Why do financial firms take too much risk? That's a question posed by United States economist John Makin following the massive write-down on subprime investments by global luminaries such as Citigroup, Merrill Lynch and Morgan Stanley.
By "too much risk", he means actions undertaken by financial firm managers that result in substantial losses for shareholders.
Such losses may lead to "systemic risks", which may force regulators and policymakers to choose between reinforcing (with bail-outs) the investing that created the problem, or allowing substantial damage to depositors and shareholders – and possibly the economy as a whole.
First, there is the principal/ agent problem. This is where managers' interests diverge from those of the shareholders, as has been clearly illustrated by the widely publicised problems of the companies mentioned above.
When substantial errors in third-quarter earnings reports were revealed, the chief executives of two institutions "resigned".
For those who review these sad cases it is tempting – but untrue – to say that financial firms take too much risk because they are managed by foolish people, Mr Makin says.
The temptation arises from revelations in October and early last month that Citigroup and Merrill Lynch – to mention the most glaring recent examples – had to revise third-quarter earnings reports downward by billions of dollars only days or weeks after the results were first reported.
The revisions were so large that the stock prices of both institutions fell sharply, while financial sector stocks retreated broadly. Consequently, the chief executives of both institutions were forced to step down.
The terms of departure for both, especially Stan O'Neal, undercut the charge of management stupidity while reinforcing the notion that both leaders had taken on too much risk for their firms.
Merrill Lynch investors could check a website that records the scores of serious golfers and learn that as the first phase of the credit crisis was raging, Mr O'Neal played 20 rounds of golf between August 12 and September 30, 2007.
They could also observe his US$48 million (NZ$63 million) bonus in 2006, which made him the second-highest-paid chief executive on Wall Street, and his exit package, estimated at US$150 million – and conclude that this man is no idiot.
He had negotiated a compensation package that paid him more than US$50 million in 2006 to take extraordinary risks and then paid him again this year, even when those risks had resulted in billions of dollars in losses for shareholders.
"O'Neal demonstrated that being a good golfer was more important to getting ahead at Merrill Lynch than doing anything about risk management, and Merrill's board of directors apparently agreed by awarding him a compensation package that paid off handsomely, whether the risks turned out to be justified or not," Mr Makin said.
Mr Makin believes the major problem for the financial sector is that trillions of dollars of subprime mortgages were created on the assumption that home prices do not fall persistently.
Now they are falling at a 5 per cent annual rate.
Also, the drop in home prices looks likely to accelerate – probably to a negative 10 per cent year- over-year rate or more – meaning that further write-downs on mortgage-based assets are inevitable.
Readers might want to take note of the cockroach theory. This holds that problems are revealed in stages – you see one cockroach, but the rest are hiding.
This is a tactic of those responsible for the problems to ease in the bad news and not cause too much damage to their companies before they have learned how to deal with the problems. The cockroaches are coming out of hiding now.
* David McEwen is managing director of Investment Research Group. He may be reached by e-mail at davidirg.co.nz.
- The Dominion Post
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