CONTENTS Preface CHAPTER CHAPTER CHAPTER CHAPTER CHAPTER Finance, Arbitrage, and Ethics The Evolution of Modern Finance Arbitrage in Action Ethics and Finance Ethics in Action Into the Gray CHAPTER CHAPTER CHAPTER CHAPTER Arbitrage and Deception Arbitraging Regulatory and Market Structures Arbitraging the Complexity Arbitraging the Rules Revisited Out of the Fog CHAPTER 10 Recognizing the Boundaries CHAPTER 11 The Ethical Limits of Arbitrage Notes Index PREFACE THE IMPETUS FOR this book came at a breakfast meeting I had with an acquaintance a little over three years ago My breakfast companion was a very accomplished practitioner who had been asked to teach a short college course on finance He wanted advice on teaching materials that incorporated ethics in teaching basic financial concepts My response was that finance wasn’t taught that way—that net present value, option pricing, arbitrage, and the like are tools and that we teach students how to use them analytically He wondered whether if we taught that way students ever learn (or even ask) about when it was appropriate to use these tools I had no particularly good answer Since then I have incorporated more focus on ethical issues in finance in my own classes Of course, events in the financial crisis and its aftermath also made the need to so more pressing These classroom discussions highlighted for me both the complexity of these ethical issues and the importance of trying to focus not only on how to things but also on when to them Perhaps more important, I realized we needed to spend even more time on the why we them—and on why finance can be used to make markets and society better-off I also think we need to have these discussions more broadly, not just in academic settings but in the public forum as well I decided to write this book because I think those issues are both interesting and important Modern finance is complicated, and even understanding how some of the more complex contracts work can be baffling to practitioners, let alone to students, regulators, journalists, and the public Sorting out the ethical dimensions can be more challenging still, in part because not everyone shares the same ethical perspective But even when there is general agreement on that front, those financerelated ethical issues often arise in the context of firms and markets, where the ethical dimensions become ever more opaque I found that even among my more finance-literate friends there was often strong disagreement about what does and does not “cross the line.” For those less well versed in finance, the answers were actually more uniform—whatever the financiers were doing was wrong! I hope this latter view is not correct, and in this book I have tried to take the reader on a journey toward sorting this out Certainly, I have enjoyed trying to put ethics and finance together, and puzzling through the various case studies made me appreciate just how challenging all this can be Perhaps some readers will share my views on where the lines are drawn, but I suspect there may be others who completely disagree What I hope is apparent to all is that ethics and finance cannot live in separate spheres—and that debate on these issues can only be to the good I know the importance of getting this right Unfortunately, I now have firsthand knowledge of what can happen when even one individual opts to cross the line and the repercussions it can have on a firm I currently serve on several corporate boards, and at the time of writing this manuscript was the chairman of the board of a global broker-dealer firm We found ourselves dealing with a Securities and Exchange Commission (SEC) investigation The particular issue, which led to a settlement with the SEC, involved what the board of directors believed was a limited pilot project that would be completely regulatory compliant and meet all required disclosures In fact, an outside review by an independent law firm concluded that, unbeknownst to the board of directors, clearly articulated company policies were violated That the violation happened five years ago and was shut down, that some in the firm did the right thing in catching and stopping the behavior, cannot undo the disappointment felt by the eleven hundred employees at the firm who always strived to put clients first We worked to rectify the situation, but it would have been far better if the behavior that caused this had never happened in the first place Many of the themes I develop here can be found in other work, and I freely admit to being influenced by a wide range of authors Some, such as Robert Shiller in his thoughtful book Finance and the Good Society, make the case for why finance can be a source for good Others, such as Raghuram Rajan and Luigi Zingales in their book Saving Capitalism from the Capitalists: Unleashing the Power of Financial Markets to Create Wealth and Spread Opportunity or Jonathan Macey in his book The Death of Corporate Reputation: How Integrity Has Been Destroyed on Wall Street, raise prescient warnings about emerging problems in capitalist systems Still others, such as the Economist magazine article “Greed—and Fear,” make the case for why finance has failed and why arbitrage played a role in that failure As will be apparent in the discussions throughout this book, a wonderful resource on ethical frameworks is the “Justice” course offered on edX by Michael Sandel (and his many related books and articles on the subject) John Bogle’s superb book Enough: True Measures of Money, Business, and Life should be required reading for all—particularly those who fear that greed is the only motivator on Wall Street I also greatly benefited from extensive discussions with a wide range of people I am very grateful to Jim Detert for his guidance on behavioral ethics, Michael Brennan and Joe Kaboski for their broad knowledge of ethics and philosophy, Brandon Becker and Jonathan Macey for insights on the many legal dimensions, David Easley for thoughtful discussions on economics, and Chidozie Ugwumba for valuable research assistance I also thank participants at the Lumen Christi conferences at the University of Chicago for spurring my interest in these general issues, and the many people who offered assistance or read earlier chapters, including Robert Battalio, William Christie, Abby Joseph Cohen, John Frishkopf, Robert Jarrow, Marcos Lopez de Prado, Hamid Mehran, Thomas Noone, Dana Radcliffe, Rafe Sagalyn, Jamie Selway, and Steve Strogatz Finally, I am particularly grateful to my two editors at Norton I consider myself very fortunate to have had the honor of working with Jack Repcheck, whose encouragement and excellent suggestions really made this project work His untimely death was a loss to so many, including this author I am obliged to Brendan Curry for stepping in to help with the final manuscript, and especially for his many thoughtful suggestions Both Brendan and I hope Jack would have been proud of this book SOMETHING FOR NOTHING CHAPTER FINANCE, ARBITRAGE, AND ETHICS IN 2001, GOLDMAN Sachs structured a complex financial contract so that its client, the government of Greece, would appear to have far less debt than it actually did This allowed Greece to satisfy the Maastricht guidelines on deficits and so meet the requirements for inclusion in the eurozone When news of this transaction came out in 2010 after the onset of the European sovereign debt crisis, uproar ensued Angela Merkel declared, “It is a scandal if it turns out that the same banks that brought us to the brink of the abyss helped to fake the statistics.” Business Week referred to Greece and Goldman as “two sinners.”1 Other observers pondered whether Greece (and Goldman) had used the tools of modern finance to deceive the market.2 Was this behavior ethical? The furor surrounding this case reflects a growing concern that modern finance is not good for society The view that sophisticated financial instruments enhance the overall performance of the economy has been replaced by the suspicion that finance diverts resources that would be better used elsewhere Joined to this are misgivings that finance has only served to enrich the few at the expense of the many The seemingly endless number of scandals at financial firms, combined with the perception that financial alchemy simply allows the already rich to steal from the unknowing, has solidified wariness into mistrust From Occupy Wall Street to the Economist magazine, the question raised is whether the golden age of finance has turned into the failure of finance There is a lot that is disquieting But I think the current blanket denunciations of finance miss the point The tools of finance are not the problem What is a problem is that some finance practitioners have lost sight of when it is appropriate to use those tools.3 Modern finance often involves arbitrage, or the use of financial tools to remove price differences for identical things trading in different markets At a simple level, arbitrage entails “buying low and selling high,” thereby forcing prices back into equilibrium At a more complex level, arbitrage uses financial tools to remove inefficiencies more generally, for example, by creating a less expensive way to borrow money than is possible with existing contracts The recent development of securitized solar energy bonds providing cheaper financing for renewable energy projects illustrates this broader application.4 When arbitrage is done right, it can lead to tremendous benefits to the economy, allowing resources to go to their best uses at essentially little or no cost (in effect, getting “something for nothing”) But these same financial tools can be used to exploit others, to take advantage of the complexity in modern markets to behave unethically When that happens, practitioners have missed the simple notion that “just because you can does not mean you should.” In short, the problem lies in the intersection of arbitrage and ethics That ethics plays a role in arbitrage activities may seem obvious to some people and incomprehensible to others Searching for a price discrepancy in a market, and then buying low and selling high is simply a strategy—it is not a moral judgment But, increasingly, it seems that practitioners may not even consider that some uses of arbitrage-based strategies are inappropriate, that there are limits on what is acceptable in markets and society short of what is simply illegal Being able to profit from arbitraging inefficiency is not ethical if it takes unfair advantage of others— as happened, for example, when JPMorgan Chase’s traders profited by taking advantage of the opacity and complexity of the California electricity market auction system to essentially get paid for not producing electricity! (We discuss the specifics of what they did in chapter 7.) But what exactly is “unfair”? We would all probably agree that exploiting the financially naïve (the proverbial widows and orphans) is not acceptable, but discerning this unfairness more generally in modern capital markets is far more complicated Decrying a lack of ethical culture misses the larger problem that exactly what is unethical is not readily apparent to a surprising number of people on Wall Street and on Main Street I believe we need to think more carefully about these issues—to recognize both that there are lines and where these lines might exist In this book, I make the case for why some arbitrage-based activities cross those lines By making it clearer how modern finance works, I hope to reduce the confusion surrounding financial activities, making it easier to appreciate both why modern finance can be used to make society better-off and why, if misused, it can have the opposite effect By suggesting some general ethical frameworks (as well as some behavioral pitfalls), I hope to provide a basis for recognizing ethical boundaries And, by examining a variety of recent financial scandals, I hope to illustrate when these lines were crossed I fully expect some (maybe all) readers will disagree with where I draw these lines, but thinking through this disagreement is exactly the introspection I hope to foster As Scott Adams so artfully described, we are venturing into the “weasel zone: the giant gray area between good moral behavior and outright criminality.”5 Before we can draw the lines between weasels and felons, between what is clever and what is simply exploitative, we must first understand how modern finance actually works For many people, this may be a surprise Modern finance is not so much about traditional financial contracts (stocks, bonds, mortgages, etc.) as about cash flows—the monies arising from these mortgage payments, interest payments, profits, or any other flow of funds These cash flows can be combined to create all sorts of financial products The resulting products are often complex, but the underlying process is akin to building with LEGO blocks—with the red and blue pieces assembling the dinosaur replaced by the March and September cash flows constructing the swap Arbitrage enters because the cash flows can be structured to create a new or “synthetic” set of financial arrangements, one that retains the desired properties of a traditional contract but achieves it by means of a different structure Arbitrage does the heavy lifting of making sure these new contracts are priced correctly relative to the original contract As I make clear in this book, the focus on cash flows and arbitrage brings the power to evaluate not only financial contracts that currently exist but also those contracts that could exist Modern finance ushered in the age of synthetic securities, and with it the ability to use finance innovatively to make borrowers and lenders alike better-off These same innovations, however, also give rise to the ethical challenges I consider in this book Some observers might wonder why these problems are arising now One theory is that banking is simply attracting the “wrong” kind of people—that the easy money available in structuring complex financial products is attracting “bad apples” who see nothing wrong in exploiting other people.6 Yet, others are less sure, arguing that “ethical problems in organizations originate not with ‘a few bad apples’ but with the ‘barrel makers’ ”—that is, with the management of the bank, or even with the nature of the financial system more generally.7 We discuss that issue in chapter in the context of Bank of America’s selling bad mortgage loans to unsuspecting buyers, but overall it seems hard to believe that ethical problems in banking are simply due to personnel issues Perhaps a more relevant question is what makes financial decision-making prone to overlook ethical dimensions? One reason may be that markets, which play an increasingly important role in the economy, can lead to a diminished sense of social responsibility—that the impersonality of market settings can lead participants to overlook moral consequences that would otherwise deter bad behavior A growing body of experimental economics research shows that considerations of “fairness,” for example, have little effect on market outcomes.8 Similarly, psychology research suggests that setting out issues in terms of money payoffs rather than nonmoney terms leads to more individualistic behavior A particularly intriguing study by the German behavioral researchers Armin Falk and Nora Szech provides troubling evidence of the influence of markets in the context of an experiment in which subjects decide between either saving the life of a mouse or receiving money.9 The mice in question are used in laboratory experiments, and mice no longer needed for such a purpose (i.e., excess mice) are killed Individuals were each first presented with a choice: option A, in which the participant receives 10 euros but a mouse is killed, or option B, in which a mouse is spared but the participant forgoes any money Individuals were then placed in a market setting and randomly assigned to be either a seller (who was given property rights to the mouse) or a buyer The buyer and seller then bargained in a continuous auction over killing a mouse for a total gain of 20 euros to be split between the two parties, or sparing the mouse for no gain The data show a disquieting difference in outcomes between the individual and the market cases In the individual decision case, 45.9 percent of participants were willing to kill the mouse for 10 euros; in the market setting, 72.2 percent of sellers were willing to so for prices below or equal to 10 euros Indeed, to get individuals to kill the mouse at the same high rate as in the market setting required a payment of 47.5 euros Do experiments with mice necessarily translate into more general settings involving people? Perhaps not, but the evidence here suggests that individuals making decisions in markets seem to put very different weights on moral dimensions than they in nonmarket settings The complexity of modern finance is also part of the problem What might have been obviously exploitative when contracts were simpler is now concealed by layers of cash flows transformed in ways that require complex calculations even to construct, let alone to value This makes it harder for the buyer (and sometimes the seller) to understand what is actually being traded Contributing to this problem is the fact that complex economic activity is now often delegated to agents who act at the behest of principals For example, the senior banker who interacts with the client is not the financial engineer who actually structures the products being delivered to the client Complexity can give rise to “indirect agency” problems in which the principal may feel more detached, and so less responsible, for any questionable ethical decisions made in the product design, while the agents may feel that “they are just following orders” and so are also not responsible for considering any ethical dimensions Aggravating this tendency are compensation contracts that focus the agent’s attention on the completion of specific, narrowly defined tasks For example, the financial engineer might be asked to “structure a contract that allows our client to bet against the housing market,” and he or she is rewarded for successfully completing that contract itself, not on the outcome of the entire project (we discuss that issue when we look at the SEC v Goldman Sachs case in chapter 6) The dispersion of decision-making across individuals can lead to no one’s taking responsibility for ethical outcomes.10 The impersonality of modern financial markets also obscures the fact that somewhere there is someone on the other side of the trade or deal Extensive research now demonstrates that the more detached the decision-maker is from the impact of an activity, the less real are the ethical dimensions.11 Thus, whereas in the “old days” the borrower and lender actually met, these days the borrower may be a homeowner in Las Vegas and the lender an insurance company in Norway, both of whom lack any real details about the other This impersonality, combined with the transactional nature of many activities in finance, surely works against incentives to build a reputation for fair dealing It can also work against building a culture of “doing the right thing” within a banking organization There is another problem: it is not always obvious what the “right” thing to actually is Winners and losers emerge naturally in markets So when things cross the line into the exploitative? The complexity and innovation of financial techniques can obscure the big picture for those actually working in the financial markets It can be equally difficult to discern for those outside the markets, particularly those not conversant in the mechanics of modern finance who may see only “greed” at work and not appreciate when and how finance can actually make everyone better-off And so our quest to sort out when the positive effects of finance generate “something for nothing,” or when those activities lead to the opposite outcome where financiers take the gains and society pays the cost To so, along the way some readers may have to learn about finance, some may have to learn about ethics, and we all have to figure out their intersection—a daunting and certainly ambitious task In the next chapter, I explain the role of cash flows in finance, what the concept of arbitrage means, and how removing inefficiencies can make markets better-off but not necessarily every individual within the market While these fundamentals underlie modern finance, I first show how the medieval contractus trinus and its more modern application in Islamic finance, the murabaha contract, are based on the same concept—create “new” securities that have the properties you want in a more user-friendly format (in these cases, create securities that essentially pay interest but not violate religious rules against doing so) I then explain the evolution of modern finance, focusing on three important steps: the concept of “homemade leverage,” the option pricing revolution, and the development of swaps I explain how modern finance allows you to transform the cash flows you have into the cash flows you need for the security that you want I also discuss why modern finance really is a step forward from the old “boring finance,” which seemingly limited the misdeeds of banks and Wall Street firms Chapter provides concrete examples of how this cash flow approach of modern finance works I show how to create mortgage-backed securities, structured loans, and synthetic corporate bonds These examples illustrate how arbitrage-based strategies work, and why winners and losers emerge as natural by-products This chapter is more technical, and readers new to finance may find it helpful 05/dutch-bankers-swear-to-god-as-trust-in-lenders-slumps-to-record 36 Justin Fox, “Time for Bankers to Start Swearing,” Bloomberg View, April 1, 2015, available at http://www.bloombergview.com/articles/2015-04-01/dutch-bankers-start-taking-an-oath-to-behave-better 37 Ibid 38 For perspectives on this, see David Brooks, “Becoming a Real Person,” New York Times, Sept 8, 2014, and Peter Steinfels, “Beliefs: The University’s Role in Instilling a Moral Code among Students? None Whatever, Some Argue,” ibid., June 19, 2004 39 See the complete oath at http://mbaoath.org/about/the-mba-oath/ 40 Luigi Zingales, “Does Finance Benefit Society?,” Journal of Finance, forthcoming Interestingly, these issues have a longer history in economics, where some have questioned whether studying economics makes people more selfish Robert Frank, for example, provides intriguing evidence that studying economics reduces cooperation and generosity See http://www.gnu.org/philosophy/economics_frank/frank.html For an informal review of this literature, see http://standupeconomist.com/are-economists-selfish-a-lit-review/ 41 William G Christie and Paul H Schultz, “Why Do NASDAQ Market Makers Avoid Odd-Eighth Quotes?,” Journal of Finance 49, no (1994): 1813–40; David Yermack, “Good Timing: CEO Stock Option Awards and Company News Announcements,” ibid., 52, no (1997): 449–76; and Luigi Guiso, Paola Sapienza, and Luigi Zingales, “The Value of Corporate Culture,” Journal of Financial Economics, forthcoming 42 Aristotle, Nicomachean Ethics, bk 2, chap 1, pp 1103a–1103b, cited in Sandel, What Money Can’t Buy, p 137 Chapter 11 A classic work in this area is Louis Kaplan, “Rules versus Standards: An Economic Analysis,” Duke Law Journal 42 (1992): 557– 629 A more recent discussion is Gideon Parchomovsky and Alex Stein, “Essay: Catalogs,” Columbia Law Review 115 (2015) Kathleen M Sullivan, “The Supreme Court 1991 Term: Foreword: The Justices of Rules and Standards,” Harvard Law Review 106, no 22 (Nov 1992): 17 I thank Thomas Noone for suggesting this point to me The CFA Institute’s Code of Ethics and Standards of Professional Conduct is one such example of a standards-based approach For a discussion of these normative issues, see chapter in Thomas Oberlechner, “The Psychology of Ethics in the Finance and Investment Industry,” CFA Institute, 2007, available at http://www.cfapubs.org/doi/pdf/10.2470/rf.v2007.n2.4697 An excellent resource on Islamic finance is Harris Irfan, Heaven’s Bankers (New York: Overlook Press, 2014) For a succinct discussion of sukuk contracts, see http://www.dummies.com/how-to/content/how-sukuk-islamic-bonds-differ-from-conventional-b.navId814096.html?print=true The Institute of Islamic Banking and Insurance estimates that 80–90 percent of financial operations of some Islamic banks are based on murabaha My discussion here draws from explanations available at http://www.islamic-banking.com/murabaha_sruling.aspx Technically, it is a bit more complicated The Institute of Islamic Banking and Insurance explains, “The whole of Murabaha transaction is to be completed in two stages In the first stage, the client requests the bank to undertake a Murabaha transaction and promises to buy the commodity specified by him, if the bank acquires the same commodity Of course, the promise is not a legal binding The client may go back on his promise and the bank risks the loss of the amount it has spent In the second stage, the client purchases the good acquired by the bank on a deferred payments basis and agrees to a payment schedule Another important requirement of Murabaha sale is that two sale contracts, one through which the bank acquires the commodity and the other through which it sells it to the client should be separate and real transactions.” For details, see Anjuli Davies, “Islamic Finance: Islamic Sukuk by Goldman Sachs Causes Debate,” Reuters, posted Feb 23, 2012, available at http://www.huffingtonpost.com/2012/02/23/refile-debate-rages-over-_n_1296351.html For a discussion of the 2014 Goldman sukuk, see “Goldman Sachs Plans Debut Sukuk Issue as Islamic Finance Goes Mainstream,” available at http://www.reuters.com/article/us-goldman-sukuk-idUSKBN0GZ1CM20140904, and “Goldman Sukuk Lures Mideast’s Top Fund Manager: Islamic Finance,” Bloomberg Business, Sept 8, 2014 INDEX Page numbers listed correspond to the print edition of this book You can use your device’s search function to locate particular terms in the text Abacus, 10, 92–99, 95, 196n ABN Amro bank, 176 ACA Management LLC, 96–97, 98, 99 accountability, see responsibility Adams, Scott, 4, 54 Adi Granth, 47 adjustable-rate mortgage (ARM) loans, 87 Adler, Felix, 60 AIG, 78 algorithms, 126, 127, 132–38, 181–82 Alt-A, 87, 195n aluminum: demand for, 119 price of, 123, 124 warranted, 118–19, 120, 198n, 199n aluminum market, 10, 102, 117–25, 167 merry-go-round operations in, 117–18, 119–20, 121, 122 American Finance Association, 178 Anarchy, State, and Utopia (Nozick), 59 Andre, Claire, 141–42 Anova, 140 Aquinas, Thomas, 64–65, 193n arbitrage, ix, 2–3, cash flows in, credit default swaps and, 41 deception and, 10, 77–78, 99, 147 ethics and, 3–4, 10, 11, 12, 46, 55, 62, 107, 117, 161–62, 180 expectation of gain as motivator of, 67 exploitation of rules and regulations through, 10, 11, 14–16, 101–25, 147, 183 financial scholarships and, 16 high-frequency markets and, 126–46 intermarket, 140–41 markets and, 26–27, 62, 101–25, 147 merry-go-round operations and, 117–18, 119–20, 121, 122 option pricing and, 19–22 perfect hedge and, 22 risk and, 27–28, 129 role and uses of, 26–28, 147 statistical, 10, 28, 127–31 technology and, 16, 103, 105–6, 126, 127–28, 132, 134, 139 workings of, 14 Aristotle, 54–55, 59, 61, 65, 99, 138, 141, 157, 179, 192n Arrow, Kenneth, 68–69 Athena Capital Research, 136–37 automation, 103 Bachelier, Louis, 20–21 Back to Methuselah (Shaw), 31 Bandura, Albert, 164 Bankers Trust, 43–44, 51, 68 banking, 90–91 in Netherlands, 175–77, 207n personnel issues in ethics of, banking oath, 175–77 Bank of America, 5, 166, 196n flawed mortgage-backed securities issued at, 10, 78, 84–92 Bank of England, 49, 73, 171 bankruptcy, 18 banks: deregulation of (1980s), 66 see also specific banks Bartholomew, John, 114 BATS Global Markets, 142 Bazerman, Max, 91, 156, 163, 165, 167, 170 Bear Energy LP, 109 Bear Stearns, 78, 79, 109, 195n Beautiful Mind, A (film), 194n behavioral ethics, 11 cognitive biases and, 91–92, 156, 163–71 “fear of god” and, 46–50 Belgium, 202n Benedict XVI, Pope, 49, 187n Bennis, Warren, 174 Bentham, Jeremy, 55, 83 Bernard L Madoff Investment Securities (BMIS), 102–6 Better Business Bureau, 58 biases, 162, 163–71 cognitive, 91–92, 156 incremental, 170 indirect blindness, 167 motivated blindess, 91–92, 165–66 omission, 99–100, 166–67, 205n outcomes and, 168–69 bid-cost recovery (BCR) payments, 113, 114 Black, Fisher, 19 Blackburn, Simon, 47 Black-Scholes model, 21–22 Bloomberg Business, 207n Bloomberg News, 121, 143, 154, 176 BNP Paribas, 167 Bogle, John, ix Bonaparte, Napoleon, 139, 168 British Banking Standards Review Council, 174 British Financial Services Authority, 136 Brownian motion, 189n Bruz, France, 150 Buffett, Warren, 65–66, 165 Business Week, Business Wire, 202n California electricity market, 10, 102, 107–17, 181–82 auction system in, 3, 110–16, 112 power plants in, 111 California Independent System Operator (CAISO), 107–16, 182 call options, 34–35, 37–38 CALPERS (California Public Employees Retirement System), 132 candor, 174–75 Canterbury, Archbishop of, 171 Capitalism and Freedom (Friedman), 63 capital structure, 17–18 Cardozo, Benjamin, 50 Caritas in Veritae (Pope Benedict XVI), 49 Carnegie-Mellon University, 17 Carney, Mark, 49, 73, 171, 175 Carr, Albert, 63–65 carrier pigeons, 139 Caruso, Eugene M., 163 cash flows, 4, 6, 9, 16, 17, 19, 20, 46, 116 fixed-rate mortgages and, 32 mortgage-backed securities and, 32–36, 85, 93 risk and, 42 securities and, 31–32 structured loans and, 36–39, 38 swaps and, 22–23, 24, 25, 36 synthetic corporate bonds and, 39–42 categorical duty, 57–58, 61 Catholic Church, 15–16, 15, 188n Charles Schwab, 104 Chatterjea, Arka, 21 Chemical Bank, 46 Chicago, Ill., 197n Chicago Board of Trade, 136 Christian, Michael S., 170 Christie, William, 179 Cincinnati Stock Exchange (CSE), 10, 102–7, 197n as first U.S electronic stock exchange, 103 Citicorp, 167 CNBC, 21 code of ethics, 53 cognitive biases, 91–92, 156 Cohan, William, 172 collateralized debt obligation (CDO), 31, 94, 95–96, 97, 99, 166, 196n synthetic, 94, 96 collateralized mortgage obligation (CMO), 35–36 Commodity Futures Trading Commission (CFTC), 73, 134–35, 137 Rule 375, 137 Rule 575, 73 compensation contracts, competitive equilibrium, 71 Confucianism, 47 Confucius, 51, 73 Congress, U.S., 52, 115, 144 consequences, 55, 57–58 unintended, 57 Constitution, U.S., 48 contingent claims, 19 contracts, 4, 6, 15–16, 20, 27, 118, 183–84 cash flows and, 39, 42–43 compensation, swaps and, 22–25 uncertainty and, 46, 48 contractus trinus, 15–16, 15, 184 corporations: ethics and, 62, 65–67 reputations and, 65–66 see also financial firms Coscia, Michael, 134–35, 138 Countrywide Financial, 10, 84, 85–90, 104, 166, 196n Hustle program, 92, 196n credit default swaps (CDS), 39, 42, 94, 95–96, 97 arbitrage and, 41 culture, ethical, 11–12, 59–61, 66–67, 171–79, 206n changing of, 173–74 currency swaps, 154, 155, 187n Dalai Lama XIV, 101 Death of Corporate Reputation, The: How Integrity Has Been Destroyed on Wall Street (Macey), ix, 43, 65 deception, arbitrage and, 10, 77–78, 99 decision making, dispersion, deficits: Maastricht guidelines on, 1, 153, 203n reduction of, 153–57 Deresiewicz, William, 177 derivatives, 148, 150–51, 155, 187n, 190n Detert, James, 164 Detroit, Mich., 119, 120 Deutsche Bank (DB), 44, 120, 148 Energy Trading, 120 Dexia, 148, 150 Dexia Group, 202n-3n Dilbert, 54 Direct Edge, 142 disclosure requirements, 52–53, 83, 89, 99 discrimination, 141–42, 145 reasonable, 145–46 Disneyland, 145 Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, 134, 135, 138, 182, 200n “Does Finance Benefit Society?” (Zingales), 178 Dudley, William, 171–72, 174 Dutch Banking Association, 175–76 Economist, ix, 52 Edelman global ranking of trust, 12 EDGAR system (Electronic Data Gathering, Analysis and Retrieval System), 144, 145 Edison, Thomas, 139 edX, ix Einstein, Albert, 45 electricity, 108 production of, 109–10 electricity market, 108–9, 108 operators of, 109 see also California Electricity Market El-Gamal, Mahmoud, 48 Energy Act of 2005, 115–16 Enough: True Measures of Money, Business, and Life (Bogle), ix Enron, 115 Epley, Nicholas, 163 Ernst & Young, 83, 195n “Ethical Breakdowns” (Bazerman and Tenbrunsel), 91–92 Ethical Culture movement, 59–60, 141 ethical perception, 163–64 ethics, 9–11, 45–61 arbitrage and, 3–4, 11, 12, 46, 55, 62, 107, 117, 161–62, 180 behavioral, 11 cognitive biases and, 91–92, 156 consequences and, 55, 57 corporations and, 62, 65 culture and, 11–12, 59–61, 66–67, 171–79, 206n disclosure requirements, 52–53 fairness linked to, 61, 73, 74 high-frequency markets and, 126–46 incentives and, 147–48 indirect blindess and, 167 and individual responsibility, 50–51 intention and motives in, 58–59, 74, 77–78 interrelatedness and, 60 laws and, 50–54, 63–65, 162 lines defining acceptable behavior in, 62 moral disengagement and, 164–65 motivated blindness and, 91–92, 165–66 omission bias, 99–100, 166–67, 205n outcome-dependent, 156, 168–69 perception and, 156, 163–64 philosophical foundations of, 54–59, 164 relativity and, 61 religion and, 46–50, 53, 59 responsibility and, 73, 165, 168 self-interest and, 56–58, 165 teaching of, vii–viii, 163, 177–79 utilitarianism and, 55–57, 192n virtue and, 54–55, 59, 65 and workplace boundaries, 63–67 Ethics (Aristotle), 54 Europe: arbitrage exploitation in, 11 financial disclosure in, 154, 155 municipal finance in, 149–50, 152 sovereign debt crisis in, 1, 157, 169 European Union, 154 Eurostat, 154–55, 204n eurozone, 1, 11, 153, 156, 203n Excellent Sheep: Miseducation of the American Elite and the Way to a Meaningful Life, The (Deresiewicz), 177 exchange rates, interest rates tied to, 148–50 Express Pass Access, 140 Extreme Alt-A, 87, 195n Fabian Society, 60–61 Facebook, 17, 53 fairness, 5, 61, 73, 74, 139–46 access to information and, 142–45 Falk, Aarmin, 5–6 Fannie Mae, 33, 84, 92 favoritism, 141–43 “fear of god,” 46–50, 59 Federal Energy Regulatory Commission (FERC), 107, 110, 113–16, 182 Federal Housing Administration (FHA), 29 Federal Reserve Bank of New York, 171 FERC Enforcement, 115 Fidelity, 104 finance: arbitrage and, see arbitrage compartmentalisation, 49 complexity of, viii, 6–8, 181 ethics in, see ethics impersonality of, 7, 46, 48–49, 85, 169–70 Islamic, 16, 48, 183–85 milestones in, 16–18 municipal, 149–52 public mistrust of, 1–2, 12–13 rules and regulations of, see rules and regulations teaching ethics in, vii–viii, 163, 178–79 uncertainty and, 48 workings of, 4–5 see also markets Finance and the Good Society (Shiller), ix Finance Ministry, 177 Financial Accounting Standards, 83 Financial Conduct Authority, 135, 173 financial crime, 53–54 financial crisis of 2008, 78, 89, 119 financial firms: ethical culture in, 11–12, 171–79 subsidiaries and, 167–68 Financial Industry Regulatory Authority (FINRA), 135, 136 financial pyramids, 45 financial scandals, 12 see also specific scandals financial scholarships, 16 firms, market value of, 17–18 fixed-rate mortgages, cash flows connected with, 32 Flash Boys: A Wall Street Revolt (Lewis), 199n flash crash, 137, 201n Ford, 169 Pinto, 91–92 Foundation for a Better Life, 60 France, 203n toxic loans in, 11, 148–53 Frankfurter, Felix, 51 fraud, 50, 84, 92–93, 97, 135, 137, 138 Freddie Mac, 33, 84, 92 freedom, 54 Friedman, Milton, 63 front running, 131, 199n Fukuyama, Francis, 191n Gabillon, Jacques, 122 Gallagher, Dan, 52–53 Gallup poll, 13 General Accounting Office, 175 Gibson Greeting Cards, 43–44, 68 Ginnie Mae, 32, 33, 35 Gino, Francesca, 156 Golden Rule, 47, 63–64 Goldman Sachs, 1, 11, 68, 78, 148, 153–57, 167–69, 172–73, 184–85, 187n Abacus deal, 10, 92–99, 95, 196n aluminum market and, 102, 117–25 code of ethics, 53 ethical culture and, 172–73 Global Commodities Principal Investments, 122 Greece and, 153–57 Gravy (algorithm), 136 Greece, 1, 11, 148, 153–57, 168, 169, 187n, 203n, 204n “Greed—and Fear,” ix Green, Joshua D., 167 Greenspan, Alan, 66, 192n Gregory VII, Pope, 191n “group think,” 175 Guiso, Luigi, 179 Halliburton Company, 28 Harris poll, 12–13 Harvard Business Review, 63 Harvard Law Review, 182 hedge funds, 28 hedge ratio, 21–22 Helmerich & Payne, Inc., 28 Henry IV, Roman Emperor, 191n Higgins, Leonard, 19–20 high-frequency trading (HFT), 103, 127–31, 199n algorithms and, 132–38 ethics and, 132–38, 142 fairness of, 61, 139–46 front running and, 131, 199n illegal activities of, 10 layering, 133, 134, 136, 137–38 pinging, 134 speed of data and, 140–41 spoofing, 134–37 statistical arbitrage and, 127–31 Hillel, 47 Hold Brothers On-Line Investment Services, 135 Holder, Eric, 53 Holmes, Oliver Wendell, Jr., 74 Hong Kong Exchanges and Clearing Limited (HKEx), 125 HTG, 136 HTG Capital, 136 human law, 64–65, 74 Hume, David, 165 Hustle program, 92, 196n IBM, 190n ICE Futures Exchange, 135 identifiable victim effect, 169–70 inclusive capitalism, 73 incremental bias, 170 “indirect agency” problems, indirect blindess, 167 insider trading, 206n Institute of Islamic Banking and Insurance, 208n interest-bearing loans, 15–16, 15, 188n interest rates, exchange rates tied to, 148–50 interest rate swaps, 23–25, 24, 42, 154 intermarket arbitrage, 140–41 Intermarket Trading System (ITS), 103, 105, 107 International Monetary Fund, 171 invisible hand, 48 Irfan, Harris, 48 Irish Stock Exchange, 184 “Is Banking Unusually Corrupt, and If So, Why?” (Posner), 90–91 “Is Business Bluffing Ethical?” (Carr), 63–64 Islam, 47, 48, 208n Islamic finance, 16, 48, 183–85 Islamic law, 184–85 Italy, 155, 157, 169 Jainism, 47 Jarrow, Robert, 21 Jefferson County, Ala., 203n Johnson & Johnson, 39 JPMorgan Chase, 3, 10, 79, 124, 155–57, 167, 195n California Energy Market and, 102, 107–17 JPMorgan Ventures Energy Corporation (JPMVEC), 109, 111–16, 112, 170, 181–82 Judaism, 47 Justice: What’s the Right Thing to Do? (Sandel), 54 Justice Department, U.S., 84, 87, 135 Kant, Immanuel, 54, 57–59, 61, 83 Kassam, Karim S., 167 Kelly, Martin, 81, 194n Khuzami, Robert, 93, 144–45 Koran, 16 Lagarde, Christine, 171, 173 laws, see rules and regulations layering, 133, 135, 136, 137–38 Lehman Brothers, 78–83, 82, 194n, 195n information disclosures of, 79 Repo 105, 10, 78–81, 82, 83, 155, 194n Lehman Brothers Holding Company, 82 Lehman Brothers International Europe (LBIE), 81, 82 Lehman Brothers New York, 82 Leinweber, David, 139, 141 Lewis, Michael, 72, 199n Liar’s Poker (Lewis), 72 LIBOR rate (London Interbank Offered Rate), 24, 24, 37, 38, 43, 64, 71 “LME Official Price,” 123 Locke, John, 47 London, 79, 80 London Metals Exchange (LME), 117–24 approved warehouses by, 118–19, 123 Macey, Jonathan, ix, 43, 65–66 Madoff, Bernie, 10, 101–7, 175, 197n market makers, 27, 103–4, 128 markets, 5–6, 29 acceptable behavior in, 53, 62 arbitrage and, 26–27, 62, 101–25, 147 competition and, 71, 103 deception and, 10, 77–78, 81, 83, 99 disclosure requirements and, 52–53 equilibrium in, 69–72 ethical boundaries in, 67–73, 162 exchange cancellations and, 129, 130 externalities and, 72 fairness and, 73 health insurance analogy of, 106 high-frequency, 126–46 impersonality of, 46, 48–49, 85, 169–70 inefficiencies in, 26, 101, 108, 147 information disparities in, 67–68, 89–90, 142–45 manipulation of, 115–17, 134–38, 170, 182 responsibility and, 73, 165, 168 rigidities in, 10, 101, 105 rules and regulations in, 50–54, 101 strategic behaviors in, 69 technology and, 16, 103, 105–6, 126, 127–28, 132, 134, 139 trust and, 51 Martin, Sean, 172 Marx, Groucho, 62, 171 Meinhard v Salmon, 50 Merkel, Angela, 1, 155 Merrill Lynch, 10, 84–87, 88, 90, 168 Merton, Robert, 19, 21 Messick, David, 163 Metro International Trade Services, 117, 119–23, 125, 167, 199n Meyer, Michael, 141–42 Michigan, University of, 142–44 Microsoft, 39 Midwest Premium, 123 Milgram, Stanley, 165, 205n Milken, Michael, 53 Mill, John Stuart, 192n Miller, Dale T., 164 Miller, Merton, 16–18, 22, 25 Modigliani, Franco, 16–18, 22, 25 Modigliani-Miller theorems, 17 Moore, Don, 156 moral disengagement, 164–65 Morgan Stanley, 78 mortgage-backed securities (MBS), 10, 31, 33, 104, 196n Abacus deal and, 92–99 cash flows and, 32–36, 85, 93–94 flawed, Bank of America’s issuing of, 10, 78, 84–92 residential (RMBS), 95 subprime, 92–94 mortgage rates, 34 mortgages, 5, 10, 29, 84–94, 195n cash flows and, 32–36 prepayment of, 34, 35 refinancing of, 34 swaps and, 23 motivated blindness, 91–92, 165–66 municipal debt markets, 149–50 Munro, Alice, 126 murabaha, 16, 184, 208n Nasdaq, 102–3, 136, 139–40, 179 Nash, John, 69, 194n Nash equilibrium, 69–70 National Best Bid Offer (NBBO), 103 National Stock Exchange (NSX), 197n natural bonds, synthetic bonds v., 40–41, 40, 190n natural law, 64, 74 Nerds on Wall Street: Math, Machines, and Wired Markets (Leinweber), 139 Netherlands, 175–77, 207n New York Society for Ethical Culture, 60 New York state, mortgages in, 29 New York Stock Exchange (NYSE), 102–6, 139–40, 144–45 Rule 390, 103, 197n New York Times, 58, 117, 155, 173 Nike, 178 Nine Principles of Union (1912), 192n Nozick, Robert, 59 Objectivist movement, 192n omission bias, 99–100, 166–67, 205n Ontario Securities Commission, 136 “On Wall Street, a Culture of Greed Won’t Let Go” (Sorkin), 174 Open Match Holdings, 197n option pricing, 16, 19–22 put-call parity, 19–20 option pricing theory, 19 options, complexity of, 19 Ordóđez, Lisa D., 170 Origins of Political Order: From Prehuman Times to the French Revolution (Fukuyama), 191 O’Toole, James, 174 outcome dependent ethics, 156 Paharia, Neeru, 167 Pan, Jun, 202n Panther Energy Trading, 134–35 Pareto optimal, 69, 71 “Pass it on” advertisements, 60 Paulson, Jon, 94–97, 98, 99, 166 Paulson & Co., 96, 97, 98, 99 pauper management, 55 payoff matrix, 69–70, 70 perception, ethical, 156, 163–64 perfect hedge, 21 Pérignon, Christophe, 38, 149, 203n pinging, 134 Ponzi schemes, 45, 102, 175 Posner, Richard, 90–91 prebates, 119 Proctor & Gamble, 44 proprietary trading, 97 put-call parity, 19–20, 189n put options, 37, 39, 94 quote dangling algorithm, 132–33 quote stuffing, 137 Quran, 47 Radcliffe, Dana, 65 Rajan, Raghuram, ix Rand, Ayn, 192n Ranieri, Lewis, 72 ratings arbitrage, 98 Ratner, Rebecca K., 164 Rawls, John, 59 reasonable discrimination, 145–46 Red Kite, 198n Reich, Robert, 65 relative pricing, 19 religion, 15–16 ethics and, 46–50, 53, 59 renewable energy, repo rates, 80, 81 repurchase agreements (repos), 79–81, 82 reputations, 65–66 regulation and, 66 residential mortgage-backed securities (RMBS), 95, 96 responsibility, 73, 165, 168 retail order flow, 104–6 riba (usury), 16 Rogers, Jonathan, 144 Roosevelt, Franklin, 52 Rothschild, Baron, 139 Royal Bank of Scotland (RBS), 148 rules and regulations: acceptable behavior and, 53–54, 63–64 disclosure requirements, 52–53 ethics and, 50–54, 63–64, 162 as exploited through arbitrage, 10, 11, 12, 52, 101–25, 147, 183 implementation issues of, 51–52, 53 laws as rooted in morality and, 64–65 market innovations and, 51–52 prosecution and, 53 reputation and, 66 responsibilities and, 73 spreads and, 104–5 standards-based, 12 “Run EDGAR Run: SEC Dissemination in a High-Frequency World” (Rogers et al.), 144 Russell, Bertrand, 60–61 Saint-Etienne, France, 149, 150 Salomon Brothers, 66, 72 Sandel, Michael, ix, 54, 56–57, 58 Sapienza, Paolo, 179 Sarao, Navinder Singh, 137–38, 201n Sassenage, France, 150 Saving Capitalism from the Capitalists: Unleashing the Power of Financial Markets to Create Wealth and Spread Opportunity (Rajan and Zingales), ix Schneiderman, Eric, 143 Scholes, Myron, 19 Schultz, Paul, 179 Scott, Walter, 77 securities: turning cash flows into, 31–32 see also mortgage-backed securities Securities and Exchange Commission (SEC), viii–ix, 52, 68, 81, 86, 92–93, 96, 97–98, 99, 107, 135, 136–37, 142, 143–45, 175 Division of Enforcement, 145 Division of Trading and Markets, 145 EDGAR system, 144, 145 securitized solar energy bonds, security trading, 14 SEC v Goldman Sachs, 7, 96–99, 166 self-interest, 56–58, 99, 165 Senate, U.S., 117, 119, 122 Permanent Committee on Investigations of, 117 Shanks, Thomas, 141–42 sharia, 184–85 Shaw, George Bernard, 31 Shiller, Robert, ix “Should Companies Obey the Law If Breaking It Is More Profitable?” (Radcliffe), 65 Sikhism, 47 Skinner, Douglas, 144 “slippery slope” problem, 170 Smith, Adam, 48 Snyder, Deirdre G., 170 social capital, 49, 73 Social Foundations of Thought and Action (Bandura), 164 social responsibility, 5–6 “Social Responsibility of Business I sto Increase Profits, The” (Friedman), 63 Sorkin, Andrew Ross, 174 spoofing, 134–37 spreads, 104–6 Standard & Poors, 39 Standard & Poors 500, 137, 202n statistical arbitrage, 10, 28, 127–31 risk and, 129 stock ticker, 139 structured loans, 148–49, 152 cash flows and, 36–39, 38 toxic loans and, 148–53 subprime mortgage-backed securities, 92–94 subsidiaries, 167–68, 202n sukuk, 183–85 Sullivan, Kathleen M., 182 Sutrakritanga, 47 swaps, 16, 22–25, 36 cash flows and, 22–23 currency, 154, 155, 187n of interest rates, 23–25, 24, 42, 154 LIBOR rate and, 24, 43 mortgages and, 23 risks of, 42–44 Sweitzer, Vicki, 164 Swift Trading, 136 Swiss National Bank, 150 synthetic bonds, natural bonds v., 40–41, 40, 190n synthetic collateralized debt obligations (CDOs), 94, 96 synthetic corporate bonds, cash flows and, 39–42 synthetic securities, 4, 16 Szech, Nora, 5–6 Taoism, 47 technology, 16, 103, 105–6, 126, 127–28, 132, 134, 139 telegraphs, 139 Tenbrunsel, Ann, 91, 165 Theory of Justice, A (Rawls), 59 Theory of Moral Sentiments, The, 48 Thomson Reuters Corporation, 142–43 Titanic, 140 Torah, 47 toxic loans, 11, 148–53, 156 Traders Magazine, 102 Trading Places, 118 Treasury, U.S., 24, 115 Treviño, Linda, 164, 172, 206n trolley problem, 205n trust, 51, 182–83 uncertainty, 48 unintended consequences, 57 Universal Studios, 140 universities, 202n moral code and, 177–78 usury, 16, 29 utilitarianism, 55–57, 192n Valasquez, Manuel, 141–42 Valeant Pharmaceuticals International, 167 Vallée, Boris, 38, 149, 203n Vanguard, 132 Veterans Affairs Department, U.S (VA), 29 virtue, 54–55, 59, 65, 193n volatility, 35 VWAP (volume-weighted average price) algorithm, 132 Wall Street Journal, 133, 136, 142, 143 Wang, Jiang, 202n Washington Mutual, 195n Waterloo, Battle of, 139 welfare, 54 Wells Fargo, 167 Welsh, David T., 170 Wheatley, Martin, 173 “Why Good Accountants Do Bad Audits” (Bazerman et al.), 170 Williams, George Gilbert, 46–47, 50 Xing Hu, Grace, 202n XKCD cartoon, 162 Yermack, David, 179 Yuengert, Andrew, 54 Zechman, Sarah, 144 zero-percent coupon loan, 149 Zingales, Luigi, ix, 178, 179 Copyright © 2016 by Maureen O’Hara All rights reserved First Edition For information about permission to reproduce selections from this book, write to Permissions, W W Norton & Company, Inc., 500 Fifth Avenue, New York, NY 10110 For information about special discounts for bulk purchases, please contact W W Norton Special Sales at specialsales@wwnorton.com or 800-233-4830 Book design by Brooke Koven Production manager: Anna Oler ISBN 978-0-393-28551-2 ISBN 978-0-393-28552-9 (e-book) W W Norton & Company, Inc 500 Fifth Avenue, New York, N.Y 10110 www.wwnorton.com W W Norton & Company Ltd 15 Carlisle Street, London W1D 3BS ... Jim Detert for his guidance on behavioral ethics, Michael Brennan and Joe Kaboski for their broad knowledge of ethics and philosophy, Brandon Becker and Jonathan Macey for insights on the many... general, people on Wall Street are as honest and moral as other people.”12 The Gallup poll on honesty and ethics across different professions is equally sobering—only 28 percent of respondents deemed... CONTENTS Preface CHAPTER CHAPTER CHAPTER CHAPTER CHAPTER Finance, Arbitrage, and Ethics The Evolution of Modern Finance Arbitrage in Action Ethics and Finance Ethics in Action Into the