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.
(Copyright
2007 Asia Times Online Ltd. All rights reserved.
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