Friday, January 18, 2008

Another corporate scandal – this time its worse!

On January 17th, Merrill Lynch announced its largest loss ever – US$9.8 billion dollars for the 4th quarter of 2007. This came as a result of a write down of the value of certain assets held by the company – US$16.7 billion loss in book value. The assets had been purchased as part of the subprime mortgage bonanza of a few years ago.

The subprime “bonanza” first turned into a “mess” then to a “crisis” and now has pushed the entire US economy to the tipping point of “recession”.

Wall Street stock prices are down – the necessary consequence of any major market miscalculation by business. President Bush is suddenly talking of a huge financial stimulus package from the federal government budget into the pockets of American consumers. When Republicans talk about dumping billions of federal dollars into consumer hands, you know they are worried about prospects for economic well-being.

These results should come as no surprise. We are living through yet another cycle of irresponsible corporate decision-making. Bad ethics – selfish exploitation of immediate advantage in disregard of long-term consequences – has once again led to bad economics.

The mismanagement of subprime lending has all the hallmarks of a classic business scandal. Truth about risk was not made transparent; too much capital was invested seeking easy returns causing an excess of activity which, self-evidently could not be sustained; and wheeler-dealers seeing fees drove the process.

On the other hand, this business scandal does not have the features of intentional fraud in manipulation of earnings reports that marked the Enron/WorldCom era. Nevertheless, it has resulted from the same character flaws in decision-making as the previous episode of financial malfeasance.

Products were prepared to be sold in our financial markets to meet investor appetite.

Then it was stock in supposedly high-growth companies. Now it was supposedly low risk, higher return mortgage products.

The dysfunction in both scandals was intentionally separating those who carried the risk from those who stood to profit, a violation of fundamental equitable principles of capitalism. In capitalism, those who hope to get the lion’s share of returns should shoulder the lion’s share of risk.

In Enron/WorldCom, risk was put on purchasers of stock and returns were earned by insiders. In the subprime mess, risk was put on low-income, poor credit rated mortgage borrowers and on the purchasers of interests in derivatives collateralized by such subprime mortgages. Fees were earned by originators of the mortgages and sellers of the derivatives who assumed no long term risk of loss.

This pushing off of risk to those who either could not bear it or who did not know about it was socially irresponsible corporate behavior.

In both the subprime mess and in Enron/WorldCom, the perpetrators of the scandals were the best and the brightest minds in our financial markets.

It is only just that now some investment chickens have come home to roost with Bear Sterns, Citibank and Merrill Lynch. But at a serious cost to the rest of us who are entirely innocent and don’t deserve to live in stressful economic conditions not of our own making.

The Enron/WorldCom cycle of scandal did not pose as much of a threat to average Americans as this malfeasance in the use of capital has. Housing prices are down; the equity wealth of most Americans is therefore down; consumer spending is down with impact on production and employment; the economic is facing a general recession.


Anonymous said...

I couldn't agree more with the comment re the "serious cost to the rest of us who are entirely innocent and don’t deserve to live in stressful economic conditions not of our own making".
I have been concerned for many years about the way financial institutions in the UK attempted to 'push' debt onto my sons (one only newly working, the other still a student). Indeed, I was sufficiently disturbed by this to write to my MP, asking him to raise the matter with senior political colleagues. Each time a reply (penned by some Civil Service flunkey, signed by some third-tier Minister) would come back, full of complacency, self-congratulation & platitudes.
Now the chickens of sub-prime lending are coming home to roost, too damn right - it's those of us who have tried to act providently and ethically who will suffer.
I've never felt particularly akin to the more vociferous anti-capitalism activists. But I'm beginning to feel that maybe their way is the right way, and we won't see an end to unethical corporate greed until a few paving-stones are thrown in the streets!

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