Sub-prime Mess: What a Way to Run a Railroad

In modern times, in the aftermath of business difficulties, many of us often exclaim, “That’s no way to run a railroad.” What we mean, of course, is that leadership was lacking, or that leaders made critical errors. The phrase is derived from the caption of a Depression-era cartoon that showed a signalman peering out of his box as two trains below him collided, exclaiming “What a Way to Run a Railroad.” Either way, that caption may well be an apt description of the way many business leaders have handled the current sub-prime mortgage crisis. As the impact of the crisis rattles financial markets and reverberates through the rest of the economy, observers are left to ponder how some supposedly financially sophisticated firms could be so ill prepared for this manmade disaster, while other firms have managed to weather the storm quite successfully thus far.

Although the circumstances behind each firm’s story are unique, there’s a common thread that runs through them and through stories of financial market derailments throughout history. All too often, boards and senior managers fail to educate themselves about what could go wrong and how to take both preventative and curative actions. The tales of seemingly successful companies that failed to identify and prepare for worst case scenarios will continue to fill judicial decisions and business school case studies for years to come. As lawyers, business analysts, and historians review the sub-prime wreckage, it will become increasingly clear that the way some of the most significant financial enterprises in the world conducted themselves in the months and years leading up to the derailment of the sub-prime market really was not, and is not, any way to run a railroad.

Slavish reliance on computer models and sophisticated mathematics put in motion the train of events that ultimately derailed our credit markets. Managements persuaded themselves that, if they applied sophisticated new financial techniques—such as Monte Carlo simulation, binomial default analysis, structured financing, and credit default swaps—to sub-prime mortgages, they could price the risk accurately and distribute it equitably, thereby changing the course of financial history. Unfortunately (and it should come as no particular surprise), there was nothing in any of this mathematical or financial alchemy that that could alter the immutable First Law of Investing: No one, no formula, indeed nothing, can transmute a fundamentally bad investment into a sound one.

By using what, in hindsight, can only be seen as unrealistically low mortgage loss assumptions to create Aaa/AAA rated instruments composed solely of sub-prime mortgages, financial engineers whipped up ever-accelerating investor demand for sub-prime mortgages. And, instead of taking steps to learn what was driving the market, how various investments were constructed, and what possibly could go wrong, and thereafter judiciously applying the brakes, boards and senior managements went along for the ride, until, ultimately, the laws of gravity ran their course. Since the financial institutions that originated the mortgages didn’t need to retain their investments, but could unload them and their attendant risks onto others, they were more than happy to originate enough sub-prime mortgages to stoke, and then fulfill, demand. The result of all this modern financial engineering is a $1 trillion train wreck that’s roiling financial markets and putting a drag on the economy.

Confusion reigned as investors began to realize that fundamental assumptions underlying and driving their investments were unsupportable. As that realization sank in, the market for structured investment-grade assets based upon faulty assumptions dried up. Registered securities that had traded generically as Aaa/AAA rated instruments began to trade like unrated and unregistered private placements. Each security now had to be scrutinized individually, in order to understand its composition and the assumptions that determine its value. Some triple AAA rated CDOs and ABSs are dollar good, while others are worthless. That, in turn meant the value of triple AAA ratings is no longer certain.

In the absence of observable market prices, companies normally would have been guided by their pricing models. But the extant models were useless, since their underlying assumptions had been discredited. The absence of effective analytical tools forced companies to make quick, visceral, decisions. For example, some firms moved to support affiliated hedge funds believing that the market dislocations were temporary and there was light at the end of the tunnel, only to wind up closing them down. Some companies used new assumptions to value positions, only to discover that, as the situation developed, these assumptions were also incorrect, leading to multiple (serial) write-downs.

Finally, boards forced chief executives to step down when it became clear they lacked understanding of, involvement in, and control over, the situation. All this disruption can be traced to inaction on the parts of boards and senior executives alike, about the assumptions and other critical moving parts that were driving their businesses. Market disruptions, confusion, and the failure of financial models became a recipe for bad decisions. As firms struggled to cope with the failure of their models, they were confronted with other quandaries:

How should firms mark securities in the absence of a market and without reliable models?

What should firms do with senior managers who have placed their faith, and the fate of the business, in these models?

How can firms craft proper disclosure when they really don’t understand what forces they are confronting?

What obligations do firms owe customers and investors who have relied upon their advice to make investment decisions?

Each firm’s reaction was different but they all shared the road to bad results.

Some initially quantified their losses without qualification, only to increase their estimates exponentially;

Some removed or “retired” their CEOs;

A number sought capital from foreign sources in private transactions, on terms that imply significant discounts from current stock prices; and

Others took nominally bankruptcy-remote entities back onto their balance sheets in order to honor implicit representations to investors.

These actions raise a host of issues, including disclosure, proper corporate governance, and failure to manage a crisis. These actions will all have long-term market and legal repercussions. They were all taken in the midst of a market crisis and uncertainty, and without sufficient, reliable information. Such immediate, seemingly expedient, decisions are dangerous. The best way to respond to a crisis is for boards and managers to thoroughly understand what makes their businesses tick, what can go wrong, what to do if things do go wrong, who will do those things, and how to make full and fair disclosure.

An easy, but potentially tragic, mistake that too often surfaces is the belief that things like this only happen to others. Some of the most sophisticated and promising (or formerly most promising) companies in the world are going hat in hand to foreign governments looking for capital, akin to the way formerly successful financiers were reduced to selling pencils on street corners during the Great Depression. Managements and boards should examine their practices and policies and take corrective action now, in order to avoid a similar fate when the next crisis hits. As this analysis is performed, the following approaches should be considered:

Ignorance Is Definitely Not Bliss. Senior management and the Board must fully understand all essential areas of their business completely. In the past, boards often believed that their understanding of the business of their companies was to be gained derivatively from management, and management believed it would learn from on-the-job training. While that’s still true as a starting point, it’s no longer sufficient, if it ever was. Both managers and directors need to tap into sophisticated, independent, analyses of business in general, and their businesses in particular. Knowing what’s ahead, as well as what’s behind, is crucial.

Directors and Managers Should Collaboratively Set Board Agendas. The old days—when directors spoke (or voted) only when spoken to (or asked to vote) by management—are over. Directors need to set yearly agendas of issues they need the board to cover, with strong input from management. Waiting until management brings an issue to the board is often akin to waiting for Godot! It isn’t enough for directors to assume that management is keeping it aware of every issue that deserves the board’s attention, directors must be certain.

Remember Pareto’s Law. The Pareto principle, also known as “the 80-20 rule,” suggests that 80 percent of an enterprise’s profit comes from 20 percent of its activities. Reporting segments should be set up to reflect that, so mangers and the board can tell at a glance what’s going well and what isn’t. If that isn’t the state of play, the board should consider reorganizing its reporting relationships.

Remember the Three Most Important Keys for Any Company. For every company, the three most important issues are (i) Risk Identification, (ii) Risk Prevention, and (iii) Risk Amelioration. A number of firms escaped the sub-prime debacle (at least thus far) because their risk management was an integral part of their business processes and they gave risk managers a full voice in decision making. In contrast, others obsessively pursued short-term profits to the exclusion of risk managers and the cautionary messages they offer. Recent hires of high-level risk managers are a clear indication of the ascendancy of a management paradigm in which risk managers have the authority to veto schemes that could unbalance risks and rewards, and boards have confidence that senior management will have the wisdom to endorse such decisions.

Companies Can Predict, Prevent, and Ameliorate Their Next Crisis. When trouble hits, the first thing that usually occurs is for fingers to be pointed in various directions. While this is definitely not something that can be prevented (because companies have no control over others), it can be minimized if companies are well prepared ahead of time. This means identifying possible catastrophes, taking measures to try to prevent them, and developing advance game plans for ameliorating them. Good companies periodically (yearly or semi-annually) have off-sites at which they contemplate various disasters that can occur, develop strategies for dealing with them, and role play to make sure everyone knows who’s responsible for what.

Follow Sara Pitt’s Postulate. My mother, who was a real-life version of Mrs. Malaprop (the character in Richard Brinsley Sheridan’s The Rivals, who frequently misspoke to great comic effect) used to advise that, “sometimes, even the inevitable occurs.” She was absolutely right, of course. Bad things inevitably do happen to good companies. These bad things don’t arise from thin air. Lists of potential catastrophes should be kept, checked, analyzed, and updated, with attention given to contingency planning for each.

Be Wary of the NOMW Phenomenon. The longevity of CEOs is definitely decreasing—hopefully not in terms of their actual life spans, but definitely in terms of their job tenure. This fact of life is well known, and can sometimes create the “not-on-my-watch” (NOMW) phenomenon. CEOs with finite contractual tenures, and even more limited periods of service, don’t always want to know about problems that might remain uncovered until they’ve departed naturally. Boards have to be aware of this potential problem and make sure their processes take that possibility into account.

Avoid Dan Snyder’s Theory of Selecting Head Coaches. For those who are fans of the Washington Redskins, it’s clear that head coaches are only as good as their last season’s results, or burn out long before anyone anticipated. The same is true for CEOs. Whether rightly or wrongly, CEOs frequently leave (voluntarily or involuntarily) before anyone expects they will and before they’re supposed to depart. And yet, very few NFL teams (the Indianapolis Colts excluded) have a successor ready in the wings. One of the most distressing elements of the sub-prime crisis is how some of the world’s largest financial institutions had no succession planning in place when the decision was made to oust or “retire” their CEOs. This seems typical of far too many companies. Even if the CEO is newly installed, young, vigorous, doing well, and healthy, there needs to be a clear succession plan in place in the event something happens to him or her, or their team. Loss of key leaders, by natural causes, unnatural events, or the loss of their effectiveness, is a serious risk of doing business. Companies have an obligation to their shareholders to be prepared for this possibility, and, if they aren’t, may have a disclosure obligation.

Transparency is Essential for an Orderly Business. The fundamental flaw that doomed the sub-prime market was lack of transparency and effective analytical tools in the hands of those creating and selling instruments. This same lack of information and analysis has other potentially dire consequences. The decisions of boards and others can be no better than the information at their disposal. Similarly, investors’ decision making can be severely impaired if critical facts are lacking. Since companies can’t disclose what they don’t know or understand, dissemination of incomplete information can be a source of significant legal and financial exposure. So, it behooves companies to insist on the best possible information and analytical tools, both for their own business and risk-management purposes and to ensure appropriate disclosure.

Haste Makes for Large Legal Bills. Many firms with significant sub-prime exposure made quick decisions in the aftermath of the market meltdown. For example, some initially decided to support affiliated hedge funds, but later reversed course and let them fail. The legal, financial, and corporate governance consequences of these hasty decisions will be thrashed out in courts for years to come. Companies marketed risky investment vehicles to their investors without understanding the risks and, once the investors were along for the ride, had to make triage decisions, also without sufficient information. And of course, it should go without saying that if a company intends to assume responsibility for its affiliated investment vehicles, it ought first be sure it hasn’t pierced its own corporate veil.

Institutions Are Only as Sturdy as Their Foundations. Players throughout mortgage-related industries remade themselves and built their strategic plans in the expectation that returns from sub-prime sources would continue indefinitely. The stark realization that the future of these businesses was built on unsupportable mathematics and models has left these enterprises with personnel and infrastructure not suited to the new economic reality and with sub-prime assets for which there is no market. This, in turn, has led to layoffs and the closure of business units. While such actions can stem some losses, many of these firms must now go back to the drawing board to devise ways to return to profitability, now that their high-margin business has been eliminated.

The Buck Stops with the Board. In the wake of the sub-prime crisis, some firms fired their CEOs. Other high-ranking executives also lost their jobs, with others sure to follow. Ultimate responsibility, though, lies with the boards that hire CEOs, and boards must act in accordance with that critical responsibility. Processes for choosing senior managers and then evaluating them should be reviewed periodically to make sure they are state-of-the-art. In addition, the board must assume responsibility for assuring an appropriate infrastructure of checks and balances that manages the desire to optimize profit with a sensible assessment of actual and potential risk.

You Only Get One Bite at the Apple. When a crisis hits, there are two conflicting, but equally destructive, impulses many companies face. The first is to say nothing, either in the hope that it will all blow over or in an effort to collect additional information. The second is to rush out with disclosure that may not turn out to be accurate. Balancing these extremes is essential. Some firms irrevocably harmed themselves and hurt their shareholders by serial write-downs. When a company finds itself in trouble, it has one chance to express its regret, divulge the facts, and indicate what lies ahead. When multiple write-downs occur, CEOs will surely be fired. But, the Board also has an obligation to understand whether this is all that is known and how that determination was made. The failure to satisfy that information can lead to huge corporate, collective and individual liability.

Everyone Needs the Same Information. Some victims of the sub-prime disaster have raised capital with hastily arranged private placements of convertible preferred stock. The dividend rate on the preferred stock has been above market, but the conversion price has been at the market. Typically, “at the market” conversion prices imply low dividend rates. When that isn’t the case, it can mean that the issuers and purchasers have a different idea of the value of the underlying stock than that reflected by the market. Issuers need to understand, and then explain, why their beliefs are different from the market’s implicit view. The failure to do so may encourage unwanted regulatory interest.

As a result of the sensational wreck of what was once the sub-prime market, the American economy will go through a period of adjustment, as various market constituencies determine how best to move forward. There is, however, a benefit to every period of adversity, like this one. Companies that successfully emerge and analyze the elements of their adversity and adopt strategies to avoid recurrence, both on a micro and a macro level, will be well positioned to prosper and avoid further bumps in the road as the economic situation improves. Those are the companies that will have learned how to avoid the train wrecks that inevitably mark a poorly run railroad.