As of this writing (early 2012), credit default swaps have resurfaced as a factor in the sovereign debt crisis of Europe, and the potential spread of that crisis throughout the US and European banking sector. Some people never learn. . . .
Financial Culture and Corporate Governance During the Bubble
HAVING CONSIDERED THE investment banking industry’s behaviour, let us return to the question of how and why CEOs and boards of directors could have tolerated this, and in particular why they could have allowed it to destroy their own companies. In part, the same financial incentives operated for them, and made them indifferent to the fate of their firms, employees, and customers. In some other cases, however, destroying their firms was clearly contrary to their self-interest, at least to some extent. Why did they let it happen? For there is no question that to some extent, the senior management of some of the banks did indeed behave irrationally.
Here, we must leave pure economics and ponder the toxic effects of too much wealth, too much power, the new culture of American investment banking, and a life conducted within the cocoon of America’s new oligarchy. Let us consider, for example, Jimmy Cayne. For those who might find what follows just slightly difficult to believe, I invite you to Google a phrase along the lines of “Jimmy Cayne helicopter Plaza Hotel bridge golf megalomaniac marijuana.”
Jimmy Cayne became CEO of Bear Stearns in 1993, and assumed the additional role of chairman in 2001, remaining in both positions until he was finally forced out as CEO in January 2008, by which point it was too late to save the company.
Mr Cayne, who appears to have been very widely disliked, was not someone you were likely to feel comfortable telling that he was destroying his firm and the world economy. Former employees have told me a variety of stories. He would convene early morning meetings in the office, order a nice hot breakfast from a waiter, and consume it during the meeting, offering nothing to his subordinates, who waited for him to finish. He would invite someone into his office, make a show of taking out two cigars, light one up, and then put the other one in his pocket. He insulted subordinates in public, using extreme profanity. His predecessor as CEO of Bear Stearns, Ace Greenberg, described him as “a dope-smoking megalomaniac.”
But that’s his good side. As Bear Stearns’s profits and share price soared as a result of the bubble, Mr Cayne became a billionaire, and he went from being arguably obnoxious to being seriously disconnected. He routinely took three- and four-day weekends, as well as extended holidays. For his long weekends, he frequently commuted from Bear Stearns headquarters by helicopter to his New Jersey golf club, where he had permission to land his helicopter on the grounds, and where he kept a house. At Bear Stearns, he reserved a lift for his sole use. A serious bridge player, he paid two Italian professionals $500,000 per year to play with him. He travelled to many bridge tournaments and also spent a great deal of time playing bridge on his computer. Despite being a staunch Republican, he also reportedly smoked a lot of marijuana, with bridge partners, fellow hotel guests, and others frequently seeing and smelling it.
When the bubble started to implode in 2007 and Bear Stearns started to come under pressure, Mr Cayne was frequently AWOL at critical times. Even on weekdays, and even when his company was collapsing in 2007 and 2008, he never carried a phone or pager when he was playing golf or bridge. He travelled repeatedly to bridge tournaments during this period, sometimes remaining away from the office a week or more. He would not participate in conference calls or meetings if they conflicted with his bridge schedule.
Bear Stearns’s troubles started for real in mid-2007, with the collapse of two of its investment funds that had been heavily concentrated in properties. On Thursday, 14 June 2007, when Bear Stearns publicly reported its first worrisome financial results, Cayne was playing golf in New Jersey; he played the following day as well. One month later, on 17 July 2007, Bear Stearns told investors that the two property investment funds were now worthless. The next day, 18 July, Mr Cayne flew to Nashville, Tennessee, for a bridge tournament, joined by Bear Stearns’s head of fixed-income products, Allen Spector, and stayed there for most of the following ten days, playing bridge. Mr Cayne was in the office for only eleven days that month. Even when he participated in conference calls, he would sometimes drop off without warning.
This did not seem to disturb the board of directors. Indeed, the impetus for Cayne’s removal as CEO seems not to have been his performance, but the increasing publicity, particularly a Wall Street Journal article in November 2007 that described his golf and marijuana habits, and his being unreachable while indulging them. Even after being forced out as CEO in January 2008, Cayne remained chairman of the board. In early March 2008, about a week before his firm collapsed and was sold to JPMorgan Chase, Mr Cayne closed on his purchase of two adjoining apartments in the Plaza Hotel for $24 million. On 13 March, when Bear Stearns entered its final death spiral, he was in Detroit, Michigan, playing bridge again; he joined the board’s conference call late so that he could finish his game first.
On 10 May, two months after his firm’s collapse, Mr Cayne attended a party held at the Plaza for new residents. The party included caviar and cognac bars, as well as a buffet that replicated an exhibit from the Metropolitan Museum of New York entitled “The Age of Rembrandt”.
Mr Cayne did suffer, of course. He lost his job; but when Bear Stearns collapsed he was seventy-four years old, near retirement age anyway, and it seems likely that in his head, he had already been retired for quite some time. The value of his Bear Stearns stock declined from about $1 billion at its peak to a mere $65 million when JPMorgan Chase bought the shares. But Mr Cayne had thoughtfully taken out lots of cash over the previous years, so his estimated net worth remains about $600 million, probably sufficient to support his myriad habits. He still lives at the Plaza (at least when he’s in Manhattan—he has several other homes, including the one next to his golf club).
Certainly extreme, I hear you say, but could such behaviour possibly be common, much less representative?
Well, yes, actually.
So, yes, it is true that some of the destruction caused by the bubble and crisis cannot be attributed entirely to rational self-interest and fraud. But that doesn’t mean that the rest was caused by innocent, well-intentioned error. Rather, it was symptomatic of a culture, and a governance system, that was seriously out of control.
During the bubble, many Wall Street executives constructed surreal little universes around themselves. The essential components of these worlds were physical isolation via private environments off-limits to their employees (limousines, lifts, planes, helicopters, restaurants), sycophantic employees and servants both at work and at home, and a compliant, clueless board of directors. Often their worlds also included trophy wives, mistresses, prostitutes, and/or drugs. Leisure activities were divided generationally. Young traders and salesmen focused on nightclubs, strip clubs, parties, gambling, cocaine, and escorts; New York investment bankers certainly spend over $1 billion a year in nightclubs and strip clubs, much of it charged to their firms as reimbursable, and tax-deductible, business entertainment. The older generation of senior executives, most of them married, tend to favour golf, bridge, expensive restaurants, charity events, art auctions, country clubs, and Hamptons estates.
Jimmy Cayne wasn’t the only one with a private elevator and a taste for helicopter commuting; in fact he was comparatively reasonable. After complaints, he eventually agreed to reserve the lift for his private use only between 8 a.m. and 9 a.m. every day. Richard Fuld, Lehman’s CEO, had a different system. Whenever Fuld’s limousine approached Lehman headquarters, his chauffeur would call in; a specially programmed elevator would descend to the car park, held there by a guard until he arrived. Then the lift took Fuld straight to the thirty-first floor, with no stops, so he didn’t have to see any of his employees. Here’s how a former Lehman employee described it (part of this is in my film):
This man never appeared on the trading floor. We never saw
him. There was a joke on the trading desk. The H. G. Wells series, the Invisible Man . . . Now, a lot of CFOs are disconnected on the Street, but he had his own private elevator. He went out of his way to be disconnected.
Stan O’Neal at Merrill Lynch had a private lift too—namely, any lift that happened to be around when he arrived. A security guard would hold the next lift that appeared, preventing anyone else from entering and, if necessary, ordering others already in the elevator to leave.
Lehman and most of the other banks also had corporate art collections, which sometimes absorbed considerable executive energy. All of the banks maintained chefs for their elegant private dining rooms, usually several of them, with access strictly controlled for executives and guests of differing levels of seniority and wealth. I’ve eaten in a few of them (Morgan Stanley, JPMorgan Chase); they’re very nice.
Everyone had limousines and drivers, of course, but there were serious toys, too. When Lehman went bankrupt, it owned a helicopter and six corporate jets. Two of the jets were 767s, which normally seat over 150 people when used by airlines, and cost more than $150 million when purchased new. In addition, however, Joe Gregory, Lehman’s president (the number two position under Fuld, the CEO), had his own personal helicopter, in which he commuted daily to Lehman from his mansion in the Hamptons. (In bad weather, he sometimes used a seaplane.) Gregory had a household staff of twenty-nine people. Citigroup owned two jets, and tried to take delivery on a new $50 million plane after it had collapsed and been rescued by the US government.
Okay, so they had toys. But what were their financial incentives, how did their boards of directors compensate them, examine their conduct, reward and discipline them? Were others as bad as Bear Stearns and Jimmy Cayne?
Yes, they were. Professor Lucian Bebchuk of Harvard Law School examined the conduct of the most senior executives of Bear Stearns and Lehman Brothers in the years prior to their collapse. In both cases the top five employees had collectively taken out over $1 billion in cash (that is, a billion from each firm) in the several years immediately preceding the collapse. This does not suggest that these men (and all ten were men) had unlimited faith in the future of their firms, nor powerful incentives to avoid risk.
Or consider Stan O’Neal. He had been CEO of Merrill Lynch for four years by the end of 2006, and had pushed Merrill aggressively into subprime securities. In 2006 O’Neal’s take-home compensation was just over $36 million, of which $19 million was in cash. But this was not his total compensation. To avoid taxes, much of his compensation was deferred, to be paid upon retirement.
In 2006 Merrill Lynch had revenues of $33.8 billion and pretax earnings of $9.8 billion. In January 2007 Merrill paid its annual bonuses—just under $6 billion, of which one-third went to people involved in mortgage securities. Dow Kim, the head of Merrill’s fixed-income unit and therefore in charge of subprime securitizations, received $35 million. As late as the second quarter of 2007, ending 30 June, Merrill Lynch was still profitable, reporting earnings of $2.1 billion. But as with Bear Stearns, in the middle of 2007 the bubble started to deflate. In the very next quarter, the third quarter of 2007, Merrill reported a net loss of $2.6 billion caused by over $8 billion in losses on subprime loans and securities. Then the company went off a cliff. For the full year 2007, Merrill’s revenues declined by 67 percent and it lost $8.6 billion. It would subsequently lose much, much more, nearly all of it stemming from decisions made while O’Neal was CEO. So what was Stan O’Neal doing during the third quarter of 2007, when Merrill Lynch was falling apart?
He was playing a lot of golf. In the last six weeks of the third quarter, O’Neal played twenty rounds of golf, sometimes with his mobile phone switched off. Usually he played on weekends, but not always. Shortly afterwards, as Merrill’s condition drastically worsened, O’Neal made unauthorized overtures to other banks regarding a potential merger. This, finally, led Merrill Lynch’s board of directors to fire him.
Except they didn’t fire him. They allowed him to resign, thereby enabling him to collect an additional $161 million, representing deferred compensation and severance—$30 million in cash, $131 million in stock. Nor has Mr O’Neal been banished from the business world; after leaving Merrill, he was invited to join the board of directors of Alcoa, on which he now sits. In fact, he also sits on two committees of Alcoa’s board. Which ones? Audit and governance. Rewards for a job well done.
Finally, consider Robert Rubin. As Treasury secretary, Mr Rubin oversaw the elimination of the Glass-Steagall separation between investment banking and consumer banking. This change greatly benefited Citigroup; and shortly after leaving the Treasury, Mr Rubin became Citigroup’s vice chairman. At Citigroup, Rubin displayed moments of disconnection from both reality and ethical standards: In 2001, acting on Citigroup’s behalf, he had called his former colleague Peter Fisher at the Treasury Department, asking Fisher for help in preventing Enron’s credit rating from being downgraded, very shortly before Enron went bankrupt. (Citigroup was a major Enron creditor, and was later fined for helping Enron conceal its losses.)
During the bubble, Rubin pressed Citigroup to take on more risk, even after being warned of the increasing dangers and dishonesty of housing loans and mortgage-backed securities. He does not seem even to have been aware of his company’s financial structure and obligations. In his testimony before the FCIC, Rubin said that it was only post-crash that he learned about “liquidity puts”, the contract provisions by which Citigroup was obligated to repurchase CDOs if they lost money or couldn’t be sold. These agreements with the structured investment vehicles (that Citigroup itself had created) added over $1 trillion to Citigroup’s real balance sheet, and caused billions of dollars in losses during the crisis. It’s too bad that Rubin didn’t read the footnotes in his own company’s financial statements, for he might have noticed the puts and raised an alarm.31
After a decade at Citigroup, during which he was paid over $120 million, Rubin resigned under pressure in January 2009. But this does not seem to have interfered with him much. He remains cochairman of the Council on Foreign Relations; is still a member of the Harvard Corporation, the small group that is effectively Harvard’s board of directors; and both he and his son were active in the Obama transition team, helping to select a new batch of policymakers. (Who turned out mostly to be the old batch, recycled; but we’ll get to that later.)
Unquestionably, none of these men made a deliberate decision to destroy their firms. But, equally unquestionably, personal incentives and personal risk focus the mind in a way that golf and bridge generally don’t. These people had way too much money outside of their companies to care as much as they should have about what was going on inside them. But the psychological atmospherics were just as important as the direct incentives. They became corporate royalty, with all the absurd arrogance, disconnection from reality, ego poisoning, and cults of personality thereby implied.
However, there were others—most famously, Goldman Sachs—who didn’t allow the temptations of helicopter golf to cloud their thinking. These very disciplined people therefore made money not only from the bubble, but also from the collapse. We will now consider them, and the implications of their behaviour for financial stability, in looking at the warnings, the end of the bubble, the crisis, its impact, and government responses to it. It is not a pretty, or reassuring, picture.
CHAPTER 5
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ALL FALL DOWN: WARNINGS, PREDATORS, CRISES, RESPONSES
SOME NOTICED THE BUBBLE quite early. In 2002 a prominent hedge fund manager, William Ackman, discovered that one of the largest bond insurers, MBIA, was actually a house of cards. It had a AAA credit rating (naturally), but was leveraged at over eighty to one, had started to write insurance on risky mortgages, and used questionable accounting methods. Ackman bought CDSs on MBIA, later adding bets against the other major bond insurer, Ambac, as well. Ackman then started an aggressive public campaign to discredit MBIA via meetings with the rating agencies, the media, and
the SEC. The rating agencies ignored him, of course. The SEC then spoke with MBIA, which responded that Ackman was spreading false rumours. In fact, MBIA persuaded the SEC to investigate Ackman, who, in the end, turned out to be completely right. (After several years losing money while waiting for the bubble to burst, Ackman finally made serious money from his bet.)
In 2004 Robert Gnaizda, a housing and financial policy analyst who ran the Greenlining Institute, a housing NGO, began warning Alan Greenspan personally. Gnaizda, who met with Greenspan and the Federal Reserve Board once or twice a year, had noticed the proliferation of toxic, highly deceptive mortgages. He provided examples, and urged Greenspan to finally use his power under the HOEPA legislation to rein in mortgage lending. Greenspan wasn’t interested.
But the first truly serious, public warning of systemic danger came in 2005, at the Federal Reserve’s conference in the resort of Jackson Hole, Wyoming, where the world’s most prominent central bankers and economists gather annually. The 2005 conference was Alan Greenspan’s last one as chairman of the Federal Reserve, and everyone was supposed to admire and celebrate his brilliant record. But Raghuram Rajan, then the chief economist of the International Monetary Fund, rained on the parade by delivering a brilliant, prescient, scary paper.1 The audience included Alan Greenspan, Ben Bernanke, Tim Geithner, Larry Summers, and most of the Federal Reserve Board.
Inside Job Page 13