By Brett Sherman, The Sherman Law Firm
Role of Risk Managers Clashed with Interests of Executives. The Result was disaster for shareholders of Citigroup, Lehman, Bear Stearns, Merrill Lynch, Goldman Sachs and others.
As a general rule, we tend to ignore the lessons of our financial past whenever the markets are humming and money is flowing. Risk managers are paid to disregard that general rule.
While the rest of us enjoy a bull market, risk managers must be corporate police officers. A vital part of risk management function is to prevent a business strategy that produces huge profits for a company during a bull market from crippling the company when a market cycle ends. During a boom, risk managers are unpopular. Hardly anyone wants to hear that a sizzling market will eventually burn out.
The unfortunate reality, however, is that market bubbles have always popped. Not only do economic boom cycles fizzle sooner or later (often abrubtly), but it is nearly always impossible to predict why or when the end will come. Perhaps one day a permanent bull market will take hold. Unfortunately, no matter how strong or long lasting a market cycle is, we can never know for sure that disaster isn't lurking around the bend. Therefore, corporate risk managers must manage risk by devising strategies to mitigate potential negative consequences in the event of a market downturn.
Consider the last market bubble, the tech-wreck. Remember how many individuals within finance and in the general public were convinced that we were in a new age of prosperity, a "new economy" in which the old rules of Wall Street no longer applied? Remember all the "paper millionaires"? Remember Dow 36,000? Remember how it all ended? Of course you do. And so do Wall Street CEO's (and former Wall Street CEO's) and risk managers.
The tech-wreck is a textbook example of a market bubble. So don't believe Wall Street investment banks when they tell you that they didn't think the housing boom would eventually end like the tech-wreck and so many other market bubbles.
Within a few short years of the tech-wreck came the housing boom and related booms in mortgages, mortgage related securities, and various derivatives. In an admitted oversimplification, Wall Street firms like Merrill Lynch, Lehman Brothers, Bear Stearns, and Citigroup gambled their futures on the housing boom. Wall Street invested heavily in mortgage securities and related products, accumulating large inventories for their own proprietary portfolios. At the same time, these investment banks highly leveraged their balance sheets, leaving them exposed to high loss potential when the bubble in home prices popped.
Wall Street firms reported record profits during the housing boom. High annual profits meant high annual incentive-based compensation for senior Wall Street executives. Therefore, the risk management function (protecting investment banks from the risks of business models that could lead to the kind of corporate implosions that will forever mark 2008) was at odds with the interests of senior Wall Street executives, who made more money by maximizing short-term returns. Guess who won that battle?
As someone once said, the brightest stars burn out the fastest. With effective risk management, Wall Street profits may not have reached the stratosphere during the housing boom, but investment banks like Bear Stearns and Lehman Brothers still could have been profitable and lived to make more money another day.
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