Monday, November 24, 2008

The Financial Crisis I: It's the Governance, Stupid!

We are seeing the butterfly effect writ large: a family in suburban Pittsburgh can't pay their mortgage, so Iceland goes bankrupt. Or perhaps a better analogy is the 1970s PBS show Connections, where James Burke showed how new inventions are based on older ones (and we wouldn't have modern telecommunications if the Normans hadn't worn stirrups at the Battle of Hastings).

Much has been written about the failure of legislators and regulators, and in a subsequent post I'll be playing pundit and make fearless predictions about regulatory responses. But in this post, I want to look at the failure of governance.

All Risk, No Reward

The current recession/depression (call it what you will) came about largely because there were incentives to take huge risks with very little apparent downside.

People bought houses they wouldn't be able to afford when their mortgage interest rate reset because they were told that they would have no trouble refinancing at a more attractive rate when the time came.

Mortgages were packaged and resold to investors, including banks. Normally, this would be a prudent thing, as having a large portfolio of mortgages should mean that most of them are sound and the few that will fail won't have a material impact on the value of the portfolio. What happened was anything but prudent: Because the lenders no longer owned the mortgage (and the risk of default), they were encouraged to lend to everyone in sight, whether or not they were creditworthy. In a recent article in the New York Times, Gretchen Morgenson reports that a mortgage loan underwriter at Washington Mutual was put under intense pressure to approve loans she strongly believed should be turned down.

Companies made investments in complex derivatives. Again, this could be a prudent move, as derivatives can be used to offset risk. However, many companies used derivatives to increase their risk. Although they potentially had good returns, they also had a huge downside risk. In part this was due to the decoupling of compensation from performance and lack of effective board oversight. Executives got substantial bonuses even though the company's stock performed badly. In a worst-case scenario they would be fired and collect huge golden parachute severances.

The net result is a financial crisis that is engulfing companies with exemplary governance practices. The gut response is to take a very cautious attitude and attempt to eliminate all risk. This is neither desirable nor practical. Things will get worse if there is no credit for worthy borrowers. Derivatives, even complex ones, can be an important tool to mitigate risk if used properly.

What to Do? What to Do?

The problem for boards, and audit committees in particular, is how to tell if a financial product is being used properly. This can be daunting when the investment is so complex you need postdoctoral studies in mathematics to understand them. That doesn’t mean they should be necessarily avoided, but they must be carefully scrutinized.

That said, what is a poor audit committee member to do? My advice is simple: don’t be afraid to look stupid. Keep asking questions. It is not necessary that you fully understand the product, but you need to satisfy yourself that management does. Ask questions such as:

  • What is the maximum downside if everything that can possibly go wrong happens? Don’t accept an answer that a worst-case scenario will never happen. We’ve just seen that it does. If the worst-case scenario is insolvency, the product should either be avoided entirely or only a small investment made.

  • What other individual factors can affect performance? In other words, what is the total risk involved and is it justified by the return.

  • How is the risk being monitored? The more significant the risk, the more closely it must be managed. This may mean real-time risk management.

  • What are the market signals that will indicate a position should be unwound? How easily can that be done? What if there is no liquidity in the market at that time?
These are just a few of many questions. If answers are evasive or unclear, it may either indicate that management knows the position has more risk than the board will be comfortable with or that they don’t fully understand the risks themselves. To turn an old cliché on its head, in these cases it is far better to speak up and be thought stupid than to remain silent and remove all doubt when the company goes under.

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