Bubbles and governance
I have long been a staunch supporter of Ben Bernanke. However, he deserves the criticism directed at him after he testified that the Federal Reserve’s interest policies between 2003 and 2005 did not contribute to the housing bubble and the subsequent financial market disaster, and that the Fed should not intervene to prevent future bubbles from growing to the stage where they threaten the financial system. The Fed is the key player, and so it must never hesitate to intervene.
But, where was the private sector as the housing bubble exploded?
Bubbles result when investors join a herd and all mistakenly believe they will know the right time to take the exit ramp. They forget the minor detail that most investors will try to do the same thing at the same time, with extremely unpleasant consequences. As well, the herd requires continuous injections of debt to maintain and accelerate the momentum. Didn’t the providers of debt see the writing on the wall in the case of the housing bubble? Why did they go wrong?
Why does the private sector FAIL in limiting the creation and expansion of bubbles? The Fed alone cannot be held responsible.
By the third quarter of 2007 it was becoming very obvious that there was something seriously amiss in the housing and mortgage markets. John Paulson was already placing huge bets against these markets, bets that paid off very handsomely.
Morgan Stanley, in its 10K report filed with the SEC for the fiscal year ended November 30, 2007, highlighted the following:
“The Company recorded $9.4 billion in mortgage-related writedowns in the fourth quarter of fiscal 2007…During 2007, asset-backed products referencing subprime consumer mortgages experienced a significant increase in expected default rates, resulting in a dramatic reduction in asset prices and market liquidity. Although other markets have also experienced periods of significant illiquidity in the past, the combined magnitude and velocity of price depreciation, as well as the continuing nature of the event, place it among the most significant market shocks ever realized.” (The dreaded Black Swan)
Something was going horribly wrong and this was obvious more than one year before the September 2008 meltdown. Did the Fed read such reports? How about Morgan Stanley’s board of directors? Did they know what the company was doing in 2005-2007? Did they take precautions to limit future losses? (Morgan Stanley came very close to being the next domino to fall after Lehman.)
Dismal corporate governance lies at the heart of the failure of the private sector!
I have taken a look at the composition of the boards of a number of key financial players in the crisis: Morgan Stanley, Wachovia (RIP), Washington Mutual (RIP), Countrywide Financial (RIP), Bank of America, Citigroup and Lehman (RIP). Using their DEF 14A filings with the SEC for the fiscal year 2007, I was able to obtain information on their boards during 2007 and the slate of directors proposed for 2008. Not surprisingly, with very few changes, the 2007 boards morphed into the 2008 boards even as these ships were sinking.
The following stand out. With the exception of Citigroup, where Vikram Pandit was the newly appointed CEO, the CEOs of all of the other institutions also were the Chairs of their boards. Boards have four prime responsibilities: select the CEO and establish his/her contract; monitor the performance of the CEO; supervise the major strategic initiatives of the company; and supervise risk management.
So we have institutions where the CEO, the hired gun, chairs the group responsible for selecting, compensating, monitoring and second guessing the CEO. FAILURE 1 – CEOs should never be chairs of the board, indeed, they should not even be members of their boards.
Next, with the exceptions of Morgan Stanley and Bank of America, the majority of the directors had been in their positions for 7 or more years – Morgan Stanley: 2 of 11 directors; Wachovia – 11 of 17; Countrywide Financial – 6 of 9; Bank of America – 5 of 16; Washington Mutual: 7 of 13; Citigroup: 8 of 14; Lehman: 7 of 11. FAILURE 2 – there should be term limits (5 or 6 years) to prevent directors from staying beyond their best before dates.
Finally, on many boards, a majority of directors had other full-time jobs, including being directors of four or more companies. Consider Morgan Stanley: among the 7 directors who had been there for 4 or less years, one was a university president and managing director of a private equity firm; one was the Director of the London School of Economics; one was on the boards 4 large and prominent companies; one was the CEO of a family-owned company; and one was a senior executive at a major global technology company. How did they find the time to do a proper job as a director? (My favorite among all the directors was the Mayor of Dallas serving on the board of Washington Mutual. I wonder how the people of Dallas felt about this?) FAILURE 3 – being a director is a full-time job.
President Obama’s proposed reforms for the financial system are a step in the right direction. Next he needs to follow with a fundamental overhaul of corporate governance.
The opinions expressed in this blog are personal and do not reflect the views of either Global Brief or the Glendon School of Public and International Affairs.