the entire economy, that is to say all of us, have experienced the costs of unethical behaviors in a matter of great macroeconomic consequence. the recent accounting and governance scandals were sufficiently numerous and serious to generate widespread concern among investors about the reliability of financial reporting in general. these scandals were a notable factor behind the u. s. stock market slide in the spring and summer of 2002, amidst the cascade of scandals culminating with worldcom ’ s revelations in june that year. and concerns about corporate governance probably contributed, at least in some measure, to the heightened business caution and sharp fall - off in business investment during this period. thus, although other, more important factors were also working to restrain real activity during this period, it seems likely that the scandals exacerbated an already weak economic situation. just as opportunistic behavior by individuals calls forth regulations as a counterweight, so too these corporate governance scandals have called forth new laws and regulations, which were probably the proper response and required to restore confidence, but which have almost surely added to the cost of doing business. the negative effect from lapses in corporate governance at the macroeconomic level in the united states is a very visible example of the national costs of poor corporate governance. social scientists have also found that at the level of the individual company poor corporate governance costs and good corporate governance pays, quite literally. some researchers have found that investments in firms which engage in unethical behavior earn abnormally negative returns for prolonged periods ( long and rao, 1995 ). 4 others find that firms that have better corporate governance also have higher stock market valuations, higher profitability and faster sales, and there is evidence that buying shares of firms that score high in corporate governance and selling shares in firms that do not yields abnormally positive returns ( gompers, ishii and metrick, 2003 ). 5 all of this is true not just in the united states, but globally as well. at the macroeconomic level, the world bank has identified corruption as the single greatest obstacle to economic and social development. the bank states that “ corruption undermines development by distorting the rule of law and weakening the institutional foundation on which economic growth depends. ” 6 fortunately, there is some evidence from studies of emerging markets that firm - level corporate governance matters more in countries with weak legal systems, and one can infer from this work that firms can partially compensate for ineffective legal systems by practicing ethical behavior. 7 let me close by saying

##ime cdos is that they evolved in response to flaws in prevailing models and incentive schemes. 10 going back further, a similar story can be told about the introduction of payment - in - kind ( pik ) interest features in the high - yield bonds used in the leveraged buyouts ( lbos ) of the late 1980s. i don ’ t think it was a coincidence that among the buyers of such pik bonds were savings and loan associations, at a time when many were willing to take risks to boost their accounting incomes. the second closely related factor on my list is changes in regulation. new regulation will tend to spur further innovation, as market participants attempt to minimize the private costs created by new rules. and it may also open up new loopholes, some of which may be exploited by variants on already existing instruments. the third factor that can lead to overheating is a change in the economic environment that alters the risk - taking incentives of agents making credit decisions. for example, a prolonged period of low interest rates, of the sort we are experiencing today, can create incentives for agents to take on greater duration or credit risks, or to employ additional financial leverage, in an effort to “ reach for yield. ” 11 an insurance company that has offered guaranteed minimum rates of return on some of its products might find its solvency threatened by a long stretch of low rates and feel compelled to take on added risk. 12 a similar logic applies to a bank whose net interest margins are under pressure because low rates erode the profitability of its deposit - taking franchise. see kacperczyk and schnabl ( 2012 ). to be clear, i do not intend this critique to apply to first - generation securitizations, such as rmbs, asset - backed securities collateralized by auto and credit card loans, or collateralized loan obligations ( where the collateral pool is composed of bank loans ). as a number of academic studies have emphasized, the basic pooling - and - tranching structure of these securitizations can help reduce adverse selection problems in markets, and thereby increase liquidity and reduce financing costs. see, for example, gorton, and pennacchi ( 1990 ), demarzo and duffie ( 1999 ), and demarzo ( 2005 ). see rajan ( 2006 ) for an early exposition of the reach - for - yield phenomenon. this mechanism is the classic risk - shifting effect described by jensen and meck