For a Few Dollars More

Lessons from the Creditcrisis

Human Ruin by Peter Callesen.

Why did banks fail?

Estimated losses• Latest estimate IMF

– April: 4.000 billion dollar

– January: 2.200 billion dollar

– April 2007: 1.100 billion dollar

• Write-downs until now– 1.290 billion dollar

(Bloomberg)• 30.000 billion dollar

loss in share prices

Just an example

Lost 31 billion Euro in 2008

In perspective

Gaza: estimated cost of rebuilding $2.8 billion

Explanations?

“Like many other financial institutions, Lehman Brothersgot caught in this financial tsunami.”

Richard S. Fuld, CEO Lehman Brothers

Explanations?

“We are all struggling to understand how this crisis happened in the first place and to find out what might have prevented it.”Martin Sullivan, CEO AIG

Explanations?“Nobody could expect that a number of financial institutions, like Lehman, AIG en Washington Mutual, would collapse, and that the stock exchanges would reach such a low level. Our dikes are high, but they appeared not high enough for this financial tsunami.”Michel Tilmant, CEO ING

Tsunami?

Too much risk

“The situation we find ourselves in is to a great extent a product of banks - all over the world - taking risks that they should not have and which in many cases they did not even understand. And governments all over the world are having to take action to deal with this.”

-Press release UK Treasury, January 19 2009.

Leverage

NINJA-mortgagesThe $103.000 shed

Marvene Halterman, 61 years old Long history of drug and alcohol abuse, 13 years unemployed

European banks are also over

leveraged

Bank executives earned a lot of money

Renumeration 2003-2007• Fuld (Leman

Brothers)– $256 million

• Lewis (BOFA)– $133 million

• Dimon (JP Morgan)– $108 million

• Blankfein (Goldman)– $102 million

• Purcell (Morgan)– $95 million

But not only the board . . • Twenty year old

analist:– Base salary:

$250.000– Bonus: $250.000

• Thirty year old trader:– Base-salary:

$180.000– Bonus: $5 million

Basic theme“As long as the music is playing, you’ve got to get up and dance. “We’re still dancing.”-Chuck Prince, CEO Citigroup, August 2007.

AIG: “Blind Eye to a Web of Risk“

• AIG Financial Products– Credit Default Swaps: 513 billion dollar on

CDO’s– 17.5% total profit AIG in 2005– Operational profit 83% of revenue– Average bonus; 1 million dollar per person

(377 man)– Loss: 25 miljard dollar – Total salary Mr. Cassano: $280 million in 8

years

Lessons• Better linkage with

organisational performance

• Better balance between salary and bonus

• Focus on long-term• Payments must

deferred until until profits have been realised

Riskmanagement and Internal Control

“We’ve got the right people in place as well as good risk management and controls.” E. Stanley O’Neal, CEO Merrill Lynch 2005.

Management “In control”

Management “In control”“Our job is to set a tone at the top to incent people to do the right thing and to set up safety nets to catch people who make mistakes or do the wrong thing and correct those as quickly as possible. And it is working. It is working.” -Charles O. Prince III CEO Citigroup, 2006

Management “In control”“Almost no one expected what was coming. It’s not fair to blame us for not predicting the unthinkable.“ -Daniel H. Mudd Former CEO, 2008

Management “In control”“The board can't run the risk book of a company.The board as a whole is not going to have a “granular knowledge" of operations.”-Robert E. Rubin Director Citigroup, 2008

What is happening here?

That’s an awful lot of weed!

Growth in CDO’s

Did anyone see it?“The management of market risk and credit risk has become increasingly sophisticated. … Banking organizations of all sizes have made substantial strides over the past two decades in their ability to measure and manage risks.”-Ben Bernanke, FRB speech, 12 June 2006.

We have systems!!!!!!

Sox 404? 2007 2008

Citigroup: V VJ. P. Morgan Chase: V VBank of America: V VBear Stearns: V n.a.Goldman Sachs Group: V VLehman Brothers: V n.a.Morgan Stanley: -/- VMerrill Lynch: V VAIG: -/- n.a.RBS: V, but exception ABN AMRO V, butLloyds TSB Group: V n.a.HBOS: -/- merged Lloyds

TSB)Barclays: V VHSBC: V, but VDeutsche Bank: V VUBS: V VCredit Suisse: -/- V, butING V VABN Amro V VAegon NV V V

AIG• PWC: material weakness relating to

risk management AIGFP (november 2007)

• Office of Thrift Supervision– Lack off 'critical elements of

independence, transparency, and granularity' (March 10, 2008).

• Annual report 2007 approved by auditor

UBS AG“UBS was not aware of the extent and the nature of its risk exposure to the Subprime mortgage and related markets until the beginning of August 2007, and was thus unable to take appropriate measures in a timely manner ” -Report Swiss Federal Banking Commision, 30 seotember 2008

But they declared otherwise in their Sox 404 statement!

Citigroup“But many Citigroup insiders say the bank’s risk managers never investigated deeply enough. Because of longstanding ties that clouded their judgment, the very people charged with overseeing deal makers eager to increase short-term earnings — and executives’ multimillion-dollar bonuses — failed to rein them in, these insiders say.”-New York Times, 22 november 2008

Risk and profit

Two sides of the same coin

Observation• Problems especially

in new financial products

• Why did Riscmanagement fail?– Insufficient

knowledge?– Wrong risk models?– Warnings ignored?– Or all of them?

• Freddie MAC– CRO warns CEO in

2004 for NINJA mortgages

– Response• You are fired

Supervision?

Bernie Madoff• Fraud $50 billion• Auditor: Frieling

& Horowitz– 2 employees– Not registered

PCAOB– No supervision

by AICPA

David G. Friehling CPA

Office Friehling & Horowitz

Non-executive directors?• Insufficient

supervision– Lehman

• Finance and Risk Management Committee only met twice a year

– Members with no Wall Street experience

New trend?

• UBS appointed three new board members with financial expertise

Rating Agencies“These errorsmake us lookeither incompetent at credit analysis or like we sold oursoul to the devil for revenue, or a little bit of both.”A Moody’s managing director in an internal management survey.

Reliable Ratings?The real problem is not that the market …underweight[s] ratings quality but rather that in some sectors, it actually penalizes quality. … It turns out that ratings quality has surprisingly few friends: issuers want high ratings; investors don’t want ratings downgrades; short-sighted bankers labor short-sightedly to game the ratings agencies. “Unchecked, competition on this basis can place the entire financial system at risk.”-R. McDaniel, CEO Moody’s.

In one document, an S&P employee in the structured finance division writes: “It could be structured by cows and we would rate it.” In another, an employee asserts: “Rating agencies continue to create [an] even bigger monster — the CDO market. Let’s hope we are all wealthy and retired by the time this house of cards falters.”-Hearing on the Credit Rating Agencies and the Financial Crisis

Final shootout

The good, the bad & the ugly

Important lessons• We must end remuneration structures/bonuses

of banks being characterised by excessive short-termism. This neither supports prudent risk management nor works in owners’ long-term interests

• Risk management departments in banks must have much more influence, status or power

• A fundamental role of the board is to provide oversight, direction and control but also to challenge where necessary. Banks need more and better qualified non-executive directors.

CVProf. Dr. R. A. M. Pruijm CPA is management-consultant, interim-manager and professor emeritus Accounting Information Systems at the Erasmus University Rotterdam. He was recently appointed as part-time lecturer Corporate Governance at the Fontys Professional University. He is a well-known expert in corporate governance, corporate social responsibility, and business ethics.

Corporate governance is a generic term that describes the ways in which rights and responsibilities are shared between the various corporate participants, especially the management and the shareholders. Corporate governance is about promoting corporate fairness, transparency and accountability.Corporate social responsibility is about open and transparent business practices, that are based upon ethical values and respect for employees, communities, and the environment, designed to deliver sustainable value to society at large and to shareholders.

For over 30 years Professor Pruijm has been speaking to top level business executives and organizations all over the world. He is author of numerous books and articles, and is a regular guest on radio and television. As an independent observer and thought-leader he is frequently consulted by the press, politicians, and business leaders.

Office: Kievit 12 -113

5111 HD Baarle Nassau

Tel. 013 – 507 03 41

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E-mail: ram.pruijm@ext.eur.nl