In this economic environment of little visibility going forward and indeed little transparency into the health of the transactional practices at the moment, you may find yourself struggling to meet partners' expectations for a continuation of the double-digit growth rates of revenue and income that most firms have enjoyed for the past six or seven years.
While I believe (as I've written) that times like these provide for the potential emergence of new leaders and laggards—based on who can more nimbly navigate the opportunities that the current deviation from "steady as she goes" provides—I also believe that the temptation to meet largely self-imposed revenue and/or income targets can lead one into peril. Two stories in the past 24 hours exemplify the danger.
From The Wall Street Journal, a nicely done historic recap of why Merrill Lynch seems to be on track to break a record it would rather leave stand, by writing down more than $30 billion and posting a third straight quarterly loss, the longest losing streak in its 94 years:
"The first tremor that rattled Merrill's profitable business of underwriting mortgage securities came at the end of 2005. As it repackaged mortgage bonds into securities called collateralized debt obligations, or CDOs, Merrill had a key partner in insurer American International Group Inc. An AIG unit bore the default risk of the CDOs' largest and highest-rated chunk, known as the "super-senior" tranche, normally sold to big investors such as foreign banks.
"But AIG was keeping a close eye on the housing boom because it had another unit that made subprime loans, those to home buyers with weak credit. AIG did a review of the market. Concerned that home-lending standards were getting too lax, AIG at the end of 2005 stopped insuring mortgage securities.
"Merrill was used to having to keep lots of mortgage bonds and pieces of CDOs on its books temporarily before selling them. But without a firm like AIG providing credit insurance, Merrill had to bear the risk of default itself.
"Instead of scaling back its underwriting of CDOs, however, Merrill put the business in overdrive. It began holding on its own books large chunks of the highest-rated parts of CDOs whose risk it couldn't offload.
"Merrill was able to hang onto the top spot in Wall Street's CDO-underwriting ranks."
The efforts to sustain the CDO gravy train became more brazen than just assuming additional trading risk. John Breit, described as a "senior risk manager," was overruled—an event without precedent—when he objected to certain Canadian underwritings. He submitted a letter of resignation to the CFO but was given a different position outside risk management stayed at the firm.
Another executive who had a custom of limiting CDO exposure was dismissed in mid-2006, and a senior trader "without much experience in mortgage securities" was installed to oversee the function of taking CDO's onto Merrill's own books.
As the housing market began visibly deteriorating in 2007, Merrill could (says the Journal) have ended its exposure to the mortgage-backed market at the price of a $1.5-$3-billion writeoff. "Instead, Merrill tried a different strategy: quickly turn the bonds into more CDOs." The goal was evidently to stay at the top of the league tables, and they achieved that soon to be dubious distinction:
"In the first seven months of 2007, Merrill created more than $30 billion in mortgage CDOs, according to Dealogic, keeping Merrill No. 1 in Wall Street underwriting for this type of security."
But the music quickly stopped and John Thain, the new CEO, is now hard at work upgrading risk controls—even to the point of rehiring the risk-conscious executive they fired in 2006. And if I read the story right, the price of avoiding a $1.5-3 billion writeoff a year ago will end up being $30-billion in writeoffs.
Separately, The New York Times yesterday featured a story covering a book about to be published advancing the theory that what caused the Titanic to sink as fast as it did (in merely 2-1/2 hours) were poor quality rivets that popped and turned what were six small slits into wounds open to the sea.
At the time of the Titanic's construction (1911-1912), steel rivets installed by machine were the highest standard, as was "best best" metal to make the rivets. But the ship's builder, Harland and Wolff of Belfast, Northern Ireland (still in business today) was severely overtaxed in its shipbuilding capacity as it was simultaneously assembling the Titanic's two sister ships, the Olympic and the Britannic. Each required 3 million rivets. According to the new book, shortages of both rivets and riveters peaked while the Titanic was under construction:
"'The board was in crisis mode,' one of the authors, Jennifer Hooper McCarty, who studied the archives, said in an interview. 'It was constant stress. Every meeting it was, ‘There’s problems with the rivets and we need to hire more people.''"
Forced to reach beyond its usual suppliers to smaller, less skilled and experienced forges, and choosing to buy merely "best" rather than "best best" iron, Harland and Wolff also reached out to inexperienced and green riveters and chose to economize at the bow and stern of the Titanic by using iron rather than steel rivets (which were used amidships). Famously, the iceberg hit near the bow.
"The company also faced shortages of skilled riveters, the archives showed. Dr. McCarty said that for a half year, from late 1911 to April 1912, when the Titanic set sail, the company’s board discussed the problem at every meeting. For instance, on Oct. 28, 1911, Lord William Pirrie, the company’s chairman, expressed concern over the lack of riveters and called for new hiring efforts.
In their research, the scientists, who are metallurgists, found that good riveting took great skill. The iron had to be heated to a precise cherry red color and beaten by the right combination of hammer blows. Mediocre work could hide problems."
Could better rivets have kept the Titanic afloat long enough for help to arrive? That is the fascinating question the book implicitly poses.
Yet I have a different question: Why was there (so it would appear) no discussion at the Harland and Wolff board meetings about slowing down production to permit first-class materials to be obtained and first-class work to be done? Presumably egos were at stake—as egos were at stake in Merrill Lynch retaining its #1 league ranking for CDO's.
Tempted you may be to rely heavily on a familiar practice or area, and lean on it hard in these times. If you do so, a word of caution: Park your ego at the door.
One last thing: Recognize that these are not normal economic times, and face that reality with brutal realism.
Merrill was not willing to recognize the brutal reality of the incipient subprime meltdown, even to the point of firing and demoting those who were. And Harland and Wolff ignored the potentially dire consequences of high-slag content (not "best best") iron and callow riveters.
As well as you know your business—and that actually only makes it worse—beware hubris.
April 16, 2008 7:40 PM
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