him to speak for his firm; rather, he asked him whether he knew anything about something regarding the firm.  What could prompt such mistaken assumptions?  I don’t think it is entirely a subterfuge; rather, I suspect that the managers’ cognitive processes had been distorted by a particular organizational or industry culture. Such cognitive warping could be part of the reason why Goldman’s managers have blind-spots concerning the institutional conflicts of interest.

To potential customers who asked how Goldman got comfortable with Anderson securities, which were put together by New Century (a mortgage servicer), the sales people at Goldman did not say that the bank was comfortable because it was betting against them by buying 51% of the shorts.  Did Goldman have an obligation to disclose the fact that the bank had bought shorts (i.e., that Goldman had an adverse interest to the client)?   Goldman’s bankers point to the potential buyers’ ability to investigate the securities themselves. The Anderson was downgraded from AAA to junk in seven months.

“Boy, that Timberwolf was one shitty deal.”  This is from an internal Goldman email from the head of a division prior to the bank selling hundreds of millions from that deal to customers. Sales people were told that that deal was their top priority. “Should Goldman be trying to sell a shitty deal?”, Sen. Levin repeatedly asked throughout the hearing.  Seventeen of the people at Graywolf’s research group were Golden alums. Was that why the sales people were told to make the deal a priority?

In general terms, some of the managers at Goldman liked the risk involved in securitizing stated-income mortgages because clients wanted to buy them.  As a market-maker, Goldman’s managers believe that there is a price for any risk, so they would sell a deal they believed to be bad because some clients would like the price. In one case, 90% of the mortgages from an originator were stated-income.  In spite of the high number of stated-income mortgages, the rating agency involved gave some of the securities the AAA rating. Did the Goldman sales people tell their clients of the extent of the stated-income mortgages in the securities? Or did the sales people assume that the clients could investigate the securities in spite of there being the AAA rating on at least some of them?  Goldman claims that it investigated the due diligence of originators, like Long Beach.   So why did the investment bank not cut off that originator?

When asked about the bonuses paid out even as the clients lost money, the Goldman managers said that the compensation incentives were or are in line with ethical behavior.  Even if Goldman lost money, its executives didn’t. So it is reasonable to ask whether the incentives are in line with “performing.”

Goldman magnified the rise and fall of the housing market. Lloyd Blankfein, Goldman’s Chairman and CEO (which is itself a conflict of interest) admitted that the bank had played a role, as did the other investment banks, in the system that included too loose lending criteria. The managers at Goldman said the bank was a market-maker for instruments that reflected those low standards. Sparks, who headed the mortgage securities unit at Goldman, said he didn’t think Goldman did anything wrong; rather, some of the deals it put together did not “perform”—meaning that they were downgraded to junk.  “Goldman made some bad business decisions.”  In a business sense, “bad” does not mean “wrong” in the sense of “ought not” (i.e., unethical).  Rather, “bad” refers to making an error in business calculations.   Similarly, David Vinair, Goldman’s executive VP, said he didn’t think there is a conflict of interest in Goldman selling a security long while shorting it on its own books.  The client buying the security long may have a different stance toward risk as well as a different time horizon than the bank.  Also, the bank may change its short to a long depending on factors that are different from those impacting a given client.  Sen. Levin countered that the conflict of interest is at the moment of sale (hence the bank’s changing preferences are irrelevant). The customer, Levin said, has a right to expect that the bank selling the security wants it to do well.  “In what sense do you mean well?”, Vinair countered.  More semantics ensued. In spite of using vague terms like “perform” (which is actually relevant to acting), Vinair wanted a definition of “doing well” from the chairman. Blankfein also said that there is no conflict of interest; he likened Goldman’s market-making function to that of a stock exchange. Investors don’t ask what positions the exchange has in given stock.  But unlike the NYSE, Goldman Sachs is not limited to its market-making function; the bank takes proprietary in the markets, or instruments, that it “creates” not only to protect its positions in the market-making transactions, but to make a profit by trading on its own books. Hence Goldman, unlike the NYSE, has financial interests other than simply making a market and such interests can warp its market-making function in ways that are not transparent to Goldman’s clients.

It seems to me that the major conflict of interest at Goldman manifests when Goldman managers suspect that a security won’t “perform” (hence the desire to short it) without telling the potential buyers of this belief.  The Goldman managers want to make money not only off its shorts, but also off the client, whom the Goldman sales staff have given a misconception of the security’s soundness either by omission or lying).  The conflict of interest deepens if Goldman managers actually know that a derivative has been put together to fail, and because the bank (or a favored client) will profit from its failure (having bought shorts), the relevant manager does not disclose what he or she knows to the client so the latter will purchase the security.  Goldman would profit both from trading the security (shorting it) on its own books aside from being a counter-party to clients taking long positions, and from being such a counter-party.  That is, profiting from Goldman’s books entails transactions beyond the counter-party transactions prompted by a client wanting to buy or sell. Not recognizing this as a conflict of interest, Sparks limited conflicts of interest at Goldman to picking between two customers, or between one of its customers and Goldman’s proprietary bank. The problem with such a narrow reading of the bank’s conflicts of interest is that it omits the impact of Goldman’s proprietary transactions based on profiting on its own capital. I wonder if this narrowness of perception isn’t related to the “cognitive warping” that was evinced in many of the non-answers of the managers testifying before Congress. “I didn’t write that” is irrelevant; so too are the bank’s proprietary transactions geared to profiting from the bank’s own books aside from being a counter-party to a client in the bank’s market-making function.

I believe that even Lloyd Blankfein viewed all of Goldman’s transactions as market-making.  But he was correct, then every single economic transaction by any party constitutes market-making; every business is making a market.  At Goldman, there was still the conflict of interest regarding the bank’s profiting on its own books not from being a counter-party to a client as part of serving the client versus from serving a buyer or seller client by being the counter-party if necessary.  Goldman can be understood to profit as a broker (a fee in putting a buyer and seller together), as well as from how it does as a counter-party in such a transaction. In addition, Goldman can profit from trading on its own books irrespective of being such a counter-party. I contend that if Goldman is to do the first function, then either of the latter two—and especially the third—constitutes a structural or institutional conflict of interest.  The second function would not be a conflict of interest were Goldman’s counter-party profits (and losses) passed on to the client.  Perhaps even the third function would not constitute a structural conflict of interest were the profits distributed to the bank’s clients.  However, to the extent that there could be an interest in currying favor with particular clients who would benefit differentially in either the second or third function, there could still be a conflict of interest for Goldman.

In general terms, a conflict of interest can be seen as involving lying (or duplicity) in order to benefit “both ways” from having two conflicting interests.  The solution is to reduce the number of interests that a party has such that he or she has no interests that could or do conflict.  This is a different question than asking what legislation is needed, for the field of business ethics ought not be conflated with the field of business & government (i.e., institutional political economy) or even with that of business & society.

Societal norms are not justifying regarding whether a given practice is or is not a conflict of interest.  Theoretically, a firm could deviate from the norms of a society in order to avoid structural conflicts of interest, or a society could simply be blind to such conflicts and a firm act to avoid them anyway.  In other words, business ethics need not involve “social responsibility”  (and the latter need not involve the former).   In the case of Goldman, the social norms regarding such conflicts of interest (i.e., structural) are in their infancy, at least in the US.  Hence, this discussion of business ethics is a distinct project.  Business & Society would investigate the disjointedness of the paradigms of the bankers and the general public–that is, how and why they differ. Business & Government would investigate legislative and/or regulatory matters concerning the conflicts of interest as evinced by Goldman.

While the three fields are related, so too are medical ethics, sociology and biology. You don’t find schools putting these three in one class because it would be cheaper.  So part of the problem concerning business ethics might be how it is treated by business schools; it (as well as CSR and business & goverment) is essentially relegated to one third of a course in most undergraduate and MBA curriculi.  Among the lessons that we ought to have learned from the financial crisis of 2008 is that of the value, or importance, of the fields of business ethics, business & society, and business & government in business schools.  Sadly, even in educating their respective scholars, these fields are conflated–hence the scholars are not apt to study sufficiently in the basic discipline of their particular field.  That is, they tend to skim along the surface in order to cover three rather than one field. Perhaps business schools have a conflict of interest of their own whereby they have an interest in cost-saving expediency and in covering all of the fields of business. The three fields being discussed here have been willingly mitigated (or enervated) into “one” such that business schools could appear to have it both ways.  The problem is when something happens like the financial crisis of 2008, which shows just how vital each of the three fields are–meaning worthy of courses of their own.

I once bought a bike at Walmart.  To my chagrin, the bike had very little coasting ability. After riding down into a valley, I looked forward to some momentum on the up side. However, there was very little upside. Shortly after passing the lowest point, I would have to begin pedaling again.  In fact, if the down-hill was not steep, I had to pedal so as not to de-accelerate while going down hill.  In regard to Walmart, it could be concluded that not every product fits into a low-cost strategy (to say “cost-leadership” would gild the lily, besides engage in fad-jargon). While pedaling from the bottom of a hill just after having come down another, I constructed a young theory of business ethics.  Namely, that it was unethical for Walmart to sell the bicycle-brand (which I do not recall) because I deserved some coasting credit. You might say that if I didn’t have to pedal going down hill, I don’t deserve any “credit” in going up hill; the ease going down is paid for by the effort going up. However, even if I had not had to pedal while going downhill, I still would have believed that I deserved some “credit” on the up side. Why should I be exempted from benefiting from the laws of nature?  It is not fair if I am excluded from the phenomenon of mometentum through no fault of my own. Walmart had unwittingly put a wrench between me and momentum by essentially “spending” it by releasing it. So I was left with the impression of an asymetry that was unnatural. Of course, gravity and friction take their toll, so one can not expect to go without any effort on the up side.  But where a product eviscerates the benefits ensuing from a natural law, the product can be reckoned as inferior from the standpoint not only of quality, but as undeserved by any buyer.  There is thus a bicycle principle of ethics, which is a sort of naturalistic ethical theory based on the principles of fairness and desert–namely, that it is unfair to deprive certain people of public goods such as momentum while others indulge. An inferior product can be reckoned in such terms.

I exchanged the bike for another of the same type.  Not only was the “new” bike also without coasting ability, its back tire was warped.  Incredibly, the “bikemaker” at the store knew this and told me, “oh, that’s from the manufacturer.”  A few days later, I returned that bike; I had in the meantime bought a used Diamondback for less than half the price. I don’t think I have ever been so glad to unload a product. Besides concluding that selling bikes is too much for Walmart managers and employees, I had a general sense of low-class retail from the experience. That is to say, I had the sense of having “just said no” to a certain culture, or market-segmentation, in business. After the incidents with the bikes, I first sought to limit my shopping at Walmart to cheaper common goods, or staples. A low-cost strategy seems to work fine with such goods. Walmart’s major fault, it seems to me, lies in presuming that its strategy can apply to any product.  However, I soon bought a pair of sunglasses, only to have them fall apart on the second day of usage. I exchanged them for another pair, which began to come apart after a week. When I returned the second pair for a refund, the customer “service” clerk demanded that I retrieve a pair with a barcode. Once she had finished with the transaction, she handed the new pair to me, saying “there you go.” Not only had the fact that a second pair (i.e., exchanged) had gone bad skipped her mind, she hadn’t bothered to remember that I was returning the product.  I thought to myself: it’s down to food and the pharmacy.

Yet a few weeks after that, I ran by Walmart to pick up seven or eight food items. After waiting in a line for five minutes, I found myself waiting still longer as the cashier kept trying to weigh the three bananas even though the weighing device at his station didn’t work.  Then he wandered around to other stations to try theirs. All the while, I was wondering why it was so important to him that he not throw in the bananas as he was inconveniencing me and it shouldn’t be such a big deal to the store.  However, he couldn’t permit himself to let go of the dogma that someone must pay, and that someone must be someone else.  The pettiness involved annoyed me as much as having to wait.  It was not so much a case of greed, for there wasn’t much money involved in the transaction.  Rather, it was a small-mindedness that refuses to admit common sense.  Unfortunately, it is a mentality all too common in low-end American business. The employees are too weak to say to themselves: what are three bananas to me and to my store. Let the other person get something for nothing (actually something for waiting, as time is money).  What is it to me if someone profits a bit from me!  Such a surfeit of strength is extrinsic to Walmart, where the mentality is: better to lose a sale of seven or eight food items than let three bananas go.  In the face of such a mentality, I walked away, leaving the employee to deal with the items.  As I passed the customer service area, I briefly told the employee there that the cashier had made me wait too long as he was trying to weigh three bananas.  “I have already spent too much time on this,” I finally said.  She replied, “Here, why don’t you tell the store-front manager; there she is.”  Had I been speaking French?  I resumed walking, shaking my head in utter disbelief. As I was walking to the parking lot, I actually felt relief that I had not bought anything at Walmart.  I wondered how such a small large retail chain could survive based on low price alone.  Unlike the cashier, I would say that there is more to life than price (especially where the differences are not extraordinary).  Perspective, once found, makes those still on the ground look like ants–the red kind, that bite. Why is it that so many people are still leaving table scraps for those sordid creatures?

Structural, or institutional, conflicts of interest are of great significance in applied ethics, even though they are often disregarded or ignored. Far more salient are personal conflicts of interest, such as when an employee pockets money meant rather than declares it as revenue for his or her company. Structural conflicts of interest are institutional in the sense that organizational arrangements inherently evince a conflict of interest such that people in them are necessarily subject to a conflict in their interests simply by participating in one of the organizations in the arrangement. An organizational or institutional conflict of interest, whether within one organization or involving relations between organizations, is not any less unethical than a personal conflict of interest because in both cases people are subject to a conflict of interest--only one being valid.  I present two cases and an argument that “firewalls” in an organization to prevent it from a conflict of interest are insufficient.

In the EU, the European Commission (the executive branch of the EU Government) sued four elevator companies that were part of a cartel in Belgium and Luxemburg.  Essentially, the Commission was seeking anti-trust damages—a first in EU jurisprudence.  Benoit Allemeersch, attorney for one of the companies, argued that the jurisdiction of the the commercial court of Brussells, the Tribunal of Commerce, violated the jurisdictional clauses in the contracts between the companies and the Commission.  He argued that the Commission acted as “police officer, prosecutor, jury and sentencing judge” in finding the existence of a cartel, and then used its own decision to make a private claim for itself before the commercial court. He argued that “the mere statement by the Commission that they respected their own ‘Chinese walls’ in making their decision and bringing the claim is not a sufficient guarantee to the defendants nor to any other citizen.” He maintained that in the case being argued, there was no “equality of arms” between the two sides, given the commission’s privileged position. According to Allemeersch, “the European Court of Human Rights requires that justice is not only done, but is also seen to be done.”  In other words, even the appearance of a conflict of interest, which can be in an institutional arrangement even if not acted upon, is enough to dismiss claims. The existence of “firewalls” within an organization does not sufficiently mitigate either the dismissal or, more generally, the institutional conflict of interest.

Even though the commission had previously argued that its own “Chinese walls” ensured the independence of the claim, Allemeersch correctly maintained that these safeguards could not be proven, tested or substantiated. I contend that the counsel is correct. Even if the Commission could show policies and procedures that act as its safeguards, such internal guidelines do not have the force of law and thus are insufficient to be relied upon—especially by external parties.  It can not be assumed, moreover, that an organization’s policies and procedures outweigh whatever internal interest happens to be dominant in the organization, given the nature of power to overflow its boundaries.

To say that the most powerful person a room is constrained by parchment alone is to be woefully ignorant of the reality of human nature.  Even if there are two equally-powerful people in the room with antipodal objectives, institutional checks and balances can only work as long as too great of a power imbalance does not exist.  If a US President is intent on invading a country, for example, and the Congress does not have sufficient power over his, the separation of powers institutionally could not be counted upon to keep Congress from rubber-stamping the President’s declaration of war.  For the President to be able to effectively declare war while being the commander in chief of the US military and the armies of the union’s republics is itself a structural conflict of interest.

Essentially, I am making a Nietzschean and Hobbesian argument that the most powerful person in the room is not apt to be constrained by invisible ”firewalls” in the room that are intended to level the powers of that person and a weaker person.  As Nietzsche writes, the strong must be strong and the weak cannot be other than weak.  To ask the strong to be weak or treat the weak as though it were strong goes against the nature of power.  In my analogy of the room, the two persons can represent heads of departments whose respective goals are at odds with each other. A “firewall” of policies and procedures is not sufficient to inhibit the more powerful head from pressuring the other.  Furthermore, the existence of a person whose authority includes both departments relativizes the firewall.  To bring in this element, I turn to the roles of rating agencies and Goldman Sachs in the American financial crisis of 2008. In the case of Goldman, the bank sold what its salespeople referred to as “crap” because the bank’s own proprietary position profited by the sales. In the case of the rating agencies, they were paid by the issuers of the securities that they were rating.  That either of these conflicts of interest were allowed to exist at all points to a proclivity among the general public to ignore institutional conflicts of interest—focusing instead on personal ones involving someone’s compensation and job.

In listening to and reading about the banks and rating agencies culpable in the American financial crisis, I doubted the “firewalls” argument given by the rating agencies.  The CEO of Moody’s for example, stated in Congressional testamony that he placed an equal emphasis on market-share and the quality of the ratings.  However, several of his former employees testified that they had been pressured not to lose a client to a competitor.  They stated that when ratings were changed, it was typically to protect the firm’s market-share (i.e., out of fear of losing the issuer).  The CEO’s faith in his own equipose as well as his firm’s “firewalls” was mistaken, even if he didn’t realize it.  To be sure, he may not have been aware of a more-powerful department putting such pressure on a less-powerful one.  It is possible, however, that the CEO was actively pushing his subordinates behind the scenes for more market-share, essentially profiting from the conflict of interest in the issuer-pays system.

In general, because an organization has an official above its firewalls, it is possible, even legitimate in terms of that position’s authority, for that official to put pressure on one side of the wall to capitulate in the interest of the whole (i.e., the entire organization).   Consider, for example, Lloyd Blankfein, who was CEO of Goldman Sachs at the time of the financial crisis.  He was over both the market-making and proprietary-trading units.  He could therefore have put pressure on the units selling securities to do so in a way that complements the bank’s own proprietary holdings.  For example, he (or his VP’s) could have pushed shorting sub-prime mortgage-backed derivatives in market-making (the clients taking long positions) because the proprietary interests of the bank would benefit from a fall in the housing market.  The bank’s sales people did indeed clients to go long even as the bank itself was going short in the belief that the housing market bubble was headed for a hard landing.  Before a US Senate committee, Blankfein claimed that the market-making and bank’s trading on its own books were unrelated unless the bank took out a position on its books as a counter-party needed by a client.  However, the bank sold clients on taking long rather than short positions on the housing-based securities even as the bank was taking a net short position on its own books above and beyond what was necessary to be a counter-party to its clients’ transactions.  This conflict of interest manifested in the duplicity involved in selling clients on what the sales people knew privately was “crap.”  As one of them wrote, if the clients knew the bank’s reason for going short, that would interfer with the bank’s ability to profit from the shorts.  Structural conflicts of interest are designed such that there is an incentive in favor of duplicity. Given a company’s overall interest and the fact that senior managers have authority over the entire firm, firewalls should not be relied upon by outside parties (or by those inside).
In the end, given the nature of human beings and power, we ought not be blindsided by claims of the efficacy of paper “firewalls.”  We ought not assume that the most powerful person or coalition in an organization will necessarily be voluntarily restrained by a weaker party in the same organization.  Moreover, we ought to take more seriously institutional or structural conflicts of interest in how we design and reform arrangements between institutions.  Where the status quo contains a structural conflict of interest, that condition ought to be put on a limited lifeline, with a deadline set for changing the arrangements.  Even if the alternative is not as efficient (it would doubtlessly not be flawless), it would be better than the status quo.  Charges of an institutional conflict of interest can be treated as red flags that instantly move to the front burner on people’s agendas.  We need not be hoodwinked by the duplicitous and self-interested into believing their asseverations concerning their own paper “firewalls.”