Fed’s dabbling with debt innovation in a time of over-leveraging is a decidedly subprime idea.
The Fed, which recently bailed out Wall Street over its subprime related credit blunders (see the testimony of Federal Reserve Board Chairman Ben S. Bernanke before the Senate Banking Committee on April 3, 2008), is now looking at ways of becoming even more creative in the economy. The Wall Street Journal reports options being considered include:
Having the Treasury borrow more money than it needs to fund the government and leave the proceeds on deposit at the Fed; issuing debt under the Fed’s name rather than the Treasury’s; and asking Congress for immediate authority for the Fed to pay interest on commercial-bank reserves instead of waiting until a previously enacted law permits it in 2011.
One option we think should be on the Fed’s table is this: do less.
American governments, corporations and households are already mired in unparalleled levels of debt. The current credit fiasco is the result of an experiment in debt gone terribly wrong. It was made worse when Wall Street got into the picture and saw the unavoidable temptation of more subprime innovation. So far, in addition to record home foreclosures, mounting unemployment and staggering corporate losses, it has resulted in the collapse of Bear Stearns, which the Fed warned before the Senate last week nearly resulted in calamity for the world’s financial system. We will have further comments on the Fed’s Wall Street bailout in an upcoming post on these pages.
If we have learned anything from the efforts of these too-clever-by-half financial players to defy the laws of physics (i.e., risk) in the economy in recent months, it is that what is lauded as creative genius one day can quickly turn into a symbol of reckless folly the next. Americans don’t need a debt experimenting Fed in a time when excesses in risk and imagination have already created a masterpiece of chaos.
It can only be hoped that his recent experience with the limelight and the cheers of the Wall Street crowd has not turned the otherwise conservatively inclined, academically trained Ben Bernanke into the Angelo Mozilo of central bankers.
Bear Stearns’s collapse confirms that excessive CEO pay, along with the feeble corporate governance that permits it, continues to be one of the most corrosive forces in modern business. It offers further evidence that, far from aligning pay with performance, oversized compensation induces risks that lead to disaster. It comes at a price that is too costly to society.
One of the striking features of corporate governance scholarship is that it reveals the same shortcomings and the same calamitous results occurring time and again throughout history.
“The sad case of Penn Central,” Dun’s magazine wrote about the giant corporate collapse in 1970, “is worth mentioning, not because it is unique, but because it is not. Many another US corporation has gotten into trouble because its directors did not do what they were supposed to do, that is, keep a warily inquiring eye on management and ask the right questions at the right time.”
A similar refrain was expressed about the boardroom before and after the Penn Central debacle. As we detailed in Part 1 of this series, Bear Stearns’s weak, distracted and ineptly led board was a contributor to its collapse as well.
Bear was not alone in displaying obvious signs of corporate governance weaknesses, however. Boardroom-wide, directors have permitted the complete discrediting -some would argue hijacking- of the executive compensation system. They have legitimized the creation of payment schemes that have induced CEOs to take on excessive risk in the hope of bringing in fees and deals that push up share values in the short-term and trigger unprecedented awards of stock and bonuses, while at the same time insulating them from the consequences of their actions by guaranteeing golden separation packages in the event of failure.
Excessive CEO pay, as I suggested in a submission to the Senate Banking committee during its Enron-related hearings in 2002, is the most corrosive force in modern business. It is fast eroding respect for the leadership of American capitalism among both shareholders and society. It was a contributing factor in the demise of Enron and Hollinger and in the scandals involving WorldCom, Tyco and many others. Its cancer is also evident in the current economic crisis. Over the past five years, when the foundation for the subprime disaster was being laid, the CEOs of Citigroup, Merrill Lynch, Countrywide Financial and Bear Stearns were paid more than half a billion dollars -$556 million- among them.
Like the toxic effects of the credit catastrophe that spread into the housing market, then to the balance sheets of major financial institutions, and finally into the wider economy, the debilitating repercussions of excessive CEO pay and the subprime misjudgments they spawned have long since moved past the shareholder annual meeting and into the recession dampened lives of ordinary people. In the last year of reported filings, James Cayne (then chairman and CEO of the company) and Alan Schwartz (then president and co-chief operating officer) were paid more than $73 million between them. Did the prospect of such huge compensation distort their judgment and tempt them to accept unwise risks and ignore red flags? It is a line of inquiry policy makers ought to pursue with Bear Stearns and throughout the financial industry.
For every year of the past five, while management misjudgments and miscalculations were laying the course for the credit crisis that eventually claimed the investment bank, the compensation committee of Bear’s board declared that it was happy with the performance of the company and that management fully deserved the compensation it was awarded. So blind was the committee to any notion of excessive risk that was being taken, it simply copied and pasted many of its statements of praise and satisfaction from one proxy statement to the next. “Therefore, the compensation paid to the Company’s executive officers reflects the Company’s strong absolute and relative performance” was how the compensation committee was fond of putting it -so fond, in fact, that it used exactly the same phrase year after year.
Close ties and over familiarity may also have been a problem with Bear’s compensation committee. The board’s pay panel was headed by 81-year-old Carl D. Glickman. While securities filings by the company claim that he has been a Bear director since 1985, biographical information provided by Cleveland State University, where Mr. Glickman is also a trustee, claims he has served on Bear’s board since 1978.
At the very least, the compensation committee’s culture, structure and decisions raise unsettling questions about whether its products are more the reflection of a cozy club mentality of close connections than the result of vigorous market forces and heavy negotiation.
As we noted earlier, long-time chairman and former Bear CEO James Cayne recently sold all his holdings in the firm to net $61 million, according to formal declarations. By some standards, that sum is far below what his holdings were worth a few months ago. On the other hand, he has long been chief officer of the Bear Stearns ship. Having set its ill-fated course, it is remarkable that he came out with anything at all. The ship is going down, but Captain Cayne managed to jump into the Fed-sponsored lifeboat before anyone else. It is not often that any single person, much less one who has been such an outspoken advocate for free market capitalism as Mr. Cayne, can trace his added wealth to the entire apparatus of the federal government coming to his rescue, and to the Federal Reserve taking actions not seen since the depths of the Great Depression.
The subprime scandal also exposed holes in the governance of other investment banks. Merrill Lynch, as incoming CEO John Thain observed, had a risk committee that didn’t function. And Countrywide Financial, which likes to think of itself as a bank, has another all-male boardroom that seldom formally meets and where the compensation committee writes with a hyperactive pen that seems unable to stop putting zeros at the end the CEO’s paycheck. How it permitted a situation where the CEO was allowed to sell a substantial chunk of his own shares at a time when the company was engaged in a share repurchase plan which pushed the price up constitutes an unbecoming stretch for even the most compliant board.
But Bear Stearns is the first institution of its kind to collapse so dramatically with the fingerprints of questionable corporate governance practices found throughout the ruins. There was a disconnect between what the board was supposed to be doing and what it actually did. In that respect, it is reminiscent of the approach taken by another board: Enron’s. It did not end well for that company, either.
The directors of Bear Stearns were paid well for their duties -at least $200,000 each. Management directors were paid in the tens of millions every year. For that sum, and under the board’s unhurried watch, shareholders and employees were treated to the privilege of witnessing the unthinkable: an 85-year-old institution that survived the Great Depression and two world wars only to slide under the turbulent sea of subprime folly, leaving a token reminder in its decimated share price that it once existed at all.
“Where was the board?” is a question governance scholars and others have increasingly come to inquire during times of corporate calamity. It has been asked of many large failures over much of the past 100 years. But for this most recent boardroom mishap an even more probing question needs to be posed: “If Bear Stearns had no chairman and no board at all, would the results have been any worse?”
Americans cannot permit free enterprise to reign just when CEOs and companies are making piles of money only to have it replaced by socialism when they are teetering on disaster.
It was the kind of deal you might expect to see among business and government cronies in China. A large bank gets into trouble. Another one comes in and is given an exclusive opportunity to buy the good assets at fire sale prices with the state agreeing to take over billions in liabilities. The head of the ruling party gives his blessing to the deal on the advice of the top regime official who, 18 months earlier, headed an investment bank himself.
Except this was not China. It happened on Wall Street, ground zero for free market capitalism, or so it is claimed. JPMorgan struck a sweetheart deal with the Fed in taking over the remains of Bear Stearns. While its demise comes as no great surprise after Friday’s run on the bank, it appears that no other institution was given the opportunity to work out a competing offer or at least one that is supported by the government and the Fed. President George W. Bush and Treasury Secretary Henry M. Paulson, Jr. approved the deal.
At $2 a share and with 7,000 to be laid off, Bear Stearns employees will call it a betrayal. The firm’s top management and inside directors, after all, have made hundreds of millions in compensation and bonuses in the past few years and it would not be surprising if arrangements have been made for some to walk away with a tidy severance/change of control package. JPMorgan will call it a good buy. Still others will call it a bailout that gives a level of comfort to the financial sector which otherwise might not prevail and may not be deserved. But in truth, this deal is hypocrisy on stilts.
When it comes to the wave of titanic bonuses, platinum parachutes and multimillion-dollar pensions for its CEOs that have swept across Wall Street and elsewhere in business, America is told it is the free market that sets the rates. Boards are merely responding to these larger economic forces over which they have no control. The same is said about enforcing provisions of the Sarbanes-Oxley Act, the Enron era package of reforms which corporate luminaries have argued overly restricts American capital and makes it tougher to compete. But when it comes to dealing with the mistakes and misjudgments of those CEOs and boards, it is government that Wall Street and others call on to intervene and save the day. The supreme, or perhaps subprime, irony, of course, is that the same financial institutions that created the problems with their overly complex and exotic investment vehicles which they themselves did not fully comprehend and cannot today accurately value are demanding relief from the Fed and anywhere else they can find it.
Ironic, too, is the fact that Americans, as consumers, investors and members of pension plans, are the ones who actually pay for the monster compensation that has come to symbolize the modern boardroom. And when the lure of great rewards prompts CEOs and boards to take risks that later prove calamitous, as the subprime fiasco demonstrates, it is the American taxpayer who is asked to pay again through the inflation-creating printing of money or the taking on of more public debt. There are many unanswered questions concerning the implications of what the Fed and the White House have sanctioned in the Bear Stearns bailout, and in the larger issue of exactly how much is being committed to prop up other financial institutions -and at what cost.
Americans cannot permit free enterprise to reign just when CEOs and companies are making piles of money only to have it replaced by socialism when they are teetering on disaster. They are entitled to more than being relegated to the position of prisoners of irony conveniently contrived by corporate and public leaders, while being stuck with a multibillion-dollar price tag for the privilege.
With absentee leaders like Jimmy Cayne at the top and a corporate governance culture straight out of the 1920s, the surprise is not that Bear Stearns fell into a confidence chasm. The surprise is that calamity did not strike earlier.
When the subprime meltdown was already giving a chilling preview of coming attractions last summer and his company’s mortgage-based hedge funds were collapsing around him, the CEO of this Wall Street icon was off on a bridge and golf vacation. Last week, during a liquidity crisis that saw the near death of the company and the resulting intervention of the Fed that carried with it echoes of the Great Depression, he was at a bridge tournament in Detroit, according to the Wall Street Journal. It is not certain where this long-time investment banking figure is right now, but odds are soon Jimmy Cayne may not have an office or a company to return to.
Last January, when the company posted the first loss in its 84-year history, Mr. Cayne turned over CEO duties to Alan Schwartz. When he’s not away escaping a corporate crisis as executive chairman -a post he has held for seven years- Mr. Cayne presides over the Bear Stearns board. And what a board it is -another one of these all male clubs that acts like a throwback to black and white movies.
The board meets only six times a year, according to company documents. The real work seems to be done by Bear’s executive committee, which in 2006 met a whopping 115 times. All of the directors on the executive committee are management insiders, including Mr. Cayne, making management effectively accountable to itself. Maybe this helps to explain why, despite the lessons of Enron and the risky nature of much of the company’s business, Bear Stearns’s board did not get around to creating a finance and risk committee until January of 2007 and why there has been so much patience with Mr. Cayne’s card-playing antics.
Just a year ago, the firm was boasting that it was well insulated from the subprime fallout. Then the stock was trading around $160. On Friday the stock closed at $30. It lost nearly half its value in just one day. When Rome burned, it is said that Nero fiddled. When Bear Stearns melted down, its one-time emperor played bridge. We will leave it to others to determine whether any smoke was present at the occasion this time.
It is widely asserted, especially on these pages, that what boards do matters. Yet it seems clear that if Bear Stearns had had no board whatever, the results could not have been any worse. One can understand how utterly lacking in effectiveness Bear’s board is when it is being led by an absentee chairman.
Mr. Cayne, who is 74, would have known the crisis his company faced given the extraordinary nature of the press release it issued on March 10th which denied any liquidity problems. Still, even when Wall Street’s fifth largest investment bank was sitting on a precipice later in the week, a bridge game trumped the fight for corporate survival for the firm’s well paid chairman.
As we have said on more than a few occasions, the stratospheric compensation that many boards award CEOs increasingly shows that both directors and top management are living on another planet. Excessive CEO pay has been a leading indicator of disaster in companies that run the gamut from Enron and Computer Associates to Countrywide and Hollinger. Bear Stearns can now be added to this list. Just last year, many commentators were celebrating the genius of Jimmy Cayne and how he deserved every penny of the $34 million he received for 2006 and the $23 million for 2005. You might think that would entitle shareholders to a little more than the calamity that has been unfolding for the past several months. You might also think it would entitle shareholders to a CEO or a board chairman who clocks in during the hours when disaster has decided to pay a visit.
Bear Stearns also makes the case that if investment banks are now able to enjoy the benefit of the Fed’s intervention -and these firms have already shown that their misjudgments are capable of causing enormous turmoil in the capital markets and ultimately in the wider economy, members of the public have a huge stake in what companies do and how well they govern themselves. They also have a major investment in whether board compensation programs reflect a rational level of thinking or whether they reflect a mentality that says the CEO is king and temps them to pursue high paying subprime-like schemes that cannot be sustained.
With absentee leaders like Jimmy Cayne at the top and a corporate governance culture straight out of the 1920s, the surprise is not that Bear Stearns fell on Friday into a confidence chasm from which it may not recover. The surprise is that calamity did not strike earlier. Which makes the failures of the Bear Stearns board and its chairman our choice for the Outrage of the Week.
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 .
When the misguided decisions of Wall Street can so radically alter the life and fate of every Main Street in America, it is time for Washington to weigh in, big-time.
Our comments about the Great American Boardroom Bailout Sweepstakes caught the attention of the ever-watchful Marketbeat column at the Wall Street Journal yesterday. We get the impression that there is some much deserved second-guessing going on about the wisdom of the solutions Wall Street –and the Fed, for that matter– have come up with to repair the damage their folly and misguided thinking have caused. The fire sale of Citigroup stock to offshore sovereign funds controlled by non-democratic regimes, for a chunk of the company at prices that would have been unthinkable just a few months ago, is finally prompting some questions among investors. And this was before today’s stunning report of a larger-than-expected fourth quarter loss, more write-downs, a dividend cut and job layoffs that are just the beginning of that sorry process. (more…)
