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29 Mar 2024 20:59
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  •   Home > News > Business > Features > The Investor

    Why do Financial Firms take Too Much Risk?

    That’s a question posed by US economist John Makin following the massive write down on sub-prime investments by such global luminaries as Citigroup, Merrill Lynch and Morgan Stanley.


    Investment Research Group
    Investment Research Group
    By "too much risk," he means actions undertaken by managers of financial firms that result in substantial losses for the shareholders of such firms.

    Such losses can lead to ‘systemic risks’ which can force regulators and policymakers to choose between either reinforcing (with bailouts) the investing that created the problem or allowing substantial damage to depositors and shareholders in financial firms, and possibly to the economy as a whole.

    Firstly, there is the principal/agent problem. This is where interests of managers of financial intermediaries diverge from those of their shareholders, as has been clearly illustrated by the widely publicised problems of companies mentioned above.

    Substantial errors in initially reported third-quarter earnings, when revealed, resulted in the "resignation" of the CEOs of two institutions. For those who review these sad cases, it is tempting, but untrue, to say that financial firms take too much risk because they are managed by foolish people, he says.

    The temptation arises from revelations in October and early November that both Citigroup and Merrill Lynch, to mention just the most glaring recent examples, had to revise third-quarter earnings reports downward by billions of dollars only days or weeks after initial results were first reported.

    The revisions were so large that the stock prices of both institutions fell sharply while financial sector stocks retreated broadly. Consequently, the CEOs of both institutions were forced to step down.

    The terms of departure for both CEOs, especially Stan O'Neal's, undercut the charge of management stupidity while reinforcing the notion that both leaders had taken on too much risk for their firms.

    While investors in Merrill Lynch could check a website that records the scores of serious golfers and learn that Stan O'Neal played twenty rounds of golf between August 12 and 30 September, 2007 - as the first phase of the credit crisis was raging - they could also observe his US$48m bonus in 2006, which made him the second-highest paid CEO on Wall Street, together with his exit package estimated at $150m, and conclude that this man was no idiot.

    He had negotiated a compensation package that paid him a total of more than $50m in 2006 to take extraordinary risks and then paid him again in 2007 even when those risks resulted in billions of dollars of losses for Merrill Lynch shareholders.

    "O'Neal demonstrated that being a good golfer was more important to getting ahead at Merrill Lynch than doing anything about risk management, and Merrill's board of directors apparently agreed by awarding him a compensation package that paid off handsomely whether the risks turned out to be justified or not."

    Makin believes the major problem for the financial sector is that trillions of dollars of subprime mortgages were created on the assumption that home prices do not fall persistently. Now they are falling at a 5% annual rate.

    Also, the drop in home prices looks likely to accelerate -- probably to a negative 10% year-over-year rate or more -- meaning that further write-downs on mortgage-based assets are inevitable.

    Readers might want to take note of the cockroach theory. This holds that problems are revealed in stages-you first see only one cockroach, but the rest are hiding. This is a tactic of those responsible for the problems to ease in the bad news and not cause too much damage to their companies before they have learned how to deal with the problems.
    The cockroaches are coming out of hiding now.

    © 2024 David McEwen, NZCity

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