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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

At the end of March, 2010, Warren Buffet spoke to business students at Columbia University.  A student asked him whether being ethical in business come from the home or a business ethics course.  Warren quickly answered that it is learned in the home.  Jeffrey Skilling of Enron was not simply applying knowledge when he acted unethically in hiding the company’s debt in “unrelated” partnerships; rather, what he knew he applied according to what he valued.  Values are not learned in the way that, say, 5=5=10 is learned; there is a feeling component—an ought—that goes along with one’s sense of what he or she values.  In other words, a person values X because she feels that X is important—not because she knows more about X (although this could be incidentally the case).

A business ethics course ought to be designed such that the students understand ethical principles and how they apply to ethical issues in business as well as to the business system itself.   Although understanding more about ethical principles in ethical decision-making, for example, can help one in being ethical, the understanding itself is not to make one ethical.  The focus, in other words, ought to be on the learning of knowledge rather than on somehow turning people into ethical human beings as if they were robots to be programmed or customers to be convinced.

Some might agree that ethics courses do not make people ethical (and ought not be designed as such), but disagree with the emphasis being on understanding and knowledge. Such “commercial business school”  advocates stress the “how to do” over explanation.  But this is to confuse training with educating.  Following bullet-points on how to make ethical decisions, for example, does not involve synthetic or analytical thought; at most, critical thinking is needed.  I submit that understanding ethical principles and their relevance to business is of value not only educationally (in terms of learning knowledge), but also in terms of business practice.  That is, knowing more about something—studying it in order to explain it—informs one’s approach to it in practice.

For example, explaining the structural conflict of interest in the rating agencies getting a cut on the securities sold that the rate can enable students to understand what a structural conflict of interest is and thus how it can be recognized.  This understanding can come into play in the business world if the former student finds herself in such a conflict or in a position to remove one (e.g., a regulator).  That the rating agencies’ conflict of interest was not addressed by Senator Dodd’s proposed financial reform bill in March, 2010 suggests the practical peril in not understanding what a structural conflict is.  Even if Senator Dodd didn’t want to solve the problem, had enough people understood it sufficiently to recognize it and wanted to remove it, the senator would have faced more pressure to include a fix. 

Perhaps if more business ethics lecturers and professors become less oriented to trying to turn their students into ethical managers, more ethical problems would be recognized and solved.  This is not to imply that every applied ethical issue can be solved, but even here understanding the competing ethical principles that are in play can make such issues less daunting, even in terms of being understood.  In other words, understanding and explanation, rather than how to, are key to education (as opposed to training), even where knowledge involves practical realms of life.  It is far too easy to become short-sighted, either in being obsessed with making others ethical or in reducing knowledge to how-t0 bullet-points on Power Point.  It is much harder to focus on the knowledge instead of shying away from it.  In the wake of Enron and the financial crisis of 2008, the world is calling out for better understanding of such things—not recipes and ideology.

Sadly, most business ethicists in business schools have scant education in ethics per se; most of their education is in management and corporate social responsibility (matching corporations with societal norms—which are not ethical principles).  Such business ethicists have little regard for the basic discipline of philosophy, of which ethics is a field (and business ethics a subfield).  It is of course important that a business ethicist understand the phenomenon of business, but it is also vital that he or she know ethical principles beyond simply “rights, duty and utility.”  In the midst of such a superficial knowledge, it is no surprise that ideology (i.e.,  imposing one’s own values) and how-to’s would take over.   The ethical dimension does not pertain exclusively to the content of such courses; the qualifications of the professors and lecturers as well as their typical agendas ought to be understood from the vantage point of a knowledge of ethics (as well as pedagogy).  This might be a case of the emperors wearing no clothes, even as the modern moralizers swear by their sterling vestments.  Unfortunately, the public does not get a look at the men and women behind the curtain.  If Enron and the financial crisis of 2008 are at all of concern to us in terms of future like occurances, it might be in our interest (as well as being an ethical obligation) to recognize and rectify the nudity going on behind the curtain. Ideally, a clamor would rise up for a better understanding of the ethical principles that are in play (or missing); we would demand such knowledge from those hired to teach it.  Yet there is the matter of the illusion of expertise being projected by the club and the general perception that this is as good as it gets.  But this is crazy, even if it is typically taken for normal.  Things are not always as they seem, and they can be improved even if it is not in their present protectors’ self-interest.

An Enron energy-desk trader said “Burn Baby Burn” on a call with another of the company’s traders when a wildfire in California was putting some electric wires at risk.  The loss of the wires would have decreased supply, and thus jacked up the cost of electricity, which Enron would provide.  Similarly, the phrase can be applied to the South Fulton, Tennessee, fire department, when its men watched Gene Cranick’s home burn to the ground because he had not paid the $75 annual fee that residents outside of city limits must pay in order to receive the “service.”  When he called 911, he was told that he was not on the list. The fire department came out to protect his neighbor’s house, then watched as fire gutted Cranick’s house. Fortunately, no one was killed in the blaze.  Had there been a death involved, I wonder if those firemen who watched could be charged with manslaughter.  Cranick offered to pay the fee on the spot, but the fire department rightly pointed out that if it allowed that practice, the only people who would pay the fee would be those whose houses are on fire.  However, we might ask whether setting or maintain such a precedent is so important that someone loses their home or even a loved one.

Were any of the firefighters Christian, it would be an odd approach to the faith to say that one should turn the other cheek in the sense of looking away from harm.  It is the person who stops to help the injured person at the side of the road who is the true follower of Jesus, as per his example and teachings. Little love was lost between the Jews and Samaritans, but Jesus had the latter rather than the Jewish rabbi as the man of God in stopping to help the man in distress.  Surely pleading a precedent would not have excused those who walked passed the man.

Beyond the religious angle, there is the matter of one’s shelter being treated as a commodity that can be lost if a fee is not paid.  If we do indeed have the right to life, liberty and the pursuit of happiness as Americans, then the right to life must surely include sustenance needs.  Basic shelter, utilities, food and medical care are germane to the right to living, and yet something as simple as not paying a fee or losing one’s job can suddenly render the basics beyond one’s reach. To those who would cite the added cost to the taxpayer, one could argue that a sustenance-only approach to entitlements could save money not just in terms of lower insurance and emergency-room losses, but also from the ending of corporate welfare and tax-deductions that are go beyond sustenance. Calling for an end to unemployment compensation, for example, while corporate welfare continues (including to defense contractors) evinces priorities that I’m not sure anyone would want to own up to, at least in public. Yet the argument is made by some.

Beyond whether government ought to see that no citizen is deprived of sustenance needs as a matter of rights, one might ask whether the insecurity that treating basic needs as commodities to be provided by private companies for a fee should be something we tolerate.  In other words, imagine how much more secure life would be for all of us if we knew that we could not fall through the cracks. Even if a person doesn’t think he or she could face the loss of shelter or health-care, the good Samaritan would not want to see anyone else even have to worry about not being able to survive.  If people in a society are not willing to guarantee at least the basics to themselves and their fellow citizens, is that society simply an aggregate of self-centered (and short-sighted) people?  To such a “society,” I would find myself joining in the chant, “Burn Baby Burn.”

Source: http://www.msnbc.msn.com/id/39516346/ns/us_news-life/