Decision Strategy – chapter 8

Once you cross the line, it escalates

It takes twenty years to build a reputation and five minutes to ruin it. If you think about that, you do things differently

Warren Buffett

The financial world was shaken to its core, when the fourth largest US investment bank, Lehman Brothers, filed for bankruptcy in September 2008. With $ 639 billion in assets and $ 619 billion in debt, Lehman’s bankruptcy petition not only surpassed other bankruptcy giants like WorldCom or Enron by a factor 10, it also came after repeated assurances that finances were sound.

Lehman Brothers had a humble beginning as a grocery business in Alabama in 1844 by German immigrant Henry Lehman, who was eventually joined by his two brothers. The business boomed and managed to survive massive challenges like railway company bankruptcies, the Great Depression, two world wars and capital suffocation from various owners, but it was the breakdown of the American housing market that finally killed it. The seed was sowed when Washington in 1999 removed the Glass-Steagall law, which separated commercial and investment banks, so the former handled capital-intensive portfolios like real estate and the latter focused on liquid assets. In 2001 CEO Dick Fuld received an investment plan from a group of math PhDs, showing how the bank would always profit, if it invested in the housing market, and he was so impressed, that he immediately borrowed billions to invest in the housing market.

Fuld was feared and admired as the Gorilla of Wall Street due to his aggressive style and lived for Lehman Brothers, where he started at 23 and quickly became the longest serving CEO on Wall Street. In 2003 and 2004 Lehman bought five housing loan businesses including two subprime services specialized in Alt-A loans for borrowers without documentation, which at first sight was ingenious – the following three years, they grew by 56% annually ending with USD 4.2bn profit in 2007 and a market value of USD 60bn. But the assumptions in the PhDs investment proposal was falling apart. The stock market had its largest correction in five years in just one day, the number of sub prime loan defaults reached the highest share in a decade and Bear Stearns had two housing funds go bankrupt. Lehmans CFO assured the market that the risks were well insured, so the strategy was not changed, and they geared their investment with a factor 44, while the five other large investment banks stayed around a factor 20-30.

The warning signs kept pouring in with Bear Stearns having a near breakdown early 2008, hedge fund managers were questioning the value of Lehmans housing loan portfolio and Lehman had the first quarterly loss in more than a decade, leading to one double-digit drop-in stock price after another. The final blow came, when Korea Development Bank withdrew from negotiations to take an active share in Lehman. Hedgefund clients left, creditors cut off loan facilities, Lehman had a second quarterly loss and Moodys Investor Service stated that Lehman had to sell the majority of its shares to avoid a rating reduction. Lehman was now losing USD 8m every minute with little cash left and made one last desperate attempt to find a buyer in Barclays to no avail. 15th September Fuld declared bankruptcy, eliminating USD 46bn in market value or 93% in just three days, and Barclays bought the scraps for USD 1bn.

Bounded Ethics were rampant in Lehman Brothers

Bankruptcies are full of learning, but what was particularly interesting here was despite Fulds clear ethics in private, then his business ethic was more “anything goes”. As bankruptcy lawyer Valukas started unravelling the events, an enormous number of lies were discovered. Whenever danger was noted, everything was covered up. Maybe to avoid showing weakness or maybe Fuld believed so much in his strategy, but the many problems and attempts to finder buyers indicated more that he was feeling the ropes tightening around his neck. So, he did what everyone else does in a high pressure situation: He lied. Maybe on purpose to mislead, maybe because he was caught in his story, maybe his pride could not handle it or maybe he would not accept his back was against the wall. The problem with the lies was that they led to more problems, less trust and wasted precious time in dealing with the very real challenges. Stopping the bleeding early and giving potential buyers enough time to consider how to integrate the acquisition might have saved Lehmans – because as we saw in chapter 7, when we are faced with a high-risk situation and short time, we stick to status quo. We all fear losing face, but that need to protect our self image can become the very reason we fail.

The second ethical break down is a more gradual erosion of ethical conduct, where a small step away from a high ethical standard sets us on downward trend towards faster and larger ethical lapses, which we may not even notice due to our blindness to change. Lehman used an increasing number of accounting tricks to make their gearing and liquidity look favorable for example by selling to ghost companies and rebuying them at a higher price thus avoiding sales of assets with losses.

The third ethical break down happened as outside auditors Ernest & Young knew about the activities and failed to report it despite direct questioning. Lehman was a huge and profitable client for them, where motivated blindness indicates that when we are incentivized to avoid certain data, then we tend to overlook it.

You see Bounded Ethics every day

Nobody is in doubt about the dramatic unethical behaviour of Enron’s Jeff Skilling, Italy’s Silvio Berlusconi or IT Factory’s Stein Bagger. The business scandals of the last 20 years have led media, politicians and academics to look for the underlying reasons for ethical breaks and the most popular approach is identifying a few evil people or systems – like Dick Fuld in Lehman, Arthur Andersen in Enron or poor regulations. But the latest research shows that most unethical behaviour happens without a conscioius choice. Of course there are people, who act unethically on purpose, but the argument here is that our ability to understand and change unethical behaviour in people rests on appreciating that we are systematically biased in certain ways:

Everyday dishonesty: The human tendency to lie up to the point, where you feel your integrity is at risk – further enhanced by your self serving bias. For example high earners will find a reason to justify why they save their money in tax havens.

Indirect unethical behaviour: This tendency to avoid seeing or even hiding exploiting or unethical behaviour by having third parties do the job for you. For example some global companies like H&M or Apple have had questionable production facilitites run by third parties.

Motivated blindness: The tendency to avoid noticing unethical behaviour, when it is against your own interests to notice them. For example classic inhability cases like the researcher, politician or leader cannot see the problem in their close relations with certain interest organizations.

In-group favoritism: Also known as in-group bias, it describes your tendency to favor members of the group you belong to over members of groups you do not belong to. For example, we tend to provide possible board positions, jobs or other opportunities to people in our network, without thinking about whether they are also objectively the best to solve the task.

Implicit attitudes: When you meet someone, you immediately activate stereotypes about the person’s race, gender, and age. For example, when we meet a female dealer and are more surprised by an aggressive negotiating behavior than if it were a male dealer.

Experience of Fairness: Your tendency to value fairness to an extent that you are willing to sacrifice your financial well-being to enforce it. For example, if a business partner offers a very unfair deal in a negotiation, we can let the whole deal fall through to teach the other party a lesson, even when it may have financial consequences for ourselves.

You cheat because you deserve it

Sometimes you lie or cheat because it is self serving, but other times you might do it, because you can – or because you cannot help it, as you are running out of the energy required to ensure proper self control. And our brains are flexible enough to change our mind after cheating to make us believe that we in fact deserved it – even worse if there is some distance between the unethical behaviour and the reward. For example 10% of professional golf players are willing to pick up the ball to place it more favourably, but 23% are willing to do the same with the club.

The creative class is special and is treated as such, which makes creatives feel more important and deserving in US studies. The trouble with that is they are more willing to steal or lie than other groups. And this is not only the natural creatives – if you prime people to believe they belong to the creative class, they steal 6 times more than the control group. So the creatives issue may be a US challenge, but priming people to feel more deserving for whatever reason is the a problem. Now how important is that? Well the typical organization loses about 5% of annual revenue to cheating and fraud, losing about USD 2.9bn in 2010.

You are about to enter a pedestrian crossing, when an aggressive driver races past you inches away. Shocked you yell at the driver, but the car is already gone. Do you think the car was an brand new Aston Martin or and old Toyota Corolla? Research shows that drivers in expensive cars are much more aggressive and selfish in traffic than those in cheaper cars. Also known as the asshole effect, American psychologist Paul Piff researched whether assholes often became rich – or if being rich in itself drove the asshole tendency. It turned out that mere thought of feeling rich or just being near money symbols would make you more antisocial, self sufficient and unwilling to help others.

In a small classroom at the University of California, Berkeley, two students are playing Monopoly, one of whom has no earthly chance of winning. The Monopoly game is rigged, so the other player is more privileged during the game. Hundreds of Monopoly games with different players show the same – winning brings out the worst in the player who is unfairly privileged to win – arrogant, dominant, entitled to his victory and even eats more of the common candy. But there are some completely different unforeseen effects of winning: When we win in a competition, we subsequently have a greater tendency to cheat others to continue to win. In short, winning leads to more unethical behavior – even in an unimportant game. Now imagine what you would do, if billions were at stake.

6S Model – ensuring transparency

It is easy to identify unethical behaviour in others but very difficult in our selves. So to combat this bias group, you might want to start by ensuring that individuals are not making decisions about cases, where they have a personal interest and then picking some of these tricks:

Structure: You need transparency and simplicity everywhere – not least in your structure and to avoid ethical breaks. A flat organization with a stringent logic and large span of control is preferable – possibly coupled with internal audit, whistleblowers and external unbiased support.

Steps: Just like structure transparency and simplicity is key. A strong process management approach can by virtue of its rationality and simplicity identify off activities and prune them. But it cannot stand alone – the Enron case was well known for their use of standardized processes, where a customer claim was passed from department A to B to C and back to A with no way of communicating between them.

Style: Some of the best options to combat limited ethics are to ensure diversity, broad compensation structures and a code of ethics that is constantly repeated and permeates the organization. Diversity means that we are not as easily talked into unfortunate actions as when we are surrounded by people who are similar to us. The compensation structure should reward groups instead of individuals, as cheating requires a larger coalition to make sense. The code of ethics may seem weak at first glance, but Ariely’s research shows that people take it very seriously if they are just reminded that there is a code of ethics.

This was the short version of the last chapter on the 6 major bias groups in 5th best management book of 2016. Next up is the final conclusion. If you cannot wait contact brian@behaviouralstrategygroup.com or +45-23103206.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s