If any of you are fortunate enough to be friends with the chief executive officer (CEO) of a Wall Street bank, now may be a good time to get yourselves invited for a cup of coffee, enjoy the views from the top floor office, play a round of golf at the exclusive country club he (I am not being sexist here, they are all men) belongs to, take a trip on the corporate jet and whatever else may grab your fancy. The reason for the time-bound offer is that your friend will most likely be out of his job by Christmas this year.
Following close on the heels of the CEO of Merrill Lynch, Stan O’Neal, who was deposed last week, comes news that the head of Citigroup, Chuck Prince, will also leave his position this week. In both cases, the evisceration of executive ranks engendered by the incumbents has caused the appointment of interim heads – simply put, the boards of both banks don’t have a clue who to appoint as a replacement.
Inevitably, these dismissals (and please don’t insult anyone’s intelligence by calling them retirements or any such euphemism) would be highlighted as the failures of Anglo-Saxon capitalism, where overly grabby CEOs somehow get their just desserts in the middle of a night of long knives. In particular, I would expect some commentaries in Europe and Asia to focus on the relative superiority of their own systems against that of the Americans.
This is wrong. Much as the process of management changes in American banks can be considered rather too newsworthy, the fact of the matter is that it happens all the time. Any system is bound to the values of corporations, and its shareholders: therefore, the search for profits is bound to falter from time to time. With the US banks, sudden changes of CEOs are meant to signal new directions for the companies, often to less volatile or more profitable businesses.
Citigroup is an excellent example. It is a motley collection of businesses ranging from traditional retail banking in the US to significant emerging market businesses as well as a large investment bank. Using the value assigned to peers in different businesses – for example HSBC, Standard Chartered and others, analysts have predicted that the implied value of Citigroup’s investment bank is actually negative. In other words, selling or closing or trimming the investment bank will actually increase the share price of Citigroup.
What about diversification? Banks get into a number of businesses because they like to diversify the decline in one area with potential increases in other businesses. That is certainly a good reason to keep an investment bank within a commercial bank, but only so long as the management quality, risk controls and basic trading philosophy gels with the rest of the bank.
It is obvious that the quality of management at Citigroup, Merrill Lynch and other banks fell victim to the rapid expansion of the business, producing too many gaps between acceptable practice and business realities. The CEOs of these banks are ultimately responsible for risk management and ensuring that enough resources are devoted to control functions.
Unnatural losses mean, obviously, that the CEOs have to lose their jobs – the next chap in hopefully learns this lesson, and fixes the element of surprise. That means, in practice that they would insist on comprehensive write-offs that can be blamed on their predecessors, from which they can show progress in coming quarters. These write-offs, while scary, serve the function of keeping markets alive.
Putting things in perspective
The useful comparison, and contrast, here would be the Japanese banks whose failures in the 1990s were essentially hidden. Let us not forget here that what has ailed the share price of American banks is the fear of more write-offs on asset values, that could help wipe billions from shareholder value.
Last week, market reports of billions in further losses to be taken by a motley crew of American and European banks helped to drive share prices sharply lower on Thursday and Friday. When these assets are written down though, we will be left with financial values that are closer approximations of reality. This would in turn start the process of asset trading in earnest.
Take an example of a new community that consists of a large number of houses in some part of California. A company owns the project, and its revenues consist of rents from all tenants. Furthermore, because the company in question wants to develop other properties, it entered into a securitization agreement with a bank, which sold this package of bonds to investors across the world including the friendly Asian central bank that manages your currency. As a goodwill gesture, the investment bank holds some of these bonds on its own books.
Now, with house prices in free fall and vacancies rising sharply, there is a real chance that rents in this development will decline as well, in turn making the cash value of the bonds written on the project more volatile. In this case, the three sides to the transaction – the company on whose name the bond is issued, the investment bank, which arranged the transaction, and the investor who bought some of the bonds – have multiple options, none of which are too nice.
Option number 1: Anglo-Saxon
The investment bank in this case can go out on a limb (especially with its brand new CEO) and say that the value of its bonds, which were bought at 100, are now only 50. This means that the investors have to take similar hits on their portfolios, if their accountants are awake. If their accountants are asleep, of course the investor can pretend that the assets are still worth 100.
By marking the books at 50, the investment bank throws open the floor for trading. Now, the benchmark price is 50 – so the company owning the project can for example make some useful comparisons based on actual rent receipt and determines that the bonds are worth more than 50. It can therefore buy back the bonds from the investment bank or the investor. In case this loss is too much for the company, it would declare bankruptcy, and sell its assets, ie, the houses, cheaper to anyone interested, with the proceeds going to pay for the debt previously issued.
Meanwhile, the investor who has taken a 50% loss can decide that this is not a game they want to play, because none of the managers have been to California and what with all the wildfires, wouldn’t want to go there either – so they choose to sell their bonds at 50 and put the losses behind them.
With the price at 50, other investors who would not normally care for these assets would get into the picture, with a view to riding the wave to say, 70. Also, with the value of the asset at 50, they can also get loans from banks to fund the purchases. All that trading causes money to flow once again, and market equilibrium is restored. In time, new houses will be built in California, and new bonds be issued once again.
Option number 2: Japanese
Faced with a similar decline in property prices in the 1990s, Japanese banks chose the second option, namely do nothing. Thus, the banks continued to value the assets at 100, and this meant that there were no losses taken initially. Unfortunately though, this also created a logjam between the investors and companies owning the property, as the latter did not want to repurchase their obligations at 100, and investors had no reason to sell at below 100.
With income falling rapidly for these companies, the banks were forced to make new loans to get their interest payments on time (what was known as evergreening) to the companies, in turn making money unavailable for more deserving borrowers. At the economic level, this completely removed the effectiveness of the banking system, creating the specter of “zombies” – companies that were really dead, but were still walking around.
Investors in such companies knew well enough that they had suffered loan losses, but would wait till the last moment before recognizing these losses. That meant they wouldn’t have the ability or the willingness to buy any more assets, in effect shutting themselves from new investments.
This is why the Japanese banking system ground to a halt in the middle of the ’90s. Even today, these banks boast asset values that pale in significance to their market capitalization, because no investor believes that the assets are actually worth that much to any outsider. This “discount” also forces Japanese banks to avoid any global acquisitions, perpetuating their domestic focus.
Between the two options, the first is clearly preferable, as it keeps the market economy well lubricated and functional. This is the context in which to look at the exit of various CEOs – that the market has more opportunities in the weeks ahead, rather than a protracted period of non-activity. American shareholders have chosen well.