Yet, that’s exactly what happened leading up to the 2008 financial crisis where banks bundled shaky and suspect mortgage loans known as collateralized debt obligations (CDOs) and resold them to pension funds and other investors worldwide. And while some financial services companies have since settled with the United States Securities and Exchange Commission for their role in misleading investors, most have not admitted fault.
Which leads to a larger question—when is it acceptable to knowingly sell a substandard product?
Charles Morris, author of “The Two Trillion Dollar Meltdown” aptly describes the period leading up to the financial crisis of 2008 as “sheer idiocy”. To start with, he says, debt to equity—or leverage—by many financial firms was as high as 100:1. In addition, high risk mortgages were more than the flavor of the month, as CDOs in 2006 were created from “more than 40% of all mortgage originations.” And of course, we haven’t even mentioned derivatives such as credit default swaps (CDS) that tied global banks together in an intricate web of interdependency.
What is the end-result of the 2008 financial crisis? The International Money Fund (IMF) estimates losses from the financial crisis at $4.1 trillion, jobless rates still hover at 12.5% or more in some states, and 401K account’s are still recovering from losses of 30-50% and sometimes more! Indeed, if anything has been learned from this global meltdown it’s that —caveat emptor still reigns—otherwise known as “let the buyer beware”.
Let’s get back to CDOs for a minute. A collateralized debt obligation is simply a bundle of 100-200 mortgages that are sliced and diced into “tranches” and then priced and sold to investors based on a risk management formula. Investment banks engaged in buying mortgages from “mortgage mills” and then packaged and resold these CDOs to investors. Not a bad concept, unless you know beforehand that the package consists of fraudulent and dubious loans that will likely never be paid.
In fact, Carl Levin, chairman of the US Senate’s Permanent Subcommittee on the Financial Crisis scolded a row of investment bankers on the process of producing CDOs and other financial products saying, “You people think it’s a piece of crap, and go out and sell it!”
But here’s the rub—as the writer of the Financial Times Lex Column describes it; “…selling crap is no crime per se.” In fact, the writer goes on to say, “If the SEC is so against the practice, it should also prevent people from the buying of crap too.”
In fact, there are many businesses that profit greatly from the buying of distressed assets including foreclosed homes, flailing companies, and even tarnished brands. Obviously, these sales should continue. However, the writer of Lex must also remember that some US states do prohibit the “knowing” sale and re-sale of defective products; for a good example see lemon laws for pre-owned cars.
A Financial Times reader responds—tongue in cheek—to the Lex column by saying if it is indeed a legitimate business practice to sell substandard products that the Lex column author, should “bear this principle in mind (the next time he/she) visits a doctor, dentist, pharmacist, lawyer or accountant.”
With the advent of the internet, the Smartphone explosion and now social media, global companies cannot afford to take the risk of knowingly selling sub-standard products. This advice of course, only applies if companies care about brand perception, reputation and integrity.
For many companies—reputation is one of the last bastions of competitive advantage. Millions if not billions of dollars in brand equity and goodwill are at stake. And consumers have long memories. There are no real shortcuts when it comes to quality.
• In an age of “asymmetric information”—where the seller often knows more than a buyer—why are brands so important?
• When is it OK to sell a substandard product?