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Tuesday, June 16, 2009

Ethics Lessons in Unusual Places: the Bear Sterns Collapse

I just finished William Cohan's "House of Cards" about the implosion of Bear Sterns. It was a very enjoyable finance drama that reinforced my belief that my classmates who work in financial services on Wall Street were crazy. However, I also read the book with the frame of ethics and business after my post about the MBA Oath. Given the discussion about ethics in the MBA program and the role of an oath due to no harm, I thought there would be many lessons in this book. There were lessons but not the ones that I had thought I would learn. There was not a lot of outright flaunting of ethical guidelines. Instead it was a tale of very principled men with strong codes of conducts navigating a very grey world. The lesson that I learned were more about how that even characters in a "Tale of Hubris and Wretched Excess" made decisions with what they deemed to be the greater good in mind. I never thought that I would write this, but there is a strong sense of ethics on Wall Street.

The Good
Two CEO's, JP Morgan's Jame Dimon and Bear Stern's Jimmy Cayne showed clear Kohlbergian moral reasoning at a stage 5 by asking "What makes for a good society?". Some could put them at stage 6 the highest level depending on interpretation. When the government approached Dimon about purchasing Bear Sterns, his thought process showed weighing the good of the country, good of the financial systems, and good of the shareholders. There was even empathy and concern for Bear Sterns in the mix.

One could argue that Cayne was more expediant in his reasoning. His lowest level was in the decision to not participate in the rescue of Long-Term Capital Management. He did not look at the greater good of the community but the greater good of Bear Sterns. I would argue that Bear Sterns was his community and Cayne was aware of the implications of his refusal to participate and did try to warn the group. This was his low point but otherwise, Cayne was very clear about his principles of how Bear Sterns should be run and how it should be fair. When Bear Sterns was being sold for $2/share, Cayne did show how he thought of the impact of shareholders, bondholders, and employees. Ultimately, he did support the sale since it was the right thing to do even though others were suggesting more nuclear options.

While Cayne was not a shining example of morality, you do realize that he is not a burning example of lack of it. Additionally, a 5 year old on a sugar rush has greater attention to detail and he was Machiavellian in his quest for power. However, he had his own definition of who was part of the greater good and very principled about how to support it.

The Bad:
Ralph Cioffi and Matthew Tannin were the only ones that provided a clear, easy example of lapse of ethics. They mispresented the risk level and subprime exposure of the Bear Sterns hedge funds to investors. The mispresentation was so blatent that a Bear Sterns employee was able to note the contradiction in subprime exposure on 2 different investor communications. This clear demonstration of lack of ethics was not common in the book at all. Cioffi was known to have such poor attention to detail that he couldn't follow basic compliance guidelines for completing a trade. He was a classic Randy Moss type player or talented athlete who immense talent was only closely followed by their inablity to follow basic rules. However, both extremes are rare.

The Ugly:

The biggest surprise to me is the moral quandry that exists in the financial world. There were 2 specific examples that are Solomn-esque in terms of their complexity.

1. Goldman Sachs valued mortgage-backed securities that made up a large part of the Bear Sterns' hedge fund's porfolio at 50% the price that everyone else did. This caused the value of the assets to drop since everyone is required to use the average valuation price. The drop was one of the big drivers that led to the hedge funds melt down. Goldman knew the consequence of what their pricing and also had exposure just like everyone else. However, they felt that their prices were truly accurate and to not publish them would also be unethical. Pricing what someone believes to be accurate can torpedo the entire financial sector today. This is an issue of Talmudic proportions.

2. If a bank does not project an image of financial strength, they risk a run on the bank and their demise. This is what happened to Bear Sterns, Lehman, and others. One could argue that overstating one's position is necessary to prevent a bank from being positioned 6 feet under in the future. Therefore, there are equally compelling reasons to be truthful about a bank's financial status and to overstate.

After realizing how bankers face these challenging ethical issues everyday, I was no longer surprised about the strong sense of ethics and principles that some of the executives in the book exhibited. The Cioffi's and Tannin's don't last long enough in the business with these daily ethical challenges.

I had expected to read stories of strip club-fueled orgies on borrowed dollars or "Barbarians at the Gates" effort to squeeze out every last dollar from a deal as a measure of one's worth. Instead I sympathized with Bear Sterns as a company that thought that they were doing the right thing and was bewildered by their demise. Their greatest sins did not appear to be of the flesh or of ethics but of not planning well for the future. They ran their business one deal at a time. While this opportunitistic culture gave them the flexibility to be nimble with deals, their lack of a plan for the future left them vulnerable to the whims of the market.

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