Fault Lines: How Hidden Fractures Still Threaten the World Economy (26 page)

I remember a meeting between risk managers of major banks and academics in the spring of 2007 at which we academics were surprised that the managers were not more worried about the risks stemming from the plunging housing market. After our questions elicited few satisfactory replies, one astute veteran risk manager took me aside during a break and said: “You must understand, anyone who was worried was fired long ago and is not in this room.” Top management had removed all those who could have restrained the risk taking precisely at the point of maximum danger. But if that were the case, then the blame for encouraging the bet-the-firm tail risk taking that was going on must lie with top management.

What was management thinking? An obvious answer is that they, like their traders, were taking one-way bets. However, an intriguing study suggests that bank CEOs in some of the worst-hit banks did not lack for incentives to manage their banks well.
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Richard Fuld at Lehman owned about $1 billion worth of Lehman stock at the end of fiscal year 2006, and James Cayne of Bear Stearns owned $953 million. These CEOs lost tremendous amounts when their firms were brought down by what were effectively modern-day bank runs. Indeed, the study shows that banks in which CEOs owned the most stock typically performed the worst during the crisis. These CEOs had substantial amounts to lose if their bets did not play out well (no matter how rich they otherwise were). Unlike those of some of their traders, their bets were not one-way.

One explanation is the CEOs were out of touch. An unflattering portrayal of Fuld has him holed up in his office on the 31st floor of Lehman’s headquarters with little knowledge of what was going on in the rest of the building.
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Indeed, in a tongue-in-cheek op-ed piece in the
New York Times,
Calvin Trillin argued that Wall Street’s problem was that it had undergone a revolutionary change in the quality of personnel over generations.
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In Trillin’s time in college, only those in the bottom third of their university class used to go on to Wall Street careers, which were boring and only moderately remunerative. But even while the dullards ascended to the top positions at the banks, Wall Street became a more exciting and challenging place, paying people beyond their wildest dreams. It started attracting and recruiting the smartest students in class, people who thought they could price CDO squared and CDO cubed (particularly egregious forms of securitization involving collateralized debt obligations) and manage their risks. As Trillin writes: “When the smart guys started this business of securitizing things that didn’t even exist in the first place, who was running the firms they worked for? Our guys! The lower third of the class! Guys who didn’t have the foggiest notion of what a credit default swap was. All our guys knew was that they were getting disgustingly rich, and they had gotten to like that.”
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The suggestion that bosses, recruited in a staid and regulated era, were of lower caliber than the employees they had recruited from the top of the class in a deregulated and high-paying era is not completely without foundation. An intriguing study of the U.S. financial sector indicates that the earnings of corporate employees in the financial sector relative to employees in other sectors started climbing around 1980, as the sector was deregulated.
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Moreover, jobs became more complex in the financial sector, requiring significantly more mathematical aptitude. Indeed, although there is little divergence between the wages of financiers and engineers at the college level, there is significant divergence among postgraduates (with postgraduate financiers increasingly earning more than postgraduate engineers). MBAs and PhDs began to fill the ranks of analysts and managers in financial firms. Therefore, not only was the financial sector demanding more highly educated people, but it was also paying them more and therefore probably attracting better talent than it had in the past—consistent with my observations that many of the smarter students in my MBA classes gravitated to finance. Clearly, deregulation and the subsequent surge in competition and innovation increased the demand for, and hence returns on, skills in the financial sector.

Although it is tempting to conclude that some of the CEOs were both untalented and clueless relative to their subordinates, the corporate hierarchy is inherently a tough climb and weeds out a lot of incompetents, especially in the unforgiving and fiercely competitive financial sector. It is hard to imagine that the majority of top management in the early 2000s, most of whom had probably joined in the already exciting 1980s and survived a number of ups and downs, were not highly capable and intelligent individuals. Sheer incompetence among the top management does not explain the crisis.

A better explanation is that CEOs were vying among themselves for prestige by making more profits in the short term or by heading league tables for underwriting or lending, regardless of the longer-term risk involved. I wrote a paper describing such incentives following bank troubles in the early 1990s, and I think the phenomenon is more widespread.
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Stan O’Neal, the CEO of Merrill Lynch, pushed his firm into the seemingly highly profitable asset-backed securities business in an attempt to keep up with rivals like Goldman Sachs. He monitored Goldman’s quarterly numbers closely and often questioned colleagues on the companies’ relative performance.
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Merrill’s lack of experience in the area eventually resulted in enormous losses and a shotgun marriage with Bank of America.

The pressures on the CEO may have come not just from shareholders or personal egos but also from aggressive subordinates. Citigroup CEO Chuck Prince’s comment in July 2007, only a month before markets started freezing up, has become emblematic of CEOs’ role in the current crisis. Replying to a journalist who asked why his bank continued to make loans on easy terms to fund takeovers, he said: “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.”
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This comment was commonly interpreted as reflecting the cavalier attitude of bankers toward risk and the mad chase for immediate profits. Months later, I met Prince at a conference where we were on a panel together, and I asked him what he had meant. He explained that even though he knew there were risks, as the first sentence of the quote suggests, he simply could not shut down lending, which was critical to securing investment banking deals: the moment he did so, he would have lost many key employees to other rivals who were still “dancing.” So the decision to continue lending was not so much an attempt to make short-run profits as an attempt to preserve Citigroup’s franchise in investment banking and its capabilities for the future. Of course, in making the kind of loans they did, his employees jeopardized not only their unit’s franchise but the entire bank. Hindsight suggests that Prince and Citigroup would have been better off if they had sat out a few dances.

A few CEOs appear to have stood up to their employees. The CEO of JP Morgan, Jamie Dimon, played a key role in preventing his bank from taking a bigger position in highly rated mortgage-backed securities, and in unwinding its existing positions, beginning in 2006.
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As he often emphasized to his staff, “We have got to have a fortress balance sheet! … No one has the right to not assume that the business cycle will turn! Every five years or so, you have got to assume that something bad will happen.”
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He also beefed up pay for risk managers, so that these positions attracted knowledgeable traders. He tried to ensure that they had clout. And although he had a much deeper understanding of derivatives than many of his fellow CEOs, he also had a rule: if he did not understand how a business made money, he would not participate in it. Not taking risks one doesn’t understand is often the best form of risk management. Firms with less confident or respected CEOs simply followed the herd over the cliff, pushed by the ambitions of their employees.

But before we attribute too much or too little foresight to CEOs, let us consider the findings of another sobering recent study, which looks at total top-management pay across financial institutions before the crisis and its relationship with subsequent performance.
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The study finds that some firms tended to pay their top management a lot more aggressively in the period 1998–2000, correcting for obvious factors like the size of the bank (big banks pay more because they tend to attract, and need, better talent). Aggressive payers included the usual suspects like Bear Stearns, Lehman, Citigroup, and AIG, whereas more conservative paymasters included firms like JP Morgan. The study finds that those who paid the most aggressively before the crisis were also those who had the worst stock-return performance during the period 2001–2008, the highest stock-return volatility, the highest exposure to subprime mortgages, and, by some counts, the highest leverage. Aggressive pay practices seem to have gone together with aggressive risk taking and subsequent poor performance during the crisis, much as my earlier discussion suggests.

Interestingly, though, the researchers repeated the exercise over a different time frame, looking at how those who compensated aggressively during the 1992–94 period fared between 1995 and 2000. Over this period, the same firms were aggressive payers, but they did phenomenally better than the conservative payers. Their stock returns were much higher, though measures of risk, such as stock-return volatility, were also high. The authors conclude that performance did not depend on the astuteness or incompetence of particular CEOs: rather, some banks had a culture of risk taking and of compensating very heavily over the short term, which attracted like-minded traders, investors (aggressive banks had more short-term institutional investors holding their shares), and even CEOs. When these banks did well during boom times, their CEOs were lionized as heroes; but when they did extremely poorly during the credit crisis, their (usually former) CEOs became villains. The CEOs were probably neither. They were just loading up on risk, including tail risk; but this time it just did not pay off.

Past experience may even have led CEOs to overestimate their ability to deal with tail risk. A passage from a
New York
magazine article about Lehman is revealing:

Soon Gelband was fired, and Lehman continued piling up risk. In its last days, it brought back Gelband to try to save the bank, but it was too late, and Lehman was bankrupted by the panic of 2008. More generally, aggressive banks’ risk taking had paid off in the past, which is why their richly compensated CEOs were sitting on enormous amounts of equity. They did not seem to realize that it was risk, not capabilities, that had brought them their past returns. And this time when they rolled the dice, what turned up was very different.

Although it would be too strong to say that CEOs had little influence—Stan O’Neal converted staid Merrill into an aggressive risk taker—perhaps the most important thing any CEO did was to arrive in the right CEO suite. Somewhat tellingly, Jamie Dimon parted ways with Citigroup and, by way of Bank One, joined the conservative JP Morgan. He tightened processes considerably at JP Morgan, perhaps partly because his admonitions fell on receptive ears. It is unclear whether he would have had the same influence at Citigroup. A
New York Times
columnist, Andrew Ross Sorkin, reports a conversation between Bob Willumstad, the CEO of AIG, and Robert Gender, its treasurer, as AIG was running out of money: “It was then that Willumstad accepted the fact that JP Morgan might not be willing to provide any further funds. AIG’s treasurer, Robert Gender, had already warned him that that might be the case, but Willumstad hadn’t fully believed him. ‘JP Morgan’s always tough,’ he reminded Gender. ‘Citi will do anything you ask them to do; they just say yes.’ But the prudent Gender only acidly replied, ‘Quite frankly, we can use some of the discipline that JP Morgan is pushing on us.’”
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In sum, the pattern of tail risk taking in some aggressive banks paid off for a considerable time. The management of these banks does not appear to have realized how much their performance depended on luck, or how their own collective actions precipitated the events they should have feared.

One question arises immediately: If indeed the aggressive banks were clearly identifiable, why did the market not punish them before the crisis? Banks that ranked in the worst quartile of performance during the crisis had much higher stock returns in the year before the crisis, 2006, than banks that ranked in the best quartile.
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So the market seemed to support the behavior of the risk takers by boosting their stock price before the crisis.