Thursday, January 31, 2008

What Went Wrong at Citi and Merrill

Economist Henry Kaufman says senior management was caught up in frenzied pursuit of short-term gain. But "Dr. Doom" still has faith in the American economy's resilience

(Businessweek) Senior managements and the boards of directors of major financial institutions such as Citicorp (C) and Merrill Lynch (MER) failed to perform their proper corporate governance roles, helping to precipitate the financial markets crisis of recent weeks, says Henry Kaufman, president of Henry Kaufman & Co. and a board member at Lehman Brothers (LEH). The Federal Reserve also failed to understand risks created by the proliferation of new financial instruments, says Kaufman, who previously served on the Federal Reserve Bank of New York. Here are edited excerpts from a recent conversation.

From a corporate governance perspective, what went wrong?
At a number of institutions, there was a failure by senior management to know the full extent of the risk-taking. It would seem that their risk modeling did not correctly assess the totality of the risk-taking in the organization.

How is it possible that firms that are in the business of taking risks didn't understand what they were doing?
It has to be recognized that most of the large finance institutions are conglomerates that are in many different types of activities, from underwriting securities to trading securities to proprietary trading. They are in domestic markets and international markets. To comprehend the totality of risk in all these activities is quite an assignment.

But aren't chief executive officers and other top managers tasked with understanding what risks their institutions are undertaking?

You may assume that, but there were other aspects that increased the risk-taking, such as the movement in the financial markets to securitization. That was a major structural change in the financial markets. You now have the opportunity to be in many different markets and assume a larger variety of risks.

[The securitization movement] also created a greater focus on near-term activities rather than the long term. When you securitize, you can package these instruments in different forms. They can be sliced and diced. You can underwrite those obligations. You can trade those obligations. You can create structured investment vehicles, which resulted in some problems. All this creates incentives for the institution to be near-term-oriented.

And there was a change in the power structure inside the institutions. Middle management, such as the traders, took on increasing importance. The more they traded, the greater the opportunity.

Are you suggesting that CEOs and top management were somehow silenced or intimidated?
I think senior management got caught up and couldn't extricate itself. If you don't participate in near-term opportunities, you lose market share. Talent leaves. Bonuses are smaller. Chances are that earnings per share may not be as strong. Therefore, senior management becomes captive.

But isn't the heart of the job of top management to resist short-term risks that threaten the long-term health of the firm?

They did have some risk analysis. Their models of price movements tend to hold up when markets don't go to extremes, but when they do go to extremes those parameters may not hold up. Central banks, including the Federal Reserve and others, did not understand or want to comprehend the implications of the structural changes in financial markets or the changes in economic behavior and what it would have meant for monetary authorities to control the extremes.

Weren't the boards of directors of Citi and Merrill and others supposed to have a handle on risk?
There is the problem of how well the various activities of diversified financial institutions are being disclosed to boards.

Managements may show gross activities to the board, but to what extent are they discussing their subsidiaries that hold some of the assets of the institution? Then there is this question: What is the financial competence of board members?

But there were some very smart, distinguished people on these boards, right?
As a general observation, board members need to be more involved and spend more time and be more familiar with the activities of these institutions.

Are you suggesting they didn't really understand what was taking place?
They depended very much on the acumen and skills of senior management.
So you think senior managers allowed themselves to be swept away by greed?
I'm not sure they allowed themselves to be swept away. But they were part of an environment where they tended to lose control. Top management should understand short-term gain vs. substantial loss. When most people are doing something, you should know very well that you've been caught up in the behavior of the crowd.

What's the key to preventing periodic crises such as this one, the savings and loan mess, and others?
One of the issues for which we have no answer is that when very big financial institutions are too big to fail, it tends to result in too much risk-taking. The other need is for the central bank to increase its supervision of financial institutions and to be much more involved in knowing what is going on in them. If that had happened, these malpractices would not have flourished.

Have any steps been taken yet to address what you seem to suggest is a structural problem?
Not yet. What's been undertaken is a rescue operation in the form of providing a huge volume of liquidity to the markets in terms of low interest rates, which will ease the pressure on institutions. The inverted yield curve gives them an opportunity to make some profits.

But is that a real solution?
Some CEOs have lost their jobs, and some senior managers have lost their jobs. We had similar developments in the 1980s and 1990s. The last problem was 2000 and 2001, and here we are again only a few years later. We had the market crash in 1989. We had problems with the S&Ls and also commercial banks. Then there is always another bubble. It's quite obvious that we have not put in the place a way to limit these excesses.

Isn't that a sweeping indictment of the financial system?
Yes. But at the same time, the American economy has done reasonably well. We have seen nothing the size of the 1930s Depression. We've had recessions. The economy picked itself up, and we continued to expand after a brief hiatus.

What should the Federal Reserve be doing differently?
The examination function must have a higher priority. The central bank cannot depend on the risk analysis provided by the financial institutions. And we should have centralized oversight of major financial institutions. Now we have the Federal Reserve, the Comptroller of the Currency, the Securities & Exchange Commission, and various other state and federal supervisory agencies all involved. In a global environment, that creates a fracture in supervision.

In addition to writing Armchair MBA for BusinessWeek.com, William J. Holstein writes for The New York Times, Fortune, Corporate Board Member, Dealmaker, and Strategy + Business.

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