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Bill George

Harvard Business School Professor, former Medtronic CEO

Category: Economic Crisis

The Perils of Focusing on Short-term Shareholder Value

Credit the board of Citigroup for facing reality by splitting the company in two.  It is a tragedy that General Motors´ leadership won´t make a similar move. Both need to recognize that the conglomerate approach to creating shareholder value does not work.

The root cause of Citigroup´s and GM´s problems- and of our current economic crisis – is the mantra of “maximizing shareholder value,” which led to an incessant focus on short-term gains. Any company that focuses primarily on short-term shareholder value will eventually destroy itself. When entire industries do so – as we have witnessed with financial service institutions and U.S. auto makers – they can drag the entire country into a deep recession.

After ten years of trying to implement former CEO Sandy Weill´s vision of turning Citigroup into a financial supermarket, its board finally acknowledged this strategy has been a colossal failure. To survive, Citigroup is returning to its roots in commercial banking, recreating the former Citicorp, the healthy bank composed of its retail and commercial banking arms, private banking, and investment banking. The second company, Citigroup Holdings, will contain its “non core” assets, including its subprime and illiquid mortgage-related assets that eventually will be spun off or liquidated.

Citigroup never integrated its far-flung units, nor did it provide its employees with an integrated information system enabling one unit to expand financial relationships with customers of other units.  Even worse, the Citigroup board never looked at firm-wide risk, assuming erroneously that the diversity of its businesses would offset the risks.  By 2007, Citigroup was so desperate to generate profits through short-term fees that it totally underpriced risk, leading to the bad investments that forced the U.S. government to provide $45 billion in bail out funds and guarantee $306 billion in bad loans.

At least Citigroup had the wisdom to recognize the music stopped some time ago.  General Motors continues on its merry dance, as its management fiddles while the company implodes.  Its board refuses to save the company by following Citigroup´s lead and splitting GM in two – a viable core business of Chevrolet, Buick and Cadillac and a holding company for all its other assets, which would be spun off or liquidated. Unless GM moves quickly, it will face with an uncontrolled liquidation of its entire business, and America will lose its one-time icon of industrial preeminence.

In spite of the Bush administration´s “Christmas bailout,” the new Obama team is unlikely to continue financing GM´s losses, just to preserve jobs that are no longer viable. Asking American taxpayers to provide GM employees with 100% health care coverage tax-free, while 47 million Americans have no health care at all, doesn´t pass the smell test.

The lesson of Citigroup and GM is that the conglomerate corporate structure, so popular in the days of ITT, Litton, and Textron, simply doesn´t work.  Customers don´t care if the parent company has a full range of offerings. They only want to know if the specific product or service they are buying is superior to competitive offerings.  As GM and Citi learned the hard way, any company that cannot provide customers with superior products and services is steadily going out of business.

In 1969 I joined Litton Industries, one of the model conglomerates of its era, and saw first-hand the flaws inherent in the conglomerate structure.  Litton had just acquired Stouffer Foods because Litton Chairman Tex Thornton dreamt of marketing the company´s new consumer microwave ovens with Stouffer´s frozen foods. The problem was that Stouffer´s tin foil containers wouldn´t work in a microwave – and so few households had microwave ovens that Stouffer management couldn´t justify redesigning its packaging.
For all the promises of “synergies” between conglomerate units, the real attraction for companies like Litton, Citigroup, and GM is the flexibility of creative financial engineering. That´s what enabled Litton to produce fifty-five consecutive quarters of earnings increases – the epitome of the “shareholder value maximization.” When the myth of Litton´s ever-increasing earnings machine was exposed, its stock dropped from $130 to $3 per share, and never fully recovered. 

The only way to create sustainable shareholder value is through the long-term creation of superior products and services that serve customers.  This is what motivates employees to peak performance, generates customer loyalty and market share gains, sustains profit growth, and provides funding for the next generation of products and services.

Creating sustainable growth in shareholder value requires a laser-sharp commitment to being the best in the world in your field.  That´s why focused competitors like Google, Genentech, ExxonMobil, Medtronic, Goldman Sachs, Intel, and Starbucks have sustained success for so many years, and created so much long-term value. 

To restore the vitality of our capitalistic model, our leaders need to acknowledge the flaws in short-term value creation and get back to creating sustainable shareholder value. This is the only way the U.S. economy will be restored to sustainable growth.

Where Were the Boards?

 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.

A Crisis of Leadership

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.

Does Anyone Care About Homeowners?

All the talk in Washington and New York these days is about the subprime mortgage collapse and the writedowns at financial institutions like Merrill Lynch (MER) and Citigroup (C). Isn’t anyone concerned about homeowners these days? More than one million Americans will lose their homes this year because they cannot keep up with their mortgage payments. So far only Treasury Secretary Henry Paulson seems worried about the homeowners who are being tossed out on the street.

I raised this issue in front of several thousand real estate developers on Oct. 26 in the course of presenting my book, True North. While most of the real estate folks were sympathetic to the plight of homeowners, the head of a large real estate investment trust was first up in the Q&A session. He described people who are losing their homes as “nothing but a bunch of speculators who falsified their mortgage applications.”

Predatory Lending Practices

Not exactly, sir. These homeowners are common folks who got talked (might I say conned?) into home purchases with no-down-payment mortgages that offered low rates in the early years until they were adjusted upward. Those people are being forced out of their homes because they can’t make the increased payments, and the value of their homes has sunk well below the amount remaining on their mortgages.

Mortgage brokers like Countrywide Financial (CFC), the nation’s largest mortgage broker, have been aggressively pushing these offerings. They have been permitted to operate outside the complex regulatory system that governs our banks and the traditional mortgage companies. Now homeowners are paying a big price for the Bush Administration’s lack of regulations to protect consumers.

On Oct. 26 Countrywide announced writedowns of $1.2 billion. Its stock has collapsed from $45 earlier in the year to the mid-teens at present, a loss to investors exceeding $16 billion. Has its leader taken the hit for these problems? On the contrary, Countrywide Chairman and Chief Executive Officer still has his job and is a rich man to boot. Mozilo sold $130 million of his Countrywide stock earlier in the year at prices averaging $40 per share. It’s too bad the rest of us weren’t as capable as Mozilo to see this disaster coming.

Tight Regulations Protected Banks

Merrill Lynch CEO Stan O’Neal (BusinessWeek, 10/30/07) wasn’t so lucky. O’Neal, a competent executive who reshaped and diversified Merrill’s business in recent years, got too far out on the risk curve in financing these mortgages. O’Neal was forced to resign and take the fall for Merrill’s $8.4 billion in writeoffs.

It is noteworthy that more conservative banks with huge mortgage portfolios like Wells Fargo (WFC) and Royal Bank of Canada (RBC) have not experienced unusually high mortgage failures. Authentic leaders like Dick Kovacevich of Wells and Gordon Nixon of RBC stuck to their traditional lending standards and lived within the tight regulations that govern North America’s banks.

In mid-October I was in Montreal to speak to executives of the Canadian Mortgage and Housing Corp. CHMC, which has insured $130 billion of Canadian mortgages, has avoided the writedowns that have plagued its U.S. counterparts. As I learned from CHMC CEO Karen Kinsley, the Canadians are more concerned with ensuring their citizens can meet their mortgage obligations than they are with short-term profits. The wisdom of their long-term view is paying off.

Mortgage Brokers Should Be Regulated

In late October Treasury Secretary Paulson took up the concerns of U.S. homeowners. He successfully jawboned institutions like Countrywide to restructure some mortgages to ease the pressure on homeowners. Why didn’t any of our regulators think about this problem several years ago before the mortgage brokers were allowed to run free? They could have saved a lot of people a lot of pain by preventing these brokers from offering misleading mortgages and repackaging them for resale to the financial institutions.

In spite of these concerns, don’t look for me to be an advocate of more regulations. Instead, I think we should protect U.S. consumers with responsible regulations that all the players in the system have to abide by. It is wrong to put tight restrictions on our nation’s leading financial institutions and to permit others, such as mortgage brokers, to operate outside those regulations. This type of uneven playing field only encourages greed and allows unscrupulous businessmen to push the limits of capitalism and foul the ground for everyone else. Free enterprise and aggressive competition offer amazing benefits as long as we all play by the same rules-and understand that we can only be successful if we truly serve our customers’ best interests.