BusEthics.2.11.2013B.ppt - San Jose State University by wangnianwu


									Professional and Business Ethics

Peter Hadreas

Course Web Page:


Inside the “Inside Job” it’s claimed that the Chair
  of the Federal Reserve, Alan Greenspan, would
not act on what looked like an impending crisis to
 some, “because of his ideology.” What ideology
              are they talking about?

                Goldman Sach’s Tower

  In Inside Job, (Part II) it’s explained that Goldman
  Sachs in 2007 bought at least $22 billion in Credit
Default Swaps from AIG and continued to recommend
  CDO to their customers. The narrator says: “The
  more many Goldman Sachs’s customers lost the
     more Goldman Sac made.” How was that so?            3
In the Inside Job, Frank Portnoy, Professor of Law and
Finance at the University of San Diego says: “I’ve now
testified before both houses of Congress on the credit
 rating agency issue and both times they trot out first-
           amendment lawyers and argue that
when we something is rated AAA that’s merely that is
        merely our opinion you should rely on it.”

    What ethical and legal injustices are involved?
      Main character: Steven Eisman
     Anti-social hedge fund manager,
He leaves Oppenheimer and Co. and founds
      his own hedge fund, FrontPoint
                Vincent Daniel
Left Oppenheimer and Co. with Eisman and joined
        Eisman’s hedge fund, FrontPoint

                    (Dr.) Michael Burry.
 an ex-neurologist who created Scion Capital. He suffers
    from blindness in one eye and Asperger syndrome.
First money manager to buy a credit default swap (CDS) on
                  sub prime mortgages                 7
 What is‘selling or going

The ordinary and conventional practice
  of buying an asset and profiting on
 selling it when the price goes up.

 What is‘selling short’ (or shorting or
             going short)?
A form of reverse trading.
An investor borrows an asset and immediately sells
it back to the brokerage house from whom s/he
bought it. The investor immediately obtains the
price of the sale, but owes the brokerage house the
asset – the amount of shares of stock or bonds. At
some point the investor must return the shares of
stock or bonds s/he sold. If the price of the asset
goes down, the investor can return it for less money
than s/he originally sold it. Profit is made when
assets lose value.
Shorting usually includes paying a fee for
borrowing the asset and paying the dividends – if
there are any -- on the asset.
                      Greg Lippman
a Deutsche Bank bond trader that created the shorting of
   bonds, the first Credit Default Swap (CDS) market.

“. . . . he [Lipmann] showed Eisman this little chart . . .
since 2000, people whose homes had risen in value
between 1 and 5 percent were nearly four times more
likely to default on their home loans than people whose
homes had risen in value more than 10 percent.”


How does Lewis’ conclusion follow? Lewis writes
(p.65): “Home prices didn’t even need to fall. They
merely needed to stop rising at the unprecedented
rates they had the previous few years for vast numbers
of Americans to default on their home loans.”

Lewis, The Big Short, Chapter 3, p. 65.
AIG FP (Financial Products)

AIG Offices in New York City
AIG FP (Financial Products)
    CEO: Joe Cassano

          AIG FP (Financial Products)

 “AIG FP was now selling credit default swaps
on trip-A-rated subprime bonds for a mere 0.12
 percent a year. Twelve basis points!. . . It was
incredible: In exchange for a few million bucks
a year, this insurance company was taking the
  very real risk that 20 billion would simply go

    Lewis, The Big Short, Chapter 3, p. 72.

           AIG FP (Financial Products)

                      Joe Cassano

That Joe Cassano, the boss of AIG FP, was the
son of a police officer and had been a political
 science major at Brooklyn College seems, in
 retrospect, far less relevant than his need for
         obedience and total control.

    Lewis, The Big Short, Chapter 4, p. 86
          AIG FP (Financial Products)
Gene Park, who worked for AIG FP bond
trading department “decided to examine these
loans that AIG FP was insuring a bit more
closely. The magnitude of the
misunderstanding shocked him.”
Gary Gorton, Yale professor said it was 10%.
A risk analyst in London guessed 20%.
It was actually 95%.

“In retrospect their ignorance [including
Cassano’s] seems incredible – but then, an
entire financial system was premised on their
not knowing and paying them for this talent.”
      Lewis, The Big Short, Chapter 4, p. 88.
Let’s consider further the statement on the last

“In retrospect their ignorance [including AIG
FC CEO Cassano’s] seems incredible – but
then, an entire financial system was premised
on their not knowing and paying them for this


      What talent is Lewis talking about?

      Lewis, The Big Short, Chapter 4, p. 88.
              Eugene Xu.
“China had this national math
competition, Lippman told people, in
which Eugene had finished second.
In all of China.

   Lewis, The Big Short, Chapter 3, p. 66.
                                Eugene Xu.
“Eugene Xu went off and did whatever the second
smartest man in China does, and at length returned with a
chart illustrating default rates in various home price
scenarios. . . The numbers shocked him. They didn’t need
to collapse; they merely needed to stop rising so fast.
House prices were still rising, and yet default rates were
approaching 4 percent; if they rose to just 7 percent, the
lowest investment grade bonds, rated triple-B-minus, went
to zero. If they rose to 8 per cent, the next lowest-rated
triple-B, went to zero.
          Lewis, The Big Short, Chapter 3, p. 80.          19
Lewis writes in a footnote, p. 77:
  Dear Reader: If you have followed the story
this far you deserve not only a gold star but an
   answer to a complicated question: If Mike
 Burry was the only one buying credit default
 swaps on subprime mortgage bonds, and he
  bought a billion dollars’ worth of them, who
  took the other $19 billion or so on the short
 side of the trade with AIG? The answer is . . .
Burry was joined by others, including Goldman
   Sachs itself – and so Goldman was in the
   position of selling bonds to its customers
 created by its own traders, so they might bet
                  against them.
      Lewis, The Big Short, Chapter 3, p. 77.
So Goldman created bundled subprime
mortgage bonds (CDOs) and sold them its own

Is there something unethical/illegal here?

Then Goldman bet against its customers’
bonds by buying credit default swaps, that is
insurance – from AIG FP it was a low as .12%
per year. If the bonds defaulted, then the credit
default swap ensured the full price of the bond.

Is there something unethical/illegal here?

       Lewis, The Big Short, Chapter 3, p. 77.
Why didn’t bond regulatory ratings stop this
world-wide deception?

But who were the rating companies?

Moody’s Corporation (Moody’s), a
longstanding corporation founded in 1909.
Moody’s has a 40% share of the world credit
rating market.

Standard and Poor’s (S&P) with even a
longer history, beginning in 1860. S&P also has
40% share of the world credit rating market.

      Lewis, The Big Short, Chapter 3, p. 77.
Why did Moody’s and S&P inaccurately rate
the subprime mortgage backed bonds?

Moody’s and S&P’s models of assessing loan
pools were very badly conceived and

“Lippmann soon found that the people he most
expected to see the ugly truth of the subprime
mortgage market – the people who ran the funds that
specialized in mortgage bond trading – were the ones
least likely to see anything but what they had seen for
years. Here was a stranwe but true fact: The closer you
were to the market, the harder it was to perceive its

Why might people who constructed the CDOs, the
bonds made up of bundled, and largely subrpime,
loans, often not see that they were very bad

Lewis, The Big Short, Chapter 4, p. 91.                   24
The credit-worthiness of individual borrowers
was (and is) measured by a FICO (Fair Isaac
Corporation) score. The highest score – most
credit-worthy -- is 850, the lowest – least credit
worthy – is 300. Moody’s and S&P assess
bonds by the FICO scores of the borrowers.

Problem #1: FICO scores don’t account for a
borrower’s income.

Question: How would this be a problem in
rating CDOs (bonds made up of pooled

       Lewis, The Big Short, Chapter 4, p. 99.
Problem #2: Moody’s and S&P asked the loan
packagers not for a list of the FICO scores of
all the borrowers but for the average FICO
score of the pool . . . The pool needed to
average around 615 to be rated as a triple-A-
rated bond.

Question: Why is rating pools of loans by an
average FICO a bad measure of the value of the

      Lewis, The Big Short, Chapter 4, p. 99.
Problem #3: Moody’s and S&P didn’t grasp
the difference between a ‘thin-file’ FICO
scores and a ‘thick-file’ FICO scores. A thin
file is a short credit history; a thick file, a long

Question: Why did failing to distinguish
between ‘thick’ and thin’ FICO scores make
FICO credit rating of bonds more unreliable?

       Lewis, The Big Short, Chapter 4, p.
       100.                                            27

Hedge fund money managers, Steve Eisman
and Michael Burry were able to take advantage
of Moody’s and S&P faulty models for rating
these bonds. How?

      The New York Times, (online) February 5, 2013 :
         by Mary Williams Walsh and Ron Nixon, . . .
“The government is seeking $5 billion in penalties against
the company to cover losses to investors like state pension
funds and federally insured banks and credit unions. The
amount would be more than five times what S.&P. made in
2011. S.&P. said it would vigorously defend itself against
“these unwarranted claims.”
“Sixteen states, including Iowa, Mississippi and Illinois,
joined the federal suit, and the New York attorney general
said he was taking separate actions. California’s attorney
general, Kamala D. Harris, said the state pension funds lost
nearly $1 billion on the soured investments. The Securities
and Exchange Commission has also been investigating
possible wrongdoing at S.&P.”                              29
slide #2, picture of Alan Greenspan: http://en.wikipedia.org/wiki/Alan_Greenspan&h
slide #3, picture of Goldman Sachs Tower, http://en.wikipedia.org/wiki/File:30hudson.jpg
Slide #4, picture of Frank Portnoy: http://www-
slide #26, New York Times Article, ‘CASE DETAILS INTERNAL TENSION AT S.&P.
: http://dealbook.nytimes.com/2013/02/05/case-details-internal-tension-at-s-p-amid-


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