Three Management Lessons From the Financial Crisis on Wall Street

In a series of unprecedented moves, the Federal Reserve stepped in as "lender of last resort" to save a financial system on the brink of disaster. Reuters news agency (September 19, 2008) called it an "extraordinary" rescue plan. First it was Bear Stearns, next were Fannie Mae and Freddie Mac, Lehman Brothers, Merrill Lynch, and AIG. Then, the Fed converted two investment banks, Goldman Sachs and Morgan Stanley, into conventional banks, a move that will significantly increase oversight and regulation of these institutions.

In a matter of months, with most of the damage occurring in a matter of days, the very foundation of the world's financial system had been shaken.

While there were many interesting details that chronicled the steps and missteps leading to this crisis, and while this saga will very likely change the face of banking (certainly investment banking) in the United States and probably the world, one interesting question that needs to be asked is how we got ourselves into this mess. Where we victims of "a pattern of dishonesty on the part of financial institutions, and incompetence on the part of policymakers" as suggested by George Stiglitz, Nobel prize-winning economist and Professor at Columbia University writing in the Guardian on September 16, 2008?

There is another interesting question that also needs to be asked. Are there lessons that all managers can take away from this extraordinary crisis?

Three lessons seem to be worth considering.

Managing in an Age of Complexity The first lesson is that we manage in an age of complexity. Software applications (ERP), as one example, can be very complex when independent modules function as an integrated system. Drug discovery (Vioxx), another example, can be complex when the easier breakthroughs have already been made. Even public works projects (Boston's Big Dig) can be complex when constrained by existing infrastructure and social issues.

Certainly, the crisis on Wall Street has taught us that the way in which our financial system has evolved over the last decade has added an unprecedented layer of complexity to an already complex system.

Consider the players and their recent behavior within this system. 1. Prospective home buyers, motivated by increasing home prices, applied for mortgages. 2. Mortgage brokers, motivated by earning commissions, were happy to oblige and write these mortgages, even when the ability of the borrowers to meet their monthly payments was uncertain. 3. The mortgages were then sold to mortgage consolidators who asked few questions as they bundled this debt into Collateralized Debt Obligations (CDOs). The objective of this bundling process was to spread the risk much like purchasing shares in a mutual fund , with its hundreds of stocks, spreads investment risk. 4. Then, the CDOs were sold as high yield investments to institutions such as banks, securities firms, and insurance companies. 5. AIG then insured the CDOs so institutions that held these instruments would be confident that their investment and income streams would be secure. Indeed this was a complex system, one built on trust (CDOs were unregulated), and one in which everyone prospered as long as the housing bubble continued to grow.

But it didn't.

Then, in August 2007, the bubble burst. Home values started to fall. Discovering that the equity in their homes was less than its value, many homeowners walked out the front door leaving the keys behind. Now, there were more homes on the market and prices continued to fall. Lower prices accelerated the process and the spiral continued.

With homeowners missing payments and eventually defaulting on their mortgages, the CDOs not only became less valuable but they also became difficult to value. What were they worth?

The CDOs were like black boxes, few could see inside, or cared to look inside. The home buyers who took out the mortgages in the first place were basically hidden from view. Transparency was gone. There were so many players - homeowners, mortgage companies, debt consolidators, insurance companies, and banks - that it was impossible to determine the quality of the debt.

Because the value of a CDO was so hard to determine, and because many banks and securities firms were either unaware of the financial risk or were in a state of denial, the value of the CDOs on the institution's balance sheet ... statements which summarize the financial health of a company ... was overstated.

Now, the ability of these institutions to borrow money, necessary in their day-to-day operations, was severely limited. Who would loan money to an institution whose balance sheet was not only overstated but whose investments in CDOs was impossible to value?

What had started as an opportunity for people to own their own home, turned into a bubble, which then brought down some of the most respected names on Wall Street, which later became a credit crisis. The complexity of the process contributed to the biggest crisis since 1929.

We Need Information not Data The second lesson is that managers need timely information to manage effectively. Raw data is of little value; in most cases what they do not need is volumes and volumes of data in rows and columns. What they do need is information, useful information in summary form that helps make sense of complex situations.

Under better circumstances it may have been possible for data to have moved upstream as part of the mortgage loan package and become part of the CDO package. Then, the institutions holding these CDOs may have had a better chance of monitoring the quality of the instruments on their balance sheet. However, even if this were the case, falling home prices and an increase in foreclosures would have continued to deteriorate the value of the CDOs.

But the data that could have been used to expose the fragile nature of these CDOs was stored in different locations or not available at all. In any event, it was not possible to bring them together. As a result, decision makers were forced to fly blind and almost every institution, certainly the ones that failed, carried the CDOs on their balance sheets at prices much higher than they were actually worth. Consequently investment banking firms like Lehman Brothers and Merrill Lynch were overvalued until reality reared its ugly head.

Would it have been possible for better and more up-to-date-information to have softened the blow? That's a difficult question to answer, but the absence of information and the uncertainty expressed time and time again about the vulnerability of the system and the inflated values of the CDOs on balance sheets, certainly suggests that the lack of information contributed to the crisis.

Denial can Bring Catastrophic Results The third lesson is that management cannot afford to be in a state of denial. In 2006, I attended a presentation at a New York investment bank and asked the senior economist at this firm for his views on an inflated housing market that some concluded was about to implode. He assured me ... supporting his argument with compelling data ... that this was an unlikely outcome.

A New York Times article by Joe Nocera on September 16, 2008, suggested that "most of the big firms have been a day late and a dollar short in admitting that their once triple-A rated mortgage-backed securities just weren't worth very much. And one by one, it is killing them." The article continued to explain that Mr. Fuld, the CEO of Lehman Brothers, went to the Korea Development Bank to ask for help in shoring up Lehman's balance sheet. It failed because Mr. Fuld demanded more for Lehman than the Koreans thought it was worth.

Denial was everywhere, from the homebuyers who felt they could afford a $600,000 house on a $75,000 income, to the mortgage originators who looked the other way, to the debt consolidators who put together the CDOs, to the banks who purchased the CDOs and kept them on their balance sheets at unrealistically high prices, and to the insurers who grossly miscalculated the risks they were taking.

Lessons Learned Complexity has increased in most industries, and in September 2008 we learned how important it is to understand the linkages that tie systems together in the financial industry. Organizations and their leaders ignore complexity at their own peril.

Information and its use to support management decision making at the strategic level is more important today than it has ever been. No one would fly a Boeing Dreamliner without information displays in the cockpit.

Denial is not a river in Egypt, it is a fatal error made by pseudo confident leaders.