When I attended graduate business school in the late 1970’s, the big “change” in finance was examining cash flow instead of earnings. After all, the logic went, how can you make fair assessments on leverage and other ratios if you do not have a basic understanding of the underlying cash flow? A few of us jokingly proposed that the solution to every case study should be the mantra, “cash is king.”
Within a couple of decades, the financial industry seemed to lose focus on examining cash flows and instead focused on earnings, which, in many cases, were generated by exotic financial instruments, some supported by outlandish leverage ratios of 100:1. Others were backed by merely a guarantee (the credit default swap market and mortgage insurance market). Evidently, institutions such as AIG and MBIA believed that receiving a one or two percent transaction fee for a guaranty was “easy money.” It’s too bad that the accountants and the MBA’s weren’t communicating since “risk” has always been a formulation in valuation analysis and the higher the leverage, the higher the risk.
The collapse of the sub-prime lending market earlier this year was just the tip of the iceberg. The tightening of credit by lenders and the mark-to-market of marketable securities were natural reactions (that should have occurred earlier) and unfortunately, have exacerbated the liquidity crunch. Even some of the most secure commercial paper has been impacted with the flight to security by individual and corporate investors in a liquidity-strapped market where there are fewer buyers of bonds.
It would be interesting to research which investor gurus called for a refocusing on the basic fundamentals. Clearly, some took action and are above the current liquidity crunch (note Warren Buffet’s recent investments in Goldman Sachs and General Electric). It’s a shame that the common-sense approach wasn’t shared by everyone. Even scale factored into the equation when you consider that Bank of America did not originate sub-prime loans but its investment division owned some of the sub-prime mortgage paper.
I am not a public policy wonk, so I do not have a particular solution from a regulatory perspective that I believe should be implemented. I think tighter regulations will evolve from this fiasco and we may never know whether or not the new regulations would have kept us from this crisis. It is interesting that when the regulators called for tighter scrutiny of Fannie Mae and Freddie Mac, Congress looked the other way under the guise that loosened credit risk would increase home ownership. Sarbanes-Oxley, which was passed and implemented after the Enron incident, did not keep the current crisis from occurring either. Many people have been affected, whether as a sub-prime mortgage borrower, as an investor in a financial institution or fund that was impacted from the investment downturn, or as a taxpayer who will contribute to the billions and maybe trillions that ultimately will result from the government’s intervention. I hope that future boards of directors of companies issuing or buying complicated financial instruments ask tough questions and make sure that the underlying risk of the instrument is understood. After all, there is no such thing as “easy money.”
