Spero Consulting

It is already Thurs­day, and we’re just get­ting around to writ­ing about a few arti­cles in Wednesday’s (Octo­ber 1) edi­tion of The Wall Street Jour­nal. They are worth men­tion­ing because they are closely related to our post on Tues­day, Big­ger Is Not Nec­es­sar­ily Bet­ter, which warns about addi­tional con­cen­tra­tion risk as the largest banks con­tinue to grow larger.

One is a very small arti­cle in Deal Jour­nal, enti­tled Big-​Bank View: Get­ting Big­ger! that we can’t find online and other is At Lehman, How a Real-​Estate Star’s Rever­sal of For­tune Con­tributed to Col­lapse.¹

We’ve com­mented a few times that big­ger banks are not nec­es­sar­ily bet­ter for soci­ety or the econ­omy because mam­moth size exac­er­bates moral haz­ard prob­lems, i.e., the too-​big-​to-​fail men­tal­ity – noth­ing new there – and because it con­sol­i­dated assets and decision-​making under fewer, idio­syn­cratic (and rationally-​bounded) per­son­al­i­ties (and cul­tures). That first par­en­thet­i­cal com­ment does read bet­ter and sound nicer than the more par­si­mo­nious, “irra­tional,” but the point remains the same.

The big-​bank-​getter-​bigger phe­nom­e­non is actu­ally being encour­aged and expe­dited by expe­di­ent fed­eral reg­u­la­tors, who seem to have absolutely no long-​term plan. Those reg­u­la­tors’ recent actions and state­ments remind us of a com­ment we once over­heard in the exec­u­tive suite of a large firm: “Sorry, but we don’t have time to develop a strat­egy, we have to act.” We’re really not talk­ing about pulling some­one from a burn­ing car or house, but even in those dire, dan­ger­ous, and instan­ta­neous cir­cum­stances, one should have an aware­ness of the envi­ron­ment and a plan if one is to have a chance of success.

The other arti­cle, about Lehman’s real-​estate débâ­cle, puts most of the blame for com­mer­i­cal real-​estate losses on one man, Mark Walsh. Of course, the ulti­mate blame lays with Lehman’s lax board and senior man­age­ment, which pre­sum­ably did not have the knowl­edge or courage to prop­erly under­stand the busi­ness and man­age risk. Addi­tional blame can be placed on senior man­age­ment for improp­erly design­ing incen­tives scheme that induced exces­sive risk-​taking, which we would guess would have been exhib­ited by a “get it done how­ever you can” mentality.

We don’t know Mr. Walsh, and sus­pect that he was doing exactly what was expected of him, but that’s our point. The folks at Lehman in res­i­den­tial real-​estate were likely doing exactly what was expected of them, too, and the com­bi­na­tion was deadly for the firm.

Because of someone’s tastes, pref­er­ences, favor­able past expe­ri­ences, igno­rance, inse­cu­rity, or neglect­ful­ness, the firm suf­fered from excessively-​concentrated risks.

Now, who would think that the val­ues of com­mer­cial real estate and res­i­den­tial real estate within a city or region might be related? Actu­ally, we would guess most adults who didn’t make it past the sixth grade could fig­ure it out, and the same goes for cur­rent mid­dle school and high school students.

In fact, our own small-​sample sur­vey reveals that a high school fresh­man will likely respond with a “Duh!” when asked, “Do you think house prices and office or store prices would go up together and down together in, say, your home­town or do you think they would be unre­lated?” We didn’t ask, but we sus­pect that they would likely note that on a day-​to-​day basis they might not be related, but over longer term they will be. Oh well. What is it about col­lege that destroys that com­mon sense?

Now, the argu­men­ta­tive reader may retort that Lehman is not a good exam­ple because it was an invest­ment bank and so wasn’t scru­ti­nized by the reg­u­la­tors as much as large com­mer­cial banks are (or will be); so, such risk won’t be an issue because bank reg­u­la­tors are on the case. Though the agen­cies and per­mit­ted lever­age ratios were dif­fer­ent, we doubt that the degree of reg­u­la­tory over­sight was much dif­fer­ent across those two indus­tries, espe­cially for the larger firms. More impor­tantly, does the con­trary reader really want to make that argu­ment? (Hint: con­sider Wachovia, Wash­ing­ton Mutual, etc.) As we men­tioned on Thurs­day, reg­u­la­tors have their own incen­tive problems.

While big­ger may per­mit con­sol­i­dated oper­a­tions and cost sav­ings. Are those sav­ings large enough to jus­tify the assump­tion of addi­tional, sys­tem­atic risk or, more pre­cisely, the loss of a diver­si­fi­ca­tion ben­e­fit, caused by the cen­tral­iza­tion of allo­ca­tion deci­sions? The past year has made us very doubt­ful that the ben­e­fits exceed the increased sys­temic risks of a few busi­ness seg­ments bottoming-​out together.