Business Ethics and the Global Crisis - Coursework Example

Business Ethics and the Global Crisis: An Analysis Introduction Ethics is an issue that has been with us since the beginning of humankind: the deepest questions that go to our freedom to choose, how we should live and, ultimately, what constitutes a 'good' life. It involves questions of individual identity, a sense of purpose and moral beliefs about what is 'right' and 'wrong' that traditionally have been the province of mythology, philosophy and religion. As such, it has been an issue of little interest to the high-tech, law-based world of business and its chief actor, the corporation. It is not difficult to see why. The uncertainty, the subjectivity and embarrassingly personal and deep emotions that are often inherent in any discussion of what is right and wrong, or good and bad conduct, make them uncomfortable, even dangerous, topics for the cut and thrust of a world based on contract. We attempt to overcome weakness through more and more rules and regulation, systems and processes. There wouldn't be an organization in this country that isn't struggling under the weight (and the cost) of the increasing compliance regime - yet things still go wrong. The fact is that the best laws and regulations, and the most thorough systems and processes, will always be vulnerable if someone chooses to get around them, or fails to do their job as they should. This is precisely what caused the global financial crisis. This paper seeks to determine the causes and effects of the global financial crisis and how it is contributing to business ethics consciousness and discourse. Through the analysis of what led to the global downturn and who steered it to move that way, this paper seeks to view the various dimensions of business practices and consumer behavior in this period. A brief description of pre-global crisis focus on CSR by business ethics scholars is presented to provide the backdrop on determining how it has changed since the global crisis. Then, the unique scenarios that resulted to the global crisis shall be discussed and analyzed to determine how it molds and affects business ethics discourse in general. Back to Basics: From CSR to Fraud Much of the focus of business ethics subjects today is on Corporate Social Responsibility where the corporation is expected to take on social roles for the community such as providing medical treatment, scholarships and environment-friendly initiatives. An ethical corporation, it is argued, is one which is actively involved in ensuring the welfare of the society and the environs in which it is operating. The prominence of CSR in business ethics literature, however, is understandable because it recognizes that companies are entitled to profits as long as they do charity works to society. As a consequence, however, other business ethics issues such as corruption, insider trading, fraud and speculation have been less attended to the point that compared to CSR, not much concern is placed on these matters (Berner, 2007). With the advent of the global crisis, however, the focus of business ethics has been redirected again to issues of fraudulent and irresponsible business practice. Discussion drawing parallels between the Great Depression and the current global crisis and with Enron and Goldman Sachs is now the fad among economics and business administration scholars (Steverman & Bogoslaw, 2010). There has been a shift of business ethics interest from non-compliance to corporate social responsibility to fraudulent and greedy behavior that led to the demise of the entire global economy. Fraud is a term used to indicate a situation, in which one party deceives or takes unfair advantage of another. Any means used by one person to deceive another may be defined as fraud. For example, if a person represents himself or herself as the agent of a business with which he or she is unconnected and causes another to make a contract to the other party's disadvantage or injury, the first party is guilty of fraud. Furthermore, if, in making a contract, a person obtains an unjust advantage because of the youth, defective mental capacity, or intoxicated condition of the other party to the contract, he or she is guilty of fraud. In a court of law, it is necessary to prove that a representation was made as a statement of fact; that it was untrue and known to be untrue; that it was made with intent to deceive and to induce the other party to act upon it; and that the other party relied on it and was induced to act or not to act, to his or her injury or damage. In equity, fraud includes any act, omission, or concealment, involving a breach of legal or equitable duty or trust, which results in disadvantage or injury to another. An example of fraud in this sense is the act of an insolvent who contrives to give one creditor an advantage over the others (Bartels, 1998). The ethical issues in the global crisis are similar in some respects to past financial scandals. Lehman Brothers falsified its financial statements much in the same way Enron portrayed itself as achieving bullish growth rate when it was actually suffering a five year consecutive loss amounting to a $586 million and a ballooning debt of $690 million (Cohan, 2009). The similarity, however, stops there. The global crisis reveals new scenarios of greed, deception and negligent behavior that have never been seen before thanks to the complexity of the products and services offered in the financial market today. What is also profound in the global crisis was how everybody, from the common mortgage-acquiring American to the officials of the government, seemed to have participated in the highly deceptive and fragile subprime mortgage-security scheme. Figure 1 summarizes some of the causes behind the housing bubble that peaked in 2006. The housing bubble set the stage for the subprime mortgage crisis. Many of the elements have complex interactions to be discussed in the preceding sections. Here, we can see that both institutions and individuals had behaved in a rather haphazard behavior. Figure 1: Housing Bubble Formation (Cohan, 2009) The biggest impact of the global crisis in the discourse of business ethics was the increasing complexity of ways and means that fraud is committed and haphazard business decisions are made. It tells a quaintly familiar but new story of neglect, fraud and plain greed. High Risk Lending Credit lending is a risk-inherent business offering usually good returns but high losses in case of default. Creditors try to minimize this risk exposure by conducting intensive investigations on the paying capabilities of the borrower. These investigations are designed to assess the financial situation of the person applying for a loan by looking into his income, assets and past credit history. Only when the lender is sure enough that the borrower will not default will it release credit funds. The usual ethical issue in credit lending involves the amount of interest charged by the creditor and the hidden costs and consequences that amplifies the amount to be paid. Unethical behavior occurs when a creditor practices usury or charging interests in excess of the amount fixed by statute or between parties or when they apply slap additional charges to amplify the amount to be collected (Amin, 2008). The borrower is also behaving unethically when he ceases to fulfill his obligation (i.e. defaulting). The global crisis presents a new and complicated form of unethical behavior both for the creditors and borrowers through the process called subprime lending. Subprime, in investing parlance, refers to the high-risk credit quality of certain borrowers who have low credit ranking, weak credit histories and likelier to default than their prime counterparts. Subprime lending was not considered bad itself and the United States actually prospered with these arrangements. The problem was that creditors became too engrossed in lending that they made large loans available to people who had no possible way of paying for it (Cohan, 2009). In 1994, subprime mortgages amounted only to $35 billion or 5% of total mortgages provided by lenders. By 1999, lender behavior changed dramatically as they expanded their subprime portfolio even to illegal immigrants for up to $160 billion or 13% of total originations. At the peak of the housing bubble, subprime mortgages amounted to $600 billion (20%) in 2006 (Woods, 2009). As subprime mortgage increased in volume, the average difference between subprime and prime mortgage interest rates declined significantly. The credit lending industry was in paranoia to the point of providing subprime mortgages even to illegal immigrants. An oft-cited example of this haphazard behavior was the $750,000 mortgage made by an banker named Eisman to a Mexican strawberry-picker in California who did not even know how to speak English and who had an annual take-home pay of $14,000. (Soros, 2008) Credit lending agencies went even far beyond accommodating high risk borrowers as they offered high risk options and borrowing incentives. One such instrument was to provide easy down payment terms up to 2% of principal value. In 2005, 47% of house purchases did not involve any down payment or whatsoever. This was only the start. Further on, credit lending agencies redefined its mortgage qualification guidelines. With the loan called Stated Income, Verified Assets (SIVA), borrowers need not provide proof of income. They were only required to state that they had income or were employed and show that they had savings in the bank. This was followed by the No Income, Verified Assets (NIVA) loans which no longer required proof of employment as long as they had proof of money in their bank accounts. Qualification guidelines kept getting looser and looser culminating in the No Income, No Assets (NINA) loans, also known as ninja loans, where borrowers need not prove that they have any income or assets as long as they had a credit score (Tett, 2009). Aside from the qualification guidelines, credit lenders constructed the interest-only Adjustable Rate Mortgage (ARM) where the homeowner are required to pay only the interest for an initial period rather than paying also a part of the principal. This was further loosened to a payment option loan where the borrower can pay a variable amount but any interest amount paid is added to the principal (which increased the basis for interests for future payments). It is estimated that a third of ARMS offered affordable interest rates as low as 4% increasing only after some period (Hull, 2008). This was done to make the mortgage seemed very affordable. The problem with the ARM arrangement was that when housing prices decreased, homeowners under ARMs had little incentive to pay monthly payments because their home equity had disappeared (Gjerstad & Smith, 2009). Mortgage underwriting procedural requirements were also relaxed especially during the boom period to the point that automated loan approvals enabled loans to be made without review and documentation. In 2007, it was estimated that 40% of all subprime loans were approved using automated underwriting. Evidences coming from former employees of Ameriquest, the leading wholesale lender in the US, indicate that the company installed a system which pushed them to falsify mortgage documents to be able to sell mortgages to Wall Street banks eager to make fast profits (Krugman, 2009). The reason for the loosening of loan standards was due to the huge amount of foreign funds flowing into US. Investors wanted to find new investments that gave higher yields than those offered by the US Treasury bonds starting in 2000. The pool of money kept increasing as highly industrializing nation such as China and Middle East countries sought markets in the US. Nonetheless, there was a low supply of relatively safe, income generating investments. Wall Street filled the void by packaging mortgage-backed security (MBS) and collateralized debt obligation (CDO). These financial instruments connected the huge pool of money to the mortgage market. Large amounts of money poured into mortgage brokers, small banks funding the brokers and ultimately, the large investment banks. Credit lending agencies needed to sell mortgage loans to sustain the system and the loosening of standards was seen to widen the mortgage-availing population (Hull, 2008). Securitization and Credit Rating practices Mortgage traditionally involved a bank as the originator of a loan given to borrowers thereby assuming the credit default risk. With Wall Street securitization, the traditional ‘originate’ model to ‘distribute’. The new mortgage process is shown in Figure 2: Figure 2: The New Mortgage Model (Ruppel, 2009) In securitization, banks were able to sell mortgages to investors thereby ‘distributing’ credit risk and generating transaction fees in the process. This was the MBS mentioned earlier. Since banks and other mortgage-issuing agencies no longer held mortgages to maturity and generated funds from the sales of mortgages to investors, they were able to replenish their funds easily and issue more loans. This provided the incentive for banks to focus on the quantity of loans generated without proper regard to credit quality. From Figure 2, one can see that a rating agency is involved in the securitization process. Credit rating agencies (CRAs) gave investment grade ratings to MBS especially on subprime mortgage loans. CRAs gave high ratings to subprime loans to the point that it was essentially giving out AAA ratings even on NINA accounts. CRAs saw these ratings as justified considering credit default insurance and willingness of equity investors to bear the preliminary losses. Nonetheless, a US Senate inquiry uncovered evidences suggesting that CRAs knew that subprime loans were toxic at the start. Even with this knowledge, CRAs kept giving high scores because they were being paid by investment banks and other sellers of structured securities (US Senate, 2009). In effect, they were giving high ratings because they were paid to do so. They no longer acted as an independent body. CRAs were quick to downgrade the credit ratings when the housing bubble began to burst. Figure 3: MBS Downgrades (American News Project, 2009) S&P and Moody’s were quick to downgrade their AAA ratings. In Figure 3, these two CRAs downgraded credit rating on nearly $1.9 trillion in MBS. While the two companies justified their action with the ‘unexpected’ bubble burst, they did act as experts in their field which is precisely what is required of them given their ‘rater’ status (US Senate, 2009). The argument is that if their ratings had been more accurate, fewer investors would have bought into these securities. However, a conflict of interest existed as rating agencies were enticed to give AAA ratings in order to continue to receive service fees or run the risk of underwriters and mortgage originators going to a different rating agency. Another possible explanation for the grossly mistaken high ratings were the increasing complexity of financial assets which became harder and harder to value. Investors relied on international bond rating agencies and bank regulators who also relied in complex mathematical models that theoretically showed risks to be small. In reality, however, the models prove to be simplistic and grossly erroneous. The new financial products became so complicated that the authorities were unable to calculate the risks and started relying on the investment banks’ risk management methods. CRAs, faced with the complexity of the structured products, also adapted the notion that the banks would not offer a synthetic product if they knew this would not succeed (Bezemer, 2009). Hence, they relied on the information provided by the makers of the synthetic products which constituted a gross abdication of responsibility. Government Policies One might wonder why the US government and American society as a whole tolerated the subprime lending arrangement even though it was sure to cave in. A combination of low interest rates, large foreign funds and government arrangements provided the necessary setting for the feasibility of subprime lending. In 2000, the US was reeling from the effects of the dot-com bubble burst which was further aggravated by the September 2001 World Trade Centre terrorist attacks. To soften the impact on the economy and minimize deflation, the Federal Reserve lowered federal funds rate from 6.5% to 1.0%. Interest rates were also driven down by US borrowing of money from abroad to finance its huge current trade deficits. Large amounts of foreign funds flowed into US, in the form of Treasury bonds purchases, from countries with high personal savings such as China and oil-rich countries. These funds created a demand for various types of financial assets consequently raising the price of assets and lowering interest rates (Atwood, 2008). Simply put, investment organizations enjoyed low interest rates and an influx of capital. In addition to easy credit conditions, competition between private and public investment banks also played an important role in the expansion of high-risk lending. Subprime mortgages amounted only below 10% of all mortgage in 2004 but doubled during the 2005-2006 US housing bubble. This coincided with the decision of the Securities and Exchange Commission (SEC) to relax the net capital rule which enabled investment banks to increase their financial leverage and expand their mortgage-securities business. Faced by this competitive pressure, government-subsidized securities investment agencies Fannie Mae and Freddie Mac decided to increase their mortgage-securities portfolio by accommodating risky lending (Gordon, 2008). Competition was not the only reason why Fannie Mae and Freddie Mac chose to expand their subprime lending business. Increasing home ownership was one of the top agendas of US Presidents from Roosevelt to Clinton to Bush Jr. Both companies were receiving government subsidies that entailed certain requirements. In 1995, the government required that 42% of the mortgage that Fannie Mae and Freddie Mac purchased were issued to low income borrowers. By 2005, the goal was set to 52%. As a result, Fannie Mae and Freddie Mac kept buying subprime mortgage securities to the point that they owned more than half of the US mortgage market (Holmes, 2007). Deceptive Business Practices Up to this point, we have made no mention of the creator of MBS and CDOs, the Wall Street. Investment agencies in the Wall Street such as Goldman Sachs and Merrill Lynch were the brains behind the MBS and were praised in the pre-crisis period as it generated a large amount of wealth for many people and organizations. In the aftermath of the crisis, however, it turned out that some of these agencies knew that the model will fail but still helped in the creation of MBS packages in the hope of gaining huge bonuses and transaction fees from investors. A case in point is the Goldman Sachs. Goldman Sachs proudly proclaims itself as a strong supporter and financer of ideas that would benefit not only their shareholders but the whole community as well. Nonetheless, the behavior in which Wall Street giant Goldman Sachs conducted its business that contributed to the global crisis is currently unraveling as the US Securities and Exchange Commission offers evidence of the company defrauding investors by selling financial products to investors while knowing that it was bound to fail. Goldman Sachs was known for marketing ‘synthetic’ financial instruments where there are no real assets in the investment made; only a bet on the performance of the assets it references. Goldman Sachs spread toxic mortgages throughout the financial system through the conscious manipulation of exotic and complex financial structures. They then proceeded to bet against the products they sold and rake in huge profits as their customers lose huge amounts of money. The company, as the SEC evidence shows, failed to tell investors that it was helping a major hedge fund for a collateralized debt obligation (CDO) but was at the same time betting against it. Paulson & Co, one of the world’s largest hedge funds, paid Goldman Sachs to structure a transaction in which it could take speculative positions against mortgage securities chosen by the fund. The deal, which took place during a massive mortgage meltdown in 2007 and as the country was about to fall into a brutal recession, was said to have cost investors around $1bn. In spite of the claim of Goldman that it had lost $90 million from its own investment in the security, the firm’s own documents show that the it was placing large bets against the US market while marketing risky mortgage-related securities at the same time (Steverman & Bogoslaw, 2010). In free-market parlance, there is no law, moral guideline or ethical injunction against profit. The problem with Goldman Sachs is that it profited by taking advantage of its client’ reasonable expectations that it would not sell products it did not want to succeed. Goldman treated its clients not as valuable partners or customers but objects of its own profit. The company derived large profits from making more risky mortgage securities available to people with high probability of default thereby making the financial system more likely to fail. In short, the company sought to do well when its clients lost money. This conduct brings into light the seeming unethical behavior of Wall Street businesses which has been traditionally seen as engine of growth that bets on America’s success and not on its failures. There were other predatory schemes uncovered such as that of the Countrywide who baited unsuspecting borrowers from entering into unsafe or unsound ‘secured loans’. The company advertised low interest rates for home financing to as low as 1% to 1.5%. Customers were then lured into adjustable rate mortgage (ARM) which had the effect of increasing the amount of interest paid as unpaid interest amounts were added into the principal. The pay-out value turns out to be much more than what was advertised (Soros, 2008). Homebuyers: Partner in Crime? As previously stated and shown in Figure 1, home buyers were also behaving haphazardly when they played an extremely risky game by buying houses they knew they could not afford. There are those who are quick to blame mortgage brokers who offered a variety of ‘innovative’ products such as NINA and no down payment schemes but the decision to take advantage of these schemes relied entirely on the purchases who is expected to make wise economic decisions. The American Dream of owning a house with several bedrooms with yard is deeply reinforced in American culture through television and movies. America was also a consumption-oriented culture. Hence, people believed that they can make significant profits through the speculation and massive appreciation of residential properties. Hence, they took advantage of ARM and other mortgage schemes in the belief that increasing home values would enable them to pay for the property and possibly profit from it when they sell it to another homebuyer. Housing prices did increase and peaked in June-July 2006 to 124% with 1997 as the base value but then American household debt relative to income increase to record levels to nearly 140% indicating that there were no more people capable of buying homes anymore (Ruppel, 2009). Instead of the continued appreciation, the housing bubble burst and prices dropped sharply. As a result of the sharp decline, many homeowners were unable to refinance their mortgages to lower rates because there was no equity created as house prices fell. The option was to reset their mortgage at higher rates but there was hardly any buyer willing to pay for the increased rates. Many homeowners, with not enough income and assets to pay their mortgages, defaulted. Many would see that mortgage brokers were at fault for providing risky loans but at the end of the day it was the borrowers who simply assumed mortgages they knew they couldn’t simply afford. In the end, it was the lenders and investors of securities that ultimately suffered as borrowers defaulted on their payments. However, are they simply motivated by greed or more compelling reason? The United Nations argue that for people living poverty especially in wealthy countries, life can be miserable and desperate and miserable. Day to day exposure to a decaying neighborhood that breeds crime, drugs, prostitution and the frustrations arising from finding work and ensuring a job lasts makes them prone to try to escape it for a while. This was exploited by mortgage brokers. As the adage goes, ‘in poverty, long term thinking is not always going to enter the realm of immediate concern’ (Gordon, 2008). Furthermore, it is likely that people in the lower levels of the social strata are not going to be financially adept compared to those further up and will tend to place trust in the banker and other financial advisor. The problem was that banks and financial institutions have become concerned in making a quick buck instead of being concerned about their customers. Ethical Climate The global crisis involved every player in the new mortgage model. Mortgage brokers and investment banks acted haphazardly to increase loan sales and profit from transactions. Government sponsored entities and homebuyers were negligent in their affairs. Much of these happened not only because of the relaxing of loan requirements and lending to subprime borrowers but also of the pervading ethical climate during the housing bubble. Ethical climate refers to the employee’s perception of the norms of an organization or society in a large sense (Bartels, 1998). Organizations with a strong ethical climate have been shown to face serious ethical problems because they have a strong set of norms comprising good ethical behavior. Managers are expected to develop strong ethical climates by providing organizational members the ability to handle ethical problems and choose to do the ethical thing. The problem in the global crisis showed that when huge profits were involved, ethical climate issues are thrown out of the office as investment banks and other loan –offering entity provide incentives to its employees to increase subprime lending quantity and take less consideration on the quality of the transaction. In short, organizations fostered an unethical climate, one which the government and the individual gladly accepted. Conclusion With the increasing complexity of the business world, new trends and issues regarding ethics arise. The global crisis, when carefully discussed and analyzed, is basically a combination of fraud, greed and negligence. Nonetheless, the complexity in which the subprime mortgages were conducted shows that society tends to adapt new levels of unethical behavior. Corruption, corporate malfeasance and insider trading no longer dominate the business ethics discourse. The global crisis placed conscious negligence and fraud as the mainstay in ethical discussions. It was no longer the corporate or organization who acted unethically but the consumer as well. The global financial meltdown has placed business behaviour under the microscope, resulting in no shortage of guilty parties charged with responsibility for the fiasco. References: American News Project (2009).  Road to Ruin: Mortgage Fraud Scandal Brewing. US: The Real News. Amin, S. (2008). Financial Collapse, Systemic Crisis. 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