Two incidents have stood out for me in the past two weeks which have shown me exactly how important that principle is. The first is contract dealings I have had involving a fairly large IT consulting firm. In this first case a gentleman’s agreement to waive a non-solicitation / non-compete clause. This quid pro quo arrangement between three companies was fine and dandy until the rubber met the road and an actual solicitation was issued stemming from a common belief that this arrangement would be honoured.

The upshot? Threatened legal action and a state of posturing by all concerned. One company trying to bully everyone else. One company turned yellow in doing the right thing for the right reasons. And one company refusing to be bullied. I don’t blame the company in the middle of all of this. Why threaten several tens of millions of dollars in annual business over a single contract worth less than 0.5% of all business being done. But it is for those very reasons that if you can’t be trusted to uphold your word – if your handshake is not worth the same as a signed contract – then what is the point of doing business.

Its not a question really because as much as everyone talks about integrity – integrity is very much a triple edged sword. It depends quite often on our own point of view and how we see the world. Or at least how we would like other people to see it. Who is right is not a question for lawyers or mediators or intermediaries. It is a balancing act of trying to find an equilibrium. Ever tried to find balance in a room with an 800lb gorilla? You need one heck of a long lever.

It is sort of like trying to negotiate with a drunk to get them off booze. They are either willing to do it or not. In the meantime you are told time and time again “tomorrow – if you just wait until tomorrow I’ll get better and then we can all be happy”. How many tomorrows do you wait for it before realising that drunk in the corner isn’t going to change his/her ways until they are left with no other alternatives? No way out – no other way to turn. 10 tomorrows? 50? 100? 500??

Fight or flight. Eventually we all need to face those realities. Bit by bit you compromise (or not) to maintain a relationship doomed to failure (or not). It is at these times you realize exactly who is worth that hand being extended  and who isn’t. Handshakes are great when times are good. Its in those times when times aren’t good, or something’s changed, or a fundamental assumption was proven wrong that you find out if people are willing to go the distance. Not because its necessarily in the best interest of their company or firm but because its the right thing to do.

When you have an 800lb gorilla at the table though that can be hard to do sometimes. So at some point though you need to figure out whether you have a backbone or not. Are you willing to stand up for what is right and not be forced to give up ground once you’ve crossed that personal line in the sand you set for yourself.

Me – I crossed that line last week and truthfully I feel like the weight of the world was taken off my shoulders as soon as I did. There was always this sense of “oh my god – what am I going to be asked to give up this time” and that feeling is now gone. Some people would have taken a bad compromise and counted their blessings. Some would have turned tail and run for the hills. Me? When I’ve reach my fill I fight! And on the important things I will fight all the way to the finish line. Because what is right, and moral, and just will always win out over those people who choose to be that 800lb gorilla bullying everyone else in the schoolyard.

That isn’t to say that there isn’t room to be humbled in realizing that sometimes those handshakes come at the cost of finding out you don’t know everything. I found it funny in a way that this second example came right on the heels of the first. A misrepresentation of what you would think would be “common sense”.

In this second example, a misunderstanding between a sub-contractor and myself ensued owing to differences of experience. See in my world, sub-contractors do not discuss invoices with the client in anyway shape or form. The primary contractor takes the lead and all subsequent procurements flow through the prime contractor. The sub-contracting firm I had arranged to sub out work to however was use to notifying the end client once the prime was about to be billed for a completed unit of work.

As you can see two vastly different models and one that we unfortunately didn’t discuss in advance. You can imagine my horror when I saw what I took to be an infringement on our client relationship. Granted there was a bit more to it than that but the point of the matter is that once an opportunity arose to talk through the situation and the rational behind what was done and why, the situation became easily resolvable. We each had a better understanding of the differences that we took to deem as “common sense” and our relationship today is stronger by far for the experience.

Beyond this however was another issue at play. We valued the total contract drastically under what the work actually took in order to complete. There was no signed contract. There was no memorandum of understanding. There was simply a gentleman’s agreement that we would each do the project for a predetermined amount.

Here was a situation that could have turned truly ugly with lesser people. I don’t mean that in a condescending way. But consider that in this case you have three partners who are willing to honour their agreements based on a handshake, mutual trust, and an ethic that says “I am good to my word”.

I would much rather deal with a single firm that is exemplary of the second example than a hundred firms that are only concerned with the bottom line. When push comes to shove you know exactly where you stand with those that live by the palm and not by the pen. It’s a lesson that those 800lb gorillas have lost in their quest to be the most dominant player on the block. Its how communities are built – through the building of bridges rather than taxing them. And it is how I would much rather conduct my affairs rather than having to second guess every possible scenario, injury, or slight and committing it to paper. Contracts can be manipulated – handshakes backed by action show trust. I don’t know about you but I much prefer my world to that of the 800lb gorilla.

To start we have the consumer with standard requirements for various types of debt instruments: mortgage, revolving credit, car loans, etc.. The consumer goes to the bank which, in a bid to remain competitive, offers an introductory consumer debt rate of sub-prime. Let’s say 1.5% for the sake of argument.

There is however no free lunch. This introductory rate is at the expense of a larger back-end rate if the consumer doesn’t pay the debt off within a set period of time, say 12 months. So in the case of mortgage debt the rate might jump to 12%, for car loans 18%, and revolving credit cards as high as 28% (as examples).

Mortgage companies and banks typically have revolving credit needs of their own to cover one and two day shortfalls in deposits on hand which they can in turn borrow from the Federal Reserve at the prime rate set by the Fed (say 2.5% for arguments sake).

This 1% difference has to be made up somewhere so mortgage companies in turn “co-insure” the risk of the debt they carry by issuing commercial paper and other investment instruments in the form of mortgage backed securities. Prior to the mid-1990s this type of practice was possible by both investment firms, banks and mortgage companies. However in the mid-1990s new regulations came out, after the mini-recession of 91-92 and under the assumption of reducing risk to the consumer, which created a ‘division of labour’ that basically forced mortgage companies to only deal with mortgages and investment houses to only deal with investments.

Profiteers however are sneaky so-and-sos. Mortgage companies could still co-insure their debt holdings by selling those debts as commercial holdings to investment houses who in turn would put those instruments into the open market. Still well within the regulations and in ordinary circumstances is sound business practice. However, this is where things turn dicey.

Instead of selling just the mortgage debt, banks and other consumer loan firms bundled mortgage debt, revolving credit, and other fixed loans together as a “mixed-risk” portfolio that paid higher interest to Wall Street that what was generally available through mortgage only backed debt. And Wall Street ate it up – or more specifically they spoon fed it to the investment community as providing higher returns for marginally more risk.

The result is a very vicious cycle. Consumers receive higher dividends which in turn provide more disposable income which in turn the lending facilities prey upon in order to make their portfolios more attractive to their shareholders. All of this based on a single asset (housing) which, over any 10 year span of time, has always increased in value.

In theory, the cycle could have been self sustaining if natural markets had been allowed to develop. Instead what we got was hyper-competition between consumer loan firms which encouraged people to max out their debt ratios for the sake of short term bottom line profits.

Keep in mind that the financial markets are still coming off of the 1980s-90s mindset that short-term profits can benefit a market if you can force your competition into a position where they become a lucrative take-over target at bargain basement prices. So somewhere in the strategic assessments is this whole concept of “don’t worry about it being sustainable, eventually there will only be a handful of players as we are either bought out or we buy out other firms at which point the market will level out”. Great idea if you can pull it off.

Unfortunately the lending frenzy meant that no viable takeover targets would appear in the market place because the amount of money being made was so profitable that no one firm could gain the upper hand on any other. And it is at this point that the nightmare starts: consumer lending firms and consumers hitting the wall at the same time across the board.

You see consumer lending firms can only lend funds as a function of the amount of deposits they have on-hand. This is where co-insurance by issuing commercial paper becomes so important. If you only have so many dollars on deposit from consumers and you are lending that money out at a ratio of 100:1, your profits are essentially capped unless you can find a way to get more money on deposit – hence the capital markets.

The capital markets however are not a bottomless pit and the analyst there can read the housing valuation statistics the same as anyone else. So as housing prices start to drop, the credit ratings of the consumer lending firms declines until the point at which it is no longer viable for the lending firm to issue commercial instruments.

Beyond this you then have the issue of consumers looking at their 401Ks and wondering if maybe those debt instruments are not such a good deal after all. So they start pulling money out and putting it into other investments with less perceived risk. Again this puts pressure on the capital markets to restrict their purchasing of mortgage debt and other investments until they can gain some liquidity.

In short – capital freezes up and the entire system starts to slowly grind to a stop.

Well, not a stop actually because as money starts to be pulled out it begins a cascading effect that trickles through the investment system all the way back to the consumer. Move your money in your 401K from debt to government bonds and the financial companies have find ways to sell off that debt to someone else or call the debt from the issuing consumer lending firm.

The consumer lending firm however has bundled mortgage debt with everything else and can’t make heads nor tails of who owes what to whom. So they go into default which again lowers their credit worthiness to borrow funds. The consumer lending firms then start to put pressure on the consumer to pay back loans of which the only thing anyone has as security for what debt they do have is their home. So in trying to pay off too much credit card debt and fixed loans, the consumer has to either re-mortgage their home (not at the sub-prime rate btw) or default.

To default thou means the consumer lending firm now takes control over the home which isn’t worth anywhere near what they valued it out as. They have a write-off on their books and they are now short money on deposit because they’ve essentially had their margin called which doesn’t reduce their risk dollar for dollar – it reduces it by a factor of 50:1 or 100:1 or whatever ratio the firm used to determine their lending limits overall.

Worse however is that these lending firms which also hold funds on deposit for consumers have to have funds aside for the daily consumer transactions of their deposit holders for things such as paying bills, taxes, purchasing daily goods, etc.. These deposits are federally insured up to certain limits. When these other consumer debt problem become severe enough, the funds available cut into consumer savings which then create a potential that consumer savings may no longer be guaranteed.

So here you are as the Federal Government and you are looking at this situation which is on the brink of having a massive call on those federally insured deposits knowing full well that there will be major civil unrest if another savings and loans crisis hits and at worst a major depression that will rival anything seen in the 1930s. See the problem here is that with integration of world money markets, a savings and loans crisis wouldn’t just stop at consumer debt. It has to the potential to trigger a massive call on Federal owned debt to other governments and most specifically China which is holding a very large stake in the US economy.

The ripple effect of a complete US meltdown would be enormous which is why we saw a concerted effort by World Banking interests to prop up the US monetary system.

Back to our story however . . . So here you are looking at the situation and you have to figure out where to inject an influx of capital. Now money doesn’t grow on trees (it comes from sheep actually) and for the US Fed to say that they are going to inject $700B into the consumer lending market is to say that they have just artificially inflated the US economy. The standard market reaction: inflation within 3-5 years – or in this case a continued devaluing of the US dollar against other currencies. This is why these funds have to be considered a “loan” rather than a straight injection of newly minted greenbacks.

The other two issues at stake are where the Fed has the greatest opportunity to recover either the funds, or assets which can in turn be sold off later, and at what point in the system is the key intersection point for the distribution of those funds to get the system back in motion.

Unfortunately that point is with the consumer lending firms. If the Fed were to give the money to the consumer (who in fact is most in need of it) then there is no real way to recover the funds within incurring massive expense and overhead. If the money were to be given to the capital markets then that might address the liquidity issues but it doesn’t address the federal deposit insurance issues which are a far more pressing problem if not averted right away. So the only point left is to provide the funds back to those people that caused the problem in the first place.

Now, I say unfortunate, because there are a number of consequences of this bailout that are eventually going to be unavoidable.

The first is that this bailout will increase the gap between the rich and the poor as the way funds move through the system as the various investment firms still take their profits out of the available funds. Since these profits are going to the top 10% of income earners that means that that bailout is essentially an income grab by the rich from the poor.

The second is that this bailout will increase the pool of economic assets held ‘in trust’ by the government. Commercial lending firms aren’t going to just be given these funds cart blanche. They will have to turn over associated assets to the Federal Government who will essentially have to sit on these properties until market values have increased enough for those assets to be sold off. Each property still needs to be maintained at a very basic level in terms of property taxes, school taxes, heat, and general maintenance – of which no one has talked about who is going to be responsible for those aspects. The maintenance charges alone could add an additional $70-140B to the bailout price tag.

The third is that there is the potential for successive governments to look at this as a potential win-fall depending on how it is managed. The problem here is that there is no pre-determination as to under what condition these properties should be sold off. So under correct management, each property could not only appreciate in value but may turn into a profitable income stream. In which case this would be the largest tax grab by the Federal Government in US history.

And all of this is done at the expense of the individual consumer who is still saddled with trillions of dollars in consumer debt and is unlikely to see a dime of benefit. Keep in mind that at the very root cause of all of this has been – and will continue to be for some time – the income disparity that has forced the consumer into these types of arrangements in the first place including good paying jobs being outsourced overseas, predatory banking practices, and consumerism run rampant.

Is this the best solution: no – not by a long shot. But for the current environment and the context in the global markets find themselves in, this is the best that can likely be done to avoid a complete meltdown.

The question we should be asking isn’t whether this $700B bailout is the right thing to be rushing through (in this case I think it is). The question we should be asking ourselves is “what do we do next?”

The problems that led to this situation are not based on questions of regulatory or monetary policy but questions of culture. Our social culture is what got us into this mess and only through cultural change will we be able to dig ourselves out of it. However the same as you cannot force a culture to become a democracy at the point of a gun, regulation is not necessarily the answer to address the root causes of how to prevent similar meltdowns from occurring in the future.