CHAPTER 1

We're in anEthical Mess!

One of evangelical Christian leader Chuck Colson's favoriteways to start a conversation about ethics was to ask someone,"What do you think caused the financial crisis?" He was, ofcourse, referring to the meltdown of the US financial system thatbegan in 2008 and caused a worldwide recession worse than anysince the Great Depression of the 1920s and '30s. The effects ofthis recession are still with us today in the lost jobs, foreclosedhomes, and large number of people who have either given up tryingto find work or are underemployed.

What do you think caused the financial crisis? Think aboutthat question for a minute. How would you have answered Chuck?My guess is that whatever your answer, it will have something todo with ethics—specifically, the collapse of ethics.

Let's look a bit more closely at the financial crisis and the variousplayers in it and what happened to each of them. The financialmeltdown centered on the home mortgage industry but infectedthe entire financial system, coming within a few days of bringingit to a collapse. The following chart will help us see what tookplace.

Here, in a very simplified way, is how the collapse occurred.Borrowers took out home loans from lenders, or mortgage brokers,who usually sold the loans to the packagers, the banks—mainlythose on Wall Street—but also to what are called "government-sponsoredentities" (GSEs) that go by the abbreviations FannieMae and Freddie Mac. These organizations would buy most mortgageloans and package them into investments. The interest borrowerspaid on these mortgages was the income the investors wereinterested in. Remember, in the early 2000s when this started, thestock market was very volatile, having just come out of the dot.com crash and the economic problems created by the 9/11 terroristattacks. As a result, the Federal Reserve kept interest ratesvery low, and they are still very low today. That's why you can'tearn much more than 1 percent interest on most savings accountstoday. Investors were understandably nervous about the rollercoasterride the stock market had become, and investing in bondsthat had very low interest rates was not attractive, so they werelooking for other investments that were more secure than stocksbut paid more than most bonds.

The banks were buying up mortgage loans that paid 5 to 7percent interest and repackaging them into investment securitiesthey sold to investors. The packagers would bundle togetherthousands of mortgages and sell them off in pieces to investorswho were eager to have high returns without the volatility ofthe stock market. The ratings agencies gave these investments(called "mortgage-backed securities," or MBS) their highest ratings(AAA), which assured investors they were safe. The mortgagebrokers, banks, and ratings agencies were paid handsome fees fortheir roles in this pipeline, and everyone was happy with the hugesums of money being made.

Even the insurance companies got into the act, because therisk to the investors was that the borrowers would default ontheir loans, thus making the investment securities based on thosemortgages less valuable. If enough of them defaulted, the securitywould be worthless, because only a trickle of interest wouldbe paid to the investors. So insurance companies like AIG soldwhat are called "credit default swaps," which is a fancy term for aninsurance policy that protects the investors should the borrowersdefault or refinance their loans. It seemed like the system was awin for everyone. So what went wrong?

At every step, something went wrong—and went wrong ethically.Borrowers borrowed more than they could repay, manyknowing they wouldn't be able to repay and would simply walkaway from their homes. Mortgage brokers became less and lessconcerned with how credit-worthy borrowers were since theywere going to sell the loans they made to the banks. They got paidwhether or not the borrowers made good on their loans. They initiatedwhat came to be called "liars loans" or "NINJA loans," whichstood for "no income, no job or assets." These mortgage brokersoften manipulated borrowers into loans they couldn't afford. Thebanks were selling mortgage-backed securities they knew wereworthless to investors, and increasingly they would bet againstthe securities they were selling to investors (referred to as "sellingthem short"). The ratings agencies blessed these mortgage-backedsecurities with their highest ratings because they were being paidby the banks to issue their ratings (putting them into a major conflictof interest). Government played its role too, by putting Fannieand Freddie into a conflicted position—they could essentially buyoff their regulators with campaign contributions, for which theybecame well known. In addition, the government pressured thelenders to increase home ownership to minority communities (theCommunity Reinvestment Act), causing them to make loans toless-credit-worthy borrowers. And the Federal Reserve kept interestrates very low for some time, encouraging people to amass adebt load they couldn't carry.

Actor and economist Ben Stein had this to say about whatcaused the financial meltdown:

Well, the crash really started in 2007. And actually, it startedeven before that, when there was a law passed, and thenrepeatedly amended in the later part of the twentieth century,called the Community Reinvestment Act, which greatlyencouraged lenders to lend to less-credit-worthy buyers.Lenders were encouraged, both emotionally and also interms of finance, by the government to do that. So lendersstarted lending to a great, great many people who werenot really credit-worthy.... This became a really, really bigbusiness, because people on Wall Street saw that, first ofall, there was hardly any government supervision of it. Whatthey saw was that they could take large bundles of mortgages.They sold them to fiduciary institutions, especiallypension funds. At the same time, they sold them short. Theysold them short and hammered them like mad by buyingcredit-default-swap insurance, which is a giant short instrument.And then they basically raked in money. And then,at the bottom of the cycle, they bought the bonds backand made money on that part of the cycle. At every level,they were deceiving the people they were...