slides

1. The Ethics of Risk Taking:
The Banking Crisis of 2008-09

2. Investment Banking
An Ethical Profile of an Industry
Special obligations of trust, reliance
and protection

3. The world of investment banking
Investment banks
Primary goals: raise capital
trade securities
manage corporate
mergers and
acquisitions
Issue and sell securities in capital markets
(security for corporate bonds, stock issues)
Manage investment funds (e.g., annuities,
hedges, pensions, mutual funds)
Subject to minimal state and federal
regulation and oversight
Commercial banks
Primary goals: income through providing
credit access to end users
(businesses and
individuals)
protection of assets for
individual through deposits
credit/capital for major
individual and business
investments
Subject to heavy state/federal regulation

4. Investment banking:
institutional “setting”
• Movement of huge sums of
capital on a daily basis
• Highly competitive
• Mobile work force: frequent
movement among competing
institutions
• (e.g., the “bonus” practice)
• Competition among small
number of firms for larger and
larger shares of the capital
markets

5. Investment banking
primary marketplace feature:
moral hazard:
exposure to possible failure or loss
should require the exercise of care
and caution in taking on financial
risk
Investment banking firms:
Uniquely responsible for insuring
against risk on part of their clients,
funds, stockholders
risk requires prudent management

6. Functional responsibilities
of investment banking
“overarching” functional obligation:
assist clients in wealth growth while
balancing risk
Management of wealth
growth and risk for clients
(client= funds, corporations,
government entities)
Structuring, securing and
managing stock issues, bond
issues, and other fund
raising strategies
Research and advice about
market conditions
Negotiating mergers

7. Investment banking
Trust relationships create levels of fiduciary responsibility:
[1] to investors directly (and partner banks, funds, corporations)
[2] to stockholders
(increase wealth and income, balance risk)
[3] to overall credit system of the economy
(by extension, to national economy as a whole)

8. Market innovations:
1990s-2000s
Widespread de-regulation of
investment banking:
-Loosen or remove govt. oversight
of financial markets
(e.g., investment banks permitted
to enter mortgage markets)
Overarching “ideology” about
markets:
“free” markets are more
efficient and innovative
Grow more quickly and
produce more wealth

9. Financial Services Modernization Act (1989)
[Gramm-Leach-Bliley Act]
Repealed Glass-Steagall Act of 1933
removed barriers separating commercial and investment
banking
Opened financial markets to trading in derivatives securities

10. Market innovations:
1990s-2000s
Alan Greenspan, Chair
Federal Reserve Board
Interest rates maintained at very
low levels
Stimulates credit markets
(consumer credit, mortgages)
Overarching “ideology” about
markets:
“free” markets are more
efficient and innovative
Grow more quickly and
produce more wealth

11. Market innovations:
1990s-2000s
As “debt pool” expands…..
Creation and sale of new form
of product by investment
banks:
Mortgage-backed securities
(MBSs)
Value of MBSs derived from
the cash flows attached to the
consumer loans they
represent
(including risky assets like
subprime Mortgages)

12. Marketing debt: an innovative way to create new markets, new
profits
Mortgage debt: [1] risk to lender
[2] reliable revenue stream
MBSs: focus on [2] – sell a “share” in the revenue
stream to investors
impact on [1] – spreads lender risk more
broadly by including other
investors
As long as mortgage repayment is reliable, there is no concern.

13. Investment Banking
resorts to ever riskier practices
mortgage-backed securities
Debt obligations that represent
claims to the cash flows from
pools of mortgage loans
These pools are bundled and
converted into securities that
are offered for sale
MBSs include both government-sponsored
mortgages (e.g., Fannie Mae, Freddie
Mac) and private label mortgage
securities

14. Collateralized Debt Obligation
Higher the RISK the greater the REWARD

15. Marketing debt: An innovative way to create new markets. New
profits
MBSs include a large percentage of sub-prime
mortgages
Pervasive business model: generate working capital (over many
years) from packaging mortgage-backed securities for sale
Successful strategy – until subprime components of MBSs
began to implode

16. What is a subprime
mortgage?
Issued to borrowers with
lower credit ratings
Borrower viewed as having
a higher than average risk
of defaulting on the loan
Mortgage interest rate is
higher than conventional
loan --- as a balance of the
higher risk

17. Widespread defaults on subprime mortgages
Effect “ripples” through investment community …
First investment banks, then institutional investors, then individual
investors

18. Investment banking
“at risk”
September 2008:
Federal government needs to purchase
toxic assets (MBSs) from failing
investment banks
Troubled Assets Relief
Program (TARP)
$300 billion taxpayers funds
Two Treasury Secretaries:
Henry Paulson
Timothy Geithner

19. BAILOUTS:
Global government rescue
of financial markets
[1] lending institutions
holding toxic assets
[2] investment institutions
holding loan-backed
securities
[3] investment insurance
institutions at risk from loan-
backed securities

20. Ethical implications of Banking Crisis
Role of individual self interest
Profit-seeking without respect to risk
“offloading” risk onto other parties
Neglect of stakeholders
Role of corporate culture
Competitive setting
Myth of invincibility
Unrealistic estimate of actual risks

21. Another casualty = TRUST
essential for banking and credit system
Contributory factor in credit system collapse of 2008-2009
As trust eroded, fear of risk caused the national credit
market to contract

22. Credit collapse leads to economic collapse
Social results: businesses close
unemployment rises
national well being declines

23. LEWIS, “HOW CAN A GUY WHO CAN’T SPEAK ENGLISH LIE?”
MATT CAMPANA
TAFT, “THE WORLD’S SAFEST BANKING SYSTEM”
TAIBBI, “LAST MYSTERY OF THE FINANCIAL CRISIS”
Wall Street and the financial system
Main Street and the retail credit system