Stephen H Baum Leadership

As the situation at Merrill Lynch evolves and more is known, my take evolves and the lessons learned can be richer. 

Much of the focus in the media is on Stan O’Neal’s severance package – extravagant considering the performance. And there is reason to be concerned about boards who, worried that they can’t recruit the best and the brightest in a competitive marketplace for top talent, endorse contracts that seem so far from performance-based compensation. And with no adjustment for failures of his or her own making. (Note: I am not speaking of good decisions that have bad outcomes). 

But there is an important story not to be drowned out. How did the failures come to pass and what are the implications for investors?

The catastrophic losses in sub-prime mortgages at Merrill are “deja vue all over again” as Yogi Berra is said to have said. Remember LTC? Long Term Capital? Merrill took large positions while Stan was head of Institutional. LTC blew up, Merrill took a hit. There were lessons learned, but by the time Stan moved into the top job, the institutional memory was gone – more than a few key executives either were fired or quit. When Stan’s ferocious competitive drive pushed Merrill into new, higher return, higher risk commodities and sub-prime mortgages, what voices were there to give warnings and counsel for risk mitigation and containment? What old hands were around to “deep dive” the complicated instruments and ask tough questions: How could these fail? What does risk protection look like? How much of these can we afford to be in?

In the early 1970s, my client at Federated Departments Stores was worried about what he saw as an imminent recession. He hired two elders into the company who had lived through the depression and two recessions to advise the young Turks who believed that the music never stops – every year is better than last year. 

The CEO of a financial institution has at least these three jobs:

– Leading the firm to create more alpha (superior returns)

– Managing the risk inherent in striving to create more alpha

– Active stewardship of the human capital as well as financial capital

Sure, the rating agencies abetted the failure by giving high ratings to what were risky investments at their core. But my view is that such ratings cannot be taken as a guarantee and it is still the responsibility of senior management to do due diligence, what-if analysis and contingency planning. Warren Buffet has been heard to say that he does not invest in what he does not understand. What was the standard of understanding at Merrill (and the other firms who went into these securities in a big way)? 

As an individual investor, I set limits on the amount placed in each risk category in my portfolio to limit the downside to my total net worth. Did Merrill treat investors’ and shareholders’ capital as if it were their own?

Going forward, it is my belief that the “tail could wag the dog:” there is still a liability large enough for major impact on those who went into these mortgages whole hog. And there is the specter of increased government regulation, which in its execution often produces unintended consequences. 

As an investor I want to know:

– Did the “fine print” allow the firms to put investments that looked safe into these instruments? Am I unknowingly an investor in these mortgages?

– What insurance does the firm carry that safeguards me from catastrophic losses?

– What is the recovery or exit strategy plan now? 

As a shareholder I want to know:

– Are the CEO and the board sufficiently experienced to navigate from here on out? If not, what is being done about it?

– What are the plan and the timetable for getting on the right path and restoring trust?

I have already opined on the fact that Stan found himself aloof and alone at his moment of trial. He admits to failure in investment and risk management. I see failure in stewardship of human capital. And I see it as almost as large a challenge for these firms as solving the problem of the tail. I have more than a few friends at Merrill. They need and will respond to better leadership and will view it as an opportunity.

 In my judgment, the financial firms and the rating agencies are in a position akin to that of the audit profession just after Enron: trust has been lost. This is a time for extraordinary leaders to take what I call Signal Acts: deeds that speak far louder than words. Consideration must be given to a broad range including those outside of comfort zones and norms. And whatever course is chosen, it must consider all stakeholders and be thoughtful and prudent and not knee-jerk about the risks that come with the solutions. 

Then we can move to address issues of board accountability and CEO compensation.