The Sunshine Report

MINIMUM STANDARDS FOR CEOs OF GLOBAL BANKS – WHAT SHOULD THEY KNOW ABOUT LEVERAGE?" rel="bookmark">MINIMUM STANDARDS FOR CEOs OF GLOBAL BANKS – WHAT SHOULD THEY KNOW ABOUT LEVERAGE?

I have been an out­spo­ken critic of too much lever­age in the finan­cial sys­tem for the past sev­eral years. On CNBC and Fox Busi­ness Net­work I have spo­ken out against the dan­gers of bank and bro­ker­age over lever­age and sug­gested that such over lever­age could cause a repeat of the Great Depres­sion. Like a giant oil slick, the finan­cial ser­vices sec­tor of the United States has been an inch deep and a mile wide for years. Clips of some of those inter­views can be found at http://www.firstcapital.com/financial_news.html. Reg­u­la­tors don’t seem to care about man­age­ment strate­gies that have dri­ven the econ­omy into the ditch and share­hold­ers don’t seem wor­ried about man­agers that lack both com­mon sense and basic finan­cial training.

The events of the last 12 months have seemed so unbe­liev­able to me that I have started to won­der if there are ANY min­i­mum stan­dards of knowl­edge and train­ing to be the CEO or CFO of a global United States based finan­cial institution.

Many jobs in the United States have min­i­mum edu­ca­tional and train­ing stan­dards. Doc­tors attend med­ical school and get licensed. Lawyers are trained in law school and take the Bar Exam­i­na­tion. Even the peo­ple that take care of our pets, fix toi­lettes and build our houses have stan­dards that they must meet before they can hold them­selves out as experts.

But, what about the exec­u­tives of large banks and bro­ker­ages? What are their min­i­mum edu­ca­tional or com­pe­tency stan­dards and do they meet such standards?

It turns out that pretty much the answer is CEOs and CFOs do not pass any exam­i­na­tion, are not licensed and have no min­i­mum edu­ca­tional stan­dard. Who is qual­i­fied to be a bank CEO or CFO has been pretty much left up to the Board of Direc­tors of each institution.

With no “national stan­dard” for bank and bro­ker­age CEOs and CFOs I decided that I would cre­ate my own stan­dards and bench­marks for mea­sur­ing com­pe­tence. So, this blog is about the stan­dards that I think should apply to the lead­ers of global finan­cial insti­tu­tions and whether or not CEOs/CFOs meet such standards.

• Edu­ca­tion. I think that edu­ca­tional stan­dards fly in the face of this country’s “Hor­a­tio Alger” ethic and are “elit­ist”. After all, Abe Lin­coln only had about 1 year of for­mal edu­ca­tion and was per­haps the great­est Pres­i­dent of the United States (http://showcase.netins.net/web/creative/lincoln/education/glance.htm). Lin­coln prob­a­bly could have run a bank or bro­ker­age (after all he ran a civil war). Vin­cent McMa­hon, CEO of World Wrestling Enter­tain­ment, is able to run a large and suc­cess­ful cor­po­ra­tion and he prob­a­bly doesn’t have any for­mal edu­ca­tions (other than per­haps in phar­ma­col­ogy). If McMa­hon can run wrest­ing he can run a bank. George Bush went to col­lege (and grad­u­ate school) but pre­tends that he didn’t. Pres­i­dent Bush runs a whole coun­try!! And, Howard Hughes didn’t grad­u­ate from col­lege even though he was pretty smart. I am cer­tain Mr. Hughes could have been a banker in today’s environment.

   

  And, since col­lege isn’t required nei­ther should knowl­edge of eco­nom­ics, finance, account­ing or eco­nomic his­tory. Nor will require­ments include higher level math such as Alge­bra, cal­cu­lus or sta­tis­tics. CEO/CFO can­di­dates shouldn’t be expected to mas­ter more than basic addi­tion, sub­trac­tion, mul­ti­pli­ca­tion and divi­sion (with a calculator).

   

• Work expe­ri­ence and/or appren­tice­ship require­ments. Abe Lin­coln didn’t have a lot of exec­u­tive expe­ri­ence before being Pres­i­dent, so nei­ther should bank CEOs/CFOs. Hedge fund man­agers, i.e., the “Kings” of cor­po­rate finance, don’t need any prior expe­ri­ence (and many of them don’t have any). So why should a higher stan­dard be imposed on CEOs/CFOs of global finan­cial insti­tu­tions?
  

   

• Min­i­mum read­ing and gen­eral knowl­edge and where to find it. There are some stan­dards that I think should apply in terms of gen­eral knowl­edge and min­i­mum read­ing mate­r­ial. How­ever, given no real edu­ca­tion, work expe­ri­ence or appren­tice­ship require­ments, these stan­dards need to be “rea­son­able”.
  

  After reject­ing the local pub­lic library as a source of read­ing mate­r­ial for high level finan­cial exec­u­tives (remem­ber I want to have rea­son­able stan­dards for our nation’s finan­cial lead­ers and most books in the library have “big words”), I decided to go to Barnes and Noble. If it is impor­tant to know it is prob­a­bly found in the exten­sive selec­tion at Barnes and Noble.

In the busi­ness sec­tion of Barnes and Noble I found two busi­ness books that seem per­fect. Nei­ther book used big words or a required lot of math, and to under­stand them an advanced degree (like an Associate’s Degree from Palm Beach County Com­mu­nity Col­lege) wasn’t required.

The first book I chose, The Lit­tle Book of Value Invest­ing is part of the “Lit­tle Book” series pub­lished by Wiley.

In the dust cover the pub­lish­ers ask “Do you care about your money?” Well, bank and bro­ker­age CEOs and CFOs are sup­pose to care about money. The pub­lish­ers claim that that only an IQ of 125 is nec­es­sary to under­stand the book. In fact, The Lit­tle Book of Value Invest­ing says that that any IQ greater than 125 is “wasted.” Well, an IQ require­ment was a new con­cept but one that I decided is rea­son­able. But what “sealed the deal” for The Lit­tle Book was the fact that the pub­lish­ers claim that the reader will “[learn] to put your money to work like a banker” (and since we are search­ing for proper stan­dards of knowl­edge for bank CEOs and CFOs….). And, for read­ers that have trou­ble read­ing, there is an audio ver­sion of this book. Barnes and Noble fea­tures The Lit­tle Book of Value Invest­ing on their web site at http://search.barnesandnoble.com/booksearch/results.asp?WRD=the+little+book+of+value+investing.

The sec­ond book, Value Invest­ing for Dum­mies, is even more nat­ural for money cen­ter bank CEOs/CFOs. Value Invest­ing for Dum­mies claims to teach how to “detect hid­den agen­das in finan­cial reports.”, “under­stand finan­cial state­ments” and “assess a company’s value”. The book explains “fun­da­men­tals and intan­gi­bles”, has “tear-out cheat sheet(s)” and fea­tures “a dash of humor and fun”.

The Dum­mies series of books are well known ref­er­ence books for dis­cern­ing read­ers and learn­ers. After all, the Dum­mies series has mas­tered such eso­teric and dif­fi­cult top­ics such as sea­sonal addic­tive dis­or­ders in their Sea­sonal Addic­tive Dis­or­ders for Dum­mies (a must read for all men­tal health pro­fes­sion­als), the conun­drum of the human genome in their ground­break­ing Genet­ics for Dum­mies work (I under­stand it is required read­ing at most med­ical schools), the mys­tery of the 1980s per­sonal com­puter in their newly revised DOS for Dum­mies (finally an easy to under­stand ref­er­ence book for peo­ple with a com­puter pho­bia) and how to kill time while wait­ing in an air­port in the sem­i­nal work Su Doku for Dum­mies (if only I had this on my last trip to Asia). The most author­i­ta­tive list of Dum­mie books can be found on the Barnes and Noble web site at http://browse.barnesandnoble.com/browse/nav.asp?visgrp=nonfiction&n=1000005131&ne=1000005131&Ns=SERIES_NUMBER.

So, what about those min­i­mum stan­dards for the global finan­cial leaders?

What should they know about leverage?

Accord­ing to The Lit­tle Book of Value Invest­ing quite a bit.

In the “Lit­tle Book” chap­ter titled “Sift­ing Out the Fool’s Gold” I learned

“The first and most toxic rea­son that [com­pa­nies don’t do well] is too much debt. In good times, com­pa­nies with decent cash flow may bor­row large amount of money on the the­ory that if they con­tinue to grow, they can meet the inter­est and prin­ci­pal pay­ments in the future. Unfor­tu­nately, the future is unknow­able, and com­pa­nies with too much debt have a much smaller chance of sur­viv­ing and eco­nomic downturn.”

The Lit­tle Book chap­ter titled “Give the Com­pany a Phys­i­cal” con­tin­ues to teach and illu­mi­nate in terms that every­one can understand.

“Much as a doc­tor con­sults patients’ charts to see what con­di­tion they are in, look to the bal­ance sheet to see what shape the com­pany is in. The doc­tor needs to know all the vital signs to make a diag­no­sis. A bal­ance sheet is effec­tively a company’s med­ical chart….”

Read­ers are told that they

“….want to make sure that the com­pany is not overly bur­dened with debt, and that there is enough cap­i­tal to stay in busi­ness dur­ing bad times.”

Lever­age trends are iden­ti­fied as impor­tant in the Lit­tle Book when it con­tin­ues to state

“…it is use­ful to observe trends over the past few years. Are lia­bil­i­ties grow­ing faster than assets? This could be an indi­ca­tion that the com­pany has to bor­row more and more money just to stay afloat…”

How­ever, Mr. Browne (the author of the Lit­tle Book) appears to be a purest (which is per­haps a con­tro­ver­sial posi­tion) when he states that he

“…prefer(s) to sub­tract intan­gi­ble assets from [equity]” when cal­cu­lat­ing the amount of debt to equity because equity less intan­gi­bles gives him “…a bet­ter pic­ture of how much actual equity there is in a com­pany that could poten­tially be real­ized if needed.”

The Lit­tle Book of Value Invest­ing con­tin­ues to warn

“In gen­eral a high debt-to-equity ratio means that a com­pany has been financ­ing its growth by bor­row­ing. Lever­ag­ing the com­pany by increas­ing debt lev­els is a double-edged sword….there is a real dan­ger of default and bank­ruptcy down the road. The less debt on the bal­ance sheet, the grater the mar­gin of safety.”

In con­clu­sion the Lit­tle Book points out

“A strong bal­ance sheet is a good indi­ca­tor of a company’s sta­mina, its abil­ity to sur­vive when the going gets tough.”

Value Invest­ing for Dum­mies has sim­i­lar lessons for CEOs/CFOs when in “Fun­da­men­tals for Fun­da­men­tal­ists” it asks and answers the “age old” ques­tion of “How much [debt] is too much?”

“[The] exces­sive use of debt sig­nals poten­tial dan­ger if things don’t turn out the way a com­pany expects them to. Lever­age is a good thing when things are going a company’s way. Debt financ­ing can be used to pro­duce more ….profit and, in the end, a big­ger business….But as every­one knows, this can work the other way….Industry stan­dards and com­mon sense apply to debt-to equity ratios.?”

Later in Value Invest­ing for Dum­mies the reader is again warned that

“Finan­cial lever­age can be a good thing – to a point, and as long as things are going well.”

So, how do the CEOs/CFOs some lead­ing banks and bro­ker­age firms stand up the stan­dard of know­ing and apply­ing the infor­ma­tion found in The Lit­tle Book of Value Invest­ing and Value Invest­ing for Dum­mies?

Let’s start with the man­age­ment team from Bear Stearns. As it turns out, when it failed Bear Stearns had the high­est debt lev­els of any of the major bro­ker­age firms. At 33.53 to 1 at the end of 2007 Bear Stearns was mas­sively over­lever­aged and appar­ently didn’t under­stand that with so much debt “there [was] a real dan­ger of default and bank­ruptcy down the road.” (from The Lit­tle book of Value Invest­ing). And the trends for the past 5 years of lever­age were bad. Man­age­ment didn’t real­ize that they were increas­ing the risk of a fail­ure and up until the very end had lit­tle idea of the trou­ble that they were in. More­over, com­mon sense would sug­gest that when the com­pany was “burn­ing down” play­ing tour­na­ment bridge prob­a­bly wasn’t the best crises man­age­ment strat­egy. Clearly, the man­age­ment team at Bear Stearns needed to spend some time at Barnes and Noble hon­ing their skills and as a result failed the com­pe­tency test (not a big surprise).

The Lehman Broth­ers team in place dur­ing 2007 also failed the com­pe­tency test. With lever­age at approx­i­mately 30.70 to 1 (and hav­ing added mate­r­ial amounts of addi­tional lever­age dur­ing 2005, 2006 and 2007) they only seem to have a mar­gin­ally bet­ter under­stand­ing about risk and lever­age than the Bear Stearns team (maybe that is why Lehman Broth­ers almost failed like Bear Stearns). How­ever, Lehman’s new CFO Erin Callan seems to pass the com­pe­tency test. Since she took over as CFO the firm has been reduc­ing its debt bur­den while at the same time increas­ing its equity and improv­ing its “Net Lever­age” ratio by almost 25%. By the way, Erin under­stands that when cal­cu­lat­ing Net Lever­age she is sup­posed to deduct good­will and other intan­gi­bles from equity as sug­gested by The Lit­tle Book. Erin appears to be the star of the Lehman Broth­ers exec­u­tive suit.

At Cit­igoup the team headed up by Chuck Prince clearly didn’t
know what was in either the Dum­mie or the Lit­tle Book series and were appro­pri­ately ter­mi­nated. How­ever, the new team lead by Vikram Pan­dit seems to have the “right stuff.” He is rais­ing cap­i­tal and reduc­ing debt as fast as humanly pos­si­ble. I guess his team has been hang­ing out at the Starbuck’s in his neigh­bor­hood Barnes and Noble.

What about First Cap­i­tal? First Cap­i­tal oper­ates at a Net Lever­age Ratio of about 3 to 1 (which is about 1/10^th of Lehman Broth­ers’ ratio after Ms. Callan began to per­form her magic and 1/15^th of Citigroup’s Net Lever­age Ratio at Decem­ber 31, 2007). We didn’t increase our lever­age over the last 5 years and are care­ful to man­age both debt and equity to main­tain what is con­sid­ered to be a “fortress” bal­ance sheet. I guess we pass the lever­age com­pe­tence test.

In future blogs I will dis­cuss addi­tional CEO/CFO com­pe­tency tests using cri­te­ria found in The Lit­tle Book of Value Invest­ing and Value Invest­ing for Dum­mies. I am con­fi­dent that First Cap­i­tal will con­tinue to pass the test but less con­fi­dent about others.