Aren’t Bad Apples the Cause of Ethical Problems in Organizations?

According to the bad apple theory, people are good or bad and organizations are

powerless to change these folks. This bad apple idea16 is appealing in part because

unethical behavior can then be blamed on a few individuals with poor character.

Although it’s unpleasant to fire people, it’s relatively easier for organizations to

search for and discard a few bad apples than to search for some organizational

problem that caused the apple to rot.

Despite the appeal of the bad apple idea, ‘‘character’’ is a poorly defined concept,

and when people talk about it, they rarely define what they mean. They’re probably

referring to a complex combination of traits that are thought to guide individual behavior in ethical dilemma situations. If character guides ethical conduct, training

shouldn’t make much difference because character is thought to be relatively stable:

it’s difficult to change, persists over time, and guides behavior across different contexts.

Character develops slowly as a result of upbringing and the accumulation of

values that are transmitted by schools, families, friends, and religious organizations.

Therefore, people come to educational institutions or work organizations with an

already defined good or poor character. Good apples will be good and bad apples

will be bad.

In fact, people do have predispositions to behave ethically or unethically. And sociopaths can certainly slip into organizations with the sole intent of helping themselves to the organization’s resources, cheating customers, and feathering their own nests at the expense of others. Famous scoundrels like Bernie Madoff definitely come to mind. Such individuals have little interest in ‘‘doing the right thing,’’ and when this type of individual shows up in your organization, the best thing to do is discard the bad apple and make an example of the incident to those who remain.

But discarding bad apples generally won’t solve an organization’s problem with

unethical behavior. The organization must scrutinize itself to determine if something

rotten inside the organization is spoiling the apples. For example, Enron encouraged

a kind of devil-may-care, unethical culture that is captured in the film, Enron: The

Smartest Guys in the Room. Arthur Andersen’s culture morphed from a focus on the

integrity of audits to a consulting culture that focused almost exclusively on feeding

the bottom line. You’ll learn that most people are not guided by a strict internal moral compass. Rather, they look outside themselves—to their environment—for cues about how to think and behave. This was certainly true in the financial crisis when the mantra became ‘‘everyone is doing it’’ (and making a lot of money besides). At work, managers and the organizational culture transmit many cues about how employees should think and act. For example, reward systems play a huge role by rewarding short-term thinking and profits, as they did in the recent financial crisis. You’ll learn about theimportance of these organizational influences and how to harness them to support ethical behavior and avoid unethical behavior.

So, apples often turn bad because they’re spoiled by ‘‘bad barrels’’—bad work

environments that not only condone, but may even expect unethical behavior. Most

employees are not bad folks to begin with. But their behavior can easily turn bad if

they believe that their boss or their organization expects them to behave unethically

or if everyone else appears to be engaging in a particular practice. In this view, an

organization that’s serious about supporting ethical behavior and preventing misconduct

must delve deeply into its own management systems and cultural norms and

practices to search for systemic causes of unethical behavior. Management must take

responsibility for the messages it sends or fails to send about what’s expected. If

ethics problems are rooted in the organization’s culture, discarding a few bad apples

without changing that culture isn’t going to solve the problem. An effective and lasting

solution will rely on management’s systematic attention to all aspects of the organization’s culture and what it is explicitly or implicitly ‘‘teaching’’ organizational

members.

This question about the source of ethical and unethical behavior reflects the

broader ‘‘nature/nurture’’ debate in psychology. Are we more the result of our genes

(nature) or our environments (nurture)? Most studies find that behavior results from

both nature and nurture. So, when it comes to ethical conduct, the answer is not

either/or, but and. Individuals do come to work with predispositions that influence

their behavior, and they should take responsibility for their own actions. But the

work environment can also have a large impact.

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Those Who Were Supposed to Protect Us Didn’t

One protection against financial calamity was thought to be the rating agencies such

as Standard and Poor’s and Moody’s. They rate the safety or soundness of securities,

including those securitized mortgage products. A credit opinion is defined as one

which rates the timeliness and ultimate repayment of principal and interest. But, like

everyone else, the rating agencies say they didn’t foresee a decline in housing prices;

and consequently, they rated the mortgage securities as being AAA—the highest

rating possible, which meant that the rating agencies considered these securities to be

highly safe. The agencies are the subject of much criticism for their role in the crisis.

If they had done a better job analyzing the risk (their responsibility), much of the

crisis might have been avoided. But note that these rating agencies are hired and paid

by the companies whose products they rate, thus causing a conflict of interest that

many believe biased their ratings in a positive direction. So, people who thought they

were making responsible investments because they checked the ratings were misled.

Another protection that failed was the network of risk managers and boards of

directors of the financial community. How is it that one 400-person business that was

part of the formerly successful insurance behemoth, AIG, could invest in such a way

that it brought the world’s largest insurance company to its knees? The risk was

underestimated all around by those professionals charged with anticipating such

problems and by the board of directors that didn’t see the problem coming. The U.S.

government (actually taxpayers) ended up bailing out AIG to the tune of $170 billion.

The risk managers and boards of other financial firms such as Citigroup, Merrill

Lynch, Lehman Brothers, Bear Stearns, and Wachovia were similarly blind.

On Wall Street, there were other contributing factors. First, bank CEOs and other

executives were paid huge salaries to keep the price of their firms’ stocks at high

levels. If their institutions lost money, their personal payouts would shrink. So, bank

executives were paid handsomely to bolster short-term profits. The Wall Street traders were similarly compensated—they were paid multimillion-dollar bonuses for

taking outsized risks in the market. What seemed to matter most were the short-term

profits of the firm and the short-term compensation of those making risky decisions.

The traders took risks, the bets were at least temporarily successful, and the bankers

walked off with multimillion-dollar bonuses. It didn’t matter that the risk taking was

foolish and completely irresponsible in the long run. The bonus had already been

paid. Consequently, a short-term mentality took firm root among the nation’s bankers,

CEOs, and boards of directors.

Finally, we can’t examine the financial crisis without questioning the role of

regulatory agencies and legislators. For example, for a decade, investor Harry

Markopolos tried on numerous occasions to spur the Securities and Exchange

Commission to investigate Bernard L. Madoff. The SEC never did uncover the

largest Ponzi scheme in the history of finance. The $65-billion-dollar swindle

unraveled only when Madoff admitted the fraud to his sons, who alerted the SEC

and the U.S. attorney’s office in New York in December 2008. Others who are

culpable in the financial crisis are members of the U.S. Congress, who deregulated

the financial industry, the source of some of their largest campaign contributions.

Among other things, they repealed the Glass-Steagall Act, which had been

passed after the U.S. stock market crash in 1929 to protect commercial banking

customers from the aggression and extreme risk taking of investment bank

cultures. The act created separate institutions for commercial and investment

banks, and they stayed separate until the merger of Citicorp and Travelers to

form Citigroup in 1998. The two companies petitioned Congress to eliminate

Glass-Steagall, claiming that it was an old, restrictive law and that today’s markets

were too modern and sophisticated to need such protection. And Congress

listened. Those 1930s congressmen knew that if two banking cultures tried to

exist in the same company—the staid, conservative culture of commercial banking

(our savings and checking accounts) and the razzle-dazzle, high-risk culture

of investment banking—the ‘‘eat what you kill’’ investment bank culture would

win out. Some said that staid old commercial banks turned into ‘‘casinos.’’ But,

interestingly, casinos are highly regulated and are required to keep funds on hand

to pay winners. In the coming months, we expect to learn more about the behavior

that led to this crisis. As we noted earlier, much if not most of it was probably

legal because of the lack of regulation in the mortgage and investment banking

industries. But look at the outcome! If only ethical antennae had been more sensitive,

more people might have questioned products they didn’t understand, or spoken

out or refused to participate in practices that were clearly questionable. As

just one tiny example, could anyone have thought it was ethical to sell a product

they called a liar loan, knowing that the customer surely would be unable to repay

(even if it was legal to do so)?

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Mortgage Originators Peddled ‘‘Liar Loans’’.

In the early 2000s, as housing investments increased in popularity, more and more

people got involved. Congress urged lenders Freddie Mac and Fannie Mae to expand

home ownership to lower-income Americans. Mortgage lenders began to rethink the old rules of financing home ownership. As recently as the late 1990s, potential home

owners not only had to provide solid proof of employment and income to qualify

for a mortgage, but they also had to make a cash down payment of between 5 and

20 percent of the estimated value of the home. But real estate was so hot and returns

on investment were growing so quickly that mortgage lenders decided to loosen those

‘‘old-fashioned’’ credit restrictions. In the early 2000s, the rules for obtaining a mortgage

became way less restrictive. Suddenly, because real estate values were rising so

quickly, borrowers didn’t have to put any money down on a house. They could borrow

the entire estimated worth of the house; this is known as 100-percent financing.

Also, borrowers no longer needed to provide proof of employment or income. These

were popularly called ‘‘no doc’’ (no documentation) or ‘‘liar loans’’ because banks

weren’t bothering to verify the ‘‘truth’’ of what borrowers were claiming on their

mortgage applications.

Banks Securitized the Poison and Spread It Around

At about the same time liar loans were becoming popular, another new practice was

introduced to mortgage markets. Investors in developing countries were looking to

the United States and its seemingly ‘‘safe’’ markets for investment opportunities.

Cash poured into the country from abroad—especially from countries like China

and Russia, which were awash in cash from manufacturing and oil respectively.

Wall Street bankers developed new products to provide investment vehicles for

this new cash. One new product involved the securitization of mortgages. (Note:

structured finance began in 1984, when a large number of GMAC auto receivables

were bundled into a single security by First Boston Corporation, now part of Credit

Suisse.) Here’s how it worked: Instead of your bank keeping your mortgage until it

matured, as had traditionally been the case, your bank would sell your mortgage—

usually to a larger bank that would then combine your mortgage with many others

(reducing the bank’s incentive to be sure you would pay it back). Then the bankers

sold these mortgage-backed securities to investors, which seemed like a great idea

at the time. Real estate was traditionally safe, and ‘‘slicing and dicing’’ mortgages

divided the risk into small pieces with different credit ratings and spread the risk

around. Of course, the reverse was also true, as the bankers learned to their horror.

This method of dividing mortgages into little pieces and spreading them around

could also spread the contagion of poor risk. However, starting in 2002 and for

several years thereafter, people couldn’t imagine housing values falling. So much

money poured into the system, and the demand for these mortgage-backed security

products was so great, that bankers demanded more and more mortgages from

mortgage originators. That situation encouraged the traditional barriers to getting a

home mortgage to fall even farther. These investment vehicles were also based

upon extremely complex mathematical formulas (and old numbers) that everyone

took on faith and few attempted to understand. It looks like more people should

have followed Warren Buffett’s sage advice not to invest in anything you don’t

comprehend! Add to that toxic mix the relatively new idea of credit-default swaps (CDS). These complex financial instruments were created to mitigate the risk financial

firms took when peddling products like securitized mortgages. CDS are insurance

contracts that protect the holder against an event of default on the part of a

debtor. One need not own the loan or debt instrument to own the protection, and

the amount of capital tied up in trading CDS is very small compared to trading

other debt instruments. That is a very significant part in the increase in popularity

at sell-side and buy-side trading desks. The big insurance company, AIG, was a

huge player in this market, and so were the large banks. The firms that were counterparties

to CDS never stepped back from the trading frenzy to imagine what

would happen if both the structured finance market and the real estate bubble burst

(as all bubbles eventually do) at the same time. Both underwriters and investors

would be left holding the bag when the music stopped playing—and the U.S. taxpayer

has had to bail out most of the financially-stressed firms to save the entire

financial system from collapse. Please note that all of this happened in a part of the

market that was virtually unregulated.

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Real Estate Became the Investment of Choice

Of course, people also want to invest in something safe, and what could be safer than

real estate? There had been relatively few instances of real estate values declining,

and when they did the declines were generally shallow and short-lived. A point of

pride in the United States was the high percentage of Americans who owned their

own homes. Investing in a home traditionally had been a very safe investment and

one that was slow to appreciate in value. But suddenly in the early 2000s, real estate

investing became a real moneymaker. With a backdrop of historically low interest

rates, real estate became such a popular way to invest that demand soon outstripped

supply and prices soared. The value of homes skyrocketed—homes that were selling

for $300,000 in one year sold for $450,000 the next. Prices rose so fast that speculation

grew tremendously. People bought houses with almost no down payment,

remodeled them or waited a few months, and then resold the houses for a quick profit.

A number of popular television programs showed viewers how to ‘‘flip’’ real estate

properties for profit.

Since the cost of borrowing was so low and home equity had grown so quickly,

many consumers borrowed on the equity in their homes and purchased additional real

estate or a new car or financed a luxury vacation. For example, suppose someone

purchased a house for $500,000 in 2003. By 2005, the home might have been worth

$800,000. The home owner refinanced the mortgage—borrowing as much as the

entire current worth of the house (because its value could only go up, right?), which

resulted in a $300,000 cash infusion for the home owner. This practice was very

popular, and it laid the groundwork for a huge disaster when the housing values fell

off a cliff in 2008 and 2009. Imagine the home owner who refinanced the home

just described. Imagine that he took the $300,000 and purchased a summer home and

a sports car and paid for his children’s college educations. Suddenly, home values

plummeted and his house lost 30 percent of its value, which was common in markets

such as California, Florida, Nevada, or Arizona, where the real estate bubble

was particularly inflated. After the real estate bubble burst, his house was worth

$560,000. Now suppose he loses his job and needs to sell his house because he can’t

afford the mortgage payments. He can’t get $800,000 for his home, which is what he

owes on his mortgage. His only choice is to work with the mortgage holder (probably

a bank) to refinance (unlikely) or declare bankruptcy and walk away from the house.

This is what a lot of home owners have done, and it is one of the factors at the heart

of the current financial crisis. Lots of folks were in on this bubble mentality, getting

what they could in the short term and not thinking very much about the likelihood (or

inevitability) that the bubble would burst.

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