Economic slump: Ethics loom large

Compared with previous recessions, the last two downturns can be pinned more on greed.

By David R. Francis

from the September 15, 2008 edition

It used to be that post-World War II recessions in the United States were the bad part of plain vanilla business cycles – inventories had piled up too high as a result of too few sales, or the Federal Reserve raised interest rates and slowed the supply of new money into the economy to battle inflation.

But the mild 2001 recession and the current slump are a bit different. Their cause, at least partly, has been dishonesty, greed, and weak business ethics. The accounting scandals at Enron, Global Crossing, WorldCom, etc., combined with the bursting of the dotcom stock bubble, pushed the economy down in 2001. Today's sinking economy, to some degree, is the result of sagging real estate values and the bad behavior of many in the mortgage industry and on Wall Street. Losses from today's financial crisis have already reached $500 billion.

In mature, highly developed countries like the US, individual acts of malfeasance are unlikely to have a widespread effect on the economy, notes Frank Vogl, cofounder of Transparency International, a nonprofit group which ranks nations each year by their degree of corruption, as perceived by investors. (Its next report is scheduled for release next week.)

But, he adds, when "so many people engaged in so many aspects of finance have lost their ethical compass and put their short-term personal gains above other considerations," such as was the case in the subprime mortgage market in the US, it can have a "profound macroeconomic impact." In other words, the broad economy gets hurt by greed and selfishness as ensuing financial losses mount and trust fades.

It is difficult, of course, to disentangle quantitatively how much of today's financial mess has resulted from shady practices and how much from simple mistakes, bad decisions, and false perceptions that home prices would rise indefinitely.

Brokers placing mortgages with new homeowners unlikely to afford payments on adjustable-rate loans could perhaps tell themselves that rising real estate values would enable new owners to refinance their homes later and keep them. Is that bad judgment or unethical behavior by brokers, with some home buyers going along?

Certainly it's unethical if dubious information about an applicant's finances is included in the documentation.

"Individuals get carried away," says David DeRosa, a finance professor at the Yale School of Management in New Haven, Conn. As he sees it, the housing problem lies more in reckless unwise decisions on home financing. In the case of financial derivatives that have got major banking firms in trouble (such as Lehman Brothers Holdings last week), part of the difficulty arose from poor risk assessment, using new financial models, he says.

In 1993, religious institutional investors began making "eerily prophetic warnings" of an impending subprime mortgage debacle in the US, says Laura Berry, executive director of the Interfaith Center on Corporate Responsibility. The ICCR represents nearly 300 faith-based institutional investors managing more than $100 billion in assets.

These firms long ago voiced concerns in regard to predatory lending practices, inappropriate underwriting standards, and the potential consequences of securitization of debt instruments, that is, the packaging of bundles of mortgages and other loans into a big single investment for sale to pension funds and other investors around the world. If the early warnings had been heeded, the world "would have avoided the kind of meltdown we are experiencing today," she says.

Ms. Berry argues that ethical investing practices, such as those strived for by ICCR members, are less likely to lead to catastrophic losses. She notes that investment funds compliant with Muslim sharia rules, including strict prohibition of investments tied to collection of interest, have performed extremely well in the current down market. Berry holds that the "old rules," the rules of ethics set out ages ago by Christian, Muslim, and other leaders, are still in place.

ICCR members often strive to encourage corporate executives to follow good governance rules, using their investment money as leverage. Corporations were created in the first place hundreds of years ago "for the public good," Berry says, not merely to benefit managers or shareholders alone. This goal gives them "their license to operate," she says.

But the former Citigroup money manager cautions that the globalization of finance and the ability to move money and financial information with great speed through modern communications has multiplied the dangers from poor and unethical investment decisions.

"We have moved from arithmetic to calculus," she says.