Wall Street suffered its most torrid weekend in recent memory, witnessing the demise of two of its oldest and biggest investment banks?the stricken Lehman Brothers has finally filed for bankruptcy protection while Merrill Lynch has been bought over by Bank of America at half the price it was worth last year. As if this wasn?t enough of bad news, the insurance giant, AIG, is also looking for emergency funding of $40 billion or a possible suitor to stem a Lehman like collapse expected within a few days if neither of the rescue options works out.
The direct fallout is, of course, on employees and shareholders. Bank of America is unlikely to retain all of Merrill?s 60,000 employees while almost all of Lehman?s 25,000 employees can expect a lay-off once the process to liquidate the firm and its assets begins?America?s bankruptcy laws allow some breathing space for an orderly liquidation. A successful capitalist system must, of course, allow ?bad eggs? to exit the market.
So far, Lehman?s lucrative investment management arm is not part of the firm which has filed for bankruptcy. Still, an attempt by the firm to sell off this arm, and other profitable assets, in an attempt to reassure markets following record losses amounting to over $7 billion, including $3.9 billion in the last quarter, failed, as did attempts to arrange a sale of the whole firm to another bank?the Korean Development Bank, Barclays and Bank of America found the proposition too risky after extensive talks. The fact is that Lehman Brothers, like may other struggling Wall Street firms, has far too many ?toxic? mortgage-based securities in its portfolio which are basically of junk value after the collapse of the housing and mortgage market. The nationalisation of Fannie Mae and Freddie Mac just recently confirmed the extent of the subprime crisis and the impact it was going to have on financial companies, which were heavily invested in the mortgage market.
The problem with any crisis in the financial sector is that it?s, more often than not, highly contagious. Firms, of course, have complex dealing with one another?firms with extensive dealings with Lehman are likely to be in the line of fire next. The entire game is also one of confidence and once that erodes, the end is near. Lehman?s stock collapsed from $80 to $8 in a matter of weeks, precipitating a collapse. Other sell-offs are imminent as markets panic and rating agencies downgrade the debt of leading firms, making it harder for them to raise money. Obviously, shareholders of collapsing firms lose heavily?a nationalisation pays shareholders a pittance (Fannie and Freddie), a bankruptcy pays nothing (Lehman) and an emergency buyout gets them a much reduced price on their shares (Merrill). This includes CEOs, who lose heavily on stock options even though they do walk away with comfortable severance packages worth millions of dollars. It?s a vicious cycle to the bitter end.
The focus at the moment is obviously on finding a cure to stem any further collapses of institutions, and to prevent a complete collapse of the US financial system, which will have ripple effects into Europe and Asia. So, all the discussion and debate around nationalisation, buyouts, emergency funding and the like is obvious. However, in the longer term, the focus must shift to prevention?given the importance of any financial system to the economy as a whole, prevention is clearly better than the cure.
Any preventive strategy or policy must reduce the amount of excess risk that was being taken in the US financial system. The incentives of shareholders, employees and senior management seem bent towards extracting maximum short term profits, which require taking risk beyond what would normally be considered prudent or acceptable. Also, the expectation that a bailout will come if things turn sour creates a severe moral hazard problem. The strategy of lending to high-risk borrowers with patchy credit histories?but who pay higher interest rates (subprime borrowers)?was one such high risk strategy which yielded high returns when the housing market was booming, but quickly turned sour once the housing market collapsed. Banks have already lost some $300 billion on subprime mortgages.
There now needs to be a rethink on corporate pay with a greater emphasis on performance over longer time horizons, which enables a sharing of losses and profit?perhaps bonuses should be distributed over say a five year period; or at the time of leaving a firm; anything that would make managers turn away from an exclusively short term, maximum profit, excessive risk taking way of functioning. Stephen Green, Chairman of HSBC, unusually for an insider, supported such a change in an interview to the BBC over the weekend.
How will it happen though? The financial industry?at the level of top management?can get together and offer to self-regulate. However, since this will require bankers to cut their own pay, it may not quite work. The other obvious option is for government (or for a market regulator) to regulate the manner in which compensation is paid?they can introduce long termism without actually determining the exact amount of salaries, which may amount to too much interference. The last option, and perhaps the most workable, is for shareholders to clamp down on management and force them to make the necessary changes?this is in shareholder interest as they always lose if things go sour.
Obviously, there is no easy solution. But a crisis of this magnitude is often the best way to push for a major change. In India, of course, the financial system, particularly banks, are much more risk-averse. However, this will change as we liberalise our system. It may thus be appropriate for shareholders, managements and the government to begin thinking about the challenges and risks of a more liberal financial system?while the benefits will be enormous, we can ill-afford a US type of meltdown.
?dhiraj.nayyar@expressindia.com