Thursday, October 9, 2008

Global Prosperity at Risk The Current Crisis and the Responsible Way Forward

Imprudent decisions on the part of US and European investment banks, banks, mortgage brokers, insurance companies, and consumers - all seeking profitable advantage - have brought the global financial network that sustains global capitalism to crisis.

Great American financial houses – even Lehman Brothers that survived the Great Depression of the 1930s - are no more; banks in America and Europe have been propped up by governments; and massive amounts of liquidity have been injected into the financial system by the US Federal Reserve System and other central banks.

This is not business as usual. Trillions of dollars in private wealth has been destroyed in a matter of weeks, some of it never to be regained. And governments have been forced to step in to protect the economically vulnerable where markets have failed.

Yet, ironically, inadequate regulation and government policies also contributed in various ways to risks being negligently addressed by financial markets, thereby paving the way for the current crisis.

Beyond dealing with the immediate crisis, the critical task will be to address the underlying causes through reforms to restore trust and confidence in financial markets. Functioning and sound financial institutions, despite their current failure to meet their fundamental responsibilities, remains of first importance for supporting a successful free market economy. Credit is now scarce and capitalism cannot properly function without it.

The triggers to this crisis were centered on a lack of: prudence in the extension of credit; rigor in valuations; and of transparency in management. This was compounded by the mispricing of risk via the bundling and sale of debt through collaterised debt securities and via complex derivative based credit default swaps. These failures reflected profound shortcomings in private sector governance both as prescribed and as applied. In short, risk was not appropriately managed; it was not even properly understood both by those creating it and by those bound to mitigate it.

Driving this lack of prudent management was a dysfunctional and shortsighted system of incentives and personal remuneration.

Compensation of senior executives, traders and fund managers was built on greed and self interest and was decoupled from long-term wealth creation. Compensation based on fees earned and other incentive-based benchmarks blinded otherwise intelligent managers to the long-term dire consequences of their decisions. Rewards rose with excessive risk taking and was provided in ways that has largely shielded senior corporate officers and fund managers from liability for their decisions.

As a result, the best interests of customers, owners, employees and communities have been systematically overlooked. Decision-makers, driven by short-term interests, paid too little to no attention to managing risk accumulation.

Short-term speculation dominated, with part of the market enriching itself by betting on and contributing to the destruction of wealth via short-selling. Not only did the regulators fail to halt the growth in systemic risk, some of the contributing market activity and behavior was allowed to remain unregulated.

This global financial crisis has further exacerbated the very low levels of trust which the global community places in business. The fact that the profits were in effect privatized to those who created the crisis through excessive rewards, and the losses are now being socialized to taxpayers has further outraged the community. Though justly perhaps, the shareholders of the ‘failed’ financial institutions responsible for the crisis have lost most of their ownership wealth.

This is not the first time that market capitalism has so failed. Less than a decade ago, global markets lived through the bust of the dot-com and telecom bubble in equities and the accounting scandals of Enron and World-Com. Before that, world financial markets were upset by currency collapses in Thailand, Malaysia, Indonesia and Russia. And before that, the United States lived through the savings and loan/junk bond bubble and bust.

More fundamentally, the current crisis represents the latest, albeit the most severe, fallout from the systemic erosion within the corporate world of the importance of ethics and responsibility in business decision-making. Ideological commitments to laissez-faire free market fundamentalism, social darwinism philosophies, and shareholder primacy at the expense of other stakeholders, have divorced business leadership from standards of good faith, wise stewardship and care for the public interest.

As a result, capitalism’s immune system of market discipline fails every so often and the cancer of “irrational exuberance”, greed and narrow self interest metastasizes. The object of reform, obviously, should be either to eliminate this deep cancer within capitalism once and for all or to boost society’s market immune system of accurate pricing, risk management and valuation transparency in order to keep the cancer in long-term remission.

At the core of all these market shortcomings were the boards of directors of the corporations involved. They were not sufficiently encased in an environment of accountability and transparency and ultimate accountability. The market failure, therefore, was ultimately a failure of governance.

With respect to the current crisis in financial markets, there are no clear remedies on the table. Business leaders are largely silent; academics have little to say beyond the immediate; and politicians, regulators and central banks are putting out fires. No one is focused on designing a sustainable future that removes once and for all the underlying problem.

Interestingly, the recent movement promoting corporate social responsibility via CSR standards, monitoring, reporting and ratings, has not proved adequate in preventing these failures of capitalism. It is now apparent that much of the CSR movement remains on the fringes and too removed from core of business risk management and strategy. Compounding the problem, business education has been lacking with a general absence of teachings in responsible and ethical business practices.

Uniquely, the Caux Round Table (CRT) Principles for Business provide strategic ethical guidance which, had it been followed, would have kept those institutions that have triggered the crisis more faithful to their obligations of stewardship, good governance and stakeholder risk management. The CRT Principles go to the heart of constructive and ethical behaviors that enhance risk assessment and stakeholder management, boosting bottom-line valuations of business success and sustaining responsible long-term wealth creation for society.

The way forward to free markets that are consistently reliable in their capacity for robust wealth creation is through the imposition of higher standards of good governance and transparency. Lack of good governance and transparency, again and again, leads market capitalism down wrong roads. Such opacity and lack of accountability has long been a fundamental flaw in institutions of private enterprise.

The following remedial steps to take responsible capitalism from the fringes of the business model and firmly entrench it in the heart of corporate strategy deserve priority attention:

• First, the principle of “enlightened shareholder value” should be codified in company law via non-prescriptive minimum standards for responsible decision-making and good governance. (The UK Companies Act 2006 provides an example of such legislation.)

o Directors should be required to document and defend their stewardship over company affairs via specific disclosure of:

 the principle risks and uncertainties likely to affect the future development, performance and position of the company’s business; and
 material risks and impacts relating to environmental matters, employees, customers, suppliers and social and community issues.

• Second, members of corporate boards should be trained corporate governance including Board oversight of the full spectrum of financial, social and business risks.

o Business is not without consequence for society and should, therefore, be attentive to the demands for responsible execution of its private office of trust and profit.

o The CRT risk assessment process of Arcturus provides an example of what can be required of companies in regard to stakeholder, social and environmental risks.

• Third, corporate boards should establish a dedicated sub-committee responsible for strategic risk consideration across the full range of stakeholder, responsibility and sustainability issues.

o The environmental, social and governance risk assessment processes and outcomes, should be subject to third party assurance.

o Boards should make annual disclosures of the material financial, environmental, social and governance risks assessment in easily understood prose that is meaningful to stakeholders.

• Fourth, executive compensation must be reformed to ensure incentives are aligned to the achievement of long-term wealth creation and reward prudent risk management rather than excessive risk taking.

• Fifth, equity and capital market regulation and taxation should be reformed to incentivize sustainable value creation and to penalize / ban market manipulation, short-selling and other value destruction.

• Sixth, derivative markets need to be regulated, including the introduction of a fully regulated exchange for credit derivatives.

• Seventh, opportunities for companies and individuals to illegally hide income by utilizing tax havens and secrecy jurisdictions should be eliminated.

These reforms will not only address the causes of the current crisis, they will have a salutary effect on a broader and longer basis. Such reforms to eliminate the underlying, systemic flaws in the system should have as an objective promotion of global social responsibility on the part of all companies.


CRT Principles for Business and the Financial Crisis of 2008

The best test of a principle, perhaps, lies in its effects, not always in its aspirations. Does it lead to constructive action? Can it influence and shape behaviors for the better, especially dysfunctional behaviors?

On the one hand we can judge the quality of a principle according to a moral calculus of abstract standards of right and wrong. But, on the other hand, we can also assess the practical worth of a principle by its power to achieve ethics in the field. This might be considered the inherent potential of a principle to obtain compliance with its preferences for better outcomes. As Karl Marx said in his Theses on Fuerbach, “Up to now philosophers have only interpreted the world. The point, however, is to change it.”

This seems especially relevant in the arena of corporate responsibility and business ethics.
Overcoming the functionality of greed and short-term self-interest is the goal of those who promote responsible decision-making in business. And a daunting task they have.

The Caux Round Table published a set of ethical principles for business in 1994, the first such set of principles for guidance of global business and the only set of such principles yet designed by experienced business leaders.

The current massive disruption of financial markets initially brought on by the collapse of the sub-prime mortgage market in the United States provides an opportunity to assess the relevance of the CRT Principles for Business.

weIf they had been followed, are there reasonable grounds to believe that the crisis could have been avoided, or at least mitigated in scope and intensity?

I think the answer is, yes, the CRT Principles might have made a difference had they been infused in strategic and tactical decisions on the part of those financial institutions which contributed to the current crisis.

First, let us consider the implications of the first CRT Principle for Business:

“The value of a business to society is the wealth and employment it creates and the marketable products and services it provides to consumers at a reasonable price commensurate with quality. To create such value, a business must maintain its own economic health and viability …”

Since the crisis is about the failure of major financial houses and banks such as Bear Sterns and Lehman Brothers, the sale of others such as Merrill Lynch and Washington Mutual, and the government rescue of Freddie Mac, Fannie Mae, AIG, Fortis, and others, we can quite quickly conclude that these companies failed to meet the ethical requirement of maintaining their own economic health and viability.

Their decision-making was wrong-headed in the accumulation of too much debt and in setting imprudent values on certain financial assets such as sub-prime home mortgages and CDOs. In their collapse, these firms caused a contraction of markets, thus erasing wealth and employment in violation of what the CRT advocates as the primary obligation of business firms.

Second, the current crisis was caused by a failure to provide quality products at a price commensurate with their inherent worth.

Sub-prime mortgages were priced inappropriately for many borrowers. Excessive and imprudent borrowings were offered to home owners. In the many cases where credit standards were waived or overlooked lenders and mortgage brokers knew or should have known as professionals that the borrowers were highly likely to default if economic conditions changed.

Borrowers were effectively sold defective financial products. Such mortgages were also sold in excessive quantities, creating an asset bubble that gave rise to perverse incentives on the part of home buyers to assume unreasonable risks of future default and foreclosure.

Similarly, the terms of many CDOs sold were not of the value that was represented to buyers. They carried more risk than was reasonable for the investment goals of those who purchased them. They were also issued in excessive amounts that undermined their long-term value.

This requirement to serve customers with respect for their needs is reinforced in Section 3 of the CRT Principles for Business with the requirement that businesses “provide their customers with the highest quality products and services consistent with their requirements.”

The first CRT Principle also holds that:

“Businesses have a role to play in improving the lives of all their customers, employees, and shareholders by sharing with them the wealth they have created.”

Here has been the greatest harm done by those who create the unsustainable markets in sub-prime mortgages and CDOs – they destroyed wealth and made worse the lives of many customers, employees, owners, creditors and communities.

Principle No. Three of the CRT Principles holds that:

“… businesses should recognize that sincerity, candor, truthfulness, the keeping of promises, and transparency contribute not only to their own credibility and stability but also to the smoothness and efficiency of business transactions, particularly on the international level.”

The current crisis in financial markets was caused by a lack of sufficient transparency in CDOs valuations which eventually undermined the smoothness and efficiency of international markets for credit and liquidity.

Principle No. Four of the CRT Principles holds that:

“[Businesses] should recognize that some behavior, though legal, may still have adverse consequences.”

It appears that in general, the provision of the financial products that gave rise to the crisis was legal. No laws were violated in lending to sub-prime borrowers or securitizing those mortgages and selling off interests in them through CDOs and in providing guarantees of payment through credit default swaps. Individuals here and there are being investigated for fraud in the sale of such products, but the products themselves were legitimate in concept. What went wrong was selling them to excess on unsustainable terms. That behavior, though legal, had adverse consequences that should have been foreseen and avoided.

With respect to their owners, those responsible for the credit crisis failed to meet other responsibilities set forth in the CRT Principles for Business. For example, they failed to “apply professional and diligent management” and to “conserve, protect and increase the owner’s/investors assets”. These failures lay at the heart of the dynamic that caused the crisis. There was strategically poor judgment exercised in the development of these markets. Risk was exacerbated to the point of destabilization; it was not properly foreseen or managed.

And, finally, those who caused this crisis failed to meet the CRT standard of enhancing community environments and standards of living. Where homes go into default when mortgages can’t be paid, communities suffer disinvestment and even blight as home prices fall and homes are abandoned to the lenders.

Had the boards of directors and senior managers of Bear Sterns, Lehman Brothers, Merrill Lynch, Citibank, Morgan Stanley, Goldman Sachs, Washington Mutual, Freddie Mac, Fannie Mae, and others who thrived for a while off the issuance of sub-prime mortgages and CDOs taken their CRT responsibilities more seriously – and insisted on products and sales strategies consistent with those practices – there would have been less risk injected into the global financial system and less provision of unsustainable financial products.

As I wrote a few years ago in Moral Capitalism, “Directors and corporate officers are hired to be agents not just for their fidelity but also for their skill. Their responsibility is to guard against high risk and imprudent courses of action.”

In that book, I also pointed to the intertwining of interdependencies and the need for trust in transactions. Capitalism breeds interdependencies through the specialization of function and the division of labor. Reliance and trust are essential for capitalism to thrive. Destruction of either leads to trouble in markets. People lose confidence and withhold their ideas, labor, and capital from productive exchange. The economy then contracts. That is what is happening now. The current crisis is really only a crisis of confidence; trust has been lost.

But how do you restore trust when it has been abused?

I wrote in Moral Capitalism that “where mistrust prevails, people fear entering into dependency relationships. Mistrust always raises the risks of enterprise. Who would invest where risks are excessive and returns uncertain?”

This dynamic explains the collapse of value in Bear Sterns, Lehman Brothers and Washington Mutual – they had billions of dollars of assets on their books but no one wanted to buy their shares. The value of Bear Sterns was $80 per share on the books, but only $2 per share in the market. Lehman Brothers went bankrupt and its owners could not realize the value of the company’s book assets as no one wanted to buy those assets encumbered as they were by debt and uncertainty.

I also noted in Moral Capitalism the sometimes negative effect of desire for money. “The interest of owners and investors in making money introduces a challenge to moral capitalism. Money is easily idolized, provoking heresy by turning us away from the things of God to the things of Mammon. There are times when we may sell our souls to gain what money promises in way of power and license. This is especially true in today’s culture of consumerism, where we have sanctified appetite over character.”

How much did this dynamic contribute to the current crisis?

I close these thoughts with a quote from an ancient Chinese text, the Annals of Lu Bu Wei, who wrote about 250 BCE

“In making judgments, the early kings were perfect, because they made moral principles the starting point of all their undertakings and the root of every thing that was beneficial. This principle, however, is something that persons of mediocre intellect never grasp. Not grasping it, they lack awareness, and lacking awareness, they pursue profit. But while they pursue profit, it is absolutely impossible for them to be certain of attaining it.”

Momento Mori: on Wall Street’s Death by Negligence

What we have known as "Wall Street" is now stunningly no more.

Manhattan’s great investment banks are gone. The last two – Goldman Sachs and Morgan Stanley - are converting into banks, submitting to more intrusive government regulation in return for more secure sources of capital.

Communism couldn't kill this Wall Street; capitalism, however, did. Adam Smith won out over Karl Marx.

This "Wall Street" died at its own hands in a form of negligent suicide. It lived by the sword of extreme market capitalism and died by that same sword. It overdosed on toxic behaviors as did John Beluchi, Jimi Hendrix, Janis Joplin, and Jim Morrison.

The epitaph, I suppose, for "Wall Street’s" mighty rise and astonishing fall should be "Sic Transit Gloria Mundi" - "thus passeth worldly glory".

Street talk for what killed Wall Street’s investment bank titans is that it was “greed” that did them in. As in a Greek tragedy, excess and hubris worked through a cycle of boom and bust to humble even the best and the brightest. It’s an old story, really, new in its techniques of subprime mortgages, CDOs, and credit default swaps, but very old in its moral fundamentals.

But I don’t think it was greed precisely that was the cause of the losses and bankruptcies.

Greed - understood as seeking a profit, as pursuing one’s interest in business transactions – has not always been so terribly dysfunctional and hurtful to the common good. Indeed most of our modern life was devised, produced, distributed and sold by capitalist behaviors and motivations. There was a baby in Wall Street’s bathwater to be sure.

Goldman Sachs, Morgan Stanley, Merrill Lynch, Bear Sterns and their predecessors brought companies to life by raising capital for them. America’s growth and resulting economic well-being rested on robust capital markets. Without them there would have been no railroads, steel mills, General Motors, Ford, Boeing, Microsoft, or all the other Fortune 1,000 and smaller companies that ever sold stock or debt securities to finance their businesses.

So what went wrong? When did this “Wall Street” of once sound investment banking houses start walking on the wild side towards perdition?

The short answer is too much leverage – too much debt. Lehman Brothers, as an example, was leveraged 30 to 1 when it failed. When its chickens came home to roost in questions about how it was going to pay off its debt as the market turned sour, Lehman had insufficient capital of its own to be credibly self-reliant in down markets.

This answer raises a further question: why the need for so much leverage?

The answer to this question gets us closer to the culprit. Lehman wanted to buy securities and other tradable assets to resell them for a profit. It borrowed money to buy assets. It was not raising capital for other companies and taking a fee for the service. That was the traditional role for investment banks. No, Lehman had become a big trader on its own account as well. Lehman and the other investment banks were buying and selling any number of assets – short sales, currencies, options, puts and calls, stocks, bonds, many sorts of derivatives – to speculate on price movements.

When done well, such trading earned huge returns and permitted lavish bonuses and life styles on the part of its owners and employees.

The point to note is that trading is not real investing. It is playing in the space left open by other buyers and sellers. Trading is short term; it is not designed to hold rights to the income or the capital appreciation of companies over the long haul. The time frame for trading is “right now”.

Trading is not a special, distinct part of capitalism with its genius for engineering modern economic growth. Trading has been with us since the dawn of time. Markets predate capitalism by millennia. Capitalism is a recent evolution in human social practices, substantially starting in Holland and England only in the 1600’s.

In the ancient Chinese state of Qi before the time of Confucius, there was a famous Prime Minister, Quan Zi. His lord, Duke Huan, loved purple cloth but grew annoyed when the price for such beautiful cloth rose too high even for him. A shrewd judge of human nature, Quan Zi advised his Duke as follows: since the dye used to make the cloth purple left a smell, the next time someone approached the Duke wearing purple clothes, the Duke should hold his nose as if the smell was repugnant to him. The Duke did so and all the courtiers, suddenly fearful of offending the Duke by wearing purple, sold all their purple clothes. The price of purple cloth in the markets of Qi immediately dropped. Quan Zi bought up all the purple cloth for a song and gave it to his now very happy Lord.

Such trading in markets has a long history throughout human history. But capitalism seeks patient capital to invest over the long haul in companies that need the cash for working capital, wages, raw materials, plant, equipment, etc. For capitalism to succeed, the right kind of investment capital markets is very necessary. But it must be a market that attracts investment, not speculation. A market in speculation is a casino.

From the beginning of capitalism, old trading habits were brought over to finance and trade the new possibilities created by the new, emerging economic system. But trading habits loosed inside capitalism have been disruptive.

The first boom and bust irrational exuberance in capitalism was the tulip mania in Holland in the early 1600’s. That mania for buying tulip bulbs was not systematically different in its origins, dynamics or eventual losses from our current boom/bust cycle in buying certain financial products.

Trading and investing thrive on different and inconsistent incentives. Traders like to take a fee from every trade; investors look to dividends and the sale of appreciated ownership shares as a company becomes successful in its business for their returns.

Trading is akin to speculation: you pay money for a chance to win. You don’t always win so your winnings over time need to compensate for your losses and the risks associated with the gambles taken. Trading and speculation are inherently short term and limited in their consideration of consequences. Their spirit is at odds with the motivations and perseverance needed to grow a business.

Capital markets exist to accommodate traders and trading in financial instruments. Investment capital is raised by selling equity and debt contracts. We can’t, as far as I can tell, eliminate trading from capitalism. Providers of capital and companies need the liquidity which the ability to sell into a robust market of buyers permits; trading sets prices, which give vital information on values and trends, successes and failures.

But the goose that lays the golden eggs is not one that lives on trading alone. Firms need patient capital - investors, not speculators renting stock for a while in order to profit from market movements. Speculators can easily divert management’s attention away from long term strategies to short term manipulations of stock prices.

The most important role of financial intermediaries is to provide capital; therefore, short term trading in capital contracts should be subordinate to the mission of finding ways to raise money for companies so that they can create jobs, products and services – and, in consequence, the precious commodity of real economic growth.

From here on out, I suggest, that financial markets be so structured that trading beyond a certain band is burdened with responsibilities that will reduce the appeal of more and more speculative trading and so bring incentives in financial markets back to the provision of patient capital.

We need a trading regime that performs useful services without spinning out of control and throwing us into spasms of wasteful excess.

We might want to consider having different kinds of markets – one for trading and one for investing, or pricing arrangements that add to the purchase price of the trade as the risk associated with each new, incremental trade gets bigger and bigger. If risk were properly priced, the demand for financial instruments would contract as risk conditions change adversely given the growth of excessive supply. Too much supply financed with debt leads to a boom, which sets us up for the ensuing bust.

But, this strategy would require taking into account up front all the external consequences – both positive and negative - for consumers, society, workers, lenders, investors, suppliers, government – that will flow from the activities funded by the extension of credit.