By Michael Lewis
Finance - specifically the voluntary transfer of capital from those who have it to those who need it for the purpose of creating and maintaining a business enterprise which rewards its investors, employees, customers and vendors, and the community at large - is a noble undertaking. Without such a mechanism, human progress would be stagnant, technological advancement erratic, and existing social systems intractable. The willingness of those who dare combined with those willing to accept inordinate, sometimes unknown risks of capital loss, has stimulated enormous benefits for mankind generally, reducing the physical burdens of daily existence, extending life, and inspiring the spirit of adventure. Financial activities are essential, but are they ethical?
It seems that some men, despite the admonishments of religion and the existence of laws, have always used guile, fabrications, and fraud to separate other men from their money, generally with the promise of great wealth, power, or benefits to the investor. Wealth, earned or inherited, does not protect its master, nor reduce the appeal of greater gains. As Ben Franklin noted, "The more (money) a man has, the more he wants. Instead of filling a vacuum, it makes one."
The likelihood of being tricked or scammed as an investor has always been present; Dr. John Bridges advised in 1573 that "a fool and his money are soon parted." Investors learned about banks and falsified financial documents from the Irish brothers James and John Sadier in 1856, and also learned difficult lessons about "goldbricks" - bricks of lead coated with gold - from American promoters of Western mining properties in 1880s, as well as the folly of trying to purchase national monuments and landmarks (Brooklyn Bridge, Grant's Tomb, Statue of Liberty) from American George C. Parker.
In recent years, the names of Barlow Crowes (England), Satyam Computers (India), and Enron (United States) are reminders that finance and investing remain perilous activities in a community of greedy men, evolving laws, absent ethics, and overworked, underfunded regulatory bodies.
Ronald A Duska, Post Chair of Ethics and the Professions at The American College, proposed five reasons why ethical lapses occur:
Lacking national laws or regulation, the finance industry was essentially self-policing, deterred minimally by individual state blue laws and often ignored Exchange regulations. Scams, frauds, and insider stock pools flourished as new, unsophisticated, inexperienced investors began "playing the Market" - unscrupulous stock brokers and investment bankers gleefully described them as "sheep to be shorn."
The stock market crash of 1929 ushered in the Great Depression, an economic sinkhole that toppled governments, ruined businesses, and devastated families. Almost half of America's banks failed and unemployment approached 30 percent in an era where most families had a single wage earner. Some historians believe that the Great Depression's impact in Germany with one in four workers unemployed and skyrocketing inflation led to the rapid rise of the Nazi party and its leader, Adolf Hitler.
Whether the stock market crash was a stimulus for the Depression or a portent of the excesses in existence at that time continues to be debated. There is, however, unanimity that efficient markets require open and honest disclosure, as well as valid information. Left to their own devices, many financiers in the early 1900s failed to exercise basic business ethics, profiting by providing false information, failing to disclose critical relationships, and committing frauds to such a degree that external regulation was necessary to restore faith in the world's financial markets.
The Securities Act of 1933, the Banking Act of 1933 (Glass-Steagall), and the following year's Security Exchange Act formalized and legalized basic ethical behavior for those who seek money from, or manage the wealth of, private investors. The Securities Act serves the dual purpose of ensuring that issuers (and their agents, the Wall Street banks) that sell securities to the public disclose material information to investors, and that securities transactions are not based upon fraudulent information or practices.
Strong leadership of the Securities and Exchange Commission created by the Act slowly restored faith in the United States' private finance system for the next half century. As a consequence, other countries enacted similar laws regarding financial activities in their jurisdictions.
Not all of the bankers agreed. Henry Kaufman, a preeminent Salomon Brothers economist, was quoted in the November 16, 1986 issue of "The New York Times," "I am not sure that this whole trend makes a net contribution to society as a whole. We cannot escape the fact that we have some financial responsibility. We are not just in the business of pushing companies around." When his fellow executive committee members disagreed, Kaufman resigned.
During the past 20 years, fraud has become institutionalized, despite the efforts of the SEC. Enron, HealthSouth, and Worldcom, aided an abetted by the country's largest legal and accounting firms, scammed millions from the public while Bernard Madoff used and updated the tactics of an earlier Wall Street conman, Charles Ponzi. International banks facilitate the establishment of illegal offshore banking accounts established to skirt existing laws and launder illegal gains from drugs and other criminal activities. Even the Institute for Works of Religion, commonly known as the Vatican Bank, has been regularly charged with money-laundering, most recently for a mafia boss.
In 1999, the Glass-Stegall Act was repealed through the efforts of the large banks and their lobbyists who insisted that the banks couldn't compete with other securities firms. At the time of appeal, the banks argued that they would only invest in low-risk securities and that diversification would lower risk for their customers. Many believe that repeal of the provisions separating commercial and investment banking was a major factor in the subsequent securitized mortgage-loan crash and the greatest recession since 1929.
In 2008, the excesses and unethical practices of the finance industry erupted in a series of mortgage-backed securities frauds, ultimately costing investors and U.S. taxpayers an estimated $27 billion. In a particular egregious example of Wall Street greed, multinational investment bank Goldman Sachs manufactured and sold a $545 million sub-prime mortgage-backed collateralized debt obligation (Freemont Home Loan Trust 2006-E) to investors without disclosing that the investments were likely to fail. A U.S. Senate subcommittee chaired by Senator Carl Levin found that the bank secretly bet against investors' position and deceived investors about its own positions in order to shift risk from its balance sheet to theirs.
The Volcker Rule, named for a former Federal Reserve Chairman, limits a bank from trading in securities for its own account (proprietary trading) and restricts the type of investments which a bank can hold. As might be expected (and similar to their reaction to the new laws of 1933 and 1934), Wall Street has mounted a full-scale attack through its agents and friendly Congressmen to delay implementation or repeal the Dodd-Frank Act.
While much of the battle between the bankers and regulators about the implementation of Dodd-Frank will be heated and hidden in closed meetings and confidential memos, according to one political insider, "There is no doubt that banks will comply with the letter of the law, and then exploit every loophole with the narrowest reading of the letter of the law."
One of President Ronald Reagan's favorite sayings was "Trust, but verify." Even though information may appear reliable, one should perform additional research to determine that the information is accurate or trustworthy. According to James A. Mitchell, Executive Fellow-Leadership at the Center for Ethical Business Cultures at the University of St. Thomas College of Business, "It is your responsibility to take control of your own financial security."
In other words, caveat emptor: Let the buyer beware.
Do you feel that ethics and finance can be compatible?
Michael Lewis is a retired executive and entrepreneur who currently writes about finance, investing, and U.S. economic policy on the blog Money Crashers Personal Finance.
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