The New York Times DealBook blog just put out a fine piece on the collapse of MF Global: A Romance with Risk That Brought on a Panic by Azam Ahmed, Ben Protess, and Susanne Craig (December 11, 2012). It’s the most comprehensive summary of the events that led to the firm’s bankruptcy that we’ve seen so far. Until the investigations are done and the books are written, it’s a good source for thinking about the credit risk lessons to be learned in MF Global’s sad story.
MF Global seems to have made a lot of risk management mistakes. It took on a big dose of market risk with its $6.3 billion exposure to the European debt crisis – over the objections of its senior risk manager. With only $1.4 billion in capital, the company could barely afford to take any losses.
There may have been operational risk issues at the firm as well. About $1.2 billion of client money has gone missing, and after weeks of searching the company’s records it’s still not clear where most of it is. At best, this is a serious systems failure; at worst, it could be a lot more sinister.
But the fatal risk at MF global was a form of credit risk called counterparty risk. That’s the risk that a firm involved in a trade fails to pay what it owes. Counterparty risk is where market risk and credit risk intersect: as a company’s trading losses grow, its ability to pay decreases.
Moody’s downgraded MF global from Baa2 to Baa3 in October, citing exposure to European sovereign debt, a regulatory capital shortfall, and poor risk management. The market had been concerned about MF global for months, but the downgrade made it official. MF global was a poor counterparty.
That triggered collateral calls, with trading partners and clearing houses demanding that the firm either close out its positions or post more collateral – usually in the form of cash. The firm that cleared MF Global’s sovereign debt trades demanded $300 million in cash collateral alone. MF Global’s risk challenges suddenly became a fatal liquidity problem.
That should not have been surprising. The same thing happened to Lehman Brothers and even to Goldman Sachs. The combination of collateral demands and a runoff in repurchase financing drove Goldman’s liquidity pool from $120 billion to $57 billion in just four days after Lehman went under.
MF Global’s counterparty credit squeeze suggests the likely explanation for the missing client money: desperate to meet collateral calls, the company used client funds to try to plug the holes in its liquidity dike. That changes the nature of MF Global’s operational risk problem. It’s worse than a mistake; it’s a crime.
Michael Woodford lost his job on October 14. He had been CEO of Olympus, the Japanese maker of medical systems and cameras, only since last July; and as recently as September, the company’s Chairman had said he was “extremely pleased” with Mr. Woodford’s performance. But then the board fired him for “causing problems for decision making.”
He definitely was causing problems. He kept asking embarrassing questions about the Olympus’ 2008 acquisition of Gyrus, another medical equipment company. Olympus paid $2.2 billion for Gyrus, including $687 million in advisory fees to AXAM, an obscure Cayman Island firm that vanished from the trade register a few months after the deal. See this interview of Mr. Woodward in the Financial Times for more information.
The Olympus case reveals big weaknesses in Japanese corporate governance: unaccountable senior executives, weak disclosure standards, and dangerously passive shareholders. At the heart of these is an issue behind many failed companies and damaged lenders — poor governance.
Board Strength
Many things contribute to good governance, but the key factor is a strong board of directors. We think there are three dimensions to board strength.
Independence. The majority of directors on any board need to be independent of management. There are different standards of independence in use around the world, if not in Japan. Among the most rigorous is one from the Council of Institutional Investors, which defines independence this way: “An independent director is a person whose directorship constitutes his or her only connection to the corporation.”
Expertise. Directors of an effective board have relevant industry and management experience. They are well equipped to evaluate the company’s strategy, operating results, and finances, as well as the complexity, opportunities, and challenges management must deal with.
Effort. Being a director is hard work. Good directors spend a great deal of time and energy preparing for meetings, working on committees, and contributing to the decisions the board must make.
Board Strength at Olympus
How does the board at Olympus measure up to these standards?
Independence. Of fifteen directors on the board at Olympus, only three were outsiders. All the rest were executives of the company. It’s not clear that any of the outsiders were truly independent. In Japan, outside directors often come from subsidiaries or the company’s lead bank.
Expertise. Japanese disclosure about directors can be quite limited. But none of Olympus’ directors appear to have any top-level management experience or be seasoned deal makers.
Effort. Judging by Mr. Woodford’s account of the special board meeting at which he was fired, Olympus’ directors aren’t a very engaged or energetic bunch. Mr. Woodford was not allowed to speak, and there was no discussion. The board simply voted to approve every resolution Tsuyoshi Kikukawa, the Chairman, put before them.
It’s Not Over
The Olympus story is still unfolding. For more information on Mr. Woodford’s sudden departure, try this report in Reuters and this article in Fortune. Troubling new information about other deals with shadowy investment firms is emerging; see this article in the New York Times. And, as Japan Today reports, Mr. Kikukawa has resigned as chairman and president but remains on the board.
Whatever else develops, it’s clear that when it comes to Mr. Woodford’s dismissal, the rapid cycle of promote, praise, and pitch overboard doesn’t speak well for Olympus’ board. The company’s fumbling, contradictory explanations of the Gyrus acquisition only make management and the board look stupid or deceitful. So far, Olympus seems to be a poor example of how to govern a company. Who knows? As the story unfolds, it may prove to be an even worse one.
There are a number of worthwhile accounts of the firms that failed or nearly failed in the great financial market collapse of 2007-2009. Too Big to Failby Andrew Ross Sorkin and All the Devils Are Here by Bethany Maclean and Joseph Nocera are two strong general accounts. House of Cards by William D. Cohan tells the Bear Stearns story very well, and Fatal Risk by Roddy Doyle does the same for AIG.
But the stories they tell are mainly about the personalities of the men who led those companies and the blunders they made in strategy and funding. None of them focus closely on risk management. So to correct that, we thought we’d start building a timeline of major risk management mistakes made in the run-up to the crisis.
It’s not comprehensive. It’s just a series of anecdotes drawn from books, press coverage, government reports, and other sources. Please help us build it up by contributing more stories. We’ll add them to the timeline as you do.
Sometime in 2005
Stan O’Neal, CEO at Merrill Lynch, puts Ahmass Fakahany, his Chief Administrative Officer, in charge of risk. Over the next two years, Fakahany dismantles Merrill’s risk organization, firing senior managers and moving the remaining risk managers off the trading floor. Merrill’s exposure to the mortgage market grows to $55 billion, and the company is forced to merge into Bank of America in 2008.
June 2006
Citigroup demotes Richard Bowen, a senior risk manager for raising the alarm over the decline in underwriting standards in its mortgage business. His report reaches Vice-Chairman Robert Rubin, but Rubin fails to act on it. The next year, Citigroup takes over $20 billion in mortgage loan losses.
September 2006
The Market Risk Committee at UBS warns of the high concentration of risk in the firm’s CDO warehouse program, which at its peak reached $50 billion. Management ignores the warning, and UBS takes $40 billion losses on its CDO portfolio in 2007 and 2008.
August 2007
Joseph Cassano, head of AIG Financial Products, refuses to give Joseph St. Denis, an internal auditor, information on potential collateral calls on Financial Product’s $420 billion portfolio of credit default swaps on mortgage backed securities. St. Denis leaves the firm, but Cassano stays. Just over a year later, when collateral calls peak at $80 billion, AIG is rescued from bankruptcy by a government bailout.
September 2007
Lehman Brothers removes Madelyn Antoncic, its well-regarded Chief Risk Officer, from the Executive Committee, clearing the way for the company’s disastrous Archstone-Smith acquisition in October. That drives Lehman’s commercial real estate exposures to $40 billion just as the market peaks. To avoid write-downs, Lehman tries to spin off its real estate portfolio. But that only highlights the company’s weakness, and Lehman fails in September 2008.
February 2008
Oliver Wyman issues an internal report criticizing Bear Stearns’ risk management for being a low priority. CEO Alan Schwartz says the report doesn’t indicate any substantial deficiencies. Within two weeks Bear Stearns’ funding evaporates, and the firm is forced to merge into JP Morgan.
It may be disappointing, but it can’t be surprising that Borders Group went bankrupt this week. It was clear some time ago the company was heading deep into distress. What made it so clear? The six classic early warning signs of financial distress. We covered the first three in our last blog post. Here’s a brief video about the last three.
We blogged about Borders Group back on January 4. Even though the company has a new financing commitment, it continues to have problems paying suppliers. It looks like Borders is still circling the drain.
Borders’ survival is questionable, but for us the more interesting question is, “How could we have have seen the trouble at Borders coming?” What were the warning signs of Borders’ distress? In this video post we talk about three of the six early warning signs of financial distress and see how they apply to Borders. We’ll talk about the other three in our next post.
Jean Marie Messier became Chairman of Compagnie General des Eaux in 1996 at the age of 38. He was a graduate of elite French universities. At age 29, he held a senior post in the French Ministry of Economy and Finance. At age 32, he joined Lazard Frères, where he became the French investment bank’s youngest general partner.
He renamed the company Vivendi in 1999. And under Messier, Vivendi’s deal flow was staggering: the company sold 39 businesses and bought control of or stakes in 65 others. The capstone deal was a merger with Seagram-Universal and Canal Plus in 2000.
The share price climbed to a record high, and Messier became a darling of the financial press. Time magazine named Messier the 12th most influential businessperson in the world, and the French Government awarded him the Legion of Honor. Articles in Business Week and Fortune compared him to Jack Welch, the legendary CEO of General Electric.
The French press called him Jean “Magic” Messier. But Messier preferred J6M, which stood for Jean Marie Messier, moi-meme maitre du monde (“Jean Marie Messier, myself, master of the world”).
Massive impairment charges hurt the company’s credit ratings in 2001, which led to problems rolling over short-term debt, which put pressure on liquidity, which hurt the share price. Messier fought back in 2002 with a massive increase in share buybacks, a special dividend, and a request for a big increase in his compensation. Directors began resigning in packs, and Messier lost his job that July.
He paid over $2 million in civil fines for misleading investors in France and the United States. Now he’s been convicted on criminal charges for the same offense. In these difficult times, it may be gratifying to see a member of the global business elite in trouble. But what’s the lesson in the Messier mess for risk analysts? How could a manager so brilliant, so accomplished, so successful get himself and his company into so much trouble?
We think the answer is at the intersection of management and character. Messier displayed many of the traits of spectacularly unsuccessful people Sidney Finkelstein describes in his excellent book Why Smart Executives Fail.
1. They see themselves and their companies as dominant. Messier overestimated his ability to control events, especially when Vivendi got into trouble in 2001 and 2002. Instead of shoring up the company’s finances, he threw money at the share price and kept insisting Vivendi had more liquidity than it really had, as if his assurances alone were enough to save the company.
2. They identify completely with the company. But the relationship is inverted: the company’s good doesn’t come first, the manager’s does. Messier believed what was good for him must be good for the company. That’s how he could ask for a raise when Vivendi was in the middle of a liquidity crisis.
3. They think they have all the answers. Messier’s self-confidence and vanity were legendary. No one could persuade him to see the mistakes in business and financial strategy that led to Vivendi’s liquidity problems.
4. They eliminate anyone who isn’t 100% behind them. Messier fired the only other widely admired manager at Vivendi, Pierre Lescure, the highly popular CEO of Canal Plus. He stuffed the board with friends and supporters.
5. They are the company’s spokesperson. Messier loved the limelight and cultivated it. He became obsessed with the appearance of success, insisting that there were no real problems at Vivendi, even when losses were growing and financing shriveling away.
6. They underestimate obstacles. Messier refused to admit the extent of Vivendi’s funding problems. His CFO tried to warn him, saying, “I’ve got the unpleasant feeling of being in a car whose driver is speeding up into the bends and that I’m in the death seat.” But Messier ignored him.
7. They rely on what worked for them in the past. When things began to go wrong for Vivendi, Messier just did more of what he’d always done. He increased the pace of acquisitions and divestitures, raised share buybacks and dividends, and made more public appearances.
Messier, for all his ability, was a catastrophe masquerading as a hero. Fortunately, he did not destroy Vivendi, the way Bernie Ebbers did at WorldCom or Jeff Skilling did at Enron. But he came close. Analysts and investors who want to avoid the next management disaster should pay attention to character, and these seven traits are a great help for that.
The Wall Street Journal reported yesterday that Borders Group Inc. was halting payments to some suppliers, and that one publisher had stopped shipping books to Borders. The end is near. As we discussed in an earlier post, if trade creditors lose faith in a company, bankruptcy is almost unavoidable. The term we use is “confidence sensitive cash flows,” which includes, in addition to trade credit, short term borrowings like commercial paper (think Lehman Brothers) and counterparty credit (think Bear Stearns). Once one supplier stops shipping, they all will stop.
Today, the Wall Street Journal reported that two senior executives had resigned (the General Counsel and the Chief Information Officer). This is another classic early warning sign. Let the countdown begin …
Here’s our list of the top 10 topics on the minds of credit professionals in 2010:
10) Risk Management – We’ve written many times this year about risk management, both good and bad. Whether it was BP and operational risk, suppliers dealing with customer concentration risk (or “Wal-Mart Risk”), or Lehman just not managing risk. This topic was on our radar in 2010 (and needs to stay there into 2011 and beyond).
9) Games CFOs Play – Aggressive financial reporting (and outright fraud) can happen at any time, but management’s motivation to do it is heightened during an economic downturn when there is pressure to “hit the numbers” (and not breach covenants, etc.).
8 ) Managing High Risk Clients – Sure the recession is over, but many companies are still struggling with high leverage, high competition, low sales growth, and high costs. Lenders and bondholders will be working with many “high risk” clients well into 2011.
7) Intercreditor Priority – When times are good (think the 2003-07 credit bubble), no one pays much attention to collateral and subordination (or covenants, or any other part of credit documentation for that matter). The restructurings and bankruptcies of the great recession reminded us how important these issues are. We fear that the market is already starting to forget these lessons (think covenant lite and second lien!).
6) Cash Flow Analysis – Cash is king. Real cash, not EBITDA. Enough said.
5) Liquidity – Many CFOs (and lenders) have learned the hard way that liquidity can be the most important element of financial strategy. Our favorite analytical tool for looking at liquidity is the liquidity position.
4) Financial Strategy- Leverage matters too. A company’s debt strategy should depend on its business needs and business risk, not just the condition of the capital markets. The levering up we saw in the boom is evidence that some companies forgot this rule – many have been working to delever since 2008.
3) The Credit Cycle - The debt markets have returned (although not to the levels of 2006-07, yet). The return hasn’t been smooth, however. Issuers and investors have been looking closely at the relationships between the loan and bond markets, perhaps venturing where they haven’t been before.
1) New Opportunities – With the economy (slowly) improving (think increasing loan demand), and bank capital on the mend (think increasing loan supply), we think the increasing bond and loan volumes we saw in the second half of 2010 will continue into 2011. Here’s hoping that 2011 brings you many new opportunities.
What “hot topics” do you see looking forward – leave a comment…
Last post, we argued that Lehman’s Repo 105 balance-sheet-management tactic was not the worst thing Lehman Brothers did on its way to extinction. Volume 8 of Anton Vakulas’s Bankruptcy Examiner’s report details a bunch of blunders with far more serious consequences.
Here are a few of our favorites:
Although management was aware of the growing problems in the mortgage markets as early as 2006, Lehman decided to take on more risk “to pick up ground and improve its competitive position.”
It chose to do that by “making ‘principal’ investments – committing its own capital in commercial real estate, leveraged lending, and private equity investments.”
And it sacrificed liquidity along the way, so that “less liquid assets more than doubled during the same time from $86.9 billion at the end of the fourth quarter of 2006 to $174.6 billion at the end of the first quarter of 2008.”
But in our view, Lehman’s biggest missteps were in risk management. Lehman’s opportunistic push for growth changed into an aggressive push to offset declines in its commercial mortgage business late in 2007 and early in 2008, and that led the company to ignore its own risk controls.
This chart from the Examiner’s Report shows how Lehman’s risk appetite grew through 2007 and into 2008. Risk appetite was Lehman’s estimate of the amount it could lose without jeopardizing employee compensation or shareholder returns.
The chart also shows how in the last two quarters of 2007 the firm exceeded its own risk appetite limit with hardly any restraint, and then in the first quarter of 2008 solved the problem not by reducing risk but by raising the limit.
There are plenty of other instances of management’s undisciplined approach to risk management:
Management played games with key risk measures and “omitted some of the largest risks from its risk usage calculation” until June 2008 and “did not revise its stress testing to address its evolving business strategy.”
“Lehman rewarded its employees based upon revenue with minimal attention to risk factors in setting compensation,” in spite of the fact that managers were supposed to “use risk-weighted metrics such as return on risk equity…to determine compensation.”
After she resisted an increase in the firm’s risk appetite in 2007, Lehman replaced its highly regarded Chief Risk Officer, Madelyn Antoncic, in the third quarter of 2007 with the Chief Financial Officer, Rick O’Meara, who had no risk management experience.
Lehman did not see risk management as a crucial discipline or as a vital safeguard for a company operating with little capital and limited liquidity in troubled markets. For Lehman, risk management was a public relations tool.
It was a show put on to reassure clients, regulators, lenders, and the rating agencies but with no substance or bite. And that misuse of risk management was far more misleading and much more damaging than Repo 105.
In the last 6 months, we’ve seen a number of “amend and extend” transactions. Typically they involve:
The extension of the maturity of a term loan and/or revolver (typically for syndicated, non-investment grade loans). This is only for lenders who agree to the extension (i.e. some lenders may keep the original maturity
Increasing loan pricing for lenders who agree to extend (to reflect current market conditions and the higher credit risk of the borrower) and an amendment fee.
Covenant relief for the borrower (reflecting operating performance below original the targets).
Why an Amend and Extend?
During normal economic times, a borrower would do a new syndication as the maturity date for an existing facility approaches. So why are we seeing amend and extend agreements rather than new facilities? Because many of these companies would have a hard time getting a new syndication done. The loan market is much more selective for high risk credits, and many of these companies have high leverage and weak cash flows.
Amend and Pretend?
It is clear why a borrower would want an amend and extend (despite the higher cost) – they get covenant relief and one or two more years to turn around the business and generate cash for debt repayment. But why are lenders agreeing to these transactions? Do they really believe the borrowers will be able to repay the loans 2 years later, or are they just deferring the day of reckoning – the day when the borrower will need to do a major financial restructuring (or even a bankruptcy) and the lenders will have to write down the value of the loans? Is it an “amend and extend” or “amend and pretend” (that the loan will actually be repaid some day)?
In How the Mighty Fall and Why Some Companies Never Give In, Jim Collins lists five stages of corporate decline. We used them to analyze Xerox in our last post. Collins uses behavioral terms to describe how companies falter, not financial measures.
We have a framework for analyzing troubled companies that complements Collins’ approach. It focuses more on financial measures than management behaviors. Ours is a tool for evaluating the symptoms, while Collins’ explains the cause of the disease.
Our Five Stages of Decline
Our financial framework for analyzing a company in decline has five stages.
Stage 1: Prosperity. A company in this stage is thriving. Sales growth, profitability, and cash flows are all very strong. Liquidity is very high, and leverage is below average for the industry.
Stage 2: Stability. In this stage, sales growth, profitability, and cash flows are strong. Liquidity is high, and leverage is about average for the industry.
Stage 3: Difficulty. Sales growth, profitability, and cash flows are decreasing. Liquidity is low, and leverage is above average for the industry and increasing.
Stage 4: Distress. Sales growth, profitability, and cash flows are negative. Liquidity is very low, and leverage is very high for the industry and increasing.
Stage 5: Default. Companies in this stage have the same characteristics as Distress. But because they have missed a debt payment, they are in some form of financial reorganization or liquidation.
Xerox in Decline
Xerox is a good example of a company going through most of these stages. Let’s take a look at some key measures as Xerox goes from stability in 1999, to difficulty in 2000, and to distress in 2001.
Xerox’s operating profitability varies some through 1999, but it’s basically stable. In 2000, the trend is much worse, and margins contract in every quarter, ending in a loss – a clear case of difficulty. In 2001, profitability improves on the strength of radical cost cuts. But it remains low, and Xerox remains in difficulty.
Xerox’s debt is stable in 1999. But it increases sharply in 2000 to fund the decline in profits – a sign of difficulty. Although debt decreases in 2001, it shifts from 30% short-term at the beginning of 1999 to 60% by the end of 2001. That is a strong indicator of distress.
Liquidity shows a fall from adequate levels in 1999 (stability) to inadequate levels in 2000 (difficulty). By the end of 2001, it’s reached a dangerously low level (distress). Here we define liquidity position as cash and available committed credit lines less short-term debt and the current portion of long-term debt.
The Company Risk Cycle
We call these five stages the Company Risk Cycle. Comparing the trends in a company’s performance and finances to the Company Risk Cycle gives you a way to anticipate what could happen next. It gives you the early warning signs of credit problems.
Of course, decline is not every company’s destiny. Economic and industry cycles come and go, and companies get worse and better as they do. And companies in trouble on their own often solve their problems and turn around the way Xerox did.
The New York Times DealBook blog just put out a fine piece on the collapse of MF Global: A Romance with Risk That Brought on a Panic by Azam Ahmed, Ben Protess, and Susanne Craig (December 11, 2012). It’s the most comprehensive summary of the events that led to the firm’s bankruptcy that we’ve seen so far. Until the investigations are done and the books are written, it’s a good source for thinking about the credit risk lessons to be learned in MF Global’s sad story.
Michael Woodford lost his job on October 14. He had been CEO of Olympus, the Japanese maker of medical systems and cameras, only since last July; and as recently as September, the company’s Chairman had said he was “extremely pleased” with Mr. Woodford’s performance. But then the board fired him for “causing problems for decision making.”
Jean Marie Messier became Chairman of Compagnie General des Eaux in 1996 at the age of 38. He was a graduate of elite French universities. At age 29, he held a senior post in the French Ministry of Economy and Finance. At age 32, he joined Lazard Frères, where he became the French investment bank’s youngest general partner.
The Wall Street Journal 
