CIT is an example of the kind of problems still facing the economy. CIT has taken on legal counsel in order to determine whether or not it should go into bankruptcy. The problem, the company has $2.7 billion in debt coming due through year end and its credit-rating has been cut “deep into ‘junk’ territory.” (See http://online.wsj.com/article/SB124744080839729811.html#mod=testMod.) It has been seeking liquidity help from the Federal Government but has not received approval yet.
Debt is the problem and it currently continues to haunt most businesses, governments, and individuals in the economy. It is a problem because this debt load has to work itself out. But, in working out the debt problem, the economy suffers and will continue to suffer.
The current debt crisis is so severe because of the credit inflation created by the U. S. Government over the last eight years of so. During expansions, credit inflations take place. This is what happens as the economy is stimulated and confidence in the private sector builds and things appear to be good and getting better. Credit inflations don’t have to directly result in general price inflation, although they can end up with this result.
In the 1990s as well as the 2000s we have had credit inflations where price increases have been relatively mild. In the 1990s we saw the stock market bubble and the credit inflation with respect to new ventures. However, during that decade we saw the federal government turn a deficit budget into a surplus budget by the end of the century. In the 2000s, we saw the housing bubble and the general credit inflation, but we also experienced a huge increase in government debt on top of everything else. Debt was good and most partook of it!
If the credit inflation during a period of economic expansion is not too excessive then the following correction that must take place can be relatively mild and reasonable and the government can come in and re-flate the economy so that the financial dislocation can be righted in a reasonable amount of time without too much “hurt” in the economy in general. Moral hazard is created, but what’s the problem with a little moral hazard? Right?
This is what happens in most minor recessions.
An exception occurred in the credit inflation of the 1970s. President Nixon was so paranoid about getting re-elected that he set about inflating the economy and connected this with taking the United States off the gold standard, floating the dollar, and freezing wages and prices. This philosophy was not abandoned by President Ford. Jimmy Carter just inflated, period. And, by the end of the decade, serious work had to be done to bring general inflation under control.
What happened in the decade of the 2000s was of a totally different nature. The debt structure that was created through this decade’s credit inflation could not be sustained. Debt was growing way more rapidly than the economy could support and the resulting imbalance was greater than at any time since the Second World War. Almost everyone was excessively over leveraged. The headlines focused first upon the subprime market and then upon Structured Investment Vehicles (SIVs) and the Collateralized Debt Obligations (CDOs). And, then it became apparent that this excessive leveraging had been going on everywhere in the economy. And, the federal government was right up there with everyone else.
There is too much debt out there! Yes, there is deficient aggregate demand, but that is not going to be corrected until the debt situation is corrected...no matter how much Paul Krugman and the Keynesian wing of the world cry out! People and businesses are going to have to get their balance sheets in order before private spending will really pick up. Unless, of course, the government is able to get a hyper inflation going again which is the classic solution for an economy with too much debt.
There are three ways for economic units to reduce debt. The first is to sell assets and pay off the debt. However, if people are uncertain about asset values this solution to the debt problem is not going to work. Second, economic units can save out of income and revenues and pay down their debt. This, of course, is the soundest way to de-leverage, but it is also the slowest way to reduce the debt on a balance sheet. The third way to reduce debt is to renounce the debt: that is, declare bankruptcy. This solution does have repercussions, however, on the value of the assets of other people and other businesses.
A firm with too much debt can face another problem. Debt matures and sometimes has to be refinanced. The problem here is that a company may not be able to refinance the debt that is coming due. In such cases, these firms will either be forced into the first way of reducing debt, selling assets and perhaps taking a loss on the sale of the assets, or it will have to renounce the debt by declaring bankruptcy.
One sees CIT examining its resources to decide what is its best option. The second option does not seem to be a viable option because CIT doesn’t have sufficient time to generate enough revenues so that it can pay down its debt. So, it is looking at a situation where it has a substantial amount of debt maturing in the next six months or so. Refinancing is an option, but with its bond ratings reduced to the ‘junk’ category, this could be quite expensive and could produce negative cash flows so that earnings could not provide revenues to pay down debt. Thus, CIT could reduce sell off assets to generate cash to pay off the maturing debt. But, how much does CIT stand to lose if it sells off assets?
If these are the scenarios, then it is good that CIT is getting advice on declaring bankruptcy. This still presents a problem. As people see this possibility facing the company, why should short term lenders continue to help finance the company and why should borrowers continue to borrow from CIT, a company that may not be there tomorrow. Also, on Monday morning investors dumped the company’s stock.
The fact of the matter is that there are many companies, governments, and individuals (and their families) that face this situation right now. And it is very, very scary.
The question is, given these problems, why should these economic units spend? They have a debt problem. And, with rising unemployment and more and more debt coming due in various sectors of the economy, like commercial real estate, why should we expect people to pick up their spending in the near term. There are other, more pressing issues to deal with. This is why the economy is not going to start to pick up much speed soon.
Almost every week there is a new “CIT” that we read about. These companies are too big to ignore. And, that is what is so worrisome. How many more of them are there?
Something else that is worrisome as well. When banks are closed by the FDIC, the general operating procedure is to place the deposits and good assets of the closed bank with a healthy bank. Word is that there are not that many healthy banks around. Thus, the deposits and good assets of banks that are closed are not being placed with healthy banks (See “FDIC’s Challenge with Busted Banks,” http://online.wsj.com/article/SB124744606526030587.html#mod=todays_us_money_and_investing.) So, we now have more banks that have been focused on their own problems taking on the problem of integrating the deposits and good assets of closed banks which can’t help but divert their attention from their own problems. As of last Friday, 53 banks have been closed this year and the expected total of bank closings for the year is over 100. If we don’t have a lot of healthy banks around now to take care of the current crop of banks that are closing, what are we going to do for the rest of the year?
Showing posts with label subprime loans. Show all posts
Showing posts with label subprime loans. Show all posts
Monday, July 13, 2009
Friday, July 25, 2008
It's All a Matter of Incentives
“Economics is, at root, the study of incentives…” (Steven D. Levitt and Stephen J. Dubner, “Freakonomics”, p. 20.) The modern economy is a “thicket of information about jobs and real estate and banking and investment.” (p. 13) And, we respond to that information, respond to the incentives built into that information “from the outset of life.” (p. 20) “There are three basic flavors of incentive: economic, social, and moral. Very often a single incentive scheme will include all three varieties.” (p. 21) In many cases, incentives lead us to cheating and lying. (In the latter case see “Nobel-winning economist who put a premium on truth.” http://www.ft.com/cms/s/0/4fa48cf4-5529-11dd-ae9c-000077b07658.html.)
The reason I am bringing up the issue of incentives today is to put into perspective some of the behavior we have observed in the economy in recent years and the results of such behavior. My major point is the obvious statement that everyone is looking for an edge. That is, people have goals and objectives to achieve, whether or not these are explicitly understood or not. As a consequence, people will respond to the incentives they observe that will move them ahead in their quest to achieve these goals and objectives.
Many of these goals and objectives are couched in relative terms. That is, the result we are looking for is not one of ‘absolute’ performance, but of ‘relative’ performance. We learn very early in life that in games like baseball, it is not important that we score 10 runs in a game, but at least one more run than our competition. In golf, we don’t need to shoot a score of 10 under par…all we need to do is shoot a score that is at least one stoke less than our opponents. And, we see that this objective holds in many other areas of life as well.
And, stating our objectives in relative terms lead us to ‘copy cat’ types of behavior. If another person, or another firm, has found a way to relative success, others will copy that way in order to duplicate that success, or, hopefully, perform at even a higher level. People that move to ‘the new way’ faster than others tend to achieve more success than those that move at a later date, although this is not altogether the case. But, this is the essence of dynamic markets. When there are opportunities for people to achieve returns that are in excess of costs, new participants will be drawn into the market if the costs of entering the market are relatively minor. In the case of financial markets the costs of entry are usually not excessive relative to the potential returns.
Another important factor is that once favorable market situations arise participants and potential participants often develop the attitude that a “new” world has arrived and that this “new” world represents the future. When this attitude develops, the perspective between the long run and the short run disappears. Thus, concern over conventional standards and conservative practices also disappears because the “new” world demands new standards and practices.
Retrospectively, we can look back at various situations over the past 30 years or so and see many examples of how people and organizations responded to market incentives in an effort to get an edge over their competition. Of course, the movement in the area of derivative securities is a prime example of this competitive behavior. The subprime mortgage market is the premier current example of this kind of behavior. There were many incentives hanging around the development of this market. There were the social and political incentives to develop this market to allow more and more Americans to achieve the ‘dream’ of owning their own home. There were the incentives for financial institutions to acquire these mortgages, package them into securities and sell them to others, thereby earning fees rather than making profits on interest rate spreads. There were the incentives for the brokers to initiate these loans to generate fees for themselves. There were incentives for funds to hold these securities because of the yields they earned and the fact that they could leverage up their portfolios to add basis points to returns. And, there were incentives for individuals and families to go ‘out-on-a-limb’ to get their own home.
Incentives work…for better or worse. Where does one put the blame? When does one go ‘over-the-edge’? The important thing to remember is that it always is a matter of trade-offs. Levitt and Dubner ask the question: “Who cheats?” And, they answer…”just about anyone, if the stakes are right. You might say to yourself, I don’t cheat, regardless of the stakes. And then you might remember the time you cheated on, say, a board game.” (p. 24) Then they go on: “For every clever person who goes to the trouble of creating an incentive scheme, there is an army of people, clever and otherwise, who will inevitably spend even more time trying to beat it…Cheating is a primordial economic act: getting more for less.” (p. 25)
Thus, certain types of behavior, as they succeed are copied. This is the way markets work. If exceptional returns are being earned, others will be drawn to duplicate the behavior that succeeds. The “new” behavior becomes a social phenomenon. David Brooks, in the New York Times, has recently discussed this “social” behavior. (“The Culture of Debt”, http://www.nytimes.com/2008/07/22/opinion/22brooks.html?hp.) Everyone jumps on the bandwagon.
However, the additional competition tends to drive out the exceptional returns and promotes even more excessive actions to perform. Again, this is the way markets work. For example, in the 1970s and 1980s there was a move to buyout companies, break them up and sell the various parts. Valuation was such that the individual parts were not being valued at their ‘stand alone’ value and consequently this strategy could succeed and generate a lot of wealth. However, as time passed, the valuations of companies came to incorporate these ‘stand alone’ values and hence people that got into this game at a later date did not achieve the rewards that those who got in earlier received. By the start of the 1990s buyouts were actually losing money in the effort to duplicate what had gone on before.
If a movement continues on for a lengthy enough period of time it becomes more and more difficult for the person operating in a more conservative way to stick to their principles. For example, a friend of mine ran a mutual fund during the 1990s; he had a fair amount of Nobel-prize money in his funds; his funds performed very well for most of the decade; and his funds stayed out of ‘tech’ stocks since he felt that their performance tended to be speculative in nature. However, toward the end of the decade his funds began to lag other funds that were more heavily invested in “technology”. As a consequence, investors began to move money out of his funds. Finally, feeling that he could not stay away from the ‘dot-coms’ he finally began to move into that area of the market. Nine months after he began this move, his performance was recorded in the main article on the front page of the Wall Street Journal. He had moved just before the crash in dot-coms began. The fund recovered, but if he had stayed with his initial principles for just a while longer, he probably would have made the lead article in the Wall Street Journal heralding his adherence to the fundamentals. (For a happier outcome see “PNC’s caution gives it last laugh over rivals”: http://www.ft.com/cms/s/0/047c7cba-568b-11dd-8686-000077b07658.html.)
The bottom line to this is that this type of behavior is not going to go away. Legislation is not going to change human behavior. “Incentives are the cornerstone of modern life.” (p.13) Congress can try and put a halt to speculation, they can attempt to halt higher leverage, they can move to prevent ‘cannibalistic’ lending behavior. Yet, if the incentives exist, individuals will find a way to get around regulators and legislators. I am not trying to justify this behavior…just accept the reality of it. The only thing I believe that can help the situation is to create greater openness and transparency in transactions and reporting. This will not change behavior but it will provide more information so that we can more fully understand what is going on in the
markets and the positions that people are taking.
The reason I am bringing up the issue of incentives today is to put into perspective some of the behavior we have observed in the economy in recent years and the results of such behavior. My major point is the obvious statement that everyone is looking for an edge. That is, people have goals and objectives to achieve, whether or not these are explicitly understood or not. As a consequence, people will respond to the incentives they observe that will move them ahead in their quest to achieve these goals and objectives.
Many of these goals and objectives are couched in relative terms. That is, the result we are looking for is not one of ‘absolute’ performance, but of ‘relative’ performance. We learn very early in life that in games like baseball, it is not important that we score 10 runs in a game, but at least one more run than our competition. In golf, we don’t need to shoot a score of 10 under par…all we need to do is shoot a score that is at least one stoke less than our opponents. And, we see that this objective holds in many other areas of life as well.
And, stating our objectives in relative terms lead us to ‘copy cat’ types of behavior. If another person, or another firm, has found a way to relative success, others will copy that way in order to duplicate that success, or, hopefully, perform at even a higher level. People that move to ‘the new way’ faster than others tend to achieve more success than those that move at a later date, although this is not altogether the case. But, this is the essence of dynamic markets. When there are opportunities for people to achieve returns that are in excess of costs, new participants will be drawn into the market if the costs of entering the market are relatively minor. In the case of financial markets the costs of entry are usually not excessive relative to the potential returns.
Another important factor is that once favorable market situations arise participants and potential participants often develop the attitude that a “new” world has arrived and that this “new” world represents the future. When this attitude develops, the perspective between the long run and the short run disappears. Thus, concern over conventional standards and conservative practices also disappears because the “new” world demands new standards and practices.
Retrospectively, we can look back at various situations over the past 30 years or so and see many examples of how people and organizations responded to market incentives in an effort to get an edge over their competition. Of course, the movement in the area of derivative securities is a prime example of this competitive behavior. The subprime mortgage market is the premier current example of this kind of behavior. There were many incentives hanging around the development of this market. There were the social and political incentives to develop this market to allow more and more Americans to achieve the ‘dream’ of owning their own home. There were the incentives for financial institutions to acquire these mortgages, package them into securities and sell them to others, thereby earning fees rather than making profits on interest rate spreads. There were the incentives for the brokers to initiate these loans to generate fees for themselves. There were incentives for funds to hold these securities because of the yields they earned and the fact that they could leverage up their portfolios to add basis points to returns. And, there were incentives for individuals and families to go ‘out-on-a-limb’ to get their own home.
Incentives work…for better or worse. Where does one put the blame? When does one go ‘over-the-edge’? The important thing to remember is that it always is a matter of trade-offs. Levitt and Dubner ask the question: “Who cheats?” And, they answer…”just about anyone, if the stakes are right. You might say to yourself, I don’t cheat, regardless of the stakes. And then you might remember the time you cheated on, say, a board game.” (p. 24) Then they go on: “For every clever person who goes to the trouble of creating an incentive scheme, there is an army of people, clever and otherwise, who will inevitably spend even more time trying to beat it…Cheating is a primordial economic act: getting more for less.” (p. 25)
Thus, certain types of behavior, as they succeed are copied. This is the way markets work. If exceptional returns are being earned, others will be drawn to duplicate the behavior that succeeds. The “new” behavior becomes a social phenomenon. David Brooks, in the New York Times, has recently discussed this “social” behavior. (“The Culture of Debt”, http://www.nytimes.com/2008/07/22/opinion/22brooks.html?hp.) Everyone jumps on the bandwagon.
However, the additional competition tends to drive out the exceptional returns and promotes even more excessive actions to perform. Again, this is the way markets work. For example, in the 1970s and 1980s there was a move to buyout companies, break them up and sell the various parts. Valuation was such that the individual parts were not being valued at their ‘stand alone’ value and consequently this strategy could succeed and generate a lot of wealth. However, as time passed, the valuations of companies came to incorporate these ‘stand alone’ values and hence people that got into this game at a later date did not achieve the rewards that those who got in earlier received. By the start of the 1990s buyouts were actually losing money in the effort to duplicate what had gone on before.
If a movement continues on for a lengthy enough period of time it becomes more and more difficult for the person operating in a more conservative way to stick to their principles. For example, a friend of mine ran a mutual fund during the 1990s; he had a fair amount of Nobel-prize money in his funds; his funds performed very well for most of the decade; and his funds stayed out of ‘tech’ stocks since he felt that their performance tended to be speculative in nature. However, toward the end of the decade his funds began to lag other funds that were more heavily invested in “technology”. As a consequence, investors began to move money out of his funds. Finally, feeling that he could not stay away from the ‘dot-coms’ he finally began to move into that area of the market. Nine months after he began this move, his performance was recorded in the main article on the front page of the Wall Street Journal. He had moved just before the crash in dot-coms began. The fund recovered, but if he had stayed with his initial principles for just a while longer, he probably would have made the lead article in the Wall Street Journal heralding his adherence to the fundamentals. (For a happier outcome see “PNC’s caution gives it last laugh over rivals”: http://www.ft.com/cms/s/0/047c7cba-568b-11dd-8686-000077b07658.html.)
The bottom line to this is that this type of behavior is not going to go away. Legislation is not going to change human behavior. “Incentives are the cornerstone of modern life.” (p.13) Congress can try and put a halt to speculation, they can attempt to halt higher leverage, they can move to prevent ‘cannibalistic’ lending behavior. Yet, if the incentives exist, individuals will find a way to get around regulators and legislators. I am not trying to justify this behavior…just accept the reality of it. The only thing I believe that can help the situation is to create greater openness and transparency in transactions and reporting. This will not change behavior but it will provide more information so that we can more fully understand what is going on in the
markets and the positions that people are taking.
Monday, February 25, 2008
The Solvency Issue
Something new seems to be happening in this current period of financial dislocation. It appears to me that banks and other financial institutions are responding to their portfolio problems more rapidly this time around than they did in the past. If this is true, in my estimation it is all to the good! The reaction may result in a sharper reduction in lending in the short run than would occur otherwise, but it will mean that the system will be moving onto the future more quickly. Within such a scenario, the concern is that if all adjustment takes place at relatively the same time, financial markets could be overwhelmed. I am not expecting this…just pointing out the downside concern.
In the past, banks and other financial institutions have responded relatively slowly to problems in their portfolios primarily because many of the problems occurred in loans and other debt arrangements that were just between the banks and their customers. The assets under consideration were not market related. In the present case, many, if not most, of the financial assets that are having problems are market related. That is they are securities connected with subprime loans, collateralized debt obligations (CDOs) and structured investment vehicles (SIVs) among other things. In most cases the institutions holding these assets did not originate them but in some way acquired them from a third party.
Why does this make a difference? Loans and other debt relationships that are directly made between two parties and where the lender holds the paper on their balance sheet as an asset generally have no ‘market’ in which the asset can be traded and a value can be determined. Since the relationship is a direct one, when the borrower runs into some kind of operational difficulty in which the terms of the loan cannot be fully met, the lender and the borrower attempt to work things out. Lenders are not under a great deal of pressure to ‘pull the plug’ on the relationship and admit that the asset on the books may be overvalued. In fact, the tendency is for borrowers to take an optimistic view of things and believe that things will work themselves out. Thus, it may take a sometime before the seriousness of the situation to be recognized and accepted. Of course, the examination of assets by regulators or accountants may speed this process along but this only takes place with a lag.
In an environment like the one just described the truth about a portfolio comes out slowly and charge offs may only come in bits-and-pieces over an extended period of time. In situations like this, Presidents and CEOs remain in place as do their management teams with the hope that everyone on board will be able to ride out the storm. But, when management stays in place there is not much incentive to change the way things are done. The status quo is maintained. Keeping things in place and hoping that the assets will begin to perform is the norm.
If things continue to go bad for the institution, eventually the organization will be acquired or a new leader will be retained to do a ‘turnaround.’ The good thing about a turnaround is that by bringing in someone entirely new, there will be no investment in what had previously been done. The goal of the person brought in to execute the turnaround is to get rid of all that is bad, bring in capable new people, scale back to what might be called the basic franchise, and then execute a new game plan built upon solid fundamentals. Since the turnaround person has nothing vested in the old way the company had been run, he or she pretty well can do what is required to change the organization. This is my experience in the three (successful) turnaround situations I have led.
These kinds of turnarounds are usually done with the same ownership. Of course, there are vehicles that have become more important in recent years that can perhaps ‘save’ an institution earlier in the firm’s downward cycle. Although these have not been used frequently with banks or other financial institutions, their methodology is instructive. These are the hedge funds or buyout funds that specialize in buying companies that are not using their basic franchise as well as they could in order to redirect them…and, in the process, make a lot of money. Whereas the turnaround specialist brought in by a troubled Board of Directors does not have the ownership control, the private equity fund or the hedge fund that buys a distressed company has absolute control. They can do what they want…change management, sell assets, close operations, restructure, and so forth. And, the organizations can do these things rapidly because they own the place and there are no governance issues that have to be dealt with.
In the current situation we have seen a much quicker response to asset difficulties in banks and other financial institutions. The reason being that the assets in question have not been originated by the organization that is holding them and there has been some kind of market in which the assets have been traded. The consequence of this, in my view, is that managements have had to recognize earlier than before the problems being experienced in these asset categories and have had to act more quickly. The result has been that the difficulties being experienced by these organizations have surfaced much earlier in the cycle that they have in the past.
In addition, Boards of Directors have not been as passive as they have been historically. The information concerning charge offs have gotten into the press earlier than ever before and the magnitude of the charge offs have made for sensational headlines. Boards could not sit idly by. They, too, had to act and the actions they took were to remove the person in charge of the organization, the CEO. I don’t believe that we have ever seen so many top executives of important companies relieved of their position in such a short time as we have seen over the past three months or so. And, in my opinion…this is good!
There is also a cumulative effect at work in this process. This is because it is easier to do something when many others are doing the same thing. It is easier to recognize losses in asset portfolios if almost everyone else is also recognizing losses. It is easier to be severe in finding losses if almost everyone else is also being severe in their judgments. It is easier for a board to remove its CEO if other boards are removing their CEO. It is easier to make major changes and restructurings as the new CEO if other CEOs are doing the same thing. Of course, one of the dangers in ‘herd’ mentality is that the ‘herd’ will go too far in the direction in which it is heading. Right now, I don’t see this happening.
What does this mean for the current situation? From my experience recognizing and disclosing problems earlier rather than later is a good thing. In a troubled time, it is good to be relatively severe in the analysis of the value of your portfolio. It is also good to replace those that have a vested interest in the current portfolio with people that do not have a vested interest in it. And, it is a good thing to restructure an organization, returning it to its basic franchise so that it can focus on what it does best. To me, the economy goes through more pain for a longer period of time if people are slow to accept that they have problems, move only slowly to correct the problems, and fail to get back to the basics of their business and proceed into the future on a sound fundamental basis. It seems to me that this time we are moving through this stage of the cycle more rapidly than before.
The assets of concern have caused people to address things earlier in this phase of the economic cycle than in the past, but these assets have some problems of their own that are creating other difficulties. One problem of major concern is how to determine the value of the securities in question. The securities themselves are very complex instruments, which mean that there are only a limited number of people that fully understand them. Also, the markets in which these securities are traded are not very active so that prices are not very reliable measures of value. An additional uncertainty is that it has not always been easy to identify the originator of the assets backing the security thereby limiting the ability of either the original borrowers or the ultimate holders of the asset to resolve problems. How these problems will be resolved is uncertain at this time. Stay tuned!
In the past, banks and other financial institutions have responded relatively slowly to problems in their portfolios primarily because many of the problems occurred in loans and other debt arrangements that were just between the banks and their customers. The assets under consideration were not market related. In the present case, many, if not most, of the financial assets that are having problems are market related. That is they are securities connected with subprime loans, collateralized debt obligations (CDOs) and structured investment vehicles (SIVs) among other things. In most cases the institutions holding these assets did not originate them but in some way acquired them from a third party.
Why does this make a difference? Loans and other debt relationships that are directly made between two parties and where the lender holds the paper on their balance sheet as an asset generally have no ‘market’ in which the asset can be traded and a value can be determined. Since the relationship is a direct one, when the borrower runs into some kind of operational difficulty in which the terms of the loan cannot be fully met, the lender and the borrower attempt to work things out. Lenders are not under a great deal of pressure to ‘pull the plug’ on the relationship and admit that the asset on the books may be overvalued. In fact, the tendency is for borrowers to take an optimistic view of things and believe that things will work themselves out. Thus, it may take a sometime before the seriousness of the situation to be recognized and accepted. Of course, the examination of assets by regulators or accountants may speed this process along but this only takes place with a lag.
In an environment like the one just described the truth about a portfolio comes out slowly and charge offs may only come in bits-and-pieces over an extended period of time. In situations like this, Presidents and CEOs remain in place as do their management teams with the hope that everyone on board will be able to ride out the storm. But, when management stays in place there is not much incentive to change the way things are done. The status quo is maintained. Keeping things in place and hoping that the assets will begin to perform is the norm.
If things continue to go bad for the institution, eventually the organization will be acquired or a new leader will be retained to do a ‘turnaround.’ The good thing about a turnaround is that by bringing in someone entirely new, there will be no investment in what had previously been done. The goal of the person brought in to execute the turnaround is to get rid of all that is bad, bring in capable new people, scale back to what might be called the basic franchise, and then execute a new game plan built upon solid fundamentals. Since the turnaround person has nothing vested in the old way the company had been run, he or she pretty well can do what is required to change the organization. This is my experience in the three (successful) turnaround situations I have led.
These kinds of turnarounds are usually done with the same ownership. Of course, there are vehicles that have become more important in recent years that can perhaps ‘save’ an institution earlier in the firm’s downward cycle. Although these have not been used frequently with banks or other financial institutions, their methodology is instructive. These are the hedge funds or buyout funds that specialize in buying companies that are not using their basic franchise as well as they could in order to redirect them…and, in the process, make a lot of money. Whereas the turnaround specialist brought in by a troubled Board of Directors does not have the ownership control, the private equity fund or the hedge fund that buys a distressed company has absolute control. They can do what they want…change management, sell assets, close operations, restructure, and so forth. And, the organizations can do these things rapidly because they own the place and there are no governance issues that have to be dealt with.
In the current situation we have seen a much quicker response to asset difficulties in banks and other financial institutions. The reason being that the assets in question have not been originated by the organization that is holding them and there has been some kind of market in which the assets have been traded. The consequence of this, in my view, is that managements have had to recognize earlier than before the problems being experienced in these asset categories and have had to act more quickly. The result has been that the difficulties being experienced by these organizations have surfaced much earlier in the cycle that they have in the past.
In addition, Boards of Directors have not been as passive as they have been historically. The information concerning charge offs have gotten into the press earlier than ever before and the magnitude of the charge offs have made for sensational headlines. Boards could not sit idly by. They, too, had to act and the actions they took were to remove the person in charge of the organization, the CEO. I don’t believe that we have ever seen so many top executives of important companies relieved of their position in such a short time as we have seen over the past three months or so. And, in my opinion…this is good!
There is also a cumulative effect at work in this process. This is because it is easier to do something when many others are doing the same thing. It is easier to recognize losses in asset portfolios if almost everyone else is also recognizing losses. It is easier to be severe in finding losses if almost everyone else is also being severe in their judgments. It is easier for a board to remove its CEO if other boards are removing their CEO. It is easier to make major changes and restructurings as the new CEO if other CEOs are doing the same thing. Of course, one of the dangers in ‘herd’ mentality is that the ‘herd’ will go too far in the direction in which it is heading. Right now, I don’t see this happening.
What does this mean for the current situation? From my experience recognizing and disclosing problems earlier rather than later is a good thing. In a troubled time, it is good to be relatively severe in the analysis of the value of your portfolio. It is also good to replace those that have a vested interest in the current portfolio with people that do not have a vested interest in it. And, it is a good thing to restructure an organization, returning it to its basic franchise so that it can focus on what it does best. To me, the economy goes through more pain for a longer period of time if people are slow to accept that they have problems, move only slowly to correct the problems, and fail to get back to the basics of their business and proceed into the future on a sound fundamental basis. It seems to me that this time we are moving through this stage of the cycle more rapidly than before.
The assets of concern have caused people to address things earlier in this phase of the economic cycle than in the past, but these assets have some problems of their own that are creating other difficulties. One problem of major concern is how to determine the value of the securities in question. The securities themselves are very complex instruments, which mean that there are only a limited number of people that fully understand them. Also, the markets in which these securities are traded are not very active so that prices are not very reliable measures of value. An additional uncertainty is that it has not always been easy to identify the originator of the assets backing the security thereby limiting the ability of either the original borrowers or the ultimate holders of the asset to resolve problems. How these problems will be resolved is uncertain at this time. Stay tuned!
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