Conventional wisdom holds that the best time to buy a ticket on a ship -or the whole ship, for that matter- is when it is not sinking. But it is not entirely clear that Bank of America, which apparently still plans to acquire the losing Countrywide Financial, understands this principle of both physics and economics. Countrywide today reported write-downs of $3.5 billion for the first quarter of this year, along with a net loss of $893 million, more than double its net loss for the fourth quarter of 2007. It was the company’s third consecutive quarterly loss.
When CEO Angelo Mozilo boasted that Countrywide would soon return to profitability following its first-ever loss in October of last year, we expressed some doubt. Evidently, it was stringing its shareholders along with the same kind of lines that got so many of its subprime customers into the mess they are in.
The numbers are large, but the biggest eye-popper was below the surface, which, as all informed followers of the Titanic saga will know, is often where the greatest danger lurks. The company set aside $1.5 billion for bad loans compared with $158 million in the comparable quarter last year -a staggering increase of 990 percent. That thud you heard might just be the iceberg.
What more surprises await next quarter? If Bank of America is still to go through with the transaction, it will likely be on the basis of the Fed’s swap-your-junk spring deal whereby weak collateral can be exchanged for Fed happy bucks, or some other form of hokus pokus, to make the mess at Countrywide easier to swallow. One has to wonder if Congress is really on top of what’s going on here, or if the Countrywide deal is another Bear Stearns in the making under a sleeping Rip Van Bernanke?
UPDATE (April 30, 2008):Perhaps we won’t have to wait for the next quarter to see if there are more suprises. The Wall Street Journal Reports today:
A federal probe of Countrywide, the nation’s largest mortgage lender, is turning up evidence that sales executives at the company deliberately overlooked inflated income figures for many borrowers, people with knowledge of the investigation say.
Care about risk was not permitted to intrude upon the holiday from reality many boards chose to take in the years leading up to their subprime cataclysm, which is why the credit crisis of 2008 can be traced to a complete failure of corporate governance.
There is a common theme emerging from the subprime debacle as it relates to the banking industry: risk was not respected. A recent internal UBS report found that the bank’s approach to risk was “insufficiently robust” and that the oversight of investment banking “lacked effectiveness.” UBS has written off over $37 billion in connection with subprime shortcomings, more than any other bank. We noted earlier that the board of Bear Stearns, whose mishandling of risk nearly brought down the whole financial system, according to U.S. government officials, did not establish a risk committee until early 2007. It met only twice in all of that year. John Thain, who succeeded Stanley O’Neal as CEO after Merrill Lynch posted the largest losses in its history, said the risk committee there did not function. A failure to treat risk with the care it deserves was also central to Société Générale, where the bank lost more than $7 billion as a result of unauthorized trades by a mid-level employee.
After Enron and other scandals, legislators in the United States concluded that boards needed to take the “surprise factor” out of financial reporting and assume greater responsibility for the prudent supervision of their companies. Section 404 of the Sarbanes-Oxley Act of 2002 sets out the expectations of cautious boards and top management in their handling of risk and the safeguarding of financial controls. It was not long ago that officials in the Bush Administration and in the business community were seeking to ease Section 404 requirements. SOX went too far, they suggested, and it was hobbling the ability of American business to compete. The irony is that at the very same time these players were claiming SOX was too onerous, they were failing to monitor risk to such an extent that it would lead to the worst credit meltdown and largest write-downs and losses in modern corporate history. Millions of ordinary Americans, as well as stakeholders elsewhere, would be dramatically impacted by the recession-causing missteps that were taken by some of the most revered names in banking.
What is becoming more apparent is that directors and top management, all very well paid, were living in a fantasy land where they acted as though the era of soaring fees and uninterrupted success would continue indefinitely. They chose to see only what they wanted and never contemplated the prospect that reality might hold a more dismal scenario. It was a time of deafening party making where the voices of reason and prudence, if they were invited to the occasion at all, were completely drowned out in the giddy bonus-popping euphoria of the modern Gilded Age’s newest members. Care about risk was not permitted to intrude upon the holiday from reality many boards chose to take on Wall Street and elsewhere in the years leading up to the subprime cataclysm. Like the Enron-type upheavals and accounting frauds that produced the most comprehensive reforms in securities law since the 1930s, the subprime debacle reveals serious shortcomings in boardroom culture and in the way directors are supposed to work.
Simply put, the credit crisis of 2008 can be traced to a complete failure of corporate governance. Others contributed speaking (or non-speaking, as the case may be) parts to the calamity, including sleeping regulators and conflicted rating agencies. But it was the boardroom that played the leading role in this unsettling drama, where the consequences when directors fail to direct were reprised in high definition, even while the scandals of the past were fresh in their minds.
It was a time of excess at every level of the corporate enterprise -except in sound thinking and common sense in the oversight of risk, in vision for looming hazards, and in CEO compensation tied to reason instead of the unsustainable illusion of growing subprime fees. Once again, the safeguards and governance tools that could have protected these companies -and, ultimately, the health of the financial system- from what is fast becoming the worst economic crisis since the Great Depression were the Rodney Dangerfield of the modern banking boardroom.
They just didn’t get any respect.
If you see a lot of people going around with neck collars soon, it’s probably because they got whiplash when reading today that the top 50 hedge fund managers last year earned $29 billion. The number-one winner, John Paulson, made $3.7 billion in 2007. If the U.S. Treasury issued them, and it may have to the way things are going for some on Wall Street, Mr. Paulson would have been handed 3,700 one-million dollar bills. That’s enough to run New York Presbyterian Hospital, one of the nation’s largest, or the City of Boston for 18 months. It would provide tuition for four years at a flagship public university like U.C.L.A or Penn State for at least 74,000 students, or a year’s worth of life-saving clean bottled water for 2.5 million children in Africa.
There was a time when multi-billion dollar figures were connected mostly with the creation of lofty projects and the operation of large organizations. Now, in the modern Gilded Age that obligingly continues for a happy few, they have become a number that appears on one individual’s annual paycheck. Not a bad situation considering the view expressed by the Fed and other U.S. government officials that had they not intervened recently in the Bear Stearns implosion and come up with their generous bailout plan giving JPMorgan Chase a helping hand, capitalism, or at least Wall Street as we know it, would have faced certain calamity.
Speaking of Wall Street, there must be something popular there about the sum of $29 billion. It is the same amount the Fed came up with to bail out Bear Stearns/Wall Street. It seemed like Jamie Dimon had to go to a lot of work to get the Fed to come up with the money, staying up all night over the weekend a while back. All he really had to do was talk to some of his hedge fund friends. They don’t appear to have a problem coming up with $29 billion -in just one year.
If only the poor, the uninsured or the struggling to survive each day in Africa and elsewhere could be so smart -or at least worked on Wall Street.
The absence of any discussion concerning all the roles held by these important Wall Street figures, including in the governance of the Fed itself, does a disservice to the stakeholders who are entitled to all the facts.
It is widely held, even by Fed Chairman Ben S. Bernanke, that the Federal Reserve System helped to bail out Wall Street when it agreed to “loan” $29 billion to facilitate JPMorgan’s purchase of distressed investment bank Bear Stearns. We will have more on the subject of that so-called loan in an upcoming posting. What has gone unnoticed and uncommented upon by the press, analysts and members of the U.S. Senate banking committee during its hearing last week, however, is the fact that key Wall Street figures, including Jamie Dimon, chairman and CEO of JPMorgan Chase, Richard S. Fuld, Jr., chairman and CEO of Lehman Brothers and Jeffery R. Immelt, chairman and CEO of GE, are directors of the Federal Reserve Bank of New York, the institution that is putting up the money.
Mr. Dimon is a “Class A” director of the New York Fed, elected by member banks to represent member banks (i.e., Wall Street). Mr. Fuld and Mr. Immelt are elected by member banks to represent the public. One might take the view that foxes are generally elected to guard the henhouse, too. The New York Fed’s governance brings to mind the crony-stocked, self-serving boardroom of the New York Stock Exchange under Richard Grasso before it was forced to make major changes to ensure higher standards of independence and accountability. It is clearly time to look at to whom and how the New York Federal Reserve is held accountable.
We know that JPMorgan benefited handsomely from the Fed’s dramatic measures. Lehman Brothers, widely rumored a few weeks ago as the next possible Bear Stearns, got a boost from the Fed’s market soothing actions. And GE, who just today jolted the market by announcing a 5.8 per cent decline in first quarter net income, was also having problems with its financial services division. Mr. Immelt told CNBC (a unit of GE) that he began to be aware in March of a weakening company outlook. (In an interview earlier that month, he indicated the company was still on target to meet its previous positive guidance.) A less volatile capital market temperament was no doubt helpful to him as well.
More and more, the picture is emerging that this was a bailout of Wall Street, prompted by Wall Street, over problems caused by Wall Street, with terms dictated by Wall Street. The Fed’s agreement constitutes the single most significant market intervention in generations. Such a decision, which places substantial taxpayer dollars on the line and the concept of moral hazard in jeopardy, should be arrived at in a manner that is beyond reproach not only in fact but also in appearance.
The absence of any discussion by the media, the Federal Reserve or legislators concerning all the roles held by these important Wall Street figures, including in the governance of the Fed itself, does a disservice to the stakeholders who are entitled to all the facts in order to properly hold government and its agencies to account. It is our call for the Outrage of the Week.
Fed’s dabbling with debt innovation in a time of over-leveraging is a decidedly subprime idea.
The Fed, which recently bailed out Wall Street over its subprime related credit blunders (see the testimony of Federal Reserve Board Chairman Ben S. Bernanke before the Senate Banking Committee on April 3, 2008), is now looking at ways of becoming even more creative in the economy. The Wall Street Journal reports options being considered include:
Having the Treasury borrow more money than it needs to fund the government and leave the proceeds on deposit at the Fed; issuing debt under the Fed’s name rather than the Treasury’s; and asking Congress for immediate authority for the Fed to pay interest on commercial-bank reserves instead of waiting until a previously enacted law permits it in 2011.
One option we think should be on the Fed’s table is this: do less.
American governments, corporations and households are already mired in unparalleled levels of debt. The current credit fiasco is the result of an experiment in debt gone terribly wrong. It was made worse when Wall Street got into the picture and saw the unavoidable temptation of more subprime innovation. So far, in addition to record home foreclosures, mounting unemployment and staggering corporate losses, it has resulted in the collapse of Bear Stearns, which the Fed warned before the Senate last week nearly resulted in calamity for the world’s financial system. We will have further comments on the Fed’s Wall Street bailout in an upcoming post on these pages.
If we have learned anything from the efforts of these too-clever-by-half financial players to defy the laws of physics (i.e., risk) in the economy in recent months, it is that what is lauded as creative genius one day can quickly turn into a symbol of reckless folly the next. Americans don’t need a debt experimenting Fed in a time when excesses in risk and imagination have already created a masterpiece of chaos.
It can only be hoped that his recent experience with the limelight and the cheers of the Wall Street crowd has not turned the otherwise conservatively inclined, academically trained Ben Bernanke into the Angelo Mozilo of central bankers.
Bear Stearns’s collapse confirms that excessive CEO pay, along with the feeble corporate governance that permits it, continues to be one of the most corrosive forces in modern business. It offers further evidence that, far from aligning pay with performance, oversized compensation induces risks that lead to disaster. It comes at a price that is too costly to society.
One of the striking features of corporate governance scholarship is that it reveals the same shortcomings and the same calamitous results occurring time and again throughout history.
“The sad case of Penn Central,” Dun’s magazine wrote about the giant corporate collapse in 1970, “is worth mentioning, not because it is unique, but because it is not. Many another US corporation has gotten into trouble because its directors did not do what they were supposed to do, that is, keep a warily inquiring eye on management and ask the right questions at the right time.”
A similar refrain was expressed about the boardroom before and after the Penn Central debacle. As we detailed in Part 1 of this series, Bear Stearns’s weak, distracted and ineptly led board was a contributor to its collapse as well.
Bear was not alone in displaying obvious signs of corporate governance weaknesses, however. Boardroom-wide, directors have permitted the complete discrediting -some would argue hijacking- of the executive compensation system. They have legitimized the creation of payment schemes that have induced CEOs to take on excessive risk in the hope of bringing in fees and deals that push up share values in the short-term and trigger unprecedented awards of stock and bonuses, while at the same time insulating them from the consequences of their actions by guaranteeing golden separation packages in the event of failure.
Excessive CEO pay, as I suggested in a submission to the Senate Banking committee during its Enron-related hearings in 2002, is the most corrosive force in modern business. It is fast eroding respect for the leadership of American capitalism among both shareholders and society. It was a contributing factor in the demise of Enron and Hollinger and in the scandals involving WorldCom, Tyco and many others. Its cancer is also evident in the current economic crisis. Over the past five years, when the foundation for the subprime disaster was being laid, the CEOs of Citigroup, Merrill Lynch, Countrywide Financial and Bear Stearns were paid more than half a billion dollars -$556 million- among them.
Like the toxic effects of the credit catastrophe that spread into the housing market, then to the balance sheets of major financial institutions, and finally into the wider economy, the debilitating repercussions of excessive CEO pay and the subprime misjudgments they spawned have long since moved past the shareholder annual meeting and into the recession dampened lives of ordinary people. In the last year of reported filings, James Cayne (then chairman and CEO of the company) and Alan Schwartz (then president and co-chief operating officer) were paid more than $73 million between them. Did the prospect of such huge compensation distort their judgment and tempt them to accept unwise risks and ignore red flags? It is a line of inquiry policy makers ought to pursue with Bear Stearns and throughout the financial industry.
For every year of the past five, while management misjudgments and miscalculations were laying the course for the credit crisis that eventually claimed the investment bank, the compensation committee of Bear’s board declared that it was happy with the performance of the company and that management fully deserved the compensation it was awarded. So blind was the committee to any notion of excessive risk that was being taken, it simply copied and pasted many of its statements of praise and satisfaction from one proxy statement to the next. “Therefore, the compensation paid to the Company’s executive officers reflects the Company’s strong absolute and relative performance” was how the compensation committee was fond of putting it -so fond, in fact, that it used exactly the same phrase year after year.
Close ties and over familiarity may also have been a problem with Bear’s compensation committee. The board’s pay panel was headed by 81-year-old Carl D. Glickman. While securities filings by the company claim that he has been a Bear director since 1985, biographical information provided by Cleveland State University, where Mr. Glickman is also a trustee, claims he has served on Bear’s board since 1978.
At the very least, the compensation committee’s culture, structure and decisions raise unsettling questions about whether its products are more the reflection of a cozy club mentality of close connections than the result of vigorous market forces and heavy negotiation.
As we noted earlier, long-time chairman and former Bear CEO James Cayne recently sold all his holdings in the firm to net $61 million, according to formal declarations. By some standards, that sum is far below what his holdings were worth a few months ago. On the other hand, he has long been chief officer of the Bear Stearns ship. Having set its ill-fated course, it is remarkable that he came out with anything at all. The ship is going down, but Captain Cayne managed to jump into the Fed-sponsored lifeboat before anyone else. It is not often that any single person, much less one who has been such an outspoken advocate for free market capitalism as Mr. Cayne, can trace his added wealth to the entire apparatus of the federal government coming to his rescue, and to the Federal Reserve taking actions not seen since the depths of the Great Depression.
The subprime scandal also exposed holes in the governance of other investment banks. Merrill Lynch, as incoming CEO John Thain observed, had a risk committee that didn’t function. And Countrywide Financial, which likes to think of itself as a bank, has another all-male boardroom that seldom formally meets and where the compensation committee writes with a hyperactive pen that seems unable to stop putting zeros at the end the CEO’s paycheck. How it permitted a situation where the CEO was allowed to sell a substantial chunk of his own shares at a time when the company was engaged in a share repurchase plan which pushed the price up constitutes an unbecoming stretch for even the most compliant board.
But Bear Stearns is the first institution of its kind to collapse so dramatically with the fingerprints of questionable corporate governance practices found throughout the ruins. There was a disconnect between what the board was supposed to be doing and what it actually did. In that respect, it is reminiscent of the approach taken by another board: Enron’s. It did not end well for that company, either.
The directors of Bear Stearns were paid well for their duties -at least $200,000 each. Management directors were paid in the tens of millions every year. For that sum, and under the board’s unhurried watch, shareholders and employees were treated to the privilege of witnessing the unthinkable: an 85-year-old institution that survived the Great Depression and two world wars only to slide under the turbulent sea of subprime folly, leaving a token reminder in its decimated share price that it once existed at all.
“Where was the board?” is a question governance scholars and others have increasingly come to inquire during times of corporate calamity. It has been asked of many large failures over much of the past 100 years. But for this most recent boardroom mishap an even more probing question needs to be posed: “If Bear Stearns had no chairman and no board at all, would the results have been any worse?”
