When things go bad, it’s easy to blame the CEO. Often, that blame is deserved. Still, it’s worth noting the intense pressure that CEOs are under to pursue strategies that eventually, perhaps inevitably, lead their companies to failure.
Take the case of Freddie Mac, the large mortgage finance company that has lost more than $80B, or more than 60%, of its market value since February 2008. Freddie Mac and its CEO, Richard F. Syron, are the subject of an extensive August 5, 2008, NY Times article that explores why the CEO would adopt a ruinous strategy while ignoring repeated recommendations that could have helped avoid the current crisis.
“He said that we couldn’t afford to say no to anyone,” said David Andrukonis, Freddie Mac’s chief risk officer. “Anyone” refers to members of Congress, which pushed Freddie Mac to buy more and more mortgages from low-income borrowers, to encourage affordable housing—even though the mortgages were increasingly risky. Once, the article reports, “a high-ranking Democrat telephoned executives and screamed at them to purchase more loans from low-income borrowers.” Freddie Mac felt the need to maintain congressional support because the federal government’s implicit support was critical to Freddie’s business model, allowing Freddie to borrow money at lower rates than it could have otherwise. “Anyone” also refers to investors. And, in the midst of the real estate bubble, “shareholders attacked the executives for missing profitable opportunities by being too cautious.”
We’re not saying that Syron went along with the madding crowd against his own better judgment. His actions indicate that he just took the wishes of Congress and investors as confirmation of his own point of view. Instead of slowing the firm’s mortgage purchases, Syron accelerated them. Instead of heeding warnings to expand its capital cushion, Syron let Freddie’s safety net shrink. And he got a lot of positive feedback for his approach. The NYT reports that he has collected more than $38 million in compensation since 2003. And Freddie Mac’s stock value climbed by 25% in the six months after Andrukonis’ prescient warnings. The stock was still up almost 10% three years later, just before the implosion.
Our autopsy of many financial engineering failures, such as Freddie Mac’s, concludes that strategists often do not foresee some external circumstance, some occurrence that falls outside recent experience and seemingly reasonable expectations. To avoid getting blindsided, we think companies relying on complex financial engineering strategies must ask whether their strategy can survive storms. We’re not talking about pleasant afternoon showers. Rather we’re talking about dreaded twenty-, fifty-, or even hundred-year floods.
In Freddie Mac’s case, that circumstance was a wide-scale decline in home prices. Could anyone have predicted the timing of such a circumstance? Probably not (except, it seems, for the traders at Goldman). Yet any sustainable strategy must be able to withstand adversity, so strategists must look into the abyss, assess how their designs would perform under harsh conditions, and explicitly decide whether the risk is worth the return. Strategists must debate the true likelihood of a major problem, keeping in mind that humans’ tendency is to underestimate the likelihood of something they’ve never experienced—as NASA designers did when they said the space shuttle Challenger had a 1 in 100,000 chance of exploding, when later calculations found the real odds were more like 1 in 100. Strategists must also identify ways that would let them see a storm coming and identify in advance ways that they might mitigate the damage.
Pressure may still overwhelm judgment, but we’ve found that aggressively looking for potential problems can bolster the case for good sense.
