The Ethical Dimension of the Market Crisis
A Q&A from the Practitioners’ Perspective: A Resource for Financial Professionals
By CFA Institute Standards of Practice Council member volunteers
and the CFA Institute Centre for Financial Market Integrity
Q. Is the current crisis in global capital markets the result of a systemic failure of market institutions, or of widespread misconduct by market participants?
A. The historic meltdown of the global capital markets is the result of a number of factors, including the actions, and inactions, of a variety of market participants. In many ways, the current collapse echoes the mistakes made in past crises: ignorance of risk coupled with widespread use of leverage.
When such wide-reaching events occur, there is a temptation to discount the role of the individuals’ actions, concluding instead that there were systemic failings compounded by a series of extraordinary circumstances that no individual or entity could have reasonably foreseen. Managers did not deliberately make bad investments; most probably believed they were doing the right thing with the information given to them. Behavior biases are likely at play in this crisis, and perhaps a herding instinct led investment professionals to make certain investment decisions because they believed that “if everyone is doing this, it must be okay.”
Q. What role does the CFA Institute Code and Standards play?
A. The economic impacts of the crisis have been discussed a great deal, but considerably less attention has been paid to the ethical dimension. An examination of the root causes of the crisis highlights a number of ethical concerns about which the CFA Institute Code of Ethics and Standards of Professional Conduct (Code and Standards) can provide guidance. Among the fundamental tenets of the CFA Institute Code of Ethics that may have been ignored are those that state (in part):
- “Act with integrity, competence, diligence, respect, and in an ethical manner”;
- “Use reasonable care and exercise independent professional judgment”; and,
- “Practice and encourage others to practice in a professional and ethical manner.”
While there are many players and regulatory flaws that contributed to the turmoil, only CFA charterholders and CFA Program candidates are obligated to abide by the Code and Standards. We believe that the industry could have benefited, and the severity of the crisis been mitigated, had these concepts and the CFA Institute standards of professional conduct been observed more broadly.
Q. Were the people who created the toxic securities aware of the risks involved? Once the products were created, was the proper analysis done (or could it have been done) when either rating or investing in these complex securities?
A. Investment Banks designed, developed, and sold new securities to meet market demand for products that could help investors manage risk or provide higher yields in a low-yield environment. The toxicity of these securities came about from the downward spiral of the housing market coupled with the scale of leverage and illiquidity that counter-parties ultimately could not tolerate. Compensation schemes based on volume rather than on quality — of borrower or collateral — stimulated many of the structured products and other derivative instruments that ultimately proved toxic.
The current crisis demonstrates that the competitive nature of the financial markets that underlies the new product development process must be balanced by principled conduct rooted in the ideas of ethical behavior and market integrity. Certainly innovation is not inherently bad, but the resulting products do impact salespeople and purchasers of these securities. Closer attention must be paid to proper analysis and disclosure at all levels.
Many investment professionals apparently did not fully understand the acronym-heavy securities — CDOs, CDO-squared, etc. — they were creating, rating, or purchasing, despite the fact that many came with a prospectus of 1,000 pages or more. Many purchasers of the securities seemingly over-relied on credit rating agencies (CRAs) to determine the product quality and safety without demanding better information or performing their own in-depth analysis. Further, the CRAs may have lacked the data and expertise to properly analyze these complex structured products, missing the reality that these highly leveraged securities were being sold to leveraged buyers who financed the products by mismatching their assets and liabilities.
Credit analysts were directed to replicate and use models developed by external parties without verifying the robustness and applicability of those models. These actions could be deemed as violations of Standard V(A), which requires the use of diligence, independence, and thoroughness in conducting investment analysis and when making investment recommendations. This standard also requires a reasonable and adequate basis supported by appropriate research and investigation for any investment action. Those responsible for the rating should understand the full features of the model and test the results against multiple scenario assumptions.
The current market crisis highlights the role of technical models in the development and rating of credit-based investment vehicles. As the rating analysis is completed, the models used need to be fully understood and tested. This includes having adequate knowledge of the information being fed into the model, as well as an adequate basis for stress-testing the model’s basic assumptions. For example, while the recent decline of the housing market is unprecedented by historical averages, some level of decline should always be included as a possible scenario. A greater level of testing on a wider range of situations could assist in reducing the magnitude of future market events.
Q. Investors were eager for the high returns these products paid, but were they made aware of and/or able to fully understand the associated risk?
A. Investment professionals have the fundamental responsibility to provide appropriate guidance and direction. Some investment professionals must have understood that the positive return pyramid was built upon an already high — and unaffordable to buyers — base of rising real estate prices. Yet the realities and risks were ignored or discounted. Standard II(C), which addresses suitability, dictates that investment professionals determine whether an investment is suitable to the client’s investment situation and consistent with the client’s written objectives, mandates, and constraints.
In hindsight, it is easy to claim that investment portfolios stuffed with unprofitable investments are “unsuitable,” but more care should have been taken. Highly leveraged, risky investments were recommended as “investment grade” based on the AAA-ratings assigned to those investments. With additional, diligent analysis, the investment profession may have questioned these structures and their placement in certain portfolios.
To complicate matters, the liquidity risks of auction-rate securities were minimized when determining the suitability of the investment. When the true value of the securities became clear, investment banks chose to offload their holdings of auction-rate securities to unsuspecting clients, despite an impending collapse of the market. This reduced the liquidity of these securities and the clients’ ability to redeem the investment on a short-term basis.
Q. Was the value of the securities knowingly misrepresented? Should there have been more disclosure earlier in the process?
A. Standard I(C), which addresses misrepresentation, prohibits investment professionals from knowingly making misrepresentations or false statements. This principle would certainly apply to statements about the value of investment holdings. If the CRAs involved withheld information about the risks of the investments, then they misrepresented the true economic value and risks of the mortgage-related securities they had rated. Knowingly omitting information that would impact a rating reflects poorly on the integrity of the firm and the decision-making process. It is essential that investment professionals obtain complete disclosure of the ratings process so they have the full complement of resources required to help inform their investment decisions.
Good ethical practice dictates more disclosure rather than less, so the recent trend away from market value accounting brings a rather alarming “Alice in Wonderland” dimension to the process. Simply stating that securities have a certain value does not make it so. The valuation of the toxic securities held on the books came into serious question when institutions were asked to apply fair value accounting and mark those assets to market. Indeed, at that point, in a declining housing market, the quickly eroding value of the securities became clear. As the markets conduct “price discovery” on these exotic instruments, we can expect to see further write-downs.
Future ratings disclosures could better reveal the assumptions used in the model, and demonstrate increased sensitivity to the results of those assumptions. Such information should clearly indicate the expectations used in assigning the ratings, and inform investors of possible impacts if the market moves in another direction.
Q. Can investment managers rely on “safe” ratings when choosing investments for clients, even if those ratings later turn out to be inaccurate?
A. As part of the process of determining the suitability of an investment, managers need to exercise due diligence in analyzing the investment. While outside ratings of the investment should be part of the review, those ratings should by no means be the sole decision driver. Investment professionals' reliance on credit ratings is another example of the systemic nature of the current crisis and the interconnectedness of market participants.
One of the most important factors in matching appropriateness and suitability of an investment with a client’s circumstances is measurement of the client’s tolerance for risk. The investment professional must consider the possibilities of rapidly changing investment environments and their likelihood to impact a client’s holdings ― both individual securities and the collective portfolio. The risk of many investment strategies can and should be analyzed and quantified in advance.
The use of synthetic investment vehicles and derivative investment products has introduced particular risk issues to the process. Investment professionals should pay careful attention to the leverage often inherent in such products when considering them for clients. Leverage and limited liquidity ― depending on the degree to which they are hedged ― bear directly on the suitability for a given client.
Q. Are the individuals who played a part in the market collapse guilty of misconduct?
A. While certain investment professionals may have exercised poor judgment in creating, evaluating, or investing in these credit-related securities, it remains to be seen whether any of their actions rose to the level of unethical or unprofessional conduct. Though there may have been potential breaches of the CFA Institute Code and Standards in more than one area, individuals must look in the mirror and judge their own conduct. It is insufficient to fall back on the general view that this was a “train wreck” and we are all victims.
The CFA Institute Code and Standards establish, among other fundamental ethical principles, high expectations for due diligence, investment with a reasonable basis, suitability of investments, and prohibitions against misrepresentation. These are the core values and principles that CFA Institute stands for. CFA Institute will investigate where it has specific knowledge of misconduct by individual CFA Institute members or CFA Program candidates who failed to meet the high standards of conduct established by the Code and Standards. But, at the end of the day, good judgment plays a critical role in a successful investment decision-making process and no code of ethics can ensure that investment professionals universally make the correct decisions at all times.
Q. Does the crisis illustrate the failure of self-imposed codes of ethics and standards of professional conduct and point out the need for more governmental intervention and oversight?
A. No, quite the contrary. This crisis vividly demonstrates why there is an ongoing need to develop a strong culture of ethics in the financial industry. As the markets continue to evolve into a global network, it is vital that all investment professionals feel ethically responsible for the integrity of the capital markets. Small lapses of this responsibility by many can bring these markets to severe crisis. Only with a strong, systematic emphasis on professional conduct on an institution-wide basis can individual behavior be effectively changed.
CFA charterholders should and do understand the importance of — and maintain a commitment to — ethics and integrity. But the current crisis serves as a resounding wake-up call to investment professionals, and to CFA charterholders in particular, not to take the markets for granted. The current turmoil reminds us all that we owe an obligation of duty to do right by the investors who place their trust in us. For this reason, investors have all the more reason to look for investment managers who hold a CFA charter and a commitment to comply with the Code and Standards.
Reactionary regulatory action can hinder market efficiency and cannot, by itself, protect investors from future turmoil. To protect against future market crisis, regulation must be coupled with a strong culture of ethics adopted by individuals and firms aimed at protecting both the client and the integrity of the marketplace as a whole. Investment firms and industry groups have a responsibility to continuously train professionals for, and promote adherence to, strong ethical codes and professional standards that help maintain the integrity of the capital markets.
The CFA Institute Code and Standards is not just a document that one learns to pass the CFA exam. Rather, the Code and Standards can and should provide everyday guidance in the investment world. Close adherence to the Code could have helped all investment professionals avoid many of the conflicts that appear to have led to or exacerbated the current financial crisis.
Q. How can we present this situation to our clients?
A. In addressing the situation with clients, honest and forthright communication is critical. We should not skirt the issues. It is important to point out the failures as well as ways to improve the system. While we cannot remove the risks of a recurrence, we can stress the importance of effective regulation, adoption and adherence to codes of ethics, and training and education of investment professionals. We can also talk about the importance of institutions like CFA Institute and the CFA Institute Centre for Financial Market Integrity. CFA charterholders, their employers, and their clients know that CFA Institute expects them to unconditionally follow the fundamental ethical principles and high standards of professional conduct embodied in the Code and Standards.