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On Wall Street and Finance
The Countrywide Conundrum
It’s more than a little difficult to imagine Angelo Mozilo, the embattled chief executive of mortgage lending giant Countrywide Financial, being a Drucker disciple. But just last year he didn’t hesitate to paint himself that way and, in at least one sense, he was right.
“As the late Peter Drucker once said, the entrepreneur always searches for change, responds to it, and exploits it as an opportunity,” Mozilo told an audience of bond holders, bankers, and others. “This is the essence of Countrywide’s culture.”
Countrywide, lashed like many other companies by the subprime storm, isn’t crowing as much anymore. A few weeks ago, it reported a loss of $1.2 billion for the third quarter. Included in that were charges related to plans to cut as many as 12,000 jobs, or about 20 percent of Countrywide’s workforce.
The First Responsibility
Meanwhile, Mozilo—long a target of critics for his king-size compensation—is under heavy fire from shareholder activists. (Drucker, too, abhorred excessive CEO pay.) And the Securities & Exchange Commission has reportedly been poking around in Mozilo’s prearranged sales of company stock.
More broadly, the mortgage mess brings to mind everything Drucker taught businesses not to do. By peddling complex financial instruments to legions of borrowers who couldn’t understand what they were getting into and were unequipped to handle the debt they were taking on, unscrupulous mortgage brokers violated what Drucker termed “the first responsibility” of any professional: to “not knowingly do harm.”
By devising ever-more-exotic mortgage-backed securities, Wall Street firms made it tough for most investors to properly assess risk and helped fuel a bubble—precisely the kind of unsustainable, short-term-profit-driven model that Drucker loathed. “Pigs gorging themselves at the trough are always a disgusting spectacle, and you know it won’t last long,” Drucker said during an earlier market shakeout in the late 1980s.
Regulation Is Key
And by taking advantage of lax regulatory oversight, subprime lenders sidestepped one of their main obligations: to make sure that sufficient standards and oversight are in place, even if it pushes up their costs. In most cases, Drucker wrote in his 1973 magnum opus, Management: Tasks, Responsibilities, Practices, “regulation is in the interest of business, and especially in the interest of responsible business.”
Without it, Drucker added, there is inevitably crisis and scandal. And that “leads to governmental inquisition, to angry editorials, and eventually to loss of confidence in an entire industry, its management, and its products by broad sectors of the public.” Which is, of course, where we are today.
But before totally giving up on subprime mortgages, it’s worth remembering they also represent something Drucker applauded (and to which Mozilo referred): a genuine social innovation.
During the 1990s the U.S. saw its homeownership rate rise more than at any time since the ’50s; it now stands at about 68 percent. Minorities, who’d been systematically locked out of the system for generations, have made strides. The number of blacks owning homes has climbed from about 42 percent in 1994 to nearly 47 percent. The rate of Latino homeownership has jumped from 41 percent to 50 percent. One big reason for these gains is subprime loans.
Obviously Risky
Yet as the subprime contagion continues to spread—and the ousters of Stan O’Neal at Merrill Lynch and Charles Prince at Citigroup indicate it’s going to for some time—the pressure will only increase to tighten mortgage lending to where it was 20 years ago.
Indeed, many commentators “have suggested that we throw out the whole market and go back to the constricted situation of the early 1990s,” Edward Gramlich, a senior fellow at the Urban Institute and the author of Subprime Mortgages: America’s Latest Boom and Bust, told those gathered at a Federal Reserve conference last summer. But “that seems exactly the wrong message to take from the experience,” Gramlich said. “The sub-prime mortgage market was a valid innovation, and it did enable 12 million households to become homeowners.”
Lending large sums to people with scant or shaky credit histories is, obviously, risky. Then again, Drucker noted in his 1985 book, Innovation and Entrepreneurship, “All economic activity is by definition ‘high risk.’”
Simple Greed
The problem with subprime lending was not the nature of the innovation itself. It was the way it was carried out. Correctly executed, “innovation is both conceptual and perceptual,” Drucker wrote. “Successful innovators use both the right side and the left side of their brains. They look at figures and they look at people. They work out analytically what the innovation has to be to satisfy an opportunity. And then they go out and look at the customers, the users, to see what their expectations, their values, their needs are. Otherwise one runs the risk of having the right innovation in the wrong form.”
In a way, that’s just what happened here. Because of simple greed, all sorts of subprime loans were sold with reckless disregard for whether these particular products were appropriate for the consumers snapping them up.
The end result, as Drucker might say, is that the crisis has put all the focus on what shops such as Countrywide have done to society. Largely forgotten is what they’ve done for it.
November 9, 2007
The Financial Crisis: What Drucker Would Have Said
Peter Drucker didn’t have a whole lot of nice things to say about those on Wall Street, at one point likening them to “Balkan peasants stealing each other’s sheep.”
Given the magnitude of the latest crisis to grip Fannie Mae, Freddie Mac, American International Group, Lehman Brothers, and their friends, one can only imagine what kind of acid analogy he might have used today.
Or perhaps he would have simply said, “I told you so.”
After all, so much of the trouble that has befallen these giants of the investment banking, mortgage, and insurance sectors—and that threatens to “undermine the financial security of all,” as President George W. Bush put it—comes from a foolish disregard for the kinds of fundamental lessons that Drucker taught about risk, reach, and responsibility.
Some prefer to complicate things, particularly now that the Bush administration has announced a $700 billion rescue package. Indeed, there is a temptation, in certain quarters, to fuzzy up what has happened here—to mask the basic management failures that are at the root of this disaster by pointing to the intricacies of credit-default swaps, “naked shorts,” and other arcana.
Luck Doesn’t Last
But as Drucker knew so well, none of this is really very complex: If you make enough dangerous bets—and amassing your fortune on a foundation of laughably loose lending standards and mountains of debt is nothing if not dangerous—you’re eventually going to run out of luck.
“No matter how clever the gambler,” Drucker asserted, “the laws of probability guarantee that he will lose all that he has gained, and then a good deal more.” He wrote these words in the 1990s, as a different group of once-illustrious institutions—Barings, Bankers Trust, Yamaichi Securities—were felled by their recklessness.
Drucker noted that top management professed to be shocked by some of the activities that had taken place at these firms, and it won’t be surprising if we hear similar talk this time around—especially if people wind up going to jail. It was reported that the FBI has opened more than two dozen probes into possible fraud connected to the financial meltdown, including investigations at Fannie Mae, Freddie Mac, AIG, and Lehman.
But Drucker didn’t buy that senior executives were blind to their employees’ egregious behavior a decade ago, and he wouldn’t buy it now. “In the first place,” he wrote, “there is a limit to coincidences. Such widespread breakdowns cannot be blamed on ‘exceptions.’ They denote systems failure.”
Too Big to Hide
Besides, Drucker added, “in every single one of these ‘scandals,’ top management seems to have carefully looked the other way as long as trading produced profits (or at least pretended to produce them). Until the losses had become so big that they could no longer be hidden, the gambling trader was a hero and showered with money.”
Of course, the pressure to produce these profits—and, in turn, prop up a company’s share price—has become unrelenting. It used to be, veteran financial journalist Bob Reed remarked recently, “the stock price was an important component of something more grand: how well the company was managed, product quality, innovations, customer satisfaction—you know, the business.” But over time, those pursuits have become largely overshadowed by just one: maximizing shareholder value.
To Drucker, this mentality was anachronistic. “One thing is clear to anyone with the slightest knowledge of political or economic history: The present-day assertion of ‘absolute shareholder sovereignty’ . . . is the last hurrah of nineteenth century, basically preindustrial capitalism,” he wrote in a 1988 article. “It violates many people’s sense of justice.”
Perhaps even more important, Drucker said, this lack of balance is unsettling in a world in which large institutions have such an enormous effect on so much—on the portfolios of shareholders, yes, but also on the lives of millions of other people, as we’re seeing right now.
Long-Term Thinking
In this day and age, “modern enterprise, especially large enterprise, can do its economic job—including making profits for the shareholders—only if it is being managed for the long run,” Drucker wrote. “Altogether far too much in society—jobs, careers, communities—depends on the economic fortunes of large enterprises to subordinate them completely to the interests of any one group, including shareholders.”
All of which leads, in the end, to the biggest thing missing today on Wall Street and in much of Corporate America: an ethic of responsibility.
Drucker believed strongly that every business must contribute to the general health of society. This means doing “good works” where appropriate. But above all, it means ensuring that the business itself is well-managed and built to last.
“The institution’s performance of its specific mission is . . . society’s first need and interest,” Drucker wrote in his 1973 book, Management: Tasks, Responsibilities, Practices. “A bankrupt business is not a desirable employer and is unlikely to be a good neighbor in a community. Nor will it create the capital for tomorrow’s jobs and the opportunities for tomorrow’s workers.”
I often tell people that there are a million reasons to read and reread what Peter Drucker had to say. This week, it’s more like 700 billion.
September 26, 2008
Financial Leadership, the Missing Ingredient
As the financial crisis went from bad to worse last week, policymakers and business executives fussed and fretted over the drying up of credit around the world. The bigger problem, though, is a severe shortage of something else entirely: leadership.
Peter Drucker—who began writing on the topic in the 1940s, long before it became fashionable—considered true leaders those who bring accountability, consistency, and a sharp sense of what must be accomplished to all they do. When it comes to the current mess, those in charge on Wall Street and in Washington have failed to deliver on all three fronts.
Most appalling, perhaps, were the performances on Capitol Hill by the former heads of Lehman Brothers and American International Group, who blamed devious short-sellers, unpredictable regulators, and careless colleagues for their firms’ woes—just about everybody, that is, but themselves. “Looking back on my time as CEO,” Robert Willumstad, AIG’s former chief, told a House oversight committee, “I don’t believe AIG could have done anything differently.”
The Height of Prudence?
Richard Fuld, who presided over the downfall of Lehman, told the panel that all of his decisions “were both prudent and appropriate” given the information he had at the time. Yet if this is true, it indicates that his organization was ill-equipped to get him the information he required—a horrendous management breakdown in and of itself.
“Harry Truman’s folksy ‘The buck stops here’ is still as good a definition as any” of leadership, Drucker wrote in his 1967 classic, The Effective Executive. Willumstad and Fuld made a mockery of the buck-stops-here standard.
Meantime, public officials haven’t displayed many exemplary leadership qualities, either. “The leader’s first task is to be the trumpet that sounds a clear sound,” Drucker wrote. “Effective leadership—and again this is very old wisdom—is not based on being clever; it is based primarily on being consistent.”
But clarity and consistency have been largely absent from the government’s response to the crisis. At first, the Bush Administration had an awful time explaining why its $700-billion rescue plan wasn’t simply a taxpayer-funded bailout for the companies responsible for the disaster. And all along, the Administration’s efforts have seemed haphazard and uncertain, as if it isn’t exactly sure what notes on the trumpet it should try to play. At one point, for example, Treasury officials belittled the idea of the government taking an ownership stake in the nation’s banks. Then they reversed course and announced Tuesday that they’d invest $250 billion in the sector.
Their action helped spur a stock-market rally after shares were completely battered last week. But it remains to be seen whether the government’s plan is even focused on the right things. It’s quite possible, after all, that it could succeed in shoring up the banking system in the short term while neglecting to ensure that another financial meltdown doesn’t materialize down the line.
One of the most serious issues that hasn’t been adequately addressed, for instance, is mandating that financial institutions divulge precisely what kinds of risks they face today and going forward.
“There have been lots of halfhearted attempts at improving this over the years, most of them driven by big credit or trading losses, concerns about systemic stability or damage to clients,” Merrill Lynch veteran Erik Banks wrote in his disturbingly prescient 2004 book, The Failure of Wall Street. “Something bad happens, regulators ask for more risk information, banks produce it for a while, no one finds it particularly useful because it is couched in such oblique terms that nothing is actually conveyed, and then it gets buried in unreadable form in the financial statement footnotes; regulators, clients, and investors forget about it, and it’s back to the status quo till the next blowup.”
This time, we must do better—but that calls for leaders who have the courage to treat not only the current calamity but also its underlying causes, including a lack of transparency.
Expanding the Boundaries
Indeed, the way Drucker saw it, one of a leader’s most important jobs is to frame carefully what he or she hopes to accomplish with every major decision. “What are the objectives the decision has to reach?” Drucker wrote. “What are the minimum goals it has to attain? What are the conditions it has to satisfy?”
Drucker pointed out that in science, these are known as “boundary conditions.” And falling short of them can be dire. “A decision that does not satisfy the boundary conditions,” Drucker asserted, “is worse than one which wrongly defines the problem.”
He recounted that President Roosevelt expanded his own boundary conditions after the “sudden economic collapse” between the summer of 1932 and the spring of 1933. Earlier, Roosevelt had pursued a relatively conservative policy of economic recovery. But when the situation deteriorated, his goal necessarily became not just recovery but comprehensive reform.
It is a path we’d be wise to walk again. The question is, will anyone provide the leadership to take us there?
October 14, 2008
10 Management Lessons from Lehman’s Demise
Former Lehman Brothers Vice President Lawrence McDonald has titled his insider account of the firm’s demise A Colossal Failure of Common Sense. Peter Drucker, meanwhile, was once said by the London Business School’s Sumantra Ghoshal to “practice the scholarship of common sense.”
With this sharp contrast in mind, here are 10 management lessons derived from Drucker’s insights, a year after Lehman went bust:
1. Executives who are preoccupied with their company’s daily stock price or consumed with quarterly earnings targets don’t make very good stewards of the enterprise. “The most critical management job is to balance short term and long term,” Drucker declared in a 1999 interview, adding that a “one-sided emphasis” on the former is “deleterious and dangerous.”
Ultimately, said Drucker, deciding “whether a business should be run for short-term results or with a focus on the long term is . . . a question of values. Financial analysts believe that businesses can be run for both simultaneously. Successful businesspeople know better.”
2. Tying individual compensation to short-term gains only exacerbates the problem. It rewards the executive “for doing the wrong thing,” Drucker said. “Instead of asking, ‘Are we making the right decision?’ the temptation is to ask, ‘How did we close today?’ It is encouragement to loot the corporation.”
The Aspen Institute recently urged companies to “define firm-specific metrics of long-term value,” and then use these measures “both to communicate with investors” and to “better align executive compensation” with what truly matters. The Federal Reserve is also considering forcing financial institutions to adopt policies that tie pay to long-term performance. Drucker would have lauded this initiative.
3. People don’t like it when those who’ve exhibited the worst cases of managerial myopia get filthy rich in the process. Inevitably, said Drucker, there is “an outbreak of bitterness and contempt for the super-corporate chieftains who pay themselves millions.” Former Lehman Chief Executive Richard Fuld, who enjoyed $40 million in pay and benefits in 2007, recently complained that he has “been pummeled. They’re looking for someone to dump on right now, and that’s me,” Fuld said.
Drucker, it’s plain, wouldn’t feel sorry for him. “Few top executives,” he once remarked, “can even imagine the hatred . . . and fury that has been created” because of their unjustified pay. “I don’t know what form it will take, but the envy developing from their enormous wealth will cause trouble.”
4. High profits don’t necessarily mean that you’re producing anything of genuine value. Lehman, in fact, reported record earnings in 2005, 2006, and 2007. That may have impressed the investment community. But that’s not what counts in the end. “Securities analysts believe that companies make money,” said Drucker. “Companies make shoes.”
5. Moving money around isn’t the same thing as producing actual goods and services. To be sure, financial instruments have a vital role to play in spreading risk and ensuring the smooth functioning of the global economy. But when Wall Street is generating 40 percent of U.S. corporate profits, something has gotten way out of whack.
Drucker called this worldwide flow of capital and credit the “symbol economy,” as distinct from “the real economy.” “Americans,” he said, “cannot live in a symbol economy where businessmen play only with numbers.”
6. When you buy and sell lots of assets at prices that are considerably higher than the underlying value of what’s being traded, the run-up can’t possibly last. “The average duration of a soap bubble is known—it’s about 26 seconds,” said Drucker. “Then the surface tension becomes too great and it begins to burst. For speculative crazes, it’s about 18 months.”
7. Even professional bankers, who ostensibly are experts in “risk management,” aren’t immune from the soap-bubble syndrome. Of course, this doesn’t mean that they don’t try to outsmart the system. The tendency is for firms to resort to “‘trading for their own accounts,’ that is, to outright speculation,” Drucker noted. “This, however, as centuries of financial history teach (beginning with the Medici in fifteenth-century Europe) has only one—but an absolutely certain—outcome: catastrophic losses.”
8. It’s especially hard to avoid those losses when you don’t want to hear any bad news. Lehman and most other investment banks refused to even contemplate the “potential danger” of becoming overly leveraged, McDonald recounts in his book. “Wall Street was listening for calm seas, record profits, best-ever growth, joy, wealth, prosperity, and b-o-o-o-o-n-u-u-s. Anything less was essentially out of the culture.” When Lehman’s fixed-income chief warned Fuld about the unsustainable bets that the firm was making, McDonald adds, Fuld “decided to bully him, to belittle him publicly.”
Other former Lehman bankers paint a similar picture, saying that Fuld and his top lieutenant weren’t interested in dissenting views. But “dissent . . . is essential for effective decision making,” Drucker said. Without it, those at the top simply can’t take on what Drucker described as “the most important task” they’re responsible for: “to anticipate crisis.”
9. As long as human beings are in charge of our major institutions, this won’t be the last crisis we see. “Scandals are a normal feature of the landscape,” said Drucker, who wouldn’t be shocked that companies are once again taking on substantial risk and selling the kinds of exotic financial products that triggered the Great Recession. “They very typically begin with something that goes wrong, and you . . . brush it under the rug. And you end up by trying to brush elephants under the rug. And then it doesn’t work any more, and it collapses.”
10. “Stupid people make stupid mistakes. Brilliant people make brilliant mistakes.”
September 18, 2009
Goldman Sachs: Failure of Innovation
Whether Goldman Sachs Group broke the law remains to be seen. But one thing is for sure: The firm violated one of Peter Drucker’s core principles of innovation.
“Innovation is an effect in economy and society, a change in the behavior of customers . . . of people in general,” Drucker wrote. “Or it is a change in a process—that is, in how people work and produce something. Innovation therefore always has to be close to the market, focused on the market, indeed market-driven.”
By sharp contrast, so-called innovations exploited by Goldman—mortgage-related securities the firm was betting would decline in value—weren’t geared to the broader market at all; they were inwardly focused and traded by Goldman for its own profit.
As Carl Levin, the Michigan Democrat who chairs the Senate Permanent Subcommittee on Investigations, has observed: “The nature of Wall Street’s function has changed. They still argue that they’re providing capital and stimulating innovation, and to some extent they are. But there’s been a significant shift here to the model where they’re out for themselves. Their client is themselves.”
Serving the In-House Trader
Drucker saw this mess coming a long time ago. In a piece he penned in 1999, “Financial Services: Innovate or Die,” he frowned on the kind of transactions that have done such terrible damage to Goldman’s reputation and, more important, to the world economy. Since the 1970s, he wrote, “the only innovations” among banks “have been any number of allegedly ‘scientific’ derivatives.
“But these financial instruments are not designed to provide a service to customers,” Drucker continued. “They are designed to make the trader’s speculations more profitable and at the same time less risky—surely a violation of the basic laws of risk and unlikely to work. In fact, they are unlikely to work better than the inveterate gambler’s equally scientific system for beating the odds at Monte Carlo or Las Vegas.”
The tendency to inflate one’s bottom line without actually creating anything of real value (a good, a service, a job, a gain in productivity) hasn’t infected only Wall Street, of course. Across countless industries, many executives now spend more time and energy on financial engineering than they do on product engineering.
Drucker, for his part, was hardly naïve about high finance. He understood full well that businesses must engage in hedging and option trading to deal with volatile fuel prices or fluctuating currencies. “Foreign exchange risks,” Drucker noted, “make speculators out of the most conservative managements.”
True Innovation: ATMs
But that is not the same as a bank actively trading for its own account, a practice that can quickly turn those who traditionally have been the institution’s primary customers into secondary considerations. “I believe banks should be banks serving clients,” Citigroup Chief Executive Vikram Pandit recently wrote to President Obama, in a statement that, in a different day and age, would have seemed as laughably obvious as the color of George Washington’s white horse.
Former Federal Reserve Chairman Paul Volcker, who has been trying to erect a wall between banks that stick to taking deposits and those that want to make risky wagers for their own advantage, commented not long ago that only one financial innovation has been worth much of anything in the past 20 years. And it isn’t the collateralized debt obligations (CDOs) at the center of the Goldman scandal. Rather, it’s the automated teller machine. “That really helps people . . . and is a real convenience,” Volcker said. “How many other innovations can you tell me that have been as important to the individual?”
Volcker’s remark was made half in jest, but Drucker certainly would have appreciated the sentiment. In his 1999 essay, he explained that in the two or three decades following World War II, a steady stream of innovations flowed from the banking sector, including the Eurodollar, the Euro-bond, the first modern pension fund, and the credit card.
He also highlighted the pioneering work of Citibank’s Walter Wriston, who, as Drucker described it, “immediately changed his company from being an American bank with foreign branches into a global bank with multiple headquarters.” Wriston’s subsequent insight, “that ‘banking is not about money; it is about information,’” Drucker said, “created what I would call the ‘theory of the business’ for the financial services industry.”
The Middle-Class Market
But ever since Wriston’s day, Drucker asserted, bankers have done little to innovate, at least for the benefit of their patrons. Drucker did, though, see a possible sweet spot for the industry: servicing individual middle-class investors around the globe.
Drucker pointed out that one of his consulting clients, the St. Louis–based brokerage Edward Jones, was the first to see the potential in this market about 40 years ago. Most of the people that Edward Jones serves aren’t particularly wealthy, Drucker wrote, but “the sums they collectively pour into investments dwarf by several orders of magnitude everything all the world’s ‘superrich’ together have available, including oil sheikhs, Indonesian rajas, and software billionaires.”
Today, Drucker added, the kind of customer to which Edward Jones caters “constitutes the fastest-growing population group in every developed and emerging country,” including Latin America, Japan, South Korea, and the cities of mainland China. “This market,” Drucker suggested, “might become the twenty-first century’s successor to the world’s first financial ‘mass market’: life insurance.”
I can’t say whether Drucker’s forecast will come true. But I do know this: We’d all be better off with innovations that look more like ATMs and less like CDOs.