An Essay by J. Richard Finlay
on corporate integrity in the post-bailout era
Recent multi-billion dollar settlements involving Bank of America and JPMorgan Chase show the staggering costs of ethical folly and the culture of moral hazard that places too many companies, and capitalism itself, at risk.
It is the curse of giants to believe in their own invincibility. It is also the curse of their acolytes, as the White Star Line discovered with its “unsinkable” Titanic and the Philistines learned with the defeat of their champion Goliath at the hands of a young shepherd boy. Yet these lessons, and countless others, over millennia have not dispelled such illusions in the world of business, where size is seen as an insulator against all manner of misadventures and the too-big-to-fail mentality shows few signs of abating. Indeed, the extent to which America’s major banks and Wall Street icons were on the wrong track when it came to compliance with the law and standards of ethics during the great financial meltdown and even afterwards is becoming even more striking. Recent reports involving Bank of America, Citigroup and JPMorgan Chase vividly make the point.
On these pages in the years and months leading up to the worst financial crisis since the Great Depression, and in numerous op-ed columns before that, I wrote about the dangers of relying on the myths of giants. Until they were categorized as being too big to fail, corporate monoliths like Bank of America, Citigroup and JPMorgan Chase were viewed as being too smart to fail. Trophy directors and fantastically compensated CEOs, with the assistance of huge PR departments that never seemed to sleep, worked overtime to present an image where success was virtually guaranteed. The reality, however, was that too many boards were recklessly disengaged from what was happening around them. Seeds of folly were being sewn by undersupervised employees more interested in creating clever short-term financial devices than sustainable building blocks of long-term business. And too many investors and journalists had become prisoners of what I call cheerleader capture. First cousin to the condition of regulatory capture, this refers to the state where it is virtually impossible for any dissenting voices to penetrate the thundering chorus of cheers by insiders and their loud choir of supporters.
There were warning signs of the unwise effects of that mindset, to be sure. Scandals involving security analysts, for instance, for which Henry Blodget became the poster-boy, revealed the dangers of a culture of cheerleader capture. In too many cases, the analysts who were supposed to be delivering objective assessments of the financial health of companies enjoyed personal and career incentives that caused them to paint a more glowing picture than justified by the facts. Citigroup was touched in several ways by that scandal.
There were the accounting frauds at Nortel, Enron and Worldcom that were so stunning they resulted in landmark legislation known as the Sarbanes-Oxley Act being passed. The collapse of Hollinger and Livent provided an interesting coda to those scandals. If these events of just a few years earlier had been taken seriously, they would have produced a higher standard of boardroom oversight that might have prevented the blunders and financial chicanery that brought the world to the brink of the financial abyss in the first decade of the 21st century.
But even before the gales of that crisis rose to full force, this space questioned the governance practices of companies like JPMorgan Chase, Citigroup, Bank of America, as well as Countrywide and Merrill Lynch, two institutions which BofA bought. We took frequent issue with the sweetheart boardroom deals that propelled their CEOs into the super-compensation stratosphere. We felt that the excessive deference accorded many CEOs reflected a perilous level of disengagement on the part of boards which in turn were failing to exercise the independent judgment needed to fully protect investors and the public franchise of capitalism itself.
Many of the decisions these companies made were fraught with ethical failures, violations of the law and just bad business thinking. Their consequences are coming home to roost even years later. Bank of America recently agreed to pay $9.5 billion in fines to settle civil lawsuits with U.S. federal housing authorities. Ken Lewis, the company’s former CEO, settled with regulators by paying $10 million personally. All told, it has cost BofA some $50 billion to resolve a variety of claims stemming from the subprime era, including the fraudulent actions of Countrywide Financial and misleading statements made in connection with the bank’s purchase of Merrill Lynch.
Improprieties at JPMorgan Chase resulted in an astonishing $20 billion being handed over to various regulatory authorities. The amount barely caused a ripple on Wall Street, where reaction to the announcement registered nothing untoward in respect of JPMorgan’s stock or the reputation of its CEO, Jamie Dimon.
Citigroup, which has also paid out huge amounts to settle regulatory claims, recently failed the Fed’s financial stress test — for the second time in two years. Its stock languishes at the unconsolidated 1-for-10 equivalent of the same $5 range it was at during the bailout crisis. Were its recent history of losses, bailouts and scandals not sufficient, there are new regulatory and legal issues arising from a potential fraud involving Banamex, a Mexican subsidiary. In one day early this April, Citigroup’s shareholders were hit with a double whammy. The company said that it was unlikely to meet a key profit expectation it had set and then announced it was paying $1.12 billion to certain investors to settle claims stemming from mortgage securities sold before the financial crisis.
Yet the level of shareholder outrage one might think would be directed at Citigroup’s board for this Job-like litany of woes has, for the most part, failed to surface, just as tolerance of years of poor boardroom practices and bad decisions earlier led to a cascade of scandals and financial losses culminating in the bank’s liquidity crisis that prompted the U.S. government bailout in 2008.
In no case has any banking or Wall Street executive faced jail time as a result of the misdeeds that resulted in these record massive payouts or those of other companies. By contrast, in any given day on Main Street, courts routinely hand out jail sentences to elderly seniors convicted of shoplifting and single mothers who pass bad cheques for even small amounts.
Like the notion of billions and billions of stars in the cosmos often attributed to the late Carl Sagan (with the help of Johnny Carson), it is hard to get the mind around the scale of these fines, payouts and penalties. And in the case of Bank of America and JPMorgan Chase, and numerous other companies from drug makers to car manufacturers along the way, it seems nobody is even trying.
What seems to be happening instead is that the wrong-headed mindset that gave birth to excessive CEO pay has infected other fields of business responsibility and decision-making. We explore this further in Part II.
When Countrywide Financial’s Angelo Mozilo told a Congressional committee in 2007 that there was a lot of fraud in the subprime business, we thought at the time it might be a prophetic statement. The Securities and Exchange Commission apparently agrees, as this week it laid civil charges of securities fraud against the company’s former CEO. What we sometime ago dubbed as Mr. Mozilo’s miraculously timed stock sales, the SEC thinks could be insider trading.
In 2006, Mr. Mozilo was among America’s ten highest paid CEOs, with a paycheck that topped $142 million. Between 1999 and 2008, he pocketed some $400 million in total compensation. It will be interesting to see whether this was one of those cases where the compensation was fully justified–as Countrywide’s board always maintained during this period–and an example of aligning the interests of CEOs with those of investors, or whether it was, instead, nothing more than reward founded on sands of subprime fraud and another example of CEO pay being aligned with CEO greed.
Much as we have long faulted James Cayne for his role in Bear’s implosion, responsibility for its ultimate failure is born by many actors, including the long-time head of its executive committee, Alan Greenberg. It proves once again that boards must actually direct. In Bear’s case, there is scant evidence that its independent directors were even in the room, much less grasped the pivitol role the firm played in the health of the entire financial system.
So now the titans of Bear Stearns itself are weighing in on who is to blame for the blunders that led to the firm’s collapse. The New York Times reports on Wednesday that Alan C. Greenberg, chairman of Bear’s executive committee, had some harsh words about former CEO and board chairman James E. Cayne. And the issue of corporate governance has been raised for the first time by the newspaper as a contributing factor in Bear’s downfall. It might be the first for The Times, but as loyal readers will know -and they actually include a number of Bear’s own employees- Finlay ON Governance was the first to bring to public attention the role of that firm’s dysfunctional and over- extended board of directors.
The Times notes:
The demise of the firm they loved was not so much the fault of either man. Instead, it was a collective failure of the governing five-man executive committee that over the years became so fixated on increasing the firm’s book value – and expecting the stock price to follow – that it lost sight of the concentrated, underhedged exposure to the home mortgage market that left Bear vulnerable.
Actually, The Times is not quite on top of the story. There were problems with the executive committee and the fact that it did so much of the heavy lifting in the firm -to the exclusion of any independent director. But the ultimate responsibility for permitting that situation rests with the full board of directors, which Mr. Cayne chaired and on which Mr. Greenberg served for decades. As we have observed before, there is little to suggest that any of the directors in the all male, management-dominated Bear boardroom were bothered by its governance structure or the bizarre antics of its chairman.
As The Times reveals:
One member of the executive committee said that Mr. Greenberg, as a longtime director, had ample opportunity to voice concerns about Bear’s vast exposure to subprime mortgages and its hedging strategies, which he did not do.
“He never said a word,” said this person, who declined to be identified because of the legal sensitivities in the matter.
The company’s independent directors were not exactly breaking sound barriers in voicing their concerns, either. In fact, one has to wonder if they were even in the room.
The company had independent directors on paper, to be sure, but they displayed a curious sense of their roles and what passed in their eyes for acceptable corporate governance in a firm that apparently was so consequential to the capital markets that its collapse could have precipitated an upheaval of the entire global financial system, as we have been told. Many Bear directors served on multiple boards involving other publicly traded companies. They did not establish a risk committee of the board until March of 2007 and it met only twice that year. There is the issue of the over-extension of its audit committee members (which we first revealed here). And like every major player that ran into serious trouble over the subprime meltdown, from Countrywide and Merrill Lynch to Citigroup and UBS, at Bear Stearns the post of board chair was not filled by an independent director but rather a member of top management. For at least two decades, we, and other corporate governance experts, have been urging that the top board position be held by an independent director. By almost every measure, Bear’s directors failed in their most important duty: to ensure the viability and sound reputation of the enterprise entrusted to them. They took many steps along the road in failing that trust.
As much as we have long faulted Mr. Cayne for his role in Bear’s implosion, responsibility for its ultimate failure as a stand alone institution is born by many actors. Mr. Greenberg’s pointing the finger at his former colleague is a little like Conrad Black blaming his Hollinger successors for that company’s dismal plight. As history teaches with predictable repetition, what boards do, or do not do, in supervising the affairs of a company, and whether directors actually direct, makes a difference in the ultimate outcome.
As the story unfolds, we suspect there will be more indications that poor corporate governance was at the heart of this once mighty Wall Street icon’s demise. Offered in further evidence of that proposition is the fact that even though he is at the center of such criticism and cashed out all his Bear Stearns stock, Mr. Cayne remains chairman of the board of directors.
Would The Times or anyone else like to explain that?
With yet more losses and its recent credit downgrade to junk status following stunning statements by Bank of America regarding Countrywide’s debt, the question is how many icebergs will this Titanic of subprime lending need to hit before the inevitable occurs?
In a posting on Tuesday this week, we suggested that Countrywide’s sinking financial state might be a worrisome signal to Bank of America, and that the sudden 990 percent increase in bad loan provisions ($158 million for Q1 2007 vs. $1.5 billion for Q1 2008) might be something of an unanticipated iceberg for the deal. More and more, Countrywide is beginning to resemble the Titanic of modern subprime lenders: an enterprise that was based on flawed principles, that had become too large for its own good and was steered by overpaid egos who never contemplated the prospect of disaster. The question is: Will it meet a similar fate?
The record is not encouraging. Somehow Countrywide managed to strike another iceberg in a matter of days. On Friday, Standard and Poor’s cut Countrywide’s credit rating to junk status. It based its downgrade on a filing by Bank of America on May 1st that discloses it might not be taking on some $38 billion in Countywide debt. As a statement from the rating agency noted:
Until this filing it was our understanding that [B of A] would acquire all of Countrywide as stated in the January 2008 merger agreement. This new filing raises the possibility that this assumption is no longer true.
The downgrade could trigger a host of draconian actions on the part of lenders and insurers of Countrywide’s obligations that will prove very costly to that company and much more expensive and complicated for Bank of America to complete the transaction.
We have previously conjectured that in its acquisition of Countrywide, Bank of America may be trying to follow the JP Morgan Chase model for the Bear Stearns takeover. In that case, JPMorgan was able to get rid of nearly $30 billion in riskier Bear securities through a Fed-led bailout. B of A’s announcement this week that it might not be backing such a huge chunk of Countrywide’s bonds and notes was considered something of a surprise among analysts. We have been predicting for some time that the element of surprise will be Countrywide’s constant companion. So far, we’re batting 1000. The biggest surprise, however, will be if this deal actually goes through before the Countrywide ship has gone down and top managers and directors have decided to jump into the lifeboats.
A couple of weeks ago, I was interviewed by Barron’s on B of A’s plans for Countrywide. I suppose my comments were too trenchant for the folks at that magazine, since they did not run them. What I said, however, seems to have been fairly close to the mark, given recent events. Here’s part of the interview:
Bank of America may not be as smart in seeing the potential downside of this acquisition as it claims. What is at the heart of many fears about the deal is a concern that we may be witnessing the creation of another Frankenstein-like Bear Stearns monster that just causes a whole new set of problems for everybody. You have to wonder if Bank of America has a plan to get some of the poorer Countrywide assets off its books, as JPMorgan Chase did with Bear Stearns, leaving others on the hook.
Stay tuned for more surprises.
Conventional wisdom holds that the best time to buy a ticket on a ship -or the whole ship, for that matter- is when it is not sinking. But it is not entirely clear that Bank of America, which apparently still plans to acquire the losing Countrywide Financial, understands this principle of both physics and economics. Countrywide today reported write-downs of $3.5 billion for the first quarter of this year, along with a net loss of $893 million, more than double its net loss for the fourth quarter of 2007. It was the company’s third consecutive quarterly loss.
When CEO Angelo Mozilo boasted that Countrywide would soon return to profitability following its first-ever loss in October of last year, we expressed some doubt. Evidently, it was stringing its shareholders along with the same kind of lines that got so many of its subprime customers into the mess they are in.
The numbers are large, but the biggest eye-popper was below the surface, which, as all informed followers of the Titanic saga will know, is often where the greatest danger lurks. The company set aside $1.5 billion for bad loans compared with $158 million in the comparable quarter last year -a staggering increase of 990 percent. That thud you heard might just be the iceberg.
What more surprises await next quarter? If Bank of America is still to go through with the transaction, it will likely be on the basis of the Fed’s swap-your-junk spring deal whereby weak collateral can be exchanged for Fed happy bucks, or some other form of hokus pokus, to make the mess at Countrywide easier to swallow. One has to wonder if Congress is really on top of what’s going on here, or if the Countrywide deal is another Bear Stearns in the making under a sleeping Rip Van Bernanke?
UPDATE (April 30, 2008):Perhaps we won’t have to wait for the next quarter to see if there are more suprises. The Wall Street Journal Reports today:
A federal probe of Countrywide, the nation’s largest mortgage lender, is turning up evidence that sales executives at the company deliberately overlooked inflated income figures for many borrowers, people with knowledge of the investigation say.
There has not been much critique of the latest Fed move, the ninth since August, to fix the ailing credit market. We would like to remedy that with the following observation.
The Fed cannot possibly continue to argue that it has given Americans and their policy makers a fair and accurate picture of the economy while making these frequent, unprecedented and horrifically costly interventions.
Americans are not passive and unaffected bystanders in what the Fed does or does not do. They are stakeholders who are entitled to assess its performance and whether it is ultimately acting in the public interest. That means more than what might be expedient for financial institutions, mortgage lenders and hedge funds that are struggling with the consequences of their risk misjudgments and still do not appear to understand the extent of their own folly.
Straight talk, not Fed speak, needs to be part of the intervention, too.
Update: The Fed’s move made a lot of money for some investors and company insiders. The stock of Countrywide Financial, for instance, a big player in the subprime mess, soared 17 percent for the day (Tuesday).
Some of these remarks were posted on The New York Times blog of Floyd Norris, one of our favorite commentators .