Search My Blog
 About Donald

Don founded Kamakura Corporation in April 1990 and currently serves as its chairman and chief executive officer where he focuses on enterprise wide risk management and modern credit risk technology. His primary financial consulting and research interests involve the practical application of leading edge financial theory to solve critical financial risk management problems. Don was elected to the 50 member RISK Magazine Hall of Fame in 2002 for his work at Kamakura. Read More

 Connect
 Now Available

An Introduction to Derivative Securities, Financial Markets, and Risk ManagementAdvanced Financial Risk Management, 2nd ed.

 Contact Us
Kamakura Corporation
2222 Kalakaua Avenue

Suite 1400
Honolulu HI 96815

Phone: 808.791.9888
Fax: 808.791.9898
info@kamakuraco.com

Americas, Canada
James McKeon
Director of USA Business Solutions
Phone: 215.932.0312

Andrew Zippan
Director, North America (Canada)
Phone: 647.405.0895
 
Asia, Pacific
Clement Ooi
President, Asia Pacific Operations
Phone: +65.6818.6336

Australia, New Zealand
Andrew Cowton
Managing Director
Phone: +61.3.9563.6082

Europe, Middle East, Africa
Jim Moloney
Managing Director, EMEA
Phone: +49.17.33.430.184

Tokyo, Japan
3-6-7 Kita-Aoyama, Level 11
Minato-ku, Tokyo, 107-0061 Japan
Toshio Murate
Phone: +03.5778.7807

Visit Us
Linked In Twitter Seeking Alpha

Careers at Kamakura
Technical Business Consultant – ASPAC
Asia Pacific Region
Business Consultant – ASPAC
Asia Pacific Region

Consultant
Europe

Kamakura Risk Manager Data Expert
Europe, North America, Asia & Australia 

 

 Archive
  

Kamakura Blog

  
Aug 20

Written by: Donald van Deventer
8/20/2010 4:39 AM 

 I have a confession to make that is risky for a risk manager.  I worked for three financial institutions with more than 30,000 employees each, and every one of them effectively failed. I worked at Lehman Brothers in Tokyo from 1984 to 1987. We all know the story of Lehman’s 2008 demise thanks to Lawrence G. McDonald’s fine book A Colossal Failure of Common Sense.  First Interstate, where I was senior vice president for funding from 1984 to 1987, was forced into a merger with Wells Fargo in the mid-1990s.  Finally, Security Pacific, where I worked from 1977 to 1982 on interest rate risk management, was swallowed up by Bank of America in 1992 in the least equal “merger of equals” in the history of mergers and acquisitions.

All 3 of these firms failed because of overexposure to commercial real estate.  That’s why it’s very hard for me to understand what it is that major financial institutions keep getting wrong when it comes to CRE exposure.  In this post, we look to a fascinating book by Security Pacific’s former CEO Robert Smith on how Security Pacific came to fail and note the lessons of its demise.

Warning to the reader: this blog contains quotations from former CEO Richard Flamson of Security Pacific.  He was rarely concerned about whether or not his listeners were offended.  If profanity offends you, we recommend that you skip to the last 2 paragraphs of this blog.

Dead Bank Walking: One Gutsy Bank’s Struggle for Survival and the Merger that Changed Banking Forever (Robert H. Smith with Michael K. Crowley, Oakhill Press, 1999) is a book I have waited more than a decade to read.  During my 5 years at Security Pacific, I worked under three of the most sophisticated chief financial officers in the banking industry, Paul Smith, Frank Cahouet (later CEO of Crocker, FNMA and Mellon), and Dr. John Kooken.  All three were brilliant and knew the organization from top to bottom, transaction by transaction, unlike the CFOs of many of the large institutions bailed out by the U.S. government during the 2007-2010 credit crisis.  Bob Smith’s book cites other Security Pacific leaders who I still admire today: Nick Binkley, head of Security Pacific’s non-bank finance companies (later Vice Chairman of Bank of America and currently director of Union Bank), Dr. Robert T. Parry (former chief economist for Security Pacific but by the time of the book President of the Federal Reserve Bank of San Francisco), former CEOs Richard Flamson and Fritz Larkin, former Vice Chairman George Moody, and George Benter.  How did a bank run by so many smart people get into fatal trouble?  It’s rare for a CEO to set the record straight, and I admire Bob Smith for writing the kind of book that Dick Fuld at Lehman Brothers should have written about his firm’s demise.

One of the reasons I admire Bob Smith, pictured at left, for writing this book is that, even among alumni like myself, it wasn’t widely known how desperately Security Pacific needed the merger with Bank of America to avoid bankruptcy.  Years after the merger, a chance meeting with Irv Margol, former Executive Vice President for personnel, was the first time I learned the truth.  Irv confided that the Federal Reserve and other regulators had cut off dividend payments from major subsidiary Security Pacific Bank to the parent company, Security Pacific Corporation, making it impossible for the parent to repay short term commercial paper coming due.  Once that happened, a failure of the parent was inevitable and the Bank of America rescue came just in time.

As Bob Smith’s title indicates, the thrust of the book is the collective struggle to save the firm.  Only one executive is singled out as swimming against the tide: David Lovejoy, who had been given the responsibility of expanding Security Pacific’s presence in the securities industry.  I first met David in 1977, when he had returned from an extended stay in London.  The top managers of the bank were based on the 53rd floor of Security Pacific’s headquarters.  The interest rate risk management group was then located on the 52nd floor with other key support groups for top management.  I’ll never forget the first time I saw David Lovejoy—when he walked onto the 52nd floor after many years away, all of the secretaries started to laugh. I turned to Irene, Irv Margol’s secretary, to find out why.  Even as a newly minted financial economist, it was clear that Irene knew every secret in the organization.  “He got a hair transplant while he was in London,” she explained, “so everyone who hadn’t seen him for a few years was really surprised.”  That was the day I resolved never to get a hair transplant, and the day I realized that David Lovejoy was going to have a big impact on Security Pacific.

At that time, CEO Richard Flamson was one of those CEOs that you don’t say “no” to.  Rumor in the ranks was that David Lovejoy was Flamson’s God son.  It didn’t matter whether it was true or not, because everyone believed it to be true.  Smith talks about Flamson’s concerns of that era:

“’Other banks have Gulfstream jets,’ Flamson argued, ‘And I’m not talking about just one or two institutions—everybody who is anybody has a jet.  We need to be able to keep pace in a quickly evolving industry.  We must not allow ourselves to fall behind the prestige curve.’ [from page 21]

Before long, Lovejoy was commuting to work with Flamson in his corporate helicopter from Newport Beach, 60 very crowded freeway miles from downtown Los Angeles.  He had the strong support not only of Flamson but of Frank Cahouet, who both ran the non-bank businesses and who would succeed Paul Smith as Chief Financial Officer.  Ultimately, as Lovejoy pushed to do more and more high profile corporate business, he found his deals being turned down by Vice Chairman Harry Meily, the head of the credit committee and a very highly respected member of senior management.  Meily was just as self-effacing as he was brilliant, and he was beloved in the ranks for both qualities.  Before long, however, Lovejoy had used his influence to emasculate the credit quality control function—he had that group moved under him.  This was the classic road to failure in banking, when loan origination and loan approval fall under one executive whose own well-being depends on new business volume.  I spend a lot of time with default forecasting now, but my very first default forecast was made the day that Lovejoy was given control of the credit approval function.  I made my plans to quit that day, because checks and balances went out the window at Security Pacific with that reorganization.  Within a few months I’d made the move to First Interstate, where still I still had a front row seat on what happened at 333 South Hope Street at the Security Pacific head office.

Not too long after this reorganization, Frank Cahouet left the organization to run Crocker Bank, and all checks and balances on Mr. Lovejoy evaporated.  Flamson dominated the organization, run with Lovejoy’s help, and Smith was often threatened with the potential return of Frank Cahouet (page 29) if Smith didn’t perform his role as President in accordance with Flamson’s wishes. Smith tells the story of a long line of famous and infamous pillars of commercial real estate that passed through the halls of the bank: Donald Trump, Charles Keating, Chris Hemmeter, and Peter Ueberroth, who had just finished his reign as head of the 1984 Los Angeles Olympics. Smith called a transaction with Ueberroth Security Pacific’s “single biggest disaster” (page 62).  Security Pacific’s aggressiveness in commercial real estate and in Lovejoy’s securities businesses began to get painful in the wake of the 1989 passage of the Financial Institutions Reform, Recovery and Enforcement Act (“FIRREA”), which was designed to cure the excesses of the first trillion dollar bailout of American financial institutions, the so-called “savings and loan crisis.” Although interest rate risk contributed much to the failure of the S&L industry, commercial real estate losses were a major contributor as well.  Under FIRREA, regulators were strongly encouraged to take an aggressive mark to market posture on the value of commercial real estate pledged as collateral for lending.

Smith described the bank’s situation this way:

“Our bank was dependent on real estate to a degree that was frightening and had been since 1931 when our predecessors christened a new real estate division. Despite the great depression, real estate was considered a necessary and prudent investment for a bank that proclaimed its economic roots to be the California land itself...the notion that loans on real estate might become the weak link in our balance sheet, in light of no historical antecedents whatsoever, was unthinkable.” (page 77)

There it is: the most dangerous thought in finance—“this risk hasn’t happened to us yet so it’s impossible for it to happen to us in the future.”

Flamson realized what falling commercial real estate prices were doing to the bank, and he communicated that in his usual vocabulary. “We are in very serious trouble. This is no joke. Jesus, Bob, the bank could fail over this crap.”  After hearing what the bank’s commercial real estate exposure was, Flamson went on, ”Oh, man. If these numbers are right, that’s over 20% of our total loan portfolio. That’s $17.5 billion of fucking exposure.”

Security Pacific and executives of other large banks tried to fight the mark to market provisions of FIRREA, but they lost the battle.  Bob Smith concludes by saying “We were no longer ‘too big to fail.’” That couldn’t have been more true.

As Smith tells the story, Flamson’s response was to take it out on the bank examiners who descended on the bank:

“Flamson’s cavernous voice could be heard in the offices on the opposite side of the building.  ‘There you go again! Trying to tell us how to run our goddamn business! It’s a wonder you nudniks can tie your damn shoelaces!  You know nothing about the circumstances of this loan and you have neither the wisdom nor the authority to instruct us how to classify it.’

“The examiner’s voice was a fractured whisper. ‘I’ve carefully deciphered the complete history of that loan.’

“’I don’t care if you’ve deciphered the Dead Sea Scrolls! Those loans are nowhere close to being downgraded!’

“’It’s patently obvious the quality of these loans is in decline.’

“’Your intelligence is in decline!  You let us do our own classifications.’

“The regulator’s face turned the color of steak tartare as he gathered up his paperwork, shoved it into a crammed brief-case and made a bee-line for the elevator.

“’Bye-bye, jackass!’ Flamson shouted after he’d departed.’

Smith goes on to describe what happened next:

“The following week Dick phoned the OCC and complained about this particular regulator.  ‘He’s inept! He couldn’t find the sun with an astrolabe at high noon. I don’t want to see his face in our bank again, and I’m not kidding around.  Why don’t you give the guy a transfer to, say, the Aleutian Islands.’” (page 96)

Flamson prevailed and Smith describes it as a “grave miscalculation” on Flamson’s part. My contact with representatives of the Office of the Comptroller of the Currency’s examiners, both then and now, was that they were first rate, sincere, and much more truthful about the state of the organization than an analyst internally who lived in fear of Flamson, or, even worse, David Lovejoy.  I’m told by my friends at the OCC that. even today, the regulator banished by Flamson is a legend for his courage and for his accuracy in assessing what was unfolding at the bank.

Ultimately we know what happened.  Flamson was in failing health from a “rare blood disease,” an object of great speculation among the staff of the bank.  Flamson stepped down as CEO in 1989. He was to pass away a few years later, and the bank soon found itself in the grasp of Bank of America.  One of the great ironies of the bank’s 1992 demise was that the primary regulator of the holding company Security Pacific Corporation was the President of the Federal Reserve Bank of San Francisco, Dr. Robert T. Parry, the former chief economist of Security Pacific.  I spent 5 years watching him contribute with intelligence and insight to the risk management of Security Pacific, so I can only imagine the irony of his conversations with his former co-workers as the bank got into deeper and deeper trouble.  Unfortunately, Bob Smith tells no tales in that regard.

Ultimately, what happened to Security Pacific was not that different from the situation that Citigroup CEO Vikram Pandit described:

"What went wrong is we had tremendous concentration in the sense we put a lot of our money to work against U.S. real estate," Pandit said in an interview on PBS' Charlie Rose show. "We got here by lending money, and putting money to work in the U.S. real estate market, in a size that was probably larger than what we ought to have done on a diversification basis.“ November 25, 2008, Reuters.com

Like Security Pacific’s management team, senior bankers were in denial about the prospect that real estate prices might fall.  From Beijing to Boston, from Tokyo to Toronto, we’ve seen that “denial” again and again.

Whenever one of your colleagues expresses those sentiments, please hand him a copy of “Dead Bank Walking” with my compliments!

Donald R. van Deventer
Kamakura Corporation
Honolulu, August 20, 2010

Tags: