Inequality in the United States
JULIA TAYLOR KENNEDY: Welcome to Just Business. I'm Julia Taylor Kennedy.
This week on the podcast we're turning inward. When it comes to global business ethics, protest movements in the United States have dominated headlines for months. New York City's decision to close Zuccotti Park to Occupy Wall Street protesters and the recent decision to reopen the park has only augmented the proliferation of headlines.
Rather than get into protest tactics or predictions of how effective the movement will be or how long it will last, we're going to zoom out and examine some of the larger lessons that Occupy Wall Street holds for the political economic climate in the United States and, of course, the related ethical questions.
The Occupy Wall Street debate has become fairly polarized, with Wall Streeters and protesters retreating to their respective corners. That's why this week's guest, Philippe Burke, is so refreshing. He's managing partner of the hedge fund Apache Capital Management, which he founded about 15 years ago, after holding senior positions on Wall Street constructing complex derivatives at Lehman Brothers and Morgan Stanley.
He is also a staunch supporter of the Occupy Wall Street movement. Burke braved the microphone to dig up the underlying ethical issues in the current U.S. economic climate. He says the problem boils down to accountability.
PHILIPPE BURKE: If you think about what happened in 2008, you had very large corporations—banks and others—who, through a series of actions that they have taken—and not all the blame is on them, but at least part of it is on them—got into tremendous financial difficulty. These large capitalistic, free-market corporations were bailed out. They were out bailed how? They were bailed out on the backs of taxpayers, essentially. So to use the language of Zuccotti Park, it's the 99 percent bailing out the 1 percent.
So that in and of itself, I know, creates a certain discomfort in lots of people. But we have all learned to deal with cognitive dissonance. We can keep different ideas in our minds that are not necessarily coherent.
But I think the issue is really beyond that. The issue is, here we are bailing out these corporations, and we're given a reason why, if you remember the speeches in Congress given by administration and central bank officials. The basic argument is that banks are essentially the conduit through which savings in the country is allocated to businesses to finance accounts receivable, inventory, to meet payroll. If that conduit is cut, a lot of business will no longer be able to operate, let alone thrive. They won't be able to hire people. They will be forced to fire people.
So there was a sense that we're all in this together. If your neighbor's house is on fire and he's smoking—remember that argument that was made?—you don't complain, "Why are you smoking?" You roll up your sleeves and you put out the fire.
The deal, in some sense, that was crafted, in all of our minds, was that we're going to save the banks, not because the banks are these godly creatures, but they are necessary for the country; it's the right thing to do. The quid pro quo is banks will then lend, businesses will have access to credit, they will be able to operate properly, thrive, hire people, and it will get us out of the recession.
I think what offends a lot of people is that that link was not carried out properly, if at all.
It's actually a complicated issue, because, while this was happening, bank examiners were going through the books of lots of banks and telling them, "You need to raise additional capital in order to meet what we think are the proper risk guidelines for these types of assets, including loans."
It's not like bankers were necessarily these evil creatures who hated America and, therefore, cut all lending. But at times of great financial distress or great distress in general in our country's history, generally people rise up and try to do things that are right for the country.
I think there's a sense among a lot of people, some of whom are speaking, like myself, with incomplete information, that the people who were saved then turned around in the next three years and threw people out of their homes. So you would have an individual sitting at home who can no longer meet his payment, and he gets a knock on the door by the sheriff with a posting saying, "You owe this amount of money to J.P. Morgan. We're repossessing your house."
Wait a minute. Didn't I just save J.P. Morgan? Why is J.P. Morgan using all that money to buy Treasuries, fund them at zero percent, earning an interest margin, and paying themselves the largest bonus in history? So that connection between my saving them and their, in turn, turning around and helping the country, including myself, seemed to have been severed somewhere in that process.
I think there is a general sense of anger that the ultra-wealthy super rich—the 1 percent—are being saved when they have losses, so losses are socialized, and when they have gains, it's all theirs.
If I'm doing something that is legal, number one, and I'm not doing things that are illegal—so I'm doing A, which is legal, and I'm not doing B, which is illegal—I'm not sure that's necessarily acting in an ethical way. I'm just being a good soldier. I'm just following the law.
Where it gets interesting is in the whole sector of activity C, where I could figure out a way to do something that's right for me, but for which the cost might be borne by someone else. It's the issue of moral hazard and also the issue of how important my own utility function is, my own well-being, financial or otherwise, and at what cost am I willing to maximize that on other people.
JULIA TAYLOR KENNEDY: Let's talk a little bit about your background. What drew you to the financial sector in the first place?
PHILIPPE BURKE: I would love to tell you that it was planned out. It was really by accident. I went to business school because I wasn't really sure what else to do. I just happened to get in. Then I thought I wanted to stay in New York. I interviewed. I was shocked that anybody would give me a job. I ended up working in finance.
JULIA TAYLOR KENNEDY: And you're very good at it.
PHILIPPE BURKE: It worked out okay. But it was not particularly well planned. I was pursuing both a business and an economics degree. Honestly, I was more interested in economics than I was in business at the time. It was almost a toss of the dice. It could have gone a lot of different ways. That's sort of what happened.
JULIA TAYLOR KENNEDY: You were working with a lot of leveraged debt and derivatives and other things in the 1990s, early on. What did you think when these products first started to become available?
PHILIPPE BURKE: Boy, there are so many anecdotes I can tell you about that. Basically, the role that I had—I was working at Lehman Brothers at the time—was to come out with financial structures that were not available in the marketplace. It was a new product-development role within derivatives. What we did was to come up with assemblies of options and other types of products that were generally referred to as exotic.
They were a little bit different than what was available. You would assemble it in a particular way to either solve a problem, which might be a yield maximization in a portfolio given a set of constraints, or it could be a hedging tool. Generally, it fell in one of those two buckets. It was either to maximize a yield or an expected return or to hedge something. You would put that together, you would figure out how to risk-manage it, how to hedge it. Then I would get it approved by management and then I would give it to the sales force, and they would distribute it out. Sometimes it worked; sometimes it didn't.
It was really thrilling. When you grew up, if you liked taking a radio, tearing it apart on the front lawn, and then putting it back together—if that was something that was fun to you growing up as a kid, then this was just a great job. You could be a kid doing it. It's not entirely clear that it has a lot of social usefulness, this sort of work, but it's a lot of fun and there were lots of fun people. It's very exciting. You're learning a lot of things.
In the process of developing new products, you might—I went back to school at the same time to study a little bit more mathematics, because I thought it might be useful. So you're learning.
It was really fun. For some odd reasons—and I'm still puzzled by it—it's a job that comes with a certain amount of glamour. For some reason, people who are not in finance find this job glamorous. I don't know why. So there were other benefits as well.
Interesting enough, of all the products that my team and I brought out, we were never turned down on a single product, except for one. I saw my former boss, the head of derivatives, recently, who used to work at Lehman and reminded him that he had turned me down on that product. I was so proud of it. Literally, I thought it was one of the best products I had ever come up with.
He told me, "Philippe, we're not going to do this, because that's the kind of product that can blow up a customer," which took a certain amount of judgment and foresight.
To me, it was just fun because mathematically it was interesting. It was a little bit of an unusual equation that you would use to solve that. It created an enormous amount of yield. It was a really fun all-around product. But he saw the potential impact if it was used in an inappropriate way. Some products can lend themselves to being misunderstood more readily than others. This was one of them. I hadn't seen that at the time. So I was very upset.
Then about three or four weeks later, one of our competitors brought out a similar product. In fact, theirs was more elegant than mine, to be honest. In any event, it proved to be just a huge success. But then it led to several accounts losing enormous amounts of money, and lawsuits came out.
So I reminisced with him that he basically had the judgment—I don't think this was necessarily an ethical issue. It was a judgment issue. He had very good judgment.
JULIA TAYLOR KENNEDY: That is really interesting. One interesting thing about it: There has been a lot in the news about how it's easy when you are developing these new products to focus on the math of it—these are very intelligent people, like yourself, that are working on it—to be almost removed from some of the risks that are involved or the long-term impacts.
PHILIPPE BURKE: The consequences.
JULIA TAYLOR KENNEDY: Exactly. Did you find that? Did you find that you were sort of, as you say, putting the radio back together, not really thinking about the long-term bottom line?
PHILIPPE BURKE: Right. Certainly in my case—I couldn't say that was the case for everybody I worked with—I spent so much time just thinking about how to put it together and how to price it and how it might be improved to solve whatever requirements I thought a customer might have that the possibility of its being either misused or misunderstood barely crossed my mind, honestly, while I was putting this together.
JULIA TAYLOR KENNEDY: Did you get a sense, approaching 2008, being in the industry, that it was being misused by some people in the industry? Or was it a huge shocker for everyone when things kind of turned around?
PHILIPPE BURKE: I think what happened as we got closer to 2007 and 2008 was a situation where the pressures were perhaps a little bit different at that point. You were in a situation where the collateral or the raw material that you were using to construct the bonds, the products that you were delivering, was getting more and more expensive or harder and harder to get at an appropriate price.
JULIA TAYLOR KENNEDY: Because there were so many bad mortgages out there? Is that what you mean? Sorry, I know we're getting into technical financial land.
PHILIPPE BURKE: I think to understand the type of pressure that someone might have sitting at a desk like this—you are sitting at that desk on January 1, and over the next 12 months you have certain expectations that are given to you or that are expressed to you by the people you work with, your boss and others. You have pressure from competitors. You have also a certain amount of pressure from knowing that that seat is valuable and there are a lot of other people who would be delighted to replace you.
All of these pressures are on you when you're working in these seats. So you are trying to put these products together, and you have a certain mandate to create these products and to deliver them. How are you going to meet them? You can meet them by simply working really, really hard and coming up with novel ways to assemble pieces, in a way that might deliver more benefit per unit of risk—just better ways of doing it than your competitors.
In the process of trying to solve these problems in a very fast-paced environment, you will come—not always, but at times—closer to the line where there's an ethical decision that you have to make. You're following the law and you're not breaking any rules. You're doing what you're being asked to do. You're delivering what you think is right. But then, whether you live in a little bubble and you have no idea what's going on in the outside world or not, you will likely encounter certain ethical issues.
I'll have to say that in all my time on Wall Street, very, very rarely have I ever encountered situations where there was a deliberate breaking of a rule. I didn't see very much of that. It's not just on my desk, but other people I interacted with. Generally, if you created a product, there was a certain expectation for the representation you would make about its risk.
There's always judgment involved in that sort of thing, but, generally, I think an unbiased third party looking at how material was put together and how the pitch was created—I think in the overwhelming majority of cases an unbiased third party would look at this and say that this was done with a high standard of professionalism. But there are cases where you might be crossing the line or getting very close to the line.
JULIA TAYLOR KENNEDY: And the question is whether the lines need to move.
PHILIPPE BURKE: Do the lines need to move or not?
You know, it's interesting. I remember, not long after coming into the business, hearing stories about people getting arrested for insider trading. It's very interesting. You hear stories of people who literally get practically no benefit, material benefit, from telling others about inside information. They might not be completely aware of at what point they cross the line into doing something that's wrong. But they generally know there's something wrong here. They don't feel comfortable about it. They're sweating. They're not sleeping well at night.
Why would they do that? It's really interesting. Sometimes these ethical lines are approached, and maybe sometimes stepped over, not necessarily entirely for purely monetary reasons. There might be all sorts of other elements in play, like, "I want to look good to my boss," "I want to rise more quickly," "I want the responsibility, the glory, the attention that comes with having done a big deal." It's very interesting how all of these elements claim your attention.
JULIA TAYLOR KENNEDY: Do you think, having gotten an MBA, that some of that character building could be better built into the curriculum at business schools?
PHILIPPE BURKE: It's possible that it could be done there. I wonder if maybe that responsibility ought to come a little sooner. A lot of people go to business school at around 27, 28 now. I think the expectation of having a certain level of character maybe should come a little sooner in life. Maybe it's still in your 20s.
But you would think that someone has a certain idea of right and wrong, and, really, the issue of ethics—if you can get away with doing something wrong and you know you won't be caught and you don't do it anyway, that moral compass. It's important that you get that in your teens and early 20s. So by the time you get to business school, I think a lot of people should be expected to have largely honed that concept.
JULIA TAYLOR KENNEDY: Hop back to the story you were telling me. You were at Lehman Brothers, went to Morgan Stanley, and then started Apache Capital Management. How did you decide to start your own firm?
PHILIPPE BURKE: I think a lot of us get the bug at some point to try to strike out on our own. It was funny. In my conversation with my boss at the time, who was very gracious with me—but part of his job is to give you the reasons why you ought not to leave; it's sort of expected that he would do that—he had a very powerful question that he asked me. He said, "Do you really think the world needs another hedge fund?"
I had a hard time adequately answering it in a convincing way to him. It just came out of left field, but it was a very strong question that he asked me about that. I forget exactly how I answered it.
JULIA TAYLOR KENNEDY: Probably yes.
PHILIPPE BURKE: Or some variation on that, yes—yes, because.
But the basic motivation was less—the reason it ended up being a hedge fund is that, for various reasons, I thought I might be able to do that better than to start a spark plug company. The real motivation was to try to start something and give it a shot. I was just very excited about the idea of starting a business. It just so happened that, having done almost nothing other than derivatives, that was a skill that I thought I might have a shot at doing really well.
JULIA TAYLOR KENNEDY: How have the past few years been at the hedge fund?
PHILIPPE BURKE: We have had our difficulties, like lots of people. It's funny. In the beginning of the year, if you had asked me, "Tell me the three things that will really succeed in the marketplace and tell me the three that will fail miserably," I would have gotten most of both categories wrong.
JULIA TAYLOR KENNEDY: And you're not alone. This is what everyone I have talked to in the industry is saying. It's really hard to predict.
PHILIPPE BURKE: It's a very unusual market. You come with a certain experience that you have had, from which you derive certain conclusions and certain ways of thinking. You also come at it with, for lack of a better word, an ability to craft a story. Oftentimes you are sitting at a desk with a number of screens, and you might have one or two televisions and you have telephones. So there is auditory information. You are speaking to people. You see things.
What you're trying to do is—all this information comes to your senses, but once it's between your ears, you have to process it and come up with a story, what's going to happen in a minute, five minutes, a day, a month, or a year. Based on that story, you will then make a judgment of whether you should buy or sell something. It's as simple as that.
But in the last 10 or 15 years, the cost of computing, the cost of the information itself, of obtaining it and analyzing it, whether mathematically or otherwise, has dropped like a rock. So now almost anybody can buy a very powerful computer and get lots and lots of information for almost nothing. Fifteen or 20 years ago, access to information was still as valuable, but there was a very large price tag associated with it, which is no longer there.
What has not changed very much in the last 10 or 15 years is the amount of time it takes to process it between your ears. That takes about as much time today as it—except that you bring with it a little bit of experience. You have touched the hot stove and you know not to do that again. There are some things that have worked and maybe you try to repeat those. So you have your approaches.
Most of us come to this market with our beliefs, but also our experience. Part of what has made trading in recent years perhaps more difficult or more challenging for lots of people is that notions of what you consider to be rich and cheap—you should do this, you should not do that, based on a particular model or measure of what's good or bad—those are of limited value when you are no longer operating in an auction market where the other players operate under the same rules that you do.
What I mean by that is, imagine that you are operating in a market and you come with a certain sense of what you should buy, what you should sell, how to do it. Remember that your objective is to try to generate income for your customers. So you try to minimize the risk and generate profit.
But imagine that there are large players who come into the marketplace who don't have an iota of worry about whether they are making money or not. They don't care whether they should hedge or not their position. They don't care about mark to market at the end of the month or the valuation of your portfolio.
If these players are very small and the overwhelming majority of people playing in that market do care about these things, at least there's a sense of rationality that you can identify with. But if there are large players who really don't care about these things, then when something becomes very expensive, you would think you should not buy it, and yet it keeps going up, and when something becomes very, very cheap, you think, "I should buy it," and yet it just keeps going down.
That's what we have in the marketplace today. There's so much intervention done by central banks, by sovereign wealth funds, by foreign central banks. They are coming in, and their objective isn't so much to make money as it is to manipulate an exchange rate or to create jobs somewhere. You have to find a way when you are operating in this market to properly account for these players and to act in a way that your behavior and your trading will not be overwhelmed by their actions. And that's a different skill set.
JULIA TAYLOR KENNEDY: It can change on a dime.
PHILIPPE BURKE: It can also change.
JULIA TAYLOR KENNEDY: That's very political.
PHILIPPE BURKE: But it makes past experience of less value in the market like that. That's why a lot of people find it frustrating.
JULIA TAYLOR KENNEDY: I can imagine.
I'm wondering sort of socially—it must be a really difficult time to be in finance. People are reacting in different ways. Do you find there is a certain pressure to react to Occupy Wall Street in a certain way or not? Is everyone sort of expressing their views differently?
PHILIPPE BURKE: I'm not a psychologist, but if I remember right, you generally go through a series of steps when something that bothers you—
JULIA TAYLOR KENNEDY: Shock, anger, depression, negotiation, all of that.
PHILIPPE BURKE: That sort of thing. I forget exactly what they are. I'm sure you know them.
It seems like the early steps were to basically dismiss them as being a group of unruly hippies who don't wash very much and don't have a common theme or even a list of demands and will likely disappear like so much tumbleweed once the weather drops. That seemed to be the first approach.
The next one was to vilify them. We're past that now, I think.
The next stage now is, I suspect that there are lots of people sitting in conference rooms in some of the larger banks saying, "This could really get big. We need to think about how to deal with this."
There will be some people who are either directly associated with Occupy Wall Street or not who will make claims that are outrageous. But there is a certain set of issues, some of which we have discussed, which I think a rational person would agree are very valid and need to be addressed.
JULIA TAYLOR KENNEDY: There are some big names coming out in support. There's personal finance guru Suze Orman, BlackRock CEO Laurence Fink. Fed chairman Ben Bernanke has said they have a point; there are some systemic issues.
Are you surprised that this is happening?
PHILIPPE BURKE: No, no. First of all, they do have an issue, and I think the right way to deal with this when an issue like that comes up is to meet it head-on and to address it—there is an issue here; we need to deal with it—rather than to vilify the opponent and hope they go away. There are cases where that strategy might work well, but I don't think it will in this case. We're past that now. So there is a real set of issues that need to be addressed. I think the right way to deal with it is to get ahead of it.
It's the same thing with regulatory oversight. I think, to a large extent, our industry—I'm speaking now broadly as if I was part of banking, and I'm really not; I'm actually a customer of the bank rather than a bank—generally, our industry has not done a very good job, I think, in getting ahead of the regulatory wave. The right way to do it is, when there is a real problem, you want to get ahead of it and say, "Here are the issues. We recognize them. These are the best ways to deal with them. We will help you craft these regulations," rather than fight every step of the way.
It might work, but I just think that has a lower probability of success. I think it will in this case, too. If all we do is fight what is widely considered to be a set of problems that need to be solved—if we just fight and dismiss them, we will end up having a far worse deal, I think, in the end. It's not a smart way of addressing it.
JULIA TAYLOR KENNEDY: Do you know anything about the Dodd-Frank bill? That was an effort to try to address some of these issues. But it hasn't really been converted into a lot of regulations.
PHILIPPE BURKE: Yes, that's the issue. There is still a lot to be written about it. It's just such an enormous universe of rules.
They include things like the whole concept, I think, of skin in the game. If you manufacture a mortgage and you are getting a whole bunch of individual loans into what's called a pool and you create a security and sell it, should the person or the institution that manufactures it have a loss if that security was poorly put together? Should they be on the hook, in some sense? How do you create that? One way is to force them to have skin in the game by retaining a certain amount of that risk. That's called risk retention.
So there is a lot of dialogue going back and forth around issues like that. There is such a need for additional regulation. One of the most striking proofs of that was an interview that—I think it was Johnny Mack who said essentially in front of Congress, "You must regulate us. We can't help ourselves."
He said it in a much more eloquent way than that, but that's essentially what he said: "We just can't help ourselves, so you must regulate us."
I think that's a cry of honesty, in a way.
JULIA TAYLOR KENNEDY: How did you decide, "I'm going to support this movement. I'm going to speak out about it"? Why did you decide to do that early on?
PHILIPPE BURKE: It was just so obviously right. It was not a very difficult decision. It's not like I had to weigh pros and cons. It was so obvious.
I'll tell you, if there was anything that I was slightly upset about, it's that it took three years for something like this to happen. But sometimes that's what happens. You need to be in the dark for a long time before it really hits you. There are certainly plenty of cases in my life where it took me years to figure something out, so far be it for me to throw stones there.
It's so clear, not just the moral hazard issue that we talked about, but also this business that if you're a little guy no one is going to help you, and if you're a big guy, the rules are so obviously geared to support you. It's very hard for me to see that as a way for America to become great or greater in the future. It's just so obviously wrong that we have taken that garden path. We really need to get back on the highway.
It was just so obvious to do. There really wasn't a lot of thinking.
JULIA TAYLOR KENNEDY: Obviously you do do a lot of thinking. Philippe Burke, thank you so much for sharing your thoughts with me. It was great.
PHILIPPE BURKE: Thanks, Julia.
JULIA TAYLOR KENNEDY: That was Philippe Burke, founder and managing partner of the hedge fund Apache Capital Management. He's also a strong supporter of Occupy Wall Street.
A lack of accountability after the economic crisis can exacerbate the income gap. But what does it mean for political rights? Let's turn to a segment from a weekly podcast of the Carnegie Council called Global Ethics Corner, which takes two minutes to unpack a global ethical issue.
Here's the Carnegie Council's Terence Hurley with an Ethics Corner on the relationship between income gaps and democracies.
TERENCE HURLEY: Does rising income inequality pose a threat to American democracy? This question has long been taboo in American politics. Yet as Occupy Wall Street spreads across the United States, the political consequences of income inequality are grabbing headlines as never before.
The income gap in the United States has risen steadily since the 1970s. Today it's the highest in the developed world. The statistics are daunting. One percent of Americans account for a quarter of the nation's wealth, and while the nation's rich have gotten richer, the poor have gotten poorer. Today one in six Americans lives in poverty.
Many of those occupying Wall Street argue that mounting income inequality threatens our democracy. They warn that as America's middle class dwindles, its ability to effect political change shrinks. Recent cuts to education, health care, and other public services only diminish opportunities for those without independent wealth.
Critics of Occupy Wall Street have denounced such claims as class warfare. They have labeled protesters as communists, populists, and anti-American. The key to success in America lies in individuals' resolve to rise above difficult circumstances. Governments, they say, should play no role in this.
But protesters that without access to equal education and health care, the majority of Americans just can't compete with the wealthy. Cuts to basic services only lessen their chances for political participation. In this sense, income inequality may not be a question of just economic fairness, but of democratic values, which raises the question: When does income inequality become political inequality?
JULIA TAYLOR KENNEDY: That was Terence Hurley of the Carnegie Council reading a Global Ethics Corner written by political scientist Marlene Spoerri.
That concludes this week's look at the underlying causes and consequences of economic unrest in the United States. I'm Julia Taylor Kennedy. Thanks to Terence Hurley, Marlene Spoerri, Julie Mellin, and Madeleine Lynn for their contributions to this week's podcast. And thanks to you, our listeners, for joining us. We're happy to hear from you. Please send questions and comments to email@example.com.
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