Lessons From Corporate Collapses

I suppose by now you are aware that Wall Street is experiencing difficult times with more large, well known companies undergoing extreme financial stress and some looking like they will go into liquidation.

I do not want to focus on any one specific company nor will I examine or speculate as to the reason one company failed whilst another has, but I would like to share with you some thoughts about what we can take out of these collapses and how you can apply general concepts to your business and keep it afloat.

Background to current events

All the trouble on Wall Street goes back to an innovative product that allowed illiquid assets to be turned into a liquid asset, Collaterised Debt Obligations (CDOs). CDOs allowed any number of debts to be packaged up into bonds and sold to investors for cash today based on the expected future cash flows that the underlying debt held. The idea was fantastic and applied to a wide range of future cash flows including music concerts, credit card debts, utility bills and of course residential mortgages which had their own designation Residential Backed Mortgage Obligations (RBMO). The debts were packaged up and given a Rating from AAA all the way down to CCC. The rating indicated how likely it was to default, AAA the least likely and CCC likely to default.

Where it all went wrong was when the rating agencies failed to classify the risk of RBMOs properly, loans made to low income persons or unemployed people were given the same ratings as loans made to well to do employed persons. The theory behind it went along the lines of people will do anything to keep their home and traditionally there is a low rate of defaults on mortgages.

Lesson begins here
Where did the banks, brokers and insurance companies get it so wrong they face dissapearing leaving a trail of mess behind them? The are several aspects to the answer:

1. Improper risk management & Improper diversification
2. Failure to understand their products
3. Failure to understand their counterparties
   

There are other aspects but I would like to focus on the ones listed above as these lessons can be applied to any company of any size.

1. Improper risk management & Improper diversification
To understand risk management you first must define risk, risk is uncertainty and it is uncertainty in business that creates volatility in earnings and profits. It is good to take on some risk as this can lead to gains but you do not want so much of it that it can wipe you out. The job of risk management is assign the correct level of risk to your company so there is some upside risk but not a level that could wipe you out.

The level of collateralised debt obligations (CDOs) purchased were extremely high and disproportionate to other assets held. Though many of the CDOs held were of given a rating of investment grade (BBB) they were not actually as safe as they seemed. CDOs were not like other debt that was issued and could have been held. Risk management should have required proper diversification not only amongst credit ratings but the types of assets.

You are probably asking how does this apply to me and my business. The answer is every time you add a new line or enter into a new venture think about the risk you are taking on. Ask yourself does the venture offer more upside return than downside? Does entering into this new venture or taking on this new product have the potential to destroy my business if it fails? What and how much do I have to gain from this venture?

If you have answered that there is significant risk or it there is little upside but a great deal of risk it may be worth passing on. In the event that there is quite a lot of downside that could wipe out your business but the upside potential is so great your job is then to design a plan to isolate the risk and have a risk management plan on paper. Isolating the risk may involve legal structures, guarantees, binding agreement with the counterparty or implementing the deal in away that differs from how it was originally envisioned.
Make sure you control the risk, don't let it control you.

2. Failure to understand their products
A great deal of heart ache at present has been caused by the lack of understanding brokers, traders, asset managers and other players in the financial markets was caused by failure to understand the products they were dealing with. You may be saying to yourself in hindsight how could it be hard to understand simple loans resold to others. Unfortunately the way the loans were packaged is far more complex than how I described them above. The loans were packaged in a complex manner each had differing legal obligations associated with them.
All of this complexity gave rise to products that many intelligent people could not understand, did not take the time to understand or even convinced themselves that they understood the product. Once the ball started rolling and profits started to appear people stuck with what seemed to be working.
How does this apply to your business? Quite simply if there is a product or service you can add to your business but you don't understand it do not add it. If you are happy with your current business offering, think about why you want to change it and what it will add to your business. Your business in an investment you need to understand it and every part of your offering. Fads come and go maintaining your core business is more important than adding on aspects to your business you don't understand. Everyone else might be admiring the emperors new clothes but you don't have to be one. If it doesn't sound right to you let the opportunity pass and take up the next one you do.

3. Failure to understand their counterparties
Each bond had a counterparty, that is the person who issued it and owed the money to the bond holder. A large problem with CDOs was that it was not clear who the counterparty was. The complex packaging meant all to often you had to trace back through several parties to find out who actually held the asset that was going to produce the cash flows.
In your business know who you are dealing with; this will give you two clear advantages. Firstly you are able to tailor your offering to your client and adapt to changes as they require it. Second are able to access information about your counterparty. Information about your counterparty has far to many advantages to list but quite obviously you know who to contact to expand your offerings, who to issue legal proceedings against if you are required to do so and lastly you can atcually communicate with them without needing to go through intermediaries or volumes of legal documents.

As events unfold in the coming weeks and months more will be revealed and there will be more lessons to learn from these corporate failures. I look forward to sharing with you some thoughts to take away from this downturn and how you can improve your business during these turbulent times.