If there were any lessons learned from the financial crisis of 2007-2008, the disaster in the gulf is evidence that we may have already forgotten some of them. BP Plc’s recent fiasco had its roots in a corporate culture that favored short-term profits without regard to long-term risk – the same philosophy that left Wall Street on its knees only two years ago. Moreover, both crises saw a betrayal of investors’ faith that federal regulators had the ability and the will to provide a bulwark against excessive risk-taking in industries where mistakes can have disastrous consequences.
With the benefit of hindsight, the most surprising thing about the collapses that rocked the financial sector is that they did not happen sooner. The problem began with a dramatic shift in mortgage lending practices. When banks held the mortgage loans they funded, they had their own skin in the game – and if they lent unwisely, they would pay the consequences. When home loans instead were sold almost immediately to packagers of mortgage-backed securities, lenders no longer had any incentive to ensure that prospective buyers were actually able to service the loans they took out. The resulting lack of due diligence, aided by dysfunctional credit rating agencies, turned the mortgage-backed security business into a kind of Russian roulette.
In the short term, however, mortgage-backed securities and the industry they spawned were also amazingly profitable. A preoccupation with these short-term gains quickly grew, fanned by executive compensation programs that offered rich rewards based on corporate performance over very limited periods. While most understood that there was at least a possibility that changes in the housing market could result in disaster in the long run, such a scenario was seen as highly unlikely – the fabled “black swan.”
This thinking, of course, badly misconstrued the true nature of risk. Risk is in essence the likelihood of an event multiplied by the harm it might cause. An event with a relatively high chance of occurring but few consequences – say, getting caught in the rain, may require little precaution. On the other hand, events that are unlikely but can potentially bring devastating harm, like an automobile accident, are something that any prudent person plans for. In the financial crisis, compensation schemes and analyst expectations fostered a system that was willing to risk the possibility of catastrophe in the long term in exchange for lucrative results in the present.
In many ways, BP’s Deepwater Horizon disaster was the result of the same dangerous thinking. While information about the events leading to the disaster is still emerging, it is well known that BP has long pushed its luck in search of short-term rewards. In 2007, when Tony Hayward took the helm as CEO of the company, he promised to improve the company’s risk management. Nevertheless, under his leadership, BP maintained its aggressive profit goals and sought out exceptionally risky opportunities in deep water drilling, despite the absence of technological expertise in dealing with deep water drilling accidents. It was this woeful lack of preparation that resulted in the company spending months testing one failed solution after another as the effects of the spill rippled through the environment and the economy of the southern United States. The consequences for BP investors have been equally awful, with share prices of the company dropping by nearly a third, and the final costs from clean-up operations and lawsuits still being tallied.
Perhaps the greatest shock to investors in BP, however, was the dilatory work of federal regulators charged with overseeing the safety of the company’s operations. Historically, investors in risky, heavily-regulated industries like banking and deep-water drilling have had the expectation that regulators will pay close attention to safety even if management and boards do not. The markets have come to learn the hard way that this confidence may be misplaced. Officials at the Minerals Management Service responsible for inspecting deepwater drilling platforms had repeatedly failed to do so – much as officials at the Securities and Exchange Commission, Federal Reserve and Commodity Futures Trading Commission failed to prevent the accumulation of excessive risk by banking giants until it was far too late.
The Dodd-Frank Wall Street Reform and Consumer Protection Act will go a long way towards restructuring the finance sector and the shadow banking industry in a way that minimizes catastrophes of risk management like the one we saw two years ago. Importantly, many of the reforms embodied in the new statute will help reduce risky corporate behavior far beyond the finance sector – such as provisions hemming in executive compensation that is excessively weighted toward short-term gain.
While the new legislation offers much to celebrate, the Deepwater Horizon Crisis is a stark reminder that investors should not let down their guard. Magical thinking about risk is still a market peril, and it remains to be seen whether regulators can do an effective job at preventing it.
Michael W. Stocker is of counsel to the law firm Labaton Sucharow. He represents institutional investors and is a commentator on financial and governance issues in national and international publications.
