Henry Kaufman, a German-born economist and financial consultant, made a name for himself as Dr. Doom during the 1970s and 1980s writing interest- rate forecasts for Salomon Brothers, where he was vice chair and member of the firm’s executive committee. The incendiary moniker was overturned when his prediction in 1982 that interest rates would fall started a market rally that many acknowledge as the beginning of the 1980s bull run. Now president of an eponymous firm specializing in financial consulting, Kaufman, was interviewed by Directorship editors shortly before publication of his new book, The Road to Financial Reformation, which sets forth guidelines for rebuilding our economy. He declined to discuss Lehman Brothers, where he was a director as the firm collapsed, but he does say that bank directors should know more about model building and that regulators should approve new directors.
You know the expression, “That which doesn’t kill you makes you stronger.” What good is coming out of the current environment?
I think eventually we will have an improved set of financial institutions and markets. There’s pressure on financial institutions to enlarge their capital position. Many of them are doing that. Secondly, within the next half year we are likely to see proposals from the government concerning the supervision and regulation of financial markets. There’s also an effort to have more coordinated supervision and regulation on the international side. So, ultimately, I think we will not return quickly again to the kind of risk taking and speculative activity that led to the recent crisis.
Do you think that we had to go as far into deregulation in order to learn the excesses or should we never have gone in that direction?
I believe a good part of the problem that we had was due to ineffective monetary policy. The Federal Reserve contributed to that ineffectiveness by gradually adhering to an approach called “economic libertarianism.” Economic libertarianism is the desire for those who do well to prosper and for those who do poorly to fail. Monetary policy practice asymmetrically contributed to a massive monetary expansion, but then when it came time to discipline large institutions, the Federal Reserve and others realized that the systemic risk was too great. We just can’t allow that.
Was it helpful or hurtful that there was an administration change right in the middle of this?
I think it probably was helpful because the former administration that was in charge did not move dynamically enough or broadly enough and I suspect they came very late to the scene in terms of recognizing the problem. The first recognition of the problem hit, of course, during the summer months of last year. It actually started with Bear Stearns and even after that, [Bush administration] officials still said we had a strong financial system. There was an unwillingness to act decisively and massively to stem the hemorrhaging that was going on.
Why do you think it took them so long to act?
My impression was that after Bear Stearns was sold to JPMorgan Chase, the administration felt that most of the problems were behind us. They didn’t fully understand the extent to which financial asset values were declining and, as a result, many investments became more marginal until at last the values were going down drastically.
What have boards of directors learned from this?
I’ll make a general observation about boards. I believe that in an overall sense, board members have to be more involved in the business. Not in the business of the business, but I think, for example, that whatever the frequency of meetings has been, the frequency has to increase. Secondly, my proposal for boards of financial institutions is as follows: board members from major financial institutions have to be approved by the supervisory authority, the official supervisory authority. New board members have to meet with the official supervisory authority and be told very clearly what their responsibilities are. The official supervisory authority has to meet with the board periodically, particularly when they have done an examination or a review. The board has to meet independently with that supervisory authority independent of the operating management. People who serve on the board of directors of financial institutions should have some knowledge and skill in model building and the esoteric credit instruments of the financial markets. Those are the kind of prerequisites I think will be helpful.
There was a lot of talk about nationalizing the banks, particularly from the media and academic pundits. Do you think there would be any benefit to moving in that direction?
I think in the long run, a nationalized banking system is a politicized banking system. It’s very dangerous. Because of the demise of a number of institutions, financial concentration actually increased during the last year and a half. And that’s a dangerous, dangerous development because that leads not to the market process of allocation of credit, but to a more subjective involvement of the government with that process. That is a danger that we still face. I would argue that if these large financial conglomerates continue to dominate as they have, the ultimate would be that they would become what I would call financial public utilities: that would mean their profitability would be controlled and their growth would be controlled. They’d be too big to fail, and that is not good for an economic system.
So you’re not buying into the calls for a scaled-back industry more focused on lending?
If that’s done, then automatically there are some activities in large financial institutions that would be decreased or removed. For example, I find it very difficult to understand why a large financial conglomerate institution, which has a big deposit function in it, should own an equity position in a hedge fund. Quite a few large financial institutions do own equities in hedge funds. I think that leads to conflicts of interest. I find it difficult, really, to understand why an institution that underwrites securities, whether it’s bonds or equities, should also, for example, be able to facilitate what you would call mezzanine financing for a business that’s being taken over. There’s a conflict of interest in the process.
How do you feel about FAS 157 mark-to-market regulation?
That is a very thorny issue, underlying the process of securitization. Securitization means a transfer of an unmarketable instrument to a marketable obligation. The moment you do that and you say it’s a marketable obligation, there’s supposed to be a price. And if there is a price discovery how can you then say, “Well you can take this obligation and hold it to maturity?” If you are going to book it and hold it to maturity, that’s one thing, but you then have to disclose periodically what the current value of that obligation is versus the cost at which you bought it. You cannot hide a loss in a securitized market. It sounds to me that you have securitized markets when everything is steady and then you move away from them when there’s a high degree of volatility. I don’t think that will fly with the investor community.
With all of these different regulations being considered, I have to guess that being on the board of a financial services firm is a pretty thankless job these days.
I think it’s a very difficult job and I would assume that over a period of time, there would be many changes made in the management of financial institutions and in the board of directors.
We’ve heard people say that in a truly effective company, the CEO is really the Chief Risk Officer. How could so many good CEOs have gotten it wrong?
Well, let me rephrase it a little bit. If you remember, a number of years ago Chuck Prince, who was the head of Citigroup at the time, said “As long as the music plays, we have to be on the dance floor.” What I suspect he meant is this: If Citigroup is not participating in the market while there is all this fluff in the system and available credit, then there’s the risk that the institution loses market share. Then there is the risk that some of the personnel may not get the reward that they aspire to. Then there is the risk that earnings per share may not be what was anticipated and the market will then say: ‘Well, somebody else is doing better than you.’ So, in that sense, the senior management becomes a captive of the system.