Response to FCIC Final Report: Part II
Management Risk & Negligence
There were many losers in this crisis, but there was a consistent, if small, class of winners: the principal executives of the major financial institutions -- both those that survived and those that did not -- all walked away unscathed and uncensured.
One can achieve nuanced understanding of the crisis by focusing on critical areas in which those principally responsible had conflicting interests, and by understanding how these conflicts were resolved. Ben Heineman articulated the basic concern of corporate governance and conflicts of interest (HLS Corporate Governance Forum 1/31/11), “The fundamental capital allocation, risk management and integrity promoting decisions which will dictate whether a firm succumbs to a financial crisis are taken by its board of directors and its business leaders.”
We should consider the pattern of stock repurchasing undertaken by all of the major participants in the financial crisis as a major point for study. Well before the FCIC report, The New Yorker published a piece on subprime mortgages laying out the common practice of buying back stock to increase returns.
“Instead of setting aside money to cover possible losses, Merrill reduced its reserves of capital, in an attempt to boost returns. At the end of 2005, the company’s board approved a new incentive program for [Stanley] O’Neal and his senior colleagues, which promised them generous rewards if the firm’s return on equity exceeded certain benchmarks in the following three years. Setting targets for return on equity is common on Wall Street; nonetheless, the new incentive program gave O’Neal another reason to increase Merrill’s exposure to risk. One way a firm can boost its return on equity is to buy back some of its own stock; this reduces the size of its capital and means that its earnings get spread over a smaller base. Another option is to increase its leverage, or borrowing. Merrill did both. In 2006, it repurchased 116.6 million shares, at a cost of $9.1 billion. It also borrowed heavily….. [a former Merrill executive told me] ‘They were buying back stock to shrink the capital, so the return on equity would go up. Shrinking capital is dangerous. When you run an investment bank like Merrill, you are always going to run into problems. It looks like they have forty, fifty or sixty billion dollars of capital, so why worry? But they also have a trillion-dollar balance sheet. They are leveraged twenty to one. If the value of their assets falls four or five per cents, they are wiped out – so keeping plenty of capital on hand is crucial.” (“Subprime Suspect” John Cassidy, The New Yorker, March 31, 2008. 78, 8)
The story at Merrill was the pattern throughout the industry in the years just prior to the crisis. Executives were encouraged to take huge risks in return for personal gain – but there was no accountability for failure. In the years 2005- 2007 Citigroup repurchased $20,457 billion worth of its outstanding shares; Merrill Lynch $18.01 billion; and Morgan Stanly $7.2 billion.
Then, during the crisis years, each bank struggled to raise new capital, the absence of which was a major factor in requiring the active involvement of foreign investors and subsidy by the U.S. Federal Government. The first TARP tranche (respectively $billions, 20, 10, 10) in September 2008 was a virtual mirror of the funds management had contracted from their capital in the previous three years. Management of capital is the single most important responsibility for a financial institution – so is it not careless, or even negligent of executives and boards to let capital fall dangerously low in a chase for quick returns? It seems to be an incarnate indictment of the quality of corporate governance of these institutions. “…how practices that had gone on for many years suddenly caused a worldwide financial crisis.” (FCIC Final Report, 444, page 472 digital version)
“The lesson taught by the rescue of Bear [Stearns] was that all large financial institutions – and especially those larger than Bear … would be rescued… the critical need for more capital became less critical, the likelihood of a government bailout would reassure creditors” (FCIC Final Report, 482, digital version p. 510). Let’s look at the fate of the top people at the bankrupt Lehman Brothers and the failed Bear Stearns:
“We find that the top-five executive teams of these firms cashed out large amounts of performance-based compensation during the 2000-2008 period. During this period, they were able to cash out large amounts of bonus compensation that was not clawed back when the firms collapsed, as well as to pocket large amounts from selling shares. Overall, we estimate that the top executive teams of Bear Stearns and Lehman Brothers derived cash flows of about $1.4 billion and $1 billion respectively from cash bonuses and equity sales during 2000-2008. These cash flows substantially exceeded the value of the executives’ initial holdings in the beginning of the period, and the executives’ net payoffs for the period were thus decidedly positive. The divergence between how the top executives and their shareholders fared implies that it is not possible to rule out, as standard narratives suggest, that the executives’ pay arrangements provided them with excessive risk-taking incentives.” (Lucian Bebchuk, et als., “The Wages of Failure: Executive Compensation at Bear Stearns and Lehman 2000-2008,” Yale Journal on Regulation, Vol. 27, 2010, pp. 257-282 Harvard Law and Economics Discussion Paper No. 657,ECGI - Finance Working Paper No. 287 )
This double barreled leveraging – borrow more, reduce equity – can hardly be explained within the vocabulary of board negligence. It is necessary to look further, beyond negligence because conflict of interest is involved.
Follow the money.