Too Big to Fail
The financial collapse of 2008 was something all of us felt in one way or another. At the time, this author’s employer kept itself intellectually honest by acknowledging the fact that it may have turbulent waters ahead due to the credit crisis. Much of this author’s employer’s day-to-day operations was funded by credit – or, borrowing money. When credit was frozen, there was serious concern that operations of this author’s firm could halt. Worse, the organization confirmed a resonant fear that its next payroll could be in jeopardy. If that were to happen, a multi-billion dollar company could be brought to its knees in a matter of days. The book Too Big to Fail highlights the seriousness of this epidemic when it speaks of General Electric, the world’s largest company, and its concerns about the credit freeze.
This report will highlight numerous points in the financial crisis of 2008. This author will attempt to educate the reader with a firm and academic understanding of business ethics. It will attempt to highlight the turning points in the economic crisis and bifurcate back to the ethicality issue. A brief history of the stock market and Securities and Exchange Commission will be offered. This author will then identify the various ways the crisis could affect a business in the private enterprise. Lessons of the crisis will be presented along with managerial recommendations.
Business Ethics
Enron, Arthur Andersen, WorldCom, Adelphia, Martha Stewart…these are all just recent examples of businesses that participated in acts not only considered unethical but also illegal. In order to qualify an act conducted by a business as ethical or unethical, it is important that a solid foundation is set that surrounds what ethical and unethical behavior actually means. According to Bateman and Snell (2004), business ethics is defined as the moral principles and standards that guide behavior in the world of business. Ethics are the laws and rules that determine the hierarchal order of values. If an issue comes up that is questionable in its ethicality, it is considered an ethical issue if the person has multiple choices that will lead him or her to a decision that could be evaluated as right or wrong. Herein lies the problem with ethical issues; they are open to interpretation of the decision-maker. To achieve a more in-depth understanding of ethics, ethical systems will be explored. Ethical systems come in many shapes and sizes but only a few will be discussed. According to Bateman and Snell (2004), universalism is an ethical system stating that individuals should uphold certain values, such as honesty, regardless of the immediate result. This ethical system basically states that everyone should be honest all the time, otherwise communication will break down. An example would be a person selling another person a car for monetary exchange and the seller knowing about a hazard that the car possesses. Under universalism values, the seller would divulge this information to the buyer knowing that the information could halt the monetary transaction. In the real-world, this is easier said than done.
Teleology is another ethical system that considers an act to be morally right if it produces a desired result (Bateman & Snell, 2004). The desired result does not have to be specific, just desired by the decision-maker. It could be money, pleasure, personal growth, or any other self-interest. Under the teleology umbrella, there are two sub-groups that branch off from it: egoism and utilitarianism. Egoism defines acceptable behavior as that which maximizes consequences for the individual. The theory behind egoism is that if everyone is looking out for his or her best interests, society’s well-being as a whole should increase (Bateman & Snell, 2004). Utilitarianism is similar to egoism, with the exception of the best interests of society are desired versus the best interests of the individual. Utilitarianism seeks the greatest good for the greatest number of people (Bateman & Snell, 2004).
Another ethical system is deontology which is defined as the focus on the rights of individuals (Bateman & Snell, 2004). This approach ensures that all are accounted for in terms of individual rights and social utility is maximized. A prerequisite is that actions require benefit for all parties and are rejected if the action could potentially harm another party. Deontology differs from utilitarianism based on the fact that something could be accepted based on utilitarianism ideals if the proposal benefits a larger number of people than it hurts. To quote Bateman and Snell (2004), “Utilitarianism concentrates more on ends, and deontology more on means.” (p. 139).
According to Bateman and Snell (2004), relativism is another ethical system that judges decisions based on decisions of others considered relevant. This model seeks group consensus for decision-making which justifies the decision’s ethicality. Virtue ethics support decisions considered ethical if the decisions come from a person with a good moral character. The moral person can then transfer moral rules by applying personal virtues. However, individuals differ slightly in this aspect. The Kohlberg model of cognitive moral development is explained:
Kohlberg’s model of cognitive moral development classifies people into one of three

categories based on their level of moral judgment. People in the preconventional stage

make decisions based on concrete rewards and punishments and immediate self-interest.

People in the conventional stage conform to the expectations of ethical behavior held by

groups or institutions such as society, family, or peers. People in the principled stage take

a broader perspective in which they see beyond authority, laws, and norms and follow

their self-chosen ethical principles. Some people forever reside in the preconventional

stage, some move into the conventional stage, and some develop further yet into the

principled stage. Over time, and through education and experience, people may change

their values and ethical behavior (Bateman & Snell, 2004, p. 140).

Most feel that executive compensation is too generous and the compensatory separation between executives and front line workers is too large. A question arises that surrounds this belief; if the executive met his or her obligation(s) to the firm, then is high compensation not capitalistic? Now that a thorough foundation has been built in understanding business ethics, the author will present the stock market and stock market regulation.
The Stock Market and SEC The United States stock market is a living and breathing entity that gives a snapshot into the overall health of the United States economy. Many feel that if government could not intervene in the regulation of the stock market, then the market would operate more efficiently. However, trading securities in the United States is indeed regulated. The two major laws that regulate the stock market are the Securities Act of 1933 and the Securities Exchange Act of 1934. According to Bodie, Kane and Marcus (1993), the 1933 Act requires full disclosure of relevant information regarding the new issue of securities. This Act ensures that new securities are properly registered and it gives insight into the new firm’s financial details. The 1934 Act tethered off the 1933 Act by requiring firms that possess securities issued on secondary exchanges to disclose specific financial information (Bodie et al., 1993). Providing the SEC approves the firm’s financial report does not necessarily mean that the Commission views the security as a good investment. The decision of whether or not the security is a good investment is left up to the purchaser or analyst studying the firm. This concept fully supports the ideology of a free and efficient market. The SEC shares market regulation with other agencies like the Commodity Futures Trading Commission which oversees trading in future markets and the Federal Reserve which takes a more holistic stance in the overall health of the United States financial system (Bodie et al., 1993). According to Bodie et al. (1993), The Securities Investor Protection Act of 1970 established the Securities Protection Corporation to protect investors from losses if their brokerage firms fail. The corporation ensures that investors will receive securities up to a $500,000 limit per customer. Since there are so many moving parts to the stock market, the SEC delegates much of the regulation to the secondary markets themselves. The National Association of Securities Dealers oversees trading of OTC stocks. Chartered Financial Analysts have a code of ethics set forth by the Institute of Chartered Financial Analysts that mitigates inappropriate CFA behavior when trading stock (Bodie et al., 1993). After the market crashed in 1987, several recommendations were made surrounding regulatory change. Of the recommendations, only one was implemented. The recommendation implemented is known as circuit breakers. Circuit breakers are defined as a lever that stops trading when market conditions warrant such an action. When the market is experiencing days of high volatility, a circuit breaker is implemented and the logic behind the intervention is to prevent informational problems which might contribute to an excessive price swing that a stock might experience (Bodie et al., 1993). This government intervention brings forth a few questions; is this mechanism simply delaying the inevitable? Is the intervention contributing to or lessening the market’s efficiency? To quote Bodie et al. (1993), “Circuit breakers give participants a chance to assess market fundamentals while prices are temporarily frozen.” (p. 103). Circuit breakers could provide a more in-depth understanding of what people should do in certain situations versus what people actually do in certain situations. This paves the way into behavioral finance and behavioral economics which throws out rationality because emotion is involved. However, behavioral finance and behavioral economics is out of the scope of this author’s purpose for this paper. The Efficient Markets Hypothesis (hereafter, EMH) states that (1) stocks are always in equilibrium and (2) that it is impossible for investors to consistently beat the market for long durations of time (Brigham & Ehrhardt, 2008). The EMH has three versions that it is comprised of; the weak-form, semistrong-form, and strong-form hypotheses. The weak-form states that all information is represented in the stock price based on historical information. The semistrong-form believes that all relevant public information is accurately reflected in the stock’s price. Strong-form firmly believes that all information, including inside information, is included in the stock’s price. The strong-form hypothesis supports the assumption that even insiders could not consistently gain from engaging in insider trading. If good stock analysts are performing rigorous technical analysis then the analysts will quickly recognize insider trading and profitable opportunities and the overall market will efficiently adjust itself.
The Crisis It was great to be an American in the early 2000s. Credit was cheap and just about anyone could receive a home loan with zero money down, no proof of a sustained income and the loan would have a very small interest rate in the first few years of the loan and then the rate could jump. These types of loans are known as adjustable rate mortgages, or, ARMS. Their purpose is to lure the borrower in to the loan with low initial payments, then the loan’s rate skyrockets and the borrower’s payment balloons. These were “bad loans” sold to unsuspecting borrowers, who, in most cases, suffered from innumeracy. The loans were pushed to borrowers by lending firms whose agents sold the idea that real estate can never lose value. These agents were telling borrowers that real estate is like a gold mine and you can tap into it whenever you like. Borrowers were encouraged to take out a line of equity on their home because the home would never lose its value and to buy the SUV or boat that they wanted. This practice was cyclical at the time. People would buy a home, its value would appreciate and the home would be sold for a profit. Meanwhile, the mortgage giants were carrying all these huge mortgages on their books. Fannie Mae and Freddie Mac were, by far, the largest companies who had all these “bad loans” on their books. In order to hedge against potential losses for these loans, Fannie and Freddie purchased insurance on these loans; much of which originated with AIG. The insurance was designed to protect Fannie and Freddie if the loans would default – thus hedging their risk and putting it all on AIG. AIG would then be on the hook for the monies if mortgage loans defaulted. So, when the rates on the ARM loans went up, in many cases, the borrower was not able to make his or her payment. This model continued and eventually many homes were foreclosed on. As less and less people purchased homes and foreclosures increased, this led to an oversupply of housing. Basic economics tells us that prices are set based on supply and demand – the more supply, the less demand. Since demand was decreasing and supply was increasing, home values plummeted. With home prices in a downward spiral, Americans continued to be unable to pay their mortgages due to increasing rates of the ARM loans, and the ones who still could pay their mortgage were disheartened by the fact that their home had lost 30% of its value. This triggered many to simply stop paying their mortgage or to walk away from their home.
Again, more and more homes were foreclosed on, thus forcing housing prices to plummet even further. With huge sums of mortgages foreclosing, Fannie and Freddie were now stuck with all these loans that would never be repaid. However, as mentioned earlier, Fannie and Freddie hedged themselves against this type of situation by purchasing insurance on these mortgages. Now, AIG was going to be on the hook to back these mortgages. Subsequent events eventually led to its credit rating getting downgraded. In September, 2008, AIG’s credit rating was downgraded below the “AA” rating. The industry practice states that firms who possess the highest credit rating need not deposit collateral when engaging in the trading of derivatives. Previously, before AIG’s credit rating was downgraded, it did not need to have collateral for its trading of these types of securities. However, once AIG’s credit rating was downgraded, AIG had a gargantuan hole it had to fill in form of collateral that it did not have. In an effort to save AIG from failure to meet its collateral obligations, the Federal Reserve announced the credit facility of $85 billion so AIG could meet its obligations with its trading partners. The events aforementioned eventually led to the economic crisis because, in essence, it was a “perfect storm” on the financial markets. It would be like an army crossing a suspended wooden bridge in a jungle in sequence and all members stepping down at the same time…bringing the whole bridge down. So, who is to blame for the economic debacle? Some say government deregulation is to blame. If stricter regulations were in place to keep the financial industry in check then there would not have been a financial crisis. Others say that borrowers themselves are the crux of the issue. Intuition would tell a normal person that someone who makes $40,000 per year should not qualify for a $600,000 loan for a six bedroom home. Did this potential borrower really think that he/she could afford a home worth over a half million dollars on a $40,000 per year salary? However, who originated the loan and qualified the person for it? This would then point and assign blame to these mortgage companies and their agents. At the end of the day, blame cannot be pinpointed and assigned to one person, party or group. All had their hands in the cookie jar and all played a part. To bifurcate the economic collapse back to the issue of ethicality, one should consider the ethical system of universalism. Again, under universalism, honesty and integrity should be upheld regardless of the immediate result. The agents underwriting these “bad loans” were, in many cases, dishonest with borrowers and convinced them that they could make the ballooned mortgage payment even when the interest rate rose. However, the money that was getting made was too easy and too tempting for these individuals to pass up. Deontology states that all parties should benefit from an action and the action should be rejected if it could harm another party. If these agents were practicing deontology, did they not benefit all when giving the borrower the home of his/her dreams? The agent himself/herself was making an easy commission and benefiting, the borrower was moving his/her family into a giant home with low initial payments and mortgage companies were making huge profits. Under the deontology arm of ethicality, if the agent knew that he/she was underwriting a “bad loan” to a borrower, then the agent was violating the rule of deontology because it could potentially harm the borrower.
How the crisis could affect a firm The economic collapse of 2008 caused much harm to American firms; both large and small. As was stated earlier, this author’s employer was affected by the collapse. In 2008, this author was employed by Cox Communications. Cox is one of the largest telecommunications providers in the United States and employs approximately 24,000 people. Many of Cox’s operations are funded by credit – including its day-to-day operations and many payroll related expenses. In October 2008, there was a growing concern that operations could be unfunded if the credit crisis did not resolve itself. A high ranking executive candidly informed employees that it could become pretty unpredictable in the next few months. This news was shocking and there was much concern among the workforce limited only to complete panic. The crisis could affect a firm, either large or small, in many ways but only a few will be elaborated upon. A mortgage company, like Fannie or Freddie, could be in possession of many mortgage backed securities comprised of subprime loans. The subprime loans contributed to overall foreclosure rates and, ultimately, decreasing housing prices. This then makes Fannie and Freddie’s mortgage backed securities worth less than before, thus weakening their overall financial health. As stated earlier, Fannie and Freddie hedged against such mortgages by purchasing credit default swaps. Now, a firm, such as AIG, would have to come up with the cash to back these subprime, or, “bad loans”. This then puts strain on the insurance provider because the firm needs to have sufficient capital on-hand to satisfy these types of terms. This self-fulfilling prophecy then results in a complete credit freeze due to the distrust of the valuation of any real estate-related security. Financial institutions are not lending and trust is all but lost among these financial giants. As a result, large companies, like GE and Cox, become concerned about the credit crisis because they simply do not know if they will be able to retrieve capital needed to fund day-to-day operations. This then also causes companies to sit on cash – hesitant to reinvest it due to uncertainty. Unemployment rises and research and development endeavors become put on hold and innovation is stagnant. This cascading waterfall effect has been plaguing the United States for the past five years…and it still does not look promising.
Conclusion
The book Too Big to Fail was excellent in outlining the dialogue among the nation’s top financial minds in both government and the private sector regarding the recent economic crisis. This author thinks of the fall of Lehman Brothers. Stated earlier was a brief history of the stock market in the United States. When Dick Fuld, head of Lehman, was pleading with Paulson to stop the short-sellers from “shorting” his firm’s stock, one cannot help but think of the fundamental efficient market hypothesis. Was the market simply acting efficiently and weeding out a bad company in possession of toxic assets? Also, when the market was dropping like a ton of bricks, did circuit breakers help prevent the bottom from dropping completely out? Should the government intervene when such conditions are present? One may never know if the crisis could have been prevented; there are many opinions that argue in favor and against such premise. This author feels that deregulation of the financial system was a contributor to the pandemic. Complex and risky financial instruments became more and more risky as a result of this deregulation. This led to greed because too much money was getting made and, ultimately, many Americans lost their homes. With the U.S. economy sputtering at best, it is becoming more and more difficult for America to be globally competitive. The U.S. is in dire need of an “industrial revolution” in the 21st century. America has become a nation of ideas; our ideas are our most abundant resource. Firms need to leverage this resource and figure out the best way to export and utilize it. Education needs to be paramount if America’s workforce is to be globally competitive. As education standards become watered down more and more, future generations will not possess the skills needed to perform basic job duties. The whole public school system in the United States is in need of drastic reform. Teachers and students need to be of primary concern, not administrators and unions. Stricter financial regulation is needed – more eyes need to see who is putting their hands in the cookie jar. The Sarbanes-Oxley Act was just a symptom of the problem; no accountability was owned by these public firms. Internal controls were lax at best and fear of reprimand prevented many from blowing the whistle on wrongdoings. Lastly, the American public needs to take ownership and keep itself in the know. Ignorance is bliss is no longer an excuse. Americans need to educate themselves on what is going on in their own country and give up meaningless vices such as reality television and mind-numbing smart-phone games. America can no longer rely on the mostly left media to give it its news. The Internet has so many different bias-free resources aimed to provide the true story of what is going on. It is up to the people to take their country back and make it economically strong again.