Was unethical behavior by bankers a major factor in the economic crash?

To follow is an excerpt from the CQ Researcher report called "Financial Industry Overhaul" by Marcia Clemmitt on July 30, 2010
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Some observers are convinced that financial markets are hotbeds of unethical conduct, but others point out that seeking profit is not only legal but is what the public demands that financial firms do.

Goldman Sachs is “a great vampire squid wrapped around the face of humanity … little better than a criminal enterprise that earns its billions by bilking the market, the government, and even its own clients in a bewildering variety of complex financial scams,” fumed financial reporter Matt Taibbi.[Footnote 14]

In 2006, Goldman sold $76.5 billion in mortgage-backed investments, of which about $59.1 billion — more than three-quarters — consisted of hundreds of home loans that either were made to people with very bad credit or had other serious problems, such as risky terms like a no down-payment requirement, Taibbi said. Then, “some Dutch teachers' union that a year before was buying ultra-safe U.S. Treasury bonds … runs into a Goldman salesman who offers them a different, ‘just as safe’ AAA-rated investment that, at the moment anyway, just happens to be earning a much higher return than Treasuries. Next thing you know, a bunch of teachers in Holland are betting their retirement nest eggs on a bunch of meth-addicted ‘homeowners’ in Texas and Arizona…. This isn't really commerce, but much more like organized crime … a gigantic fraud perpetrated on the economy that wouldn't have been possible without accomplices in the ratings agencies and regulators willing to turn a blind eye,” said Taibbi.[Footnote 15]

“It is unacceptable to continue allowing Wall Street to put their short-term gambles ahead of the long-term prosperity of Main Street America,” said Sen. Jeff Merkley, D-Ore., who sought to ban so-called “proprietary trading” — banks trading securities for their own profits rather than on behalf of customers — but secured only minor limitations on such trades. “We've seen how proprietary trading can cause conflicts of interest when firms bet against securities they help put together for their clients,” Merkeley said.[Footnote 16]

Sen. Carl Levin, D-Mich., who cosponsored Merkeley's proposal, labeled many bankers' primary motivation “extreme greed.”[Footnote 17]

In many cases, both sellers and buyers of the complex investments called “derivatives” are “cheaters,” charged Frank Partnoy, a professor of law and finance at the University of California, San Diego, and a former associate at the New York City-based financial services firm Morgan Stanley. Some derivatives allow people to avoid taxes by making their investment portfolios appear to have a different mix of risks and assets than they actually do, he said. In a so-called “equity swap,” a “bank that sells the swap makes money, and the purchaser … makes money because they effectively get to liquidate a portion of their stock position without paying tax. They both win,” but the public loses a legitimate part of the tax base, Partnoy said.[Footnote 18]

“Ethical rot” and “perverse incentives … caused the ongoing financial crisis,” said William K. Black, an associate professor of economics and law at the University of Missouri who was a federal bank regulator during the savings and loan meltdown of the late 1980s. For example, “executive compensation and the compensation systems used for appraisers, accountants and rating agencies were designed” to create a business climate in which “fraudulent and abusive lending and accounting practices drove good practices out of the marketplace.”[Footnote 19]

“I don't think those who went into finance are greedier or more deficient in moral scruples than others,” but the incentives in the way financial markets currently operate “led them to behave” as if they were, said Joseph E. Stiglitz, co-winner of the 2001 Nobel Prize for economics and a professor of economics at Columbia University. The idea that “you have to pay me more if I succeed in increasing profits” became “conventional wisdom,” leading bankers to neglect the fact that banks “are a means to an end” in the economy, “not an end in themselves.”[Footnote 20]

“A good financial system” manages risk, allocates capital and runs the economy's payment system “at low transaction costs,” said Stiglitz. “Our financial system created risk and mismanaged capital, all the while generating huge transaction costs” — financial firms' outsized profits compared to other industries. While bankers claim that products like derivatives created real value in the economy, “it is hard to find evidence of any real growth associated” with these “so-called innovations,” Stiglitz said.[Footnote 21]

“So deceptive were the systems of creative accounting” employed in pursuit of large returns that bankers “didn't even know their own balance sheets, and so they knew that they couldn't know that of any other bank,” Stiglitz said. No wonder then that lending between banks — which allows bankers quick access to cash they can then loan to businesses — froze up in a crisis of trust that helped topple the world's economy, he said.[Footnote 22]

Financial-industry executives mostly reject such charges.

Far from ignoring obligations to society, most bankers embrace their social purpose, said Goldman Sachs Chairman Lloyd Blankfein. “I know I could slit my wrists and people would cheer,” but accusers don't realize that the bank does “God's work,” Blankfein said. “We help companies to grow by helping them to raise capital…. This, in turn, allows people to have jobs that create more growth and more wealth. It's a virtuous cycle.”[Footnote 23]

Some bankers have exhibited a “failed moral compass” by “hiring people and promoting people based simply … on commercial productivity” rather than the “many other criteria that could be used,” acknowledged Brian Griffiths, vice chairman of Goldman Sachs International. Nevertheless, “my reading of [Scottish philosopher and economist] Adam Smith is that self-interested actions,” though “they may sometimes be selfish,” produce social good, he said. (Smith's 1776 treatise An Inquiry into the Nature and Causes of the Wealth of Nations theorizes that an “invisible hand” guides the free market to produce and price things correctly, despite seeming chaos.) “I think that the injunction of Jesus to love our neighbors as ourselves is a recognition of self-interest” as a positive social force, said Griffiths.[Footnote 24]

Banks do only what society asks of them, says Amy Sepinwall, an assistant professor of legal studies and business ethics at the University of Pennsylvania's Wharton School. “We live in a get-rich-quick culture, and we ask people [in the financial industry] on our behalf to make as much money as possible in as little time as possible, so in a way we're sort of licensing this.”

“Individuals prefer to spend rather than save, and, as a result, demand the kind of financial alchemy that can transform one's house into a virtual ATM or one's exceedingly modest savings into a fiscal cushion that can sustain a long, comfortable retirement,” Sepinwall said. Thus, the risk that crashed the system “is the inevitable price of our preferences for leisure over toil and consumption over savings.”[Footnote 25]

The Issues:
* Will the new law avert another crisis?
* Are tougher rules for financial firms needed?
* Was unethical behavior by bankers a major factor in the economic crash?
* Should big banks be broken up?

For more information see the CQ Researcher report on "America at War" [subscription required] or purchase the PDF

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Footnotes:
[14] Matt Taibbi, “Will Goldman Sachs Prove Greed is God?” The Guardian [UK], April 24, 2010.
[15] Matt Taibbi, “The Greatest Non-Apology of All Time,” The Smirking Chimp blog, June 19, 2009.
[16] “Merkley-Levin Amendment to Crack Down on High-Risk Proprietary Trading,” press release, Office of Sen. Jeff Merkley, May 10, 2010.
[17] Ibid.
[18] Joe Kolman, “The World According to Frank Partnoy,” DerivativesStrategy.com, October 1997.
[19]. William K. Black, “The Audacity of Dopes,” Huffington Post blog, May 28, 2010.
[20] Testimony before House Committee on Financial Services, Jan. 22, 2010.
[21] Ibid.
[22] Ibid.
[23] Quoted in John Arlidge, “I'm Doing ‘God's Work.’ Meet Mr. Goldman Sachs,” London Times online, Nov. 8, 2009.
[24] Regulation, Freedom and Human Welfare, St. Paul's Institute panel discussion, transcript, Oct. 20, 2009.
[25] Quoted in “‘A Race to the Bottom’: Assigning Responsibility for the Financial Crisis,” Knowledge at Wharton newsletter, Dec. 9, 2009, .