Summary
It is self evident that Lehman Brothers would still be in existence today had they rewarded Fuld and his cronies for not changing the risk structure of the bank, and not leveraging it into oblivion.
The lesson here is one that all professional business people know full well, but some seem to have forgotten, bonuses should be aligned to key performance indicators (KPI's) that genuinely add value to the company's bottom line.
Analysis
With the anniversary of the collapse of Lehman Brothers, the largest in corporate history (outstripping Enron by a factor of 10) and the tipping point of the global financial crisis, it is a pertinent time to remember the key lesson that can be drawn from this catastrophic failure.
The Telegraph notes:
"Huge rewards followed for those who took the risk. By 2007 turnover was more than $19 billion and staff took home $9 billion in pay and bonuses. Between 2000 and 2008 Dick Fuld took home between $310 and $500 million...
America's leading bankruptcy lawyer Harvey Miller may be among the better placed to judge what brought Lehman Brothers' proud 158-year history crashing down.
"When I went to college, I learnt in economics that you do not finance long-term investments with short-term money, and that is what happened," he says. "And I believe it happened because greed took over and the returns were so big.
"So many people were making so much money that they lost all fear, and risk did not become a factor in doing anything."
In short the collapse of Lehman Brothers was caused by unabated and uncontrolled risk taking, fueled by greed and avarice rewarded by excessive poorly targeted bonuses.
However, this is not the first time that a poorly designed reward structure has caused excess risk taking which in turn causes financial disaster.
In the 1990's I personally witnessed, on a much smaller scale, a similar outcome brought about by a poorly designed bonus structure.
The salesmens' bonuses in this particular company were aligned to turnover targets for IT systems, without the "annoying" restrictions of minimum margins and debt levels (debtor days, cash flows and debt recoverability) on the contracts won.
The "salesman" of the year had won a £3M contract, that earned him a fat cash bonus and a company Porsche. He was lauded by his peers, and feted by management as an example of "best in class".
Sadly, although the turnover achieved by this sales contract was substantial (in terms of the size of this company), the costs of fulfilling the contract were even more substantial; to be precise they came in at £4M. The result being a loss on this contract for that company of £1M.
The irony being that the company would have been better off paying the salesman a bonus and giving him the Porsche for not entering into the contract.
Applied to Lehman Brothers, it is self evident that Lehman Brothers would still be in existence today had they rewarded Fuld and his cronies for not changing the risk structure of the bank and not leveraging it into oblivion.
The lesson here is one that all professional business people know full well, but some seem to have forgotten, bonuses should be aligned to key performance indicators (KPI's) that genuinely add value to the company's bottom line (after interest, depreciation, tax and amortisation see De Beers Finances - The Dangers of EBITDA ).
This author consults with leading institutions through GLG
Analyses are solely the work of the authors and have not been edited or endorsed by GLG.
