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From Gordon Gekko to Investing With a Conscience

BY Jeff Gardner

October 5-11, 2008 Issue | Posted 9/30/08 at 4:00 AM

 

In 1987, Michael Douglas starred as banker Gordon Gekko in Oliver Stone’s Wall Street. At one point in the film, Gekko addresses a group of shareholders and says, “Greed is good.

“Greed is right. Greed works. Greed clarifies, cuts through, and captures the essence of the evolutionary spirit.”

Wall Street was only a movie, but Gekko’s bravado, it would seem, was mirrored in a reckless corporate strategy by many U.S. finance firms. However, as with any of the deadly sins, though the initial impact is heady, sooner or later you pay for the transaction. For a large portion of the U.S. financial services industry, September 2008 will be remembered as the month when the accounts came due.

How much? Something in the nature of $700 billion to $1 trillion, according to estimates. To raise that amount of money, the federal government would need to borrow from itself and pass the bill on to taxpayers for generations to come.

Karen Walker, founder and managing partner of the Catholic Business Journal, said she found the bailout “alarming,” and worried that “it is a quick-fix, knee-jerk ‘solution’ by the same entity, the federal government, whose bad financial decisions more than eight years ago encouraged ill-qualified buyers to take on mortgages beyond their means.”

What happened?

Our modern finance industry, not unlike oil, is an integral but often messy feature of our economy. Companies large and small rely on the borrowing of money for everything from covering payroll to developing products and expanding their markets.

Banks and mortgage companies also borrow money from firms like Morgan Stanley and Goldman Sachs, and then make it available to businesses and would-be homeowners in the form of small loans and home mortgages.

Completing the credit cycle, large mortgage finance firms like Fannie Mae or Freddie Mac buy up mortgage loans, bundled together in what are called mortgage-backed securities, and thus encourage the lending of these loans by your corner bank or strip-mall mortgage company. With fees for every transaction, our finance industry generates money — lots of money — without creating a single product.

How much money? Consider that in the early 1980s, the U.S. financial services industry generated about 10% of all U.S. corporate profits. As of 2008, according to The Economist, the industry was generating about 40% of all U.S. corporate profits. These numbers are even more striking when one considers that the financial services industry employs only about 5% of the U.S. corporate workforce.

But why did companies like Fannie, Freddie, Merrill and others buy so many mortgages and take on so much risky debt? The answer to this question, according to Gina Emrich, director of marketing and research at Epiphany Funds, is the same one Gordon Gekko gave: greed.

“Some of these finance companies,” Emrich said, “had taken on 50 times more debt than they had in assets. Why would anyone think that this was a good idea?”

(Epiphany Funds, offered by Texas-based Trinity Fiduciary Partners, carefully screens all companies and makes investment decisions based on the social justice teachings of the Catholic Church.)

Martijn Cremers, a Catholic, is an associate professor of finance at the Yale School of Management. He cited market reasons for the crisis, but acknowledged that virtue and vice played their roles.

“Yes, I do think that this can be partly explained by ‘greed,’ but also by a whole plethora of human weaknesses that almost everyone shares — laziness, overconfidence, opportunism,” he said. “And the current crisis would not have happened without the steep rise and then fall in house prices, for which there is plenty of blame to go around. Briefly put: The general trust in the mortgage-backed securities market broke down, liquidity dried up, and now no one really knows what all this stuff is worth.”

Throughout the 1980s and 1990s many passengers enjoyed the ride on the financial services gravy train. From Wall Street CEOs who received huge salaries and bonuses to ma and pa investors who held stock in the finance companies, millions of Americans borrowed, spent, and borrowed some more, all assuming that somehow the “buy now, and pay later” party would never end.

But it did.

Starting in 2001 with the burst of the dot-com bubble and the Sept. 11 attacks, the U.S. economy slowed — a lot. The increase in housing values waned, and the worth of the real property behind billions in loans began to decline.

The financial services industry, however, kept pushing debt, buying mortgages and giving out more credit to consumers, creating a whole new class of American debtor: the subprime mortgage holder.

“What has really been missing in corporate America,” said Emrich, “is a fundamental sense of humility. For the last decade, corporations and individuals alike have demanded a whole lot for very little. On a scale of one to 10, with 10 as the highest, the overall wise behavior of corporations and individuals in the last 10 years would, in my opinion, rank at about three.

“Some of the blame,” Emrich continued, “for the overborrowing in our finance industry must be placed at the feet of the American investor.”

Over the last decade, lenders of all sizes offered loans that featured little to no interest at first, but then ballooned or “adjusted” to double-digit interest rates later, resulting in monthly payments beyond the ability of the borrowers to pay.

When a critical mass of homeowners could not pay their mortgages and defaulted, the housing crisis of 2007 and 2008 began. As the mortgage-default rate spread, large companies like Fannie Mae and Freddie Mac, which were holding billions in mortgage-backed securities, collapsed and were taken over by the federal government.

A number of other large finance companies were also holding billions in mortgage loans, all enjoying the interest from these loans, and all assuming that the principal on the loans would be repaid.

As a panic over the falling value of mortgage-backed securities spread, some of these companies, like Lehman Brothers, filed for bankruptcy and are gone. Others, like Merrill Lynch and AIG, only just escaped disintegration. Merrill Lynch sold itself to Bank of America, and AIG, after losing 95% of its value in the first six months of 2008, received an $85 billion emergency federal loan.

By the third week of September 2008, global banks actually stopped lending each other money, with many unsure about who could repay a loan or if there were any real assets behind the loans in the first place. A U.S. or global economy without a free flow of loans is like a fast-running engine without oil — certain to overheat, fail and then stop, leaving millions without paychecks, store inventory or even, as is the case for U.S. agriculture, seed to put in the ground.

What does the Catholic faith teach about all this?

Walker called the financial world a form of stewardship.

“From a Catholic ethical perspective, we are called as individuals to be good stewards of what we have and not to envy what we don’t have,” she said. “We are called to help and serve each other in Christ’s name. That involves conducting our business affairs in a savvy and ethical manner. If we fail, if we make bad choices, we learn from them.”

Jeff Gardner is CEO of CatholicRadioInternational.com

You can reach him at jgardner@catholicradiointerntaional.com