Bad Business Practices Lead to Bankruptcy

Bad Business Practices: How to Torpedo Your Company Part 2

I could probably go on forever about bad business practices as an infinite number of examples abound. I’m sure that would get tiresome, so I won’t do that. But I feel it would be remiss of me not to include a few more I think are particularly interesting to learn about.

UPDATE: As predicted, in my last article, My Pillow already stands to lose a substantial amount of money.

An Unexpected Lesson in Incompetent Business Practices: Jack Welch

This I’m sure is bound to surprise some people. Jack Welch’s tenure as the CEO conferred upon him almost mythological status. Many people acted as if Welch walked on water. They clung to his every bit of wisdom and advice. General Electric rewarded him with a $417M severance package when he retired, the largest for an executive in American history. Not content to retire quietly, Welch created a for-profit MBA program. All over LinkedIn people proudly display “Graduate of the Jack Welch Management Institute” on their profiles. I don’t know what the quality of the education is at Welch’s eponymous school, but regardless, I cringe when I see that.

And it’s not because of Welch’s callous disregard for the struggles of common people. Nor his disdain for the worth of people who don’t rank among the ultra wealthy. He caught plenty of flak during his life for that sort of commentary. So, I won’t pile on any more. I’m more interested in his bad business practices, since not nearly enough has been said about that.

The Biggest Self-Own In History

Years after his dismissal from the service of Kaiser Wilhelm II of Germany, Otto von Bismarck remarked on his deathbed “Jena came twenty years after the death of Frederick the Great; the crash will come twenty years after my departure if things go on like this.” Twenty years later, Germany capitulated to the Allies, ending WWI.

Welch made a similar prediction, though the implications of his prescience were not what he had foreseen. He lead GE for twenty years, and said his effectiveness would be measured by the company’s performance over a similar time period after he left. Welch retired in 2001. Since then, General Electric’s market cap has fallen from $450B to $102B as of the day I’m writing this. GE’s financial situation became so perilous it has had to slash its dividend multiple times. The dividend declined from as much as $.96/share to $.04/share per year. In 2018, GE was delisted from the Dow Jones Industrial Average for the first time in 110 years. Jack Welch basically said “I was a terrible CEO” without meaning to. This sort of self-own would make Donald Trump Jr proud. Or upset, depending on how he chose to look at it.

So, how did Fortune’s Manager of the Century muck things up so badly?

Apparently, by transforming GE from a reliable manufacturer of machines and every items like lightbulbs into a bloated monstrosity buckling under the weight of its sheer size. Evidently, accumulating companies and doing everything you can to make money heedless of the risks can come back around and bite you.

The most obvious screw up was GE’s business practices around banking and finance. Welch and his successor, Jeffrey Immelt, who deserves his own share of blame for GE’s troubles, built GE Capital into a “too-big-to-fail” bank over the years. Their lending policies that didn’t scrutinize the quality of the loans the company was making. Consequently, this mastodonic moneylender nearly brought the company to its knees during the financial crisis of the late 2000’s. The losses were staggering enough to threaten the future of all of GE. The Fed designated GE as “systemically important” in 2013. This meant GE didn’t have access to the Fed’s discount window until then. As such, GE Capital couldn’t rely on the Fed for a bailout when things went south.

Fortunately, the timely intervention of Warren Buffett prevented GE Capital from taking the whole company careening off a financial cliff. May have saved the US economy from a similarly grisly fate as well. The damage done to GE was nonetheless very profound, and the company’s wounds are still healing. Immelt announced a plan to sell most of GE Capital, and in the ensuing years the company has managed to offload a lot of the troublesome financial albatross. Additionally, I should point out GE has been criticized for their approach to accounting. The company took efforts to make its books difficult to decipher demonstrating some understanding of the problems they caused. Guess there was at least some level of awareness of the bad nature of their business practices.

Honesty: Unfortunately, it Can Be a Bad Business Practice

You may recall that last year JCPenney filed for bankruptcy. The more than a century old clothing retailer is certainly a victim of the shift in consumption away from brick and mortar retail. But, there’s more to it than that. JCPenney’s business practices ignored a lot of data, relying on intuitive conclusions that fundamentally misunderstood human nature. The results left something to be desired, like profit.

Retailers engage in some of the most well studied forms of psychological manipulation known to behavioral scientists. Among other tactics, retailers will manipulate the appearance of price to subtly influence people’s perception of the cost of acquisition. If you’ve ever wondered why something costs $13.99 instead of $14, it’s because we tend to associate the dollar amount, in this case $13, with the cost when we see it displayed in this form. $13 obviously being less than $14, we’re all but convinced one of these prices is lower.

Creative use of sales is another tactic meant to exploit flaws in human rationale. Take two items, one full priced at $20 and another priced at $25 with a 20% discount, totaling $20. Reading this sentence, you detect no difference in the sale price. But, when such prices are not juxtaposed like this, the human mind detects an illusory distinction. What I’m saying is, the use of “sale” engenders in us a greater desire for the on-sale item, irrespective of the price. Our sense of urgency and fear of loss are triggered when we see “sales”. We often fail to take into account the price relative to the value of the item. Instead, we think in terms of how much it’ll cost when the “sale” is over. Thus, we feel a stronger urge to buy an item on sale.

What JCPenney Did

JCPenney, guilty of same bad business practices

What we don’t realize is retailers have these “sales” all the time. They’re not really sales, since retailers just mark up the prices, then discount them with perpetual sales.

JCPenney’s CEO, Ron Johnson, an Apple veteran, decided to take a more noble approach. He surmised that JCPenney could win over more customers with honesty. I’m sure his mom was very proud. JCPenney did away with sales and kept their pricing as it was. They were also more transparent with their pricing, removing the .99 from the price tags. Would have been nice to see this strategy succeed. The implications being that retailers would follow suit and be more honest with their customers, and that the human mind has become too formidable to be manipulated by simple illusions.

Alas, it was not to be. JCPenney’s same store sales plummeted by as much as 32% in Q4 of 2012, the year Johnson was hired. Predictably, Johnson’s tenure did not last long, and he was fired in 2013, just a year and a half after his announcement as CEO.

When Business Practices in One Place Don’t Equal Success Elsewhere

There’s an important lesson here I touched on in my last article that I want to reiterate. That lesson is that success in one area isn’t always replicable, and being successful does not make a person an authority in anything else per se. Johnson enjoyed tremendous success in his role as Sr. VP of Retail Operations at Apple. As the New York Times put it, he turned “the boring computer sales floor into a sleek playroom filled with gadgets”. His vision for Apple stores gelled well with Apple’s image and company culture.

Not so much for JCPenney. Johnson apparently disdained JCPenney customers, thinking they needed to be “educated” about the new pricing instead of accepting responsibility for his strategy’s failure. His lack of staged rollouts at Apple didn’t translate well at JCPenney, as it didn’t give them the opportunity to see the policy fail on a micro level and abandon the project before it went company-wide. Had he experimented with a few stores to begin with, Johnson and the board may have been able to detect the customers lack of enthusiasm for the thrill of pursuing time sensitive (perceived to be) markdowns. This lesson was something even legendary investor Bill Ackman, who supported Johnson’s candidacy for CEO, had to learn the hard way after Johnson’s failure.

How Bad Business Practices Took Down a Wall Street Legend-Preface

Lehman Brothers, the worst kind of business practices.

You may remember the downfall of Lehman Brothers in 2008. It’s collapse is the largest bankruptcy in United States history. The failure of Lehman Brothers is often credited with having turned what might have been a run-of-the-mill bubble popping induced recession into the greatest economic calamity since the Great Depression. I’m not educated enough to conclude the truth of that narrative. But I can convey the tale to those interested.

The catalyst of Lehman Bros failure can be attenuated to excessive risk taking. Mortgage lenders were extending credit to subprime borrowers, those with very low credit scores, to purchase homes in the run up to the bursting of the housing bubble. Many firms, including Lehman Bros, bought these loans and combined them with other debt of various quality into securities called Mortgage-Backed Securities (MBS) and Collateralized Debt Obligations (CDO). These firms traded these securities often, and used leverage, debt meant to increase their return on investment, to purchase. Lehman took things a step further. They acquired subprime and Alt-A mortgage lenders, vastly increasing their exposure to the mortgage market contagion.

Side note: How Leverage Works.

Let’s say you have $100M to invest. You invest it in company A. Company A’s shares go up 10%. Your investment is now worth $110M. Now let’s say alongside your $100M you borrow $900M and invest $1B in Company A. That same 10% increase nets you $100M in returns, you now have $1.1B. Putting aside any fees and interest, you now have $200M in equity and $900M in debt. Paying off the debt leaves you with $200M, a $100M increase over the money you began with, giving you a 100% ROI off of a 10% increase in the value of your investment. Conversely, should your investment lose money, your losses are magnified. A 10% loss on that $1B investment leaves you with $900M in equity. Against a $900M debt, you are left with nothing.

The Collapse of the Housing Bubble

Many of these subprime loans were issued to borrowers who not only had poor credit, but lacked verifiable income. Often, they were extended without requiring a down payment. Some such borrowers had multiple mortgages. Many of these were adjustable rate mortgages (ARM), which start off with a very low “teaser” interest that resets to a higher rate, usually after two years. These ARMs were championed by none other than Alan Greenspan, long-term Fed Chairman and, at the time, widely considered a financial guru. Greenspan’s reputation has taken something of a hit since then, but I digress.

When these ARMs began to reset, many subprime borrowers, lacking creditworthiness and money, began to default in droves. A downward spiral of sorts began. The defaults led to a glut in supply that outpaced demand, a noticeable change from previous years, when demand for new homes outpaced supply, causing a drastic increase in new home building. Without the requisite new home buyers, home prices began to plunge. The housing bubble, a massive run-up in housing prices due to the frenetic new home building, burst. Many homeowners found their homes underwater, meaning the debt outstanding was worth more than the homes themselves. These homeowners decided it made no sense to pay for an asset worth less than its cost, and many walked away.

The Chickens Come Home to Roost

Like so many, Lehman Bros was leveraged to the gills to buy the MBSs and CDOs that contained a lot of mortgage debt, which was now experiencing record defaults. These securities were subsequently losing a lot of value, costing Lehman and their peers a lot of money due to the magnification of these losses due to leverage.

At the time Lehman Bros declared bankruptcy they had $639B in assets against $613B in debts. They were solvent, but this just belied the rot within. Lehman Bros relied on repurchase agreements (Repos) to fund daily operations. Basically, Repos are a form of overnight to 48 hour borrowing where a borrower sells an asset and agrees to buy it back the next day. Presuming the asset value doesn’t change, they buy it back at a slightly higher price, the difference of which is the interest on the loan. The exposure Lehman had to the growing contagion of the housing market collapse caused their counterparties who would normally lend to them under such arrangements to lose confidence. Because they were so highly leveraged, a small decrease in the value of their assets would wipe them out, which is what their counterparties were concerned about.

Basically, they told Lehman they didn’t want to lend them money this way because the risk of Lehman’s collateral, their CDSs and MBOs, meant they could plummet in value even during such a short timeframe, and they demanded more collateral, which Lehman didn’t have. Consequently, Lehman couldn’t fund day to day operations and with no buyout or bailout forthcoming, had no choice but to declare bankruptcy.

The Externalities of Bad Business Practices: How Everyone Else Was Affected

I’ll cover my ass again by saying the narrative that Lehman Bros collapse triggered the greater financial meltdown is disputed in some circles. But it has a lot of support, so I’ll tell it and leave it up to you to decide.

Money Market Mutual Funds are a mainstay of the financial system. Maintaining a constant net asset value of $1/share, they are considered some of the safest investments. They provide investors quick access to liquidity, as the shares are easy to sell, and provide reliable dividends, making them a consistent and profitable investment. The integrity of MMM Funds are crucial to the healthy operations of markets. The money they raise is often invested in highly rated debt, providing companies with financing for day to day and other operations. Companies store cash in them, to be drawn upon later. Lehman Bros shows us that day to day cash flows are inconsistent. That’s not unique to Lehman Bros, it’s a simple fact of doing business. Thus MM Funds are a reliable way for companies to meet obligations, such as payroll.

One of the oldest and most revered MMM Funds was the Reserve Primary Fund. Reserve Primary was invested in Lehman Bros debt, to the tune of $785B. Prior to Lehman’s rapid collapse, its debt was consider high quality. Because Reserve primary could not collect on the credit it extended to Lehman Bros. It announced its shares could only be redeemed for $.97, rather than the normally guaranteed $1 . This is an event known as “breaking the buck“.

What it All Comes Down To

Investors in the fund panicked, moving their money into MMM Funds invested in government debt, looking for that guarantee they no longer got from Reserve Primary, which subsequently liquidated. The panic continued to spread, sending more investment dollars into government debt. The yields on such were so low they lost value to inflation. That’s how profound the panic was.

And from such panic, it is said, is where economic calamity directly comes from. Commercial paper, alternatives to bank loans companies and financial institutions issue for short term financing, within 270 days, became very difficult to come by. Investors in such, the biggest of which are MMM Funds, bought a lot less commercial paper as their investors got spooked and withdrew their money. This causes serious problem for businesses as they are bereft of an otherwise dependable source of day-to-day credit and liquidity they need. Layoffs ensue as companies struggle with everyday expenses due to inconsistent cash flow like payroll. Investment in R&D tends to dry up. Worst case scenarios, company failure, often ensues in much greater occurrence than under normal conditions.

So, while commercial paper drying up is pretty consistently credited with the ensuing economic malaise, Lehman’s role is subject to debate. Maybe that’s why I find it interesting to write about.

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