Ethics Newsline®

Is Ethics Driving Down the Markets?

Feb 18th, 2008 • Posted in: Commentary

by Rushworth M. Kidder

Before the economy soured last year, a friend of mine got a call from his stockbroker, who was recommending a new kind of “structured investment product.” Trying to explain it, the broker gamely began reading from the information in front of him. But the more he read, the more muddled he got.

Finally, my friend asked him some simple questions: What comprised it, how long it lasted, how it really worked.

“I could just see him scratching his head,” my friend chuckled. And finally the broker said, “Look, I’ll send you the whole thing, and you can read it yourself!”

My friend is himself an accomplished portfolio manager — and this was his chosen broker. Yet here were these two professionals, trying to make sense of a product that, as my friend says, was described “in language that probably even lawyers couldn’t understand.”

The product? It was a derivative made up of bundled subprime mortgage loans — exactly the kind of vehicle that has tanked in recent months and sent the economy into a dive.

That dive may persist, though in congressional testimony last week neither Treasury secretary Henry Paulson nor Federal Reserve chairman Ben Bernanke was predicting a recession. But whatever we call it, the financial downturn raises profound moral questions. Was it caused by blameless human error? A failure of complex computer technologies? An infestation of unforeseeable software bugs? Or is there an ethics component here? Are we seeing not cyclical collapse but cynical collusion? Is this a loss of market value — or of moral integrity?

For answers, I turned to Marshall Acuff, who in 31 years with Smith Barney became its managing director and remains a widely quoted media guru on markets and investments. In his view, the driving force of the current downturn was the increasingly speculative nature of the housing market.

“People just wanted to get involved,” he said, “and they didn’t pay adequate attention to the hows and the whys and the whats.” Nor did the banks, eager to write loans, pay much attention to the credit-worthiness of borrowers or their ability to repay. When borrowers defaulted, the bubble began to burst.

But would the bursting, on its own, have generated the current situation? Not, he feels, without the investment banks. In an effort to extract even more profitability, they began bundling thousands of individual subprime loans together and selling them as securities.

“One could be somewhat cynical,” Acuff notes with his characteristically Southern diplomacy, “and say that the new products were not fashioned in a manner in which someone without a great deal of technical knowledge” could understand them.

To put it more bluntly, as New York attorney general Andrew Cuomo’s office is fond of doing, the question is whether the investment banks deliberately withheld information about the significant risks inherent in these products. He’s investigating that question and may bring charges if laws have been violated.

But what if these products skate just inside the law? Even if these products were legal, were they ethical? Did they honor such core moral values as truthfulness, respect, and responsibility?

Truthfulness, it would seem, requires full disclosure of risk and an honest desire for clarification, which Acuff finds missing here. Instead, he sees some similarities to the collapse of Enron, whose managers put together arcane, complex financial instruments to “create the impression of growth when in fact there isn’t that much growth.”

Respect for the client also has suffered, as sellers of these products took advantage of a certain giddiness in the temperament of the times. This sort of deception, says Acuff, “typically happens when times are good” — again, as in the Enron period. Selling such products is harder, he says, when times are “more challenging” and people are being more careful and “going back to the basics. But when times are good — ‘Hey, I got structured products!’”

But in the end, the issue comes down to responsibility. “The banks themselves, and perhaps even the government, should have some responsibility for educating the public,” he says. Policymakers also should move strongly to restore equilibrium, which he feels is happening, and they should impose “stiffer requirements” to make these products understandable. He also faults the credit rating agencies — Standard & Poor’s, Moody’s, Fitch Ratings — for giving such high marks to these products.

But the real responsibility, he feels, lies with the individual. “If something isn’t simple enough that you can understand it in two minutes,” he says, “I’m not sure you want to get involved with it.”

“At the end of the day, you can have all the regulation out there,” he says, “but if someone doesn’t take responsibility to become educated, then the risk of this sort of thing probably will continue to exist. You should know yourself, you should know and understand what it is that you want to do and how you want to do it.”

Knowing yourself is, essentially, a question of values. In markets, as in life itself, you can’t substitute rules for values. Yes, new products need regulation, but there’s an enormous moral hazard in pretending that public law can relieve us of personal responsibility. In the end, the marketplace is more mental — and moral — than we like to recognize.