Monday, March 23, 2009

A Lesson from AIG for the Bank Bailout Plan

One of the reasons given for the awarding of bonuses at AIG was the need to keep people around that had “expertise.” That is, if we lose the “experts” we are really in trouble!

This, to me, is one of the greatest fallacies in the corporate world.

It is a fallacy for two very important reasons. The first fallacy is that people are irreplaceable. The second fallacy is that the people that performed badly in the past can get you out of the mess they got you into.

In my experience, no one is irreplaceable and the minute that you begin to believe that either you or the people in charge are irreplaceable you are setting yourself up for big problems. We do not need Rick Wagoner of General Motors nor do we need Vikram Pandit of Citigroup. They are not indispensable in any recovery or turnaround of the companies that they are a part of. Neither are the traders, or the quants, or other executives that got these companies where they are.

We are sold a “bill of goods” about how important these people are to the organization, yet it is remarkably surprising that when they are gone things don’t fall apart. In most cases the situation improves and the company performs at a higher level. It just seems as if in a complex and difficult situation that putting “someone new” in authority is the more dangerous path.

Time-after-time we see that replacing these people is not dangerous. In fact, it turns out to be the best thing that could happen.

Obviously, the incumbents want you to believe that they are indispensable. They will do everything that they need to do to convince you of their importance to future success. And, this includes groveling to the government to assure that they will be kept in place when and if the government bails out their organization or takes it over. Rick Wagoner is sure acting different these days when he is desperate to retain his position at General Motors that he did when he arrogantly arrived in Washington, D. C. on his first trip to the “big” city to appear at Congressional hearings.

Let me add here, however, that this is one of the worst things that the government does when it bails out a company. Because government doesn’t know any better, it often buys into the argument that the current leadership should stay on after the bailout because it has the experience and knows the company better than anyone else does. Government assistance tends to entrench existing management. After all, since the government has worked with this management team to create the bailout in which they are now companions rather than adversaries. That is, they are in bed together.

This is a good reason why government needs to let the shareholders or the bankruptcy courts handle most of these situations. If a management change is needed, there needs to be a practiced means of proceeding toward an orderly transition of power rather than have government insert its heavy hand into the process. Even if government appoints new executive leadership, the choice is usually a person who is an “expert” with “experience” in that firm, which, again, limits the possibilities that the firm will move ahead into the future rather than stay mired in the past.

My experience with the second fallacy also leads me to believe that the “experienced” people should be removed. During the savings and loan crisis, I don’t know how many times I heard the executives of failing thrift institutions seeking money in an IPO tell potential investors, “Yes, we were the ones that managed the organization that brought it to the edge of failure, but, we have learned from this experience! You should give us $100 million in our IPO.”
What have these executives learned?

They have learned how to fail, that’s what they have learned!

There was an interesting article in the business section of the Sunday New York Times which discussed investing in start up companies. I remember myself, because I have worked in that space, that one of the old “truths” of investing in young entrepreneurs is that you should look at people who have failed in earlier business attempts and it even was a “badge of honor” to have failed many times. Recent research does not support this conclusion. On average, those that have failed starting businesses tend to continue to fail. This attitude relating to failure was advice given to venture capitalists or angel investors that are looking desperately to place money. The situation arose during “booms” when there was too much money chasing too few deals. Nothing replaces the success of an entrepreneur as a guide to potential future success.

Still one has to be careful here. Two cases come to mind. First, Nassim Nicholas Taleb in his book “Fooled by Randomness” discusses traders that succeed fantastically because they are in the right spot at the right time. Through no skill of their own do they achieve success, and, because they now think that they are geniuses, go on and lose most if not all of what they gained in their one success. Obviously, these people are not geniuses and should not be treated as such. What you want is people that continue to succeed and succeed in ways that are not just lucky successes.

Second, in an “up” market, almost everyone can succeed, sometimes spectacularly. This can happen in overheated housing markets, in firms that are of the variety, and in growing and running financial institutions. Credit bubbles help. The sad thing about this is that the people that have just benefited from the “bubble” and not from their “skill” are not found out until the “bubble” bursts. Then the true reason for the success of these individuals becomes obvious.

Furthermore, if a chief executive or a management operated in an environment that was “hot” and where increased risk taking and adding additional leverage were the skills needed in order to succeed they are not the chief executive or management to operate within an environment that is “cool” and where reducing risk and de-leveraging are the tools required. Speed racers are not needed on streets where the speed limit is 25 miles per hour.

It should be clear that the people that get you into a mess are not the people you should count on to get you out of the mess. But, again, the government usually does not see this except in cases of fraud or other types of criminal behavior. Therefore, the government will often stick with those people that are experienced in failure.

These comments can be applied to any approach the government takes to resolving issues in the private sector, whether it be in terms of dealing with the toxic assets of financial institutions or bailing out failed managements in the auto industry. The government must be realistic in what it can do. A bank bailout plan that just brings in private investors to relieve institutions of bad debts while leaving bank managements in place is not going to give the financial sector and the economy what it needs.

Yes, something needs to be done about the bad assets banks have on their books. Losses have to be absorbed by the banks and their owners, themselves, or the government must absorb the losses. The insolvent banks, and auto companies, need to be closed or put into bankruptcy. The world needs to move on and the bad decisions of the past must be accounted for. Someone must pay—sometime. Unfortunately, when government gets involved, the solutions to things often only get postponed or delayed. That is not what the financial markets or the economy needs at this time.

And, this includes Cerberus and Chrysler Corp. Cerberus made a wrong deal at the wrong time. They need to move on.

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