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)?