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"This was an accident waiting to happen," keynote speaker Jerome Kenney '67 said. The vice chairman for Merrill Lynch was referring to the recent mortgage industry meltdown.

Finance Conference targets ‘inexcusable mistakes’

Experts at Kellogg student-run event analyze range of topics, from corporate malfeasance to mortgage industry meltdown

By Ed Finkel

11/19/2007 - When David Fitzpatrick ’77 left United Technologies in 2002 to become chief financial officer of Tyco International — one of the poster children of corporate wrongdoing in the early years of this decade, along with Enron and WorldCom — people asked if he had gone crazy.
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During his keynote address at the Kellogg School’s daylong Finance Conference, held at the James L. Allen Center on Nov. 14, FitzPatrick had a simple answer for why he did it: “The turnaround opportunity was enormous.”

After spending “countless hours” with accounting, legal and investment advisers, FitzPatrick concluded that “in many respects, Tyco was a legitimized Ponzi scheme,” which had become self-perpetuating due to compensation incentives to “buy, buy, buy.”

FitzPatrick focused on “cash first” to make sure the company did not go bankrupt, then undertook a portfolio review of Tyco’s businesses to see how many were pulling their weight or had the potential to do so. Then, he tried to figure out the “secret sauce” that melded the disparate lines of business together.

Between September 2002 and December 2005, when FitzPatrick retired, he evidently found the right recipe: The company saw its equity cap value soar from $27.8 billion to $78.6 billion, debt tumble from $24.2 billion to $15.5 billion, earnings rise from a net $9.2 billion loss to a $3.7 billion gain, and cash flow go from $0.8 billion to $5.4 billion.

“Companies that become arrogant become vulnerable. They engage in wishful thinking,” he said. “There are consequences, and we all know what those are.”

A conference panel discussion on credit risk management featured FitzPatrick and Bettina M. Whyte ’75, chair of the advisory board of Bridge Associates LLC, where she helps companies undertake financial and operational restructuring.

When Whyte visits companies for the first time and asks whether they have enough money to meet their next payroll, she said that top executives commonly answer, “I don’t know.” As FitzPatrick did at Tyco, she also often encounters management “in total denial, thinking if they work harder at the disaster,” it will turn around by itself.

Among the warning signs Whyte notices are “fuzzy or ever-changing” strategies, lacking or inconsistent communication and “vague, changing explanations” for what’s gone wrong. She often starts the turnaround as FitzPatrick did, by focusing on cash flow first. “When push comes to shove, you don’t run a company by its profits. You run a company by its cash,” she said. “If you don’t have it, you’re dead.”

Whyte said she urges managers to get out of denial, think proactively and cut costs. “Most importantly, communicate, communicate, communicate,” she said. “Speak with one voice. If things go bad, tell people they’ve gone bad. It builds credibility.”

Another keynote speaker, Merrill Lynch & Co. Vice Chairman Jerome Kenney ’67, dissected more recent denial and wishful thinking in another sector of the economy: real estate. U.S. housing prices rose 103 percent from 1997 through earlier this year, the Kellogg graduate said, and many in the homebuilding and mortgage industry — along with their investors and rating agencies on Wall Street — did not foresee the “riptide” that has eroded those gains.

But the separation of mortgage origination from investment, coupled with the tripling of high-risk mortgages from 16 percent to 48 percent those originated between 2001 and 2006, created conditions that helped lead to the bubble of mid-decade, said Kenney, who formerly was head of Merrill Lynch’s corporate strategy, business development and research. Other factors included the loss of faith in the stock market, low interest rates, easy credit and the emergence of “flippers” who invested and then quickly sold homes, he said.

“This was an accident waiting to happen,” Kenney said. “I consider this one of Wall Street’s most inexcusable mistakes. The more sophisticated firms should have known better and been able to hedge against the risks. Investors were counting on the rating agencies — and they should be able to count on them.”

During a panel exploring the world of hedge funds, participants discussed “alpha,” a measure of a security’s risk-adjusted performance. They also wondered whether corporate governance failures would change the structure of Wall Street during the coming decades, with firms turning toward private ownership through structures like hedge funds.

“The privatization of public markets will continue. That’s a good thing,” predicted Jeffrey Ubben ’87, managing partner of hedge fund ValueAct Capital. “We have a busted system of corporate governance.”

But Tony Elavia, chief investment officer at NYLIM Equity Investors and another conference keynote, predicted that hedge-fund governance will need to change in the years ahead too.

“In the past, hedge fund managers refused to say how they do their magic,” Elavia said, but there is a push for more upfront accountability today. That’s because investors have learned — in some cases the hard way — that “there is only so much ‘alpha’ out there.”