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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

To simplify how Goldman Sachs got into trouble with the SEC: According to Annie Lowrey, the hedge fund Paulson & Co. handpicked mortgage-backed securities that were doomed to stop performing, being backed with subprime mortgages, and Goldman packaged them into a kind of bond. Paulson & Co. bet against the bond by buying short-sales, with Goldman acting as the broker. At the same time, Goldman sold the bond to other clients without disclosing that Paulson had engineered the bond to fail. The SEC filing notes that those other clients lost $1 billion. Goldman had no direct stake in the success or failure of the CDO. It made money either way. “This litigation exposes the cynical, savage culture of Wall Street that allows a dealer to commit fraud on one customer to benefit another,” Chris Whalen, a bank analyst at Institutional Risk Analytics, said in a note to clients on April 16, 2010. Someone at Goldman said on the same day that “the SEC’s charges are completely unfounded in law and fact.” If the SEC charges hold up (and it is doubtful that the agency would bring such charges without supporting documentation; it is more apt to miss something than go overboard), I am astonished that the people at Goldman simply dismissed the matter out of hand. It might make sense as their legal defense, but if the bankers are convicted, those lying ought to be fired even if they were not a party to the scheme. It also appears that the bankers lied about whether they made money in betting against the housing market. “The 2009 Goldman Sachs annual report stated that the firm ‘did not generate enormous net revenues by betting against residential related products,’ ” Senator Levin, chairman of the US Senate’s committee on investigations, said in a statement in April, 2010. “These e-mails show that, in fact, Goldman made a lot of money by betting against the mortgage market.” When a spokesperson for the bank says something in the future, a rational person will be wont not to trust him or her. Lying has (or ought to have) consequences rather than being dismissed as harmless PR or a legal defense. The bank’s credibility is at issue here. The SEC has accused Goldman of outright lying to customers in order to make money both ways on a deal. Even though this ought to reflect negatively on Goldman’s future business, bigger issues involved that ought to consume more of our attention than how Goldman fares.

Given the strength of the financial sector’s lobby in Washington, this case involving Goldman suggests that we, the American electorate, were unwittingly putting our financial system and our republics in danger by enabling the lobby to have such effect in watering down the regulatory reform in the wake of the financial crisis of 2008.

In the election cycle in which the US Senate’s agricultural committee took up legislation that would regulate all derivatives (2010), people and organizations affiliated with financial, insurance and real estate companies gave members of the committee $22.8 million. Wall Street firms raised $60,000 at two fund-raisers for the committee’s chair’s re-election campaign in the cycle before the committee took up the legislation. Many of the chairs constituents want a crackdown on the speculation. This put Blanche Lincoln in a difficult situation, ethically speaking. At the very least, accepting money from the firms that would be subject to the legislation involves the appearance of a conflict of interest. I contend that given human nature, even such an appearance ought to be avoided or even outlawed. At the very least, it is unseemly in a republic, and I would argue dangerous to its viability.

Furthermore, as if the banks’ culpibility in the crisis was not sufficient to cancel their reservations at the regulatory table, the Goldman case strongly suggests that the banks ought not to be trusted as contributors to regulatory reform. And yet they push ahead to reduce the regulatation, in spite of it all. A child who drops his milkshake doesn’t turn around and tell his mother that she better not clean it up and that she had better not get involved if it happens again. Rather, such a child stands back. As if there is not enough of a natural feeling of shame at having made a mess, there is, or ought naturally to be, an even greater sense of shame in presuming to be in a position to direct the clean-up according to one’s self-interest over objections that the person who caused the problem is not the one best suited to fix it. Even if corporations can enjoy the legal fiction of personhood, there are actual human beings running them, and it is telling when those people dismiss their innate shame in their presumption–even pretending that it is not presumption! We are to blame in not calling them on it, and relegating them. We must relegate them if they won’t do it for themselves, as would be natural for them to do. In other words, we ought to call the artiface for what it is and relegate it as a parent would naturally tell a spoiled and misbehaving yet dogmatic child to go to his room. We, the American people, are enablers; bad parents. We ought to look toward solving the bigger problem, which the case of the Goldman children intimates.

The theory of regulatory capture points to the government’s need for information that the industry being regulated can provide. This theory ignores the broader power-base that an industry is apt to have in lobbying the government (and supporting candidates). In other words, information is just small change from the standpoint of an industry’s ability to influence a government. A better theory would have its primary focus on the macro level, asking the question, in effect, whether (and how) a republic is compromised by its moneyed corporations and banks. Besides looking at campaign finance law and uncovering actual lobbying practices, we ought to look at how much the society in question values money, commerical gain, wealth and economic freedom. We ought not be limited to the managerial or technocrat perspective in ascertaining whether our financial system and indeed our very republics are in danger from being used by unscrupulous firms or industies according to that which fits their peoples’ desires. Once we have uncovered the real problem, we really won’t have any excuse for not fixing it, and we would be bad parents indeed if we let the children fix it.

Sources:
http://washingtonindependent.com/82571/sec-charges-goldman-sachs-over-subprime-tied-product  http://opinionator.blogs.nytimes.com/2010/04/16/goldmans-stacked-bet/?ref=opinion
http://money.cnn.com/2010/04/16/news/companies/sec.goldman.fortune/index.htm?postversion=2010041616 ; http://money.cnn.com/2010/04/16/news/companies/goldman_sachs_questions.fortune/index.htm?postversion=2010041615 ; http://www.nytimes.com/2010/04/20/business/20derivatives.html?hp
http://www.nytimes.com/2010/04/25/business/25goldman.html?ref=us

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.

A commentator on Fox News said that the banks should not stop the foreclosure process because that would not be good for the free market. He said that people who cannot afford their houses should lose them. He was apparently unaware that putting a large number of houses on the market would cause home values to decline further, and that the market mechanism itself had been part of the problem in the financial crisis of 2008.  Protecting the free market is not our goal, yet he took it as the assumed telos, or final end. Lest it not be obvious he was also displaying a blatant disregard for the suffering of others. The possibility of people going homeless is apparently not of concern to the market advocates whose only concern is the market itself—a mechanism that Alan Greenspan has admitted contains structural flaws.

On another day, I heard another commentator on Fox News say that too much government in the financial sector is “the problem,” I was dumbfounded because one of the lessons of the financial crisis…wherein the global financial system almost collapsed…has been that the market and its firms can actually increase volatility from unregulated bubbles (and fraud).  To say that too much government caused the crisis has is completely opposite!  To be sure, Freddie Mac and Fannie Mae contributed to the problem, but the source was that the private-sector bankers wrote unsustainable sub-prime mortgages and sold them to private investment bankers who turned them into securities (which were then rated by private rating companies…some as AAA!).  To say that “too much government” in the economy was the cause is to warp reality to one’s own ideology.  That is to say, ideology can be amazingly resistant to change in the face of the facts on the ground. That the Republicans are doing well at all in the wake of the crisis, given their deregulation platform (and that government is the problem, not business), is remarkable except for the fact that we averted crisis.  Had Democrats on the Hill refused to save the banks (though they should have been just as interested in saving troubled home-owners!), the financial system would have collapsed.  The commercial paper market had already frozen. To be sure, the aid should come with the requirement that exec compensation would be limited (the banks should have been deemed legally bankrupt but for the government bailout and thus their exec comp contracts declared null and void), and strict anti-foreclosure rules set.  That these things didn’t happen attests to the power of even a complicit industry’s lobby in Washington. Had the financial system tanked, I bet the pro-business republicans would be facing a 1932-like Democratic landslide.  Ironically, the Democrats’ averting a disaster in which banks were complicit has benefited the Republican party, which is avidly pro-business and anti-government even in the wake of what Alan Greenspan admitted to be a flaw in the market mechanism itself (concerning volatility and bubbles—irrational exuberance). What amazes me is that such an admission is lost on an ideology that remarkably still have staying power.  That the Republicans are able to avert losing seats in Congress suggests to me how strong that party is. Ultimately, the lessons from the financial crisis of 2008 would…one would think…seep into the Republican platform to moderate it, just as Alan Greenspan (former Federal Reserve Chair) has recognized that his paradigm contains a fatal flaw.  In other words, I would expect that how we would look at the market mechanism itself (including private enterprise and commodities) would change following the crisis.  Perhaps one of the lessons from the midterm elections of 2010 is that this might not happen, at least for awhile.