Lecture Outline—Financial Crisis Case Study—Part 2
Showed more scenes from “Inside Job” documentary video – Covering the Derivatives and battle to regulate them, ultimately lost, in 1990s; Housing Bubble (unsustainable growth in risky sub-prime lending)); The Crisis (collapse of housing market & finance industry); and Accountability & lack of (major players in finance industry who destroyed companies and economy but made tens of millions of $ and faced no penalty – which shows the effect of “Limited Liability” for corporate leaders)
More key terms:
Leverage & Leverage ratio --Capital in reserve requirements for banks, have to keep some on hand incase investments or loans go bad and you have to cover the losses. Traditionally, banks keep 1 $ on hand for every $3 or $10 (at most) loaned out or invested. – a leverage ratio of 1:3 or 1:10. With derivatives, banks could increase leverage greatly to 1:30 and even above, meaning many banks had little cash on hand in case investments went bad.
Collateralized Debt Obligations (CDO’s)—Bundles of any type of loan—home mortgages, car loans, student loans, credit card debt, etc. – into a single security and sold to investors, like a mortgage backed security (MBS). This term becomes used interchangeably with MBS and CDOs are often made up of lots of sub-prime home mortgages. (Ch. 11)
Liquidity—Cash on hand, many finance organizations have little of this. Goldman Sachs was exception, they did keep lots of cash on hand (Ch. 11)
Moral Hazard—Reinforcing (& not penalizing) bad behavior, like borrowers taking loans they can’t pay back & wanting debt forgiven, or lender making very risky & fraudulent loans and then expecting someone else (like govt.) to bail them out / pay for their losses.
Repo lending market / Repo Transactions—Short term loans in exchange for assets -- like giving a bank MBS’s or CDO’s in exchange for cash, and then having to pay back cash in 1 week and getting your CDO’s MBS’s back. Lehman did this and counted loans as sales /revenue, accounting fraud that hid $40-50 billion in losses until other banks lending them money grew suspicious and stopped (Protess et al web rdg., & Ch. 22)
Goldman Sachs (Ch. 11) -- Why Goldman Sachs (GS) so profitable and why other investment banks are so envious of this, esp. Merrill Lynch. GS Change over time—les client focused, more profit focused and ruthless. Lots of conflict of interest (betting against clients, and misleading them or not telling) [See also Protess et al web rdg. on this fraud]; close to clients can see all the info. Very successful, what were keys to success—organizational culture (re cash, risk management, and communication) was different from other banks.
Merrill Lynch (ML) try to imitate and catch up to GM. ML has very different organizational culture from GM, esp. re: communication and risk management. O’Neal shifts ML culture toward taking more risks, big risks. ML becomes large player in underwriting Collateralized Debt Obligations (CDOs). ML sells tranches and also keep some on own books (owns them), some $5-6 b billion.
ML executives who try to warn CEO O’Neal in 2006 that ML is taking on too much risk and SP housing market is showing signs of big problems, those (wise) executives are fired shortly after.
Ameriquest Sub-Prime Morgage originator & CEO Randall Arnall (Ch. 14)—49 State Anttny. Gens. sue Ameriquest (AQ) for massive fraud and abuse of borrowers. AQ widely regarded as one of very worst and most abusive Sub-Prime mortgage originators. In 2006 AQ settles by paying $325 MN fine and agrees to new list of business practices. AQ never recovers and cannot make money under new (non-fraud, non-abusive) business practices, declines and bankrupt by 2008. Meanwhile, AQ CEO Arnall has lots of allies in DC in fed govt.
Countrywide (Ch. 15)—CEO Mozilo hid CW sub-prime risk, but said SP practices were bad in lending industry but not at CW, while privately showing much worry about CW SP practices. CW increases SP lending and requires less info. & documentation from borrowers. Lots of fraud encouraged. This was change from earlier practices, an organizational culture change. All done to get more market share and remain #1 home lender. CW keep riskiest pieces of securitization (some $32 BN) and goes broke in 2008, sold to Bank of America for 84% loss, while year before was its most profitable (this sale is covered in Ch. 19).
Gathering Storm (19) – Bear Stearns 2 large hedge funds collapse in 2007, after being heavily weighted toward Sub-Prime Mortgage Backed Securities / CDO’s, AAA rated but failing. BS managers in denial, think AAA rating means something. Hid extent of SP investing by BS funds from their investors. Stiock price for BS remains high until few months before its funds collapsed. Fund managers not well qualified and in denial… though some danger (& hid it). Rating agencies missed risk—worst credit risk management failure ever. Rating agencies reluctant to downgrade SP mortgage-related products (tranches of CDO’s and MBS’s that were AAA rated), because feared mass sell off and panic if they did; finally started to in July 2007…
The Dumb Guys (Ch 20)—Merrill Lynch in denial that they have any significant SP risk. Key managers hid Sub-Prime Mortgage MBS / CO risk, as they massively increased ML’s subprime exposure / investment grow by factor of 9-10 (900-1000%) from $5-8 bn. to $55 bn., in one year from 2006-2007 – nearly all of which is later written off as loss. Still believed AAA ratings meant low risk for S-P mortgages…
The Volcano erupts (Ch. 22)-- Bear Stearns investment bank collapses in March 2008. BS stock drops 97% in one week and they are bought at bargain price by Bank of America, Near end, Repo market refuses to lend anymore to BS, decides its AAA rated SP investments are not worth much. Lehman Bros. collapses Sept 2008, after high leverage 30:1 on huge real estate and posting large losses in summer 2008. [Also, see Protess et al. web rdg. for Lehman’s fraudulent accounting of $50 billion of Repo loans as sales—as noted as noted in video I showed on this also.] Collapse of Lehman starts financial crisis and recession. Treasury dept. takes over (nationalizes) Fannie and Freddie in Sept 2008 so Lehman problems would not spread to F&F. Costs $200 bn. Feds see this as necessary of or else housing market would collapse entirely. AIG (insurance company) bailed out in Sept 2008 by fed. govt. for initial cost of $85 bn., and later much more ($182 bn.)
Organizations / Bureaucracy Concepts to keep in mind in looking at all this:
Organizational Networks
Key features of bureaucracy “ideal type” -- Hierarchy, Div. of Labor, Technical Expertise for employment, Rules & Regs, Written comm. & records, etc.
Disadvantages of bureaucracy – Bureaucratic Secrecy, Goal displacement, Empire Bldg., Hierarchy & Abuse of Power, managers seek to avoid blame, Resistance to change, rigidity, undemocratic tendencies, irrationality of bureaucratic rationality, etc.
Social Impact of Bureaucracy
Management styles-- Rational systems view VS. Human Relations model
Need for Organizational Accountability & Change—done via critical reflection first to think about what is going on and see problems… then leads to resistance
Relationship between: Human Agency –Social Structure/Orgs.
Social Mind and Reflectivity and Resistance
Bureaucracy & Human Rights -- Need for & difficulties in organizational and corporate accountability
Corporations and Human Rights -- Corp. power, Corp. Personhood & Limited Liability (Sjoberg) web rdg)
Orgs. & Disasters and Crises --Key is not the particular disaster / crisis, but rather how orgs. Respond, “Positive Asymmetry” (always expecting best), Manager difficulties seeing failures and crises—see “normal” conditions