Subject Code: MGMT10002 Student ID Number: 569082 Tutorial Day/Time: Wednesday/9:00 am Assignment Name or Number: Essay 2 GFC Analysis

Subject Name: Managing and Leading Organisations Student Name: Joycelyn Vanecia Utomo Tutor Name: Austin Chia

On September 2008, the bankruptcy of the fourth largest investment bank, Lehman Brothers, led to a series of systemic risks and triggered the Global Financial Crisis (GFC), resulting in a recession worst that the Great Depression in 1930s (Enderle, 2009). According to economists, the main cause of the GFC could be stemmed back to the unethical practices conducted by different members of large financial institutions, let alone contributions the US government made through their decisions. Ethics can be defined as the moral principles that provide a sense of right and wrong for an individual (Robbins, 2012).

The aim of this essay is to argue how poor ethical practices by financial service industries and the US government led to the GFC, as well as examining its linkages with other managerial theories. The paper will be structured into three major components in chronological order; it will begin by exploring the conditions of the external market that created opportunities for the creation of toxic financial instruments, then evaluate the response taken by the financial services towards these temptations, and finally discuss the aftermath of the crisis which includes the inadequate actions by government and consequences of the crisis to the global economy.

OPPORTUNITY-FILLED ENVIRONMENT The toxic products that were created by investment banks in Wall Street is said to be the root cause of the GFC (Enderle, 2010). Nevertheless, the idea of creating these goods itself first came through opportunities in the external environment. These changes happening in the market can be further analyzed by the External Environment Framework that refers to the set of forces or conditions outside the organisation in which an organisation operates within, impacting the ability of managers to identify opportunities

and threats and respond to them accordingly (Robbins, 2012). The outermost layer of is the General Environment, which includes forces such as political, economical, sociocultural, and technological just to name a few that has potentials to indirectly influence its operations and performance over time (Samson & Daft, 2012, 88).

The role of politics in causing the GFC is of utmost importance. After the Great Depression, the Glass-Steagel-Act was put forth to function as a separator of commercial and investment bank activities, preventing risky investments with depositors money that once caused the savings and loans crisis in the past (Michello & Deme, 2012, 105-107). However in 1999, the bill was abolished, thus starting a period of deregulation (Ferguson, 2009). Insufficient government control not only created a free market where industries could constantly innovate with dangerous financial instruments, but also legal-loopholes, meaning that without solid ethical base, although an organisations practice is legal, it may be unethical.

Despite the fact that Wall Street is notorious for participating in sophisticated criminal activities when given the opportunity to do so, petitions by regulators were continually condemned since the industries were backed with large lobby groups and academics that have the power and resources to influence policy-making (Bernstein & Eisinger, 2010). Lobbying is the effort to influence government into adjusting policies to benefit the organisations operations, in exchange with monetary support, such as campaign funds (Greycourt, 2008). When governments succumbs into these temptations over its risks towards the nation, it conveys that they decided with Individualist-Approach, an ethical concept of contending to promote an individuals best long-term interest (Samson & Daft, 2012, 177). In fact, financial lobby groups spent $170 million for the 2008 election, the year the crisis happened (Gonglof, 2012). Lobbying also managed to influence the

Securities and Exchange Commissions (SEC) who were supposed to manage risks to relax leverage limits for investment banks up to 30:1, thus allowing them to borrow heavily (McKenna, 2009). As Gnaizda stated, its a Wall Street Government! (Ferguson, 2010).

In the US, there is a shared socio-cultural norm on the importance of home-ownership, the American Dream (Ferguson, 2010). Owning a piece of real estate symbolizes success in their culture, and politicians have unethically placed pressures and encouraged even citizens who are less credit worthy with home ownership, by having Government Sponsored Entities (GSE) to make housing more affordable, in order to gain campaign support. This is believed to have contributed significantly to the housing bubble, the rapid growth of home prices (Greycourt, 2008). America also had a stable economic condition, with low unemployment rate, and to recover from the collapse of the dot-com crisis, the Federal Reserve (Central Bank) lowered interest rate to 1%, which in turn encouraged banks to borrow excessively (Petrova, 2009).

On the other hand, Task Environments are forces like competitors and customers that directly impacts daily operations and overall performances of an organisations. It is impossible for an industry to ignore these factors as it determines its success (Samson & Daft, 2012). Financial services in Wall Street are known for being highly competitive since they were sharing and fighting for the same market share (Schecter, 2010). This puts pressures on banks to stay agile and forces constant changes in order to keep up with the pace of its competitors (Rajan, 2009). In an environment that is performance-based, the big banks developed a High-Achievement Culture, a culture concerned with resultorientation; valuing competitiveness, aggressiveness, personal initiatives, and encourages risk-taking to an extreme level that generates improved performances (Samson & Daft, 2012, 115). This type of culture is fueled with rewards, and in the case of the financial

industries, the amount of bonus received by an employee is determined by the profit they bring into the organisation. Furthermore, deregulated market intensified the competition with wrongful product innovation (Olson, 2012).

Continual changes with customer trends also shaped the products and services the industries offered (Samson & Daft, 2012, 89). In this case, customers refer to homeowners, investors, and shareholders. In addition to the increase demand for affordable housing, the ageing population also provided large amount of retirement funds available for investments, both of which would later impact the choice of market the financial industries decided on entering. International investors were also brought together through the exploding use of complex, unregulated financial products known as derivatives (Rajan, 2009).

TURNING OPPORTUNITIES TO PROFIT A market with less government interventions, low interest rates, and high leverage provided industries with the opportunity to take risks and create better financial products in terms of its profitability. And rapid growth in housing prices attracted the various organisations into the real estate market. These merely provided opportunities, what the industries did in respond to these factors came down to their corporate ethics. Before exploring the concept further, it is necessary to first understand the nature of these financial instruments and Securitization system developed by the institutions.

Traditionally, when homeowners pays monthly mortgages, money went to their local lenders, who were careful regarding the credit-worthiness of borrowers since mortgages usually took decades to repay (Ferguson, 2010). With securitization, lenders sold

mortgages to investment banks that combines these mortgages with many others including credit card debts and student loans into complex derivatives known as Collateralized Debt Obligations (CDO), which are sold to investors (Kirk, 2009). CDOs are structured financial vehicles that are issued to tranches with varying credit risks and return profiles. In order to compensate for higher risks, the riskiest parts with subprime loans had higher interest rates, thus yielding more in return (Adams, 2008, 12-14). Investment banks then pays Credit Rating Agencies (CRA) to evaluate CDOs, and most of them, even those consisting subprimes, were given an AAA rating, the safest government securities possible, making it popular with retirement funds that were only made sound investments (Davidson, 2010).

As CDOs became popular in early 2000s, this signals lenders to pump up volume of loans to obtain more mortgages. This was achieved through easy lending, where most loans were given to borrowers with poor creditworthiness and insufficient documentations, and not surprisingly, would default. These mortgages had misleading terms that after several months would alter teaser rates and increase payments drastically. By 2006, the amount of subprimes funds issued worth $600 billion (Ferguson, 2010). With this new system, default imposed no risk to any party, since lenders could retain houses back if it goes to default then sell it off quickly to the hot market. Investment bankers did not care either, the more CDOs sold, the higher their year-end bonuses. And if valuation by rating agencies proved wrong, there were no liabilities against them since these were based on opinions (Monjonnier, 2012)(Rajan, 2009).

AIG, the largest insurance company, produced another dangerous derivative, the Credit Default Swap (CDS). With CDS, owners, and even speculators could insure CDOs, and if it fails, AIG promised to cover its losses. This is an extreme risky gamble since the degree

of loss would become proportionately higher. When the housing bubble later inflated, the banks began betting against the failure of CDOs with CDS, including the ones they issued themselves, without consulting this information with their investors (Petrova, 2009). This proves that the industries were aware of the threats they were imposing to the stakeholders and community. The organisations were unable to manage transparency, the degree which an organisation shares information with its stakeholder public. While operating in secret, and not acting with the best interest of their clients and shareholders, organisations are clearly defying trust (Robbins, 2012).

Although drawing in large profits during the bubble, what securitization does is pass on the risk of default from one part of the chain to the next, and employees were rewarded with large bonuses based on these short-term revenue (Bencivega, 2009). The large financial industries had a mentality of being too-big-to-fail, meaning that if there were threats in their business, the government will eventually have no choice but to bail them out, and there will be no legal charges since legal-loopholes existed through deregulation (Rajan, 2009). In fact, those who will pay the largest price if there were a failure in the market would be borrowers and investors (Ferguson, 2010).

These business practices were legal, however, when industries are able to predict the potential harm and refused to change its way, it question their ethics. Unethical behaviors occur when decisions enable the organisation to gain at the expense of society. Decisionmaking and Business Ethics coexist, dealing with internal values that are part of corporate culture and shapes decisions concerning social responsibility with respect to the external environment. These internal values of the environment consist of three key aspects employees, management, and culture (Samson & Daft, 2012, 88&175). Corporate culture

refers to the set of values and beliefs that strongly influence employee behavior and management (Weber, 1995).

An organisation with an ethical culture are one that adopts strong Corporate Social Responsibility (CSR), which can be defined as the obligations to make choices and actions that will contribute to the welfare and interests of not only the company itself, but also the organisation. In the CSR pyramid framework, there are four main responsibilities an organisation must be mindful of from the most significant to the least; economic, legal, ethical, and voluntary (Samson & Daft, 2012, 183&191). Nevertheless, the series of decisions taken by the various financial industries interprets that their only goal was profit maximizing. Just as discussed of their high-achieving culture, the large incentive system that were based on performances corrupted ethical decision making within the companies. Between 2003-2011, Wall Street paid out $200 billion on bonuses alone, and those benefiting from this privilege are only those seated on the top management positions (Gonglof, 2012). Studies by Sucharow showed that majority of Wall-Streeters believed unethical behavior helps promote their success, and compensation structures created temptations in compromising their ethical standards and even violate laws if they could get away with it, which is exactly what legal-loopholes made possible (Alden, 2012).

Codes of ethics in cultures are shaped through Leaders (senior managements and CEOs) since they act as a role model or organisational heroes that inspire the company, standardising practices and behaviors that are acceptable and intolerable. However, when leaders send out the wrong message to employees like rewarding unethical acts this signals that these behaviors are cheered on. Studies showed that despite displaying Charismatic Leadership leading with energy and eagerness to employees, and are well liked and inspiring, senior managers in Wall Street are ego-driven, acting at their best

interest of personal greed, willing to take unethical risk in order to pursuit financial rewards, and to the extent of manipulating their stakeholders (Boddy, 2011)(Samson & Daft, 2012,192). The main sources of powers these leaders possess of are rewarding, which is punishing and control, and referent, being admired that it inspires loyalty (Samson & Daft, 2012, 193-194). Nevertheless, these powers would not have manifested since the only power leaders have over employees are determined by the power workers return to them. Therefore, it could be said that the culture encouraged each members involved being willing accomplices. As the industries went out of control from dangerous incentives, it did not take long for them to destroy their own organisation from the inside.

THE CRISIS AND AFTERMATH As unregulated derivatives and subprimes practices became excessive, default rates increased and borrowers were facing foreclosure. By 2007, the bubble crashed and the real values of CDOs filled with subprimes were being exposed. The investment banks had too many of these toxic assets they were unable to sell and began running out of cash. By mid-2008, the industries began to drop in stock prices because consumer started loosing confidence in the market, and Bear Stearns and the GSEs were the first to hit turbulence (Jones, 2012).

This came as a shock to the Federal Reserve, as they were unprepared and had no Contingency Planning, which is defined as an organisation plan for response to emergency and unexpected conditions. Despite numerous warnings regarding the danger of financial practices during the bubble, the government did not plan in advance, which would have aided their decision-makings. The government was aware that the failures of Bear and the GSEs would cause a domino effect on the banking system. However, if they

were to be bailed, it would cost taxpayers money, raising ethical concern on the banks being rescued for their own wrongdoings (Donaldson, 2012). This caused an ethical dilemma for the government, meaning both alternative choices are undesirable because of negative ethical consequences (Samson & Daft, 2012, 176).

The government took the Utilitarian approach, an ethical concept that the decision produces greatest good for the greatest number of people (Samson & Daft, 2012, 177). Bear was forced into being acquired, backed with $30 billion of taxpayers money to heal their balance sheet. Before even recovering from bailout exhaustion, Lehman also started fluctuating, but was allowed to fail in order to punish the banks (Williams, 2008). This was based on the Justice Approach that decisions must be based on standards of equity and fairness (Samson & Daft, 2012, 178). Nevertheless, lack of contingency planning and situational leadership backfired, causing a systemic risk. If the government were more prepared, they would have predicted that failure of Lehman would stop interbank lending and freeze the market, leading to the collapse of AIG who had issued numerous CDS insuring Lehmans CDOs, causing more bailouts, totaling $700 billion in 2008, nevertheless too late too overturn the crisis (Donaldson, 2012).

In result, the global economy became destabalised as unemployment rose. As consumers lost their buying power, many industries went out of business. This reached a global scale since the banks operated in several countries, and foreigners who invested on CDOs also experienced the market failure. In the end, only the senior managements and CEOs of the big banks were able to escape the crisis, keeping the bonuses they earned throughout the years (Donaldson, 2012).

THE BLAME GAME

The securitization chain and poor government decisions led to the worst recession in history, and this questions who is to be blamed: the government, subprime lenders, investment banks, or CRA? Notwithstanding, they were all willing accomplices, where if one had made the choice to change their ways, it would have stopped the flow of funding into the system immediately, but profit was apparently above people.

In conclusion, this essay has explored the GFC, from the external environment that created opportunities for financial service industries, the corrupted internal environment the various institutions displayed, and poor planning and ethical dilemmas by the government. Although some argued that these doings are ethical since investors and home buyers must be responsible for their business decisions, the fact that the industries and their monopoly over government has placed millions in foreclosure, unemployment, and wrecked the global economy, proves that the crisis was indeed a crisis of ethics.

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