---

The following excerpt is taken from Chapter 1 of The Integrity Dividend: Leading by the Power of Your Word by Tony Simons.

From the publisher: In The Integrity Dividend Tony Simons shows how leaders' personal integrity drives the profitability and overall success of their organization. This groundbreaking book is based in on solid research and reveals that businesses led by managers of higher integrity enjoy deeper employee commitment, lower turnover, superior customer service, and substantially higher profitability. This improved performance is the integrity dividend.

Chapter 1: The Dollar Value of your Impeccable Word

Stan Myers, president and CEO of SEMI, a global semiconductor industry association, tells the following story about the impact of keeping his word. When he was CEO of Mitsubishi Silicon America, he planned to move his R&D department from the San Francisco Bay area to Salem, Oregon. Many employees were not interested in moving. As an incentive, he offered a retention bonus to people who would stay the full eight months until the move and help to recruit their replacements. If they took another job before the eight months, they would get severance, but would not get the retention bonus. One young engineer, Alan, got another job, did not get his retention bonus, and finance did not pay him his legitimate severance, which was several thousand dollars. He never asked for it. About a year later, Stan, the CEO, learned about the mistake. He had his people cut the check, found and visited Alan's new workplace, and asked the president of the company to bring Alan up to the conference room for a conversation.

Alan came in and he said, 'What are you doing here? I haven't seen you for a while,'

Stan said, 'Yes, Alan, but I wanted to tell you we forgot to pay you your severance.'

Alan was overwhelmed. More than 15 years later, Stan heard again from Alan. Alan had started up a successful company. He sought out Stan to present him with an engraved iPod Nano, thanking him for his leadership and friendship.

I draw two points from this story. One is that the simple act of keeping a promise can have a huge impact on a person. The second point is scarier: Alan did not expect his employer to keep his word. The fact that Stan acted as he did struck Alan as extraordinarily unusual. CEOs are very busy. Nobody likes to admit a mistake. There probably would have been no fallout if the check had never been written. There would have been understandable reasons for Stan Myers not to have acted as he did. But the fact that he did says something about the man as a leader. And it helps to explain his great success in that role.

It's easy to break a promise. It's even easier to forget the price of breaking it. After all, who can measure that price? Few would deny that a broken promise lowers the morale of your employees, but what's the real dollar cost--the bottom line impact? Or what is the payoff of keeping a promise? It should be simple to align your words and actions in a way that employees can see. But if it's so simple why do most employees say their managers do not do it? Maybe it is not so simple.

Consider how two executives described to me the benefit of an impeccable word--and the cost of lacking one:

Good leadership is, 'Whatever I say I'm going to do, I'm going to do.' That means I have to know what my limitations are and what I'm capable of delivering. As a leader if you don't fulfill your commitments, I can't think of anything that can hurt you more than that.

--Frank Guidara, President and CEO, Uno's Chicago Grill

If your staff see you cutting corners, then they're not going to take you seriously. And then they're not going to take the values that you're trying to instill seriously. Because you're not taking the values seriously.

--Deirdre Wallace, President, The Ambrose Group

Like these successful executives, you, too, most likely want be an honest and respected leader. But this book is about more than being respected. As its title says, it's about The Integrity Dividend--and why and how keeping your word as a leader pays off on the bottom line. One thing that sets this book apart from others that discuss the importance of integrity is that it tells how I have been able to accurately measure its positive dollar impact. As you will see more in later chapters, successful executives I talk to recognize the dividend, too, but until now it has not been well measured.

I am not asking you to be motivated by any intrinsic payoff, though I think there are several. Integrity, for me, is about being more effective, because people see you as consistently following through on your word and demonstrating the values you profess: more effective as a leader, because you more readily capture the hearts of your followers; as a communicator, because people know you mean what you say; as a partner, because you can be counted on; as a customer because you complete business transactions more efficiently; as a supplier, because buyers can know what they will get; and as a brand, because you keep your promises--and promises are all that a brand is. Integrity contributes hugely to executive effectiveness.

Behavioral Integrity: A Recognized Fit Between Words and Actions

Most successful executives intuit the importance of a reputation for integrity. It plays a major role in our public discourse, as politicians of all stripes revel in accusing their opponents of lacking it. People sense its importance, perhaps especially now, as corruption scandals break careers, lives, bank accounts, and the faith of millions. But in 2005, "integrity" was the single most looked-up word on the Merriam Webster dictionary website, which implies that people are not exactly sure what integrity means. Think about that for a minute: people know integrity is important but they are not sure what it means.

Often people use the word "integrity" to describe a general quality of acting ethically. Ethics are important, but they are not what this book is about. For the purposes of this book, integrity means the fit between words and actions, as seen by others. It means promise-keeping and showing the values you profess. This book is simply about keeping your words lined up with your actions--keeping promises and living by the same values you talk about--seamlessly, as in the integrity of hull of a boat. It means being seen as living by your word.

Behavioral integrity is not about the content of a person's values, though I believe that content is very important. It is about how well a person follows through on the values he or she espouses. I can judge people despicable for what they value. But if they walk their talk and keep promises, I will--grudgingly--concede that they have behavioral integrity. A colleague of mine once proclaimed at a department meeting that his decisions would be guided strictly by self-interest, and that he had no concern for what the department or the school needed. I did not like working with the guy, nor did I trust him. But he was living up to his word, and I had to give him credit for behavioral integrity.

It is not enough to keep your word; others have to be aware that you are doing it. And here is where it gets sticky: Like beauty, behavioral integrity is in the eye of the beholder. Consistently keeping promises and living by your stated principles are, of themselves, difficult. Being seen as consistently doing these things is a challenge worthy of the best of us. People we manage spend a lot of time watching us and trying to figure us out. They generally notice and understand more than we realize. But they also carry their own baggage, their own hurts, cynicisms, and biases, and their judgments about our integrity are colored by everything from their own parental issues from childhood to previous bosses to personality to the particular moments they happen to witness. As effective leaders--or business partners, suppliers, board members, whatever--our challenge is to penetrate the veil of others' subjective perceptual processes and convey integrity regardless of them.

That added step of managing others' perceptions makes the challenge more difficult than it might have seemed. It is not enough to manage your own level of consistency. You have to manage others' perceptions of it, without lapsing into cynical manipulation, which probably would not work anyway.

Leadership, Trust, and the Integrity Dividend

It is difficult for anyone to define, measure, and develop leadership, in part because leadership involves trust, inspiration, challenge, strategic vision, and much else. But leadership is critical to just about any company's performance, and there are many books about it, many offering terrific insights. Still, I suggest that the basic insight of this book--a fundamental, challenging one with a demonstrated financial dividend, has not heretofore received the kind of attention it warrants.

Consider the issue of trust, about which there has been a recent flurry of leadership books. Most agree that trust is a critical ingredient for leadership, since few people will follow someone they do not trust. Most also agree that trust is complicated, involving reliance, emotion, and respect, and a sense that the trusted person will look out for you. This book will argue for looking particularly hard at reliance as a crucial ingredient for building and keeping trust. Reliance is the belief that a leader keeps his word; fulfills his promises; show the same values he professes. That is what "walking the talk" really means. If people do not see this consistency, leadership cannot happen, at all. You cannot even get out of the starting gate as a leader if people do not believe your words. Behavioral integrity is a simple idea, though very hard to put into practice. But if you can do so, your powerful word pays off in powerful, concrete dividends.

Later chapters of this book will say how to capture the integrity dividend. Before moving on to them, however, let's look at some of the growing evidence that the dividend really exists.

A Scientific Study: The Dollar Value of an Impeccable Word

A few years ago, a colleague of mine at Cornell University's Hotel School, Cathy Enz, was fascinated by the idea of clear corporate values as a powerful tool for enhancing effectiveness. At the time I had not yet latched onto the idea that how well a leader's actions lined up with his or her words would make a critical difference in that leader's effectiveness. Through many of our conversations, I kept coming back to the idea that talking about values was one thing, acting on them was another, and that aligning those words and actions might be the most powerful combination by far. By that time I had also begun to regard as toxic the common exercise of drafting up a statement of values that sits in a few desk drawers. It gives rise, I thought, to cynical employees who see their bosses pretending to values they do not implement. And cynicism kills spirit, and so undermines the company's bottom line performance in a thousand small and large ways. But at that point my thoughts were just theory without clear supporting evidence.

Management scholars have generated significant recent research on several concepts related to word-action alignment. Trust is widely recognized and demonstrated as a key performance factor in teams and leadership in general. A study of NCAA college basketball teams found that players' trust in leadership drives the quality and consistency of team performance[i][ii]. Several studies have shown that trust in leadership drives subordinates' positive attitudes and their willingness to expend effort beyond formal job definitions[iii]. Fairness perceptions[iv] and perceived violations of "psychological contracts"[v] have also been shown, over many studies, to affect employee attitudes, discretionary effort, and retention. But with a very few exceptions, the previous relevant research had focused on individual outcomes rather than company-wide outcomes. No one had zeroed in on the idea of leaders living by their word, linking it to company performance as its final outcome.

I began to look for ways to test the bottom line impact of word-action alignment. Testing the bottom-line impact of anything in the real world is not especially easy. To test a single factor like integrity, you need a lot of businesses that you can compare directly to each other. Franchises make a good testing ground, as you can filter out a lot of variation, comparing the performance of independent business units that are very similar in most ways but have different managers who lead with different styles.

I found help in this investigation from Pete Kline, then the CEO of Bristol Hotels and Resorts. Bristol Hotels and Resorts operated over 110 hotels in the US and Canada, including Holiday Inn franchises. Pete is a brave man who also intuited the truth of the claim I wanted to test. We focused on 76 Holiday Inn hotels that were in the US and not unionized. Bristol agreed to share the financial performance, employee turnover, and guest satisfaction information for each hotel. Bristol asked me to design its employee survey to include penetrating questions about how much people trust their bosses and how good they think that boss' word is.

For the project, I collaborated with Professor Judi McLean Parks of Washington University, an expert at measuring employee perceptions of their implicit and explicit employment deals – what she calls the "psychological contract." By applying solid scientific practice (focus groups, careful pre-testing, pre-validated questions where feasible, multiple questions "triangulating" on each underlying idea, and objective operational performance measurement), we created a survey that could measure a chain of impact running from behavioral integrity perceptions to attitudes to behaviors to the bottom line.

At a few hotels we ran focus groups about what behavioral integrity looked like, and pilot-tested the survey, translated into five different languages. Then we asked employees at all 76 hotels to complete the survey. They did so anonymously, on company time, with a raffle for sweatshirts and dinners out as an incentive. Most employees filled out paper surveys, but we set up "read-aloud" tables for the roughly 7% of employees with limited literacy[vi]. At each hotel, we asked line employees, supervisors, department managers, and the general manager to say how strongly they agreed or disagreed with statements like:

• My manager practices what he/she preaches.
• When my manager promises something, I can be certain that it will happen.
• I would be willing to let my manager have complete control over my future in this company.

The first two questions regard behavioral integrity, and the third regards trust. The questions are phrased as extremes, so that a statement of strong agreement indicates a deep belief in integrity, or a deep feeling of trust. I did not want to ask questions with which it would be easy to agree.

Each hotel employed around one hundred and thirty employees spread over six to eight departments. Typically the biggest departments by far were housekeeping and front office. Around two-thirds of all employees (more than sixty-five hundred) completed our surveys. For every manager with four or more employees, we generated feedback reports that described employees' relationships with that manager. For each hotel we collected employee turnover information, the results of independently conducted customer satisfaction surveys, and financial performance information for the months following the employee survey.

We averaged employee perceptions at each hotel, and applied path analysis (more on that below) to evaluate all the links in a chain of impact at the same time. We expected to find a chain that runs from employee perceptions of their managers' behavioral integrity, to employee trust in their managers, to their commitment to the company, which would in turn drive both employee turnover and discretionary service behavior. Discretionary service behavior should drive customer satisfaction, and profit should be affected by both employee turnover and customer satisfaction.

The results of the study were so clear that they surprised even me. As Figure 1.1 shows, the average employee perception of how much the employee's manager kept promises and lived by stated values drove hotel profitability more strongly than the five other attitudes measured by the survey.

Figure 1.1. Strength of Association Between Business Profitability and Different Employee Attitudes (please see book for graphic)

Let's take a minute with that result alone: How strong your employees feel their managers' word is--their assessment of their managers' behavioral integrity--is more important to your company's financial performance than employee trust, sense of fairness, commitment, or satisfaction. These other attitudes also matter, to be sure. But behavioral integrity came out as the single most powerful driver of profit. It might be more important that the workers know you mean what you say than whether they like you or the company or their work. First comes the word. Everything else follows.

The survey had asked employees to respond to statements with a number from 1 ("strongly disagree") to 5 ("strongly agree"). Results showed that one-eighth of a point difference in the average employee behavioral integrity ratings between two hotels on this scale pointed to a difference in profits of around two and a half percent of revenues; the eighth-point difference raised the portion of each dollar of revenue that the company got to keep as profit by two-and-a-half cents. Typical revenue streams for that size and tier of hotel run around $10 million annually, so that difference in behavioral integrity raised profit by an average $250,000 per hotel per year. Many of the hotels with high management integrity converted over ten cents more of each revenue dollar into profits than others. Does behavioral integrity make a difference to the bottom line? The evidence said emphatically--hugely--yes. We had detected the integrity dividend.

Here are the details of the chain of impact that we saw:

• Where employees feel their managers keep promises and live by the values they describe, they trust their managers more.
• Where they trust their managers more, they become more emotionally committed to the company--caring more deeply about its mission and taking pride in working for it.
• Where they feel greater emotional commitment to the company, they are more willing to stay in their jobs, and to go beyond their formal job descriptions by providing discretionary service to satisfy guest requests.
• Guests who experience discretionary service from hotel employees like it and feel more satisfied.
• Satisfied guests translate to repeat business, which boosts profits. Employee retention boosts profits as well.

Here is a simpler way to describe the chain: Where employees reported high integrity on the part of their managers, we saw:

• Deeper employee commitment, leading to
  
• Lower employee turnover and


• Superior customer service; all leading to


• Higher profitability.

This study took place in a single industry--the hotel business. Is there evidence of a similar bottom-line integrity dividend in other industries? After all, the hotel business is unique in some ways. It is a service industry that sells positive guest experiences. The pivotal role of customer contact in determining the quality of the final product suggests that employees' emotional response to their work might be more important for hotels than for, say, a manufacturing business. Hotels also employ a less educated labor force than most white-collar businesses. However, there is no evidence that sensitivity or response to managers' integrity issues depends on education level.

As a framework for systematic studies, the notion of behavioral integrity is new--even if the essential idea has long been discussed as an element of good leadership. Other scholars have already started to build on this initial work, and are creating a research community, with sessions devoted to the topic at annual Academy of Management conferences. In coming years I expect to see similar research results in other industries, as more scholars explore the causes, consequences, and management of the issue. Apart from that future research there is already strong evidence that the behavioral integrity effect holds true in other industries as well. For one thing, the attitudes and behaviors that are driven by behavioral integrity (trust, perceived fairness, employee commitment, turnover, and discretionary effort) are already well demonstrated performance drivers in a variety of both service and manufacturing industries[vii]. Further, all the executives I spoke with--in a wide variety of industries--agreed that behavioral integrity plays a pivotal role in determining attitudes toward leadership and ultimately in driving performance. Chapter 2 will begin to discuss what the integrity dividend looks like in other industries.

The Integrity Dividend in Practice: Checking with Executives

Braced by my evidence that managers' promise-keeping and living by stated values drives profitability, I interviewed about a hundred successful executives to learn more about how behavioral integrity works. I spoke with leaders in high-tech manufacturing, health care, real estate, restaurants, hotels, food service, and non-profit, as well as union leaders, and a handful of executive coaches and consultants. My primary criterion for selection was that the executives be successful in their chosen fields, as shown by a pattern of promotions and executive positions. I sought to understand the payoffs and the challenges around behavioral integrity through their eyes, figuring that most successful managers have something to teach me and others working on this issue.

I conducted hour-long interviews, usually by telephone. The result was over 2,000 pages of transcription, which I and my research team broke down into discussion themes. We looked for patterns, extracted and developed stories that related to those patterns, and massaged the pooled insights of these many executives to yield the book you are reading.

I asked the executives about how they perceive the challenges and consequences of word-action alignment or its lack. I also asked them for both general and specific advice. Their responses are valuable in two main ways. First, as I noted above, they demonstrate that the integrity dividend is not unique to the hotel industry. Second, they flesh out the whys and hows of behavioral integrity in deeper, more practical detail. The techniques the executives propose are research-grounded in the sense that they drive the kind of integrity perceptions that create the dividend shown in the Holiday Inn research. However, it is also true that the process of talking to these executives and drawing out and combining their insights may resemble art more than it resembles science. I am learning about integrity along the way. I expect that you will, too.
The interviews yielded four main themes, which we will explore in coming chapters:

• The payoff of behavioral integrity is greater personal and organizational effectiveness --it builds personal credibility and trust, which enhance your ability to get things done through people.


• Employees who trust their leaders work harder and with clearer direction. Trust also leads to greater efficiency in customer relationships, supplier relationships, and union relationships.


• Some of the hardest things to manage about behavioral integrity come down to recognizing and reckoning with our own personal habits and the ways we have learned to interact with people. Some of our well-intended actions serve to undermine our integrity and thus our credibility. Elements of self-knowledge and self-control are thus integral managing behavioral integrity. You have to be willing to occasionally sacrifice in the service of keeping your word. To create a word as good as gold, you sometimes have to demonstrate the value of your word by paying for it.


• Executives can extend behavioral integrity and its dividends through leaders and practices throughout the organization. It is not just about personal relationships. Through careful modeling, training, coaching, accountability and incentives, impeccable follow-through can become a mutual expectation that forms part of the structure and the culture of the company. Make it a shared priority and watch your effectiveness build.

Challenges Rather Than Easy Answers

You may be thinking that behavioral integrity cannot be easy. It isn't. It is hard work, accepting one's word as one's absolute bond and making that bond as solid as steel. The payoff, of course, is that your word of steel is as valuable as gold, because great integrity is rare and people are drawn to it. The challenge is especially great for people who take on the job of managing others in a company hierarchy. Most managers' days are filled with brief tasks, noise, and fires that need putting out. It isn't easy to keep track of commitments. Sometimes your boss countermands your decisions--at the cost of your own credibility. Sometimes the need to keep relationships smooth leads you to sugar-coat the truth, and sometimes that sugar coating leads others to feel betrayed if they mistook the frosting for the cake.

Managing behavioral integrity demands very careful communication as described in Chapter 5. People misunderstand each other all the time--and they feel no less betrayed when the promise that was broken was wrongly understood. And people so often ignore the escape clauses we insert into our promises, such as "I'll try" or "I hope" or even "probably." People often hear the message they hope to hear, or the message they expect. People bring their own cynicism and other kinds of baggage to interactions, and they will sometimes assume you are lying before you speak.

Your position within the company sometimes adds other challenges to living by your word. Leaders are sometimes expected to project confidence and certainty even when they lack it. Managers are sometimes asked to produce short-term results at any cost, or to publicly endorse policies with which they do not agree. As subordinates, leaders and managers sometimes face bosses who prefer deference over honesty. As negotiators, they often fear that truthfulness sacrifices a competitive edge.

When companies face change, the challenges become greater still. Policy shifts are often confusing, and sometimes, as a manager, you have to introduce changes that violate values you yourself promoted. Sometimes in your ambivalence you send mixed messages. And sometimes the policies themselves seem to contradict each other in the values they imply. Then there are initiatives about which you may not be allowed to speak, like layoffs, acquisitions, and mergers.

These challenges are often attended by other difficulties you must face, including tradeoffs, the need to forsake expedient solutions, hard conversations you must have, and personal weaknesses you (like all of us) must acknowledge and confront. The executives and coaches I interviewed for this book have faced them, too, and sometimes they made mistakes. But more often they overcame them--and collected the integrity dividend.

I cannot say with certainty that integrity will always yield the practical outcomes you want. But I can say that its lack, over time, kills spirit among those who follow, and that excellent leadership is fundamentally about building and focusing spirit toward extraordinary achievement.

As a leader, you should finish this book a little wiser, a little more insightful, and a little more effective. It is not about how you can feel better about yourself or how you can better live up to your moral values or those of society. It is about creating more effective relationships and more effective businesses through alignment. Develop a powerful word, because it will serve you well.

Summary

This book is about building an impeccable word in order to increase your effectiveness and that of the people around you. Behavioral integrity is about having that impeccable, powerful word. It is about keeping promises, showing the values you profess, and being seen as doing so. It is not at all easy, especially as the goal is to do so all the time.

Make no mistake: Others evaluate your integrity constantly. And the challenge is harder still when you consider the subjective biases they bring to that evaluation.

Behavioral integrity is not the whole challenge of leadership--there are many other skills and abilities involved in leading. It is not even the whole challenge of building and maintaining trust; there is more involved in that, too. But neither trust nor leadership happens without behavioral integrity, without certainty that the leader means what she says. Behavioral integrity is, in the language of logic, a necessary but not sufficient condition for trust or leadership. It is a cornerstone upon which trust and leadership must be based.

A careful scientific study tracked the consequences of behavioral integrity and measured the dollar impact of it as it operated through hotel worker attitudes and actions, affecting service delivery and the bottom line. The study suggested that employees' sense of their boss' strong behavioral integrity might be a more important performance driver than employee satisfaction, commitment, sense of trust, or feelings of fairness.

Extensive conversations with executives have confirmed both the impact and the challenge of behavioral integrity, and have provided ideas about how others have met the challenge. This book is aimed at helping you to master that challenge and so to reap the integrity dividend.

As mentioned earlier, Chapter two explores the integrity dividend in a variety of industries. Chapter three deepens our model of behavioral integrity's drivers and payoffs. Chapters four through six explore common challenges to managers' behavioral integrity and how to address them. Chapters seven through nine focus on developing behavioral integrity at the company level. Chapter ten briefly applies the same framework to relationships outside the company.

Each chapter ends with brief points designed to help you apply these ideas to your workplace. The first three chapters have a set of questions labeled "consider." Later chapters add a section with specific tools and techniques, labeled "act."

Into Practice
Consider:

• Where have you seen high or low behavioral integrity on the part of your current or a previous leader or boss? How did it affect your work attitude? Your level of discretionary effort? Your peers?


• How high a priority is keeping your word? How much would you sacrifice in order to keep your word?


• Where do you find it challenging to keep promises or live up to stated values? How much does the resulting gap cost you?

Tony Simons, author of THE INTEGRITY DIVIDEND, is an Associate Professor at Cornell University where he teaches organizational behavior, negotiation, and leadership. He is also a business consultant and speaker who focuses on trust in leaders, executive team member trust, and trust in supply chain relationships. He received his B.A. from the University of Chicago and his masters degree and doctorate from Northwestern University.

For more information, please visit www.integritydividend.com.

George Soros has led an extraordinary life, having survived Nazi Germany and Stalinist Russia to become one of the richest men in the world. He is one of the most successful financial speculators in the world, and as such, has a deep understanding of financial markets. He released a book in May, The New Paradigm for Financial Markets: The Credit Crisis of 2008 and What It Means, in which he stated "Eventually, the U.S. government will have to use taxpayer money to arrest the decline in house prices. Until it does, the decline will be self-reinforcing, with people walking away from homes in which they have negative equity and more and more financial institutions becoming insolvent..." That recently came to pass, to the tune of $700 billion dollars. Mr. Soros begins the book by soberly analyzing exactly how we got into this crisis, and we've excerpted that material below.

Setting the Stage

The outbreak of the current financial crisis can be officially fixed as August 2007. That was when the central banks had to intervene to provide liquidity to the banking system.

[...]

The crisis was slow in coming, but it could have been anticipated several years in advance. It had its origins in the bursting of the Internet bubble in late 2000. The Fed responded by cutting the federal funds rate from 6.5 percent to 3.5 percent within the space of just a few months. Then came the terrorist attack of September 11, 2001. To counteract the disruption of the economy, the Fed continued to lower rates--all the way down to 1 percent by July 2003, the lowest rate in half a century, where it stayed for a full year. For thirty-one consecutive months the base inflation-adjusted short-term interest rate was negative.

Cheap money engendered a housing bubble, an explosion of leveraged buyouts, and other excesses. When money is free, the rational lender will keep on lending until there is no one else to lend to. Mortgage lenders relaxed their standards and invented new ways to stimulate business and generate fees. Investment banks on Wall Street developed a variety of new techniques to hive credit risk off to other investors, like pension funds and mutual funds, which were hungry for yield. They also created structured investment vehicles (SIVs) to keep their own positions off their balance sheets.

From 2000 until mid-2005, the market value of existing homes grew by more than 50 percent, and there was a frenzy of new construction. Merrill Lynch estimated that about half of all American GDP growth in the first half of 2005 was housing related, either directly, through home building and housing-related purchases like new furniture, or indirectly, by spending the cash generated from the refinancing of mortgages. Martin Feldstein, a former chairman of the Council of Economic Advisers, estimated that from 1997 through 2006, consumers drew more than $9 trillion in cash out of their home equity. A 2005 study led by Alan Greenspan estimated that in the 2000s, home equity withdrawals were financing 3 percent of all personal consumption. By the first quarter of 2006, home equity extraction made up nearly 10 percent of disposable personal income.

Double-digit price increases in house prices engendered speculation. When the value of property is expected to rise more than the cost of borrowing, it makes sense to own more property than one wants to occupy. By 2005, 40 percent of all homes purchased were not meant to serve as permanent residences but as investments or second homes. Since growth in real median income was anemic in the 2000s, lenders strained ingenuity to make houses appear affordable. The most popular devices were adjustable rate mortgages (ARMs) with "teaser," below-market initial rates for an initial two-year period. It was assumed that after two years, when the higher rate kicked in, the mortgage would be refinanced, taking advantage of the higher prices and generating a new set of fees for the lenders. Credit standards collapsed, and mortgages were made widely available to people with low credit ratings (called subprime mortgages), many of whom were well-to-do. "Alt-A" (or liar loans), with low or no documentation, were common, including, at the extreme, "ninja" loans (no job, no income, no assets), frequently with the active connivance of the mortgage brokers and mortgage lenders.

Banks sold off their riskiest mortgages by repackaging them into securities called collateralized debt obligations (CDOs). CDOs channeled the cash flows from thousands of mortgages into a series of tiered, or tranched, bonds with risks and yields tuned to different investor tastes. The top-tier tranches, which comprised perhaps 80 percent of the bonds, would have first call on all underlying cash flows, so they could be sold with a AAA rating. The lower tiers absorbed first-dollar risks but carried higher yields. In practice, the bankers and the rating agencies grossly underestimated the risks inherent in absurdities like ninja loans.

Securitization was meant to reduce risks through risk tiering and geographic diversification. As it turned out, they increased the risks by transferring ownership of mortgages from bankers who knew their customers to investors who did not. Instead of a bank or savings and loan approving a credit and retaining it on its books, loans were sourced by brokers; temporarily "warehoused" by thinly capitalized "mortgage bankers"; then sold en bloc to investment banks, who manufactured the CDOs, which were rated by ratings agencies and sold off to institutional investors. All income from the original sourcing through the final placement was fee based—the higher the volumes, the bigger the bonuses. The prospect of earning fees without incurring risks encouraged lax and deceptive business practices. The subprime area, which dealt with inexperienced and uninformed customers, was rife with fraudulent activities. The word "teaser rates" gave the game away.

Starting around 2005, securitization became a mania. It was easy and fast to create "synthetic" securities that mimicked the risks of real securities but did not carry the expense of buying and assembling actual loans. Risky paper could therefore be multiplied well beyond the actual supply in the market. [...] Towards the end, synthetic products accounted for more than half the trading volume.

The securitization mania was not confined to mortgages and spread to other forms of credit. By far the largest synthetic market is constituted by credit default swaps (CDSs). This arcane synthetic financial instrument was invented in Europe in the early 1990s. Early CDSs were customized agreements between two banks. Bank A, the swap seller (protection purchaser), agreed to pay an annual fee for a set period of years to Bank B, the swap buyer (protection seller), with respect to a specific portfolio of loans. Bank B would commit to making good Bank A's losses on portfolio defaults during the life of the swap. Prior to CDSs, a bank wishing to diversify its portfolio would need to buy or sell pieces of loans, which was complicated because it required the permission of the borrower; consequently, this form of diversification became very popular. Terms were standardized, and the notional value of the contracts grew to about a trillion dollars by 2000.

Hedge funds entered the market in force in the early 2000s. Specialized credit hedge funds effectively acted as unlicensed insurance companies, collecting premiums on the CDOs and other securities that they insured. The value of the insurance was often questionable because contracts could be assigned without notifying the counterparties. The market grew exponentially until it came to overshadow all other markets in nominal terms. The estimated nominal value of CDS contracts outstanding is $42.6 trillion. To put matters in perspective, this is equal to almost the entire household wealth of the United States. The capitalization of the U.S. stock market is $18.5 trillion, and the U.S. treasuries market is only $4.5 trillion.

[...]

It was bound to end badly. There was a precedent to go by. The market in collateralized mortgage obligations (CMOs) started to develop in the 1980s. In 1994, the market in the lowest-rated tranches--or "toxic waste," as they were known--blew up when a $2 billion hedge fund could not meet a margin call, leading to the demise of Kidder Peabody and total losses of about $55 billion. But no regulatory action was taken. [...]

Signs of trouble started to multiply early in 2007. On February 22, HSBC fired the head of its U.S. mortgage lending business, recognizing losses reaching $10.8 billion. On
March 9, DR Horton, the biggest U.S. homebuilder, warned of losses from subprime mortgages. On March 12, New Century Financial, one of the biggest subprime lenders, had its shares suspended from trading amid fears that the company was headed for bankruptcy. On March 13, it was reported that late payments on mortgages and home foreclosures rose to new highs. On March 16, Accredited Home Lenders Holding put up $2.7 billion of its subprime loan book for sale at a heavy discount to generate cash for business operations. On April 2, New Century Financial filed for Chapter 11 bankruptcy protection after it was forced to repurchase billions of dollars worth of bad loans.

On June 15, 2007, Bear Stearns announced that two large mortgage hedge funds were having trouble meeting margin calls. Bear grudgingly created a $3.2 billion credit line to bail out one fund and let the other collapse. Investors' equity of $1.5 billion was mostly wiped out.

The failure of the two Bear Stearns mortgage hedge funds in June badly rattled the markets, but U.S. Federal Reserve Chairman Ben Bernanke and other senior officials reassured the public that the subprime problem was an isolated phenomenon. Prices stabilized, although the flow of bad news continued unabated. As late as July 20, Bernanke still estimated subprime losses at only about $100 billion. When Merrill Lynch and Citigroup took big write-downs on in-house collateralized debt obligations, the markets actually staged a relief rally. The S&P 500 hit a new high in mid-July.

It was only at the beginning of August that financial markets really took fright. It came as a shock when Bear Stearns filed for bankruptcy protection for two hedge funds exposed to subprime loans and stopped clients from withdrawing cash from a third fund. As mentioned, Bear Stearns had tried to save these entities by providing $3.2 billion of additional funding.

Once the crisis erupted, financial markets unraveled with remarkable rapidity. Everything that could go wrong did. A surprisingly large number of weaknesses were revealed in a remarkably short period of time. What started with low-grade subprime mortgages soon spread to CDOs, particularly those synthetic ones that were constructed out of the top slice of subprime mortgages. The CDOs themselves were not readily tradable, but there were tradable indexes representing the various branches. Investors looking for cover and short sellers looking for profits rushed to sell these indexes, and they declined precipitously, bringing the value of the various branches of CDOs that they were supposed to represent into question. Investment banks carried large positions of CDOs off balance sheet in so-called structured investment vehicles (SIVs). The SIVs financed their positions by issuing asset-backed commercial paper. As the value of CDOs came into question, the asset-backed commercial paper market dried up, and the investment banks were forced to bail out their SIVs. Most investment banks took the SIVs into their balance sheets and were forced to recognize large losses in the process. Investment banks were also sitting on large loan commitments to finance leveraged buyouts. In the normal course of events, they would package these loans as collateralized loan obligations (CLOs) and sell them off, but the CLO market came to a standstill together with the CDO market, and the banks were left holding a bag worth about $250 billion. Some banks allowed their SIVs to go bust, and some reneged on their leveraged buyout obligations. This, together with the size of the losses incurred by the banks, served to unnerve the stock market, and price movements became chaotic. So-called market-neutral hedge funds, which exploit small discrepancies in market prices by using very high leverage, ceased to be market neutral and incurred unusual losses. A few highly leveraged ones were wiped out, damaging the reputation of their sponsors and unleashing lawsuits.

All this put tremendous pressure on the banking system. Banks had to put additional items on their balance sheets at a time when their capital base was impaired by unexpected losses. They had difficulty assessing their exposure and even greater difficulties estimating the exposure of their counterparts. Consequently they were reluctant to lend to each other and eager to hoard their liquidity. At first, central banks found it difficult to inject enough liquidity because commercial banks avoided using any of the facilities which had an onus attached to them, and they were also reluctant to deal with each other, but eventually these obstacles were overcome. After all, if there is one thing central banks know how to do, that is to provide liquidity. Only the Bank of England suffered a major debacle when it attempted to rescue Northern Rock, an overextended mortgage lender. Its rescue effort resulted in a run on the bank. Eventually Northern Rock was nationalized and its obligations added to the national debt, pushing the United Kingdom beyond the limits imposed by the Maastricht Treaty.

Although liquidity had been provided, the crisis refused to abate. Credit spreads continued to widen. Almost all the major banks--Citigroup, Merrill Lynch, Lehman Brothers, Bank of America, Wachovia, UBS, Credit Suisse--announced major write-downs in the fourth quarter, and most have signaled continued write-downs in 2008. Both AIG and Credit Suisse made preliminary fourth-quarter write-down announcements that they repeatedly revised, conveying the doubtless accurate impression that they had lost control of their balance sheets. A $7.2 billion trading fiasco at Société Générale announced on January 25, 2008, coincided with a selling climax in the stock market and an extraordinary 75 basis point cut in the federal funds rate eight days before the regularly scheduled meeting, when the rate was cut a further 50 basis points. This was unprecedented.

Distress spread from residential real estate to credit card debt, auto debt, and commercial real estate. Trouble at the monoline insurance companies, which traditionally specialized in municipal bonds but ventured into insuring structured and synthetic products, caused the municipal bond market to be disrupted. An even larger unresolved problem is looming in the credit default swaps market.

Over the past several decades the United States has weathered several major financial crises, like the international lending crisis of the 1980s and the savings and loan crisis of the early 1990s. But the current crisis is of an entirely different character. It has spread from one segment of the market to others, particularly those which employ newly created structured and synthetic instruments. Both the exposure and the capital base of the major financial institutions have been brought into question, and the uncertainties are likely to remain unresolved for an extended period of time. This is impeding the normal functioning of the financial system and is liable to have far-reaching consequences for the real economy.

Both the financial markets and the financial authorities have been very slow to recognize that the real economy is bound to be affected. It is hard to understand why this should be so. The real economy was stimulated by credit expansion. Why should it not be negatively affected by credit contraction? One cannot escape the conclusion that both the financial authorities and market participants harbor fundamental misconceptions about the way financial markets function. These misconceptions have manifested themselves not only in a failure to understand what is going on; they have given rise to the excesses which are at the root of the current market turmoil.

Excerpted from The New Paradigm for Financial Markets
Copyright © 2008 by George Soros.
Published in the United States by PublicAffairs™,
a member of the Perseus Books Group.

The following excerpt is the prologue of David M. Snick's The World is Curved: Hidden Dangers to the Global Economy, which is being released today. The book has received praise from some heavy hitters in the world of politics and global economics, such as Alan Greenspan, George Soros, James Schlesinger and Bill Bradley. Former Secretary of the Treasury Lawrence H. Summers states:

David Smick understands, as few do, that international finance depends on politics and passions as much as on policies. Agree or disagree, his sense of where we have been and where we are going deserves close attention. He writes in a way that makes giving close attention a pleasure.

Prologue

______

t was not without enormous frustration that I approached writing a book about today's new global economy. After all, what do we make of a world financial system that one minute appears to be performing beautifully, and the next acts as if the world is coming to an end? One minute the cybernetic (computer) revolution has transformed the economy into a veritable global wealth machine, as stock markets around the world soar to new highs. The next moment, markets plummet. People then read newspaper stories suggesting the value of their home may soon be less than their mortgage. They discover that their family's life savings--even their cash left in supposedly ultrasafe money market funds--could soon go poof in the night.

In trying to fully grasp the significance of the new global system, I began by rereading the seminal book on the subject of globalization, Tom Friedman's bestseller The World Is Flat: A Brief History of the Twenty-first Century. Friedman compellingly describes globalization as it is, with concentration on the global supply chain for goods and services.The stories are mesmerizing--taking the reader from India's Silicon Valley in Bangalore to villages in northeastern China. Friedman's book describes how digital technology shortened the distances between countries and revolutionized the global supply chain. This permitted people to engage in business with one another across the globe, with each nation bringing its comparative advantage to the table of world commerce. An award-winning columnist for The New York Times, Friedman wisely warns that the U.S. economy must adapt to this new and changing environment or retrench economically. The book stands as a historic achievement in introducing a broad audience to the new world of opportunity and challenges beyond national borders.

After rereading The World Is Flat, I had lunch one day at the Hay-Adams Hotel in Washington, D.C., just across from the White House, with an old friend, John Despres, who had been Democratic U.S. senator Bill Bradley's longtime foreign policy guru. "John," I said as we were being seated, "I am trying with great frustration to get my arms around globalization. Frankly speaking, from the perspective of the financial markets, the world is not flat. Unlike the world that produces goods and services, in the financial world nothing happens in a straight line. Instead, there is a continual series of unforeseen discontinuities--twists and turns of uncertainty that often require millions of market participants to stand conventional wisdom on its head. In the financial world, John, nothing much seems to happen in a straight line."

A pensive man in his sixties who chooses his words carefully, Despres sat there thoughtfully. He stroked his chin, pondering as he gazed off into the distance past Lafayette Park to the front columns of the White House. "So what you're saying," he slowly began, pausing for several more seconds, "is that the world is not flat; the world is curved."

"Yes," I responded, "for the financial markets, the world is curved. We can't see over the horizon. As a result, our sight lines are limited. It is as if we are forced to travel down an endless, dangerously twisting and turning road with abrupt steep valleys and risky mountainous climbs. We can't see ahead. We are always being surprised, and that is why the world has become such a dangerous place."

By way of background, financial markets have always been plagued by uncertain and incomplete information--a lack of transparency. There have always been things that investors and traders didn't and couldn't know. But in the new global economy, this crazy ocean of global liquidity has not only increased the number of unknowns but also rearranged their relationships and relative importance.

There are new players with new perspectives. All of a sudden, a huge pool of funds is competing around the world for investment opportunities. Bankers, businesspeople, and governments in industrialized economies are now competing with entrepreneurs, start-ups, and old state-controlled companies in emerging economies to attract those funds. With new kinds of securitized debt, mezzanine investing, and outrageously complicated financing instruments, it is almost impossible to figure out what is going on at any give time. Investors need new kinds of information to make good decisions. But exactly what kind of information is that? And where do they get it?

Financial markets have always operated on inequalities of information and analysis. You think or know A. I think or know B. But today's policymakers and market traders must depend more than ever on their gut instincts. The playing field is bigger, the stakes are higher, and the system, because of its size and complexity, is unbelievably fragile. It is a house of cards that could come tumbling down for any number of reasons. That won't necessarily happen, but politicians and policymakers need to be careful. They need to start caring about things that never much mattered to them before.

After all, what do we really know about what is about to unfold in China, which has an economy that even its own leadership cannot fully understand? What do we know about the mind-set of the Japanese housewife who, as strange as it sounds, plays a huge part in the direction of the flow of the world's savings? What do we know about the accuracy of the accounting ledgers of even our largest, most trusted financial institutions or of the sophisticated financial instruments these firms deploy? What do we know about the long-term strategic implications of today's excess savings being controlled by nondemocratic governments? And what are the social and political implications of global wealth being so unevenly distributed?

In addition, the markets lack information about what may be the most critical issue of all--whether the trend of globalization itself will be allowed to continue. The politics of globalization are heating up fast as the anxiety produced by the power of free-flowing capital and goods skyrockets. Amazingly, a recent Wall Street Journal/NBC poll revealed that in the United States, by a two-to-one majority, even Republicans believe free trade is hurting America. The troubling turbulence of the subprime-driven Great Credit Crisis of 2007-2008 hasn't helped matters either. It is the latest rallying cry for the antiglobalization forces gathering on the horizon.

"Perhaps most troubling," I said as our lunch concluded, "is that most people today lack a historical perspective. The boom period is being taken for granted. Median-age American voters today were born in the mid-1960s. They have no recollection of the stagflation and long gas lines of the 1970s, the period before today's globalized economy. They have never known anything but a highly productive economy, with impressive stock markets and ample jobs. Many key constituencies of globalization have been lulled into complacency. Therefore, the period ahead will be one of potentially imprudent, overly reactive policy change.

"To top it all off," I stressed to Despres, "policymakers don't appreciate the fragile nature of today's global financial system and how financially induced prosperity can stealthily slip away through the unintended consequences of well-intentioned policy actions that attempt to legislate or regulate economic security. Today, we find ourselves in a situation in which the globalized financial system both enables and threatens our national well-being."

I concluded by suggesting that Friedman's book brilliantly presents the first installment of the globalization story, but there is a second installment as well--the financial side of the story. That's the subprime side where, for example, a small village in Arctic Norway can see its entire financial future destroyed because its financial managers invested heavily in a Citigroup product called a collateralized debt obligation. When the housing markets an ocean away in Florida and California collapsed, the debt obligations soured, and the Norwegian village had to shut down kindergartens and health care services for the elderly.

At the end of our conversation we turned to history, agreeing that nothing about the world's current political, economic, and financial predicament is new. Indeed, today's world economy bears a striking resemblance to the integrated markets and overwhelming prosperity of the period from 1870 to 1914, which noted economist John Maynard Keynes described as "an extraordinary episode in the economic progress of man." That, too, was a period punctuated by continual financial crises--and also of great prosperity. Ironically, today we ask the same questions as they did in 1914: What does it take to sustain this new, successful global economic system? What policymaking perils could reverse this wealth creation? Stagflation? Deflation? Protectionism? What unexpected financial explosion or implosion could create waves--curves--that the world remains unprepared to handle except through trade wars, strict capital controls, and other beggar-thy-neighbor policies--all policy blunders resulting from human error?

Today's industrialized world wants the Chinese to better manage their currency but remains unsure of the precise policy prescription or even of the capabilities of the conflicted Chinese leadership. The world hates America's twin budget and current account deficits, but no one has yet figured a safe way out of them. Nor does it seem like an answer will come any time soon. Much of the world's excess savings sits in the hands of nondemocratic regimes, led by China, and the oil producers, including Russia, but what this portends for the future, nobody knows. The Federal Reserve, in coming to the rescue of the investment firm Bear Stearns in March 2008, appears to have provided a government guarantee of the investments of the entire financial sector, not just the banks. The long-term implications for regulatory oversight, and thus the level of lending, under this new policy are anybody's guess. We live in a globalized world where we have to care much more about one another's problems, while simultaneously solving
our own.

In his book, Friedman warns American policymakers of the need for tax credits, improved teachers' salaries, and novel approaches to creating, attracting, and retaining the new creators of value--the engineers. Yet retaining the free flow of capital to keep globalization's bloodstream pumping may also require the most sophisticated team of global financial brain surgeons. That is because the world today lacks a financial doctrine, or even much in the way of a set of informal understandings, for establishing order in a financial crisis. Instead, we have to grope and manage incrementally, like trying to perform delicate brain surgery with one hand tied behind our back and the other wearing an ill-fitting boxing glove. The financial markets have simply become too big, and at times too threatening, for our governmental institutions to be fully effective in maintaining stability.

The 1870-1914 period, eerily similar to what we face today, met a bitter new reality with the opening shots of World War I. Within a decade and a half, capital and trade flows collapsed, which helped set the stage for the Great Depression. Today one of the world's prominent global monetary policy theorists, and a governor of the Federal Reserve, Frederic Mishkin, argues ominously that "the possibility of another Great Reversal is very real." Martin Wolf of the Financial Times writes that "the breakdown of the early twentieth century occurred, in part, because of the pressures to accommodate rising powers in the global economic and political order." He suggests that today's rise of China and India will create comparable pressures--"a spiral of mutual hostility that undermines the commitment to a liberal international economic order."

Of course, the world won't cast some dramatic veto to end the current system as we know it. The industrial world financial markets have garnered too much political power for that to happen. Reversals seldom come in one cruel, visible, planned policy blow. Instead, like death from a thousand cuts, they come from a series of small, seemingly benign, but dangerously destabilizing changes that reach a terrifying tipping point of market uncertainty and fear. That is what happened during the subprime crisis, and today we are increasingly at risk of further financial calamities that threaten a vicious spiral of destruction and heartache.

I undertook the task of writing about this complicated system we call the new global economy because I have had a front-row seat, and probably played some modest role in its creation. Over my thirty-year career, I have watched the forces that created financial globalization unfold, and I have consulted regularly with some of the major players in the field of global finance. I feel obliged to share what I have learned with those who have not been afforded such access.

Over the years, I first served as the chief of staff to a senior member of the U.S. congressional leadership, and then as an adviser on economic issues to both Democratic and Republican presidential candidates. For the last twenty years, I have worked with some of the world's most successful money managers, including George Soros, Michael Steinhardt, Louis Bacon, Stan Druckenmiller, and Julian Robertson, through my global macroeconomic advisory firm Johnson Smick International (previously called Smick Medley and Associates). We serve as specialized quasi journalists--like a paid cable TV service compared with free network television.

In addition, I founded and continue to edit The International Economy, a magazine geared to the global central bank and finance ministry community. I also conceived and organized the U.S. Congressional Summits on the Dollar and Trade, a series of important conferences in the late 1980s and 1990s involving the world's finance ministers, central bankers, and the U.S. congressional leadership.

For two decades I have interacted daily with the most senior economists and most visible market traders on the front lines of financial globalization. They have all been grappling with the same issue: how to survive and prosper in this troubling new system.

In January 2007, more than six months before the outbreak of the subprime crisis, I commented one evening to the other guests at a Washington dinner party that "the average person today would be shocked to know how much the global financial system, though robust, faces a potential risk to its own survival. It is vulnerable to a psychological herd effect that could wreak havoc with the industrialized world economies." On the drive home from the dinner party, my wife, Vickie, remarked, "You should write a book on the subject. If the central bankers and Wall Street know what's behind the curtain, why shouldn't everyone else? Why don't you say what all the big money players already know about how these uncertainties could affect all of us?"

I therefore credit my smarter half for recognizing the need for such a book, and for providing the needed spark that motivated me to take on this project.

Excerpted from The World is Curved
copyright © David M. Smick, 2008
Published by Portfolio, a member of Penguin Group (USA) Inc.

To continue, pick up a copy of this book here.