Monday, November 2, 2009

Too Smart to Fail

Posted on the Kamakura blog by Donald van Deventer:

Throughout the 2007-2009 credit crisis, we’ve heard “too big to fail” over and over again. Somewhat less frequently, we’ve heard “too small to succeed,” a phrase about those banks who were in trouble but not big enough to be rescued by the U.S. government. What these troubled times call for are banks that are “Too smart to fail.” This blog looks at what it takes to meet that standard.

We had some fun in our October 19, 2009 blog entry where we relayed a New York Times quote from a senior executive at Citigroup who said that deposed CEO Charles Prince didn’t understand the difference between a CDO and a grocery list. It’s becoming increasingly obvious that one of the best predictive variables when it comes to understanding failures of financial institutions is the brain power of the CEO and the people around him, both at the Board level and in senior management. Why are we as an industry just coming to this realization?

One of the reasons brainpower hasn’t historically been important in choosing a bank CEO is that, in the old days, it was only one of many attributes of a CEO that determined success. Charismatic leadership, when you’re running a retail bank with hundreds or thousands of branches, has been more important to a bank CEO’s success in the past than the CEO’s ability to understand the difference between a collateralized debt obligation and a grocery list. That’s all changed now, thanks in large part to Wall Street. I once posed a question to one of the smartest people ever to work at Kamakura, David Kuo. David was a mathematician who got to Harvard from Taiwan after living in Harlem for a few years. After David graduated from Harvard, he went to a boutique securities firm in the arbitrage department. “What have you learned since you started?” I asked. David answered “Arbitrage is the process by which people who are smart take money from people who are not.” A bank CEO has to be smart enough to understand that the only reason Wall Street exists is to take the bank’s money. It’s as simple as that.

The fact that brainpower matters isn’t a new idea. One of my favorite books is the controversial but wonderful book by the late Richard J. Herrnstein and Charles Murray, Bell Curve: Intelligence and Class Structure in American Life. This extraordinary book remains one of the best sellers on even 13 years after it was published:

Recognizing that there is no high quality measure of intelligence in a single index, the authors can still make a very strong case that people who are not very smart make mistakes (e.g. teenage pregnancy) a lot more frequently than people who are smart. In banking 30 years ago, when I started, the mistakes you could make in banking weren’t very numerous. Here were a few of the things people did to avoid making common mistakes:

  • Make sure the tellers in the branch don’t steal your cash
  • Make sure the computer experts in the IT department are not paying themselves the rounding error on interest rate payments to depositors
  • Make sure the instructions for wire transfers are real. One of the most fun incidents I witnessed as a young banker at Security Pacific was the theft of $7 million dollars by an IT consultant in the wire transfer department who just called up and gave instructions to wire $7 million from a corporate client’s account to his new Swiss bank account. Senior management didn’t know where the money went until the FBI discovered the guy paying retail price in Zurich for diamonds sold by the Russians
  • Make sure the traders can’t trade much.
  • Make sure that retail borrowers are not liars.
  • Make sure that the collateral exists and you have done all the right things to secure the collateral
  • Make sure you price loans and deposits correctly. If you are getting much more volume than your peers, you’re making a pricing mistake.
  • Make sure no one responds to that letter from “Saudi Arabia” offering to buy $500 million of the bank’s bonds at Treasuries less 200 basis points, because it’s a scam.

Now, banking has become a lot more complicated because banks aren’t just buying Treasury bonds from Wall Street any more. Banks, insurance companies, and pension funds have the world’s biggest bull’s eye on their chests because the menu of what Wall Street sells is much longer and much more complicated. Wall Street is selling loans it didn’t make. It’s selling life insurance policies it didn’t originate. All Wall Street does is wrap the package and put ribbon on it, and they get paid more for what’s inside the box than the merchandise cost them. How can people not understand this? “Arbitrage is the process by which people who are smart take money from people who are not.”

In addition to all of the mistakes that bankers had to avoid 30 years ago, there is a longer and more complicated list of things that financial services CEOs and Boards have to worry about. Because the Wall Street bonus system has become more common in the full range of financial institutions, from the CEO to the lowliest clerk the misincentives are as common as they are among the teenagers collecting for drug dealers in David Kuo’s home town of Harlem. Don’t believe it? I personally worked with three people who later served time in prison or have been convicted of felonies—One each from Lehman Brothers, Salomon/Merrill Lynch, and Countrywide. “Just because they wear a suit doesn’t mean they’re not a crook” is a saying one shouldn’t forget. Being smart as a board member or CEO in financial services means remembering things like this:

  • When the CEO’s bonus is in the tens of millions of dollars, he will not report problems to the Board until after he’s received the wire transfer of his bonus
  • When a member of the Board needs the compensation as a Board member, he will never ask the hard questions a Board needs to ask (“I could never raise that issue. Angelo would have fired me from the Board,” one director of Countrywide once told me).
  • Derivatives traders on a bonus system aren’t making profits—they’re just arbitraging your credit rating. They will do as much volume as possible until your rating sinks to a level at which you can’t do any more business
  • When a bonus system is in place, not a single person in that business unit has an incentive to tell senior management “this business is no longer profitable.”
  • When a financial institution doesn’t know what a security is worth, Wall Street will try very hard to sell them a lot of that security
  • When a financial institution doesn’t know what a security is worth, its own staff will originate them, sell half (by tranching) at a profit which drives their bonus, and put the other half (which has a loss identical in amount) on the balance sheet of the financial institution. Charles Prince and Stanley O’Neal, please note—this is how you lost money in CDOs
  • When bonuses are large and lies can increase your bonus, at least in the short run, people will lie

These points are now obvious. In the current environment, the CEO of a financial services company has to be just as shrewd as an old time mafia boss who knows that everybody working for him could be stealing from him. In the old days, I truly believed that the bankers I worked with were much more honest and intelligent than average, and it was true. Of the bankers I worked with 30 years ago, not one went to prison. By comparison, 2 of my 400 public high school classmates went to prison and, as mentioned above, 3 of my former co-workers in investment banking and finance in recent years have gone to prison.

Being “too smart to fail” means much more than being cynical about people’s motives both on Wall Street and inside one’s own organization. It means avoiding mistakes like these:

  • The head of Phibro is not worth $100 million dollars when the Phibro business unit can only be sold by Citigroup for $250 million. Citi’s size and former credit rating simply allowed an above average human being to take big positions. He’s not worth 1/20th of what he was paid, and Citi management didn’t know it. See the luck and skill bullet point below for more on this.
  • “We just lost a lot of money in our credit portfolio, so our budget for credit risk management technology has just been cut” is such an embarrassment that even the people who have to relay that message laugh when they say it
  • Harvard’s recently announced losses of almost $500 million on swap contracts resulted in margin calls that Harvard came dangerously close to being unable to meet. Clearly, you can’t take positions which have variable margin requirements unless you can meet the margin calls, no matter what happens to the price of the position
  • “The margins in this business are so small that we can’t afford the expense of a risk management system” means you need to get out of the business before it’s too late
  • “We’re managing risk in the Group Treasury, but we don’t need to use the same technology in our mortgage business. Our CEO has total confidence that the line guys in the mortgage business totally understand the business.” That institution failed.
  • In trading and investment management performance measurement, there’s an enormous difficulty in distinguishing between luck and skill. More than 20 years ago while I was at Lehman, we used to joke about it. You start with 16 traders. After a year, half had losses and 8 of the group would be left. After another year, you’re down to 4. After still another year, you’re down to 2. And finally, there’s 1 left. He’s been right for five years in a row and gets a huge bonus. Ironically, at “the old Lehman” management understood this and was legendary for just taking nickels and dimes that were sure arbitrage bets, with no huge open positions, unlike recent Wall Street fashion.
  • “In a crisis, all correlations go to one” is a confession that one’s understanding of finance is not good enough to be “too smart to fail.” As this chart from the recent crisis shows, when home prices drop by more than 20%, more banks fail in the United States:

  • The correlation of home prices with bank failures wasn’t obvious in the data when home prices changed by relatively small amounts. Nonetheless, being “too smart to fail” means understanding that you have a problem if you are making 80% loan to value mortgage loans and the home price drops in value by 20%.

We’ve made the point in this blog before that you need a license to drive a car in the United States, but you don’t need a license to be the CEO of a financial institution that can draw on the full faith and credit of the United States when the CEO makes a mistake. We need to replace “too big to fail” with “too smart to fail.” We need CEOs who meet a higher standard that Dick Fuld, Angelo Mozilo, Charles Prince, and Stanley O’Neal. And that responsibility rests with the shareholders and the Board of Directors. They need to take that responsibility to avoid a repeat of the last two years.

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