Thursday, June 25, 2009

Morality and Market Regulation

Finance is one of the most heavily regulated sectors of Canadian society. This is due to the fact that the expectation of fairness is paramount to the upholding of confidence through the persistent viability and efficiency of capital markets. The financial services industry is arguably the most visible face of finance to ordinary citizens; it is an industry that impacts the well-being of not only direct participants in the markets, but also affects many third parties such as stakeholders and other community groups. Provincial regulators and securities commissions seek to instill confidence and trust in financial services organizations through legislation and the consequent regulations that derive from such enactment of law. However, as Boatright states: “The law is a rather crude instrument, and it is not suited for regulating all aspects of financial activities, especially those that cannot be reduced to precise rules” (Boatright 2008: 9). It seems that after a deleterious financial incident seizes the public’s attention, legislators rush to implement new regulations and laws to curb deviant behavior. Some concerned citizens are left with the impression that the operative adage on Bay Street is “if it is not deemed illegal, then it is morally okay.” For the vast majority of participants in the financial services industry this is simply not the case. The management of investment firms realize that the companies and individuals to which they provide their services expect not only compliance with the laws but also implicitly demand ethical treatment. What then is the connection between law and morality in the case of the securities industry?
It must be stressed that there is a difference between compliance and ethics. CSI Global Education Inc. (CSI) is the educational body of IIROC and has the exclusive mandate to provide many of the courses and exams required to work within the securities industry in Canada. The following is stated in the Conducts and Practices Handbook Course (CPHC):
Compliance is, basically following the rules, whether those rules are legal requirements or firm policies. Ethics involve not only complying with the letter of the law but also complying with the spirit of the law. Therefore, ethics goes beyond prescribed behavior, and address situations where rules are not clear or are contradictory. It is possible to take an action that is unethical, even though one is complying strictly with the rules. (CSI 2007: 1.2)

MacIntyre asserts that “…regulation which is concerned with the safety or quality of goods and services is not itself and expression of any particular moral standpoint, but is rather a substitute for morality at just those points in our social fabric where we no longer possess adequate moral resources” (MacIntyre 1980: 31). Although MacIntyre is clearly supportive of regulation, he recognizes the ‘systematic inconsistencies’ in our conceptions of justice.
On the one hand, we tend to think of morality positively, where citizens pursue human goods through the notion of community, family, the workplace and other social relationships. We conduct ourselves in a fashion that positively contributes, through participation and communication, in the community: the pursuit of good for all of its members is a common priority of all individuals. On the other hand, we view our social milieu as one of self interest and ceaseless competing desires amongst individuals and rival groups. This negative view holds that self satisfaction and the resultant conflicts that ensue require that we should be protected from each other. In regard to the former view of justice, MacIntyre claims: “From the standpoint that envisages the goal of political society as the creation and maintenance of communities, we do indeed need a system of public law, but only as a system of last resort” (MacIntyre 1980: 32). Using medical malpractice suits as an example, MacIntyre suggests that these legal actions do not rise due to greater negligence on the part of the medical profession but because of the breakdown in trust between physician and patient. The erosion of the moral relationships between individuals has resulted in the law being relied upon much more frequently instead of a social vehicle of last resort.
Where protection from others is paramount, reliance on the law is not an action of last resort but a primary instrument in the functioning of society. MacIntyre explains:
[W]hen law is thought of in the second way, as a device for protection of one against another, then fear or self-interest become the dominating motives…When the law is in good working order it is not when everyone is obeying the law from fear, or when everyone is obeying the law from calculated self-interest. It is when obedience to law expresses a genuine allegiance to law. Thus it is precisely when the law is least needed, when it is least invoked, that it is in its best working order. When by contrast there is continuous resort to the law, it is generally a sign that moral relations have to some large degree broken down. It is a sign that the motives which make us invoke the law are those of fear and self-interest. And when fear and self-interest have been brought into play, law itself tends to be morally discredited. (MacIntyre 1980: 32-33)

At the time of this paper being written, global markets are experiencing the consequences of a combination of factors, predominately the catastrophic sub-prime loan fiasco and ensuing banking crisis in the United States. This financial debacle and other factors including the speculative bubble in the commodities markets, lead by petroleum products, have resulted in a period of extreme volatility and uncertainty in financial markets. In the early stages of the aftermath of the global monetary crisis, investment firms have been denounced for participating in devious sales practices and implementing deceptive investment policies. It should be noted that transgressions of ethical expectations and regulatory statutes are frequent in the final stages of markets cycles, only to surface as the ensuing downturn gains momentum.
Financial markets are cyclical in nature, ostensibly being driven by the aggregate psychology of the investing public
[2]. History has repeatedly demonstrated that mass psychology manifests periodically as hysterias, driven by both fear and/or greed, which is invariably accompanied by deceitful and fraudulent behavior on the part of unethical parties participating in financial markets. The hope and optimism of rising markets develops into a period of exuberant euphoria, which is characterized by excessive acquisitiveness and blatant disregard for risk. Inevitably the ‘boom’ is followed by the ‘bust’ or descending market prices but not before predatory firms and individuals exploit the naiveté of investors who are typically overcome by avarice in the distribution stage of the market cycle. The declines are often dramatic, punctuated by periods of panic with culmination of the bear phrase occurring in an environment of acrimonious fear and despair amongst the investing public. In a setting where exploitation of investors by parties with malevolent intentions is prevalent, securities regulation can only operate under the conditions of the protection of self-interest and fear. Unfortunately, without the investing public having a general knowledge of what causes periods in the market where securities laws are typically transgressed, securities regulation is only effective in a reactive manner. Galbraith summarizes this point:
What have not been sufficiently analyzed are the features common to these episodes, the things that signal their certain return and have thus the considerable practical value of aiding understanding and prediction. Regulation and more orthodox economic knowledge are not what protect the individual and the financial institution when euphoria returns.... There is protection only in a clear perception of the characteristics common to these flights into what must be conservatively described as mass insanity. (Galbraith 1993: 1-2)

The crash of 1987 is a good case in point. After the crash in October 1987 the blame was directed towards several parties including the federal government for running such large deficits. Program trading and portfolio insurance were also condemned for their adverse effect on short-term market behavior. Diminutive mention was attributed to the orgy of speculation that led up to the fateful day of October 19th, 1987. The insider trading scandals involving Dennis Levine and Ivan Boesky which led to the indictment of Michael Milken of Drexel Burnham Lambert, were merely symptoms of the speculative bubble that had been forming during the mid 1980s. The markets had succumbed to the vices of fear and greed, subsequently demonstrating that existing regulations were not able to deter reckless and immoral behavior.
A more recent example has had a devastating effect on the global economy. Easy credit for the American housing market led to the inevitable financial bubble that like all other ‘manias’ was bound to crash. Initially, small regional lenders of residential mortgages began to experience an increase in defaults on sub-prime mortgages and non-traditional mortgages.
[3] The problem began to mushroom when high risk mortgages that were being bundled, ostensibly to lower risk to the securities firms and their clients, began to collapse in value. These mortgage backed securities being held typically by investment banks and hedge funds were flaunted as being of ‘investment grade’ due to the diversification of the bundling process and risk management strategies utilizing derivative products. The entire process began to unravel, directly leading to the collapse (to date) of Countrywide Financial, Fannie Mae, Freddie Mac, Bear Stearns, AIG Insurance and Lehman Brothers.[4] The financial crisis presently enveloping Wall Street was allowed to get to unmanageable proportions due to the dubious sales practices of residential mortgage brokers and the faulty ‘financial engineering’ of mortgage backed securities that relied on the apparent sophistication and expertise of Wall Street money managers. As shall be demonstrated below, the alleged expertise of financial professionals resulted in what Alan Greenspan terms a ‘once in a century’ financial crisis. Once again the regulators were caught in a position of being reactive to the economic crisis as a result of unbridled avarice and short sightedness.
MacIntyre summarized the role of regulation in society as follows:
The result: regulation is the best we can do… I see it as a minimal device that has been developed in order to compensate for the grave defects of a culture where the fabric of morality is being torn apart and where government cannot act in the ways that we would want it to if moral community were a real possibility. Regulation is a necessary makeshift. Churchill once said that democracy is the worst form of government except for all others. Regulation, it seems to me, deserves a similar verdict. (MacIntyre 1980: 33)

[1] On December 11, 2008 the Securities and Exchange Commission ("SEC") charged Bernard L. Madoff and Bernard L. Madoff Investment Securities LLC. with securities fraud for an alleged massive Ponzi scheme perpetrated on their advisory clients. According to the U.S. Attorney's office, Madoff admitted to defrauding clients for up to $50 billion in a massive Ponzi scheme that was committed over a number of years. Madoff conducted an investment advisory business providing investment services for wealthy clients, institutions, schools, and charities. Madoff's services were marketed as providing steady double-digit returns even in the most turbulent of markets.
Sometime in 2005, according to the SEC suit, Madoff's investment-advisory business morphed into a Ponzi scheme, taking new money from investors to pay off existing clients who wanted to cash out. As the market declined precipitously in the autumn of 2008, Madoff continued to report to investors that his funds were up which would have been a relatively remarkable performance. During the same time, the stocks of the Standard & Poor's 500, where Madoff supposedly did most of his trading, had dropped a weighted average of 37.7%.
Despite his gains, a growing number of investors began asking Madoff for their money back. In the first week of December 2008, according to the SEC suit, Madoff told a senior executive that there had been requests from clients for $7 billion in redemptions. Soon after, Madoff met with his two sons to tell them the advisory business was a fraud — "a giant Ponzi scheme,"— and was nearly bankrupt. The sons reportedly contacted their lawyer, who then alerted federal authorities to the fraud. Before being caught, Madoff was working on a scheme to dole out his funds' remaining $300 million to the firm's employees and his family members. For details of the complaint against Madoff see:

[2] An abundance of research and analysis of stock market cycles is available through both commercial and academic sources: (Galbraith 1993: Graham 1973: Shefrin 2002: Herbst and Slinkman 1984: Bauman and Miller 1995)
[3]Subprime mortgages are those lent to people with poor credit who might not otherwise qualify for loans. Non-traditional mortgages include those with adjustable interest rates, interest-only payments and other enticements.

[4] Fannie Mae and Freddie Mac were the largest American purchasers of mortgages. They were taken over by the U.S. federal government on Sept. 8, 2008, as the two mortgage giants struggled with deep losses and investors lost confidence. Bear Stearns and Lehman Brothers were investment banks that offered strategic advisory services for mergers, acquisitions, and other financial services for clients, such as the trading of derivatives, fixed income, foreign exchange, commodity, and equity securities. Bear Stearns was acquired by JPMorgan Chase in March 2008 after becoming illiquid due to loses in the Mortgage Backed Securities markets. Lehman Brothers suffered the same fate in September 2008 but was allowed to file for bankruptcy protection. On the same day Merrill Lynch was acquitted by Bank of America possibly averting yet another bankruptcy of a major Wall Street firm.

[5] MacIntyre’s position that regulation is a ‘necessary makeshift’ implies that it does have an important role to fulfill in a just society. The relative strength of the Canadian banking system as compared to other countries affected by the current economic crisis (2009) aptly demonstrates that effective and efficient regulatory systems stabilize the financial environment to a greater degree than the laissez faire attitude adopted by American financial regulators.

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