As the financial crisis continues to whipsaw the markets, the question we need to ask is: "Where were the boards of directors of Lehman, AIG, Bear Stearns, Countrywide Financial, Wachovia, Washington Mutual, Fannie Mae and Freddie Mac?"
Were they lulled into complacency by their CEOs? Or did they lack the insight to see that their firms had placed themselves in great peril if there were major disruptions in financial markets? Or were they looking at computer models rather than applying the judgments they were selected to make?
Regardless of the reasons, the boards of directors of these firms are directly responsible to their shareholders for the firm's viability and survivability, and they should be held accountable for their failures. Yet no one is focusing on how these boards failed to exercise the fiduciary duties they assumed when elected by the shareholders.
If history teaches us anything, it is that financial markets can and will gyrate wildly from time to time. Of all corporations, financial institutions must keep their balance sheets and cash balances in line to weather the kind of storms we are currently experiencing. The bursting of the housing bubble was predicted back in 2006 and the excessive debt consumers were holding was also evident. Yet, the directors of these firms kept approving higher and higher levels of leverage as the storm clouds grew ever darker on the horizon.
Even the early signs that the housing bubble had burst in early 2007 were ignored. Didn't anyone notice the filing for bankruptcy protection of mortgage lender New Century Financial? By taking on the same kind of mortgages, wasn't it obvious that Countrywide Financial would be next - forced to sell itself to Bank of America after its stock declined 85% -- and would drag down the banks that were repackaging these mortgages as AAA securities?
My Harvard colleague Ben Heineman, former general counsel of General Electric, writes, "It is clear that the boards of our major financial institutions did not understand the risks the entities were taking." He further asserts, "The boards of financial institutions did not choose CEOs wisely in recent years. The institutions pursued profits with overleveraged and ill-understood strategies and banished tough risk assessment from the center of decision-making." Sad, but true.
Confirming Heineman's thesis, a year ago a former colleague of mine joined the board of one of the world's largest banks. At his first audit committee meeting he asked to see management's assessment of the firm's cumulative risks. He was told bluntly by the audit chair, "This bank is far too large to look at cumulative risks, as risk management is delegated to all our units." In the following six months, the bank was forced to write off over $20 billion in losses, and the CEO had to resign.
In response to the Enron and WorldCom crises, the Sarbanes-Oxley legislation of 2002 , with its intended improvements in board governance, was rushed through Congress in just thirty-one days. Since then, we have witnessed the growing power of shareholder advisory firms like ISS that aim to improve board governance. Apparently, neither these firms nor Sarbanes-Oxley caused the boards of these failed institutions to step up their oversight of management and the risks it was taking.
Where were the board audit committees when management was rationalizing that their computer models gave the best indication of the value of their holdings, instead of marking them to market as required by "fair value accounting"? Some financial firms and politicians are now arguing that mark-to-market accounting caused the problem and should be abandoned. To the contrary, marking to market is the only way to force managers and boards to face reality and provide shareholders and debt holders with an accurate valuation of the firm's assets.
If the government accepts this flawed line of reasoning and abandons mark-to-market accounting, we will not have learned anything from this debacle. As a consequence, we will have yet another crisis in a few years. The innovative financial instruments will be new, but the root cause will be the same: a focus on short-term gains enabled by the under-pricing of risk and inaccurate accounting. Doesn't anyone recall the Nobel Prize-winning economists who brought us the Long-Term Capital Management fiasco in 1998?
In their failure, these boards of directors forced the Federal Reserve and the Treasury Department to step in and take over their responsibilities. As a result, it seems almost certain that the U.S. government will have to impose greater regulations on all financial institutions, and thereby assume some of the fiduciary responsibilities previously held by their boards of directors.
As capitalists, this is certainly not the outcome that any of us would have intended. But it is the logical consequence of what happens when boards fail in their responsibilities. The solution is not to diminish the responsibilities of directors, but rather to hold them accountable to fulfill their fiduciary duties and to enforce negative consequences when they fail to do so.
Posted Oct 8, 2008 by Bill George |
Filed in: Politics
Last night´s second presidential debate proved that the presidential election is over.
To his credit, Senator John McCain has decided to accept an honorable defeat at the hands of Senator Barack Obama instead of the ignominy of losing the mud-slinging contest being urged on him by his advisors.
Like Roger Federer losing in five sets to Rafal Nadal in this year´s Wimbledon championship, for McCain it is better to keep your head up high and come back to play another day. This year may mark McCain´s last chance to become president, but he can emulate Senator Edward Kennedy in continuing to serve his country with distinction and honor as a senior U.S. senator.
With a barrage of polls this week indicating that the voting public - especially in key battleground states - is moving steadily to Obama´s side of the ledger, McCain could have come out swinging and thrown everything but the kitchen sink at Obama. As Obama seized the upper hand on the economic issues, McCain´s advisors told him this was his only chance. Governor Sarah Palin had been holding a dress rehearsal for McCain with lines smearing Obama, like "he´s palling around with terrorist who would target their own country."
For his part, Obama declared that he would not throw the first punch, but he would counterpunch. He warned McCain that if he threw the "guilt by association" mud ball at him, McCain would get the "Keating Five" mud ball splattered all over his face. McCain wisely backed down.
In fairness to John McCain, he is up against an extraordinary opponent who is far better organized and calmer in a crisis, and who has a better grasp of complex subjects like the economic mess we are in. Just as Senator Hillary Clinton learned in the primaries, it is extremely difficult to compete simultaneously with Obama´s unwavering strategy and his unrelenting organization on the ground.
The current economic crisis hasn´t helped McCain´s case either. Americans are deeply worried about their financial futures and angry about having to bail out Wall Street. Yet all McCain can offer is the trimming of a few earmarks. During the recent near-panic in the credit markets, Obama has proven himself to be a very good listener and a good learner. He has steadily supported those in charge of taking action to avoid even deeper problems, without trying to attract attention or credit for himself.
In retrospect, McCain would be in a more competitive position today had he chosen former Massachusetts Governor Mitt Romney as his running mate. Romney was a successful businessman and leader of one of the nation´s largest states who has a keen grasp of economics and financial markets. Like Palin, Romney is a social conservative.
But like the fighter pilot of his earlier years, McCain opted for a diversionary tactic in selecting Palin, in spite of having met her only once at a governors conference. With that impulsive move, he simultaneously wiped out his experience advantage over Obama and his credibility to address the economic crisis.
No doubt this seemingly endless campaign will take a few more twists and turns before election day. With a hungry media waiting for any morsel that can be turned into a prime time story, the candidates will probably toss a few bones their way.
But none of this will change the outcome of the election. On November 4th, Barack Obama will be elected our next president, with more than 350 votes in the electoral college.
When he takes office in January, Senator Obama will inherit a country with massive economic problems, a failing health care system, an incoherent energy policy, and a declining public education system while being entangled in two wars. Obama will need all the wisdom, listening skills, and thoughtful advisors he can find.
The current crisis on Wall Street is being characterized in technical terms that few Americans understand: subprime mortgages, credit default swaps, mortgage-backed securities, and CDOs.
But this is not a crisis caused by the failure of complex financial instruments. This is a crisis caused by the failure of leaders on Wall Street.
The heads of firms like Bear Stearns, Lehman Brothers, AIG, Countrywide Financial, and Washington Mutual all too often sacrificed their firms´ futures in order to maximize short-term gains. This meant under-pricing of risk in exchange for immediate fees and taking on inordinate levels of debt to invest in complex, highly uncertain instruments.
Compounding their errors, these leaders were unwilling to face reality when the value of their holdings tanked, as many declined to mark these instruments to market. Instead, they argued that their complex financial models yielded a superior valuation for their holdings. In some cases, this "mark-to-model" approach, or what Berkshire Hathaway (BRK.A) Chairman Warren Buffet calls "mark to myth," led to their undoing as people inside or outside the firms had difficulty figuring out what their assets were really worth. Had they followed the long-term investing philosophies of Buffet, these firms would be still be around.
A financial failure? No, this is a leadership failure.
The first job of any leader is to preserve the viability of the enterprise. These leaders focused on short-term gains and large bonuses for themselves, instead of ensuring the survivability of their companies and building them for the long-term. In this sense, their behavior mimicked failed leaders from earlier in the decade like Jeff Skilling of Enron and Bernie Ebbers of WorldCom, except there is no indication here of any illegal actions.
In contrast, five leaders of financial firms stand out for their prudent leadership as they prepared for this crisis by anticipating the impact of systemic risks and emphasizing the long-term health of their firms: Dick Kovacevich of Wells Fargo (WFC), Jamie Dimon of JP Morgan Chase (JPM), Ken Lewis of Bank of America (BAC), Lloyd Blankfein of Goldman Sachs(GS), and John Mack of Morgan Stanley(MS).
- Wells Fargo´s Kovacevich built the nation´s leading mortgage banking portfolio by emphasizing sound lending practices and avoiding the unqualified mortgages that led to the demise of mortgage bankers like Countrywide Financial.
- JP Morgan´s Dimon and Bank of America´s Lewis kept their balance sheets clean and healthy so that they were prepared to purchase distressed firms like Bear Stearns, Washington Mutual, Countrywide, and Merrill Lynch (MER) at bargain basement prices.
- Goldman´s Blankfein and Morgan Stanley´s Mack built liquidity and carefully managed risks as their firms shifted to the bank holding company model.
When it comes to authentic leadership in this crisis, no one stands out more than Treasury Secretary Henry Paulson. As a member of the Goldman Sachs board since 2002, I had the opportunity to observe him at close range. Were it not for Paulson - and his adaptability, tenacity, and ability to get other leaders to face reality - the U.S. financial condition would be in far worse shape than it is.
When he took the Treasury post, Paulson never dreamed of bailing out Wall Street financial firms, because his primary focus was on restoring relationships between the U.S. and finance ministers around the world. As the crisis unfolded, he immediately stepped up to leading the country through it. Using skills honed for decades as an investment banker, Paulson was able to bring the administration and warring political parties to agreement on the $700 billion bailout package approved by the House on Friday.
Paulson is a fervent believer in the free market system, but he recognized that without U.S. government intervention, this crisis could topple our entire financial system. We can only hope these latest moves, coupled with government takeovers of failed institutions, are sufficiently strong to restore confidence in the market and rid the economy of excessive bad debt.
This is just the latest--and largest--in the once-a-decade crises that Wall Street goes through. We shouldn´t forget the savings and loan debacle of the 1980s, the collapse of Long-Term Capital Management in the 1990s, and the bursting of the technology bubble in 2002. Yet creative financial people continue to invent new models and new instruments that create short-term gains, often without understanding the pitfalls they represent.
Many pundits blame these problems on greed, but greed is nothing new. The underlying characteristic of all these fiascos is the same: brilliant managers who thought they could out-smart the market, instead of leaders with the wisdom to build sound firms for the long-term.
The boards of directors of the failed firms bear a heavy responsibility for their failure to select the right leaders and to monitor their actions. All too often they permitted high-profile, ego-driven leaders put their image and drive for power ahead of their responsibilities as leaders.
We will never avoid these problems until boards of directors start selecting authentic leaders to run their firms known for character, substance, and integrity. These attributes are essential if we want to restore the strength and primacy of the U.S. financial system and build our economy for the long-term.
