Can this financial crisis accelerate the evolution toward "Good Business?"

In the wake of the biggest private enterprise bailout in US economic history, we are staring at the obvious: managing for short term gain only too often creates economic crises. 

In 2008, there seems to be no end to the wealth destruction the subprime collapse has unleashed.  But let’s not forget that the subprime mortgage crisis is just the latest in a series of economic meltdowns that typically enrich a few and impoverish the many.  Before the word “subprime” dominated the headlines, there was Enron.  Remember WorldCom?  The Savings and Loans crisis which already destroyed billions in value?

What do they all have in common?  Each followed rapid growth fueled by dubious business practices; from outright fraud and dishonesty to short term greed, and a lot of poor judgment.  The more prevalent the dubious practices, the worse the crisis.

So how do crises get started?  Usually they start with some “smart” person finding a “flaw” in the system that allows business to generate abnormally high returns—and then exploiting it successfully.

When others observe the success, they want in on it.  The euphoric infection begins.  No one stops to consider whether the high returns generated are based on true wealth creation or just a manipulative game plan.  AND…who would be so foolish to miss out on an opportunity to make more money?  Your bosses and your investors may not forgive you if you don’t play the game.

Fifteen years ago the US financial industry embarked on a steroid growth plan fed by financial engineering.  It flourished until it eventually accounted for 40% of total corporate profits.  Meanwhile its share of value added was only 15% according to BCA Research (cited in The Economist of March 19, 2008.)  Still nobody seemed to notice that something was fishy.  It is true that if anyone raised a concern, they would be laughed out of the room by the enthusiasts of securitization and derivatives: “Don’t you know things are different now; we can slice and dice risks.  We can even ring-fence risk”… or so they thought.  And system risk (when every market collapses at the same time or in a domino-effect) came roaring back.

Yet again we failed to understand all the correlations in the economy, and maybe we never will.  We certainly did not understand how the synergy of marginally poor decisions by each one of the players (See Note 1) could accelerate into such a system collapse. 

Now the implosion of large segments of the financial industry is pulling down the entire economy with it.  Whatever criticisms there are against the Fed right now, almost everyone understands it is vital to keep money flowing if we are going to avoid an economic disaster of the depth of 1929.  As taxpayers, we will all bear the brunt, but the cost will pale compared to that of a total economic collapse.

In the end, we are all in this.  True a few people who got the game going left the table with a lot of money in their pockets, but everyone else is holding the bag.  So let’s stand back and see what we can learn.

If Wall Street represented the smartest of the smart in traditional capitalism, it appears that capitalism has lost at its own game.  Remember how Milton Friedman capsulated the rules of free enterprise in his 1970 article “The Social Responsibility of Business is to Increase its Profits?” Well, Wall Street certainly did that!  But the profits were not what they appeared to be.  Stellar bank profits of a few years back vanished.  In the past 18 months Merrill Lynch lost about a quarter of its earnings since the beginning of the decade, according to FT Research.  Citigroup losses wiped out more than half of its earnings since 2004 according to the New York Times.  Shareholders of Countrywide, Bear Stearns, Fannie Mae, Freddie Mac, Lehman, Merrill (who next?) have watched their capital evaporate.  So much for unfettered capitalism!

The deregulation of the financial industry was supposed to allow market forces to achieve equilibrium.  Savvy sophisticated investment banks were certainly not going to do anything stupid, were they? But the newfound ability to increase financial leverage was more than most could resist, because assets mostly financed by debt provide incredible returns on equity.  More was more, until it was too much, but then it was really too late.

One lesson that begs to be learned is that markets are not efficient when there is a frenzy mentality in place; most players make the same mistakes when there is the potential of immediate profit.  It is time to abandon the mechanistic illusion of efficient rational markets.  Markets are driven by people, and people have emotions.   Research, out of the UK, shows that traders are in fact hard-pressed to make rational decisions.  (See Note 2) 

Of course, regulators will now try to figure out how to prevent a recurrence of the same abuses that got the ball rolling.  (While others, notably Congress, point fingers at the regulators themselves for failing to anticipate the problems.)  And there is some truth to the notion that people sat on their hands while yet another market bubble was developing.   Unfortunately regulation alone will not prevent the recurrence of crises as every new rule becomes an opportunity for creative minds to find a way around it.

So is there no end to this cycle of boom, burst and bust?  Perhaps it is too soon to say.

It is probable things will not change until people change their perspective on what really matters.  In times of crisis, the link between sound values and economic health is at its most obvious.  Soon however markets recover and the lesson is forgotten.  We stop scrutinizing questionable practices.   We no longer examine whether growth is based on value creation or just plain deception.  Never mind all that, as Wall Street and the media are cheering on restored market growth.

Or, can we carve a new path for a more sustainable economic system based on sounder business practices and a focus on the long term?  Can we adopt the model of conscious capitalism that Patricia Aburdene describes in her book Megatrends 2010?

There are reasons for optimism, and the current economic situation may actually help.  Large segments of the business community have already embraced a new, more holistic long-term approach.  The movement of Socially Responsible Investing has long known that companies which embrace sustainability and social responsibility perform better.  Over the past two years, mainstream investors are discovering that as well; to wit Goldman Sachs’ new SUSTAIN investment strategies or Merrill Lynch’s Values-Based Investing.  After the current financial meltdown we expect that investors will be more attentive to long term holistic strategies rather than short term results that mostly favor management compensations.

What will it require?  A stakeholder model of capitalism for starters.  But it will also require that management and investors be clear that long term prosperity can only come from sticking to the simple decision to do good business.     In the middle of market frenzy, it will mean having the courage to hold the course, rather than falling to the temptation to make the most money in the shortest amount of time.
 
At Good Business International, we want to identify and support the companies that are making the right decisions in all aspects of their business.

Note 1:
The Risk of “Bad Business” Practices

Mortgage Brokers
Incented to generate more mortgage volume to collect more commissions,
Not at risk for the poor credit evaluation of borrowers
Eventually marketing subprime loans to people without explaining the risk of rate adjustments, or just plain hiding the dangers

Investment banks
Generating fees on greater issuance volume.
Expanding financing markets.
Attracting more investors. 
Tinkering with securitization models to create more new financial instruments of “different” risk/reward profiles.

Rating agencies
Collecting fees on greater volume of new bond issues.
Putting their stamp on risks they did not understand because they did not make the investment in staff and systems.
WIlling to rely on the models of the investment banks.

Investors
Seeking a higher return, and ready to believe the ratings even though nobody could any longer follow the split risks and cash flows of the instruments they invested in.

Return to text
 

Note 2  

What Rules Financial Markets? Emotion or Reason?

As events unfold in the markets,traders experience wild emotional swings as their brains are bathed in a broth of hormones alternating from testosterone to cortisol. 

From feelings of being “on top of the world” to abject panic, this emotional roller-coaster eventually erodes sound judgment and encourages herd mentality.

Anyone that has witnessed behaviors on a trading floor will relate to these findings.  For more reading on this, see the recent provocative article “Science unveils hidden drivers of stock bubbles and crashes” at ABC News.

Return to text

Alain Bolea is a former investment banker with Deutsche Bank. He is currently a financial consultant who advises companies and managers on how to bridge spirituality and economics. http://www.business-advisors.net/

2008 © Alain Bolea