Recent Turmoil in American Financial Markets: Implications for Investment Banking in Nigeria
158 year Old Lehman Brother's recent financial difficulties and eventual bankruptcy filing is a shocking testament to the adverse effects of untamed risk. The firm, one of the Oldest and largest companies, in Wall Street was forced to declare bankruptcy after unsuccessful attempts at getting a buyer for itself failed (due partly to the unwillingness of the US Treasury and Federal Reserve to protect potential buyers against all or some of the risk inherent in a purchase of the company).
Lehman Brothers, with total assets exceeding $630 Billion, represents the largest bankruptcy in US Corporate history and is estimated to be more than 10 times larger than the Enron Bankruptcy. The fact that a firm with less than 30,000 employees and only a couple of offices worldwide was able to generate over $630 Billion in assets, says a lot about its frenzied accumulation of assets and reckless embrace of risk. Lehman brothers, which is the 4th Largest pure play investment bank in America, had experienced rapid growth over the last few years and declared two consecutive full record profits in 2005 and 2006 and Q1 2007. In a bid to boost profitability and generate assets in order to play catch up with much larger rivals such as Goldman Sachs and Morgan Stanley, the company readily originated, underwrote and invested in increasingly opaque and illiquid mortgage instruments with highly questionable credit quality. As defaults from subprime borrowers rose, Lehman became particularly vulnerable as it was highly exposed to the mortgage markets and had invested heavily in the riskiest of these securities in order to boost profits, to cap it all the company was also highly leveraged. Highly Leveraged investments in illiquid securities that was supported by borrowings from subprime borrowers, must sure qualify as a perfect recipe for disaster.
The lessons for the Nigerian markets are quite significant, as the Lehman woes have come at a time when the Nigerian Equity Capital Markets are experiencing a market downturn. The most important lesson from Lehman's bankruptcy episode, is the need to balance revenue and profit growth with appropriate risk management and controls. If appropriate risk management had been deployed by the firm, it will not have invested highly leveraged funds in some of those mortgage securities, which turned out be its nemesis and ultimate undoing. Nigerian investment and securities firms will need to realise that abnormal profits from the stock market are an exception rather than the norm and they must learn to balance the urge for supernormal profits with the need to ensure that the company does not go bust. It is instructive that as late as April last year, Lehman Brothers had just declared the largest quarterly profit in its corporate history, and less than eighteen months later (September, 2008) it was already filing for bankruptcy.
Nigerian securities must start to build appropriate risk controls to manage their exposure to the capital markets, they must be able to have an idea of what their Value At Risk (VAR) is with certain percentage declines in the stock indices. Furthermore, investment and trading committees should include Risk Managers, as it is done in Goldman Sachs where traders and Risk Managers sit together on the trading floor and traders and risk managers are rotated together in positions. Furthermore, John Thain current CEO of Merrill Lynch, had served as both the Head of Mortgage trading and chief financial officer (with responsibility for risk management) at Goldman Sachs before he was appointed as President (number two man) at the investment banking. He therefore had a good grasp of both risk generation, through his trading career, and risk management (through his stint as Chief Financial Officer).
I believe this widespread difficulties being experienced by investment banks across the US should make Nigerian firms (particularly those with active trading operations) reflect on their own operations, strategies and investment policies. How many Nigerian firms know what their Value At Risk is at the end of every trading session or week?. How many of them have risk managers and are these risk managers an integral part of the investment decision process and what is their level of input to investment decision making? Does the firm balance the impulse to generate profits with the need to manage liquidity and ensure quality of risk assets. Are arguments for and against an investment opportunity presented at investment decision meetings? Are the potential upsides and downsides of an investment analyzed and argued before investment decisions are made (this was not done at Lehman brothers as the risk managers were relegated to the background and the traders took over all decision making and characteristically saw only the potential upsides in investing in the ultimately toxic securities)?
Every Nigerian investment house needs to ask itself these questions and answer them in the affirmative if it is to survive in the long term. The devastating effects of untamed risk has been proved by the fact that in April 2007, Lehman Brothers declared the highest quarterly profits in its 158 year history and eighteen months later (September 2008) the company is already in the bankruptcy courts fighting for its survival while talks of liquidation keeps going round.
