Ask More of Business

Asking More Commentary: Perspectives from Mendoza College of Business

Commentary Post - Ed Conlon

Fixing the financial market mess: We can't ignore values

June 1, 2010

This is Part 1 of Ed Conlon’s commentary about the causes of the financial market meltdown and what role leadership values play in finding answers.

Plenty of books and articles have already been published about the financial industry crisis, which began in earnest in fall 2007. I suspect there will be more.  All describe bits and pieces of what happened. Some offer analyses and ideas about why the crisis occurred. A few place blame. 

A reasonably clear picture of the crisis is emerging, with lots of behavioral detail.  About the “what,” we know that there was general over-investment in securities backed by low-quality (subprime) mortgage loans.  Means were invented to market securities that were backed by low-quality mortgage loans as high-quality investments.  

The “whys” generally hinge on two themes.  The first of these asserts that the people who spearheaded this business are said to be self-interested and greedy.  Faced with the possibility of creating new lucrative business opportunities, investors and banking executives were overly willing to believe that large numbers of bad loans could collateralize high-grade, low -risk securities.  Investors and banks simply had to be in that market.

At its heart, all it took to believe this premise was an assumption that the underlying asset – real property – would continue to increase in value.  This assumption placed a limit on the losses that might arise from a loosening of credit to lower-income Americans who were interested in financing a home purchase or obtaining a second mortgage against their current home.  All would be fine if you were willing to accept this central idea about real estate values: What goes up, would not be likely to come down, at least not in a widespread fashion.  Since it was difficult for bankers and investors  to retrieve an instance of this kind of collapse from recent memory or recent history, the premise wasn’t difficult to accept.

The second theme involves those who were creating the financial instruments in the chain that linked borrowers to investors. In their creative zeal to engineer levels of risk that would be acceptable to investors, these brokers created instruments and a process so complex that it was hard for many to fully grasp and understand without very careful – even intense – study of exactly what assets and assumptions supported the value and risk of the securities being created.  Even the companies charged with rating these securities were easily confused.  In the recent books about the financial crisis written by very skilled writers, whole chapters describing this process often need to be read and re-read to fully grasp exactly how the entire chain of financing worked!

So, then, what can be done to mitigate the possibility of this happening again?  Increased regulation of the financial industry, for sure, is a possible option, and there is little doubt that we will see more financial regulation in our near future.  However, regulations tend to be far more static than markets, and the humans who comprise markets have consistently proven adept at finding ways around regulation.  At best, regulation is destined to trail behavior, where human behavior is in constant movement to escape the restrictions created by regulation and, only periodically, do regulations catch up with behavior. Even then, that happens only for brief moments. 

A better answer lies in two possibilities.  First, can we influence the values of those who decide, ultimately, to participate in the creation and sale of financial products?  This, at its heart, requires assuring that persons in these positions have the right set of sustainable values.  Second, can we cut through the complexity and make it easier for everyone to understand exactly what they are buying and selling.  These are two challenges that this crisis raises for today’s business schools.