Home Uncategorized 1) Is The Formal Cultural System Within A Firm The Most Important Factor In Creating An Ethical Workplace? How Do Formal Cultural Systems Attempt To Promote Ethics?

1) Is The Formal Cultural System Within A Firm The Most Important Factor In Creating An Ethical Workplace? How Do Formal Cultural Systems Attempt To Promote Ethics?

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April 22nd, 2022

Table of Contents

Cultural System

This is ethics and governance module. This assignment requires you to write an essay of 2000 words. Times New Roman with font size of 12. 15 references are required in this essay which Harvard referencing style has to be used. The report must consist of the introduction which is whether u agree or disagree with the formal system being the most important factor and also the overview of the essay, body which consist of the arguments of formal and informal. at the same time you need to state how the formal cultural systems attempt to promote ethics eg. rewards and the selection. and the conclusion which summarize the whole essay and what do you think of formal system and is it rationale for everyone to follow the same ethics. You can read up more on Trevino if you want to have a better understanding of this question.

Ethics & Governance Lecture 1: Introduction to Ethics & Governance

Overview Today

A brief introduction to the course’s management, readings and assessments

Plagiarism – academic integrity

Essay writing – study research techniques

Ethics and morality

Ethics and the law

Ethics in business and corporate governance

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Readings

There is no prescribed textbook for this subject.

There are essential readings on the myRMIT studies website.

A lot of the material in the course has been developed from these two texts which are excellent references:

1. Mallin, C A, 2010. Corporate Governance, Oxford University Press, UK.

2. Trevino, LK & Nelson, KA (2011) Managing Business Ethics: Straight Talk about How to Do It Right (5th Edition), John Wiley, USA.

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Assessment Overview

Research Essay (2000 words) 40%

Due date: TBA.

Exam 60%

Scheduled during examinations period

All assessment tasks must be submitted to pass & 50% must be attained in order to pass

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Assessment 1: Research Essay

(2000 words)

Choose one of the following three topics:

Is the formal cultural system within a firm the most important factor in creating an ethical workplace? How do formal cultural systems attempt to promote ethics?

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For the essay:-

Use at least 15 references:

* six academic journal articles peer reviewed

* six other quality references

Electronic and Hardcopy submission.

Turnitin

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Assessment Criteria for the Essay

Key issues relating to the question have been developed

Original and clear argument

Logical and convincing discussion

Ideas and assertions substantiated through use of high quality reference material and key academic perspectives/views used to develop arguments

Appropriate Harvard style referencing (intext and list of references)

Number and quality of references

Clear and comprehensive written style (spelling, grammar, syntax etc.)

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Harvard referencing style continued

Harvard is an author-date referencing style widely accepted in scholarly circles. Each reference is indicated in the text by the author and date of the publication cited, sometimes with added information such as page numbers. The full details of these references are listed at the end of the text in a Reference list. Please follow this information given to you by us regarding referencing.

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Harvard Referencing continued

Here is another clear guide to show our students and staff how to reference using the Harvard Referencing style.

Harvard Citation Style Examples

Follow this link for a simple and clear way to use Harvard Citation Style Examples –

http://guides.is.uwa.edu.au/content.php?pid=43218&sid=318559

The PDF for the above url is also on the on MyRMIT Learning Hub for this Course – see Assessment

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REFERENCING FROM THE INTERNET

You cannot copy works (text, images, media etc.) off the

Internet without referencing your source.

If you are using text, an image or other media from a webpage, you must reference the material.

Check with your lecturer or course guides for your course requirements.

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Essay assessment criteria

See the Course information Document for assessment criteria for the essay.

Ethics vs Morality

Morality reflects a person’s or group’s standards of right and wrong. Moral understanding is usually developed passively.

Ethics is the assessment of moral standards. Ethics is developed actively – through the use of theories and experience.

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BUSM 3199/3115/4198 Ethics & Governance Lecture 4: Creating an Ethical Organisation

Today

So what are we are saying is:

B = f (P & E)

BEHAVIOUR

ENVIRONMENT

PERSON

Outline

The work context

Organisational culture

Ethical formal and informal cultural systems

Ethics codes

Ethical leadership

The relationship between leadership, culture, ethics codes and behaviour

Learning objectives for today

Know the characteristics of an ethical organization

Discuss the difference between ethics of value and ethics of compliance

Understand the ethical formal and informal cultural systems

Discuss a code of ethics

Discuss ethical leadership

An Ethical Organisation

Trust

Effective communication

Openness

Objectivity and fairness

Integrity

Transparency

Values

The organisation as a context

individual personality is unimportant in organisational criminal behaviour, as it results from role fulfilling rather than individual pathology (Schrager & Short 1978)

a reliable picture of moral conduct can be ascertained “not so much in direct observation of the decision maker as in a firmer grasp of the decision maker’s environment” (Frederick 1992)

Bad apples and bad barrels: Most people are the product of the context they find themselves. They look up and around… (Trevino and Brown 2004)

Organisational membership

Persons in organisations are socialised in their roles (Katz and Kahn 1978).

Through this process, people accept the organisational goal structure and the culture (Clinard & Yeager 1980).

The expected role behaviour is learned from others’ expectations and the rewards that they receive from their organisational membership.

Ethics of Values? or Ethics of Compliance?

Values approach – is proactive and inspirational; emphasises expected behaviour, high standards

Compliance approach – is reactive and punitive; emphasises required behaviour, obeying the law

Organisational culture

Organisational culture affects people in organisations

The organisational culture includes the basic assumptions concerning what is right, proper and fair (Gottlieb & Sanzgiri 1996).

Expresses shared assumptions, values and beliefs and is the social glue that holds the organization together. It’s “how we do things around here.” (Trevino & Nelson 2006)

Ethical formal cultural systems

Leadership: creates, maintains and changes culture. Most important aspect of an organisation’s ethical culture

Selection and reward systems

Structure – authority, responsibility and ethical culture

Policies and codes- their effectiveness depends on other formal and informal systems. Ethics must be in the blood line of the organisation.

Orientation and training programs.

Decision making processes assumptions and scripts

(Trevino & Nelson 2006)

Reward systems

Reward systems can encourage unethical behavior

People do what’s rewarded

Rewards don’t have to be explicit

Think about how attempts to motivate can backfire

Set goals for ethical conduct

(Trevino & Nelson 2006)

Ethics Codes

Have been around since the early 1900s

An international movement towards business ethics codes began in 1980s

Post-Enron, stock exchanges such as NYSE and ASX encouraged the adoption of formal ethics guidelines for company officers.

Formulating a code of ethics

A code of ethics is, in essence, a formalisation of moral principles and responsibilities

The need for a code of ethics

Requirement by law, e.g. in U.S.

Safeguarding reputation

Improving customer service (and thus sales)

Seeking like-minded partners and suppliers

Attracting and retaining the best employees

Responding to internal and/or external pressure

A code of ethics should be organisation-specific. E.g. Religious body vs commercial company; small vs large company

Codes are guidelines, not laws. Spirit of following the code is more important than the form. E.g. A waiter greeting with sincerity vs merely following what is required

Approaches to Ethics

General principles

Corporate mission

Code of conduct

Specific policies

1. General Principles

Examples: Singtel, GIC

Ensure that our employees uphold the code of ethics with integrity.

But details of the principles unavailable publicly

2. Mission

Example: Marketing Institute of Singapore

“Uphold the good name of Marketing Institute of Singapore and Singapore, Academic Standards and Student Welfare”

http://www.mis.org.sg/about/ethics.aspx

3 & 4. Code of Conduct, Specific Policies

Example: FJ Benjamin

Personal responsibility of each director and employee to understand and comply with the code of conduct

On entertainment, while it is an acceptable form of business, directors or employees should turn down meals or entertainment which are excessive in nature or frequency, so as to avoid loss of objectivity when conducting the company’s business

Ethics codes effectiveness

Code effectiveness depends on cultural values and communication

Use collaboration to create/revise the code

Discuss/debate code frequently

Use code to resolve ethical issues

Communicate ethical decisions

Reward behaviour that is consistent with the code

(Stevens 2008)

Six Steps for Effective Implementation of a Code of Ethics

Distribute the code of ethics comprehensively to employees

Assist employees in interpreting and understanding the application and intent of the code

Specify management’s role in the implementation of the code

Inform employees of their responsibility to understand the code and provide them with the overall objective of the code

Establish grievance procedures

Provide a conclusion or closing statement, such as one from Cadbury Company: “The character of the company is collectively in our hands. Pride in what we do is important, and let us earn that pride by the way we put the beliefs set out here into action.”

Ethical informal cultural systems

Informal cultural systems

Informal norms

Heroes and role models

Rituals

Myths and stories

Language

Developing and changing the ethical culture

(Trevino & Nelson 2006)

Org. Culture and Leadership

Leaders affect culture through:

attention

critical incidents and crises

role modeling / teaching / coaching

criteria for scarce resources, rewards, status, recruitment, selection, promotion, retirement, excommunication

others: formal statements, structure, systems, processes, physical setting, rituals, stories, etc.

The responsibility of managers

Managers have responsibility for ethical behaviour in organisations because they affect culture, policies and practices

Begin with clear standards

Design a plan to continually communicate your standards

Managers are role models

(Trevino & Nelson 2006)

moral manager

Reputation for

Ethical

Leadership

Having a good character

Setting ethical

standards,

expectations etc.

(Trevino & Brown, 2004)

Ethical leadership

Moral person

Traits

Behaviours

Decision making

moral person

Integrity

Trustworthiness

Honesty

Do the right thing

Concern for people

Being open

Personal morality

Hold to values

Objective/fair

Concern for society

Follow ethical decision rules

Trevino, Hartman & Brown, 2000

moral manager

Role modelling through visible action

Rewards and discipline

Communicating about ethics and values

Executive Ethical Leadership Reputation Matrix

Hypocritical leader

Ethical leader

Unethical leader

Strong

Weak

Moral Manager

Weak

Strong

Moral Person

Ethically silent leaders

(Trevino & Brown, 2004)

Weak in ethics as a person, weak in ethics as a manager = Unethical leader

Weak person, strong manager = Hypocritical leader

Strong person, weak manager = Silent leader

Strong person, strong manager = Ethical leader

Guidelines for effective ethics management

Understand existing ethics culture

Communicate importance of ethical standards

Focus on reward systems

Promote ethical leadership in the organisation

(Trevino & Brown, 2004)

Conclusions

An ethical organization requires ethical leadership – people look up and around

An ethical leader is a strong moral person and strong moral manager

A code of ethics is a guideline. For it to have meaning within an organisation it has to be part of the culture.

Case Study Codes of Ethics Creative Technology & FJ Benjamin

Read the Creative & FJ Benjamin Code of Business Conduct and Ethics and consider:

a) what are the ethical principles underlying these codes? – is it a values based approach or a compliance based approach?

2. Do you think these codes would be effective? Consider Stevens (2008) – reading for Week Four.

3. Are there ways in which the codes implementation should be supported?

4. What else would you do as a manager to make an organisation ethical?

Review Question

1. What is the role and content of an ethics code in an organisation?

2. Explain when and why codes of ethics are ineffective and discuss the arguments presented by Stevens (2008) and Trevino and Brown (2004).

3. Outline the differences between a hypocritical and an ethically silent leader (Trevino and Brown 2004). What are the likely outcomes of having either of those leaders in an organisation?

4. What can organisations do to improve the ethical behaviour of their employees? Give examples.

5. Is unethical behaviour in business the result of ‘bad apples’? Discuss in relation to organisational culture (‘a bad barrel’).

To provide clear guidelines to help with decision making on issues that might be of ethical nature.

Context – “Bad apple or bad barrel?

Most people if led/influenced to unethical behaviour will do it, therefore, the need to lead people to ethical behaviour.

Employees must see that formal policies go beyond window dressing – “walk the talk”

Has to be talked about day in day out

3. Hypocritical – “talk but not walk”. Silent – says nothing/does nothing. Inconsistent behaviours, dependent on the individual and easily swayed to be unethical.

4. Set ethical standards; role model ethical conduct; use rewards and punishment to reinforce ethical behaviour – hold people accoutable; let people know what is expected; training; use of media; use of case studies; manager kits

5. The influence of culture on behaviour – what it takes to succeed around here, what people see rewarded. What does it take to go against the dominant culture? Example Enron.

References

Clinard, MB, & Yeager, P. C. 1980, Corporate crime, The Free Press, New York.

Frederick, NL 1992, ‘Ethics and Integrity – Beyond Internal Controls’, Managerial Auditing Journal, vol. 7, no. 1.

Gottlieb, JZ & Sanzgiri, J 1996, ‘Towards an ethical decision making in organizations’, Journal of Business Ethics, vol. 15, pp. 1275-85.

Katz, D, & Kahn, R. L. 1978, The social psychology of organizations, 2 edn, Wiley, New York.

Schrager, L & Short, J 1978, ‘Toward a Sociology of Organizational Crime’, Social Problems, vol. 25, pp. 407-19.

Stevens, B 2008, ‘Corporate ethical codes: Effective instruments for influencing behavior’, Journal of Business Ethics, vol. 78, pp. 601-9.

Treviño, LK & Brown, M 2004, ‘Managing to be ethical: Debunking five business ethics myths.’ Academy of Management Executive, vol. 18, no. 2, pp. 69-81.

Trevino, LK, Hartman, L.P., & Brown, M 2000, ‘Moral person and moral manager: How executives develop a reputation for ethical leadership’, California Management Review, vol. 42, no. 4, pp. 128-42.

Trevino, LK, & Nelson, K. A. 2006, Managing business ethics: Straight talk about how to do it right, 4 edn, John Wiley & Sons, New York.

Online References

Jeff Skilling – ENRON

http://www.youtube.com/watch?v=XFTihsjO-og

Some background to Tyco: Former CEO Denis Kozlowski

http://www.youtube.com/watch?v=MYmLaVYsyHw

Milgram Experiment

http://www.youtube.com/watch?v=BcvSNg0HZwk

Stanford Prison Experiment

http://www.youtube.com/watch?v=Z0jYx8nwjFQ

Next Week

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Fifth Edition

LINDA KLEBE TREVIÑO Distinguished Professor of Organizational Behavior and Ethics

Smeal College of Business

The Pennsylvania State University

KATHERINE A. NELSON Lecturer

Fox School of Business

Temple University

JOHNWILEY & SONS, INC.

MANAGING BUSINESS ETHICS

Straight Talk About How To Do It Right

E1FFIRS 07/09/2010 Page 2

VP & PUBLISHER George Hoffman

EXECUTIVE EDITOR Lise Johnson

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Library of Congress Cataloging-in-Publication Data

Treviño, Linda Klebe. Managing business ethics : straight talk about how to do it right / Linda Klebe Treviño, Katherine

A. Nelson. – 5th ed.

p. cm.

Includes index. ISBN 978-0-470-34394-4 (pbk.)

1. Business ethics. 2. Business ethics–Case studies. I. Nelson, Katherine A. II. Title.

HF5387.T734 2010

1740.4–dc22 2010020659

Printed in the United States of America

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E1FTOC 07/09/2010 Page 3

BRIEF CONTENTS

SECTION I INTRODUCTION

CHAPTER 1 INTRODUCING STRAIGHT TALK ABOUT MANAGING BUSINESS ETHICS: WHERE WE’RE GOING AND WHY 2

SECTION II ETHICS AND THE INDIVIDUAL

CHAPTER 2 DECIDING WHAT’S RIGHT: A PRESCRIPTIVE APPROACH 38

CHAPTER 3 DECIDING WHAT’S RIGHT: A PSYCHOLOGICAL APPROACH 71

CHAPTER 4 ADDRESSING INDIVIDUALS’ COMMON ETHICAL PROBLEMS 111

SECTION III MANAGING ETHICS IN THE ORGANIZATION

CHAPTER 5 ETHICS AS ORGANIZATIONAL CULTURE 150

CHAPTER 6 MANAGING ETHICS AND LEGAL COMPLIANCE 207

CHAPTER 7 MANAGING FOR ETHICAL CONDUCT 255

CHAPTER 8 ETHICAL PROBLEMS OF MANAGERS 292

SECTION IV ORGANIZATIONAL ETHICS AND SOCIAL RESPONSIBILITY

CHAPTER 9 CORPORATE SOCIAL RESPONSIBILITY 322

CHAPTER 10 ETHICAL PROBLEMS OF ORGANIZATIONS 354

CHAPTER 11 MANAGING FOR ETHICS AND SOCIAL RESPONSIBILITY IN A GLOBAL BUSINESS ENVIRONMENT 399

INDEX 449

iii

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CONTENTS

PREFACE XIII

SECTION I

INTRODUCTION

CHAPTER 1 INTRODUCING STRAIGHT TALK ABOUT MANAGING BUSINESS ETHICS: WHERE WE’RE GOING AND WHY 2

Introduction 2

The Financial Disaster of 2008 4

Borrowing Was Cheap 4

Real Estate Became the Investment of Choice 5

Mortgage Originators Peddled ‘‘Liar Loans’’ 5

Banks Securitized the Poison and Spread It Around 6

Those Who Were Supposed to Protect Us Didn’t 7

Moving Beyond Cynicism 9

Can Business Ethics Be Taught 13

Aren’t Bad Apples the Cause of Ethical Problems in Organizations? 13

Shouldn’t Employees Already Know the Difference between Right and Wrong? 15

Aren’t Adults’ Ethics Fully Formed and Unchangeable? 16

This Book is about Managing Ethics in Business 19

Ethics and the Law 20

Why Be Ethical? Why Bother? Who Cares? 21

Individuals Care about Ethics: The Motivation to be Ethical 21

Employees Care about Ethics Employee Attraction and Commitment 23

Managers Care about Ethics 23

Executive Leaders Care about Ethics 24

Industries Care about Ethics 26

Society Cares about Ethics: Business and Social Responsibility 27

The Importance of Trust 27

The Importance of Values 29

How the Book is Structured 30

Conclusion 32

Discussion Questions 32

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Exercise: Your Cynicism Quotient 33

Notes 34

SECTION II

ETHICS AND THE INDIVIDUAL

CHAPTER 2 DECIDING WHAT’S RIGHT: A PRESCRIPTIVE APPROACH 38

Introduction 38

Ethical Dilemmas 38

Prescriptive Approaches to Ethical Decision Making in Business 39

Focus on Consequences (Consequentialist Theories) 40

Focus on Duties, Obligations, and Principles (Deontological Theories) 42

Focus on Integrity (Virtue Ethics) 46

Eight Steps to Sound Ethical Decision Making in Business 52

Step One: Gather the Facts 52

Step Two: Define the Ethical Issues 52

Step Three: Identify the Affected Parties (the Stakeholders) 53

Step Four: Identify the Consequences 54

Step Five: Identify the Obligations 56

Step Six: Consider Your Character and Integrity 56

Step Seven: Think Creatively about Potential Actions 57

Step Eight: Check Your Gut 58

Practical Preventive Medicine 58

Doing Your Homework 58

When You’re Asked to Make a Snap Decision 59

Conclusion 61

Discussion Questions 62

Exercise: Clarifying Your Values 63

Case: Pinto Fires 64

Notes 69

CHAPTER 3 DECIDING WHAT’S RIGHT: A PSYCHOLOGICAL APPROACH 71

Introduction 71

Ethical Awareness and Ethical Judgment 71

Individual Differences, Ethical Judgment, and Ethical Behavior 75

Ethical Decision-Making Style 76

Cognitive Moral Development 77

Locus of Control 84

Machiavellianism 85

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Moral Disengagement 86

Facilitators of and Barriers to Good Ethical Judgment 88

Thinking about Fact Gathering 88

Thinking about Consequences 89

Thinking about Integrity 91

Thinking about Your Gut 93

Unconscious Biases 94

Emotions in Ethical Decision Making 95

Toward Ethical Action 97

Revisiting the Pinto Fires Case: Script Processing and Cost-Benefit Analysis 102

Cost-Benefit Analysis 103

Conclusion 105

Exercise: Understanding Cognitive Moral Development 105

Discussion Questions 106

Notes 107

CHAPTER 4 ADDRESSING INDIVIDUALS’ COMMON ETHICAL PROBLEMS 111

Introduction 111

Identifying Your Values—and Voicing Them 112

People Issues 114

Discrimination 115

Harassment, Sexual and Otherwise 119

Conflicts of Interest 122

What Is It? 123

How We Can Think about This Issue 125

Why Is It an Ethical Problem? 126

Costs 126

Customer Confidence Issues 127

What Is It? 127

How We Can Think about This Issue 131

Why Is It an Ethical Problem? 131

Costs 131

Use of Corporate Resources 132

What Is It? 132

How We Can Think about This Issue 136

Why Is It an Ethical Problem? 136

Costs 136

When All Else Fails: Blowing the Whistle 137

When Do You Blow the Whistle? 139

How to Blow the Whistle 140

Conclusion 145

Discussion Questions 145

Notes 147

CONTENTS vii

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SECTION III

MANAGING ETHICS IN THE ORGANIZATION

CHAPTER 5 ETHICS AS ORGANIZATIONAL CULTURE 150

Introduction 150

Organizational Ethics as Culture 151

What Is Culture? 151

Strong versus Weak Cultures 151

How Culture Influences Behavior: Socialization and Internalization 152

Ethical Culture: A Multisystem Framework 153

Alignment of Ethical Culture Systems 154

Ethical Leadership 156

Executive Leaders Create Culture 156

Leaders Maintain or Change Organizational Culture 157

Other Formal Cultural Systems 166

Selection Systems 166

Values and Mission Statements 168

Policies and Codes 169

Orientation and Training Programs 171

Performance Management Systems 172

Organizational Authority Structure 175

Decision-Making Processes 178

Informal Cultural Systems 180

Role Models and Heroes 180

Norms: ‘‘The Way We Do Things around Here’’ 182

Rituals 182

Myths and Stories 183

Language 185

Organizational Climates: Fairness, Benevolence, Self-Interest, Principles 187

Developing and Changing the Ethical Culture 188

How an Ethical Culture Can Become an Unethical Culture 189

Becoming a More Ethical Culture 190

A Cultural Approach to Changing Organizational Ethics 192

Audit of the Ethical Culture 193

A Cultural Systems View 193

A Long-Term View 194

Assumptions about People 194

Diagnosis: The Ethical Culture Audit 194

Ethical Culture Change Intervention 196

The Ethics of Managing Organizational Ethics 198

Conclusion 198

Discussion Questions 198

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Case: Culture Change at Texaco 199

Case: An Unethical Culture in Need of Change: Tap Pharmaceuticals 201

Notes 203

CHAPTER 6 MANAGING ETHICS AND LEGAL COMPLIANCE 207

Introduction 207

Structuring Ethics Management 208

Making Ethics Comprehensive and Holistic 210

Managing Ethics: The Corporate Ethics Office 211

Ethics and Compliance Officers 212

The Ethics Infrastructure 214

The Corporate Ethics Committee 215

Communicating Ethics 215

Basic Communications Principles 216

Evaluating the Current State of Ethics Communications 219

Multiple Communication Channels for Formal Ethics Communication 220

Interactive Approaches to Ethics Communication at USAA 222

Mission or Values Statements 224

Organizational Policy 226

Codes of Conduct 227

Communicating Senior Management Commitment to Ethics 227

Formal and Informal Systems to Resolve Questions and Report Ethical Concerns 235

Using the Reward System to Reinforce the Ethics Message 238

Evaluating the Ethics Program 239

Surveys 240

Values or Compliance Approaches 242

Globalizing An Ethics Program 243

Conclusion 245

Discussion Questions 245

Case: Improving an Ethical Culture at Georgia-Pacific 247

Appendix: How Fines Are Determined under the U.S. Sentencing Guidelines 252

Notes 253

CHAPTER 7 MANAGING FOR ETHICAL CONDUCT 255

Introduction 255

In Business, Ethics Is about Behavior 255

Practical Advice for Managers: Ethical Behavior 256

Our Multiple Ethical Selves 256

The Kenneth Lay Example 257

The Dennis Levine Example 259

Practical Advice for Managers: Multiple Ethical Selves 259

Rewards and Discipline 260

People Do What’s Rewarded and Avoid Doing What’s Punished 260

People Will Go the Extra Mile to Achieve Goals Set by Managers 261

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How Goals Combined with Rewards Can Encourage Unethical Behavior 262

Practical Advice for Managers: Goals, Rewards and Discipline 263

Recognize the Power of Indirect Rewards and Punishments 264

Can Managers Really Reward Ethical Behavior? 266

What about the Role of Discipline? 267

Practical Advice for Managers: Discipline 269

‘‘Everyone’s Doing It’’ 270

People Follow Group Norms 270

Rationalizing Unethical Behavior 270

Pressure to Go Along 271

Practical Advice for Managers: Group Norms 271

People Fulfill Assigned Roles 272

The Zimbardo Prison Experiment 273

Roles at Work 274

Conflicting Roles Can Lead to Unethical Behavior 275

Roles Can Also Support Ethical Behavior 275

Practical Advice for Managers: Roles 276

People Do What They’re Told 276

The Milgram Experiments 277

Obedience to Authority at Work 279

Practical Advice for Managers: Obedience to Authority 279

Responsibility Is Diffused in Organizations 279

‘‘Don’t Worry—We’re Taking Care of Everything’’ 280

Diffusing Responsibility in Groups 280

Diffusing Responsibility by Dividing Responsibility 281

Diffusing Responsibility by Creating Psychological Distance 282

Practical Advice for Managers: Personal Responsibility 283

Conclusion 284

Discussion Questions 285

Case: Sears, Roebuck, and Co.: The Auto Center Scandal 285

Notes 289

CHAPTER 8 ETHICAL PROBLEMS OF MANAGERS 292

Introduction 292

Managers and Employee Engagement 292

Managing the ‘‘Basics’’ 295

Hiring and Work Assignments 295

Performance Evaluation 296

Discipline 299

Terminations 301

Why Are These Ethical Problems? 303

Costs 303

Managing a Diverse Workforce 304

Diversity 305

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Harassment 306

Family and Personal Issues 307

Why Are These Ethical Problems? 309

Costs 309

The Manager as a Lens 310

The Buck Stops with Managers 310

Managers Are Role Models 313

Managing Up and Across 314

Honesty Is Rule One 315

Standards Go Both Ways 315

Conclusion 316

Discussion Questions 317

Notes 318

SECTION IV

ORGANIZATIONAL ETHICS AND SOCIAL RESPONSIBILITY

CHAPTER 9 CORPORATE SOCIAL RESPONSIBILITY 322

Introduction 322

Why Corporate Social Responsibility? 322

Types of Corporate Social Responsibility 329

Economic Responsibilities 329

Legal Responsibilities 330

Ethical Responsibilities 330

Philanthropic Responsibilities 331

Triple Bottom Line and Environmental Sustainability 334

Is Socially Responsible Business Good Business? 337

The Benefit of a Good Reputation 338

Socially Responsible Investors Reward Social Responsibility 338

The Cost of Illegal Conduct 339

The Cost of Government Regulation 340

What the Research Says about Social Responsibility and Firm Performance 343

Being Socially Responsible Because It’s the Right Thing to Do 346

Conclusion 348

Discussion Questions 348

Case: Merck and River Blindness 349

Notes 351

CHAPTER 10 ETHICAL PROBLEMS OF ORGANIZATIONS 354

Introduction 354

Managing Stakeholders 355

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Ethics and Consumers 356

Conflicts of Interest 357

Product Safety 365

Advertising 369

Ethics and Employees 373

Employee Safety 374

Employee Downsizings 378

Ethics and Shareholders 381

Ethics and the Community 386

Why Are These Ethical Issues 388

Costs 388

Conclusion 389

Discussion Questions 389

Notes 394

CHAPTER 11 MANAGING FOR ETHICS AND SOCIAL RESPONSIBILITY IN A GLOBAL ENVIRONMENT 399

Introduction 399

Focus on the Individual Expatriate Manager 400

The Difficulties of Foreign Business Assignments 400

The Need for Structure, Training, and Guidance 400

Foreign Language Proficiency 401

Learning about the Culture 401

Recognizing the Power of Selective Perception 403

Assumption of Behavioral Consistency 404

Assumption of Cultural Homogeneity 404

Assumption of Similarity 405

Ethics-Related Training and Guidance 405

How Different Are Ethical Standards in Different Cultures—Really? 411

Development of Corporate Guidelines and Policies for Global Business Ethics 413

The Organization in a Global Business Environment 417

Deciding to Do Business in a Foreign Country 417

Development of a Transcultural Corporate Ethic 425

Conclusion 429

Discussion Questions 429

Case: Selling Medical Ultrasound Technology in Asia 431

Case: Google Goes to China 434

Appendix: Caux Round Table Principles for Business 440

Notes 444

INDEX 449

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PREFACE WHY DOES THE WORLD NEED ANOTHER BUSINESS ETHICS TEXT?

The popular business press is replete with feature stories describing ethical melt- downs and how those corporate misdeeds have eroded the public trust of business leaders and their organizations. As most of us learned at our parents’ knees, trust and reputation are built over many years and take but an instant to be destroyed. So here we stand at a crossroads. Is it going to be business as usual for business? Or are busi- nesspeople going to commit to regaining the trust of our peers, our families, and our fellow citizens?

In response to this crisis of trust, universities across the country are scrambling to design new courses that incorporate leadership, communication skills, the basics of human resources management, and ethics. That’s why we wrote this book; we want to make the study of ethics relevant to real-life work situations. We want to help businesspeople regain the trust that’s been squandered in the last few years.

This book is different from other business ethics texts in several key ways: First, it was written by an unusual team. Linda Trevi~no is Distinguished Professor of Orga- nizational Behavior and Ethics in the Management and Organization Department of the Smeal College of Business at the Pennsylvania State University. Her prolific re- search on the management of ethical conduct in organizations is published in the field’s best journals and is internationally known and referenced. She has more than 20 years of experience in teaching students and executives in university and non- university settings, and she also has experience as a corporate consultant and speaker on ethics and management issues. Kate Nelson is a full-time faculty member at the Fox School of Business at Temple University in Philadelphia, where she teaches management, business ethics, and human resources to undergraduates. Before joining Temple’s faculty, Kate worked for more than 30 years in strategic organizational communication and human resources at a variety of companies including Citicorp, Merrill Lynch, and Mercer HR Consulting. She also has worked as a consultant spe- cializing in ethics and strategic employee communications and has designed ethics programs for numerous organizations. We think that bringing together this diverse mix of theory and practice makes the book unique.

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Second, the approach of this book is pragmatic, and that approach is a di- rect response to complaints and suggestions we have heard from students, employees, and corporate executives. ‘‘Make it real,’’ they have said. ‘‘Tell us what we need to know to effectively manage people. Take the mystery out of this subject that seems so murky. Get to the point.’’ This book starts with the assumption that ethics in organizations is about human behavior in those organi- zations. We believe that behavior results from a number of factors, many of which can be influenced by managers and the organizations themselves. As a result, this book is organized into sections about individuals, managing in orga- nizational context, and organizations in their broader environment, the ethical dilemmas managers face, and how they might solve them. It also features philo- sophical and psychological factors of decision making, ethical culture, how man- agers can influence employees’ behavior through ethical leadership, what corporations are doing to encourage ethical behavior and corporate social re- sponsibility, and international business ethics.

Third, we have used a different mix of examples than is found in conventional business ethics texts. Most texts focus on high-level, corporate dilemmas: ‘‘Should senior executives be paid at a particular level? Should this industry do business in China? Should American environmental laws apply to American companies operat- ing overseas?’’

Although these are interesting issues, the vast majority of students and employees will never have to face them. However, they will have to hire, man- age, assess performance, discipline, fire, and provide incentives for staff, as well as produce quality products and services and deal effectively and fairly with customers, vendors, and other stakeholders. As a result, although we do feature some classic corporate ethics cases, many of the cases in this book center on the kinds of problems that most people will encounter during the course of their careers. All of the ‘‘hypothetical’’ cases in this text are based on actual incidents that have happened somewhere—it’s the real stuff that goes on every day in offices across the country.

Fourth, this book was developed with the help of students at a number of universities and with guidance from numerous managers and senior executives from various corporations and organizations. We have incorporated the latest re- search on ethics and organizational behavior into this text, and much of the ma- terial that appears within these pages has been tested in both university and corporate settings.

Fifth, we believe this book is easy to use because it is organized to be flexi- ble. It can be used alone to teach an ethics course, or it can be used as a supple- ment to a more conventional, philosophical text. The sections in this book basically stand alone and can be taught in a different sequence than is presented here, and the book also has many cases and vignettes you can use for class dis- cussion. Wiley will create custom versions of the text with selected chapters if requested to do so. To help teach this course, the instructor’s guide provides resources such as outlines, overheads, discussion questions, and additional cases

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for class discussion; it also supplies references to many other resources that can be used to teach the course.

ANOTE TO STUDENTS

This book was written for you. We have listened to your complaints and your wish lists and have tried to pare this complicated subject down to a di- gestible size. The cases that appear in this book all happened to people just like you, who were not as prepared to deal with the dilemmas as you will be after taking this course. Before you get into this book, we have one suggestion: know that regardless of how large an organization you find yourself in, you’re not some little cog in a giant wheel. You have the power to change not only your own behavior and knowledge of ethics but also the behavior and knowl- edge of the people you work with. Use that power: the job you save may be your own.

We also want to suggest that when interviewing for your next job, you try to make sure that you’re joining an organization that values ethics. Are ethics and val- ues described in the firm’s recruiting materials? Do organizational representatives talk about ethics and values during their interviews with you? When you ask about how their organization demonstrates ethics and values, does your interviewer respond enthusiastically, or does he or she look like a deer caught in headlights so you in- stantly know that he or she has never even considered this question before? It’s much easier to get into an ethical organization in the first place than try to get out of an unethical one later on.

ACKNOWLEDGMENTS

It takes a lot of work by a lot of people to make a project like this come to- gether. We’ll begin with some joint thank-yous. Then, because this process has been so meaningful for each of us, we will separately share our more personal thanks.

We both offer our heartfelt appreciation to current and former executives who helped us with this and previous editions, in particular, Larry Axline, Jef- frey Braun, Jacquelyn Brevard, Earnie Broughton, Steve Church, Frank Daly, Srinivas Dixit, Ray Dravesky, Kent Druyvesteyn, Dennis Jorgensen, John O’Byrne, Joe Paterno, Robert Paul, Jo Pease, Shirley Peterson, Vin Sarni, Carl Skooglund, Nan Stout, Phil Tenney, and George Wratney. All shared their valu- able time and advice, some of them on multiple occasions. Their wisdom can be found throughout this book, but especially in Chapter 6. They helped bring the subject of managing business ethics to life.

We also wish to thank Gary Weaver (University of Delaware) for being our philosophy adviser for the first edition, and Dennis Gioia (Penn State faculty member and dear friend) for sharing his Pinto fire case and especially his reflections.

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John Wiley & Sons, Inc. is a fine publisher with a superb team. These people encouraged, nudged, nudged, and nudged again. We have many Wiley people to thank for helping to make this book a success.

The book’s past and present reviewers also contributed significantly to making this a better book, and we thank them as well. We also thank our students and partic- ularly Penn State undergraduate, MBA, and Executive MBA students who provide us with excellent feedback and advice semester after semester.

SPECIAL ACKNOWLEDGMENTS—FROM LINDA K. TREVIIÑO

I have always wondered what makes people do especially good and bad things. As the child of Holocaust survivors, I have a unique perspective on and curios- ity about such issues. My parents and their families escaped Nazi Germany be- fore Hitler began killing Jews en masse, but not before my maternal grandfather was severely beaten and not before my fraternal grandfather was taken to a con- centration camp (euphemistically referred to as a work camp at the time). My father’s family received papers allowing them to emigrate from Germany to the United States shortly before the war began (in spring 1939), allowing my grand- father to be released from the camp where he was being held. Both families landed in New York, where they survived through sheer grit, perseverance, and belief in the American dream. Although my family never dwelled on their expe- riences in Germany, I grew up with a special sensitivity and concern for equality and fair treatment. I traveled to Germany with my dad and brother about 30 years ago. We visited the tiny towns where Mom and Dad were born and met some wonderful German people who had helped them or at least tried to. I walked through a German village holding hands with the elderly woman who had been my maternal grandmother’s best friend and who urged the family to leave Germany because she anticipated the worst. I met another elderly woman who had cared for my father and aunt when they were children and who tried to take care of their home when they were forced to leave everything behind. These were special people, and the opportunity to connect with them holds a special place in my heart. So my family and background influenced me in ways I can’t fully grasp with my mind but in ways that I feel in my soul. And I know that my quest to understand what makes people do good and bad things has something to do with that influence.

Many special people have helped along the path that brought me to the writing of this book. I’ll begin by thanking my mentors in the doctoral program at Texas A&M University’s management department. Many thanks to Stuart Youngblood (now at Texas Christian University), Don Hellriegel, Richard Woodman, Dick Daft (now at Vanderbilt University), and Mary Zey, who encouraged my early theorizing and re- search in business ethics. They told me to go with my gut and to do what was impor- tant, and they supported my every step. My exceptional colleagues in the

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Management and Organizational Department at Penn State have also been supportive all along the way. They have read my papers and challenged me to think harder and make my work ever better.

My thanks also to the colleagues who have worked with me on ethics-related research over the years and who have been partners in learning about the manage- ment of business ethics: particularly Gail Ball, Michael Brown, Ken Butterfield, James Detert, David Harrison, Laura Hartman, Jennifer Kish Gephart, Don McCabe, Bart Victor, Gary Weaver, and more. This shared learning has contributed to the book in important ways.

Shortly after becoming a faculty member at Penn State, I had the good fortune to meet my friend and coauthor, Kate Nelson. I was intrigued by a brief Wall Street Journal article about Kate’s work at Citibank (you’ll read more about that later). We met and became fast friends, who (believe it or not) loved talking about business ethics. We decided to write an article together, and the rest, as Kate says, is history. Kate brought the real world into this book. She was also willing to tell me when I was getting too academic (not her words exactly). It became clearer and clearer to me that we were supposed to write this book together, and I’m very glad we did. Thanks, Kate!

The article became a book proposal that we first shared with publishers at the Academy of Management meeting in 1992 (almost 20 years ago now). Shortly there- after, Bill Oldsey (formerly publisher at John Wiley & Sons, Inc.) showed up in my office at Penn State. His enthusiasm for the book was immediate and infectious, and he talked us into writing a textbook rather than a trade book. I want to thank Bill for the special part he played.

Over the years, Penn State colleagues, administrators, and donors have contin- ued to support my efforts in the area of business ethics. I am grateful to the Cook family, especially the late Ann Cook, for supporting business ethics at Smeal and the Cook Fellowship that I held for a number of years. My thanks also to Mrs. Mercedes Shoemaker (and her late husband, Albert) for supporting the Shoemaker program in Business Ethics that has brought us wonderful speakers on the topic of business ethics year after year. Finally, I am especially grateful to Dean James Thomas for naming me Distinguished Professor of Organizational Behavior and Ethics.

My association with the Ethics Resource Center Fellows program (see www. ethics.org) has connected me with executives who manage ethics in large business organizations as well as consultants and those in government who are interested in making the business world (and the rest of the world, for that matter) a more ethical place. I appreciate the relationships and the learning that have come from this associ- ation as well as the time these executives have shared with me. In particular, I appre- ciate the funding that this group has provided for research that has found its way into this book, especially research on executive ethical leadership.

My heartfelt thanks also go to family members, colleagues, and many dear friends not only for cheering me on (as usual) but also for their many contributions to this book. They have served as readers and interviewees. They have provided clip- ping services, helped me make contacts, and offered ideas for cases. They were there

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when I was overwhelmed. I can’t thank them enough. Finally, I thank the light of my life, Dan, for the inspiration, love, and support he provides every day of my life and for being one of the most ethical human beings I know.

SPECIAL ACKNOWLEDGMENTS—FROM KATHERINE A. NELSON

I began to learn about ethics and integrity as a very young child in a family where ‘‘doing it right’’ was the only option. I was blessed to grow up hearing about how your reputation is priceless and you must always guard it and act in ways that enhance that reputation. As a result, my biggest debt is to my parents, the late Harry R. and Bernadette Prendergast Nelson (formerly of New Hartford, New York), and my brother, James V. Nelson of Pasadena, California. My parents worked tirelessly to set Jim and me on the right path, and Jim’s generosity and enthusiastic support encouraged me not only to teach ethics but also to write this book. (Jim proved to me that one can be an investment banker and have high ethical standards, and I’m very proud of him.) I’m also grateful to Jim’s wife, Susan, for her many encouraging words of support and for giving our family its two most precious additions, Conor Vincent and James Patrick Nelson. Thanks to my dearest friends, for their friendship, love, and support: Rose Ciotta, Elizabeth Dow, Carol Dygert, Ann Frazier Hedberg, and Gail Martin. Thanks also to the educational institutions that provided me with a sound footing in values: Utica Catholic Academy in Utica, New York, and the Col- lege of Mount St. Vincent in Riverdale, New York.

If I had ever known how much fun it is to teach, I might have made the transition to academia much earlier. Many thanks to the deans at the Fox School of Business at Temple University—including Moshe Porat, Rajan Chandran, and Diana Breslin Knudson, who took a chance on my teaching ability—and thanks to my many students past and present, who have enriched my life in ways I could not have imagined. Sincere thanks also to my many colleagues at Temple, who were so welcoming to this corporate refugee and who made me feel so much a part of this wonderful institution, especially: Norm Baglini, Gary Blau, Debbie Campbell, Kathleen Davis, Arlene Dowd, Deanna Geddes, Terry Hal- bert, John McClendon, and Don Wargo.

Thanks go to the many managers who, each in his or her own way, taught me that business ethics need not be an oxymoron: Christopher York, Don Armi- ger, Peter Thorp, Judith Fullmer, Jerry Lieberman, and Jane Shannon—all for- merly with Citicorp in New York City; and Debra Besch, Charlie Scott, and Lea Peterson, all currently or formerly with Mercer HR Consulting in Philadel- phia and Boston. And thank you to Allan Kennedy, the coauthor of the ground- breaking book from the late 1970s, Corporate Cultures. While working at Citicorp as a McKinsey consultant back in 1985, Allan was the very first person who encouraged me to go into ethics by helping me germinate the idea of de- signing an ethics game for Citicorp.

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The most important thank-you goes to my wonderful husband, Stephen J. Morgan—an honorable man if there ever was one—who inspires and loves me every day. This book and my teaching would not be possible without his support, wisdom, and encouragement.

Of course, a final thank-you goes to my coauthor, Linda Trevi~no, for her dear, dear friendship and for working with me to produce this book in what, in comparison to accounts from other writing teams, was an almost painless experience.

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SECT ION I INTRODUCTION

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CHAPTER1 INTRODUCING STRAIGHT TALK ABOUT MANAGING BUSINESS ETHICS: WHERE WE’RE GOING AND WHY

INTRODUCTION

Back in 1993, when we sat down to write the first edition of this book, people won- dered if business ethics was just a fad. At that point, companies were just beginning to introduce ethics into orientations and management training programs. In academia, business ethics was just beginning to gain traction as a subject for serious academic study and some business schools were going so far as to require a business ethics course to graduate.

Back then there was still the feeling among many experts that business ethics— like time management, quality circles, and other management buzzwords of the day—would soon become a footnote in texts that described business fads of the late twentieth century. Despite multiple waves of scandal over the years, these have often been portrayed as temporary blips. For example, one prominent business writer for Fortune Magazine wrote an article in 2007 entitled ‘‘Business is Back!’’ Here’s a choice excerpt . . . ‘‘It must be said: The shaming is over. The 51/2 year humiliation of American business following the tech bubble’s burst and the Lay-Skilling-Fastow- Ebbers-Kozlowski-Scrushy perp walks that will forever define an era has run its course. After the pounding and the ridicule, penance has finally been done. No longer despised by the public, increasingly speaking up and taking stands, beloved again by investors, chastened and much changed—business is back.’’1 Could he have been more wrong? Business managed to outdo itself on the shame index yet again just about a year later. We’ve seen these ethical debacles occur regularly for the past 25 years. As a result, we’re convinced that business ethics is far from a fad. It’s an ongoing phenomenon that must be better understood and managed and for which business professionals must be better prepared.

We tell our students that serious ethical scandals often result from multiple parties contributing in their own small or large ways to the creation of a catastrophe. As you’ll

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read later on in this book, Enron’s collapse in 2001 was not just the failure of Enron executives and employees, but also the failure of Enron’s auditors, the bankers who loaned the company money, and the lawyers who never blew the whistle on Enron’s shenanigans. However, no scandal of recent years—not even Enron—matches the financial industry debacle in 2008. The crisis was unparalleled in its scope and has fueled public outrage like no other business disaster in our lifetime. The aftermath has people around the world angry and mistrustful of companies, governments, regulators, rating agencies, and the people who work in them. If there was ever a crisis of trust and confidence, this is it. It is also a textbook-perfect example of how numerous people’s actions (and inactions) can conspire to spawn an almost unimaginable calamity.

Recent business history has proven beyond any doubt that divorcing business from ethics and values runs huge risks. Rushworth Kidder,2 the highly regarded ethics writer and thinker, recently wrote about the financial debacle and the resulting public anger. He eloquently described how free marketers cite Adam Smith’s Wealth of Nations to justify a breed of capitalism that abhors regulation and focuses on short- term profits over long-term stewardship. Kidder wisely noted that 17 years before his more famous book, Smith wrote another one entitled The Theory of Moral Senti- ments. Smith’s first book deserves more attention because he always presumed that the messages from these two books would go hand in hand. Smith’s ‘‘moral senti- ments’’ work rests on the assumption that human beings are empathetic; they care about others, and they derive the most joy from human love and friendship. His book opened with the following statement: ‘‘How selfish soever man may be supposed, there are evidently some principles in his nature, which interest him in the fortune of others. . . . ’’3 Smith believed that a good life derives from the expression of ‘‘benefi- cence,’’ not from material wealth. He acknowledged that self-love (which he also acknowledged) can spur the individual to better his own condition by besting com- petitors. But he argued that this must be done in a just manner and in the spirit of fair play as judged by an informed, ethical, and impartial spectator. We care what others think of us because we are first and foremost social beings. But we also are moral beings who want to do the right thing because it is the right thing to do (not just to win the praise of others). According to Smith, virtuous persons balance prudence (mature self-love), strict justice, and benevolence, and ideal societies are comprised of such persons. Finally, a flourishing and happy society is built upon a foundation of justice and rules of conduct that create social order. Smith was confident that human- kind would progress toward this positive ethical state; he called on leaders to avoid the arrogance of power and, instead, to be virtuous statesmen. Kidder’s point was that capitalism will succeed only when firmly tethered to a moral base, and he reminds us that Adam Smith—that hero of free marketers—knew that better than anyone.

We completely agree. We began this book almost 20 years ago with the firm belief that business isn’t just ‘‘better’’ when companies and businesspeople are ethi- cal, but rather that good ethics is absolutely essential for effective business practice. This is not just empty rhetoric. Work is essential to life, and most people work for a business of some kind. How we work and the standards we uphold while we are working affect much more than just commerce. Our business behavior also affects

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our personal and company reputations, politics, society at large, and even national reputation. For example, the 2008 financial crisis, while global in scope, had its roots in the United States, and the nation’s reputation has suffered because of the behavior of individuals and companies. Similarly, China’s reputation has suffered because of contaminants found in Chinese exports such as infant formula, drywall (used in construction), and children’s toys. So, corporate misbehavior does not happen in a vacuum, and it’s not just corporate reputations that suffer as a result. These scandals cast long shadows, and they often affect entire industries and countries. In this com- plex and increasingly transparent world, where reputation influences everything from who wants to hire you or trade with you to who buys your products to who finances your debt—and much more—unethical behavior in business is a very big deal indeed. So, let’s take a closer look at the elephant in the room: the near collapse of the financial markets in 2008 and what it has to do with business ethics.

THE FINANCIAL DISASTER OF 2008

The implosion of the financial markets in 2008 was largely not the result of illegal behavior. For the most part, the activities that brought down the U.S. economy and others around the world were not against the law, at least not yet (government regula- tors and the legal system often play catch-up after ethical debacles in business). Many of those activities, however, were unethical in that they ultimately produced great harm and were contrary to a number of ethical principles such as responsibility, transparency, and fairness. Let’s start with some of the factors that laid the ground- work for the disaster in the United States.

BorrowingWas Cheap

First, borrowing money became really cheap. In 2000, stocks in high-technology com- panies had soared to unsustainable heights and that bubble finally burst. To soften the effects on the U.S. financial markets, Alan Greenspan, who headed the Federal Reserve at that time, lowered the Fed Funds rate (the rate at which banks borrow money from the Federal Reserve) to almost zero. That move, seemingly innocent at the time, injected huge amounts of money into the U.S. financial system. It made the cost of borrowing so low that it fueled a glut of consumer borrowing. Suddenly, it was amazingly cheap to buy a new car, a wide-screen television, a backyard pool, a larger home, a second home, and all sorts of designer goodies. There was even encourage- ment to indulge. Following the terrorist attacks in September 2001, President George W. Bush told people that if they wanted to help the economy they should go shop- ping. And people did. Household debt levels rose to $13.9 billion in 2008, almost double what households owed in 2000, and savings dipped into negative territory. (Since the financial crisis, household savings have risen to 6.9 percent.4) Responsible borrowers should have thought about what they could afford rather than what bankers would lend to them. And responsible lenders should have established that borrowers could actually afford to pay back the loans before lending them money.

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Real Estate Became the Investment of Choice

Of course, people also want to invest in something safe, and what could be safer than real estate? There had been relatively few instances of real estate values declining, and when they did the declines were generally shallow and short-lived. A point of pride in the United States was the high percentage of Americans who owned their own homes. Investing in a home traditionally had been a very safe investment and one that was slow to appreciate in value. But suddenly in the early 2000s, real estate investing became a real moneymaker. With a backdrop of historically low interest rates, real estate became such a popular way to invest that demand soon outstripped supply and prices soared. The value of homes skyrocketed—homes that were selling for $300,000 in one year sold for $450,000 the next. Prices rose so fast that specula- tion grew tremendously. People bought houses with almost no down payment, remodeled them or waited a few months, and then resold the houses for a quick profit. A number of popular television programs showed viewers how to ‘‘flip’’ real estate properties for profit.

Since the cost of borrowing was so low and home equity had grown so quickly, many consumers borrowed on the equity in their homes and purchased additional real estate or a new car or financed a luxury vacation. For example, suppose someone purchased a house for $500,000 in 2003. By 2005, the home might have been worth $800,000. The home owner refinanced the mortgage—borrowing as much as the entire current worth of the house (because its value could only go up, right?), which resulted in a $300,000 cash infusion for the home owner. This practice was very popular, and it laid the groundwork for a huge disaster when the housing values fell off a cliff in 2008 and 2009. Imagine the home owner who refinanced the home just described. Imagine that he took the $300,000 and purchased a summer home and a sports car and paid for his children’s college educations. Suddenly, home values plummeted and his house lost 30 percent of its value, which was common in mar- kets such as California, Florida, Nevada, or Arizona, where the real estate bubble was particularly inflated. After the real estate bubble burst, his house was worth $560,000. Now suppose he loses his job and needs to sell his house because he can’t afford the mortgage payments. He can’t get $800,000 for his home, which is what he owes on his mortgage. His only choice is to work with the mortgage holder (probably a bank) to refinance (unlikely) or declare bankruptcy and walk away from the house. This is what a lot of home owners have done, and it is one of the factors at the heart of the current financial crisis. Lots of folks were in on this bubble mentality, getting what they could in the short term and not thinking very much about the likelihood (or inevitability) that the bubble would burst.

Mortgage Originators Peddled ‘‘Liar Loans’’

In the early 2000s, as housing investments increased in popularity, more and more people got involved. Congress urged lenders Freddie Mac and Fannie Mae to expand home ownership to lower-income Americans. Mortgage lenders began to rethink the

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old rules of financing home ownership. As recently as the late 1990s, potential home owners not only had to provide solid proof of employment and income to qualify for a mortgage, but they also had to make a cash down payment of between 5 and 20 percent of the estimated value of the home. But real estate was so hot and returns on investment were growing so quickly that mortgage lenders decided to loosen those ‘‘old-fashioned’’ credit restrictions. In the early 2000s, the rules for obtaining a mort- gage became way less restrictive. Suddenly, because real estate values were rising so quickly, borrowers didn’t have to put any money down on a house. They could bor- row the entire estimated worth of the house; this is known as 100-percent financing. Also, borrowers no longer needed to provide proof of employment or income. These were popularly called ‘‘no doc’’ (no documentation) or ‘‘liar loans’’ because banks weren’t bothering to verify the ‘‘truth’’ of what borrowers were claiming on their mortgage applications.

Banks Securitized the Poison and Spread It Around

At about the same time liar loans were becoming popular, another new practice was introduced to mortgage markets. Investors in developing countries were looking to the United States and its seemingly ‘‘safe’’ markets for investment opportunities. Cash poured into the country from abroad—especially from countries like China and Russia, which were awash in cash from manufacturing and oil respectively. Wall Street bankers developed new products to provide investment vehicles for this new cash. One new product involved the securitization of mortgages. (Note: structured finance began in 1984, when a large number of GMAC auto receivables were bundled into a single security by First Boston Corporation, now part of Credit Suisse.) Here’s how it worked: Instead of your bank keeping your mortgage until it matured, as had traditionally been the case, your bank would sell your mortgage— usually to a larger bank that would then combine your mortgage with many others (reducing the bank’s incentive to be sure you would pay it back). Then the bankers sold these mortgage-backed securities to investors, which seemed like a great idea at the time. Real estate was traditionally safe, and ‘‘slicing and dicing’’ mortgages divided the risk into small pieces with different credit ratings and spread the risk around. Of course, the reverse was also true, as the bankers learned to their horror. This method of dividing mortgages into little pieces and spreading them around could also spread the contagion of poor risk. However, starting in 2002 and for several years thereafter, people couldn’t imagine housing values falling. So much money poured into the system, and the demand for these mortgage-backed security products was so great, that bankers demanded more and more mortgages from mortgage originators. That situation encouraged the traditional barriers to getting a home mortgage to fall even farther. These investment vehicles were also based upon extremely complex mathematical formulas (and old numbers) that everyone took on faith and few attempted to understand. It looks like more people should have followed Warren Buffett’s sage advice not to invest in anything you don’t comprehend! Add to that toxic mix the relatively new idea of credit-default swaps

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(CDS). These complex financial instruments were created to mitigate the risk finan- cial firms took when peddling products like securitized mortgages. CDS are insur- ance contracts that protect the holder against an event of default on the part of a debtor. One need not own the loan or debt instrument to own the protection, and the amount of capital tied up in trading CDS is very small compared to trading other debt instruments. That is a very significant part in the increase in popularity at sell-side and buy-side trading desks. The big insurance company, AIG, was a huge player in this market, and so were the large banks. The firms that were coun- terparties to CDS never stepped back from the trading frenzy to imagine what would happen if both the structured finance market and the real estate bubble burst (as all bubbles eventually do) at the same time. Both underwriters and investors would be left holding the bag when the music stopped playing—and the U.S. tax- payer has had to bail out most of the financially-stressed firms to save the entire financial system from collapse. Please note that all of this happened in a part of the market that was virtually unregulated.