Hell hath no greater fury than a collaterized debt obligation scorned…or at least spurned, which could be why so many CDOs were bought and sold, bought and sold, and bought and sold. Then again, when you look at the havoc created by all those loose CDOs, maybe they should have been spurned in the first place. Indeed, if only.
Any observer of the parlous state of financial markets and its impact on the global economy might be reminded of Albert Einstein’s words: “Only two things are infinite, the universe and human stupidity – and I’m not sure about the universe.”
While there are many technical explanations for the current financial markets mess, and while some of the central figures such as Alan Greenspan are at least admitting that they underestimated the amount of leverage, or overestimated the willingness of the major financial institutions to control their own profligacy, for many people there remains a central question: Why did so many supposedly smart people – executives, economists, entrepreneurs, directors, regulators, investors – do so many seemingly stupid things? Why did so many individuals and organizations get so far in over their heads? What made them think that one hundred or one thousand times leverage was sustainable? Why did they use credit swaps without understanding the counterparty’s risk? Why did they ignore the clear warnings over many years that this housing-induced credit bubble was building and would almost certainly burst? As a lesser luminary than Einstein, namely Dr. Phil, would say, “What were they thinking?”
This was NOT a situation in which everyone just “got it wrong.” There were better-run financial institutions that did not touch the toxic debt with which so many others loaded up their balance sheets. Nor did they engage in complex, off-balance sheet financing. Therefore, they did not have write-downs. There were investors who recognized all the danger signs of previous bubbles and moved their money out of the stock markets well in advance of the summer slowdown and October collapse. There were pension funds that recognized the rating agencies’ conflicts of interest and the over-statement of credit-worthiness of various debt instruments, and who moved their funds into true investment-grade vehicles. But many of the largest financial institutions in the world, many central bankers and prominent economists, indeed whole countries such as Iceland, DID get it wrong. And when the markets collapsed as dramatically as they did, even those who were not implicated in the foolishness were affected by it.
No Simple Explanation
The number-one candidate in the blame game is “greed”. But while certainly a factor, it is, by itself, too simple an explanation. It denies the fact that many of the same people at the center of these financial machinations were generous philanthropists, supporters of good causes, active in their communities. Some had given up highly paid roles in the private sector to do public service. There were many who did not stand to benefit personally from the risky investments they made yet they made them anyway. Although greed was a factor, fingering it as the explanation just doesn’t hold up to close scrutiny.
Nor do I suspect that criminal behavior had much to do with this situation, although there will undoubtedly be findings of criminal or civil fraud, once the legal wrongdoings of this tangled web emerge.
Nor would a lack of skills in risk management be a primary cause of this debacle. Companies such as Merrill Lynch, AIG, Wachovia, Bear Sterns, and Lehman Brothers had no lack of such skills, although some of the smaller banks and CFOs and treasurers of smaller companies that parked surplus cash in asset-backed commercial paper or CDOs, may have been in way over their heads.
When the dust settles, we will likely find a much more prosaic explanation: good, old-fashioned “stupidity”. This “stupidity” does not connote a lack of intellectual capacity; many of the players in this game were people who had achieved high levels of academic excellence and had previously been outstanding performers in the worlds of business and government. To understand “stupidity” it is necessary to deconstruct it and to show that it can subvert even the keenest intellect under certain conditions.
The Alchemist’s Spell
For every dollar of toxic debt that was floated on the market, there had to be a buyer, at least until the market for these CDOs, SIVs, ABCP, etc. collapsed. Throughout history, we have seen the power of alchemists’ promises to turn lead into gold, achieve cold fusion, and so on.
This is what the sub-prime mortgage situation was all about. Some irresponsible, perhaps unprofessional players in the mortgage industry sold people houses they could not afford on terms that clearly misled them about their future repayment obligations. Then a few persuasive alchemists – a.k.a. financial engineers – convinced a larger number of investment bankers and wholesale money market managers, insurers and investors that a basket of highly dubious mortgages could be mixed with good mortgages, and that a substantial portion of the resulting basket could be sold as high-grade securities, and that derivatives of those high-grade securities would themselves be high-grade securities. Abracadabra …lead becomes gold and this gold was sold all over the world to thousands of corporate and individual investors in a “globalized” financial services industry.
Alchemists have always had appeal for the greedy, the naïve and the lazy – – those who really do believe that you can get something for nothing without stealing it and those who are not prepared to work hard, do their own due diligence and try to really understand what’s going on. The lure of an additional 10-20 basis points proved irresistible to many people, from individual money market managers, to treasurers of municipalities, to companies with some cash saved up for a rainy day or some future investment.
But it’s a perverse irony that these types of investments are also most appealing to those who have to work hard for the money they make, which is why so many investment scams recruit doctors, dentists and professionals who make their money on a fee-for-service basis. They are lured by the prospect of making money without having to work for it. Something for nothing – or at least for not much – has a fascinating appeal for those who have had to work hard for much of what they have. And, stupidly, they invest in these schemes.
With repeated episodes of “winning” comes a belief that winning is an entitlement and that losing is not possible. Perennial winners cloak themselves in a mantle of righteous armor that is impervious to criticism, self-doubt, or pleas to exercise caution. Like Icarus of Greek mythology, they soar higher and higher until they fly too close to the sun and discover that they are, indeed, only mortals who perish when their wings melt in the extreme heat.
In the years 1993-2008, with a blip in 2001-2002, we have been living in a growing economy, albeit one fueled by increased personal indebtedness. So many in the financial services industry, especially in investment banking, got so used to success that they could not envisage failure. These “masters of the universe”, celebrated and then ridiculed by novelist Tom Wolfe in Bonfire of the Vanities, felt invulnerable, superhuman and beyond the reach of even the most fundamental laws of economics. Their schemes for making money became more and more audacious; sub-prime mortgages morphed into highly leveraged CDOs; derivatives of these became CDOs-squared with multiples of that leverage. The party was going on forever and the piper never had to be paid – or so they thought. One after another, investment bankers appeared in front of Congressman Henry Waxman’s Committee on Oversight and Government Reform in October 2008 and proclaimed that “they never saw it coming” or words to that effect.
Whereas individuals display hubris, successful, highly cohesive groups exhibit groupthink, a kind of collective hubris described by sociologist and journalist William H. Whyte and researched by Irving Janis and others. Such groups tend to develop the illusion that they are invulnerable and unanimous in their thinking, and a deep belief that their actions are moral. Naturally, these beliefs make them feel that nothing bad can happen to them. These illusions blind them to the warning signs of potential danger and desensitize them to anyone within or outside the group who might raise concerns about group decisions or actions. They stereotype, denigrate and demonize anyone inside or outside their immediate circle who may think that what they are doing is ill conceived or just, plain wrong. They prevent those with dissenting views from gaining access to key decision-makers.
There were many who warned of the grave dangers of being courted by those building financial houses of cards on the top of a financial bubble, from Nobel Prize-winning economists to former policy makers. There were people inside banks who sounded cautionary alarms but whose views were rejected as non-entrepreneurial or too risk averse. There were e-mails and text messages flying around the rating agencies that stated, frankly, that much of this financial engineering was a chimera. But the disease of groupthink acts to repel critics, to shut out dissenters, to marginalize those who are critical of the way things are done by the “winning” team. It has been linked to the Bay of Pigs debacle in the Kennedy administration, to the failures that NASA experienced with the Challenger and Columbia space shuttles and to other apparently “stupid” actions by “smart” people. It should come as no surprise to see it at work in many, heretofore-successful financial companies.
There is an old saying that “good bankers get a return on their money but also make sure that they get their money returned!” However, over the last twenty years, the compensation of many in the financial services field has not been based on this saying. In many organizations, individuals got substantial bonuses based on short-term financial results and short-term performance of stock options or restricted stock. If those stock prices had a high degree of risk built into them by the actions those leaders had taken to achieve short-term performance, this risk was distributed to all stockholders or left with the remaining stockholders when those who had been rewarded had cashed in and moved on.
This type of reward creates a powerful incentive for management to raise the risk profile of the organization to achieve short-term results, often to the detriment of the long-term shareholder. That boards of directors allowed this to happen is one of the most egregious failures of corporate governance in recent years, and lies at the root of the anger, disgust and contempt that many people feel about the state of executive compensation in those companies that failed or that have had to be rescued at substantial risk or cost to taxpayers.
Governance Fails – Again
Apart from the narrow issue of executive compensation, this financial crisis has once again focused attention on corporate governance and the role of directors. “How”, people ask, “could the management of firms such as Merrill Lynch, Bear Sterns, UBS, AIG and many, many others be allowed to bet the firm in the ways that they did? Where was the oversight, the governance that should have prevented this happening?”
It may take a long time and much research of a very difficult type to really answer this question. However, there are some plausible hypotheses that might explain yet another failure of governance.
Many directors joined the boards of financial institutions in the days when life was a lot simpler. It was not hard to understand such things as minimum capital requirements, capital tiers, non-performing loans, and so on. When CDOs, SIVs, credit swaps, and so on came along, it was easy to feign an understanding of these risk management vehicles. It was also hard for directors to speak up and say: “Stop! I don’t understand these things,” and resist their adoption until they did understand them. So they got used to accepting such practices mutely, not recognizing the risks that were being taken, rewarding senior executives handsomely for short-run returns, comforting themselves that since much of this reward was in the form of stock or stock options, the interests of management and shareholders were compatible. When the houses of cards started to collapse it was extraordinarily difficult for such directors to demand explanations of schemes that they had so blithely and recently approved and which, by then, had reached such huge levels of complexity that even those who had spent their whole lives in risk management had difficulty understanding. And, by the time the actions of management became fully known, it was too late.
A second hypothesis is that boards were content to have one or two directors who truly did understand the risks that were being taken act on behalf of the board, either as a risk management committee or as director-monitors. If these “expert” directors were industry insiders, their perspectives and susceptibility to the forces described above were likely to be those of their respective senior management teams, especially if they had been selected and in effect served at the pleasure of those managers. Hence, they were either unable or unwilling to guide the boards in their oversight responsibilities. The very existence of these so-called expert directors may have led to non-expert directors abdicating their governance role.
Finally, a board is a group of individual directors. For all of its good intentions and for all of its “independence,” a board is subject to the same social influences, including groupthink, as other groups. After years of basking in the glow of delivering outstanding results to shareholders, it is understandable that a board might resist questioning, if not scrutiny, as well as the urge to challenge managers who were pursuing the very strategies that had brought so much past success. While this may be understandable, it is not acceptable.
Too Much Opportunity, Too Little Diligence
One of the most eye-opening findings from this financial morass is that financial paper-rating companies were being paid to rate paper by those issuing the paper. Those same issuers then benefited substantially from the ratings that were assigned. From the evidence given in front of Representative Waxman’s committee in October 2008, it is not unreasonable to conclude that these rating agencies were just not doing the kinds of jobs that buyers of various forms of securities and commercial paper had a right to expect. Many enterprises and individuals relied on such ratings to make their own investments. Some – individual investors – may have been surprised at the crassness, cynicism or cupidity of the rating agencies as reflected in this congressional testimony; but many of the professional investors knew of this baked-in conflict of interest yet trusted the rating agencies enough to sell paper based on their ratings. Why?
One hypothesis is that they willingly participated in the commercial equivalent of a party game. They knew the securities were highly questionable but believed that if they kept passing them on to others, often in the form of financially engineered products, they would not be left holding the hot potato when the music stopped. Another hypothesis is that they were so tempted and seduced by the seemingly endless opportunities to keep making money that they just failed to exercise duty of care. They didn’t do their homework! They put their trust in people who were themselves compromised because they were just too busy chasing multiple opportunities to perform the required due diligence.
This is not an unusual behavioral consequence of presenting many attractive choices to someone at the same time. The more choices, the less discriminating people are and the less they exercise caution or diligence in selecting among them.
Hormones trumping Neurons
The investment banking industry has always attracted clever, competitive high-achievers. Such high achievers are seldom satisfied with doing well – they are motivated by winning and accept no less. For them, it’s all about winning. It was impossible to enter a trendy watering hole in the financial district in New York, London, Paris or even Toronto in the first half of 2006 without sensing the testosterone-laden aura surrounding the young, aggressive, results-focused investment bankers.
High achievers like these throw caution to the wind. They are prone to making errors of judgment that can cause damage to many, as they seek to win rather than merely to achieve a good or satisfactory outcome. Judgment – which involves the use of intelligence, thoughtfulness and learning from past successes and failures – is abandoned for the desire to win at all costs. That they are often young simply means that they have not had the personal experiences from which they could learn. Not only do they push the edge of the envelope but they come to believe that failing to push, or worse, counseling restraint, is an admission of a lack of “the right stuff” to succeed in the incredibly competitive world of investment banking.
In the case of our financial markets, the consequence was a triumph of hormones over neurons and some reckless risk-taking.
The Smart People
There were those financial institutions and individuals – executives, managers, directors, and investors – who did not get caught up in the hype and excesses of the financial markets of the last decade, and will get through this current mess reasonably unscathed. They approached this about-to-happen catastrophe with good, practical common sense.
- They didn’t get involved with what they did not understand either as investors or sellers of investment products to others.
- They did their homework on those things that really mattered.
- They didn’t trust advisors unless they really know their expertise and were satisfied that they were working in their interest rather than in the interest of someone who was trying to sell them something.
- They understood that you don’t get something for nothing in this world, that increased reward came with increased risk, and they resisted the alchemists’ spells.
- They didn’t allow past successes, or hubris or groupthink, to blind them to the risks in every new decision.
- They recognized that while hormones are good, when it comes to investing, neurons are better! They curbed the desire of many of their less experienced and aggressive staff to get involved in the more complex financially engineered products.
- They developed sensible policies and procedures by which they would screen products for investment of their own funds or recommendations to their clients and they kept reasonable controls on the actions of less experienced staff.
The Ultimate Stupidity or an Age of Reasonableness?
It will take years for the real cause and effect analyses of this financial meltdown to be completed and, even then, there will be questions about “who did what and why.”
The greatest “stupidity” of all would be failure to take to heart philosopher George (Jorge) Santayana’s oft-misquoted warning: “Those who do not learn from history are doomed to repeat it.”1 Lessons have been – indeed are being – learned from this mess but it is not a given that these lessons will stick. Asset bubbles have come and gone in the past; the dot com era that spawned the insane rise in the Nasdaq, the Asian property asset value collapse and the Long Term Capital Management fiasco are recent rather than ancient history.
Will the excesses of the last few years be repeated or will we have a smarter approach to regulation, better governance, and better risk management? Politicians, central bankers and even some leading lights in the financial services industry are making the right kinds of noises. For the sake of those whose pensions, savings and future hopes of financial freedom have been so badly affected by the collapse of the housing and financial markets, and the recession it appears to have caused, one can only hope so.
1 Santayana’s actual words were “Those who cannot remember the past are condemned to repeat it” but the usual misquotation is used above.