By: Thomas Lee Abshier, ND
What was the culpability of Wall Street leaders in the collapse?
While Wall Street and the banking industry was not the source of the subprime mortgages, they bundled and sold them to unsuspecting investors as AAA rated investments. Bear Stearns, JP Morgan, Lehman Brothers, et al, were the facilitators of penetrating toxic debt into the most risk-averse portfolios. Their deception ultimately resulted in their own collapse and with it the world economic system.
Porter Stansbury’s editorial in his newsletter, The Growth Stock Wire, inspired the following essay. He quoted Jimmy Cayne, CEO of Bear Stearns global investment bank and securities trading and brokerage, in his denial of knowledge about the high risk involved in the Mortgage Backed Securities his firm marketed. Jimmy Cayne’s surprise and shock at the MBS’s failure was totally implausible.
The Andrew Klavan YouTube Video summarizes the players and genesis of the 2008 financial crisis. The same players that created the crisis are now writing and promoting the terms for “Financial Reform”.
The Cost of Caveat Emptor
By: Thomas Lee Abshier, ND
The foundational cause of the collapse of 2008 was produced by Congress passing legislation that incentivized making loans to unqualified homeowners under the “morally superior motives” of helping the poor attain the American dream of homeownership. When the economy slowed as the Fed raised interest rates, ARMs readjusted, and oil prices soared to over $140/barrel, the economy slowed, jobs were lost, and people began to default on their loans. This scenario was sufficiently obvious that a 2002 NYT editorial acknowledged the subprime mortgage scheme would result in a housing bubble that would burst if there were an economic downturn. The leaders of the financial industry knew the actual poor quality of the paper underlying the Mortgage Backed Securities (rated as AAA by S&P), sold it enthusiastically to trusting investors, and prospered personally by facilitating the transactions. The lack of moral will to fully inform their clients about the risks and quality of what they knew and believed was overvalued paper, transferred excessive risk to investors unaware of the actual quality of the product they had purchased. The withheld representation produced a deep penetration of high risk contracts into the heart of countries, banks, pension funds, companies, and individuals whose major consideration was wealth preservation. Such investors would have never put their capital in these instruments had they known the true risk. The brokerage houses knew the MBSs were contaminated with low quality loans, but tried to cover the risk by using Credit Default Swaps (CDS) as insurance against failure. But, the drop in value and breadth of exposure was so great, the entire system strained and broke under the weight of the failing mortgages, with the resultant failures of the MBSs and CDSs. The entire mis-rating of the subprime contaminated MBSs and subsequent deception of the unsuspecting investor, could have been laid on the doorstep of S&P for rating these Mortgage Backed Securities as AAA (which were instruments that bundled together both high and low risk mortgages). Many experienced and informed brokers almost certainly had a sense of their poor quality, as evidenced by the internal emails within Goldman Sachs who had been selling an MBS product, and writing to a colleague about their poor quality.Ultimately, participating in the sales of mis-rated securities put the investment houses in a position where a downgrade of the securities they underwrote eventually forced them into bankruptcy. They fell victim to laws (e.g. Cash reserve margin vs. outstanding loans, Sarbanes-Oxley, and mark to market rules) that required ever-higher cash reserves to be held as margin in backing ever-lower rated securities. These investment houses were forced to declare bankruptcy by law when their cash reserves dropped below prescribed levels. In effect, our laws require financial institutions to declare bankruptcy, a form of financial hari-kari or honor suicide. The survival of the investment houses was put at risk by underwriting and selling paper that they knew did not have the value they presented. The truth-withheld resulted in self-destruction.As Conservatives, we are tempted to defend the concept of the free market and all its players as emissaries of capitalism and economic freedom. And while a free market will ultimately and eventually expose the fraudulent and corrupt, we should not defend the banking industry and Wall Street and its complicity in spreading the MBS risk to other investment markets and countries. The brokers of securities have the power to participate, stay neutral, or oppose any investment opportunity or strategy. Those in the position of detailed and arcane knowledge regarding underlying the quality of investments had a responsibility to give full disclosure about the quality of the products they knew were mis-rated. It is because of ignoring this responsibility to fully inform their clients that their own brokerage houses eventually collapsed. Possibly, even probably, the compensation the financial advisors (MBS salesmen) received for passing on these investment vehicles overrode their professional judgment, objections, and willingness to give full disclosure. The common defense of “Caveat Emptor” (Let the Buyer Beware) implies that the seller has no responsibility in the transfer of defective merchandise, and the buyer must decide suitability, quality, and price regardless of the fullness or truthfulness of representation by the seller. But as we have seen, there is a cost to misinformation and withholding information, ranging from loss of trust to bankruptcy and prison.As advocates of the Free Market, we defend the market’s wisdom, judgment, and ability to evaluate risk and value. Every financial transaction has both a buyer and seller who enter into an exchange contract freely. To declare one side wrong implies an absolute perspective, a God-like ability to declare the buyer or seller wrong and bad, or good and right. But we hesitate to make such absolute judgments because the reasons and feelings that produce the decisions to buy and sell are not always rational. In a free country, and a free market, we have the right to buy or sell regardless of the defensibility of a rationalization. The free market affords us the right to right to buy or sell based on feelings instead of facts and reason.
Nevertheless, the transaction is based on false premises when there is an incomplete disclosure of all relevant information known by the seller. Of course, the buyer should get multiple opinions about the quality of an unknown product, regardless of the character, knowledge, or level of disclosure. The seller may simply be unaware of all its defects and weaknesses, but he becomes more culpable for the consequences of the product failure as his awareness rises of the possible defects and failure modes. The line of culpability is clearly crossed when a seller purposefully, consciously, and selectively omits relevant considerations about an item’s structure and function.
And while the motive of withholding is increased profit in the moment, the effects of withholding information from the buyer will ultimately result in the long term impoverishment of the system. The customer may be injured in wealth and/or health, the reputation of the firm may suffer, and production may slow and become inefficient to accommodate laws and buyer distrust. The sales and compensation scheme of the large financial brokerage houses during the period leading up to September 2008 bubble burst, was the moral equivalent of prostitution. They were paid large amounts of money as the incentive for performing unethical/immoral acts.
The free enterprise system can function in the presence of deception, defects, and corruption, but every violation of ethical standards (full disclosure, quality and standards, and competition) will put elements of the system at risk. With sufficiently broad and extreme violations of Godly ethics, the free market system itself will be at risk of extinction by the imposition of government regulation ranging from bothersome to total. The vibrant health and survival of free enterprise depend upon every person living and speaking truthfully from their highest commitment to Godly business ethics. Freedom and free enterprise will remain strong only when each person is willing to take their place as a moral force and say “no” to the temptations for personal gain that seduce us away from honest and full disclosure of personally known risk.