As banks and other financial services concerns sheepishly try to explain away their devastating losses on subprime mortgages, one of the reasons they offer is that their sophisticated mathematical risk management models, which were based on historical mortgage default rates, somehow did not work this time around.
If history is any indication, the CEOs of these institutions will order their risk managers back to the drawing board to formulate new, improved models. That's the wrong approach.
As Walter B. Wriston, the legendary former chairman of Citicorp, used to say, "Trouble always comes through the window you're not watching."
It is not likely that financial services firms will ever be able to devise the perfect quantitative model that will alert top management to a debacle in the making. Each time they will discover — after the damage has been done, of course — that there was some unexpected turn of events that the quants failed to account for.
Instead, CEOs and directors must adopt a more common-sense approach that relies on the good will and experience of employees who might not be mathematical wizards but know when some business practice or activity does not pass the smell test.
In virtually every corporate scandal I have covered or followed as a student of financial crises, beginning with the 1982 collapse of Penn Square Bank of Oklahoma City, at least one person witnessed wrongdoing, unethical behavior, or imprudent business practices and courageously tried to stop it.
At Continental Illinois, which failed in 1984 largely because of $1 billion of bad oil and gas loans purchased from Penn Square, a banker named Kathy Kenefick yelled and screamed about Penn Square but was ignored and derided.
Ditto for Enron and Worldcom in the last round of scandals, and for Fannie Mae, Freddie Mac, Citigroup, Moody's, and Standard & Poor's in the current round. These bearers of bad news were typically brushed off as misguided or disgruntled.
Inevitably, government investigations and civil lawsuits will uncover more examples.
Rather than continue to shoot the messenger, the financial services industry, and indeed all of corporate America, should focus on developing risk management and governance systems that reward and honor these whistle-blowers. These systems must enable the most junior clerk who smells trouble that threatens the institution's survival or reputation to bypass the chain of command and communicate concerns, without fear of retribution, to the CEO and the board risk management committee.
Top managers should make it clear, in writing, that protecting the company's reputation is every employee's duty. Public companies that implement such programs and can convince investors that they are committed to making them work might actually be rewarded with higher market valuations than those that do not subscribe to this approach.
Implementing this kind of program might also enable private-sector institutions to get one step ahead of Congress and bank regulators as they contemplate reform legislation aimed at preventing future meltdowns.
Such a system will not save institutions that insist on flirting with financial disaster — only those whose top management values the input of people in the trenches. There will always be CEOs and directors who, for various reasons, reject the warnings of the in-house doomsayers.
For example, according to an Aug. 5 report in The New York Times, Freddie Mac CEO Richard F. Syron was alerted by his chief risk officer in 2004 that the mortgage finance giant was buying questionable loans, but Mr. Syron disregarded those concerns.
Some will surely argue that risk management systems that rely on corporate Cassandras would not have done any better than the quantitative models in preventing mortgage-related losses, because no one could have predicted that default rates would reach levels not seen since the Great Depression. According to this line of thinking, "hindsight is always 20-20." That's nonsense.
An examination of the financial services companies that have failed or suffered debilitating losses in the last quarter-century will likely show that their problems stemmed from more than just bad luck and honest miscalculations. More often than not malfeasance, including fraud, misrepresentation, and accounting shenanigans, has been a contributing factor.
Likewise, when the jury finally comes in on the Crash of '08, I'm convinced that the evidence will demonstrate that if financial institutions caught up in this debacle had taken seriously allegations by their own employees of questionable conduct associated with the origination, sale, or securitization of subprime mortgages, their losses would never have become life-threatening. The housing boom and bust itself might have been containable.
In this crisis, as in earlier ones, we have discovered that a relatively small number of misguided people can destroy great institutions, bring down the financial system, and wreak havoc with the global economy. Similarly, a few stand-up, right-minded people can prevent that from happening. Corporate America must finally give them the tools and support they need to do so.