Crisis Management: Lessons from the C-suite
The long-term economic implications of COVID-19 are not yet understood, but lessons from earlier crises can guide those responsible for the recovery.
how the financial industry handled the I WATCHED WITH INTEREST
COVID-19 crisis that emerged in late 2019. It was truly a challenging time in every way as leadership had to balance grave health issues with the potential collapse of the economy. What made it unique was that it was not caused by economic factors but by a health crisis. Its vast implications are barely understood as of this writing, but I hope the lessons of earlier crises can serve to guide those responsible for the recovery, or for the management of a future crisis of any scope.
In my time as a senior executive at Bank of Montreal (BMO), there were four periods of crisis that required some exceptional management skill as well as luck to survive. One of them was, of course, the 1998 ‘merger that never was’ with Royal Bank. Before that, there was the real estate crash of 1990, and after it was the 2001–02 dot-com bubble collapse. And then there was the derivatives crisis in 2008, which occurred immediately after my retirement in 2007. How are they the same and how are they different? And how did BMO manage through all of these periods of crisis and disruption to avoid the pitfalls that tripped up other banks? In this article I will indicate some of the lessons learned from each of these significant crises.
1990: The Real Estate Market Collapse
The 1990 crash was a general economic depression, but the big raw factor in it was a collapse in the real estate market in Canada. Why? First, because the banks were being too aggressive at lending for construction projects. That’s why the banks have now got something called the 75 per cent rule; in other words, today developers have to have achieved 75 per cent financing of their project through pre-development sales before the banks will finance the project.
Before the 1990 crash, banks would finance 100 per cent of the project, and then the builders would undertake their sales. If they didn’t sell enough, they went bankrupt. Nowhere was this more common than in the condominium market. For example, builders would have obtained bank financing for condominium
units each worth, say, $400,000 on the market and could raise only maybe $300,000 on average per unit, which wouldn’t even cover what they owed the bank. Before they were finished, the loans were underwater. That all changed after 1990, and since then fewer condo projects have gone bankrupt, because the banks are no longer lending on speculation. They will finance a project only when the developer comes to them with at least 75 per cent of the financing already in hand.
The second factor in the 1990 crash was on the retail side. You hear about a thing called the gross debt service ratio (roughly the proportion of the gross debt obligations you would be paying each month while owning a particular property). In my day, it would be 37 per cent. So, if your gross debt service ratio was north of 37 per cent, we wouldn’t lend you the money for the mortgage to buy the house. You had to have a gross debt service ratio lower than 37 per cent, including the cost of the mortgage (although borrowers with good credit and a reliable income were sometimes allowed to exceed these guidelines).
Many of these retail loans were also made in anticipation of changes to zoning in the hotter markets in Canada that would boost the value of the investments. People were often spending the anticipated appreciation before it ever was realized. When those changes didn’t happen, investors were left underwater and the properties went bankrupt. According to betterdwelling. com, the average sale through the Toronto Real Estate Board (TREB) was $273,698 in 1989. “Over the next seven years, the average price dropped and finally bottomed in 1996 at $198,150. If you bought at the peak, and sold at the bottom — you lost $75,548, or roughly 27.6 per cent of your purchase. It took 13 years for the average price to recover in Toronto.”
When the developers failed and large parts of the residential market collapsed, the banks found themselves holding a glut of properties and having to carry a number of buyers until the market rebounded (which it eventually did — and then some). Notwithstanding this, the Canadian banks weathered the storm. Other financial institutions were not so fortunate and found themselves eventually out of business or absorbed by the large banks. The banks survived in large part because the big Canadian banks are very conservative, and so are most of their customers.
In fact, do you know where we have our lowest loan losses, historically, through thick and thin? The Atlantic provinces. You don’t think of that intuitively, but Maritimers are very conservative people because theirs has been a slower-growth economy. They’re not buying the next big hype. This is my personal philosophy, not necessarily substantiated by fact and science, but acquired through contact with the borrowers in the Atlantic provinces for many decades. Real estate remains a very aggressive commodity in other parts of the country, but the forces fuelling the growth — outside low interest rates — are more external rather than internal.
Next Up: The Dot-com Bubble
The 2001–02 dot-com bubble crash was the next major disruption to the financial markets and the next huge challenge we had to manage during my tenure at head office. The rise of the internet in the late 1990s and the e-commerce phenomenon created an explosion of opportunities and bright ideas. All of a sudden, entrepreneurs everywhere had found a way to tap into the global market. The upside was endless — or so they thought. It was the classic entrepreneurial mentality at work, but on a grander scale than ever before: with your money and my brains, we’ll do wonderful things. Good for them if they could find someone else to finance their dreams. That’s what all these dot-com entrepreneurs were looking for, and the investment community was all too keen to get caught up in the excitement of what looked like unlimited opportunity.
From my perspective at BMO, all these guys on the covers of business magazines acted as if they’d invented this new way of doing business. Three smart guys, one from Harvard, would come to my office at the bank and pitch the latest dot-com concept, looking for investors to lend them $100 million to finance their dream. And lots of banks, angel investors, private equity
If you’re investing in companies and commodities that you don’t understand, you’re more likely to get burned.
finance and others got on board in a big way. Everybody was into these science-fiction companies that had zero customer revenue. It was all a concept, an idea, a wonderful thing — and many in the financial industry thought they’d better get in on some of that action before the markets discover what’s going on.
For me, this was where my software-development background came in. I’d receive these people in my office with their great pitches and they’d think, ‘Who’s this old guy? What does he know about this hip technology?’ I’d hear them out, and then simply ask, “Where are the revenues? How much have you budgeted for the complexity of this software?” Suddenly the smiles disappeared. They had met someone who wasn’t buying their dream scenarios. And then I’d kick them out of my office. Our bank was largely spared the worst of the collapse in investments as a result.
What they were in fact doing was creating a massive bubble in the market. The dot-com craze and the companies that drove it were seductively attractive propositions, but they were mostly ideas and dreams built on nothing — zero sales, zero results, just endless opportunity and upside. Where were these fantastic expected revenues actually going to come from? How do you measure the potential of a whole new kind of business model no one has seen before? But there was so much temptation in the investing community to get in on the hype and get a piece of the action that many turned a blind eye to the risk and all the questions and jumped on board.
During the dot-com bubble, the technology-dominated Nasdaq index rose from under 1,000 to more than 5,000 between the years 1995 and 2000. In 2001 and through 2002, the bubble burst, with equities entering a bear market. According to investopedia.com the crash “saw the Nasdaq index, which had risen five-fold between 1995 and 2000, tumble from a peak of 5,048.62 on March 10, 2000, to 1,139.90 on Oct 4, 2002, a 76.81 per cent fall. By the end of 2001, most dot-com stocks had gone bust. Even the share prices of blue-chip technology stocks like Cisco, Intel and Oracle lost more than 80 per cent of their value.
It would take 15 years for the Nasdaq to regain its dot-com peak, which it did on April 23, 2015.”
Of course, this wasn’t the first time in history that investment mania had reached fever pitch over an asset that simply was not there. The dot-com crash wasn’t the first bubble to burst, and it won’t be the last. Tulipmania occurred in Holland in the early to mid-1600s, when tulip bulbs were reputed to be trading as high as six times the average person’s salary. (It’s a good story about the concept of some commodities getting overblown, but it’s mostly untrue.) The South Sea bubble that burst in 1720, ruining many British investors in an elaborate hoax, was probably a better example as a comparison, but nobody really wants to understand that one.
It could turn out to be the same sort of phenomenon with Bitcoin and other cryptocurrencies. There’s no real substance behind them. Everyone’s applauding the idea until someone loses $290 million, and then lenders are going, ‘Oh, who’s going to bail us out? What about the regulations?’ The point is, if you’re investing in companies or commodities that you don’t understand, you’re more likely to get burned. As Warren Buffett has famously advised, “Never invest in a business you cannot understand.” And another oft-quoted corollary to that, also from Buffett: “Risk comes from not knowing what you are doing.” But it’s hard for many investors to resist the temptation to get in on the hype.
2008: The Global Financial Crisis
Finally, there was the global financial crisis of 2008. The biggest financial collapse since the Great Depression of 1929 was fuelled by speculation on real estate derivatives and led to the Great Recession as capital dried up around the world. The Big Short, as Michael Lewis called it, was a very serious situation for the entire financial industry, and many investors — the ones who survived it — are still feeling the aftershocks from it.
As we know, legendary financial names such as Bear Stearns and Lehman Brothers disappeared in the process. Small nations such as Iceland had to be rescued from bankruptcy.
Periods of crisis are inevitable in the tenure of any leader.
The U.S. estimated that as much as US$ 9 trillion dollars was added to its debt over the decade following the financial crisis. In the first quarter of 2009, Japan’s output plummeted a record 14.2 per cent, and the 16-country Euro currency zone saw a 10 per cent retreat. U.S. housing prices dropped 31.4 per cent. The Treasury Department spent $440 billion on automobile and bank stocks and $182 billion to bail out insurance giant AIG. A total of $144.5 billion was moved from stocks to treasury bonds, precipitating a huge drop in stocks worldwide. Unemployment rates remained above nine per cent till after 2010.
What made the 2008–09 financial crisis different from the other economic recessions before it was that this one created a worldwide liquidity issue. A little history first.
Mortgages are loans that are typically paid back over time, with the terms of the loan being renewed regularly, say every five years. The bank funds this loan with a deposit that has the same five-year term. So, the loan is ‘match funded’. If the borrower pays the loan off in fewer than five years, the bank is still obligated to pay the interest it agreed to on the deposit for the rest of the five years. Therefore, the person paying off the loan pays an interest penalty to enable the bank to meet its commitment to the depositor.
That’s the system in Canada. But in the U.S., the system became different over time. In many U.S. states, customers could pre-pay the mortgages without paying an interest penalty. Of course, this made it impossible for the bank to put the loan on its balance sheet at the outset, in an effort to avoid the risk of having to continue to pay the depositor the contracted interest rate without receiving the corresponding contracted loan interest to fund the obligation. So, two things happen: 1) the bank sells the mortgage it has just originated to the market; 2) but it also loses the contact with the borrower in the process.
And so developed the U.S. as the secondary market for mortgages (which persists to this day). Banks and other ‘originators’ routinely sold the mortgages they had originated into the secondary market. Two large government-sponsored entities, known as Freddie Mac and Fannie Mae, were very significant participants in their secondary market. This has become a huge collection of loans that are effectively anonymous as to who and where the borrower is, which makes it very hard to follow up when the loan goes into arrears.
Thankfully, we have a different model in the Canadian banking system, where the vast majority of mortgages are done by people at the local branch in Truro or Trail who know the borrower. They’re a retail customer of the bank, not some number in cyberspace. And we can fund it long-term by issuing a certificate of deposit on it. In the Canadian banking system, you maintain contact with the borrower.
In contrast, in the U.S., there was this floating wholesale market run by the investment bankers on Wall Street, with no regard for one of the fundamental principles of business that I have long adhered to: Just because you are allowed to do something doesn’t mean it’s the right thing to do.
At the same time, there was political pressure to expand home ownership. The preferred (and easy) way for politicians to accomplish this ‘socially beneficial’ goal was to put pressure on mortgage grantors, banks and others to loosen up lending standards and criteria, and pressure the wholesale market to accept loans of lower quality in their pools.
Then it got worse, when the financial wizards who thought up these derivatives got credit rating agencies like Moody’s or Standard & Poor’s to give this mess a triple-a rating. But these products that were triple-a rated weren’t really triple-a quality. They were more like C-minus. These collateralized debt obligations in the U.S. housing market, and their financing, were a bubble of wholesale funding on an insecure product. At the first sign of a liquidity squeeze, it all began to collapse, taking down the very financiers who were in the business of doing this, starting with Lehman Brothers. That cascaded into the whole financial system, because there’s an interlocking of wholesale lending practices between banks to fund each other. It got very scary, very fast. Author Michael Lewis does a masterful job describing this
process in The Big Short.
While it originated in America, the crash had severe repercussions in Canada. Luckily, the Canadian economy entered the recession later than most other Western economies and was protected from the wildest of the real estate practices that sank the U.S. But the systemic problems were still felt across the whole banking industry. Now it’s not just their problem; it’s all of ours — we’re in this together. You immediately had the Bank of Canada, the government and the heads of the banks all saying we’ve got a real serious problem here, what are we going to do?
Although they said they hated to do it, the U.S. federal reserve and American banks provided liquidities. They poured more money into the system to get over this liquidity problem. The Canadian economy could not distance itself from the imminent collapse of industries such as the auto industry, for instance. So, we were obliged to provide large amounts of stimulus into those industries to keep them solvent — and protect tens of thousands of jobs. It took CEOS working around the clock every day with the heads of the government and central banks to do this in 2008.
Bill Downe (Rotman MBA ‘78), our new CEO in 2007, was in these kinds of meetings to represent BMO. Talk about Johnnyon-the-spot. I had put Bill in charge of capital markets after he’d been running the U.S. businesses, and the capital markets guys were unsure: ‘How could you put a commercial banker in charge of an investment bank?’ But Bill proved his mettle during the liquidity crisis. And BMO (with other Canadian banks) rebounded even as the American and global systems were still in turmoil.
Thanks to our prudence in Canada — and some leadership at the political level starting with then-prime Minister Stephen Harper, finance minister Jim Flaherty and Bank of Canada Governor Mark Carney — we managed to dodge the worst of the fallout from the crisis that shook people’s faith in the financial system. To me it proved another classic example of the strength of our banking regulations and, in contrast, the danger of letting politicians get into the mortgage business — as happened in the
U.S. when they liberalized lending laws. While I had just left the CEO post at BMO, I couldn’t have been prouder of how we reacted in a time when quick thinking and cool heads were needed.
In closing
Today my successors at BMO are dealing with an insidious challenge — the COVID-19 pandemic — that has few, if any, precedents in recent memory for the banking system. The stress on the health and financial systems of the world is unprecedented. Old solutions no longer apply; creativity and flexibility are paramount. But I hope, as the ripples of this pandemic make their way around the world, that people of character and resolve emerge to guide us as they have in the past. As always, I remain a believer in our creativity and resolve.
When asked by a reporter in the 1960s what he most feared, British Prime Minister Harold Macmillan was reported to have said, “Events, my dear boy. Events.” Periods of crisis are inevitable in the tenure of any leader. Through all the pivotal crises I witnessed and weathered at BMO, I learned there is no substitute for good old-fashioned strategy — accompanied, one always hopes, by flawless execution if, and when, the next crisis unavoidably hits.