Business & Professional Ethics
for Directors, Executives &
Accountants, 8e
Leonard J. Brooks and Paul Dunn
South-Western, Cengage Learning, Boston, MA, 2018
Chapter 8 – Subprime Lending Fiasco – Ethics Issues
Chapter Questions and Case Solutions
Chapter Questions…………………………………………………………2
Case Solutions……………………………………………………………….7
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Chapter Questions
1. How much and in which ways did unbridled self-interest contribute to the subprime lending crisis?
Almost everyone in the subprime mortgage meltdown was only looking after their own narrow
self-interest and not the board interest of their clients or the economy.
• The homeowners, who knew that they could not afford to own a home, were ignoring
the fact that the when the mortgage came up for renewal they would not be able to
2. How could increased regulation improve the exercise of unbridled self-interest in decision making?
Market failures often occur when there is an inefficient allocation of costs and benefits.
Externalities are costs or benefits that are borne by third parties, i.e., parties who are not part of
3. How could ethical considerations improve unbridled self-interest in ethical decision making?
Ethics help to constraint unbridled self-interest by broadening the decision-maker’s horizon.
stakeholders.
4. Identify and explain five examples where executives or directors faced moral hazards and did not
deal with them ethically.
• Creating securities that had no hope of being realizable
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5. How much should the exiting CEOs of Fannie Mae and Freddie Mac have received when they were
replaced in September 2008?
Executive compensation is multi-faceted. Compensation is used to attract and retain
employees; it is used to motivate and reward good performance; and it is used to discipline bad
performance. If employees are responsible for both their good and bad decisions, then they
6. The government bailout of the financial community included taking an equity interest in publicly
traded companies such as American International Group (AIG). Is it right for the government to
become an investor in publicly traded companies?
Arguments can be made both for and against government bailouts. (See the discussion of ethics
7. Should CEOs who made large bonuses by having their firms invest in mortgage-backed securities in
the early years have to repay those bonuses in the later years when the firm records losses on those
same securities?
Arguments can be made both for and against having executives repay their mortgage-
backed security bonuses after their firms incur losses as a result of investing in
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8. Should the CEOs who refused to have their firms invest in mortgage-backed securities in the early
years because the risks were too great receive bonuses in the latter years because their firms did
not incur any mortgage-backed security losses? How would determine the size of these bonuses?
Bonuses are used to both reward past performance and encourage future performance.
9. Should organizations that have a risk-taking culture, such as the one developed by Stan O’Neil at
Merrill Lynch, enjoy the gains and suffer the losses, without recourse to government bailouts?
Investors know that there is a risk in investing in the stock market. Stocks can go up or
10. Are the criticisms that mark-to-market (M2M) accounting rules contributed to the economic crisis
valid?
See the discussion of Ethics Case Mark-to-Market (M2M) Accounting and the Demise of
11. The global economic crisis was caused by the meltdown in the U.S. housing market. Should the U.S.
government bear some of the responsibility of bailing out the economies of all countries that were
harmed by this crisis?
There were a number of factors that contributed to the current economic meltdown.
They are listed in Chapter 8. They include greed on the part of lenders and
12. Given that the marketplace for securities is global, and that the risks involved can affect people
worldwide, should there be a global regulatory regime to protect investors? If so, should it be based
on the regulations of one country? Should enforcement be global or by country?
Regulations, in part, reflect the cultural values or standards of a nation. This is why it is
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13. Should members and executives in investment firms be forced to be members of a profession with
entrance exams and with adherence to a professional code such as is the case for professional
accountants or lawyers?
This would be an interesting and useful development, but would be resisted, I am sure,
by the investment community since they either don’t see what they do as having a
14. Does the Dodd-Frank Act go far enough, or are some important issues not addressed?
See, for example, the following publications:
• Bator, Paul (July 21, 2010). “Does FinReg Address the Material Issues Surrounding
• Thoma, Mark (July 15, 2010). “The Dodd-Frank Financial Reform Bill.” CBS
Business & Professional Ethics for Directors, Executives & Accountants, 8e
15. What were the three most important ethical failures that contributed to the subprime lending
fiasco?
To some extent the answer depends on opinion rather than fact, but there are several
possibilities, including:
• Passing extraordinarily risky securities onto unsuspecting investors without proper, clear
disclosure of those investment risks in the investment documents.
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Case Solutions
1. Questionable Values Produce Resignation at Goldman Sachs (Chapter 8, pages
626–627)
What this case has to offer
This case provides a look at: (1) the values system that pervaded Goldman Sachs during what could be
called their “greedy or exploitive era” that followed what could be called their “professional or fiduciary
era”, and (2) the consequences that resulted from an unethical corporate culture. Goldman Sachs was
It is also interesting for readers to see how cultural red flags can permeate the speech and actions of
employees, and consider how improvement might be stimulated by concerned employees as
whistleblowers or using other techniques. The discussion in the text (see p. 531-532) on being aware of
and identifying ethics risks should be quite helpful in bolstering this discussion.
Teaching suggestions
I would begin the case by asking the class what they thought the consequences were for Goldman Sachs
that arose from their unethical corporate culture, such as: losing good employees and executives,
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Discussion of ethical issues
According to Greg Smith, the culture he describes existed in 2012, long after the 2008 financial crisis and
subsequent fall out, suggesting that the lessons have not been learned and the problems are at least as
bad as they were before the crisis.
1. How could the culture described be changed?
Changing the corporate culture described will require ethical leadership to steer and incent the
process, determined continuous evaluation and feedback involving the identification and
2. Who will need to cause this culture to change?
The top company leaders must actively speak in favor of a new culture, stating why and its
importance, and they must be supported by other managers all the way down the line. The CEO
3. What will have to happen to cause this change?
Management at all levels must buy into the rationale for and specific values specified in
4. Is it likely that Goldman Sachs will be able to hire the best and brightest recruits unless they change
the culture described? Why and why not?
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According to research done on U.S. Ivey League students, students are unwilling to take
5. Corporate psychopaths would likely be attracted to a firm with Goldman’s modern culture. How
would Goldman ensure that they are not hired?
Goldman should work with industrial psychologists to develop screening tests intended to reveal
Useful Articles, Links, and Videos
William Cohan Interview on Goldman Sachs: Video – Bloomberg Television [June 13, 2011(?)], accessed
Cohan on Psychopaths and the Financial Crisis: Video – Bloomberg Television [January 3, 2012], accessed
In this interview of Bill Cohen (author of Money and Power: How Goldman Sachs Came to Rule
the World (see References, below) by Erik Schatzker on Bloomberg Television’s “InsideTrack,”
Cohen is questioned about Clive Boddy’s Journal of Business Ethics article (see References,
below) that contends that psychopaths in large corporations played a major role in the financial
crisis.
Cohen, William D. (2012). Money and Power: How Goldman Sachs Came to Rule the World. Anchor
Books, New York.
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Boddy, Clive R. (2011). “The Corporate Psychopaths Theory of the Global Financial Crisis.” Journal of
Business Ethics, 102, 255–259.
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2. Naked Short Selling – Overstock.com Lawsuit against Goodman Sachs & Merrill
Lynch (Chapter 8, pages 627-628)
What this case has to offer
This is an interesting case in which profit-oriented organizational cultures encouraged employees to
because of naked short selling.
Teaching suggestions
Have the class discuss organization cultures. In particular have the students think about the differences
between a profit-oriented culture and a responsible, business-oriented culture.
• A profit-oriented culture focuses on earning profits and does not focus on how those profits are
generated.
Discussion of ethical issues
1. Should short selling be outlawed?
One of the purposes of the stock market is to be a forum where firms can raise money. Investors
invest in companies with an expectation of earning a reasonable return on their investments. An
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2. Should naked short selling be outlawed?
Short selling can be undertaken by a seller if s/he owns the stock or not. If the short-seller
3. How would you describe the ethical cultures at Goldman Sachs and Merrill Lynch with respect to
failed trades?
The ethical cultures at these two brokerage houses appear to be profit-oriented rather than
4. Short of wholesale firings, fines and jail terms, can you suggest ways that the ethical cultures at
Goldman Sachs and Merrill Lynch could be corrected?
Senior management at these two brokerage houses have to change the culture from being
Useful Articles, Links, and Videos
See also Useful Films & Videos in Chapter 8.
“Short sellers not to blame for 2008 financial crisis, study finds,” Matthew Biddle, University at Buffalo
This news release says that a new study to be published in the Journal of Financial Economics by
researchers that include a University at Buffalo School of Management assistant professor,
Veljko Fotak, “focused on fails caused by naked short sales…and found these trades were not
responsible for falling stock prices.”
Business & Professional Ethics for Directors, Executives & Accountants, 8e
3. Lehman Brothers Repo 105 Manipulation (Chapter 8, pages 628-640)
What this case has to offer
The bankruptcy of Lehman Brothers (LB) remains the largest bankruptcy filing in U.S. history. In 2008,
the investment banking firm was holding over $600 billion in assets.
This case constitutes an example of a company entering into a web of business transactions that might
be legal, and could even be in accordance to accounting standards, but appear unethical given their
negative consequences. LB’s bankruptcy played a major role in the U.S. financial crisis of 2008.
Teaching suggestions
An interesting way to introduce this case is to talk briefly about the size and consequences of the
financial crisis of 2008. Next, I start the discussion on the specific causes of LB’s problems, and ask
students whether or not it was an avoidable problem.
Discussion of ethical issues
1. What was the most important reason for Lehman Brothers failure?
There were several general reasons contributing to the failure of LB. The Examiner’s Report,
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“There are many reasons Lehman failed, and the responsibility is shared. Lehman was more
the consequence than the cause of a deteriorating economic climate. Lehman’s financial
However, the most important direct cause of the firm’s collapse was that LB overinvested in
sub-prime mortgage securities (MBS). As explained by the Examiner’s Report (p. 4):
“In 2007, as the sub‐prime residential mortgage business progressed from problem to crisis,
The losses that the firm’s sustained as a result of its investment strategy became unsustainable
in 2008, when the financial markets lost confidence in LB, and the firm was unable to borrow
funds to continue with its daily operations. As explained in the Examiner’s Report (p. 3):
“Lehman funded itself through the short-term repo markets and had to borrow tens or
hundreds of billions of dollars in those markets each day from counterparties to be able to
open for business.”
2. What is leverage and why is it so important?
Leverage is the effect of borrowing to buy an asset, creating a liability but enabling the equity
holders to benefit from the residual ownership in the asset. It is important because is the basis
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3. Prepare the journal entries for a Repo 105 transaction sequence for $1 million in securities.
Sell $1 million in financial assets before quarter-end:
CASH 1,000,000
FINANCIAL INSTRUMENTS (Asset Account) 1,000,000
4. In your opinion, how large should a Repo 105 transaction be to be considered material, and why?
There are two auditing standards defining the concept of materiality, ISA 320 (IAASB) and AU
312 (AICPA). Under these standards, the exact definition of materiality is somehow vague;
As an example, the general thresholds recommended by the PwC Audit Guide (available at
• For a profit-oriented entity, up to five percent (5%) of profit/loss before tax from
continuing operations.
• For a not-for-profit entity, up to one percent (1%) of total expenses or total revenues, or
up to one-half of one percent (0.5%) of total assets.
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$3.46 billion would be considered material. Given the weak financial condition of LB, it is likely
that the actual amounts of liabilities hidden by the Repo 105 transactions were material to the
financial statement users.
5. Was LB’s interpretation of SFAS 140 – that Repo 105 transactions could be treated as sales –
correct? Provide your reasons.
Arguably, LB’s interpretation was incorrect because the substance of these transactions was not
a final sale, given the intention of repurchasing those securities later on. Moreover, Lehman
treated these transactions as sales when other investment banks treated them as financing.
Furthermore, an article published on the Wall Street journal on March 12, 2011, suggests that it
would be difficult to question LB’s interpretation:
“SEC officials generally have concluded that the transactions were consistent with
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Following LB’s bankruptcy, and other difficult cases dealing with securitization of assets, the
FASB amended some deficiencies in SFAS 140 by issuing SFAS 166. The Summary of SFAS 166
states that:
“This Statement clarifies that the objective of paragraph 9 of Statement 140 is to determine
whether a transferor and all of the entities included in the transferor’s financial statements
This Statement defines the term participating interest to establish specific conditions for
reporting a transfer of a portion of a financial asset as a sale. If the transfer does not meet those
conditions, a transferor should account for the transfer as a sale only if it transfers an entire
financial asset or a group of entire financial assets and surrenders control over the entire
transferred asset(s) in accordance with the conditions in paragraph 9 of Statement 140, as
amended by this Statement.
6. If, as the Examiner’s Report states, LB continued to collect the revenue from the securities involved
in the Repo 105 transactions, how could LB say that they had given up ownership?
This practice is explained in the Examiner’s Report (p. 771):
“During the term of a Repo 105 transaction, as with a typical ordinary repo transaction,
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7. An emerging issues Interpretation Bulletin accompanying SFAS 140, gives examples indicating Repo
102 transactions would not qualify as sales, but Repo 110 would. Why do you think this Bulletin was
issued?
There were several EITFs modifying and explaining SFAS 140, the main reason behind the
140 suggests that it was need to clarify issues in a timely fashion.
8. Knowing that LB could not obtain a “true sale” opinion from a U.S. lawyer under U.S. law, should LB
have tried to obtain the opinion from a U.K. law firm? Why and why not?
The Repo transactions were not carried directly by LB, but indirectly through a subsidiary in the
U.K., Lehman Brothers International Europe (LBIE) because that jurisdiction was where a
The Examiner’s Report explains the conditions of the opinion provided by the U.K. law firm (p.
784):
“Lehman was able to get a true sale opinion from the Linklaters law firm in London, in
several iterations, under the laws of the United Kingdom.
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9. Do the Repo 105 arrangements constitute fraud? Why and why not?
It is difficult to determine whether or not these arrangements constitute fraud. Their accounting
treatment was allowed under the applicable accounting standards at the time. Moreover,
determining fraud hinges on proving wrong intentions by the perpetrator, as explained by the
10. What is the auditor’s responsibility if a fraud is suspected or discovered? What professional
standards are most important in such cases, and why?
ISA 320 (IAASB) and AU 312 (AICPA) explain the auditor responsibility with respect to fraud.
In general, the auditor’s responsibility is to plan and perform the audit to obtain reasonable
11. If you were the audit partner in charge in the U.S., what would you have required be done in regard
to the Linklater “true sale” letter?
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1) Ask whether the opinion could be verified by a U.S. firm using a U.S. context; and,
2) Evaluate the evidence from the lawyer’s opinion in combination with other audit
12. Should consolidated financial statements of a U.S. parent company include (i.e. consolidate) foreign
subsidiary accounts prepared on a basis not considered appropriate U.S. GAAP?
Before consolidating foreign subsidiaries, their financial statements have to be prepared using
the parent’s accounting standards.
13. Would the adoption of IFRS have prevented the Repo 105 misrepresentations?
Arguably, the IFRS focus on the economic substance of transactions over their legal form should
have helped to account for the Repo transactions; however, IFRS and U.S. GAAP had very similar
14. What should the following have done upon learning of Matthew Lee’s whistleblower’s letter – LB’s
management, board of directors, and the external auditors, E & Y?
LB’s management, board of directors and E&Y should have taken the complaint more seriously.
15. Arthur Andersen tried to keep its Enron audit problems quiet, whereas E & Y spoke out in its own
defense. Was it a good idea for E&Y to send a letter, such as the one reproduced above, to their
clients? Why and why not?
By sending that letter to its clients, E&Y aimed to reinforce its clients confidence in the firm;