Corporate fraud and misconduct in the 2008 banking crisis

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).

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.

In order to regain the stability that once characterized the banking industry, we must turn back to the values that were the source of its strength in the past. Shareholder value was not the only thing that mattered, but keeping it as a guiding principle kept banks from taking to many risks. They kept the shareholders and their reaction in the back of their mind. This made for more cautious lending decisions and slower growth, but it also meant long-term stability. The establishment of solid goals is one of the most important concepts that allows for long-lasting decisions. Severn guiding principles, found in Sheshunoff (2002) are the key to returning to long-term stability and shareholder value. These are:

1. Establish Goals that are clear and realistic

2. Develop Strategies and Tactics to help realize the goals

3. Manage Risk

4. Improve Earnings in a controlled manner by building a solid foundation

5. Capitalize on Growth Opportunities, but don't be caught up in sales

6. Use the Right Technology

7. Continually Build the Team consistently in accordance with these goals.

Returning the banking industry to stability will take a long time. It will require a return to the principles that guided it in the past. Banks can no longer concentrate on sales and immediate realization of revenues. They must concentrate on returning to some key founding principles, including making shareholder value a priority, instead of barely a consideration at all.

No one knows what the future holds for the banking industry. Giants may fall, serving as a warning to those that remain to pay attention to their basic principles. The government may bail out these failed banks, prolonging their death and preserving a failing system in the end. In the end, some will survive and some will not. As the story continues to unfold, shareholders will continue to lose value, either as institutions fail, or through damage to healthy institutions.

An examination of currently proposed remedies appears to reveal several potential approaches, all of which are short-sighted by the standards of the past. Nationalism may help to save those that are "too big to fail," but it will only represent a short-term measure unless fundamental changes are made in the philosophy of the institutions themselves. They cannot focus on this quarter's profits, or next quarter's profits, but they must focus on the 30-year lifespan of the loans that they make. None of the proposed "fixes" will result in anything more than short-term solutions, unless banks are willing to go back to the foundation upon which they were established.

In the end, one can only hope that banks have learned their lesson and that they will return to the values that made them strong in the past. Those that did learn their lesson will represent an excellent investment opportunity. Those that continue in the reckless manner that they are today, are likely to become institutions of the past. The future of the banking industry depends on a return to the responsibility that comes with placing the shareholder at the top of the priority list.