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Monday, May 16, 2011

The Financial Crisis of 2008: On the Role of Negligence Breaching Fiduciary Obligation

Roger Lowenstein laments that “New York Times columnist Joe Nocera lamented that ‘Wall Street bigwigs whose firms took unconscionable risks … aren't even on Justice's radar screen.’ A news story in the Times about a mortgage executive who was convicted of criminal fraud observed, ‘The Justice Dept. has yet to bring charges against an executive who ran a major Wall Street firm leading up to the disaster.’ In the same dispassionate tone, National Public Radio's All Things Considered chimed in, ‘Some of the most publicly reviled figures in the mortgage mess won't face any public accounting.’ New York magazine saw fit to print the estimable opinion of Bernie Madoff, who observed that the dearth of criminal convictions is ‘unbelievable.’ Rolling Stone, which has been beating this drum the longest and with the heaviest hand, reductively asked, ‘Why isn't Wall Street in jail?’”

Lowenstein interprets these sentiments as implying “that the financial crisis was caused by fraud; that people who take big risks should be subject to a criminal investigation; that executives of large financial firms should be criminal suspects after a crash; that public revulsion indicates likely culpability; that it is inconceivable (to Madoff, anyway) that people could lose so much money absent a conspiracy; and that Wall Street bears collective guilt for which a large part of it should be incarcerated.”

Lowenstein argues that “(t)hese assumptions do violence to our system of justice and hinder our understanding of the crisis. The claim that it was ‘caused by financial fraud’ is debatable, but the weight of the evidence is strongly against it. The financial crisis was accompanied by fraud, on the part of mortgage applicants as well as banks. It was caused, more nearly, by a speculative bubble in mortgages, in which bankers, applicants, investors, and regulators were all blind to risk. More broadly, the crash was the result of a tendency in our financial culture, especially after a period of buoyancy, to push leverage and risk-taking to the extreme.”

Lowenstein also ticks off a loose monetary policy (i.e., extremely low interest rates), unaccountability at Fannie Mae and Freddie Mac, weak financial regulation, and an overconfidence in “risk management” methods in arguing that we should not be reductionist in ascribing the crisis to fraud alone or even primarily.  

Analysis:

Lowenstein is undoubtedly on firm ground in labeling the crisis a “multi-causal” affair. In a general sense, the positive feedback loop wherein everyone benefitted from a rising housing market turned to a negative feedback loop once that market decided to take a hard landing. However, even though he makes a good point that criminal fraud was probably not pervasive on Wall Street, he downplays the litigation that is still possible in going after senior managers at Wall Street banks for negligently breaching their fiduciary obligations to stockholders—the negligence being in the sheer recklessness (which I suspect is a function of individual personalities).

For example, Richard Fuld essentially ignored his risk committee at Lehman Brothers as he added leverage up to forty times value in order to continue buying CDO’s and commercial real estate by the bucketful—his ultimate objective most likely being to bring the bank up to the big league (e.g., with banks such as Goldman Sachs). Would not such recklessness based on egotism constitute fiduciary negligence? It is as though Fuld were under the illusion that the stockholders’ wealth in the bank was his own because of how much of the stock he himself held.

As another example, even Alan Greenberg over at Bear Stearns may have been negligent in not alerting the board as Jim Cayne, the CEO at the time, became “more aloof and full of himself” even as two of the bank’s hedge funds were going down in July 2007 (Greenberg, p. 145). Incredibly, Cayne was playing in a card-game tournament in Nashville for over a week as the executive committee labored daily over whether to liquidate the two hedge funds at the bank that were losing money from their mortgage-related securities and the ensuing redemption calls from nervous investors. Virtually everyone in the senior management of Bear Stearns should have informed the board of Cayne's conduct (i.e., his priorities, which evinced immaturity befitting the man's pot-smoking at the tournaments and even at work). If the directors would have failed to act (e.g., being too cozy with Cayne), the board too should be held by stockholders as woefully negligent.

Furthermore, being on the risk committee, Greenberg may have been negligent in deferring to Warren Spector on the risk issuing from the fixed-income area (e.g., mortgage-backed securities). Claiming that Spector was “imperious” in that area is no excuse for Greenberg failing to exercise diligence given the amount of business the bank was doing in CDOs. Greenberg recounts that “multiple variables contributed to an extremely complex dynamic, yielding consequences that I hadn’t previously encountered” (Greenberg, p. 156). However, he admits to have told Warren a few years earlier to unload CDO’s within 90 days because of the risk involved. Greenberg simply gave up in pushing back from the financial pressure of the large profits being made. Accordingly, he gave up on due diligence on the risk committee and should be held accountable by Stearns stockholders. 

Incidentally, I admire Greenberg for his straightforward recounting of the events leading up to the collapse of his bank, even though I do not buy his account of his role on the risk committee. Perhaps the lesson is that even an ethically solid and competent person is fallable, and may even inadvertantly fall into a negligent pattern of complacency in the midst of momentary profit. The depth of the causes leading to the financial crisis may be evinced, moreover, in that a person such as Greenberg became unintentionally complicit. As Greenberg himself observes, Jamie Diamond at Morgan had urged his bank out of the mortgage-related securities business altogether as far back as 2006 as the housing market was peaking. From this vantage-point, Greenberg himself must surely know in hindsight that he had fellen short.

Whereas Lowenstein claims that one of the causes of the crisis was that risk management methods were followed, I contend that they were relegated or ignored even by the risk averse because the standards stood in the way of large profits. To be sure, Greenberg and others on risk committees relied on the AAA ratings from Moody’s and S & P (though Greenberg had been sufficiently worried to urge quick sales of the bonds). Even so, it should have been prime facie evident that a mortgage-based bond is not a Treasury bond. Furthermore, the rating agencies’ managements should not be held blameless, as they did the bidding of Bear Stearns and Lehman in exchange for lucrative fees;  there was undoubtedly fraud or at least negligence in this conflict of interest.  

Whereas fraud may have been limited largely to salesmen at mortgage brokerage firms and the rating agencies, breaches in fiduciary obligation were, I suspect, running rampant on Wall Street. In other words, money being easy and regulation being light (or non-existent in the case of the CDOs) did not give the banks’ managements a pass on their fiduciary obligation to exercise a duty of care over stockholder’s equity in the banks. Whereas cheap leverage and lack of oversight are context, recklessness with others’ wealth may constitute the principal cause—the lack of concern for risk being part of it.

Generally speaking, boards allowed senior managements—as evinced in the persons of Dick Fuld and Jim Cayne—far too much rope with which to hang themselves. It is astounding to me that people like Fuld and Cayne were able to get anywhere near the authority of a CEO. Their glaring immaturity and incompetence may point to a systemic problem in corporate governance going far beyond what even institutional stockholders realize. It would seem that the boards of Lehman and Stearns were either asleep or in somebody’s pocket (which involves at the very lease a stark conflict of interest). Although holding the managers accountable for their recklessness leading up to the financial crisis of 2008 would be a step in the right direction, stockholder interest warrants systemic reforms to corporate governance itself such that “upper” managements are given much shorter leashes (and stature).  


Sources:

Roger Lowenstein, “Why No Wall St. Bigwig Has Been Prosecuted,” MSNBC.com, May 16, 2011.

Alan Greenberg, The Rise and Fall of Bear Stearns (NY: Simon and Schuster, 2010).