I was recently read a free chapter from a book called “Billion Dollar Lessons” written by Paul B. Carroll and Chunka Mui. These two gentlemen have a consulting firm specializing in corporate strategy aimed at avoiding acquisition disasters. The chapter that they offer from their textbook is called “Faulty Financial Engineering.”
The view that they put forward is that financial engineering is toxic. The position is supported with quotes from Warren Buffett and other notables. Why is financial engineering toxic?
I first became involved in financial engineering is the early 1980s when I worked for Citibank Canada. The bank had just started up Citicorp Investment Banking. Markets were opening up and the banks were challenging the Glass-Steagall Act. The term Glass–Steagall Act usually refers to four provisions of the U.S. Banking Act of 1933 that limited commercial bank securities activities and affiliations within commercial banks and securities firms. Congressional efforts to “repeal the Glass–Steagall Act” referred to those four provisions (and then usually to only the two provisions that restricted affiliations between commercial banks and securities firms). Those efforts culminated in the 1999 Gramm–Leach–Bliley Act (GLBA), which repealed the two provisions restricting affiliations between banks and securities firms. The GBLA was a watershed event in contributing to the financial crises that followed perhaps facilitating the occurrence of those events.
When I was involved in financial engineering the objective of the game was still to add value to the client. The goal was to achieve certain client objectives in the financial realm.
Around that time Salomon Brothers and others structured the first cross currency swap. The swap was structured to allow the counter-parties to achieve certain risk management objectives. Swaps were a corporate finance tool, not a traded instrument. In 1981 IBM had a large amount of Swiss Franc and Deutsche Mark debt. At the same time, the World Bank wanted to borrow in Swiss Francs and Deutsche Marks. IBM was facing a rather substantial amount of currency risk. The Swiss government had limited the World Bank’s access to the Swiss Franc debt market. Because of the interest rate differential between funding in US Dollars and Swiss Francs, the World Bank would have liked to borrow in Swiss Francs. So after much time and effort, Salomon Brothers engineered a swap transaction between IBM and the World Bank to help them both achieve their financing/risk management objectives. The transaction was arranged to meet a specific need.
As markets evolved, swap transactions were commoditized. The need rational seems to have disappeared and the banks transformed swaps into a tradable and trading instrument while further broadening the product. With the amount of financial leverage (minimal capital required to support the product) and the high returns on an ROE basis, the market exploded in the late 1980s. (Another topic worthy of further exploration. The amount of capital required to support swap and other derivative transactions and structures was reduced over the years). The chapter’s title is “Faulty Financial Engineering.” So their objective is to look at a number of firms that crashed and burned as a result of aggressive “financial engineering” mostly on the financing side of their businesses. The authors look at the demise of Green Tree Financial Corporation (GTFC) and attribute it to faulty financial engineering.
Let’s go back to square one. Remember that financial engineering is defined as “combining or carving up existing instruments to create new financial products.” Nothing inherently devious here. It has gone on since the first financial product was developed-money.
The authors go on to say that GTFC’s first financial innovation was offering a thirty-year mortgage instead of one with a fifteen year term that was standard at the time for a mobile home. An “innovation” is a “new idea, method or device”. I guess it was a new idea to this particular market, not an innovation in and of itself. The collateral or security that GTFC took to secure itself were mobile homes. Most in the business at that time and now presumably knew that these assets were depreciable property. Unlike residential real estate, these were assets that had a shorter economic life than the financing that was being offered by GTFC.
The authors further criticize GTFC implicitly as the borrowers were generally unsophisticated and only looked at the monthly payment rather than their total indebtedness when entering into the financing. This had serious implications for GTFC at a later time. The reality is that the entire leasing industry is based on this premise when it comes to consumers. A smaller monthly payment is what attracts many to car and equipment leasing. Nothing really new here and certainly nothing unique to GTFC.
Their next stop is an analysis of the financial engineering involved in the funding of these assets by GTFC.
But let’s pause for one minute here before we move on to GTFC’s funding model analysis. Let’s look at GTFC’s business. The first problem we have here are poor lending practices. Regardless of the manner in which GTFC funded their assets there was some bad lending going on. The business model was flawed from the start. Medium term assets were funded with long term liabilities. And on top of that, these were assets that would depreciate quickly in value, much like driving the car off the lot. So at some point unless they were incredibly lucky or incredibly smart at GTFC their chickens would come to roost regardless. The question is, was there any financial engineering to blame?
Now let’s just have a very cursory look at the funding of these assets. We could spend a lot of time trying to analyze the financing vehicles used. But they are complex. (First yellow flag, buyer beware). The authors’ lengthy discussion of these structures is a gross oversimplification, perhaps intended for the novice reader. They perhaps by necessity needed to gloss over some of the structural and economic issues. In my view, the real question here is did everyone know what they were getting into? Clearly, GTFC either knew the risks embedded in their business model or they didn’t. Similarly, either the investors understood the risk of what they were buying or did not. If they didn’t understand the risks, why did they buy the paper? If GTFC didn’t understand the risks to their business why did no one notice?
I’m have has this discussion on a number of fronts when discussing accounting or finance. In the end, where does responsibility lie for all the things that went wrong with GTFC? The list is long:
- Bad decisions by both the borrower and lenders/investors;
- Credit agencies who seemingly learn by trial and error. They seem to be so enamored with the complexity of the structures that they fail to apply “horse sense” on looking at the deals. They bear little responsibility for anything that goes wrong because they are simply expressing an opinion on the structure;
- Greedy management and investment bankers. This has already been discussed everywhere “ad naseum”. Those who are motivated by greed and ego will always find a way;
- The deal culture in the financial services sector;
- Incentive compensation that shapes behavior;
- Sloppy application of accounting principles and policy;
- Sometimes co-opted auditors who are as often as not part of the deal team .
The list goes on and on. Ultimately, is it the financial engineering that is the problem or the financial engineers?
So what is truly remarkable about this piece of analysis is the failure, in my opinion, to look at the root causes: Greed, poor corporate governance, incentives on main street and Wall Street, over reliance on rating agencies, lack of due diligence (an old joke-due diligence is for wimps). There are many causes, but isn’t shooting the financial engineer the same as shooting the messenger for the message?
Many years ago when I worked at Citicorp Investment Bank I saw a deal team challenged by a senior executive. He had just attended a presentation from a bunch of “propeller heads”. Detailed, complex, everything you would want to justify a deal. The executive pulled out a napkin. He told the deal team that unless they could explain it on the napkin, they couldn’t do the deal. Where has this gone? Complexity, we love it. We have done our homework, we have done our jobs. The math is so robust that it can’t be wrong. After all, the financial experts had vetted the deal. With all these PhD s on board, how could the conclusion be wrong? Financial crises after financial crises and we don’t seem to get it. Greed trumps due diligence, ego trumps common sense, the deal trumps naysayers. Has anything really changed?
In this case the discussion circled back regarding the flawed decision by Conseco to purchase GTFC (a mess) and save it from oblivion. So in advising senior executives about the “common sense” of a transaction, there is one important question that needs to be answered. Has the CEO already decided to go ahead with the deal before the consultant even walks in the door? I believe that the train has left the station once the CEO decides that the deal is a good one. They all (buyer and seller) become committed to the deal at some point come hell or high water. There is no going back.
So I wish Messrs. Carroll and Mui the best of luck in playing the devil’s advocate.