The Hindu Business Line : Paying the price for risky strategies in financial services

The problems of the financial services industry in one country have a fallout on other nations as well. Thanks to ease of money movement, and fewer national restrictions on the instruments being traded, the spread of the Asian financial crisis in 1997-98 around the world was a wake-up call for everyone.

C. Gopinath

It can never be good for a CEO’s ego if the company’s stock price rises on the announcement of his departure from the company. But at least two CEOs in the recent past, both from the financial services industry in the US, have had to face that situation.

Considering that they do not get hurt financially when they are fired, nor do they seem to have much difficulty landing another job, or getting a few millions as a book advance, a hurt ego is perhaps the only price to pay for failure at that level. The most recent victim is Mr Stanley O’Neal of Merrill Lynch. The company’s stock price that had fallen about 31 per cent on news of its losses shot up 8.5 per cent on hearing the top man was going! Just last month, the board asked him to step down. Merrill Lynch incurred a loss of $7.9 billion (Rs 31,059 crore) in the third quarter. The loss that he announced to the analysts in a conference call was almost 80 per cent higher than what he what he told his board, which was $4.5 billion (Rs 17, 692 crore).

As though that transgression was not enough, he topped it by initiating a merger talk with a rival, Wachovia Bank, without prior clearance from his board. A merger is a major initiative often resulting in adjustments to strategy and the board would certainly like to know about it and deliberate before hand. In the current environment of concerns about corporate governance, a board that has been shocked with the news that the firm’s losses are greater than what it was led to believe is certainly not going to sit quiet and learn from the newspapers that they are in a merger. They decided that he should go.

Personally, Mr O’Neal did not make out too badly. His severance package is estimated to be about $160 million (Rs 629 crore). If his plan to merge had gone through, he may have personally netted $250 million (Rs 983 crore). Either way, you don’t need to worry about where his next meal is coming from. But the board must have certainly wondered if this man was playing an end-game with the company they put him in charge of.

Some other top executives have also felt the pressure. Countrywide, the nation’s largest home mortgage lender is busy marking down the value of the securities it holds. The head of investment banking and other executives at the bank UBS AG resigned a month ago after the bank incurred a loss of $3.4 billion (Rs 13,367 crore) on account of the mortgage mess enveloping US banks.

Mr Charles Prince, CEO of Citigroup, resigned in the face of losses from mortgage assets when the losses turned out to be many billions more than estimated. The bank’s stock, which has fallen nearly 30 per cent this year, is said to have risen 3 per cent on news of his quitting.

sub-prime mortgage mess

Much of the fallout has been coming from the mess around sub-prime mortgages. For those of you who have been busy doing other things recently, this is the home mortgage that is given to the least-credit worthy individuals. Well-run banks would normally treat them as too risky for a mortgage, although there always were a few banks willing to lend to them at high rates. But in the recent past, greedy for the higher return (albeit with higher risk) that they bring in, that spirit of irrational exuberance, many lenders were going beyond their own norms. (The federal regulators were looking in the other direction when this was happening.)

The weak borrowers, who are now unable to make their monthly payments because the interest premium has shot up due to a new basis for their interest calculations, are being eased out of their homes that are then foreclosed. Many were on adjustable rate mortgages, which let borrowers make low payments in the early years, with sharp increases later. The property is put up for auction and in the current depressed home market, the bank has to swallow the loss. The extent of loss across the industry has been estimated at tens of billions.

Although Merrill Lynch was not directly lending to these borrowers, they were underwriting what are called collateralised debt obligations and not putting in place sufficient risk controls. (Within a period of 18 months, Merrill Lynch’s holding of these obligations rose 40 times.) That was a part of Mr O’Neal’s strategy of moving from conventional money management and stock underwriting business to high risk investing with its own money.

Giving the CEO a long rope

The question that is also relevant in this situation is what would be the cost to the company from the continued presence of the individuals who have been shown the door. That is the judgment of the board and that is what they are there for. When the going is good, boards tend to leave it to the CEO and give him or her a long rope.

Perhaps one question that the boards of these companies may find it worthwhile to ponder is whether the company is reaching a size and complexity that is too big for their CEOs to manage. Boards love continuous growth and CEOs love it too, for size brings prestige and reach. Stock markets and investors love profitability. There are times when the growth and profitability do not go together. Every marginal addition of a business line or geographic segment adds people and assets and revenues. The complexity that comes with it combined with the pressure to show profit growth drives these leaders into increasingly risky lines.

In good times, the margins are sufficient to cover up mistakes and absorb inefficiencies. When the economy slips or there is a major hit, the fault lines become apparent. Mr O’Neal of Merrill Lynch is credited with pushing the firm into sub-prime debt securities. Of course, he also did well for the firm in the asset management business. Perhaps the Board feels guilty for letting him ride free for so long and not having reigned him earlier. So they call his exit as ‘retirement’ and give him a nice package, perhaps swallowing some of the guilt. Mr Prince of Citigroup was unable to manage the behemoth he inherited that included businesses ranging from insurance, and stock-broking to banking. Acquisitions had not been integrated and various fiefdoms continue to thrive within the group.

Now, everyone is watching what the heads of similar firms are doing. A front page story in the US financial daily The Wall Street Journal reports how the CEO of Bear Stearns Cos., a securities firm, was playing bridge in a tournament ‘without a cell-phone or e-mail device’ when two of the company’s hedge funds were losing value and the firm was in a crisis. The reporter also thinks it worthwhile to mention that the CEO plays golf alone and does no business on the links! The lesson: A CEO needs to be in the driving seat all the time, else he will be sent home with millions in his pocket.

An international problem

The problems of the financial services industry in one country these days is not just a national problem but an international one. Thanks to ease of movement of the money, and fewer national restrictions on the instruments being traded, the spread of the Asian financial crisis in 1997-98 around the world was a wake-up call for everyone.

If you need a reminder, just look at the sympathetic movement of stock market indices when there is sudden drop in one country. The lenders of the sub-prime mortgages have been securitising their loans and spinning them off elsewhere in smaller and smaller packages so everybody can have a piece of the cake, and hold it while it has gone rancid. So many banks in Europe, for instance, are holding their piece of this problem wondering what went wrong. It is time for financial regulators around the world to inquire into why the US regulators failed to catch the sub-prime mess early.

(The author is a professor of international business and strategic management at Suffolk University, Boston, US. He can be reached at cgopinat@suffolk.edu)

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