Introduction (a slight bit of revisionist history is ok now and then...)
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1492: The Italian explorer sailed his three ships from island to island, staking claims for the Spanish King and Queen throughout the calm, crystal blue waters of what would later be called the Carribean Sea. His three ships navigated the placid sea for months, and the Italian and his men explored islands we now call Cuba, Puerto Rico, and Jamaica, among many others. March, April, May, June, July, August, and September passed. The weather was perfect. The sea was calm. These were the best sailing waters in the world proclaimed the Italian. He had "discovered" paradise.
Then, in early October, a mild storm came and went. After so many months of perfect weather, some of the crew were uneasy about the sudden turn in the weather. Perhaps this was a bad omen? "Nonsense." Days later, another storm, noticeably stronger than the first. Aberrations, the Italian insisted. Even in the calmest sea there must be an occasional storm. Many of the men, now convinced that their run of good luck was over, urged the Italian to safely anchor the three great ships in one of the many naturally protected harbors on the islands the men had explored. The Italian was stubborn. He refused to listen. He had already compiled an enormous treasure - more gold than he had ever imagined, and he was not about to interrupt his accumulation of treasure because his men were worried about some wind and rain.
Then came a storm unlike any the explorer or his crew had ever witnessed. It sunk one of the three ships, nearly destroyed the other two. Many men drowned. Nearly all of the gold was lost. The Italian was ashamed. He had ignored the warnings of the crew. Now all was lost. All of those months of calm seas - the calmest seas the explorer had ever encountered.
He had seen bad storms in his life. He had seen men die at sea, ships sink, and treasures lost. But it he had rarely seen even a cloud for months and months. Terrible storms had not happened here. Therefore they could not happen here (though he really did not believe his own words).
Although he had sailed the Caribbean for nearly a year, this was his first October. Each October, the hurricanes came to the calm waters. It was a lesson he could have learned from the safety of a protected harbor - had he not been blinded by greed.
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Your turn to play CEO
As an attorney, I'll be the first to admit that hindsight is 20-20. However, this post (in which I am asking you to imagine that it is December 2006) has nothing whatsoever to do with hindsight. On the contrary, I want you to pretend that you are winding down the year 2006 as Chief Executive Officer of a major Wall Street investment bank. There is something you know at that time (hence no hindsight issue) - something quite important. And you've known it for at least ten years, maybe even two decades.
Financial Panics
Here is what you know Mr. or Ms. CEO - financial panics have become a fact of life on Wall Street. The frequency of market bubbles and bursts has increased exponentially during your tenure at or near the pinnacle of your profession. There were exactly zero true market panics between 1929 and Black Monday 1987. However, through December 2006, you've lived through at least six "market panics" in twenty years, including 5 in the preceding decade alone (in 1987, 1996, 1997, two or more in 1998, and 2000).
Maybe not so coincidentally, almost all of Wall Street's investment banks went from private partnership to public corporation during the 1980's, right before the new panic era. Perhaps Wall Street was just a bit less cautious with its money once the risk of loss shifted from the partners to public shareholders. What do you think, Mr. or Madame CEO?
Anyway, all of these panics were unexpected to one degree or another (whether in terms of timing, intensity, or even crises that were completely unforeseen). Each of these panics sent intense shockwaves cascading through markets, sometimes infecting market sectors that were unrelated to the genesis of the panic itself (through the ugly tentacles of "contagion").
Since you are (for purposes of our exercise) the leader of one of the most important financial institutions in the entire world, you really can't credibly deny that you understand some seriously important concepts from the six major panics that seized markets starting on Black Monday 1987.
Having been in the thick of the action and privy to lessons learned in the aftermath of these crises, you would have had to have been incompetent for years to miss out on the following wisdom: Panic in the financial sense means pretty much what panic means in every other sense. Some event (it could be a major occurrence or a series of smaller tremors that eventually build to a critical mass), triggers a crisis of confidence in a given sector of the world economy (perhaps doubts about a booming U.S. housing market?). Once a crisis of confidence is triggered, animal instinct - herd mentality - takes over and truly frightened human beings (investors and investment professionals) stampede in a bloody fight for self-preservation. A run on financial markets ensues, feeding on itself in a vicious cycle until hearts stop thumping, collective blood pressure levels out, and panic begins to subside.
You also know - based on your experiences with recent panics - thatalthough the timing of triggering events, and even the severity of panics themselves, may have been unforeseen, the strong probability of similar events occurring again - especially during economic "booms" - is entirely foreseeable. You also know that it is only a matter of time until a company that surfs the biggest wave, wipes out and drowns.
Something is going to happen to derail the gravy train eventually. You know this. After all, you run a major investment bank. Since 1987, you know you can only to limit the downside to your company from the next crash is live by one guiding precept - Expect the Unexpected. Translation - Fail to truly stress the importance of effective risk management at your peril.
The more experience you gained with panics, you realized, the more you knew you should not play games with trying to predict when the next one might come. You only knew that it would come. Therefore, the only protection against disaster - the only true hedge - was to keep an even keel. You had to manage risk prudently, avoid temptation of easy money, resist the pull of greed. Even the most prudent risk management, of course, can fail. But easing up on the reigns of risk management could be truly deadly to any company at any time. This was the lesson you learned from the panics you lived through. But you ignored it anyway.
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PART TWO: Wall Street CEO Do's and don'ts (since your are the CEO, feel free to disagree)
- Do Prepare for the next crash that you know is all but inevitable by making sure your company manages risk sufficiently to limit potential down-side exposure.
- Don't recklessly manage your publicly-held company for excessive short-term profits at the expense of long-term stability.
- Do concede that it doesn't do shareholders any good to have your stock shoot to the moon if it crashes back to earth (except for the lucky ones who sold out at lunar levels).
- Don't tie the fortunes of your company to hard to price mortgage-related products that depend on a dangerous and grossly negligent assumption that the U.S. housing market cannot collapse.
- Don't let a loss of confidence in your firm by creditors (for whatever reason, rational or irrational) kill you because your company is leveraging its balance sheet at an obscene level of 33 times equity.
- Don't be so irresponsible that you focus on squeezing every penny of profit from the mortgage securities boom today and neglect the potential ramifications of your business strategy for tomorrow.
By Brett D. Sherman
Let me put this whole Columbus thing in a more actualized form for you.
The regulators did not want Columbus to find a new continent, “horror!”, “too risky!”, the regulators wanted Columbus to find a “safe haven” and paid out a lot of absurd low capital requirements to the banks who could find a haven deemed AAA by some few safe-haven rating agencies.
And somehow, as normally happens with human fallible rating agencies, someone tricked them into awarding the wrong five stars, and the world suffered the most horrendous indigestion.
Posted by: Per Kurowski | 19 February 2010 at 07:09 AM