At dinner last night, I was talking with my father about my sense that we have had a collapse of trust in the institutions of the western democracies over the last decade.
A good society has a sense of fairness. I feel that this sense of fairness has been lost. There is a widespread intensifying of the sense of injustice around me in Spain where I live, in Ireland where my family live, and in each of the countries I visit on vacation and work (UK, USA). I have a feeling that some segments of society have been punished while other groups have got away with grand scale corruption.
The big question at dinner last night was why have no bankers gone to jail? There have been some massive fines payed by almost all of the major investment banks – big numbers – but not a single individual banker is at risk of time behind bars. How can this be?
The Straw that broke the Camel’s Back
In the case of the financial wrongdoings of Bernie Madoff, we had a clear case of one single individual breaking clear laws over a 35 year timeframe. He was clearly guilty and went to jail.
The Financial Crisis has complex causes that remind me of the fable “the straw that breaks the camel’s back”. Imagine a camel loaded with straw. There are a team of people loading the camel. They keep adding straw to the camel’s back. One piece is added, the camel is ok. Another piece is added, the camel is ok. A third piece is added, the camel collapses. Who is to blame? The person who placed the final piece of straw? The government who did not set a clear weight limit for camels? The transport company who owns the camels?
In the Financial Crisis, we have a similar situation. One bit of deregulation didn’t break the camel. One poorly underwritten mortgage didn’t break the camel. One innovative but complex new financial product didn’t break the camel. The camel was broken by the combination.
Causes of the Financial Crisis
The financial crisis that began in 2007-8 with the collapse of the mortgage-backed securities has caused enormous stresses on governments and people’s living standards. The International Monetary Fund estimated that large U.S. and European banks lost more than $1 trillion on toxic assets and from bad loans from January 2007 to September 2009. These losses are expected to top $2.8 trillion from 2007 to 2010. U.S. bank losses were forecast to hit $1 trillion and European bank losses will reach $1.6 trillion. Between June 2007 and November 2008, Americans lost an estimated average of more than a quarter of their collective net worth. (source http://en.wikipedia.org/wiki/Financial_crisis_of_2007–08)
What caused the crisis? There are 7 major factors that drove the financial system towards the crisis of 2007-2008:
- Growth of sub-prime lending – lending to people without stable income or liquid assets increased massively between 2004-2008; they went from 10% of all mortgage operations in 2004 to over 20% of mortgage operations in 2007.
- Housing price bubble – Between 1998 and 2006, the price of the typical American house increased by 124%.
- Easy credit – From 2000 to 2003, the Federal Reserve lowered the federal funds rate target from 6.5% to 1.0%
- Weak underwriting practices (and fraudulent in many cases) – by the final years of the U.S. housing bubble (2006–2007), the collapse of mortgage underwriting standards was endemic.
- Deregulation – Allowing for creation of derivatives (mortgage-backed securities) and off-balance sheet financing. Warren Buffett famously referred to derivatives as “financial weapons of mass destruction” in early 2003. Financial institutions in the shadow banking system are not subject to the same regulation as depository banks, allowing them to assume additional debt obligations relative to their financial cushion or capital base.
- Over leveraged consumers and institutions – USA household debt as a percentage of annual disposable personal income was 127% at the end of 2007, versus 77% in 1990. In 1981, U.S. private debt was 123% of GDP; by the third quarter of 2008, it was 290%
- Financial Innovation – which added massive complexity to the system. FT columnist Martin Wolf said that “…an enormous part of what banks did in the early part of this decade – the off-balance-sheet vehicles, the derivatives and the ‘shadow banking system’ itself – was to find a way round regulation.”
It was Countrywide Financial that led the subprime boom – the process of selling mortgages to anyone – no matter their collateral, no matter the value of the underlying assets – and then packaging them up into groups of thousands of mortgages, getting them “rated” as investment grade.
Were banks guilty of criminal activity?
I think the key three factors under banker control are weak underwriting practices, over leveraging and financial innovation.
In the case of over-leveraging, even the Fed chairman Alan Greenspan believed that the world had entered into a new, safer era where central bankers had achieved control over inflation. The world view of all bankers and economists was that major volatility was removed from the financial system. In this situation, higher leverage would be a rational strategy. This was not criminal activity, purely a rational response to a widespread belief about volatility.
In the case of weak underwriting practices – this was something that was clearly allowed to happen by management, but no senior banker seems to have actively promoted this practice. I still think that a leadership responsibility is to be aware of how the results are being achieved – it seems many senior bankers were happy with the results and asked few questions about the process. There is little provable criminal activity at leadership ranks; however this is profoundly poor leadership. In the military, senior officers would have no option except to resign if soldiers regularly ignored rules and regulations.
In the case of financial innovation, it seems that many of the innovations were not designed to deliver a product that was better suited to the customer needs – they were innovations deliberately structured to sidestep regulation. There was a deliberate strategy to create mechanisms to avoid the regulator. This is a crime. Individual bankers created and sold these new innovative products.
Were individual bankers responsible for these practices?
In the case of the Financial Crisis, we have a much more complex and interconnected set of actions that in their combination led to the crisis. If a person with a house and a mortgage loses his job and cannot pay the mortgage, this is not criminal action. The person and his bank realistically believed that he would receive a salary long enough to make his obligatory payments on the loan. In some ways, the banks were surprised by the major collapse in house values – something that was not predicted and had a massive impact on the viability of their business model. If it were this alone, then the bankers were not guilty of any crime.
However, major fines have been paid by most of the major investment banks. Why have they paid financially, but not with individual loss of freedom? How can a corporation be guilty if no single individual has done wrong? A corporation is legally separate from a person, but it represents the actions of people.
Why have no bankers gone to jail? “Plausible Deniability” Our courts assume innocence until proof of guilt. This requires criminal action to take place, have witnesses and be under the responsibility of an individual. Bankers and lawyers are able to build good stories that muddy the waters of individual responsibility. The fact that no bankers are in jail is not because the world’s criminal prosecution services have a love of banks – I bet any number of middle ranking prosecution lawyers were looking to make a career out of nailing a big name banker. If they haven’t nailed a banker, it is not through a lack of prosecution effort to build a case.
Boris Johnson, mayor of London and future candidate for Conservative Prime Minister of the UK has proposed this week a change in the law regarding British Citizens who travel to Syria, Iraq. Instead of the prosecution having to show without reasonable doubt that the purpose of their trip was to commit criminal activity with the Islamic State; the individuals would be required to show that their trip was clearly not to participate in any criminal action. It worries me the idea that individuals could lose the right to presumed innocence. However, there needs to be some areas of life where it is not enough to put the onus on the other side to prove guilt, there should be some onus to show that you are fully responsible for your, and your team’s actions. If someone is a leader at a major bank or if someone takes a trip this month to Syria – I think there should be a balance toward that leader or that traveller needing to document that they have proactively been fully responsible for the consequences of their actions.
Leadership responsibility needs to include a responsibility to audit the actions of your subordinates. This is a value system problem rather than a regulation problem. We cannot regulate trustworthiness.
I’ll leave it to a future post to explore the systemic actions that can rebuild trust between people, and trust in major institutions.