Why are some banks failing, and others aren't?
I have an intuition that some of the reason that some banks/financial institutions are failing (Wachovia, Lehman Brothers, etc.), and others aren't(Bank of America, Wells Fargo) , is due to a difference in values, a difference in leadership throughout the company, and past key decisions.
This is somewhat inspired by an Oct. 11 article: http://www.pressdemocrat.com/article/20081011/BUSINESS/810110362
While we wait for Jim Collins to write a book on why some survived, and others didn't, what do you think? What have been the keys to success for the banks who have thus far survived?
Clarification added December 11, 2008:
As many point out below, the crux of it seems to be the debt to asset ration - 70/30, 45/55, etc. But, I wonder, why is it that some chose to manage risk so incredibly differently from others? Was it simple greed? Was it a larger system? What is it in the organizational culture that kept some banks afloat, and others not?
Answers (22)
Investment banks like Lehman and Bear Stearns failed because they used ridiculous leverage to buy supposedly "safe" derivative securities. When these securities started going under, they didnt have enough capital to cover the losses. Chartered banks like Wachovia are failing because they own the actual mortgages (or pools of mortgages) on which these derivatives are/were based on, as well as the derivatives. They can't sell these securities to meet their short-term capital requirements.
The main reason certain banks are quickly failing and others are surviving is in the amount of REAL debt that they are (or were) carrying.
The whole mess began several years ago, when certain banks started using Credit Default Swaps (CDS) in order to "decrease" their debts. Those CDS are simply a way for companies to insure their credit so that they can continue to increase their debts beyond the legal amounts allowed. This is why American International Group (AIG) was one of the companies that pretty much collapsed this year - they sold billions of dollars worth of CDS, and when the foreclosures spiraled our of control, they could not meet their obligations.
To make it more "simple" to understand, a company's maximum debt percentage should be 70% at the most (the other 30% should be equity). Debts over 70% are unsustainable and very risky. Normally, companies would not pass through this threshold. However, the CDS allowed companies to downplay their real debts and, therefore, accumulate more debt, beyond that 70% threshold. Several banks in the US and outside of the US did that. All the banks that did that are now in trouble because the insurance companies that sold those CDS did not have the funds required to insure all the bad debts from the foreclosures. This is why CIBC, for instance, is the main bank in Canada in trouble, since it is the one that bought the majority of CDS within Canada (hence answering your question - voila!).
So to put the domino effect in perspective:
1. Banks used CDS to downplay their debts, "passing" the risk to the insurance companies
2. Banks sold $$$$$$$$$$$$ in subprime mortgages, opening the market to people who would not otherwise be able to afford
3. Net income of population decreases due to a variety of reasons (price of oil skyrocketing, for instance)
4. Due to the decrease in their net income, they become unable to pay their credit cards (a lot of people depend on debt to survive those days, and when a small change occurs, out of a sudden they can't keep up with payments).
5. Eventually, they run out of debt, run out of money, and completely default on their mortgages as well
6. Once a lot of foreclosures started popping up everywhere, banks started to have debt problems themselves
7. Banks went back to their insurance companies to claim their policies
8. Insurance companies had way too many banks and too many foreclosures to pay, but they didn't have enough assets to back them! (Uh-oh)
9. Insurance companies fail to pay their debts to the banks and start collapsing
10. Banks don't have enough to put back in the chequing accounts of millions of people...
ECONOMIC COLLAPSE
Oh wait, no..... government bail out. Which, by the way, is just another form of debt which will have to be paid by our children. Poor children.... as if the war in Iraq wasn't enough....
... I'm getting political now, so I will end this here.
Let me know if you have any questions!
I agree with the previous posts, and would suggest that some banks never had any subprime exposure, while others kept their original loans on their books rather than selling them to those packaging the CDOs. Another important issue is diversification of the loan portfolio: some banks had far too high a percentage of residential mortgages, while others had significant auto, home equity, signature, and commercial loan business to stabilize their balance sheets (somewhat). Also, some banks - and especially credit unions - don't even offer adjustable-rate mortgages, and they have strict policies about the percentage a mortgage payment is of a borrower's income, and as such these more conservative institutions have largely avoided this particular catastrophe.
That being said, they will not necessarily be immune to what may life ahead: even as these drastic interventions allow mortgages to be re-written to avoid further foreclosures, many banks that have significant credit card and auto loan programs will likely face increasing default rates on these loans as unemployment increases, so there will be other pressures on banks to survive this. The average American household has near $80K of consumer debt, and at some point, this will cause the bankruptcy trend to rise, and the banks will suffer.
The silver lining of all this - yes, there is one - is that perhaps the American people will finally realize that living in such excessive debt at the personal, community, and national level is not a sustainable approach for extended periods of time. It's a tough way to learn a lesson, but we need to return to living within our means, individually and with our government and business budgets.
Frank F.
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Strong banks are much-more frugally managed than weaker ones, they take fewer risks, they manage risk better, they do not over-extend themselves, they do not lend recklessly to those who are not qualified to borrow, and so on. They are less greedy and they have a better appreciation for the real value of money. They are better at managing their own balance sheets.
It all comes down to organizational culture, which stems from leadership capability.
Lynn W.
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Regulated commercial banks have pretty much been held to standards ... like lending from deposits. Some of these are going to have problems with economy downturn.
Unregulated investment banks are suppose to be able to do whatever they want ... and were suppose to be allowed to fail based on their actions.
In the wake of the crash of '29, Glass-Steagall was passed to keep the safety&soundness of regulated banking separate from the risky unregulated investment banking. A decade ago Glass-Steagall was repealed ... PBS program discussing the "wall street fix"
http://www.pbs.org/wgbh/pages/frontline/shows/wallstreet
So besides the independent unregulated investment banks ... other regulated institutions started showing up with investment banking units.
Recent comment about some of the practices of investment banking units (not just bears-stearn and lehman)
Best practice transfer pricing calculations would have made it clear that neither Bear Stearns nor Lehman Brothers had more than a marginal chance of survival when funding 30 year sub-prime mortgage loans with thirty day borrowings.
....
There was a separate issue about the 30yr subprime mortgages having been packaged as toxic CDOs and then got triple-A ratings. However, funding long term purchases with short-term borrowing has a long history of bringing down institutions ... related article from sf fed (not just i)
http://www.frbsf.org/econrsrch/wklyltr/2000/el2000-26.html
and a related yr old article talking about a lot of financial institutions carrying a lot of such transactions offbalance (and may be still lurking):
http://www.forbes.com/entrepreneursfinance/2007/11/13/citigroup-suntrust-siv-ent-fin-cx_bh_1113hamiltonmatch.html
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Richard G.
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We have not heard both shoes dropping on this one. Only one shoe has hit the floor.
One shoe was Collateralized Debt Obligations (better known as bundled mortgages transformed into securities). The institutions that had problems were ones that got heavily into CDOs because they sold real well to investors and made lots of money in the way of commissions for themselves and their companies, and because they had good investment returns, so it made people look like geniuses in the investment world with such wonderful returns. That shoe came off and we see the affects of its noise as a couple of trillion of dollars in investments take a dive on Wall Street.
The other shoe is scarier. The Credit Default Swaps (CDS) that "guarantee" to pay the CDO holders if the investment goes bad is still on the foot. The "shoe laces" became untied and the governments around the world are doing everything they can to keep it on the foot so we all do not incur the stink of the sock. No one really knows the size of these guarantees, other than it is somewhere between $16 and $18 trillion. That's why all the nations got into the bathwater together. And that's why banks don't trust giving money to other banks. If the CDS' go bad, well ..., welcome to the new dark age.
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Clarification added October 15, 2008:
Take a look at "A Look At Wall Street's Shadow Market" by 60 Minutes from October 5th. It's better than any scary movie made to date.
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Hi Genevieve,
You are right, in that it came down to: the culture of the bank's management (and their board):
- investments (investing in subprime mortgage-linked assets)
- leverage (overexposure to downside risk / poor risk management)
- inadequate liquidity (cash is needed every day to settle obligations).
JC Brandon
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The downward movement in capital markets over the past 8-9 months has obviously also contributed in this banks fall. The fallen banks, at the start of this bearish trend, continued with their exposure, and increased, to cover underlying losses, on the hope of recovering in the event of a market turnaround. Over a sustained period of 8 months or so, the situation got worsened all across the sectors. And history suggests the financial turmoil or derpession cycle begins with the financial sector - getting hit the most. And not all banks are falling, atleast of now, which could be contributed to management's conservative policy, exposure to lesser hit sectors, better management of liquidity and lesser aggressive approach in the sense of business development. This isnt the first time of such falls and would not be the last. In different parts of world, financial sectors take the brunt of depressive business cycles, because they deal with money. From hereon, expect the vicious cycle of failing of giants, unemployment, lack of demand, cash crunch, inflation, etc.
Paul V.
Ervaren kwaliteitsprofessional met voorliefde voor organisatie ontwikkeling
Some odd 25 years ago some genious tried to get the best out of people by rewarding them. 'It', the inventor of this thing called it a bonus. Long before the credit-crisis started I learned that in the US it is possible to get your bonus, uyour one-way out ticket and a golden handshake at the same when you would be so kind as not to look for anaother job in the same business and keep your mouth shut.
Great country, have not yet herad the results of the last Mc Cain-Obama debate. I wish my fellow globe-users in the states a modest president with guts to stop spending money at useless attractions, healthier debt ratio to enable pay-back national debts and their contribution to freedom without greed.
No I do not look forward to another book of Jim Collins on this subject. Build to last and Good to Great give enough reason to read other works. Try Senges' Presence.
Jørgen B.
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A simple view point:
Old virtues as calculated and realistic risk profiles is the short and to the point answer why some are still in self-sustained business.
On the more emotional side greed (too high risk profiles) - the urge to become bigger over night etc.
Trust that above gives some fruit for thoughts, brgds./jorgen
Almost all the banks have taken the beating upto the extent of their exposure to these risky ventures. Investment banking has bled to death and the reason is their relentless pursuit to earn money without gauging the risk factor. Its not only the US banks but any bank from any country which has invested in the 'sub-prime' has been hit hardly.
Another reason apart from being exposed to sub-prime has been the timely corrective actions eg citibank foresaw the odds and averted the eventuality.
US Fed role has also been quiet important but yes poor Lehman is a story in itself.
Gary S.
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Hi Genevieve,
I personally think the differences have to do with the culture of the businesses. If you have read "Good to Great" and "Execution", both Collins and Bossidy are clear that successful businesses have both short-term and long-term perspectives. In "The Goal", Eli Goldratt stated the the goal of every business is to make money NOW and in the FUTURE. I believe that the organizations that have failed did so because of greed that was driven by focusing on the short-term picture. If you have no strategy that reaches into the future, you are doomed to failure before you start.
Just my 2 cents.
Gary
Stephen J.
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"Simple Stephen" says:
Funny how some people are harder hit than others by it.. ones who maybe were not very clever with theirfinances... maybe had a bigger house than they could "really" afford... maybe taking the skiing and summer holiday (the breaks in between didn't count!)
The lease on the bigger Merc... and the maxed out Credit Card at tesco's when buying ranother bottle of "on sale why not" champagne...
Those that saved, didn't overspend, and thought about tomorrow don't seem to be doing too badly....
Seems to me that banks and companies do the same....
Notice how many questions there are on linked in about how to reduce costs, increase sales, and generally get better at business all of a sudden?
Why don't people ask these questions when times are good??? Those that do tend to survive!!!! (Those that are askng nw mayjust have a shot!!)
Regards,
Stephen Jones
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Asad R.
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Hi Genevieve,
This is just the beginning of global financial crisis. Catastrophe cannot be prevented by taking actions just before it’s about to occur. Bailout could only help in delaying the catastrophe, it sends wrong message to the Wall Street and encourages in their wrongdoings. I do not think that the bailout would solve the market fundamentals. It only helps in injecting the liquidity into the financial sector.
I think USD 3 to 4 Trillion Cash Injection is required to calm the market. Most of the injection is against borrowed money, so how can borrowed money solve the problem. The cost of fund is also gradually going to rise and printing of money would see sharp surge of inflation. It will be tougher for capital market, assets will be required to have healthy balance sheet. Banks & Financial institutions are concentrating on quality lending. Globally lending standard has been tightened and lenders are unsure about the health of the borrower balance sheet and therefore, may not be willing to offer liquidity which would continue to cause credit crunch. Meltdown has fully exposed the regulators.
Toxic Financial flaws require to be quarantined, which in simple terms means “clear the mess”. Therefore, I think the SOP's, which is accounting procedure needs to be revisited. Strong regulatory measures are required to avoid future crisis. According to CEO of a large global bank “only half of the 8,500 US banks will survive”. So weaker banks are likley to suffer furthermore, as obtaining credit is the bigest challenge, though global Central Banks are there to help.
Imagine the size of US Economy is $ 14 Trillion. US Domestic debt already USD 9.5 Trillion, will jump to 11.2 Trillion. Out of which Mortgage a little over USD 12 Trillion, unregulated Credit Default Swaps USD 54 Trillion Greed is the real cause. The global economy has been intentionally inflated through borrowed money, which leads to Higher Global Growth, Higher Per Capita Income, Higher Consumer Demand, Higher Bank Deposit, Higher Lending, All was only possible due to Borrowed Money and when the Interest Rate moves either way or whenever the Limit of Two Counterparty are fully utilized. So nothing could have been done and the crisis is unavoidable.
Therefore, the bubble needs to be pricked so that the air can be passed off. I am expecting another big crack in the financial market sometime in the 1st quarter of 2009 due to year end balance sheet adjustment and large size maturities. So, 2009 will witness another difficult year and the crisis is unlikely be over until 2010.
Cheers
Asad
I'm interested in the parallels between this banking crisis and the S&L crisis of 1990-91.
It seems interesting that both crises come at the time of a national presidential election. It also comes during a wartime push (both times in Iraq).
I believe that executive compensation packages should reflect the success or failure of companies. I believe that a borrower must be given plain understanding of their loan structure and related risks. However, I do not believe that banks should be overly regulated (more then they are).
The paralysis we are experiencing is due to the undervalued assets that support current loans. That is a function of the market. I don't think a free-fall in home prices is a good idea. However, a gradual reduction of home values would be warranted. However, if the government tries to control prices in the marketplace, it will fail. Just as price controls failed in the early 70's.
I don't fully understand the bailouts. However, since the government is required to protect depositors' monies, I think it is within their purview to make sure that FDIC member banks are acting ethically and maintain their collateral coverage. If they are uncovered (i.e. unsecured), then if the Fed's move in to protect depositors, they should be entitled to take over the assets at the expense of the shareholders' equity and the executive's jobs and compensation. The assets should be placed in a trust and they should be liquidated in an orderly fashion to slowly drain value out of the marketplace.
Mark
Sharon Z.
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Genevieve -
There are a lot of great answers here that point out significant causes to the bank failures. Having a strong risk culture in place was critical but it was very hard for even the best to resist the greed and feeding frenzy for the exotic instruments that paid so much.
I will just add just a few more lines
1. Greedy Leadership
2. Greedy Investors
3. Greed, Greed, Greed
4. Lack of Oversight and Regulation of the industry
Remember Bush over the summer that it looks like Wall Street has been havin' a party for long time and it looks like their about to be hungover?
This is binging at its worse! The boards were having a party, senior managers, investors, invited guest everybody was having a party on a ship that was heading over a waterfall. Who was the lookout? Where was the doctor? When the funds dried up, why was the party still going on? As we see it has taken AIG leaders weeks to sober up - they still feel entitled to party? Astounding isn't it? The weakest kind of leadership and a complete lack of accountabiliy.
BofA and Wells are much more stringently regulated by Fed and others.
Regulation and oversight was very loose for investment banking companies and insurers like AIG so no one was regulating the funding mismatches, liquidity, the volume and leveraging of these institutions until is was too late. These measures are tightly reviewed and regulated for Bank Holding companies etc.
Someone mentioned CRA - CRA regulation has NEVER required any bank to assume greater risk than is prudent or beyond its lending policy. It allows prudent lending to low to moderate income individuals. Most of the banks failing were not regulated by CRA(and other Fair lending regs) anyway and thus put huge burdens on people who could not repay the loans.
Regards,
sharon
Clarification added December 11, 2008:
Typos: Oops
Revised: Remember when Bush said over the summer that it looks like Wall Street has been havin' a party for long time and it looks like they're about to be hungover?
Lou G.
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Genevieve, I cuoldn't agree with you more. To trully understand the failures, we have to understand the inner cultures at the financial institutions in question.
It was not simply greed, but surely greed had something to do with it. It was not simply poor leadership, although one could imagine what would have happened if leadership was exemplary. How about the motivations of the typical associate on the field? Did they care enough to cry "Warning!" when they saw thir investors/loan officers making ridiculous deals, even though bank policy dictated the deals were sound?
I can tell you that the leadership in those banks that are staying afloat had the same opportunities as the ones that failed, but undoubtedly as was pointed out, made more conservative investments. Was that by choice, or simply good luck. Or maybe their associates don't care enough to take such risks.
I am also told, its not over yet. So I wonder what the future of your question will look like. Perhaps Jim should wait.
Now, lets try it nother way. Lets pretend that out there we have a bank or other financial institution, or an auto manufacturer that is not motivated by greed, but by fair capitalistic practices. Lets pesume that the 'values' that are broadcast on the corporate website, and in every HR document produced by the company are equally and trully understood and agreed to by EVERY employee of the firm (that includes management.)
Of course, a firm such as this would have to have exemplery management. The type of management that knows how to hold themselves accountable, as well as those they come in contact with. Lets watch as these managers optimally motivate their employees in such a way that every employee in the firm is motivated purely by socially concious growth of shareholder value.
Lets observe them utilize clear communications in every aspect of their role. As they describe corporate strategy, as they describe roles and responsibilities, as they give direction, and as they accept critique.
I wonder if such a company would fail as miserably.
Phew! LOVED THE QUESTION! Thanks!
Regards,
Lou Gasco
MüTō Performance Corp.
Lou.Gasco@MuToCorp.com
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Peter G.
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Unsustainable targets for lenders plus unsustainable bonuses = failure
Look at the mails above and how many figures are mentioned and how much financial analysis was done. Does anybody know the amount of families that have lost their home? The amount of employees that were strategically bullied? The amount of people in depth due to the greed? It’s much easier to follow the movements of the share price isn’t it? Ethical Management and Corporate Responsibility for its customers and employees have failed as well. Does anybody know the relation of winners and losers in that game?
Josh C.
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Hi Genevieve,
I think the quality of the investments, including debt instruments, has more to do with success and failure than the simple debt/equity ratios.
I do think that strategy, and to some extent values, plays a large role. Those firms that were smart enough--and more likely honest enough--to understand the house of cards that was being built will make it OK. This is also a result of the visibility that the risk management operations were accorded and whether the senior execs took those roles seriously (or not).
Josh.
Terri L M.
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Those that made loans to people who obviously could not pay them back, or invested in bad "securities" (there's an oxymoron!) are in trouble. Those who used the basics of investing in solid securities and loaned money to people capable of repaying the loans with interest are on a solid foundation. Just good basic business sense.
Maria M.
Strategic Business Advisor from Planning to Execution, Speaker, Trained Life Coach, For Financial Advisors & Accountants
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I feel the reason is not just about greed. Bear Stearns went against it's own values. Those values served them well for a whole lot of years, and through economic times. I wrote an article on the 20 Lessons small business owners everywhere can learn from the death of an 85 year old company. (link below)
Having said that, I heard ACE Greenberg on Charlie Rose in October say (paraphrase) that a big part of the problem is that the Investment Firm model no longer works and won't work.
A rumor starts (true or false), next comes a pulling out of money and then others won't lend to them. No one can get through a run on the bank w/o there being some sort of guarantee -- unless you're George and it's a wonderful life is on TV.
Banks have a model that has, no matter what the rumor, the FDIC guarantee behind it, so more people feel more comfortable leaving their money there. Although many, many took their money out of WAMU, many kept it in the bank.
