Monday, March 5, 2012

Brian Clough and Bill Belichick on the Financial Crisis

Years ago, while scrimmaging during a soccer coaching clinic for one of my first licenses, I heard the English coach scream, "Most goals come from two men trying to do one man's job!"  He had just witnessed a play where my team had unfortunately been scored upon. I was a culprit, as I was in a bad position when the ball was fired into the goal.  I didn't really understand what he meant, but his passion was evident in many ways, including the large vein standing out, throbbing in his neck. 

Some time after that, I was reading an interview with  Brian Clough, the legendary English coach who was the only manager to lift the old First Division trophy with two different clubs, Derby County and Nottingham Forest. It became evident to me that the origin of what I had heard in my clinic was from Clough's philosophy.  Over many years of playing and coaching to today, I now know and understand that he was right! 

Fast forward to the recent Super Bowl, and Bill Belichick's famous rant, "Just Do Your Job!"  Believe it or not, this is basically  the same insight Brian Clough had.  I recall a Giant running play when Amed Bradshaw ran off right tackle and was stuffed at the line by the nose tackle and his partner, both doing their jobs.  The running back bounced out, looking to go right, and the Patriot linebacker was lining up the tackle, as Bradshaw continued to drift, looking for an option. On the outside, the contain man, whose job it was simply to ensure that Bradshaw didn't turn the corner, instead chose to bite and tried to make a tackle for a loss.  That was NOT his job.

Instead, Bradshaw used a stiff arm, ran over the DB and burst outside.  Because of one man not doing his job, the linebacker was now out of position and had to chase, not down the line, but from behind. Down field, Bradshaw was able to get blocks from receivers who wound up in great positions to block the surprised corners. Two men tried to do the linebacker's job: make the tackle at or behind the line. The second man didn't do his job, which was to contain, but he looked for a moment of glory and caused a collective failure. Sounds simple, but it's not a simple insight, by any means. Cloughie was a smart guy, as is Belichick!

Whenever I've run my Finance departments, I've always emphasized keeping it simple and just doing your job to the best of your ability, asking for help if it's needed. If you've hired good people, trained them well, and they buy into the concept and the team comes together with mutual accountability, it's a good recipe for success.

How does this relate to the financial crisis?  Simple: nobody did their jobs during the crisis. If Belichick had been  in Henry Paulson's place, he would have pulled up his hoodie and gone apoplectic.  I'm going to quickly use two of the most egregious bad actors in the subprime mortgage lending business as examples.  I've attached links to some useful documents for readers who want to go through some of the gory details.

By year-end 2006, New Century Financial was the third largest originator of residential subprime mortgages in the nation, originating $52 billion in that year alone. On February 7, 2007, New Century announced restatements of results for the first three quarters of 2006, due to errors in accounting for the effects of mortgage repurchase obligations from securitizations which were unraveling. On April 2,2007, New Century filed for bankruptcy protection with $26 billion in assets.  The most informative document on New Century is the hard hitting report of the Special Master Michael J. Missal, done for the Delaware Bankruptcy Court.

From its humble beginnings as a REIT, IndyMac Bank became the 9th largest originator of residential mortgage loans nationwide, hitting a peak annual origination volume of $90 billion in 2006.  From 2001-2006, indexing 2001=100, by 2006 IndyMac's stock index value was 222 compared to 158 for the Russell 1000 Financial Services Index.  Executive compensation, indexed to EPS and ROE skyrocketed based on the value of option awards and performance bonuses. The stock price collapsed less than one year later, and by the spring of 2008, IndyMac was shown to be a house of cards. The best reading on this case is the report of the Inspector General of the FDIC

Who didn't do their jobs at New Century and at IndyMac?
  • Executive management and the board of directors allowed a toxic "tone at the top" to flourish which celebrated outlaw production of mortgages by uncontrolled brokers, who overrode IT, internal audit and underwriting controls with impunity.
  • SOX 404 certifications and auditor reviews of internal controls clearly failed with no weaknesses uncovered until 2007. 
  • Audit committees replete with CPA's and financial experts signed off on implausible financial results. The 2006 loan loss provision for IndyMac was $20 million, the same absolute amount as in 2003: originations in 2006 were $90 billion compared to $23 billion in 2003!  And, since 2004 management and the board had clear indications of deteriorating performance in the securitization trusts and in originations.
  • External auditors never challenged any of the reporting practices, including the use of gains on sales, which often accounted for a significant proportion of reported earnings, which drove management compensation.  Mark-to-market accounting may or may not have been a major culprit in the total crisis, but it was clearly misapplied across the subprime industry's worst actors.
  • Internal audit and underwriting processes failed because although their monthly work clearly showed the problems, they could not establish a direct communication to the audit committee, and so were squelched by the loan production groups who reigned supreme.
  • SEC counsel and corporate counsel failed to require adequate disclosures of risk, current financial condition and forward looking statements.
  • Federal regulators, particularly the Office of Thrift Supervision, failed in their routine, periodic audits of IndyMac Bank.  This failure caused material loss to the FDIC and was clearly called out in the report of the Inspector General of the FDIC.  The OTS was folded into the OCC as a result. 
  • Equity analysts, credit analysts and credit rating agencies all failed to do their jobs to help investors.  Instead, they served as cheerleaders, driving their own revenue models.  
 We clearly don't need another regulatory nightmare like Dodd-Frank on top of what was already in place.  Any or all of these mechanisms above should have served to surface the strategic, business and financial risks of subprime lending and the mechanisms in place should have forced adequate disclosure and proper valuation of revenue, reserves, income and balance sheet items.  Listen up!  Do your job!

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