Too Big to Fail?

Too Big to Fail?
April 6, 2009 Joseph Paris

When does a company become too big to fail and by what standards?  How can the casual passer-by – not to mention the learn’d industry or government analyst – tell when a company poses too great a risk?Can a government or global / regional economy become too big to fail?If so, then what?

In the United States (and elsewhere) there are anti-monopoly laws – such as the Sherman Antitrust Act – which are intended to protect against a company becoming too powerful and which were first introduced whilst Teddy Roosevelt was President of the United States.Such laws have been used in the past against companies such as Standard Oil, AT&T, IBM and Microsoft (to name a very few).

So, how did so many companies today become so large that their failure (or even stumble) would have catastrophic consequences around the globe and how did the risk go unnoticed?What should be done to ensure that protections are in place to prevent their recurrence, and by whom?

  • Banks

The Bank Reform Act of 1933(aka 2nd Glass-Steagall Act) established the Federal Deposit Insurance Corporation (FDIC) and included the separation of banks according to whether they were commercial banks or investment banks –commercial banks were prohibited from engaging in activities related to investment banking and vice-versa.

Certain aspects of the Bank Reform Act of 1933 were eroded beginning in 1980 with the Depository Institutions and Monetary Control Act.  It was followed by the 1982 Garn – St. Germain Depository Institutions Act and the 1999 Gramm-Leach-Bliley Act.  These three Acts, in effect, eliminated the separation of the bank types and allowed commercial banks to also act as investment banks.  Subsequently, this resulted in the restoration of risks related to conflicts of interests that the original “Bank Reform Act of 1933” sought to eliminate; namely, the granting of credit (lending) and the use of credit (investing) – by the same entity and within themselves.

In 1999, sub-prime mortgages were just 5% of all mortgage lending.  At the peak of the credit crisis in 2008, sub-prime mortgages accounted for almost 30% of all mortgage lending.

Certainly, there were regulations to protect against harm.  There were distinct subsidiaries within financial institutes which were supposed to act as firewalls to protect one another.  But what good is a firewall if each subsidiary is underwriting the activities of the other?  All of this relied too heavily on “self-regulation” – as there was not bandwidth in the government agencies to effectively monitor the activity and risk.  “Too many speeders, and not enough traffic cops” – as it were.

There are many banks in the land; many of them are small banks catering to regional customers.  The vast majorities of these banks, by and large, avoided being directly hit by the mortgage meltdown (although they are now feeling the “ripple-effect” in their commercial loan portfolio and loans to people who have lost their jobs).

My answer: Reinstate the portions of the Bank Reform Act to separate the commercial activities from the investing activities within a bank – updated for the needs of the modern financial and commercial world where trillions of dollars can move (and need to move) at the press of a button.

Some people will argue that self-regulation can work – to which my response is that it took less than a decade after the last of the protections were repealed for the system to be once again brought to the abyss by greed and arrogance.  As my father always says, “Trust everyone, but always cut the cards.”

  • Insurance Companies

As with banks, there are many insurance (and re-insurance) companies in the world.  And most of them did what they do best – manage risk.  They manage the risks associated with insuring your home, driving to soccer practice, working, and your health.  Let’s face it; if something bad can happen, they are there to ease the way.

But what happens when an insurance company, thirsty for greater returns, invests heavily in financial vehicles which are beyond the traditional – when the goings-on within these vehicles are opaque at best and where the level of risk is truly unknown?  Nothing – until things start going badly.  And things ALWAYS go badly – eventually.  This is why insurance companies exist at all – because bad things happen.

The problem exists when the insurance companies become so intertwined with the financial markets as to be virtually indistinguishable from commercial and investment banks.

And what faith should we place in ratings agencies such as Moodys that operate under an inherent conflict of interest?  Were their ratings of companies and their financial instruments being paid for by the very companies being rated?

It’s human nature – when one avenue that has proved lucrative in the past is hampered or otherwise shut down, people will look for the work-around.  It’s a shell game with the government usually being a step or two behind.

What we must do is look beyond the numbers to their context.  What do the numbers mean?  From where are they derived?  With transparency, an objective evaluation can be made of the subjective presentation, and we have to ensure that risks are mitigated to the manageable.

A Personal Anecdote :  Some years ago, perhaps it was the early 1990’s, I tried to overnight a diskette with a program we developed to a client in the United Kingdom.  A few days later, it was returned by the courier with a note from Customs stating it could not be delivered since the contents of the diskette were not certified as being free of national security interests.  I looked at the diskette, and the note and just rolled my eyes.  I called my client and asked that he turn his modem on (yes, it was that long ago) and proceeded to upload the contents directly to his computer.

  • Private Equity and Hedge Funds

In my opinion, the rise and proliferation of Private Equity and Hedge Funds was an “unintended consequence” of the “Sarbanes-Oxley Act (which was passed in 2002 as a result of the last episode of corporate malfeasance.)

Compliance with the law’s requirements placed an incredible burden on publicly traded companies – so much so that many smaller publicly traded companies could not afford to become (or remain) compliant.  However, this did not eliminate the need for capital in smaller companies and institutional and wealthy investors still wanted a place to invest their funds where the opportunities for greater returns might exist.

This combination – the need for capital and the source of capital for transactions that would be beyond the reach of “Sarbanes-Oxley” regulations – resulted in a proliferation of Private Equity and Hedge Funds.

Back in October, there were many discussions about Hedge Funds regarding their short-selling of banks and other financial institutions.  As far as I can determine, these short-sellers were the “canaries in the coal mine ”.  Instead of being blamed for the resulting collapse in share prices they should be applauded for sounding the alarm.  The only problem was that nobody was really listening to the sound of the alarm bells.  Remember, the price of a share should reflect a company’s ability to perform and earn a profit, thus attracting people who are willing to show their support by investing – nothing more.

There are existing regulations which, if adequately enforced, would protect everyone involved from some of the shenanigans that have occurred in the past.  Perhaps there should be an annual fee (tax?) paid by the firms to cover the cost of their oversight and maybe, they should also carry insurance to protect against fraud (but not investment losses).  All in all, from my observation and experience, I believe that Private Equity and Hedge Funds have largely served a useful purpose and should be allowed to continue mostly as they have.

  • Heavy Industry

Determining the economic risk – and what to do about it – in the failure of a national icon is even more difficult.  Determining the risk is especially complicated when the failure was obvious and inevitable – the result of decades of mismanagement and an abject lack of leadership.

Take General Motors (GM), for instance.  GM has been losing market share since the late 1950’s to foreign competition (not just Japan ) and their forays overseas (such as the partnership with Fiat*) have largely been duds.

* Ironically, it cost GM a payout of $2 Billion to Fiat to end the relationship – now Fiat is the White Knight who has come to rescue Chrysler .

Back in GM’s heyday, and with far fewer competitors, it made sense for GM to have several makes of vehicles to address the market segment stratification.  Brands such as Chevrolet, Pontiac, Oldsmobile, Buick, Cadillac, and eventually Saturn and Hummer – each with its own engineering, marketing, and overhead, as well as distribution channel – all catered to a different customer.

Although GM finally did attrite Oldsmobile a few years ago, they did not go far enough.  With an ever-decreasing share of the marketplace and an ever-increasing cost per unit (both in direct and indirect costs), GM’s tactic was to defer, defer, defer.  They deferred addressing employee pension and healthcare issues.  They deferred addressing the redundancy in their product lines and distribution channel.  They deferred making all of the tough decisions necessary to evolve and remain competitive.  They lacked what they desperately needed – true leadership.

To fix GM – which is fixable – they must: i) keep the Chevrolet and Cadillac automobile brands, as well as their SUV’s, and eliminate all of the others; ii) relegate the GMC brand to making ONLY larger trucks; iii) get their direct and indirect costs in line with their domestic competitors; iv) eliminate the redundancies in their supply-chain and distribution channel; v) restructure or eliminate all of their longer-term obligations, including those related to employees and non-performing assets.  All this must be done with a sense of purpose and urgency.

Pragmatically, the only way I see any of this happening is for GM to re-organize through bankruptcy.  The type of transformational change that GM must endure, and the timeframe in which they must accomplish the task, is that borne of crisis and the options are limited.  Presently (at least at the time I am writing this article), there are too many stakeholders – each with their own myopic views, self-interests and pre-prejudices – for a comprehensive alternative plan to be negotiated and effected in the time required.

Whether or not GM (and Chrysler ) is “too big to fail” is not as obvious.  It is certainly less obvious than if the financial institutions were to stop the flow of cash throughout the economy.

There are many companies that will still make automobiles and there are many people who will buy the automobiles made.  They just won’t work for – or buy from – GM.  Should the government and its citizenry get so deeply involved in what amounts to a micro-economic situation?  Should capitalist ideals and Darwinism be put aside to save a national icon?

Can a manufacturer be “too big to fail” without being a monopoly?  I don’t believe so, and I don’t believe we should act as if it is.

So, what does “too big to fail” mean?  How can one tell when a business is too big as to pose a threat to the national or global economy?  To me, the acid-test is when a business becomes so large (though not necessarily a monopoly) that its failure threatens to bring an economy to its knees and the citizenry is compelled to risk funds to keep the company alive or to spend funds in order to repair the damage.  If a company does become so large as to be a risk, it should be broken-up.

One thing is certain; those companies who look to the government for capital have essentially sold their company to the government – the investor of last resort, if you will.  And I am happy to see the government demonstrating its influence at GM, and other companies where we are now the majority shareholder / investor, in a measured and pragmatic fashion.

How can one definitively tell if a company poses such a risk?  Beats me…

BONUS:  Things that make you go, “Hmmmm…”

Last month, I flew to Nashville to attend a conference.  It was a tough flight, having missed my connection at JFK and being re-routed through Atlanta.  I finally arrived in Nashville a full six (6) hours later than I was first planning and – much to my chagrin – my bag did not come off the plane.

I had to wait to report the bag as missing until after the conveyor stopped and all of the unclaimed bags that remained were taken from the conveyor and organized in a pile on the floor.

One of the “bags” in particular caught my attention.  It was actually a silver canister in the shape of a cube with all manner of orange and red stickers on it – stickers with messages such as “Urgent”, “Bio-Hazard”, and “Human Tissue for Transplant”.

There it sat, unclaimed, with all of the other unclaimed bags – long after everyone else had departed with their loved ones and belongings.  Even when I was done with the paperwork to report my bag as missing, it was still there.

“Hmmmm….”

 

Paris is the Founder and Chairman of the XONITEK Group of Companies; an international management consultancy firm specializing in all disciplines related to Operational Excellence, the continuous and deliberate improvement of company performance AND the circumstances of those who work there – to pursue “Operational Excellence by Design” and not by coincidence. 

He is also the Founder of the Operational Excellence Society, with hundreds of members and several Chapters located around the world, as well as the Owner of the Operational Excellence Group on Linked-In, with over 25,000 members.

For more information on Paris, please check his Linked-In Profile at: http://de.linkedin.com/in/josephparis

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