We conclude with this Essay surveying the corporate corruption landscape in 2017 and the conditions supporting or impeding those who would “resist.”
To carry out this survey, we begin with three questions. Answering these questions should give us perspective on how far we have come since the Enron era and what remains to be done:
The recent corporate corruption record offers a mixed-bag ledger. On the plus side, there has been a conspicuous absence of industrial company accounting scandals. Said differently, in terms of bad accounting we have seen nothing like a WorldCom or an Enron. Many factors have contributed to this improvement. SOX made a positive impact. This happened on many fronts, the two most important of which concern Board Audit Committees and the Public Accounting firms. In recent times, the quiet word in industrial America has been that the Chairman of the Board of the Audit Committee has a very hot seat. This seat is now challenging in terms of content, prone to liability and hard to fill with competent directors. This last point would not be the case if Boards were not taking their job of scrutinizing accounting results much more seriously than before 2001.
As for the CPA firms, they gained back some autonomy once SOX forced them to stop “racing to the bottom” on accounting in pursuit of consulting revenues. The fact that their hiring now lies in the hands of the Audit Committee rather than the CEO is an added plus. So too is the considerable liability that attaches to audit firms which miss material misstatements or omissions. CPA firms hate this, but it reinforces their focus and resolve. The fact that they must communicate in writing with the Audit Committee on major accounting issues also strengthens their hand. Information on hot issues cannot be kept away from the Directors by a management eager to avoid scrutiny.
The Financial Crisis provided a huge, negative counterpoint to these improvements. Once again a raft of abuses became apparent. Once again the accounting firms proved malleable or supine in the face of managements determined to hide distressing facts from the public. The lead up to the Financial Crisis was launched by accounting scandals at both Freddie Mac and Fannie Mae. These scandals cost CEOs like Franklin Raines their jobs and forced changes in CPA firms. As the crisis clouds rolled in, so too did the cases of fraudulent reporting. Two Bear Stearns “carry” funds blatantly misrepresented their subprime mortgage exposure before going bankrupt. Citigroup also misrepresented its exposure when reporting 3Q’07 results. The restatement cost CEO Charles Prince III his job. Only a couple of months later, Citi was forced to take over $100 billion in subprime mortgage instruments back onto its balance sheet. The Structured Investment Vehicles (SIVs) warehousing these instruments could no longer roll over their commercial paper funding. How KPMG, Citi’s auditor, allowed the firm to distort its reporting and wire its way around FASB’s Variable Interest Entity rules has never been fully explained. Ernst & Young’s embarrassment came in allowing Lehman Brothers to manipulate its balance sheet via Repo 105 transactions that no U.S. law firm would approve. Even PWC, which garnered favorable press for outing AIG’s weaknesses in controls, allowed that firm’s Financial Products group to write subprime credit default swaps without any reserves for potential losses or the need to post collateral. Critics accused PWC of being late in calling AIG to account. One can only imagine the beneficial consequences of PWC forcing AIG-FP in 2006 to have prepared for a down SCDO market.
Clearly the recent record on Finance industry financial reporting deviates from that of industrial America. Cases since the Crisis, notably the P/L reporting at MF Global and the accounting scandal at Citi’s Banamex, show the CPA firms either not finding big problems or not forcing the firm to disclose them.
How should we interpret this Industrial/Financial divergence? We would suggest the record shows that when the firm is big/complex enough and/or the stakes are big enough, a determined CEO can still face down the auditors. So far, those conditions have characterized the financial industry more than industrial firms. There is no guarantee that this will continue. Indeed, there is reason to believe that the industrial sector is getting more risky even as the financial sector heads in the opposite direction.
Assessing the current state of the Financial Industry requires a revisit to the causes of the Crisis and to the post-Crisis remediation efforts. Many diagnostics of the Crisis proceed chronologically. They begin with events in the 1990s and move into the origins of the subprime mortgage bubble, its dissemination via Wall Street and the final reckoning when banks woke up to their insolvent circumstances. There is nothing wrong with this standard approach. However, more insight may be gained if we work backwards. If we start with the immediate cause of the 2008 “run on the banks” and work back to how the potential for this run was created, we may discern more clearly what was critical and what was ancillary.
The immediate cause of the Crisis was the freeze-up in interbank lending. Said differently, by September 2008 lenders did not want to roll over their funding of Lehman Brothers, and increasingly that of Merrill Lynch, Citigroup, Bank of America, Morgan Stanley and Goldman Sachs. How was it possible that lenders would “cut off” such premier counterparties, all of whom remained investment-grade rated at that point in time?
The first answer is that they had become both huge and very highly leveraged. Lehman’s balance sheet was levered 40:1 or more. All the investment banks were in the same neighborhood. Balance sheets routinely topped $300 billion and some approached $1 trillion in assets. This combination of size and leverage meant one thing—if a sizeable asset class got into trouble, the associated losses could materially impair firm equity. Mark-to-Market accounting would also force this news into the market place at least every 90 days.
Picture a firm with $500 billion in assets and $15 billion in equity capital. It is levered ~33x. Assume it contains a $100 billion class of questionable assets. This asset class now loses 15% of its value, a figure not at all out of line with what happened in the Crisis. The firm’s equity would be wiped out, and every one of its lenders knows this math.
Thus, the key questions are how did the firms get so levered and how did this dodgy asset class come into being?
Like most issues of this magnitude, the answers are complex. However, they boil down to this: a “race to the bottom” took place among financial firms abetted by staggeringly poor performance by the industry’s gatekeepers—the regulators and the Rating Agencies. Financial institutions found they could generate historically high Returns on Equity and huge compensation packages for management by combining high leverage, securitization of subprime mortgages and active trading of these instruments. As the cases show, Goldman was generating over 30% ROE before the crisis and Morgan Stanley almost 27%; annual pay packages for their CEOs reached $45 M and $41 M respectively. Intoxicated by these incentives, self-disciple eroded and ethical interest in the details of securitization evaporated at most firms.
On leverage, the crazy quilt of bank regulators did little to rein in the institutions they supervised. Even after the Fannie/Freddie accounting scandals, the GSE’s regulator was unable to stop the firms from re-levering to stratospheric levels. Commercial banks like Citi used structured approaches to disguise their true leverage. Investment banks, which were not subject to FDIC or CoC supervision, felt free to get as levered as the markets would allow. Surveying the scene, the Greenspan Federal Reserve still counted on market discipline. What it didn’t count on was that discipline’s coming first being delayed and then blowing in like a storm.
The Rating Agencies arguably were worse. They completely missed the overleveraging of the banks as a credit rating issue. Once again markets witnessed the spectacle of titan institutions tottering on the brink of bankruptcy but still carrying investment-grade debt ratings. Even worse, the Rating Agencies allowed Wall Stree to talk them into using a macro-statistical approach to rating the highly complex subprime RMBS and CDOs. Without ever sampling the underlying mortgage collateral, simply assuming it was of comparable quality to much smaller volumes of historic subprime mortgages, the Agencies stamped huge quantities of toxic securities as investment grade and even AAA.
As for the toxic securities, they were generated as a by-product of a historic “race to the bottom” among mortgage originators and the Wall Street firms doing securitization packaging. What’s critical here is that by 2006, this descent was producing securities worth far less than their face value—many were essentially worthless as they were built from mortgages whose debtors lacked any basis for servicing their debt. Yet, and this was the critical point, these securities attracted the same high credit ratings from the Agencies as did earlier vintages. By failing to sample the underlying collateral, the Agencies missed the quality deterioration. Global investors bought the securities thinking the ratings assured them of quality comparable to corporate or government bonds with similar ratings. Investment and commercial banks doing the packaging and trading, kept sizable amounts on their balance sheets as new product raw material and trading inventory.
Thus was the stage set for a “run on the bank” meltdown. A sufficient volume of securities whose value was grossly overrated sat on the balance sheets of grossly over-leveraged banks. When the penny dropped—hey, maybe these securities aren’t worth anything close to par—it suddenly was not difficult to imagine that the equity at Bear Stearns, Lehman Brothers, even Citigroup, might be wiped out. Nobody knew how many of these instruments were contaminated by worthless mortgages – nobody had inspected the collateral. Nobody also knew how far prices would fall—after all, how can you “bottom fish” when you can’t distinguish a worthless CDO from one likely to see an 80% payout? Finally, nobody knew how much junk various institutions possessed. The banks had been very successful in disguising their subprime exposure. Some thought they were hedged—so long as their counterparties were capable of absorbing what now looked like huge losses. Counterparty risk suddenly compounded the primary risks visible at Bear Stearns, Lehman and Citi. When it became clear that even a “strong” counterparty like AIG lacked loss reserves for its CDSs, even “smart” firms like Goldman Sachs were suddenly at risk.
This bank run story is the essence of the Crisis. Others have correctly traced back the roots of the Crisis into loose monetary policy and such things as the Affordable Housing lobby/regulations driving the subprime securitization industry to come into being. These root causes are part of the story. That said, there had been other subprime security crises in the past—these did not develop into a worldwide contagion. What made this one different are the factors cited above—gross overleverage at financial firms, the generation of fraudulent, essentially worthless securities that were then grossly miss-rated and miss-priced in the market, and the retention of large amounts of these on the over-leveraged balance sheets of securitizing/trading banks.
It is against the forensic verdict that we can now evaluate the remedial steps taken since 2008.
This assessment must begin with Dodd-Frank (D-F). This gigantic piece of legislation was the government’s principal response to having to bail out the banking system. D-F receives few words of praise from either Wall Street institutions or the financial press. Yet, the judgment here is that D-F has been far more effective than its critics admit. Let’s survey this effectiveness and then ask—”Is it enough?”
For starters, D-F and re-empowered regulators have dramatically brought down bank leverage. Some of this happened before D-F’s passage, as the Morgan Stanley case makes clear. However, D-F’s framework demands stronger equity capitalization and penalizes systematically important institutions with even lower leverage limits. The evidence of progress on this front goes beyond mere accounting ratios. Firms like GE and MetLife have sold businesses rather than be classified as systematically significant financial institutions. Meanwhile, banks’ returns on equity now reside stubbornly in single digits. Recent MS&Co and Goldman ROEs are in the 6–8% range, a stark contrast to their 2006 performance. Repeated Federal Reserve “stress tests” demonstrated to the banks a new incentive structure—distributions to shareholders will be sharply curtailed until firms show they are well capitalized AND have robust risk management systems. To comply and boost their capital bases, many banks are shrinking activities and selling off businesses they no longer see as profitable under the new rules.
Enhanced capitalization combines well with the Volcker Rule’s sharp limits on proprietary trading. The former requires firms to charge more capital to trading while the latter curtails the situations where trading is allowed. The net result is to reduce the attractive trading opportunities available to firms. As a result, many have sharply reduced or even eliminated their proprietary trading desks—an August 2016 WSJ article memorialized Citi’s last proprietary trader leaving to go to a hedge fund.
In two other areas the post-D-F record is more mixed. The Rating Agencies operate largely as before—which is to say they remain public, for-profit firms selling ratings to their customers. The government’s response to their Financial Crisis role was essentially to threaten them with dismantlement if they repeated their mistakes. D-F did demand more transparency about method and regulators did sue S&P for in effect “selling its ratings.” So, the record is mixed—Rating Agencies retain the same perverse incentive structures and conflicts of interest in their business model, overlain with a macro-threat of massive government retaliation. For now, this has forestalled any repeat of the Agencies’ dismal 2003–08 performance. However, D-F has also encouraged more rating agencies to come into being. Counterintuitively, this “reform” may end up encouraging another ratings “race to the bottom” such as occurred among Moody’s, S&P and Fitch on subprime securities.
As for the regulators, they have become much more proactive and enforcement minded. As mentioned, the Federal Reserve stress tests have proven to be a powerful tool for reshaping bank behavior. Since 2011 the SEC and DOJ have also become much more active in pursuing law breaking. They’ve had great success extracting huge settlements from the banks for the pre-Crisis frauds. Critics complain this penalizes shareholders rather than the managements that perpetrated the frauds. There is an element of truth to this. That said, with the exception of Goldman’s Lloyd Blankfein, all major bank CEOs have “turned over.” Few if any of the new managers want to explain another round of $US multibillion impairments to earnings and dividends. As the Citi-Banamex case shows, bank CEOs know there is a limit to how many scandals they can survive. Enforcement, and the fear of punishment are reinforcing a rediscovered Wall Street concern for ethics.
All this is to say that D-F and its associated regulatory regime have proven quite effective in reining in bank risk-taking. Critics, especially those still concerned about “Too Big to Fail” have largely missed the approach being taken. The big financial institutions have been confronted with a new incentive structure. It encourages them to get smaller and to pick and choose which franchises can withstand the higher capital requirements. A kind of voluntary shrinkage has followed along with a recommitment to more traditional banking activities. When Goldman Sachs starts advertising to take online bank deposits and make credit card refinancing loans, clearly something has reshaped the franchise.
The short answer is that the reforms are not enough. They will contain mischief on Wall Street for an undetermined period of time. However, by opting for a regulation/oversight model rather than more fundamental reform, they have left intact risks that likely will reemerge in the future. Regulation contains risk-taking. It is dependent on energetic, independent, competent and politically strong regulators. For now, U.S. regulation of the financial sector exhibits these characteristics. It is doubtful that those conditions can be sustained indefinitely.
The principal reason for doubt is that the financial sector isn’t earning its cost of capital under present-day rules. Look again at the ROEs of Goldman Sachs and Morgan Stanley. These are industry leaders and they are not earning their cost of capital. Possibly that will change for the better as interest rates rise. Still, the generalization has validity—current regulation is putting heavy pressure on financial firm returns. Pressures will mount to increase profitability. With that will come renewed incentives to invent high margin transactions and franchises by whatever means possible. Will the internal ethical and compliance cultures within the firms then be robust enough to preempt such tendencies? Or, will we again discover that financial firms invested in layers of oversight without accomplishing much change in firm culture? Will the regulators still be vigilant and proactive? Or, will their senses be dulled by the appearance of regulation having succeeded, by the repeat visit of banking lobbyists and the arrival of new political winds in the nation’s capital?
There are several other reasons to worry. One is the large, relatively unregulated non-bank financial sector. There are now some disclosure standards for hedge funds and private equity. That said, these controls are very modest compared to banks. The problems then are twofold: 1) is new financial “race to the bottom” going to be driven into this light-regulated sector; and 2) how much risk comes back into the banking sector via counterparty risk? Ponder these questions—how much risk does a large hedge fund take, how much of this is done via derivatives, and how visible is this derivative risk to the banks financing the fund’s positions? If the answers are a) a great deal, b) a high percentage, and c) not very much, one can sense the large magnitude of this unaddressed risk.
A second cause for concern is the ongoing structural weaknesses at the gatekeepers. Public Accounting firms failed to force reporting of the building of mountains of risk at their financial clients. It does not appear that anything has changed there. Indeed, the MF Global and Banamex cases show CPA firms still largely irrelevant to developing scandal. Another worrying fact is that SOX’ requirement for CEO/CFO sign-off on financial reports has not been enforced. No meaningful enforcement has been carried out against a Wall Street firm under this SOX provision. If this continues, SOX’ CEO/CFO liability provision risks will become a dead letter. If that happens, what does it imply for SOX’ other measures on auditor independence? Then there are the Rating Agencies whose perverse incentive structure perseveres. How confident can we be that given a chance to grow revenues and boost the stock price, executives at Moody’s, S&P and Fitch will sustain rigorous evaluation methods even at the cost of market share?
The third cause for concern is the incomplete reformation in internal bank cultures. Earlier essays spoke at length about the transition from a banking to a ‘Big Trading’ culture. At present, this trend has been halted and partially reversed. Will that reversal continue? A culturally healthy financial sector exhibits certain characteristics. For one thing, firms are “client-centric.” It was not just boilerplate when John Whitehead, as Goldman’s Managing Partner, penned those famous words about “Our Clients Interests Always Come First.” At that time banks competed on their reputations for serving client interests and general integrity. That competition died out by the 1990s and it really hasn’t come back. Second, a healthy financial sector raises up leaders who speak for the industry, criticize practices that undermine law, and act forcefully when missteps occur at their own firm. There was none of this leading up to the Financial Crisis and disappointingly little after the crisis. Third, a healthy industry invests in the integrity of its culture and harvests benefit in terms of years without scandal and a reputation as a high-integrity place to work. Can anyone think of a major financial institution characterized by these conditions? Maybe a few, J.P. Morgan and Morgan Stanley might qualify in some respects. For most it is still very much a work in progress.
These residual risks imply that the financial sector remains in a “could go either way” condition. Possibly the very strong current regulatory overlay will encourage continued reform and buy time for this to happen. Quite possibly things could go back in the wrong direction. Robust regulatory models are difficult to sustain. The techniques of regulatory capture are well honed and funded. The banking sector will be increasingly hungry to restore higher profitability and lucrative compensation. Big Trading is repressed but not gone. The non-bank financial sector remains an incubator of new strategies, financial products and risk.
One factor that can tip the scales in a healthy direction is the ongoing treatment of resisters and whistleblowers. To this last topic we now turn.
As documented in these pages, the conditions have never been more favorable for those who would resist corporate corruption.
In stark contrast to Sherron Watkins’ 2001 circumstances, today’s resisters enjoy robust legal protections. These come first and foremost from the combination of SOX and Dodd-Frank’s whistleblower protection provisions. Companies looking to retaliate against whistleblowers face serious sanctions. Conversely, prospective whistleblowers enjoy not only statutory protection but the reality of a legal industry devoted to their protection. As documented in the following section, a well-established infrastructure now exists through which a prospective whistleblower can test out its case and hire an attorney trained and ready to do battle with an employer.
Even more important, a variety of bounty programs now exists through which successful whistleblowers can achieve very significant payouts. The False Claims Act litigation detailed in the Sherry Hunt/CitiMortgage case is only one example. The SEC’s whistleblower bounty program, in its infancy when that case was written, is now test driven and proven. Indeed, the SEC’s website provides detailed instructions for would-be resisters and the Commission periodically reports on both the number of whistleblower leads it receives and its payouts following successful enforcement actions.
The bounty programs are important because they weaken the corrupt firm’s biggest means of intimidating whistleblowers—the tactic of dismissing the employees “for cause” (other than their bringing forward corruption) and discrediting the employee so that they become unemployable in the same industry. Eric Kolchinsky of Moody’s endured this tactic and later wrote of the inadequacy of SOX’ damage provisions for financial industry employees. Now, that situation is fundamentally altered.
A viable path for whistleblowers has positive feedback effects for resisters working issues within their firm. The knowledge that a resister can hire a lawyer and take the issue to the authorities creates a strong incentive for firms to work ethics issues “in-house.” This in turn encourages firms to maintain the integrity of their internal control systems. There is a much better chance today that the ombudsman hotline will function as intended if senior management fears that incriminating information will shortly make its way to the SEC or DOJ.
As 2016 gives way to 2017, the outlook on Financial Sector risk is thus “it could go either way.” It is not hard to anticipate slow erosion of the regulatory framework now containing excessive banking sector risk. There is, however, a chance that whistleblower activity can combine with regulator “macroprudential” risk management to sustain a health sector for the foreseeable future. For this to happen, regulators are going to have to continue to value whistleblowers as a critical force for resisting corporate corruption.
The observation remains that during the Financial Crisis ethical leadership was conspicuous by its absense. It is difficult to think of any leader of a financial firm who both resisted the industry’s “race to the bottom” AND worked openly to alert markets and government to abuses. Once the Crisis passed, bank CEO testimonies were largely exculpatory. Now with the Crisis a decade old, the CEO focus has begun its predictable shift towards dismantling the very regulations intended to assure they don’t repeat their mistakes.
Many reasons can be advanced for this leadership failure. The one getting least attention is the general decline in ethical “formation” within America’s culture and educational system. Ethical formation is about building character and enshrining values larger than self-interest. It has to be built because self-interest is ever present, strong, and often pulls in an opposing direction. Some institutions, the military academies come to mind, still invest heavily in this form of character formation. The vast majority of academic institutions no longer do so. Indeed, Academia’s dominant narrative now associates character formation and transcendent values with “outdated thought systems” and “cultural oppression.”
In this climate it should not be surprising that ethical leadership has become a scarce commodity. Indeed, the trivialization of ethics is at times astounding—as with Andy Fastow now making university appearances as an “ethics speaker.”
The good news here is that university students still retain a lively interest in ethics. On some level they sense they will be at risk when they begin their careers, and they are interested in finding workplace environments where they won’t have to check their consciences at the door. One objective of this book is to help them discern such workplaces and to enable them to cope with one that turns out less ethical than they seemed.
Many of these students also aspire to positions of leadership. If they connect the dots between the type of workplace they desire and the leadership they seek to attain, the questions of how to build and maintain an ethical culture will present themselves.
For these students, the important question then becomes: “is there anything you value more than your personal success?” For too many, the answer is “I haven’t really thought about it.” In fact, what these young people are saying is that they haven’t been prompted to ask the question during their school years. This book gives them a vivid demonstration of what can happen when that question is systematically neglected. It documents three decades of scandal after scandal. If we want this to really change, we are going to have to reinvest in ethical formation of our young people. If we want to see more ethical leadership from future senior executives and more courageous whistleblowers in the future, we are going to have to teach them anew that resisting corporate corruption is grounded in a belief in something greater than yourself.
18.224.57.231