Presented By: M I Henderson October 2010

RISK& Other Four Letter WordsAn Alternative View On The Real Reasons Behind The Global Financial Crisis Presented By: M I Henderson October 2010

Who Are We? • Multi-disciplinary organisational & people effectiveness consulting • Focus on practical solutions to common business problems • Consultants are a network of subject-matter experts • Clients industries mostly: • Financial and business services • Telecoms • Consulting industry • South Africa, SADC and East & West Africa

Topics • An Alternative View On The Real Reasons Behind The Global Financial Crisis • What really went wrong? • What was driving the problem? • What is likely to happen from here? • The impact on credit granting in South African

Disclaimers and Rules of Engagement • Today is not going to ‘politically correct’ • Not a repetition of the conventional explanations • Look at things differently - that does not mean that the conventional view is wrong … just perhaps that it is more complex that we at first thought • Largely international examples – draw your own local parallels.

Why It Will Not Be the Same Again“SCUMDOG MILLIONAIRES” • Dumb, Dumber and Dumbest? • Pass the plate ……. • Pleading poverty from the steps of the corporate jet Who wants to be a banker these days? “Watching an industry commit political suicide is not a pretty sight” …Economist Oct 2009 “The culture of entitlement and greed which was fostered and entrenched by the 1996 Class Project within state owned entities and organs.”

The Events

The Result? Public opinion: It must be someone’s fault …. Someone has to pay ……….… It must not happen again …… (PS. …..its also a vote winner!)

Scapegoats ….Its Payback Time • The greed-driven banking CEO’s • Inadequate legislation and regulation • Boards that were carried along with the tide • The whole capitalist process?

What Got Us Here & What Went Wrong?(the ‘Conventional’ View) • Inadequate financial regulation - Too much de-regulation? • Political interference in lending (Fannie Mae, Freddie Mac … + nearly SA Banking Charter) • Mark-to-market accounting rules • Executive greed and short-termism • Structure of financial incentives -especially share options: - Not tied enough to performance - Too much • Too easy • Weak accounting and tax rules • Lack of moral leadership • Corporate governance failures • Some just too big to fail?

All The Signs Were ThereEven if you have never read any economic history

The Consequences Cost US taxpayers more than 2.5 x real cost of WWII

So What Really Went Wrong? Leadership Failures

Risk Management • Many never worked in a recession - --- ‘Confused brains with a bull market’. • Risk assessment became a box-ticking exercise. • The ‘deal-makers’ had more glamour & organisational standing • The Madness of Crowds’ and ‘Peer Pressure’ …………….Citi CEO .. “When the music plays you gotta get up and dance” • Tone was set from the top ….. t/o growth, EPS, M&A • High gearing (> 30x) + reliance on short-term debt to fund long-term assets • Given a smart sanitised name ….. Sub-prime (aka Ninja Loans) • Too much reliance on rating agencies …….. (paid by the debt issuers) • The spectacular rise of credit insurance …….. insure what you can’t measure • The search for the silver bullet lead to complexity • Many banks IT systems could not cope and aggregate (mostly counterparty) risk across borrowers or across the bank

Complexity “The revolutionary idea that defines the boundary between modern times and the past is the mastery of risk: the notion that the future is more than a whim of the gods and that men and women are not passive before nature.” “Against The Gods” – Paul Bernstein – 1996 • Mid-1970’s Black-Scholes model for pricing derivatives (Chicago’s Options market) • 1990’s … Bankers Trust and JP Morgan – started to develop thinking around “value-at-risk” (VAR - how much you could expect to lose under a variety of scenarios) • Mid-1990’s onwards --- banks hired lawyers, engineers and mathematicians – the more Phd’s the better - to build models that measured risk to 5 decimal places ………………….But typically the models only used 3 to 5 years of data • Mid-2000’s +/- 25% of graduates at the top universities came from finance • Financial engineering was born • CDO, CDO-squared, SPV, SIV, CDS, automated computer driven trading etc • Weapons of financial mass destruction …….. Warren Buffett (2003)

The Man That Caused It All? David X. Li (born in China in the 1960s) is a quantitative analyst and an actuary who in the early 2000s pioneered the use of Gaussian copula models for the pricing of collateralised debt obligations (CDOs). The Financial Times called him "the world’s most influential actuary," In the aftermath of the Global financial crisis of his model has been called a "recipe for disaster". Like blaming Einstein for Hiroshima?

Complexity “The over-50s did not know what the under-30s were doing.” ………Johann Rupert “We fell in love with the quantitive methodology underpinning the new instruments” . .....Dr. Laura D. Tyson The sociology of markets: “Heavy use of models may change the markets they are supposed to map” ……Prof Donald MacKenzie “Quants love to over-engineer ….. you may need a plumber but you get a professor of fluid dynamics”

Governance Failings • Debt sold off but still a contingent liability …. Not measured or recorded • Complexity and new techniques made it difficult for non-execs • Quarterly meetings do not encourage understanding • The ‘sociology’ of big company boards – dissenting voices not appreciated • Bank boards typically very large – accentuates this • Board duties and responsibilities not clearly spelt out • Too few unconnected non-executive directors • Performance measured by benchmarking to peer groups …………... What if they are all doing the wrong things? • Correlation between dysfunctional systems - and growth and takeovers

Governance Failings:The Cult of The CEO • Autocratic bosses who walk on water – don’t expect to be told bad news: • Chuck Prince at Citi only told Sept 2007 that they had $43 billion toxic assets • Empire builders not managers …. Let alone leaders • The pitfalls of benchmarking - lets all do the wrong things together • Exceptions ….. Jamie Dimon (JP Morgan Chase) started to back off in 2006 and got flayed by analysts and shareholders • Bottom line is that many boards failed: • To identify and assess risk • To set appropriate goals and objectives • To structure reward correctly • Loading top people with shares can be an aid to corporate governance but not a substitute for it

Irrational Exuberance Drivers who slow down at an accident but then accelerate afterwards – only cautious for a short while The warning signs were there: • The failure of Long-Term Capital Management in 1998 • The Asian, Japanese and Russian banking crisis • The dotcom bubble • Enron, WorldCom etc (AAA according to the rating agencies ) • Rising loan : value ratios in housing • Aggressive selling resulting in multiple credit cards per consumer • Rising consumer debt levels • Rising PE’s despite periodic market attempts to correct in mid-2000’s • Economic history has lots of parallels

Regulatory Failings • Many of the new instruments were just too complex to understand: • Typical securitised CDO bundle of loans would run to 30 000 pages • Faith in the new technology lead to Basel II – which relied heavily on banks internal models • A belief that markets can be largely left to police themselves • Did not fully understand level of inter-connectivity: • Everything is connected to everything else …………… Lenin • Systemic failure …….a financial death spiral in which firms suck one another into the abyss. • Could not see the Black Swans for the trees? • When greed exceeds fear, trouble follows.

Asymmetric Incentives • Years of cheap money led to the under-pricing of risk • Negative / very low interest rates fuelled consumer demand • Misguided policies to promote home ownership • Securitisation and mortgage origination fees were paid up-front …..Originate, flog and forget • Too big to fail – too many relied on the Greenspan Put • And then there was the pay issue ………………

Asymmetric Incentives Not what you may expect to find ……… • Did financial institutions really run into trouble because they were over-paying their executives? • Better decisions if they had say, 85% of their personal wealth in company shares rather than, say, 80%? • Lehman, Bear Stearns and AIG had very wide-spread employee share ownership – staff lost everything • But generally, it was better to be an employee than a shareholder • Often mis-aligned or poorly thought-out incentive metrics • Rewarding failure ….. moral hazard ? • Complexity: The real problem was deal-maker and dealer incentives - not execs

Societal Changes - 1 • What about the impact of organisational culture and staff selection – we measure and value: • Performance (esp. compared to peer group) • Stretch targets • Growth, increased market share – even in mature markets • Creativity and innovation (does this sound like risk taking?) • The ‘Up or Out’ approach to career progression • Competitive people will hit their numbers. • Aiming to be #2 or #3 in your strategic plan is likely to be career limiting • Most execs did what they thought was expected and/or what they thought the performance metrics required. Was it their fault that there was an asymmetric risk-reward structure? • Is it really all just about money?

Societal Changes – 2The problem With Young People Today • Few had seen – none had worked – in a downturn • They grew up with (invented?) technology • They are difficult to intimidate and generally free of fear. Failure doesn’t frighten them • Life is a computer game – just press the reset button • Money motivated • Tend to have problems getting on with boomers

Societal Changes – 2The problem With Young People Today “How were we supposed to know that people who lied about their income and assets would walk away from mortgages on houses in which they had no equity? That wasn't in our computer model. It's not our fault”

Jack Welch’s Legacy “ The dumbest idea in the world …. It is a result not a strategy” …….. Jack himself (2009) • Nailed to the cross of shareholder value: • Slaves to the analysts • Measured by quarterly earnings reporting • Share price and EPS was all that it was about • Benchmarking substituted for strategy • Thinking and focus became very short-term • Often mutates into CEO cult worship • But … Shareholders are not the only stakeholders • And …. do CEO’s really influence events …. What about markets & customers & competitors? m

Leadership Failures • Massive amount spent on leadership development in last 20 years • Management is not the same as leadership • More to leadership than just the metrics

Conclusions - 1 • “It has cost us a lot to learn how little we really knew” • In fragile financial markets, Black Swans (extreme events) happen a lot more frequently than probability models suggest • Meltdowns happen twice as frequently as before WW1 • - 7 major ones in 20th century

Conclusions - 2 • Adam Smith was right – 240 years ago - wrote about the Agency Problem • Managing risk is as much about judgement as about numbers • Don’t reject high-tech finance tools – just understand their limitations • Basel III?………. likely to focus on increased capital and liquidity • Legislation: • Limit pay and bonuses? • Hedge funds, derivatives & structured products? • The Volker Rules? • Regulate non-bank banks? • The loan origination chain has to better managed – needs checks and balances • Better staffed and more powerful risk functions • Regulators have already become much more aggressive and demanding • e.g. SA’s new Companies Act • Re-write shareholder value text book • Need for a culture change ……...Integrity? … Now that’s something I’ll pay for! • Financial Engineers? … It is better to be roughly right than exactly wrong … Keynes

The Future? • Trouble ahead • What started as an Anglo-American risk management failure has focused minds on Euro-land weakness • Euro zone • UK & USA • SA

Acropolis Now ? • Paying for the public sector • Demographics – the future of pensions & a welfare state • Median age increase from 38 to 52 by 2050 • OECD estimate (2003) that only 39% of Europeans 55 – 65 work • Generally low birth rates from ‘old’ Europe • North – South split? • Austerity measures have not started to bite yet

UK & USA? • Painful adjustments being made • UK public sector spending being cut 25% to 40% • Currencies and interest rates UK - not ‘straight-jacketed’ by ECB • A culture of biting the bullet when required • China has too much to loose? • US$ a ‘safe haven’ • $ strengthened and US stock market outperformed BRIC markets! • Both have young and growing populations • A generational process

South Africa ? • Euro zone & UK problems - find new markets • Positive demographics - Young (if unskilled) population • Basel III = 3 x capital holding + increased liquidity • Fewer loans • Less risk • Higher prices • Being sheltered from the storm may not have been helpful in the long-term • We’ve addressed some of the issues but not all • Teach financial history • Demographics & generation theory • Behavioural economics • Risk management challenges • Unforeseen NCA impact • 50% of consumers are in arrears • 200 000 are flagged for debt counselling • Affordability requirements will slow credit growth • Makes credit – esp. housing – difficult for young people

. Questions? Contact: Michael. I. Henderson +27 (0)82 490 3113

Presented By: M I Henderson October 2010