Shareholder Value as America Watched

Shareholder Value

As America watched stock prices tumble and the very foundation of the economy shaken, bank Presidents, Board Members, and CEOs hopped private jets to attend lavish affairs. Attempts to bail out America's leading banks has been set against a backdrop of corporate irresponsibility on the part of banking officials. Shareholders watched their investments drop in value amidst claims of woe and gloom by banking official, while top executives of some of America's biggest banks continued to engage in pork belly spending. The coffers of the shareholders became lean, while the bellies of the bankers became fat. The following research will explore the practice of profiteering at the shareholder's expense as it relates to recent events in the banking industry.

Too Big to Fail

When Bank of America closed the deal to obtain Merrill Lynch for a mere $24 billion dollars, shareholders were not informed of several factors that blemished this supposed match made in heaven (DeStefano 2009). Bank of America knew that Merrill Lynch was in trouble and the deal almost did not go through. To anyone on the outside, it looked like damaged goods. However, in order to sweeten the pot, government officials are rumored to have offered incentives to Bank of America's Ken Lewis, to ensure that he did not back out of the deal (DeStefano 2009).

Even when it became apparent that the financial situation with Merrill Lynch was more dire than anyone expected, officials at Bank of America refused to tell shareholders, leading them on to believe that this was a good investment (DeStefano 2009). Merrill Lynch executives received compensation and benefits totaling $15 billion in 2008 (DeStefano 2009). Their bank accounts continued to grow, while Merrill Lynch proceeded to post quarterly losses of $15.31 billion dollars in the fourth quarter of the same year (DeStefano 2009).

Merrill Lynch is not the only one to withhold negative investment information from shareholders. Wachovia's CEO, Robert Steel, is currently under investigation for misleading statements to shareholders prior to its deal with Well's Fargo & Co. (DeStefano 2009). This statement was the result of statements made on the show "Mad Money." The statement suggested that the bank had a "great future as an independent company" (DeStefano 2009). At the time of his statements, arrangements for the deal were already well underway.

Events such as these flood the nightly news media. Meanwhile, investors become increasingly weary of the stocks that they purchase. They are becoming distrustful of the statements issued. They want transparency in the banking industry. They want to be assured that they are making some sound investments. They want to make certain that their money is being managed properly and not merely funding another person's wealth.

Governmental Role in the Scandals

The Treasury originally offered a bail out plan to banks that were healthy, but that had been hit hard by troubled assets (DeStefano 2009). However, this plan drew criticism as it became apparent that this would not be the basis for receiving bail out monies. Instead, of going to solid banks, such as PNC Financial Services group, Inc., that were not in immediate danger of collapsing, the monies were awarded to banks that whose failure was considered important to the economic infrastructure of the country, regardless of their apparent solvency (DeStefano 2009). This policy has drawn considerable public criticism from both inside and outside of Washington circles.

Are Mergers Good for Shareholders?

When Bank of America bought Merrill Lynch, shareholders were not made aware of the bad investment. In 2006, a study was conducted to explore the effect of mergers on shareholder returns (Mayer-Sommer, Sweeney, and Walker 2006). The study found that although mergers can create deeper penetration of an existing market or expand a banks area and customer base, mergers rarely enhance shareholder value (Mayer-Sommer, Sweeney, and Walker 2006). This was certainly the case when Band of America bought the failing Merrill Lynch.

Only in unusual circumstances does a merger result in increased shareholder value. One example cited in the study was when Southern Financial Bank acquired First Savings Bank of Virginia. In this case, First Savings Bank of Virginia made plans to be acquired eight years before the deal took place. Its officers and directors held a large number of outstanding shares, which simplified the merger process (Mayer-Sommer, Sweeney, and Walker 2006).

One view of mergers and acquisitions is that it represents one way to reduce excess capacity in a mature or declining industry (Kaen, 2003). The question on every shareholder's mind is who captures the value in a merger. Evidence suggests that the target company's shareholders have the greatest potential for increased value (Kaen, 2003). However, this is only true if the combined value of both companies increases (Kaen, 2003).

There is always a chance that the acquiring company's value may fall (Kaen, 2003). There are several reasons why this might occur. One reason is that the acquiring company pays a price that is too high for the target company (Kaen, 2003). Another scenario is that the target company is in poor financial shape and is considered a burden on the acquiring company. This is where shareholders and managers clash (Kaen, 2003).

Bank Nationalization: What's in it for the Shareholder?

The recent banking crisis has led to talks about the nationalization of banks to prevent the same situation from developing again in the future. The debate over the possibility to nationalizing banks is a topic of great debate. At the current time, it only exists as an idea, with no action being taken in either direction.

Shareholders have many worries today. They must worry about risks associated with the market and what it will do to the bank's portfolio (Hutchinson, 2009). They must also be concerned about what nationalization will do to the any remaining value in the investment (Hutchinson, 2009). The final worry of shareholders today is whether government intervention will result in lower interest rates, meaning thinner profits for the organization and individual shareholder value (Hutchinson, 2009).

Nationalization has three primary effects that compromise shareholder value. The first is that it distorts the marketplace. Nationalization would apply to banks that are in danger of failing if something drastic is not done. For shareholders of those banks, they are probably not seeing any gains or dividends (Hutchinson, 2009). Investments into these banks have probably lost as much and 90% of their investment. Some of them are only still in existence due to the Troubled Assets Relief Program (TARP) (Hutchinson, 2009).

There are two choices for these banks, fold, or undergo nationalization. Either option leaves the shareholder with little of their original investment left. However, nationalization is not just a threat to shareholders of failing banks; it also has an effect on healthy banks that will not be nationalized under the current proposal (Hutchinson, 2009). To understand this, one has to understand the principal of market share. '

Propping up failing banks and allowing them to remain open long past their life expectancy is like putting a hopelessly lost patient on life support. There is no way for them to recover fully, and the process only prolongs the inevitable. In the mean time, they still retain a faithful following of customers. If they were allowed to fail, surrounding healthier banks could suck up the customers left in the void. This would increase the acquiring bank's value and customer base (Hutchinson, 2009). Healthy banks would be able to suck up a larger portion of the market share that is currently being held by a hopeless case (Hutchinson, 2009). Allowing the wealthy to disperse throughout the remainder of the market would be the best thing to do for the banking industry as a whole.

As long as ailing elephants remain alive, they suck the life out of healthier institutions. In the mean time, their CEOs and top executives continue to live lavish lives and misspend the few last remaining dollars trying to hold onto something that is already gone. Nationalized banks would be likely to increase lending volumes by artificial means. This would take an even greater customer base from healthy competition. This means lending at lower margins. If this occurs, it will take the banks a much longer time to return to a healthy status. As these banks continue to mend themselves, it sucks even more competition from healthy banks (Hutchinson, 2009).

Nationalization would artificially decrease shareholder value by allowing large, failing institutions to take a significant market share from healthier, more stable banks. It is argued that nationalization would prolong the recession by misplacing efforts into the weak, while at the mean time turning the strong into the weak. Allowing the larger failing banks to be propped up is like feeding the old ailing dinosaurs by allowing them to suckle from smaller, healthier prey.

Nationalization is a bad idea for the shareholder because they will suffer, even if they have made sound investments into strong, healthy banks. Propping up banks that have failed through their own bad decisions is a waste of taxpayer money and represents favoritism among officials. The only ones who will gain from these measures are the CEOs, managers, and Board of Directors. Shareholders will suffer through the actions of the few. Due diligence will be rewarded with dwindling returns for the shareholder.

Does Shareholder Value Matter Any More?

The old theory was that if banks took care of shareholder value, everything else would fall into place (Nocera 2009). Shareholders were considered one of the most important responsibilities that executives had. This was how it used to be. However, recent events make it apparent that creating shareholder value has a downside as well. As managers struggle to increase shareholder value, they ignore many business basics. They increased value has not real foundation and soon, as the company collapses under the debt loads used to create the perceived value, it is shareholders that have he most to lose (Nocera 2009).

Lately, the focus has been on getting the banks into lending mode again in order to stimulate the economy, regardless of the long-term effects on the shareholder (Nocera 2009). The focus is on finding a solution to the immediate crisis. Everyone hopes that these measures will build long-term stability, but as we discussed earlier, propping up the big banks may mean that we are only prolonging the inevitable failure.

Recently, shareholders have hardly been in the picture, as negotiations continue to focus on giving the banks a pair of crutches. When banking officials arrived in Washington to discuss the possibility of bailouts in private jets, it caused public outrage. This move was viewed as irresponsible use of company assets. It "demonstrated" to the public that they were only out for themselves, without regard to the needs of the company or to its shareholders. It appears that shareholder value has taken a back seat to other issues, at least for the current time being.

Shareholder value can be equated to good corporate citizenship. Managing with a focus on shareholder value means developing long-term focus on customer relationships. It means holding to business values that represent integrity and a responsibility to the whole. It reflects a caring attitude and the desire to be a good community citizen. Developing solid shareholder value can be considered an important strategic objective for banks.

The mortgage crisis reflects poor risk management on the part of banking institutions. They made loans that did not reflect solid investments. They did this in the name of increasing volume that was reflected in positive gains on the revenue side of the balance sheet. This did increase shareholder value for a short time. The banking industry was booming and became a haven for speculative investors. They had faith that bank managers were making good decisions and that this growth would continue. Shareholders were in Buy and Hold mode, as the reported revenues, and profits continued to climb.

Shareholders had no way of knowing what was about to come. All they could see was the balance sheets and the number continued to climb into the black. They could not see the details of the loans that were being made to create this illusion of prosperity. They could not see the poor credit scores, and the deals that were allowed to "slide by" even though, the buyers could barely afford the mortgage.

Risk management is the key to the banking industry. Lenders must use good risk-management strategy to build a solid base for long-term growth. In the beginning, homebuyers made unrealistic decisions about what they could afford and lenders let them get away with it. The banking industry laid risk management aside and focused on sales. Loans became more like a commodity than an investment. Using this mind-set, risk management was practically abandoned and the frenzy began. Bankers knew better than this in the back of their mind, but the lure of quick cash drew them in and they made a run for the top that would rival anything attempted in the past.

Shareholders and building long-term value was shoved to the back of their minds and bankers chanted the mantra of, "Sell, sell, and sell." Buyers who could never have dreamed of home ownership in the past could now afford the house of their dreams. All the while, short-term profits grew. Shareholders were caught up too, as they bought banking stocks by the billions, driving prices through the roof. However, this scenario was bound to come crashing down from the very beginning.

The banking industry, which in that past had been so careful to not allow it to enter into too much risk, suddenly had to come to the realization that many of the buyers could not afford their investments. Buyers began to default and homes began to lose value. Soon it all began to spiral down, as bad risks became bad assets. Shareholders continued to have faith and trusted banks to act in their best interest. However, now their eyes are open and they must come to realize that some of them will never regain their losses. They realize that their best interests were not at hand and some of them feel duped.

Where Do We Go From Here?

Now that we know how we got here, the next question is where we go from where we are now. We can't go backwards, so we must go forward. Shareholder value, or the abandonment of it, is one of the key components of the banking crisis today. Had bankers treated lending like the investment that it should be, with attention to potential risk vs. long-term gain, this problem would have never occurred. Instead, they forgot the shareholder and traded them in for short-term sales and profits. This shift in attitude was a key driving force behind the banking crisis. The abandonment of the basic principles of the banking industry, including shareholder value was a key component in the number of bad loans that were made.