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Honesty in the credit market 

By Barbara Black

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Ethics, trust, governance and due diligence have never been more pressing subjects for business scholars than they are right now.

The U.S. sub-prime mortgage crisis, which started last summer when people couldn’t pay their mortgages, started a financial earthquake that rocked huge American and British banks and investment houses and is dragging down the U.S. economy. The crisis alarmed government agencies to the extent that they stepped beyond their normal sphere in an effort to stabilize the market.

Even the normally cautious Canadian banks were seduced by the easy money, although it seems they will recover. The Caisse de dépôt et placement lost more than $13 billion of our pensions.

There’s plenty of blame to go around, according to finance professor Lorne Switzer. He is Associate Dean, Research, in the John Molson School of Business. He holds the Van Berkom Chair in Small-Cap Equities, and he’s the Associate Director of the Concordia-HEC Institute for Governance in Private and Public Organizations.

Switzer says there was so much capital available in the 1990s that both borrowers and lenders got greedy. The intermediate institutions bought into the shaky mortgages by acquiring and reselling them in the form of asset-backed commercial paper (ABCP), a financial instrument few of us had heard of until recently, without exercising due diligence. ABCP was supposed to be like a savings account with a slightly higher interest rate, but as thousands of investors in Canada discovered, it was a risky investment.

Business schools have taught for decades that companies should do their best for their shareholders or proprietors, but this is a practical objective without an ethical dimension, Switzer said.

“Maximizing shareholder wealth often involves tradeoffs. Some shareholders might be satisfied at the expense of other stakeholders. Doing the ‘right thing’ should transcend all tradeoffs, but human beings are fallible.”

Virtues such as honesty, respect for others, not impinging upon the autonomy of another, doing one's best — actions like these are done without expectation of reward. And there’s no penalty for bad behaviour if you don’t get caught.

Sometimes it’s a case of making poor decisions and then compounding them, he said. Businesses are required to do their financial reporting on a short-term basis, which may impair their judgment. “If you have to focus on producing results for one quarter ahead, that might be at the expense of having better results one year ahead.”

Some critics are calling for more regulation in the credit sector, but Switzer doesn’t expect to see it.

“The financial sector has typically argued strongly against regulations that impinge on their behaviour. The basic viewpoint was that major financial institutions are sophisticated players who know very well how to evaluate risk and control for it. It is ironic, however, that they expect that the government to bail them out when they are proven terribly wrong.”

Asked when the current credit crunch will end, Switzer said, “Markets are pretty resilient. I think the bottom will appear when the best players, like Goldman Sachs, who bailed out of their ABCP positions before the debacle, start buying whatever is left of these mortgage pools.”

We wondered if financial instruments like ABCPs are used inappropriately. “Obviously they were used inappropriately in the case of the scandalous sub-prime mortgage pools, but these instruments can be effective to pool the risk of individual assets, creating a portfolio that has less risk than its individual components. ABCPs can be created from any type of asset-backed security, such as a student loan or a credit card.”

Switzer finds it interesting that some of the leading “traditional” economics and finance scholars have shifted their focus to ethics in recent years. For example, Michael Jensen, an emeritus professor of Harvard, has created a model of business integrity that can be taught and used by business professionals.

Jensen defines integrity as wholeness, soundness, being complete and in perfect condition. That means honoring one’s word, doing what you said you would do, and if you can’t, admitting it and cleaning up the mess.

Switzer subscribes to this approach, and will host Jensen at Concordia next fall for a conference on business ethics.