Local Official Involvement in Shadow Banking

An interesting question arises from a big investigative article in yesterday's Miami Herald:  is it unethical for a mayor and his wife to be part of a shadow banking network in their city?

The city is Hialeah, the second largest in Miami-Dade County. The shadow banking network arose during the boom years, when individuals who could not get loans but wanted to buy properties talked to their friends, who introduced them to their friends, to get high-interest, short-term loans.

Assuming that the loans were legal, would it be unethical for a mayor or other local government official to make them? Or, better, under what circumstances would such loans constitute unethical conduct?

It does not appear that the mayor was using his position to benefit himself or others. If anything, the issue is more the other way around. Was he benefitting politically from his loans?

According to the article, some of  the mayor's borrowers and their family members gave thousands of dollars to the mayor’s campaigns and to a political action committee that supported him. Assuming the contributions were legal, there are three issues here.

One, could these contributions actually have been interest payments, that is, was the mayor effectively using his shadow banking to help fund his campaigns? One response to this question would be, since the mayor could have used his own money anyway, the only difference would be making it look like he had more supporters than he really did (and saving him from paying taxes on the profit).

Two, is there an appearance of preferential treatment in the way the mayor combined his business and his political career? The reporters talked to Kenneth Thomas, an independent Miami bank industry expert, who said that shadow banking systems are not unusual, but that he had never heard of a politician lending money to his constituents. “Usually, political figures won’t want to do anything that could raise questions about a conflict of interest. This is why bankers should stick to banking, and politicians should stick to politics. Whenever you mix banking and politics, you have that potential problem.”

Disclosure of a Spouse's Finances
Three, did the mayor disclose his loans? It turns out that he only disclosed one out of six loans he made. The ones he did not disclose totaled about $1.1 million. He did not disclose them because they were made through companies controlled by his wife. Under state ethics rules, he didn’t need to disclose those because the companies were registered to his wife, not to him.

If you didn't think "protecting" spouses from disclosing their finances is a problem, you hopefully will now. Through January, the mayor took the position that the loans had nothing to do with him; they were his wife's business. Then the story changed. He said that he packaged the loans with his wife, that the money came from an inheritance from his father and money he'd made in condo conversions.

Outcome Bias
And then, in March, came the clincher:  “My wife and I did this from our savings. We were victims in this whole thing.”

It's true, the mayor was a victim of a Ponzi scheme. The schemer was convicted last year. The mayor is owed $750,000 on loans to the Ponzi schemer, as well as more than $300,000 on three other loans.

But had the boom lasted, the mayor might have made hundreds of thousands of dollars. The fact that he was one of the losers makes no difference to whether it was right for a mayor to make such loans and whether it was right for him not to disclose them. By calling himself a victim, he is trying to appeal to what Max H. Bazerman and Ann E. Tenbrunsel, the authors of the new book Blind Spots: Why We Fail to Do What's Right and What to Do about It, call "outcome bias." Outcome bias is "the tendency we have to take results into account, in a manner that is not logically justified. … People too often judge the ethicality of actions based on whether harm follows, rather than on the ethicality of the choice itself."

Doing Business with Shadowy Characters
One problem with participating in such a shadow system is that some shadowy characters can be involved, like the Ponzi schemer. That puts an official in the middle of state and FBI investigations, not to mention civil suits and investigative articles such as the Herald's. This is not a good way to gain the public's trust.

Officials considering getting involved in even completely legal shadow endeavors should think more than twice. But if they feel they have every right to go ahead and make some money on the side, or help out their friends, they should make it clear to everyone involved that everything that happens will be made public from the start. Disclosure will make the more shadowy characters think twice about doing business with a government official. They will realize, "Hey, this guy is on the same side as the police, even the FBI. I don't want him around." If you keep things secret, you're effectively saying you're not on the side of the law.

In short, you've got to choose. Be a public servant and do everything by the book, or be prepared to have your government career end abruptly when the news comes out, even if you broke no law.

Robert Wechsler
Director of Research-Retired, City Ethics

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