There are numerous forces to blame for the financial crisis. Some blame the government. Others blame greed. Still others blame slumbering regulators. While everyone has a point, the real cause of the financial crisis is corporate Darwinism. Over 20 years of boom times, natural selection picked bankers, and bureaucrats, and elected officials who were great for the boom, but completely ill-suited to respond or even understand a credit crisis, particularly one of the magnitude which our country experienced in 2008.
The principle of Darwinism is pretty simple. Organisms adapt to changes in their surroundings by nature selecting traits that are suitable to survival. Whether it is a finch in the Galápagos Islands or a moth in London, spices that cannot adapt to change will die off. This process is normally associated with animals, but it affects all organisms including abstract ones like corporations.
The process works within a corporation surprisingly similar to that which operates in nature. The only difference between evolution in nature and evolution in a corporation is the speed of the transformations. Corporate Darwinism moves much faster because humans can learn traits where as a bird in the Galapagos requires generations to grow a longer beak.
Corporate Darwinism selects traits by promotion. Once a trait is promoted, the corporation seeks to replicate that trait across the organization. The best example of this is when a manager is hired from the outside, and the first thing he or she does is hire people from his old organization. When someone is promoted internally, everyone around that person tries to emulate the traits which resulted in promotion. Promoted traits literally breed into a corporate culture.
To understand how the process works in corporations you need only study the reward system. If the system rewards long hours, you will find people at the company who are willing to sacrifice personal lifestyle for the good of the company. It isn’t that they are more selfless, but anyone unwilling to work within the system of rewards normally leaves or is pushed out.
I worked in and around banking for 20 years. During that time, I saw only one recurring system of reward, the willingness to take risk. I saw bright people promoted. I saw charming people promoted. I saw tall and short people promoted. The common thread in all promotions was the willingness to push buttons without regard to possible consequences. This selection process started at a very low level, and persisted through-out the organization. It isn’t that they were not bright or talented, but all of them had one thing in common, risk tolerance.
During my time in banking, I also knew very talented people who weighted the cost and benefit of their decisions. These people were systemically removed from the pool because the trait wasn’t valued. In the absence of a reward, people leave. Probably the best manager of people with which I worked was at Citibank. Eric Snead was a very talented manager who brought all of the skills needed for management. He recognized talent. He was very good at scoping work, measuring ability of people on his team, and motivating them to get the task done. He unfortunately had sensible view of risk, and his management did everything that they could to get him to leave, which he eventually did.
Over time, Corporate Darwinism selected risk tolerance as a survival trait in banking. That trait became more significant to survival during the economic boom because people at some level are promoted because they produced earnings streams, or sales, or some measure of profitability. The boom made stupid transactions seem wise, and foolish risks were rewarded. In boom times, the more risk tolerant the person the better his level of success. This is what Chuck Prince meant, when he said that you have to dance as long as they play the music. The most important thing to understand about booms and Darwinism is the statistically likelihood of the system promoting someone with a sensible risk perspective becomes lower and lower.
So the boom introduced a bias to people who discounted risk. At the same time, one of the causes of the boom was changing the selection process, cheap money. Over the past 20 years, the response of the Federal Reserve to every economic crisis was increased liquidity. That is a fancy way to say give bankers very cheap borrowing costs. Over time, Darwinism selected the managers who treated capital as though it were free and endless.
So by 2007, it should surprise no one that Darwinism had selected companies like Bears Sterns for survival. It was levered 30 to 1. The economy had made its corporate culture wildly successful. It made billions packaging and selling loans. When one bet was rewarded, they took on more risk in the next one. This is how you expand from prime loans to alt-A to sub-prime. Bankers call this universe expansion. The bankers didn't make the era. The era made the bankers.
Unfortunately, the traits which led to success in the boom era were exactly what made them unable to survive in 2008. Darwinism had selected decision makers who had virtually no sensitivity to risk and people who were oblivious to the cost of capital. The survivors of 20 years of success were simply unable to grasp bets losing. The head of Bear Sterns appeared on CNBC to assure the investors days before it was to be forced into bankruptcy. Many of the companies who caused the credit crisis could have tapped the capital markets for equity within months of complete failure. Those who did pursue additional equity only took very little. Darwinism had selected bankers and regulators who never considered that a credit crunch was even possible. When it happened, they were just deer staring at headlights of the oncoming traffic.
There is one other factor to consider. In 1998, the United States government repealed Glass-Stegal which had placed strict limits on how much risk a bank could assume. Much more than the legal aspect, the repeal of this regulation altered the pool of applicants on which the bank could draw. The change introduced a pool of candidates that were much more willing to take risks, ones that were backed by the taxpayer.
My guess is that many corporate cultures outside of banking encourage risk. They do so however with their own capital. So the market place manages these entities. If the maker of widgets takes on poorly placed risk, the market punishes the widget maker. The problem with banks is that if the banker takes on poorly placed risk, the market punishes the taxpayer.
The short version here is that animals called bankers grew in size and proportion in a boom environment. Nature selected those who were the fittest for that environment. In 2008, the environment changed and the animals were like dinosaurs looking at the glaciers.
