Monday, October 06, 2008

6 Lessons We Should Have Learned Already

6 Lessons We Should Have Learned Already

reat leaders are forged in times of crisis. The credit crisis that surrounds us creates an opportunity to learn--but only if we begin by understanding that the crisis is not the result of one-time mistakes or bad luck.

Instead, the collapse of Washington Mutual, Wachovia, Lehman Brothers, AIG, Bear Stearns, Merrill Lynch, and others soon to fall stem from discredited strategies that should have been avoided, according to the research into 2,500 major failures that we did for our Harvard Business Review article, "Seven Ways to Fail Big" and for our recently published book, Billion-Dollar Lessons: What You Can Learn from the Most Inexcusable Business Failures of the Last 25 Years.

Here are six lessons that, had they been learned a decade ago, would have kept us from being in our current mess:

1. It doesn't work to let dealmakers make all their money up front. Whether it's lenders hawking mortgages, bankers pushing bonds, or salespeople closing contracts before the end of the quarter, dealmakers have to have responsibility for the health of those decisions years down the road. Where possible, the individuals who make the deals should also have their compensation depend on the long-term performance of those deals.

Green Tree Financial showed how dangerous it can be to separate up-front fees from long-term responsibility. In the 1990s, Green Tree offered mortgages on mobile homes that made no long-term sense -- the mortgages lasted 30 years, while the underlying assets had a useful life of just 10 to 15 years. Yet, because Green Tree employees from the CEO on down had so much of their pay tied to the growth in the number of mortgages, the company churned out flawed loans at an ever-accelerating pace. When problems started to surface, Green Tree actually managed to sell itself to Conseco for almost $6 billion in 1999. Conseco subsequently wrote off all the profits that Green Tree ever recorded and went into bankruptcy proceedings.

Subprime lenders, having missed the Green Tree lesson, likewise became addicted to up-front fees and generated an astonishing number of bad loans that were turned into securities and sold.

2. Risks may correlate more than you think. In other words, a single problem can take you down if it's severe enough.

Long Term Capital Management thought it had diversified its risks in the 1990s but found its whole portfolio turning sour simultaneously and collapsed in 1998. Having missed that lesson, this time around companies such as Merrill Lynch and WaMu built huge portfolios of mortgage-related securities that relied on historical data suggesting that housing markets were localized -- in other words, the market in Denver was independent of the market in Sacramento, which was independent of the market in Pittsburgh. In fact, the credit crunch has clobbered all markets and all classes of lenders.

3. In a crisis, liquidity can disappear overnight.

LTCM thought that, in the event of problems, it could always unwind its positions in orderly fashion. In fact, all buyers disappeared. The same thing happened to Merrill, WaMu and others. The market got so scared so fast that nobody would buy their debt portfolios at almost any price. While Bank of America might have bought Merrill at a bargain for $50B, they also acquired $64B of toxic debt that will eventually mushroom the true cost of the acquisition.

4. It's incredibly dangerous to buy a business unless you understand it in excruciating detail.

Conseco showed the danger. It had a great record of buying and integrating companies, but they were all in insurance. Conseco didn't know anything about mortgages. It was so clueless about the problems with Green Tree's business model that it actually stepped up the mortgage business, right to the point where it collapsed. AIG repeated the mistake when it started offering credit-default insurance on mortgage-backed securities that it didn't understand. Merrill made this mistake when it decided it could copy Goldman Sachs and invest its own capital in what turned out to be toxic loans. (And Bank of America may have made this mistake when it agreed to buy Merrill, whose retail brokerage operation, investment banking unit and investment portfolio are outside its expertise.) As a colleague of ours says: Don't assume someone smarter than you will understand the risks you're taking on.

5. Whenever anyone says they've managed to do away with risk, head for the hills.

LTCM said its portfolio was impervious to risk. AIG and others said the same thing about the securities that were built based on subprime mortgages. We've no doubt that yet others will be saying the same as they argue for ways to take advantage of others' mistakes as the current crisis unfolds.

6. Perhaps the greatest lesson of all is that bad strategies can happen to great companies and smart people, even those acting on seemingly thorough analysis and the best of intentions. The humility that comes with this lesson should cause the smartest companies and managers to instill process and cultural mechanisms that absorb these lessons and avoid such mistakes in the future. (We don't have the space here to go into it, but that has a lot of do with creating a culture of constructive debate and deliberation. We discuss this in our HBR article and have even made the relevant chapter free at our web site.) 

The next generation of great leaders will be the ones who absorb these lessons. Everyone else is doomed to repeat the same mistakes.

Paul B. Carroll wrote for the Wall Street Journal for 17 years. He is the coauthor of Billion-Dollar Lessons and the author of Big Blues: The Unmaking of IBM.Chunka Mui is the coauthor of Billions-Dollar Lessons and the coauthor of Unleashing the Killer App. He is a fellow at Diamond Management & Technology Consultants. For more on their work, visit

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