Shrugging Towards Recession

Too many executives gave the nod to financial instruments they just didn't get

What can the average person do to help the economy? — Jane Brown, St. Louis

Not much that would surprise you, we're afraid. Just hunker down, but don't panic. Recessions happen, and recessions end. The main thing you can do in the interim is live within your means.

Your question, though, raises an interesting point. You ask what the average person can do. But it wasn't average people who got us into this mess. First, there were the frighteningly overzealous—or disturbingly clueless—brokers who sold home loans to people who couldn't afford them. Then there were the borrowers themselves, who took the loans under the influence of too much hope, too little personal responsibility, too vague an understanding of finance, or all three. Meanwhile, far away on Wall Street, there were the investment bankers, following on years of abundant easy money chasing fewer and fewer deals, who financed ever more mediocre acquisitions that failed to close as credit markets dried up.

And then...there were the financial engineers who really blew things up. These very unaverage brainiacs, working at firms all over, spent the past few years inventing increasingly complex and incomprehensible debt instruments. You've heard the acronyms: CDOs, CDSs, SIVs, whatever. Their names were as mysterious as their contents, a strange brew of subprime loans, triple-A stuff, and everything in between. But complexity wasn't the problem. Lots of innovations are complex. The problem was that these products were sold into a yield-hungry market without enough top managers abreast of why or how they made money.

Until they weren't making it anymore, triggering a fallout that consists of billions of dollars of write-offs.

Now, it has been some time since consumers understood all the Street's products. But the Wall Street leadership buying and selling those products should have a firm grasp, and our point is, we're not sure they did this time. Everywhere we go, we hear experienced executives surprised by the toxicity of the alphabet soup of new debt instruments and shocked by the size of the hole they left behind when they exploded. And, with a few exceptions, we doubt the level of comprehension was much greater at the companies dealing them. Indeed, we'd speculate that managers at most firms let the profits pour in—even encouraged and rewarded those profits with huge bonuses—without being able to explain to themselves, or anyone, how all that cash was actually being earned.

Wrong? Absolutely. But you can picture it happening. When these debt instruments started to debut, many top managers probably did ask how they worked, and someone who got it probably tried to explain, but both parties likely shrugged off any gap in understanding. The products were new, after all. Who knew how they would fare? Then they started faring very well, and managers quickly let the profits speak for themselves. The hefty bonuses spoke even louder.

Just briefly, compare that to what normally happens in finance or industry. When a product debuts—from a leveraged lease to an iPhone—managers know the business-model drill. And if net income surges, they can pinpoint why by looking at shifts in the marketplace. Profits may not come easy, but they make sense.

In the frenzy over CDOs, CDSs, SIVs, and the like, such transparency grew hazy. The financial engineers understood what they were creating, but their managers probably didn't. And their managers' managers, all the way to board level, probably didn't either. They didn't dig. They didn't ask: "Who's going to finally end up owning this paper?" or, "Why do these products have such good credit ratings?"

Recent history has shown that when it comes to management and governance failures, ignorance is no defense. But we didn't need Enron, or this credit crunch, for that lesson. Nor will we necessarily need the legislation that will result from this mess. In business, when profits seems too good to be true, they usually are, and it's a leader's job to figure out what's going on. When they don't, too many people, average and not, end up paying the price.

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