FINANCIAL CRISIS

Some of my readers have asked me to comment on the financial crisis.  Much has been written about it, and beyond the political rhetoric, there are some very intelligent analyses of what happened and why.  To me, the three obvious root causes were:

  • The disconnected and fragmented sub-prime mortgage creation and investment system, combined with the incentives of all players in the supply chain of these mortgages to grow rapidly and to take on excessive risk;
  • The unintended consequences of an excessive dependence on “mark-to-market” accounting, which caused financial assets to be written down in value to an artificial “market price,” even if the holder had no intention of selling them, and even if the market for that asset really did not exist.  This artificially low asset valuation would not have mattered, except that lending agreements and other financial arrangements depended on maintaining a minimum level of asset values.  The deterioration of asset values due to these artificially low valuations created a death spiral for companies, because the agreements usually required them to shore up declining asset values with additional credit that simply was not available.
  • The mind-boggling complexity of these financial instruments and transactions, which made it extremely difficult for anyone to understand when participants were truly in trouble, until it was too late.   This is also why the rating agencies, on which investors depend to evaluate the riskiness of these instruments and transactions, failed so miserably.

John McCain and others have talked about “corporate greed” as a root cause.  I find that to be an oversimplification of reality.  Greed works when it rewards people for doing things that benefit everyone; it fails to work when it triggers destructive or highly-risky behavior.

In this case, compensation packages caused greed to trigger excessively risky behavior.  The simple reason for this was that, in virtually all these cases, the profit from these instruments and transactions came in immediately and financial services executives were rewarded immediately, but the risk was not evident until much later.  This gravitation toward excessive risk was made even worse by pay packages that had no meaningful upward limit.  Super-sized annual bonuses or stock option grants magnified the misalignment toward excessively risky behavior.

What made matters worse is that these executives could move on to another organization having pocketed the money from these risky behaviors.  Moreover, like stock options, upfront bonuses do not align executives with shareholders and bondholders.  If someone makes $100 million in profits for his or her firm in one year and pockets a $10 million bonus, but loses $500 million the next year either because of the same transaction or different transactions, they get no bonus, but they do not give the $10 million back.  In effect, the fundamental flaw of compensation systems is that they are aligned only on the upside, not the downside.

Similarly, with stock options, someone can take a number of actions to pump up the stock price, exercise options where there have been gains, pocket the gains, and then leave the firm, leaving future shareholders and executives to clean up the mess from the actions that temporarily pumped up the stock price.

As a member of three public company boards of directors, including an independent director membership on two boards, and as a former CEO, I have always been extremely mindful of making sure that executive pay truly aligned executive rewards with shareholder needs.  I particularly focused on insuring that none of the companies I served ever had compensation packages and systems that triggered excessively risky behaviors.  As a CEO, I stayed aligned with shareholders by not selling stock, even though there were many times when I could have sold and made much more profit than I will ultimately make.  I took this approach because I believe that CEOs have to send a message that they believe in their company’s stock, and that insider selling is a very bad message.

Risk is always an element of business decision making, but we should never create environments in which the risky behavior is rewarded to the extent it was here.

2 Responses to “FINANCIAL CRISIS”

  1. Steve Licardi says:

    Mike, As someone that I have a great deal of respect for I enjoy reading your blog. Regarding the financial crisis,in your opinion, what do we need to do to work our way out of it. I am not convinced the $700 billion is the answer. I would like to see a committee made up of up the heads of the financial institutions weigh in on it. After all, the Gov’t got us into this mess by requiring sub prime lending through the CRA. I have a problem with them getting us out of it.

  2. Bill Hibbard says:

    Very glad to read your insights on the financial crisis. My understanding is that all three root causes you describe are connected to specific government policies. The excessive risk you describe in the first cause is tied to the relaxation of the “net capital rule” for broker-dealers by the SEC in 2004, which allowed Bear Stearns, Lehman and Merrill Lynch to use too much leverage. The “mark-to-market” accounting you describe in the second cause is a rule of the Financial Accounting Standards Board in 2007. The lack of understanding you describe in the third cause is not only due to complexity, but also due to the Commodity Futures Modernization Act of 2000, which prohibited federal regulation or reporting requirements for credit default swaps (I understand that this non-transparent market is estimated at about $60 trillion). Have I got it right, or am I oversimplifying?

    More generally, what government policies would you recommend to prevent similar crises in the future? Perhaps this question is too big for a comment, and deserves its own blog post. Thank you.

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