There is no premium on stupidity and greed. Both are universal human traits we see the world over. Often in combination, they lie at the root of failure.
Earlier today I read a McKinsey ‘conversation starter’ which proposed a way for the frozen banking system to thaw and start lending again. The piece was novel in its thought process but failed to address the elephant in the room question: do the banks have to survive? Here’s the basis upon which McKinsey makes its argument:
So what needs to be done? The answer first requires a brief detour into Accounting 101, which will also explain why the market in bad loans has so far been moribund. At present, assets on bank balance sheets are valued in either of two ways: fair value or hold-to-maturity value. Where possible, fair value uses mark-to-market accounting; however, absent the ability to determine a real market price, a mark-to-model approach must be used. In hold-to-maturity accounting, so long as principal and interest get paid under the terms of the original loan agreement, assets remain on the balance sheet at their original value. Most securities are valued using fair-value accounting (unless they are treated as long-term investments). Most loans use hold-to-maturity valuations. To date, the lion’s share of the mark-downs absorbed by banks have been on securities and loans subject to fair-value accounting. However, more than 60 percent of the credit on the balance sheets of US banks uses hold-to-maturity accounting, and it is within these assets that the bulk of future losses will occur.
Now assume you want to create a market for such impaired assets. The problem with fair-value accounting is that in the absence of a real, active market to set prices, the only alternative is to mark to someone’s model. But whose? Since private investors are motivated to make money, they want to use conservative assumptions to value securities. That, in turn, gives banks little incentive to sell—and so most have not. Absent government coercion, such a standoff will probably continue. As for the even bigger amount of potential bad loans that banks now value under hold-to-maturity accounting, the problem is that while you can actuarially foresee, under various assumptions, that some percentage of a portfolio will go bad, you can’t know which specific loans will default or how much of the original loan value you will recover. That too is a recipe for inaction.
To break the logjam, we propose that the government step in and establish a voluntary program to create a real market price and terms for the sale of bad assets.
McKinsey believes that absent of action the total hit could be north of $1 trillion – a huge sum by anyone’s standards and almost impossible for the man in the street to comprehend. Using its proposed scheme, the hit is $300 billion, still a monster number. So far, no amount of money has been able to allay banker fears so why would an extra push fare any better.
The banks’ ‘wait and see’ intransigence in dealing with the problem cannot continue indefinitely. Predicated as it is on preservation for the benefit of shareholders at all costs, it does nothing to help anyone and least of all the businesses the banks are in business to help, the businesses upon which its lifeblood interest and fee earnings depend. Instead we see a lemming like, navel gazing approach that might as well say ‘shut for business.’
GE, the company many hold up as the model for a well run conglomerate has hit the skids. Its finance arm which accounted for more than half its profits in 2007 is in trouble. No-one is quite sure how deep the problem really is but right now, it’s share price is at a 17 year low.
Reuters looks at GE’s problems from a management perspective, asking why a company that has made so much of a virtue from training is in so much difficulty:
But as GE faces its worst crisis in decades, its managers seem suddenly bereft of good ideas, its deep bench seems less up to the task at hand and the mystique surrounding Crotonville has tarnished.
The harsh truth is that GE’s training may be great but the company is unable to turn on a dime, even under normal conditions. I once undertook a project for one of its small subsidiaries. It was painful. Contract negotiations which should have taken days dragged on. Getting a useful list of contacts was an ongoing nightmare. Agreeing content seemed fraught with nit picking detail. The net result was that we more or less added 50% to the project completion time. Looking back, the culprit was GE’s insistence on following process protocol, even when it was glaringly obvious that those processes were getting in the way. That may or may not be contributing to GE’s current woes.
More likely, GE is discovering what I’ve known for a long time: succession of brilliant leaders is not a given. You can train people all you like but following in the footsteps of people like Jack Welch takes a lot more than that. It is the folly of assuming that talent does not matter and that somehow leaders can be molded in a classroom. It’s not true.
Francine McKenna is debating the rights or wrongs of letting GM go to the wall. It’s an ongoing debate in the US where GM has become a source of national pride and reputation. The thinking Francine exposes is neither logical nor sane:
The economic condition of Detroit and Michigan in general is already horrible and keeping unhealthy, insolvent, illiquid companies like GM on life support just prolongs the agony and delays the acknowledgement that a completely new economic base must be developed.
When asked, I’ve said time and again that the US could do worse than look to what happened to the UK automotive and coal industries during the late 70′s and 80′s. Once a global powerhouse, automotive more or less vanished overnight. Appalling labour practices, massive inefficiency and zero innovation left a once great industry on its knees, begging government for hand outs.
Fortunately, the UK government was neither in the mood nor had the resource with which to help. The doom mongers forecast decades of economic blight and for sure, there was a period when millions were left wondering what to do. The same thing happened when the coal industry collapsed – essentially under the weight of politically intransigent labour leaders but ultimately assisted by Margaret Thatcher, the Iron Lady.
Argue all you like about the merits of keeping people employed in otherwise depressed areas but the economics of the British automotive and coal industries made no sense. Keeping them on indefinite life support was not a price worth paying.
Standing from afar, the solutions for US industry woes are simple. Let these industries and companies take their pain. If it means break up and restructuring then surely that beats attempting to maintain what are now seen as flawed models. In some cases greed has taken institutions to the brink. In other cases, it is pure folly. Right now, irrationality is winning in the face of the obvious. Now is the time to innovate but first you’ve got to let the past go. As Francine succinctly concludes:
Like a lot of other people in this current economy, the auto industry, its employees, and those dependent on it will have to shed false pride and concerns about their “image.” We all have to reinvent ourselves. It’s always better to undertake those reinvention projects on your own time rather than to be forced.
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