What is the difference between making a bad business decision associated with derivatives and engaging in unethical conduct using derivatives?
The 2008–2009 global recession was caused in part by a failure of the financial industry to take appropriate responsibility for its decision to utilize risky and complex financial instruments. Corporate cultures were built on rewards for taking risks rather than rewards for creating value for stakeholders. Unfortunately, most stakeholders, including the public, regulators, and the mass media, do not always understand the nature of the financial risks taken on by banks and other institutions to generate profits.
Problems in the subprime mortgage markets sounded the alarm in the 2008–2009 economic downturn. Very simply, the subprime market was created by making loans to people who normally would not qualify based on their credit ratings. The debt from these loans was often repackaged and sold to other financial institutions in order to take it off lenders’ books and reduce their exposure. When the real estate market became overheated, many people were no longer able to make the payments on their variable rate mortgages.
When consumers began to default on payments, prices in the housing market dropped and the values of credit default swaps (the repackaged mortgage debt, also known as CDSs) lost significant value. The opposite was supposed to happen. CDSs were sold as a method of insuring against loss. These derivatives, investors were told, would act as an insurance policy to reduce the risk of loss. Unfortunately, losses in the financial industry were so widespread that even the derivative contracts that had been written to cover losses from unpaid subprime mortgages could not be covered by the financial institutions that had written these derivatives contracts. The financial industry and managers at all levels had become focused on the rewards for these transactions without concerns about how their actions could potentially damage others.
In addition to providing a simplified definition of what derivatives are, this case allows for a review of questionable, often unethical or illegal, conduct associated with a number of respected banks in the 2008–2009 financial crisis. First, we review the financial terminology associated with derivatives, as they were an integral part of the downfall of these financial institutions. Derivatives were, and still are, considered a legal and ethical financial instrument when used properly, but they inherently hold a lot of potential for mishandling. When misused, they provide a ripe opportunity for misconduct. To illustrate the types of misconduct that can result, this case employs a number of examples. First, we examine Barings Bank, which ceased to exist because of a rogue trader using derivatives. Next, we look at United Bank of Switzerland (UBS) and its huge losses from bad mortgages and derivatives. Bear Stearns, an investment bank that suffered its demise through derivatives abuse, is the third example. Finally, Lehman Brothers is an investment bank that was involved with high-risk derivatives that also led to its bankruptcy. At the conclusion of this case, we examine the risk of derivatives and potential ethical risks associated with the use of these instruments in the financial industry.