Inequality and Conflict of Interest in Evaluation

September 8, 2014 Inequality and Conflict of Interest in Evaluation

Ernest R. House

In recent decades, conflict of interest in evaluation has increased in pharmaceutical evaluation, social and education evaluation, and financial evaluation. In addition to producing incorrect findings, conflict of interest has also increased inequality. My focus is on how conflict of interest in finance evaluation increased economic inequality. First, how is conflict of interest manifested in finance evaluation? Second, how did this play out in the financial crisis? Third, what were the effects on inequality?

Conflict of Interest in the Great Financial Crisis

The financial event of our time has been the collapse of the financial markets in 2008, the worse economic crisis since the 1930s. Conflict of interest in evaluation was a contributing factor. In the old days when you wanted a mortgage to buy a house, you went to your local banker, who evaluated your credit worthiness, issued a mortgage, and held the mortgage for 20 years. If the loan went bad, the lender suffered a loss. Ensuring that you could handle the loan was in the lender’s interest. It was important to evaluate mortgage applicants honestly.

In the new mortgage system, the lender did not keep the loan but sold it to others, who sold it to others. The maximum profit for the lender was in making loans and passing them on quickly. Not being stuck with mortgages long-term, lenders had few incentives to carefully assess the borrower’s reliability. In fact, the incentives worked against careful evaluation. Mortgage quality deteriorated into “liar” and NINJA loans--borrowers with no income, no job, and no assets who lied to obtain mortgages.

Shortly after the crisis in 2009, I talked to a mortgage lender in Chicago. When asked why these highly questionable practices were followed, he said, “Among my thirty sales people, I had a young woman in her twenties who had no previous experience with mortgages. The first year she made a million dollars. The second year, she made more.” The young woman had no incentive to care about the borrowers or those buying the mortgages. Nor did her boss. Both made large sums of money by ignoring or bending the criteria for evaluating applicants. Lenders were rewarded for the quantity of loans, not the quality.

But who would buy such risky mortgages? Investment bankers packaged the loans with traditional mortgages and developed quantitative models showing the probability of the loans failing together was very low. Why were the bankers promoting such risky securities? Their bonuses were enormous. If the securities failed later, there was no penalty for them. What did they care what happened to investors?

The bankers took these packages of securities, called CDOs (collective debt obligations) to the bond rating agencies. The professional bond raters realized there were serious problems, but the rating agencies had their own conflicts of interest. If they gave these securities bad ratings, the bankers would take their business elsewhere. Plus, the rating agencies ran lucrative consulting contracts on the side with these same banks. They might lose their consulting business. In the end, the rating agencies awarded many securities triple “A” ratings, falsely assuring investors, such as pension funds and municipalities all over the world.

The financial debacle that ensued would have been limited except for another innovation called a credit default swap (CDS). These are derivatives that offer insurance against collective debt obligations failing. The swaps are not called insurance because if they were, they would have to be regulated, and insurers would have to offer proof that they could cover their obligations. These derivatives are not regulated. The banks held many “toxic” securities until they could unload them. AIG, the giant insurance company, said it would sell credit default swaps to insure the CDOs. A London branch of AIG sold billions of dollars of swaps with no way of backing its obligations.

Some Wall Street banks went a step beyond. Hedge fund manager John Paulson asked Goldman Sachs to create special packages of CDOs that were highly likely to fail. Goldman Sachs put together such suspect packages and sold them to their own clients, telling their clients these securities were high quality. Paulson and Goldman Sachs bought credit default swaps against the securities. Other banks and hedge funds did the same. When all this came tumbling down, hedge fund manager Paulson personally made two billion dollars. AIG went bankrupt.

While this was happening, where were the government agencies that were supposed to protect the public? Alan Greenspan headed the Federal Reserve when the housing bubble began. There was strong criticism of subprime mortgages, and the Federal Reserve had the authority to stop these practices. However, Greenspan believed that markets were self-correcting. In his view, bankers would not engage in activities that were damaging because they were too prudent. After the crash, Greenspan said that his belief about self-correcting markets had been wrong, though he denied that the Federal Reserve was responsible in any way. Ten years earlier, when the Wall Street banks had lobbied the government to repeal the Glass-Steagall act during Clinton’s administration, Greenspan had been in favor of repeal and of allowing banks to increase their debt leverage to 40 to one. The Glass-Steagall Act had been passed in the 1930s to prevent banks from engaging in highly speculative activities. Clinton’s Treasury Secretary Robert Rubin, who came from Goldman Sachs, championed this deregulation inside the administration. The Clinton finance team, including Laurence Summers and Timothy Geithner, protégés of Rubin, effectively prevented the regulation of derivatives. Banks make ten times the money on unregulated derivatives as on regulated ones.

When the crash came, AIG, the seller of the swaps, could not afford to pay the banks and hedge funds. The insurer had seriously miscalculated. Normally, when a firm goes bankrupt, its creditors receive a fraction of the money owed them. In this case, the US Treasury and the New York Federal Reserve came to the rescue. They took the highly unusual step of bailing out AIG’s debts and paying 100 percent of what AIG owed to the banks and hedge funds, though the government had no obligation to do so. At the time, the Treasury Secretary was Henry Paulson, former head of Goldman Sachs, and the head of the New York Federal Reserve was Timothy Geithner, Rubin’s protégé. By this time, Rubin was chair of Citibank, which was in trouble. This bailout cost taxpayers $180 billion dollars.

In summary, conflict of interest led to biased evaluations at several levels of the finance system and contributed significantly to the crisis. Of the ten or so evaluative and quasi-evaluative judgments embedded in these transactions, at least eight were seriously biased. For example, the woman evaluating mortgage applicants, her boss evaluating her performance, the quantitative models assessing CDO risks, the ratings of the mortgage securities, defective government regulation, the evaluation of policy changes, AIG’s assessment of credit default risks, and so on.

How Inequality Resulted

How did these activities increase inequality? First, there was a huge run-up in household debt. People who could not afford to buy houses had lenders knocking on their doors offering mortgages that did not require documentation. Many purchased houses. As prices increased, homeowners borrowed more against the equity in their homes. House prices and debt increased.

Meanwhile, the companies peddling the mortgages sold the questionable loans to the big banks. The banks disguised the loans inside complex bundles of securities and sold them as quality investments. When borrowers began defaulting, house prices dropped, and many homeowners owed more than their house was worth. Banks seized the properties and sold them at cut-rate prices, driving house prices even lower. As prices dropped, people around the country cut back their spending. Consumer demand fell precipitously, and businesses discharged millions of workers.

How were these losses distributed? Two economists, Mian and Sufi, compared what happened to the bottom 20% of homeowners in net wealth to the top 20%. Low net worth homeowners suffered most. They were most dependent on borrowing to purchase homes. They were highly leveraged with debt averaging 80% of their net worth. Their wealth was almost entirely in their homes. By contrast, the wealthiest 20% of homeowners were leveraged to only 7% of their net worth. Their wealth was mostly in non-housing assets.

For example, imagine a homeowner saving $20,000 to purchase a house for $100,000. After the purchase, the homeowner would have $20,000 in equity. Then house prices drop 30%. Now the house would be worth only $70,000. The homeowner’s equity is wiped out entirely, and the homeowner still owes $80,000, more than the property’s worth. The net worth of the wealthy (top 20%) homeowners also dropped, but their loss was a small percentage of their total wealth (about 8%). Meanwhile, bond prices increased 30% between 2007 and 2012, but only the wealthy owned bonds.

With house prices falling, people throughout the country hoarded their money. Consumer demand dropped sharply, resulting in massive job losses. Job losses in the stricken areas were worse, but job losses spread to areas that did not suffer housing declines. For example, 25% of the autoworkers in Tennessee lost their jobs, though there was no housing boom or bust in that state.

Consequences for Inequality

How much did these events contribute to inequality?

• The median household wealth in the U. S. was $87,992 in 2003. By 2013, it had declined to $56,335, a loss of 36%. Much of this loss was in home value. The worth of those at the 95th percentile in net worth increased by 14% during this ten year period.
• The net worth of the least wealthy homeowners went from $30,000 to near zero between 2007 and 2010, (Mian and Sufi, 2014).
• African Americans lost 53 percent of their net worth, Hispanics lost 66 percent of their worth, and whites lost 16 percent of theirs between 2005 and 2009. That left the average African American family with a net worth of $5677, one-twentieth the wealth of the average white family.
• Before the recession, wealth inequality in the U. S. was severe. In 2007, the wealthiest 10% owned 71% of wealth. By 2010, the wealthiest 10% owned 74%, a significant increase.
• The U. S. gross domestic product fell 4.7%, the worst economic period in 70 years.
• From 1984 to 2009, the U. S. did not have a single month in which unemployment reached 8%. In the crisis, the U. S. lost 8.8 million jobs, with 10 percent unemployed. For seven years, there was zero job growth.
• One key indicator of economic distress is the percentage of long-term unemployed. From 1948 to 2007, the U. S. never had a long-term unemployment rate that reached 13%. By April 2010, the percentage of long-term unemployed was 45% of total unemployment, a figure not seen since the 1930s.
• By 2014 the labor participation rate, the percentage of workers employed, dropped to 62.8%, a 35-year low.
• During the 1930s, the Roosevelt administration saved many homes through government help. Many experts thought the government should help this time. However, Henry Paulson in the Bush administration and Timothy Geithner and Laurence Summers in the Obama administration did not think that helping homeowners was worth a major effort. They spent far more bailing out banks rather than helping homeowners. About 75% of the allocated money was spent on the banks versus 2% on homeowners.
• Following the savings and loan scandal in the 1980s, a much smaller crisis, 1100 people went to jail for fraud. Following this last crisis, which by most accounts involved fraud on a massive scale, one middle-level person went to jail. Obama and his officials decided not to prosecute the bankers and others responsible because that might upset the financial system. Recently, the government did levy some substantial civil fines.

In summary, millions of people incurred large debts and lost their homes and jobs. What caused the debacle? Primarily the actions of the banks and private mortgage companies. Who lost the most? Those at the bottom of the economic structure. Who gained the most? The executives at the banks, mortgage companies, and some hedge funds. When banks were caught in the downdraft, the government bailed them out. The government did not bail out homeowners.

From the perspective of evaluation, privatizing and deregulating the housing market led indirectly to the corruption of the evaluation and quasi-evaluation processes in finance, as manifested in low documentation loans, deceptive securitizing, incorrect security ratings, and so on. Only after these evaluative processes were compromised did the boom and bust occur. The defective evaluation activities were not the primary cause of the debacle, but they were significant contributing factors. Those at the top of the wealth hierarchy gained, while those at the bottom lost significantly, thus increasing economic inequality.