Thursday, November 1, 2007

Risk Management: Should the Investment Banks Have Remained Partnerships?

To state the obvious, investment banks have a risk management problem. Merrill just wrote of $8 billion and its CEO abruptly retired. Bear Stearns' president left under a cloud this past summer, and questions now swirl around its CEO. Questions also swirl around the CEO of Citigroup. Senior executives at a number of banks have hit white water in their careers. An analyst downgrade of Citigroup today contributed to a 362 point drop in the Dow Jones Industrial Average.

These are supposed to be smart people. And they're supposed to have smart people working for them. How could it be that they'd record losses in the hundreds of millions or billions--and just for one quarter? You'd think they'd have effective risk management systems, not only because that's part of their jobs, but also because the consequences can be so great.

But are the consequences so great? Stanley O'Neal, the now retired CEO of Merrill, reportedly left with $161 million. You could buy a jet and a yacht with that much money and still have plenty left over for caviar and champagne. Chances are many other departed executives didn't end up homeless and selling apples on the sidewalk. Of course, they suffered embarrassment and probably some loss of income. Their careers may have been sidetracked for a while. They may have to hold onto the leased Mercedes instead of upgrading to a Bentley. But peanut butter and crackers remain scarce in their diets.

Once upon a time, investment banks were partnerships (specifically, what lawyers would call general partnerships). Legally speaking, this meant each partner was liable to the full extent of his personal wealth for the firm's debts. If the firm had catastrophic financial results, a partner's coop apartment on Park Avenue was at risk. As were his Cadillac, art work, watches, china, savings, and investments. In other words, he could lose everything he had.

All of the partners were bound to pay the debts and liabilities that every other partner incurred on behalf of the firm. If a partner on the trading desk made some bad bets on bonds using margin and lost money, the partners in the mergers and acquisition department were at risk for payment of the margin debt. And if the partners in M&A gave some ill-conceived advice about the value of a deal, and wound up having to settle a class action lawsuit, the partners on the trading desk were at risk for paying the judgment in the class action lawsuit. All of the partners were bound by and bound to each other.

Consequently, the partnerships took risk management very seriously. When the fellow in the office next door can deprive you of your home, and you can deprive him of his, both of you will carefully evaluate the risks of your activities against the rewards. Downside risks concentrate the mind wonderfully, and partnerships concentrated on risk management.

Fast forward to 2007. All of the investments banks have become corporations. The ownership of corporations is embodied primarily in their common stock, which provides limited liability to shareholders. You can lose the amount of money you invest in the stock, but you can't lose more than that. The limited liability feature of corporations has allowed them to accumulate vast amounts of capital. It's the characteristic that, first and foremost, encourages investors to commit their capital to the corporation.

But investors hate to lose the money they've invested in the stock. Even if they won't lose their homes, cars and big-screen TVs, they still feel the pain of downside risk.

The top executives that run the major investment banks, however, are heavily insulated from the risks of doing a poor job. Compensation agreements provide golden and even platinum parachutes. Failure is punished by dumping shiploads of money on the poor performer. Executives are given the incentive to take excessive risk. How else will they make more money than by failing?

There is no possibility that the major investment banks can be reconstituted as partnerships. They're too big and far flung. Furthermore, they've lost the special culture of mutual trust blended with mutual scrutiny that successful partnerships have. Instead, their massive risk management failures present corporate governance problems of the first degree.

Management is the first line of defense in risk management. Management has failed. The Board of Directors are the next line of defense. By all appearances, they have failed, having placed too much reliance on management. Granted, CDOs and other asset-backed securities are complex. But it's the responsibility of the Board to supervise management, and, in particular, to prevent management from damaging the corporation. Directors should change executive incentives, so that management suffers real and painful financial losses if the company suffers losses. Heads I win, tails you lose executive compensation agreements reward taking excessive risk. If so-called top tier executive talent won't sign up without such protection, don't hire them. These executive compensation arrangements haven't been producing top tier financial results; try something different. Pass real risk of loss onto the CEO and concentrate his or her mind wonderfully.

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