Phillip Purcell, former chief executive at Morgan Stanley, now head of Continental Investors, offers up The Five Lessons Bankers Must Relearn (Financial Times commentary, 10 August, 2008).
It is difficult to find fault with Mr. Purcell’s five lessons from from the current financial meltdown
- it’s about profits, not revenues
- executive compensation should be based on long term profits
- leverage is a two edged sword
- diversification of income & assets is a must
- risk management must be maintained as a culture in financial institutions
However, Purcell’s analysis does not mention two fundamental drivers that I believe are core issues behind the current crisis.
The Conflation of Banks with Investment Banks.
This blurring of the line between two very different financial cultures is the state of the industry in the US, but it has not always been so. In fact, the bank failures of the 1929 crash were largely a result of banks being allowed to trade in securities, as well as making margin loans to client investors guaranteed by securities — the traditional domain of investment banks. Following the 1929 crash, the Glass-Steagall Act prohibited US banks from trading in securities. For the better part of half a century Glass-Steagall acted to preserve a conservative risk-averse culture within the national banks. The formula for bank profitability was leverage against a high quality loan portfolio (20:1 debt to equity was considered normal for sound banks). The US government (i.e. the taxpayer) provided the ultimate security for the banks, via the FDIC.
The more risky activity of underwriting and making a market in securities was left to the investment banking houses. These institutions enjoyed greater profits in good times, and suffered greater losses (including massive layoffs) in bad times. As a result, they were inherently less credit worthy, and much less securely leveraged than banks. When investment banks failed, it did not directly affect the average American’s bank accounts, and there was no liability to the taxpayer. The investment banking houses were, in a sense, expendable.
But the US Congress repealed the Glass-Steagall Act in 1999, allowing the activities of banks and investment banks to merge again — including actual mergers and acquisitions. In most cases, the results destroyed shareholder value (for example, the Nations Bank + Bank of America merger resulted in the destruction of shareholder value equal to the entire net worth of Bank of America before the merger), and over-leveraged the balance sheets of the resultant institutions. Over-leveraged, that is, for the quality of the assets in the portfolio. The dominant corporate culture in most of the newly formed companies was the investment banking culture, not the conservative, credit quality conscious bank culture.
As a nation we forgot the lessons of 1929. Eliminating Glass-Steagall introduced a fatal flaw to the financial industry. As Mr. Purcell notes: “…leverage works not just on the upside but on the downside as well. Excessive debt can turbo-charge profits during a boom, but can result in crippling losses when the bubbles burst.” When the next major credit downturn came — as an unanticipated consequence of high-flying new financial products engineered by investment bankers — the originators of these products failed and threatened to take down the entire US banking system with them. The investment- banking-houses-turned-banks were no longer expendable, and this time the Fed could not let them fail. The result: the greatest taxpayer financed US government bailouts in history.
The Responsibility of the Credit Rating Agencies.
Much of the blame for the current mess can be laid at the doorsteps of Moody’s, Standard & Poors and Fitch, the three major credit rating agencies. The conflict of interest is not unlike that which existed between the major accounting firms and their clients circa 2000. The conflicts in the accounting industry stemmed from the fact that the Big Six (once known as the Big Eight and, more recently, the Big Four) accounting firms made most of their money not by auditing, but by consulting engagements — including figuring out how to engineer financial products (“Special Purpose Vehicles” designed to address specific needs) that escaped detection and fair reporting by their own auditing teams. In the same way, the rating agencies are paid large fees for developing ratings on the credit strength of the clients that pay those fees. How this conflict of interest has been allowed to persist for decades is its own scandal.
The knee-jerk government response to the post-Enron accountancy failures was
- Dissolve the most immediately culpable Big Six firm (Anderson)
- Take the auditing function away from the Financial Accounting Standards Board and place it back directly into the hands of the Securities and Exchange Commission.
The FASB, along with its system of industry-self regulation, was deemed to have failed the public interest. After much ado, FASB was able to head off the threat to their charter and retain the auditing function, albeit with staggering new levels of complexity (Sarbanes-Oxley) and cost. Another credit reporting failure like Enron could in fact change the landscape of the industry, turning the audit function from its present high-prestige professional status into another modest-paying government bureaucracy like the IRS.
This credit crisis is in no small measure attributable to the credit rating agencies failing to properly assess the risk inherent in the various complex Collateralized Debt Obligation type instruments, and the entire system of underwriting, origination, warehousing and placement that sprung up in the late 1990s and early 2000s. So far the agencies have received only modest chastisement for their complicity in the debacle.
I would not be surprised to see new regulations aimed at the industry in the form of:
- Separating banking from investment banking again
- Closer government control of the investment rating process.
In the long run, risk and return go hand in hand. As Harry Markowitz pointed out with his securities market line, the two exist in tandem. Risk-adjusted-return is a kind of standard currency for financial managers — and has been for some years. Those who would hype the return promises and try to obfuscate the true underlying risks are, in a sense, no different from the charlatans of old who shaved coins and traded in false weights & measures. But today, the schemes are infinitely more complex and difficult to detect.
Happily, a new class of money manager is emerging today who is less obsessed with short term returns than with risk/returns. Some have become masters of the new investment paradigm, driving down risk in their portfolios rather than reaching for the last basis point of yield possible. Hopefully, this new brand of money manager will stand as a skilled craftsman, delivering value year in and year out by nothing more or less than honest and diligent assessment of the risk-return characteristics of each new investment opportunity. A greater adherence to this paradigm in our recent past would have saved us all a great deal of harm. Embracing it now can do us a lot of good in the immediate future.
