How Scandal Became Crisis

That large financial institutions ought to behave in an ethical manner seems perfectly obvious. But how bad behavior lay at the core of the current financial crisis may not be so apparent. I suggest that the medium of transmission from scandal to crisis followed two paths: loss of trust and abandonment of customers.

Trust

When a corporation behaves ethically, it might be functioning well or poorly, and it might be a good or bad firm to invest in, but at least we know how it will behave: It will obey the law, treat its employees respectfully, be honest in its public disclosures, honor its commitments, be a good citizen in the communities where it operates, and so on. But when a corporation (or, God help us, an entire industry) behaves badly, we have no idea what to expect. One day they are shoving mortgages down our throats and the next day you can't get a mortgage to save your life. One day they are standing behind ARS auctions and the next day they are nowhere to be seen. One day they are honestly disclosing their financial condition and prospects and the next day they are lying through their teeth. One day they are innocently selling us subprime paper and the next day they are quietly shorting that paper behind our backs.

Financial firms, much more than other firms, live and die on trust. The very definition of a bank is a firm that borrows short and lends long. A bank might take customer deposits—offering customers instant liquidity—and loan them to people who want 30-year mortgages. An investment bank might borrow in the overnight market and make trades that won't unwind for weeks or months. So long as people trust the financial firms, all is well. But once trust evaporates the jig is up—there is no way a bank can call in long-term assets to pay off the short-term demand.

Unethical behavior in the financial industry eventually became so widespread that trust evaporated—no one could possibly know what firms in the industry would do next, and so no one would play ball with anyone in the industry. This caused the failure of the weakest, most leveraged, least trusted firms, and it caused commerce to freeze up for firms that were stronger but still distrusted. Even inside the industry, banks wouldn't lend to each other because each believed that the other was lying about its own financial condition. Thus does a breakdown in trust lead directly to a financial crisis that cannot be fixed until trust—not just capital—is reestablished.

Customers

The disappearance of any sense of fiduciary responsibility to the financial industry's customers caused the industry to become unmoored. So long as financial firms felt an obligation to their clients, there were serious limits on how bad their behavior could become. But once they learned that customers could be treated badly and the only consequence was that profits went up, the industry went straight to hell in a handbasket.

Mortgagors, buyers of ARS, shareholders, bondholders, owners of subprime paper, and wealth management clients were all abandoned by the industry, and along with that abandonment went any limits on how the firms might behave. As I noted above, a sense of responsibility to its customers is the only legitimate reason for a firm to exist. Once the customers walk—and they have walked away from the financial industry in gigantic numbers—the industry is doomed.