Introduction: Ideology Overwhelms Experience

The financial crisis sprang from two mutually reinforcing institutional transformations – one on Wall Street and another in Washington. Fueled by an explosive mix of megamergers, massive capital formation, increased leverage, and runaway technical wizardry, the Wall Street business model evolved from providing a diversified mix of financial services for valued clients to one dominated by the investment of a firm’s own capital in increasingly complex and risky securities, often at the expense of a firm’s customers who came to be viewed as counterparties. The most telltale sign of Wall Street’s transformation was the exponential growth and increasing importance of precisely the kind of proprietary trading, particularly of CMOs, at the center of the financial crisis. Facilitating all this was a parallel retreat in Washington’s oversight of the financial industry.

Introduction

On Monday, September 15, 2008, Lehman Brothers, a prominent investment bank that traces its roots to 1850, declared bankruptcy and thereupon triggered a global financial crisis. Literally overnight, borrowing came to a standstill, and widely held assets could not be converted into cash. The liquidity crunch immediately crippled banks owning substantial amounts of securities linked to subprime mortgages and spread very quickly to every sector of the global economy and all types of debt securities. Unable to sell even normally safe and highly liquid investments, on Tuesday, September 16, 2008, the Primary Reserve Fund, the oldest money market fund in the United States, in an action eerily reminiscent of Depression-era bank runs, shocked the financial community by freezing customer accounts and indefinitely halting withdrawals. Ordinary consumers were thus harshly reminded that there were no safe havens for their savings in this economic storm, adding another layer of uncertainty and instability to the financial markets. Within weeks of the Lehman bankruptcy, the resulting shock to the financial system inflicted severe and long-lasting damages on the economy, throwing tens of millions of people out of work and slowing economic growth. Half a decade later, the global economy still limps along in the aftermath of the financial crisis.

The financial crisis sprang from a precipitous decline in the value of mortgage-related securities. The bursting of the mortgage bubble completely wiped out Lehman’s capital base. Other venerable Wall Street institutions including Merrill Lynch and Bear Stearns narrowly averted total collapse through hastily arranged mergers with Bank of America and JPMorgan Chase, respectively. Virtually every major financial institution had massive exposure to the mortgage market relative to its capital base, and even those banks not in danger of imminent collapse suffered staggering losses severely limiting their ability to engage in ordinary consumer lending activities and basic interbank transactions. Because of the financial sector’s centrality to capital and credit markets, the U.S. Congress authorized a $700 billion government bailout to prevent further failures and safeguard the financial system from total collapse.

Introduction

Beginning roughly in the last two decades of the twentieth century and culminating with the 2008 financial crisis, the dominant Wall Street business model transformed from a customer-driven focus with a minor proprietary trading component to one where principal transactions, and in particular trading in mortgage-backed securities, came to dominate the profits and attention of the brightest minds in the financial industry. This transformation represents a major shift in Wall Street’s business model. The bulk of Wall Street’s profits today are no longer derived from providing financial services to clients. Instead, Wall Street firms generate profits mostly from investing their own capital. The rise of principal transactions occurred not coincidentally just as the financial industry was also experiencing enormous growth in scale as, in the two decades preceding the financial crisis, every major Wall Street firm went from being a privately funded partnership to a publicly held company.

In Chapter two we introduced the idea that profit disjunction occurs when the profits of Wall Street are not aligned with the prosperity of the economy as a whole. In this chapter, we examine how Wall Street profits became unhinged from and dangerous to the general welfare of society. We describe not only how Wall Street became dependent on proprietary trading and the perverse compensation incentives encouraging moral hazard and excessive risk taking, but also how Wall Street became so large that its potential failure as a business sector threatened the stability of the global economy. Our purpose in doing so is not simply to address the issue of “too big to fail” and the bailout. Our objective is to demonstrate how the shift in Wall Street’s business model from serving clients to proprietary trading accompanied a crisis in Wall Street values that in no small measure contributed to the financial crisis. We are concerned, in other words, not only with the threats Wall Street poses to the general economy when it fails, but also with the dangers it creates when it is successful following the postmillennial proprietary trading business model. We begin our analysis, however, by recalling a long bygone era when ongoing customer relations, based upon trust and mutuality, were an essential foundation for the creation and success of the financial industry.

Introduction

Government can help align Wall Street interests with those of Main Street by channeling self-interested behavior into socially useful outcomes. It can serve as a watchdog, attempting to detect and prevent illegal behavior. Government cannot, however, replace the role of business ethics. Despite numerous regulatory failures and outsized errors in business judgment, the financial crisis was fundamentally a moral crisis. At great cost, we learned that greed, unless tempered by good values, does not “work” from a social perspective. Ethically unmoored, Wall Street became a danger to free markets, the economy, and itself. Only a massive public bailout saved it from the consequences of its own moral decay.

Wall Street today remains morally adrift. It no longer adheres to the customer-driven values that sustained it since the 1930s, yet it has not adopted values and ethical principles suitable for its evolving business models. It lurches along in a moral wasteland from which it may take years, if not decades, to emerge. The prototypical postmillennial Wall Street executive is ethically untroubled, even when securities sold to clients are virtually assured to lose value. Goldman Sachs CEO Lloyd Blankfein captured the essence of this moral sensibility when he described his formative experience at the firm’s commodities trading unit: “We didn’t have the word ‘client’ or ‘customer,’ we had “counterparties” – and that’s because we didn’t know how to spell the word ‘adversary.’” In an earlier era, Wall Street professionals would not have tolerated this kind of sentiment or rampant abuse of customers. However, the postmillennial financial executive lacks relevant principles for sound ethical judgment. The values of the past no longer apply, but no principles have emerged to replace them. In earlier chapters we analyzed how Wall Street arrived at this moral quagmire. In this chapter we consider the prospects for restoring values to a central role on Wall Street.

Introduction

The turn of the millennium brought about radical change in the relationships of Wall Street firms with customers as well as to the broader economy and society – from clients to counterparties, from long-term relationships to transactional business, from guardians of efficient markets to exploiters of markets. In the postmillennial era, Wall Street firms exploit their expertise through proprietary principal transactions with counterparties whose interests are often in direct conflict with the firm. Transactions in which a firm’s expertise is shared with clients have become less important to the bottom line. Wall Street has, as a consequence, become less fit to fulfill its crucial free market roles of disseminating information about market value and serving as a vehicle for the efficient allocation of capital.

Ironically, Wall Street in the postmillennial age prospers by creating and exploiting inefficiencies in the free market and not by helping it work efficiently. The new Wall Street model requires firms to withhold information and analysis from those with whom they conduct business. When the alignment of interests between Wall Street firms and customers was severed so too was the crucial link that enabled information to flow through the financial markets. There were still functioning financial markets that valued assets. However, particularly in relatively illiquid and opaque markets such as that for mortgage-backed securities, the postmillennial Wall Street model has embedded within it unprecedented incentives to lie and keep secrets from the market in the hopes of gaining temporary profits from resulting informational asymmetries and inefficiencies. As a result, Wall Street transactions sometimes obscure markets rather than provide information about them.

Introduction: Business and the Social Contract

Do Wall Street firms have any duties to society other than to maximize profits while obeying the law? Many believe that every business owes moral duties extending beyond the bottom line to promote social goals such as human rights, diversity, or the environment. One justification for this expansive view of corporate responsibility is based on the idea of the social contract that Locke, Hobbes, and Rousseau employed to elucidate the moral and political foundations of the state. Just as in political theory society precedes and authorizes the powers of the state, corporate power and wealth are premised on a contract with society. The very existence of a corporation as a “fictitious person” with legal rights and protections for investors – for instance, the “corporate veil” of limited liability protecting shareholders from any personal liability for the debts incurred by the corporation – is made possible by society. The accumulation of wealth by private business is made possible by the fertile ground of social capital and within the stable legal framework and property right protections of civil society. In return, it is reasonable to expect that businesses operate in a manner that benefits society.

This idea of the social contract is a formal moral justification for our intuitive sense that the accumulation of wealth is made possible by communal contributions creating reciprocal social responsibilities for business beyond simply maximizing firm profits.

More than four years after the financial crisis that erupted in September 2008, there has been no dearth of books analyzing its origins. Numerous government hearings, documentary films, journalistic investigations, and a national independent commission report have all added to our understanding of the crisis. Certainly a reader might reasonably question the purpose of a new book on the subject. Our simple answer is that the financial crisis was fundamentally a crisis of business ethics rooted in almost three decades of moral, financial, and institutional transformation on Wall Street. Indeed, the most important finding of Wall Street Values is that business ethics and values matter, and that no amount of structural reform and government regulation will ensure the stability of the global financial system unless the ethical practices and values of Wall Street professionals are aligned with market efficiency and the public welfare. In this book we detail when and how Wall Street’s business model and values diverged from the public interest, and we offer a roadmap for realignment.

At the same time that we seek to avoid the Charybdis of redundancy, we are mindful too of the Scylla of obsolescence. As Wall Street Values goes to press, each week brings fresh news of Wall Street’s ineptitude and malfeasance – the botched Facebook offering by a once top-tier investment bank, a “London Whale” losing billions of dollars in unsupervised trading bets for a global bank renowned for its risk management prowess, and a financial firm entrusted with executing market transactions for customers big and small losing nearly half a billion dollars in one morning because of a software glitch that kept automatically trading without any human control. A reader might reasonably question the point of a book written before these developments fully unfold. Again our answer returns to the primacy of ethics, particularly in a time of change and turmoil. Two and a half millennia ago, Confucius, writing at a time of great transformation and uncertainty in ancient China, compared virtue to the North Star, remaining in its place while all the other stars moved about it. So too we believe that focusing on the ethical roots of the financial crisis elucidates how our financial institutions can operate in a manner that nurtures both profits and social prosperity.