Washington’ s takeover of Fannie Mae and Freddie Mac gained the quick support of Wall Street, who never meets a bailout it doesn’t like, and the thanks of Beijing, whose playbook it seems to be borrowing.
Months after U.S. Treasury Secretary Henry M. Paulson, Jr. reassured the world ‘s markets that “We are closer to the end of this problem than we are to the beginning,” the Bush administration this week seized mortgage giants Fannie Mae and Freddie Mac. With that single act, the United States -long-reputed bastion of free enterprise, and led by the first MBA-trained president ever- undertook the largest nationalization of private enterprise in modern history. It was by far the most striking culmination, at least to date, of the folly, hubris and Titanic misjudgment that has seen Wall Street, boards and regulators take a holiday from risk and reality that can now be measured in trillions of dollars in write-downs, lost shareholder value and the worst economic crisis since the Great Depression.
Like the government-sponsored Bear Stearns rescue that preceded it, this, too, is a bailout that has the fingerprints of Wall Street all over it. Morgan Stanley played a pivotal role in advising Mr. Paulson on how the deal would be orchestrated. In fact, all of the government’s recent interventions have been done in consultation with Wall Street’s biggest firms.
With the stroke of a pen, the decision to place the strangely named pair into a “conservatorship” removes key private sector competitors from the mortgage business that was so lucrative to Wall Street’s top banks and institutions, while at the same time ensuring a steady flow of mortgage funds into the market. Wall Street got what it wanted again, and showed its gratitude by the Dow soaring more than 300 points in the first few minutes of trading after the decision was announced. And the U.S. government is now the biggest mortgage backer in the world.
Reasonable men and women will differ as to whether the bailout of these institutions was wise or not. What cannot be disputed is that it was the result of one of the most costly governance and oversight failures ever.
What brought the U.S government to this remarkable place in the history of its free enterprise system? How was it possible that these two firms were permitted to play such a pivotal role in the economy that their stake in the mortgage market was actually measured in the trillions? How could regulators and boards of directors have failed to such an extent that this mother of all bailouts became necessary?
I doubt that there will be much of an appetite to pursue these questions, which is exactly why, in a culture where accountability and good governance always took second place to short-term greed and self-interest -and that was on a good day- such a calamity happened in the first place.
Over time, investors, investment bankers and executives became incredibly wealthy from Fannie and Freddie. The two CEOs of these firms made more than $30 million last year alone. The financial rewards from these institutions were viewed as the legitimate fruits of a fabled market-driven free enterprise system which, it is claimed, operates best when government stays out of the picture. Naturally, these rewards were privatized. Now that the jig is up, it is claimed by many, including a deafening chorus on Wall Street just fresh from its long running show where it was clamoring for ever lower interest rates from the Fed, that government cash is necessary to clean up the mess and stabilize the market. The losses, which already are counted in the billions, will be socialized. And thanks for thinking about Adam Smith.
The earth did not exactly shake from the howls of outrage heard among defenders of free market capitalism when the takeovers were announced, or from the College of Wall Street cardinals where the vice of hypocrisy rarely evokes the specter of shame. And it is the idea that Wall Street winds up making money from either success or failure, that free enterprise or government bailout is just fine with this crowd as long as the money keeps rolling in, that is the most galling.
It is always a measure of the fundamental strengths of any system of government or economics that the spires of its principles are able to withstand the gales of expediency. Looking at how happily the market embraced this latest government intervention, which occurred on a draconian scale heretofore typically associated with South American dictatorships, the toppled ruins on Wall Street, and in those other places where principles are expected to matter, are not a pretty sight.
The Alice in Wonderland world into which U.S. capitalism has descended, where profits were based on flaky business models, indecipherable investment vehicles and assets held together by thin air, has long had its antecedents in a similarly dysfunctional system of CEO pay. This, too, is a world diverged from reality and common sense, where monster-size bonuses often had nothing whatever to do with performance or outcomes and where fortunes were regularly awarded by boards on the basis of shoddy results, if not outright failure. Is it at all surprising that it was this same system that tempted CEOs to misjudge the prospects of risk and to take actions that were based on how next year’s bonuses would be affected rather than what was in the long-term interests of investors. It is not that far a stretch from a boardroom culture where bonuses were routinely awarded even for poor performance to one that would see a pandemic creation of investment vehicles that proved to be empty in terms of value and risk consideration.
Criminal fraud at the level of Hollinger or Enron, or misfeasance such as was found at Fannie Mae when previous management cooked the books in order to push up their own pay, may not abound throughout corporate America. But the seeds of the folly that is at the center of CEO pay and the disaster it so often heralds may well be viewed by history as having been synonymous with the disconnection of value, values and meaningful governance/oversight that has brought the economy and the American business system to this perilous point in time.
And the price tag for all of the government’s actions over the past year -the Bear Stearns rescue scam (as noted on these pages before, the Fed never really took on the $29 billon loan; it bought the collateral outright), its apparently never closing and endlessly accommodating discount window, and now this latest Wall Street bailout? Nobody seems to know. And few appear to be asking even during a presidential election year. The costs seem likely just to be pushed off in one form or other, whether in the guise of soaring inflation, galloping deficits, higher interest rates or a weaker dollar, to a future generation. The rewards of the government’s latest intrusive efforts will be privatized once more. Their risks and the costs that lie ahead will be socialized again.
One more point of interest: the Fannie and Freddie move was met with approval by countries which hold substantial instruments of U.S. debt, including significant amounts of paper obligations on the part of these financial institutions. China, a totalitarian state that professes communism but increasingly practices capitalism, especially praised the move by the United States, a land which trumpets capitalism but increasingly seems to practice the fine art of socialism.
In the distorted, upside down world that America’s leaders, financial wizards, regulators and directors have created, what pleases Beijing most seems only fitting.
A brief essay on the subprime credit consequences when CEOs fail to lead, directors fail to direct and regulators fail to regulate
It began as a term that few had even heard of barely 18 months ago and most experts dismissed as an insignificant blip in a fundamentally robust economy. But yesterday, George W. Bush signed into law the most extensive -and expensive- free market repair bill since the Great Depression, thanks to what we have come to know as the subprime mortgage meltdown. The legislation marks another ironic milestone for this Republican, MBA-trained apostle of the private enterprise system. In 2002, he put his signature to the Sarbanes-Oxley Act, which, in the wake of Enron and numerous more accounting-related corporate frauds, also brought the power of the federal government closer to the boardroom than at any time since the 1930s.
The Housing and Economic Recovery Act of 2008, which also serves as a bailout for Fannie Mae and Freddie Mac, addresses precisely the flaws and failures which successive business leaders and government officials said would never occur in the modern era. Depression-time failures, runs on banks, and the collapse of huge financial institutions that were typical of the 1930s, they said, were a thing of the past. But just as those events were a product of human shortcomings and unbridled greed, so too is the present day crisis the result of CEOs whose bonus-obsessed lack of vision made them unsuited to lead, directors whose risk-oblivious nature made them incapable of directing and regulators whose focus on the battles of the past made them incapable of regulating. Exhibit One in this regard is the more than $30 million in compensation the CEOs of Fannie Mae and Freddie Mac, the struggling mortgage giants that prompted the recent government bailout, were awarded by the boards of those companies during the past year when the seeds of their horrific losses were being sewn.
Only a few months ago, the priority of the new treasury secretary, Henry M. Paulson Jr., and the Bush administration was to roll back enforcement under Sarbanes-Oxley, which many in the business community claimed was hampering American competitiveness. Blue ribbon committees composed of impressive and accomplished corporate men and women were formed to look at ways of blunting the regulation of business. All the time they were focused on this objective, the time bomb of the subprime credit disaster was ticking away. But the business world, and Wall Street in particular, disposed typically to hearing only the siren song of great bonuses and increased fees, did not heed the tick, tick, tick of impending calamity that was of their own making. No alarm bells sounded, at least on Wall Street, about the overly complex financial instruments that were being created, or the possibility that the ever- faster moving gravy train would meet with an abrupt generational derailment. So much has the landscape shifted that the man from Wall Street who was brought in to loosen the reins of corporate regulation has now become the architect of the most sweeping government intervention since FDR. And his boss, the first MBA graduate in presidential history, will have presided over the most staggering run up of the national debt in U.S. history.
Republicans and other traditional advocates of government restraint have fallen so far from their Milton Friedman, laissez-faire pedestals that they have given Secretary Paulson what amounts to a blank check for unlimited backing of these government-sponsored enterprises whose names sound like something out of a 1920s Gershwin musical. It is a hard swing from earlier days, when Fed chairman Ben S. Bernanke testified before Congress that he didn’t expect the credit crisis would spread to other parts of the economy. Just days before the meltdown at Fannie and Freddie, Henry Paulson was predicting “we are closer to the end of this problem than we are to the beginning.”
Much of the litter prompting the actions of the Bush clean-up crew came about through Wall Street’s obsession with bigger bonuses and more fees, and insufficient attention as to how they were achieved. A good part of the world, though happily we did not count ourselves among this group, really believed for a while that some of these fellows actually deserved and earned their bonuses, which, in many cases, amounted to $40 million, $50 million or even more than $100 million in a single year. We have long contended on the subject of excessive CEO pay that it is well to remember that its recipients are endowed with no superhuman traits.
Unfortunately, too many in the boardroom and on the stock exchange floor seemed to think the more a CEO received, the more he was able to jump over tall buildings in a single bound. But as Merrill Lynch’s Stanley O’Neal and Citigroup’s Charles O. Prince schlepped out of their offices for the last time after presiding over record multi-billion-dollar losses, they seemed remarkably fallible -even with the millions in bonuses and severance they carted away in the process. Also gone with the toppling of CEO after CEO who failed to live up to their Marvel Action Comics billing is the idea that their compensation is the business just of shareholders. Look at the casualties of home ownership and the record foreclosures that are sweeping America, a trend that can be traced to the creation of flimsy investment vehicles designed only for their quick fee and bonus producing content for Wall Street and mortgage lenders, and you see how much Main Street America has at stake in the compensation inducements that crony boards hand out to their country club CEO buddies.
It was a nice party while it lasted. Shareholders did well. Directors commanded ever higher fees for their slumbering counsel in what was an impressive reprise of their roles during the Enron era scandals and long before, during another time of Wall Street excess culminating in the market crash of 1929. Top management became elevated to god-like status with remuneration packages commensurate with that standing.
The shell game continues. Just this week, Merrill Lynch announced that it was selling off $6.7 billion in what many regard as toxic mortgage investments. The problem is, only two weeks ago those assets were valued by the company at $11.1 billion. The company’s write-downs -so far- we are told exceed some $40 billion. But to be honest, whenever numbers climb over the $25 billion mark we generally have to reach for the oxygen mask and lose track of the details in the process. Another problem: Merrill has to loan the buyer most of the money to take over the sludge. It’s a little like the Fed buying up $29 billion in feeble Bear Stearns assets to help out with the JPMorgan Chase deal. Except they called it a loan at the time. Nobody is calling it that now. Thinking about Fannie Mae, one is reminded of the scandal there when government investigators found top management fiddled with the books in order to prop up their bonuses. In 2006, U.S. regulators filed more than 100 civil charges against former CEO Franklin Raines and other officials of the company, accusing them of manipulating earnings to maximize their bonuses. It was among many ethical lapses that will be uncovered during the heady times of recent years.
Now the party is over. And, as they had to in the 1930s, it is the taxpayer who must pick up the tab for the broken furniture and all the other casualties of the splurge of over-indulgence that marked what we have called before the Modern Gilded Era. When incomes in America begin to approach the level of disparity which existed in the 1920s, as they did in the past couple of years, perhaps it is a warning sign that reason and judgment have reached a dangerous state of undersupply in the economy, and in society as well.
With the stroke of a pen this week, America’s debt will have been increased by nearly a trillion dollars; its deficit now the greatest in the country’s history. Many of the owners of the corporations who gambled and lost on these ill-conceived schemes will be bailed out. Some homeowners may benefit from the legislation, and a higher standard of regulation -which should not have required a Titanic-like catastrophe before its need became obvious, will prove beneficial in the future. But the greatest beneficiary is Wall Street, which has consistently held the view that there is no better system than modern free market capitalism, except, of course, modern government enterprise when it shows up with its purse open. For there is no more beautiful sight to the errant Wall Streeter than when Mr. and Mrs. America come to junior’s rescue after he wraps the BMW of self-aggrandizement around the lamppost of ever looming, but never fully contemplated, reality.
The point of all of this is not to disparage capitalism, especially the idea of responsible capitalism -a principle we have long advocated and believe is fundamental to the innovation, creativity and advancement of a free and prosperous society. But it is to further illustrate that capitalism is merely an engine, not an Adam Smith-invented autopilot. How well it operates, what value it creates, what havoc it wreaks are dependent upon the skills, vision and integrity of the men and women to whom it is entrusted.
Many of the wrong people were entrusted with it this time. The price has been steep. The damage to the reputation of this unique economic system has been considerable. The consequences of insatiable greed, and of governance and regulatory systems that failed to check it, have been historic.
It might be hoped that for the hundreds of billions of dollars American taxpayers are shelling out for the economic debacle which in some respects rivals the Great Depression, they also will have paid for the education of future actors on Wall Street, in the boardroom and in the regulatory halls of government, who will have learned something of the vice of unrestrained excess, something of the virtue of a financial system more grounded in both value and values and something of the sacred trust that is bestowed when society loans power and opportunity to those whom it allows to lead, direct and regulate.
Maybe the fabled investment bank is getting to the point where only employees will be interested in holding the stock of a company whose chief products recently have been poor judgment and bad results
The firm lost a record $2.8 billion in the last quarter. Much more in write-downs has been registered. The stock stands not at a 52-week low or a five-year low, but at a low not seen since 2000. Colossally bad decisions have been made by this firm on several fronts, some leading to the recent ousting of top executives. With that background, it’s hard to see how the word “bonus” could even be whispered. But that’s exactly what has happened at this beleaguered icon of Wall Street. Reports indicate that Lehman plans to issue a mid-year stock bonus to its employees.
If you want a glimpse into the kind of thinking that has brought Lehman to the crisis it’s now facing, this is it. Shareholders are hurting; homeowners and families throughout the U.S. are experiencing economic pain unseen perhaps in generations. Job losses and cutbacks, from big auto and Bear Stearns to major airlines and Starbucks, are mounting fast. But at Lehman’s, it’s Christmas in July.
Running a business the old fashioned way by building value and creating sensible products that stand the test of time seems to have become passé on Wall Street. So, too, has the idea that there are times when some sacrifice on the part of management and employees is justified, especially when the rest of the country is suffering. This, it would seem, is the predictable result of the kind of self-aggrandizing leaders and disengaged boards that have also come to be synonymous with Wall Street.
Maybe Lehman employees should get more stock, because the way the firm is going, you’d have to wonder what sane investor would put their confidence in a company whose chief products in recent months have been poor judgment and bad results.
Which hat was Mr. Fuld wearing when he said he took responsibility? And where was the Lehman board while this crisis was unfolding? No one bothered to ask.
Lehman Brothers formally reported today what it had announced last week: a staggering $2.8 billion loss for the second quarter. At a conference call, CEO Richard S. Fuld, Jr. said the buck stopped with him:
“This is my responsibility…,” he told analysts and the media on the call.
But which Richard Fuld is taking responsibility? The Richard Fuld who leads Lehman’s management team and is its CEO, or the Richard Fuld who heads the Lehman board to which he reports and is its chairman? Or is it the Richard Fuld who chairs Lehman’s two-man executive committee? Perhaps Mr. Fuld wears so many hats that even he is confused about what department his “responsibility” falls under.
Did Mr. Fuld not agree with the investment decisions that resulted in the huge loss? One notices that he did not offer to return any part of his bonus or compensation for the years in which Lehman’s poor decisions were being made. The seeds of the $2.8 billion loss, and much more in write-downs, weren’t sown just in the past three months, you know.
We have raised Lehman’s corporate governance shortcomings here before. What is surprising is that no questions of this type were introduced by the media or analysts when they had Mr. Fuld on the other end of the call today.
It might have been appropriate to ask if the board signed off on the recent changes that saw the ousting of President and COO Joseph Gregory and CFO Erin Callan. Is the risk committee meeting more frequently than the two occasions it did in the past year? What thought has been given to separating the positions of CEO and board chair or mothballing the executive committee as most companies did decades ago? Are there any plans to attract new blood into Lehman’s aging boardroom, which already sees two 80-year-olds playing key roles?
It is not possible to contemplate or tolerate a situation where one person holds three top positions in a company and then puts responsibility for a multibillion-dollar loss on those lower down. If you want all power concentrated in one set of hands, so too must be the blame for calamity when it strikes.
It was an ideal opportunity to inquire about the board culture and structure that has brought Lehman to its reversal of fortune and will shape the tone and future of the company for years to come. The media and analyst community, who like to portray themselves as guardians of the interests of ordinary shareholders, missed it this time.
They often do.
A focus on shortcomings in the boardroom and fixing a broken corporate governance model should be the next move.
In the wake of the striking and surprising losses at Lehman Brothers, we noted on Tuesday:
It is traditional to ask why the CEO, and perhaps other top managers who were responsible for these decisions, are still at their desks. Many at other companies have been booted out. CEOs at Merrill Lynch, Citigroup and UBS come to mind. Accountability at Lehman seems to have no real consequence or manifestation.
The ousting of company President and COO Joseph Gregory and CFO Erin Callan, announced today, is a good start but is hardly an acceptable conclusion to the changes needed. Now the focus should be on Lehman’s shortcomings in the boardroom and fixing a broken corporate governance model.
The boardroom needs new blood. Of the investment bank’s 10 independent directors, three are in their seventies and two are in their eighties. The executive committee, which consists of CEO and board chairman Richard S. Fuld, Jr. and 80-year-old independent director John D. Macomber, should be shelved. The finance and risk committee, chaired by 80-year-old Henry Kaufman, should get active. As first revealed by Finlay ON Governance, this committee met only twice in 2007 and in early 2008 even when risk was becoming the 800-pound gorilla in everybody’s Wall Street boardroom.
As long as the CEO is permitted to head both management and the board, allowing Mr. Fuld to effectively report to himself, it is doubtful that Lehman will make the changes it needs to ensure the discipline of accountability that is essential to the survival and success of any business today.
This was a board that took a leisurely approach to overseeing the risk decisions and standards that led to billions in losses and write-downs, was content with a governance structure that concentrated power effectively in the hands of the CEO and sees no need for change at the top. And shareholders actually paid the directors for this performance.
Underperforming assets come in more than just numbers at Lehman Brothers. They are a substantial part of its boardroom, as well. Company chairman and CEO Richard S. Fuld, Jr. and President and Chief Operating Officer Joseph M. Gregory made more than $60 million in compensation between them in 2007 according to the most recently reported figures. And despite announcing in April, at the annual meeting, that “the worst of the impact of the financial markets is behind us,” Mr. Fuld presided over a stunning and unexpected loss of $2.8 billion for the second quarter. So far, Lehman’s write-downs exceed $11 billion.
So what exactly has Lehman been doing? For one thing, it decided -rather inexplicably, given the attendant circumstances involving the Bear Stearns collapse- to buy $2 billion in residential mortgages made to less than top credit borrowers. Lehman CFO Erin Callan called the deal a “great opportunity” on March 18th. (The Wall Street Journal reported on March 17th that JPMorgan Chase had agreed to buy Bear Stearns with Fed backing.) But the move executives prided themselves on in March turned out to be rather sour by June. The company took an additional $2 billion in write-downs involving residential mortgages, mostly in the Alt-A “space,” as Ms. Callan prefers to call it. This is the same Ms. Callan who announced in March that the investment bank was raising $3 billion in fresh capital but that it was “not really needed” to deal with write-downs or losses. It was a spin produced by an aggressive new CFO in the hope of bolstering confidence. Now it looks more like a silly stunt that reveals a company that didn’t know what was happening around it.
You might ask how, during a time of market turmoil in March that required an unprecedented level of intervention by the Fed (which it testified before Congress was necessary to avoid a total meltdown of the financial system) is it possible that Lehman would have taken on more risk in the form of these Alt-A loans? Would not a strong dose of conservative, risk averse medicine have been more appropriate?
For these answers we turn to Lehman’s boardroom, where we find the troubling fingerprints of dubious corporate governance, as we have so often in the worst Wall Street crisis since the Great Depression. It is a board that was pretty much hand-picked by Mr. Fuld, who has been Lehman’s chair since 1994. Only three directors have been appointed in the 21st century.
It is also a board that appears content to leave all the top jobs to -what a surprise- Mr. Fuld, who serves as company CEO, board chair, and chairman of the powerful two-man executive committee. The other member is independent director John D. Macomber, who is 80 years old. The executive committee met 16 times in 2007, more often than the board itself or any other committee. Executive committees, which both defunct Bear Stearns and deceased Hollinger also operated, are considered relics of the past and are not well embraced by most modern corporate governance experts. Best corporate governance practices also call for separation of the positions of CEO and board chair, with an independent director filling the latter post.
You would probably think that in a company where the effective management of risk is such an important determinant of success -or the lack of it- the board’s risk and finance committee would be quite active. That expectation is all the more heightened given that 2007 was a time of increasing worry about the quality of assets and risks in the financial industry. So it is with a sense of bewilderment that we discover Lehman’s finance and risk committee, headed by 80-year-old Henry Kaufman, met on only two occasions during that year. It’s a little reminiscent of Bear Stearns’s board committee of a similar name and mandate, which also met just twice in 2007. We know how that turned out.
Directors at Lehman Brothers were paid well for their services in fees that range from a low of $325,000 to a high of $397,000. Directors also sit on the boards of other publicly traded companies and numerous public institutions on top of their duties to Lehman shareholders. Marsha Johnson Evans serves as a director of Weight Watchers International, Huntsman Corporation and Office Depot, as well as chairman of Lehman’s nominating and governance committee and a member of both the compensation committee and the finance and risk committee. Roland A. Hernandez serves as a director of MGM Mirage, The Ryland Group, Vail Resorts and Wal-Mart Stores, in addition to Lehman. He is also sits on advisory boards for Harvard University’s David Rockefeller Center for Latin American Studies and Harvard Law School, as well as the board of Yale University’s President’s Council on International Activities. He, too, is a member of Lehman’s less than overworked finance and risk committee. Mr. Fuld also has other pressing duties. As we reported before, he is a director of the Federal Reserve of New York, which played a leading role in the great Bear Stearns bailout, a move, as we noted above, that is claimed (by its architects and supporters) to have saved the world’s entire financial system from collapse.
Lehman is a company that took on added risk when everyone else was fleeing from it, raised capital which it claimed it did not need, and lost more money than it, or others, ever expected. On such occasions it is traditional to ask why the CEO, and perhaps other top managers who were responsible for these decisions, are still at their desks. Many at other companies have been booted out. CEOs at Merrill Lynch, Citigroup and UBS come to mind. Accountability at Lehman seems to have no real consequence or manifestation.
This was a board where most of the directors have been around since the firm’s initial public offering in 1994, which took a leisurely approach to overseeing the risk decisions and standards that led to its recent blunder, and was content with a governance structure that concentrated power effectively in the hands of the CEO. It apparently sees no need for a change in its own governance, or that of top management either. It took a bet that its approach would work and it lost big time in the form of billions in losses and write-downs, diluted share value (because of added capital offerings) and a plunge in the price of its stock.
So the real question is: Why are these underperforming assets, also known as Lehman’s directors, still in the boardroom?
