In an Uncertain World

by Robert Rubin

  By the end of the long bull market, America was living through an explosion of amateur investing unlike any the world has ever known, except perhaps in the late 1920s. Twenty-four-hour business news channels such as CNBC and CNNfn began providing the background hum in airports, restaurants, and gyms. Securities analysts, once the least glamorous toilers on Wall Street, became well-paid celebrities. People with no background or training were quitting their jobs and setting up shop as day traders. All of this tremendously accelerated the emphasis on the short term.

  Of course, the focus on quarterly earnings is not purely a pernicious development, but has both positive and negative consequences. In the mid-1980s, I talked about this with Mark Winkelman, my partner at Goldman, who ran our foreign exchange and commodities activities. “You know, the terrible weakness of our system is that it’s so short-term focused,” I said.

  Mark didn’t agree with me, because he felt that a short-term focus forced companies to face problems. With ideal corporate managers, a focus only on the long term would be optimal. But human nature being what it is, managers can use the long term as an excuse for not addressing problems. “Look at Japan,” Mark said. “They have patient capital and a long-term focus. And the result is they don’t face their problems.” At that point, many people thought Japan had developed an economic model superior to our own. I’ve come to appreciate that Mark was at least partly right. People who aren’t held accountable in the short term often won’t make tough decisions and use the long term as their excuse. They say, “We’re investing in the future.”

  But as time went on, the short-term focus became greater and the balance got out of proportion. Focus on the short term caused corporate decision makers not only to face problems—which was good—but also to give too little weight to the long term. When I left Washington in 1999, I was astonished at how much greater the short-term focus had become during the bull market. Commentators on the business news channels virtually never spoke about the five-year prospects of companies or had serious discussions of valuation. They talked instead about the short-term direction of the stock and quarterly earnings—or, with dot-coms, revenue growth, “eyeballs,” and visions of days to come. Today, an analyst who forecasts the five-year prospects for Ford Motor Company will probably never make a living. His customers want to know what the next quarter’s going to be like. Virtually every time a company misses expectations about quarterly earnings, by even a penny or so, the stock goes down in knee-jerk reaction, rather than the “missed quarter” being analyzed to see whether that miss had any ramifications for the longer term. As an illustration of how distorted the system has become, any technology purchasing manager for a big company will tell you that the best time to buy a high-tech service is in the last week before the end of the quarter, when technology companies are desperate to find income they can recognize in time to boost their quarterly earnings.

  I remember one lunchtime conversation I had with the CEO of a well-known industrial company. He said, with great frustration, that the market’s short-term focus made it impossible for him to adequately implement an exciting long-term strategy his company had developed. To make the point, he described how he had just met with a major institutional investor and had set forth his company’s long-term strategy. “To accomplish this long-term purpose, we need to invest now,” he had said, “and we’ll have these wonderful benefits down the road.” And the institution’s response had been: “We don’t want you investing for the future. Not because we disagree with you about the long-term benefits, but because we’re not going to be there for the long-term. What we care about is your next quarter.”

  When I got to Citigroup and began working at a public company for the first time in my life, the realities of this problem were driven home to me. My initial reaction was that Sandy Weill was focused on quarterly results in a way that might not maximize our income over time. But I’ve come to recognize that Sandy’s near-term drive exemplified what’s sensible about the Mark Winkelman point—and is one of Sandy’s great strengths as a manager. Sandy’s view is that you have to keep on top of people ferociously with respect to the current quarter for two reasons. The first is that people are forced to face issues they might otherwise defer. The second is that the short-term stock price does matter. A quarterly numbers disappointment generally drives a stock down. And the lower stock price hurts morale, reduces your ability to make acquisitions, and makes it harder to retain key employees who have been given stock options or shares that become theirs only after they’ve been with the company for a specified period. In fact, stock options themselves have been greatly criticized for exacerbating the problem of excessive short-term focus. But properly used, they can serve a useful purpose in giving employees a long-term ownership stake in the company.

  But to the extent that companies place undue weight on short-term performance, corporate earnings may be suboptimal over the long term and our economy as a whole may fail to realize its full potential. Given the realities of life, companies may rightly feel that the right balance is more toward the short term than is needed to accomplish the purposes Mark Winkelman identified. The thus far unanswered policy challenge is what, if anything, can be done to create an environment where investors—and, by extension, companies—shift their focus more toward the longer term.

  ONE FACTOR IN the changing public attitudes toward the stock market was the wave of corporate scandal that overtook markets beginning in late 2001. After companies including Enron, WorldCom, and Tyco, once touted as models of the new economy, collapsed in recriminations, investigations, and prosecutions, the idealization of corporate America gave way to a sense of mistrust. Citigroup was enmeshed in this because it was involved in lending, structured finance, or other transactions with many of these companies, which were among the largest in the country. In addition, Citigroup owned Salomon Smith Barney, one of Wall Street’s major investment banking firms. And while the specific circumstances differed from place to place, all of the major firms were engaged in activities that, while clearly troubling in retrospect, were common to the whole industry. Practices such as allocating desirable IPO shares to favored customers and not clearly separating stock research from investment banking were well known to the regulators and the media, but they had seldom been seen as problematic until the great bull market came apart.

  Once people focused on these practices, it was obvious that they, as well as issues around accounting and corporate governance, needed to be addressed. Citigroup did that by making some fundamental changes in the way it did business, and it settled with its regulators on Wall Street research issues as well as Enron-structured finance transactions, though private civil litigation relating to these matters is likely to continue for some time. The other major Wall Street firms went through a similar process and all adopted roughly the same new standards and practices. There were also important and useful legislative responses, such as the Sarbanes-Oxley Act of 2002, as well as new regulations from the federal agencies—though all of this is not without cost in terms of increased process and paperwork.

  But a broader question remains—one that, if understood, may help to minimize the incidence of future problems. Why didn’t regulators, legislators, and industry participants—myself included—recognize and act upon these issues much sooner? Why didn’t more members of the media, who in writing about some of the accomplishments of star research analysts sometimes cited their success in developing investment banking business, focus on the issue of conflict of interest? How was it that the gatekeepers—the accountants and lawyers—did not recognize and act on these matters? Perhaps the answer is that the great bull market masked many sins, or created powerful incentives not to dwell on problems when all seemed to be going so well—a natural human inclination. Also, I do think most people assumed that, even with the conflicts, research analysts—and, in the context of another set of issues, accountants—wouldn’t intentionally mislead investors, and I think that was true in the great prep
onderance of cases.

  The key to successful reform—with both corporate governance issues and Wall Street practices—was to make sure legislative and regulatory responses effectively addressed the problems without undermining the efficiency of our capital market system or the many strengths of our corporate government system. One cautionary note is that many worry that what has been done has had unintended effects on corporate decision making. Jack Welch put it well at a small dinner we attended together in 2003. He said that the only topic CEOs used to want to talk about was growth. Now all they wanted to talk about was corporate governance. In a climate where in hindsight honest mistakes or risk-taking decisions that turn out badly are confused with dishonesty, managers can become far less willing to take a chance of failure. While clearly there was a need for additional protections, the key going forward is to make sure reforms are implemented in a way that preserves the strengths of our system.

  THE ENRON STORY also had an unexpected side effect for me. In November 2001, when Enron was already in very serious financial trouble, the company was seeking to merge with Dynegy, another energy-trading firm. Citigroup was a creditor of Enron and would ultimately recognize losses on that position. Enron’s well-being also raised a substantial public policy issue for the country—a concern, widely reported in the press, that the company’s possible bankruptcy could seriously disrupt energy markets in the United States because Enron was the central trading hub in a number of those markets. Although those feared consequences ultimately didn’t materialize, at the time they resembled the concerns about the collapse of Long-Term Capital Management, which had led to intervention by the New York Fed in 1998.

  In Enron’s case, creditors were concerned that if the credit rating agencies downgraded Enron’s debt, counterparties would no longer be willing to engage in trades or long-term contracts with Enron. That would almost surely doom a Dynegy merger and lead to Enron’s collapse since, at this point, without the financial support of Dynegy, Enron could no longer remain a viable trading company. Enron’s creditors would certainly suffer if it went bankrupt, but many feared that the economy as a whole could take a significant hit as well.

  Several banks that were Enron creditors agreed that they might be willing to put up more money to support Enron in order to maintain its credit ratings and the strength necessary to keep trading, thus allowing the Dynegy merger to go through. There was, however, a substantial concern that the ratings agencies would downgrade Enron before the rescue package could be put in place, and a corresponding view that with just a few more days, a package might well be assembled. In that context, I placed a call to Peter Fisher, a senior official at the Treasury Department, whom I had known when he was at the Federal Reserve Bank of New York. I asked Peter whether he thought it would make sense for him or someone else at Treasury to place a call to the rating agencies and suggest briefly holding off on any downgrade of Enron’s debt while the banks considered putting in more money. I prefaced our conversation by saying that my suggestion was “probably a bad idea,” but that I wanted to see what he thought. As it happened, Peter thought it would be a mistake for Treasury to intervene in this manner, and that was the end of it.

  I was, however, subjected to a good deal of subsequent scrutiny about my call to Peter. Of course, in the wake of Enron’s implosion and the stunning revelations of fraud and misconduct that followed, it became obvious that the company couldn’t have been salvaged. I can see why that call might be questioned, but I would make it again, under those circumstances and knowing what I knew at the time. There was an important public policy concern about the energy markets—not just a parochial concern about Citigroup’s exposure—and I felt that if a modest intervention by Treasury could potentially make the difference in avoiding a significant economic shock for the country it was worth raising the idea with an official there.

  I was guided in this thinking by the knowledge that I would have wanted to hear suggestions of that kind when I was at Treasury, and knowing that I would have been entirely comfortable rejecting them if I thought they didn’t make sense for the country. I believed that Peter Fisher would have a similar mind-set—interested in hearing ideas that might conceivably be helpful, but unabashed about turning such ideas down if he thought that was the right course. And that is exactly what Peter did.

  A subsequent bipartisan congressional staff review of my call to Peter concluded that nothing improper had transpired. By that time, however, the call had become fodder for a personal attack against me, not because of anything related to the call itself, but because of my role in the ongoing debate about economic policy and because I’d come to personify the policies of the Clinton era. At that time, the economy was still very weak and commentators were increasingly comparing President Bush’s economic stewardship unfavorably to President Clinton’s. I wrote a lengthy op-ed piece in the Sunday Washington Post about how to rebuild economic confidence, which expressed great concern about tax cuts that undermined long-term fiscal discipline. My engagement in the economic debate seemed to infuriate some tax-cut proponents, who then seized upon the Peter Fisher call and everything else they could think of to attack me. (“You’re a mouse and they think you’re a gorilla,” Bob Strauss pointed out.) The nature of the attack became clear when the Republican National Committee e-mailed hundreds of journalists an inflammatory “opposition research” memo that dredged up long-discredited accusations that I misled Congress during the debt-limit crisis in 1995 and made various unwarranted assertions about Enron. A Republican congressman went on CNN and made the connection explicit: he said my call to Peter Fisher was fair game for attack because I had chosen to criticize the administration’s economic policies.

  After my years in government, I suppose I shouldn’t have been surprised about being the object of ad hominem attacks when I challenged the opposition on policy issues. But I still think that this approach to policy differences and to politics does a deep disservice to the vigorous exchange of views so essential to our democratic political system.

  ANYONE WHO PARTICIPATES in financial markets—whether as an individual investor, a Wall Street bond trader, or a company CEO—has to make fundamental decisions about risk. At an individual level, such choices affect one’s financial well-being and peace of mind. At the corporate level, they affect profitability levels. And at the broadest collective level, decisions about risk have potentially enormous economic consequences. In a world of immense global trading markets, the success of institutions, the liquidity and efficiency of markets, and the safety of our financial system depend to a great extent on how well the complex process of risk determination is carried out by the vast numbers of participants—individuals and businesses—involved in the financial markets.

  Many people arrive at accepting some level of market or trading risk through instinct, aversion, or feel. My approach, by contrast, has always been to try to make risk decisions on an analytic basis—even if they involve judgments about such intangibles as how much one can handle emotionally and the less-than-rational actions of others in the markets.

  In making any decision about risk, the logical first step is to try to determine at what point additional risk no longer carries potential rewards that exceed the potential losses, given the respective probabilities of the good and the bad. The actual measurement of these probabilities, of course, is immensely complicated. But this calculation, which can be organized on an expected-value table, remains the most fundamental basis for decisions about risk.

  However, the problem quickly grows more complicated. As an illustration, consider the choice a major financial institution such as Citigroup faces in choosing an optimal level of trading risk—that is, the level of risk incurred by the firm’s own traders trying to maximize return on some portion of the firm’s own capital. That is a far more complex question than it might seem to be at first, with many dimensions that can’t be quantified on an expected-value table.

  To begin with, a public company such as Citi
group is very different from the private firm Goldman Sachs was when I was there. A public company’s stock price is a function of its earnings and the multiple the market decides to put on those earnings. And financial markets value stable earnings growth more highly than a volatile earnings path, even if the total profits at some projected end point are the same. So a public company has to determine both what will maximize its earnings over time—adjusting that calculation for risk—and also the effect of greater volatility on the multiple. Only after making these judgments can one make an educated guess about what level of risk will maximize a company’s share price over time.

  At a large financial company today, none of this is easy. In part, the difficulty arises because of the immense size and complexity of a firm’s positions, which typically include stocks, bonds, derivatives, and currencies. In part, it arises because of the intrinsic difficulty of deciding which risks correlate with one another and which are likely to offset one another. And in part, it is due to the inherent uncertainty in trying to estimate rewards, risks, and probabilities. It is also extremely difficult to get managers to be ruthlessly analytic and to put their emotions and opinions aside.