Don’t Trust the Financial System? Here’s What We Need to Do
© Neil Hamilton and Elisabeth Kirchner
This article appeared in the August 15, 2011 edition of Minnesota Lawyer.
Building Trustworthiness by Allocating Responsibility
Empirical evidence shows a serious and continuing problem of trustworthiness in the financial system leadership, both in government and business. A survey taken by the Financial Trust Index in May 2011 found that four out of five people still lack trust in America’s financial system and that 57 percent of Americans are angry at the current economic situation, which is only 3 percent lower than December 2008, the height of the financial meltdown.
Building Trust Requires a Better Accounting of Who Is Responsible for the Crisis
Almost three years after the financial meltdown, the dust is hopefully settled enough to look back at what went wrong and look forward to what do we do now. One window for looking at what went wrong is the 2011 National Financial Inquiry Commission Report. Both the majority and the minority of the commission voiced their disappointment and anger at government and business leaders of the financial system. The majority stated that they place special responsibility with the public leaders charged with protecting our financial system, those entrusted to run our regulatory agencies, and the chief executives of companies whose failures drove us to crisis. These individuals sought and accepted positions of significant responsibility and obligation. Tone at the top does matter and, in this instance, we were let down. No one said “no.”
While the majority focused more of its disapproval on business leaders and the dissent placed more responsibility on government leaders, the dissent also voiced their anger at business leaders, saying, “An essential cause of the financial and economic crisis was appallingly bad risk management by the leaders of some of the largest financial institutions in the United States and Europe. Each failed firm that the Commission examined failed in part because its leaders poorly managed risk.” The report is clear: our leaders in both sectors failed us.
Leadership Failures in Both Government and Business
While there is some disagreement whether government leaders or financial business leaders are more to blame, it is clear at this point that both leadership groups bear substantial blame. In a new book, Reckless Endangerment (2011), a biting analysis of the financial meltdown causes, Gretchen Morgenson, a Pulitzer Prize New York Times journalist and Joshua Rosner, a housing finance expert, state that the “American economy was almost wrecked by a crowd of self-interested, politically influential and arrogant people.” They put significant responsibility on Fannie Mae and Fannie’s chief executive James Johnson’s dubious policies that only focused on credit histories—a change from comprehensive profiles of borrowers—in order to shorten the lending process to minutes. This practice was not unnoticed by the private sector, and “Fannie Mae led the way in relaxing loan underwriting standards, a shift that was quickly followed by private lenders.”
While Reckless Endangerment puts substantial responsibility on Fannie Mae, the authors also have plenty to say about private sector enablers: “No industry contributed more to the corruption of the lending process than Wall Street.” The authors point out that brokerage firms were only too happy to look the other way while providing capital for the multitude of risky loans. The authors were also harsh toward the banks, as “their greed and self-interest took the mortgage mania to heights it could not possibly have reached without Wall Street’s involvement.” Taken all together, the book concludes that “anyone with a brain could see that borrowers’ increased reliance on such loans would come to a disastrous end. But the loans were immensely profitable and so lenders kept pushing them and Wall Street kept funding them.”
What Were Our Government Gatekeepers/Watchdogs Doing?
One of the frustrating conclusions about the causes of the meltdown is that those who should have been protecting our economy looked the other way or in many cases contributed to it because of their connections with each other. Reckless Endangerment points out that those in the public financial sector were caught in a revolving door with the private sector. Look, for example, at Goldman Sachs. Robert Rubin was a Goldman Sachs board member before he became U.S. Treasury Secretary, when he fought to repeal the act that separated investment and commercial banking. He then became a vice-chair for Citigroup, where the company drowned itself using risky maneuvers. Henry Paulson was the head of Goldman before becoming the Treasury Secretary who would administer the bailout to Goldman, Fannie Mae, and others. On the public side, Fannie Mae used its profits to contribute to congressmen or their families, as well as fund research to show the benefits of Fannie and pay groups to lobby for them, all while trying to downplay any and all risk. All the major financial firms, both public and private, have stories of major players switching between the public and private sectors, working for their own personal interest rather than for the public good.
Government and Private Industry Leaders Escaping Criminal Prosecution
Nearly all the executives in both the public and private sectors have not only escaped criminal prosecution but, according to Morgenson and Rosner, these executives also “continue even now to hold sway in the corridors of Washington and Wall Street.” These executives, almost without exception, have not taken responsibility for their actions, nor have they been forced to accept responsibility by criminal charges. Prosecutors can only show colossal failures of judgment about risk made out of self-interest and have been unable to prove a willful intent to defraud.
Allocating Responsibility Through Civil Litigation
A few individuals and some firms will be held accountable through civil litigation. For example, Angelo Mozilo, the promoter of subprime mortgages, settled Securities and Exchange Commission civil charges of security fraud and insider trading for $67.5 million. Goldman Sachs and Wells Fargo both settled SEC civil claims of improper sales for $550 million and $11.2 million, respectively. JP Morgan settled with the SEC regarding claims that it misled investors in the sale of a complex mortgage-backed security for $153.6 million. There could be more cases to come with U.S. Attorneys General requesting meetings with Bank of America, Morgan Stanley, and Goldman Sachs regarding their roles in the mortgage crisis. On top of SEC settlements, private litigation may also impose civil liability. For example, Bank of America recently settled a claim with its investors regarding fraudulent mortgage securities for $8.5 billion, the biggest settlement to date to come out of the crisis. To date, we are unaware of any civil penalties imposed on government leaders responsible for the meltdown.
Whac-A-Mole Won’t Restore Trustworthiness
Whac-A-Mole criminal and civil litigation does not address the central problem, because the vast majority of the leadership failures were not unlawful. The key problem of the financial meltdown was not rampant illegal acts by executives but devastating failures of self-restraint and prudential judgment on the part of government and business financial sector leaders. For example, the U.S. Senate report on the financial meltdown talks about how in 2005, Washington Mutual gave bonuses to salespeople who could make large amount of loans, even though they had reports of loan fraud. Eventually, firms started to realize that while these loans may bring in profit, they were extremely risky. The time leading up to the meltdown was like a very expensive game of Hot Potato, where every firm, with millions of dollars in subprime loans, was trying to pass the loans to another company.
Dodd-Frank and Devastating Failures of Self-Restraint and Long-Term Prudential Judgment
Dodd-Frank statutory changes and the ensuing regulations coming out now will provide some regulatory bulwark against off-the-map leverage and extreme risk taking. However, there are virtually no systemic efforts to change the acculturation of government and private sector financial leadership from extreme short-term self-interest and revolving doors toward both long- term enlightened self-interest and an internalized sense of significant responsibility and obligation for those who seek and accept these leadership positions. We have not yet seen our institutions of culture, principally the professional organizations and higher education organizations in business and law, step up to the plate with serious self-assessment of responsibility for the meltdown and initiatives to foster each new entrant’s formation of an internalized ethical professional identity.
The solution to the public’s low trust in government and business financial sector leaders is not principally through more statutes and regulations. The solution is principally to change our acculturation of our financial sector leaders. Trustworthiness flows from the perception and reality that our business and government leaders are people of integrity and have some self-restraint in light of their fiduciary duties.
What Can Lawyers Learn from These Leadership Failures?
Many business and government leaders in the financial sector are lawyers, but primarily, lawyers are counselors to these leaders. Lawyers tell stories, ask questions, and counsel about unintended consequences, long-term sustainability versus excessive short-term self-interest, errors of prudential judgment and negligence, and risk management including reputational risk management and public perceptions of trustworthiness. Lawyers counsel about probable government statutory and regulatory responses if financial sector leaders fail to earn public trust. Lawyers work to build ethical cultures of compliance, risk management, and ethics. The financial sector meltdown and the continuing lack of trust in this sector’s leadership give lawyers many cautionary stories about the consequences of extreme short-term greed and disastrous prudential judgment. These stories need to be internalized so that lawyers can better counsel our country’s business and government leaders in the future.