Financial Power and Leverage

by: John M. Mason

In my Thursday, May 29, post on “Finance, Credit Cards, and the Fed: Three Comments” I made reference to “the loss of respect for the field of finance.” Given some of the comments I have received on this subject over the past week I want to follow up with what, I think, is crucial in understanding the role of finance in the world and how strong leadership in the field of finance is necessary if the goals and objectives of companies and governments are to be achieved. I am willing to accept the criticism that I am saying nothing new and that my comments are so fundamental that they can just be skimmed over before moving on to something more important. The problems that accompany an attitude like this are that they lead to ignoring these fundamentals and the “something more important” cannot really be attained if the fundamentals are ignored.

Finance is secondary to what companies and governments do, including financial companies. Strong financial leadership facilitates and allows companies and governments to focus on what they should be focusing on - the goals and objectives of the company or the government. Weak financial leadership ultimately can result in companies and governments losing their focus because they have to deal with financial dislocations, that is, they have to put out fires and engage in restructurings. Strong financial leadership should contribute to what it is that the company or government does best because a strong financial position enhances the power and leverage a company or government already has achieved. Weak financial leadership reduces, and then often overcomes whatever position of strength a company or government has attained.

On a personal level, I have had the opportunity to lead several successful turnaround situations in the financial industry. In all cases I can say that weak financial leadership either caused the difficulty the company faced or exacerbated the results due to the other bad decisions that were being made in the organization. In order to turn these companies around it was necessary to get the financial affairs of the company “under control” so that the organization could “re-focus” on what it could do best. In terms of banking organizations, the re-focusing had to do with becoming a financial intermediary once again. That is, although the institutions were “financial” institutions, their major business was “intermediating” between borrowers and depositors. Re-establishing strong financial fundamentals allowed management to direct its focus to the things that made the banks competitive in their markets.

It is, of course, very easy for managements to lose focus when there seem to be incentives that can “add” to the performance of an organization by dabbling in extra-curricular financial adventures. But, should H&R Block (NYSE:HRB) really have been dealing in subprime mortgages? The argument had been given that H&R Block needed to offset the slowing down of it tax-preparation business, but what did it know of the subprime mortgage market? The incentives of making such a move seem so obvious to a management, however, and it is always hard to maintain one’s focus and discipline in the face of such incentives.

One has to ask, in retrospect, why the management of H&R Block didn’t keep its focus and re-tool its business model. Where could H&R Block have built on what it did best rather than explore areas it had little or no knowledge of. Maybe, in the face of the competition coming from the Internet, an organization like H&R Block could not sustain the competitive advantage it once held. But, that is another problem. The difficulty that a firm faces is that once management moves away from its primary business it is very hard to reverse the momentum.

Another example pertains to the use of debt and the exorbitant reliance on leverage. For example, we are told over and over again that the only way to make any real money in many arbitrage opportunities where only small spreads exist is to massively leverage a position so as to magnify the returns on a deal. And, of course, the nature of the arbitrage cannot be revealed because if everyone knew about the deal, the spreads would go away. Well, massive arbitrage bets make the spreads go away and raise the question as to whether or not trading really produces, on average, positive returns over time. One also has to ask the question about whether or not situations of asymmetric information are really that plentiful in an environment where information is readily available and “super crunching” is becoming ubiquitous. To me, strong financial leadership can stand the glare of openness and transparency.

Governments can also exhibit weak financial leadership which can contribute to a nation’s loss of power within the world community and a lessening of its influence in international relationships. Financial markets can lose confidence in the administration of a country if that administration loses its fiscal discipline. This loss of confidence can result in a consequent decline in the value of a nation’s currency.

A depreciating currency weakens the economic position of the country relative to the other countries it trades with. This position of weakness either reduces the other strengths a nation might possess in the world, or, it can exacerbate the problems being created in other areas due to poor government decisions. Strong financial leadership within the government of a country can contribute to the respect and influence a nation has in the world community. Strong financial leadership within a government enhances the other economic strengths that the nation possesses.

There are many other areas where financial leadership can have an influence on the power and leverage a company or government has relative to other companies or governments. Strong financial leadership does not allow financial issues to dominate those things that a company or government should be doing. Strong financial leadership can contribute to the position a company or government can achieve because it allows that company or government to relate to others from a position of strength, a position where the company or government can really do what it does best, and back it up. And, that is what a company or government should do is focus on what it can do best!

I believe that this sermon is especially necessary at this time because of the impending change in the leadership of the government of the United States. I believe that a new administration in Washington, D. C. must exhibit strong financial leadership based on sound fundamental financial practices. I believe in this for two reasons. First, it is important for the United States to re-establish itself as a world leader. Times have changed and although the United States never lost its position as the only superpower in the world, its relative position has changed in that several other nations have economically become much stronger. (See my post of Thursday, May 22, “The World Has Changed. When will America Realize It?”)

Secondly, other leaders within the United States tend to emulate the culture established by the President and his administration. If the government does not follow sound financial principals it sends signals out to the rest of the community that it is not necessary for those within the community to pursue sound financial principals either. In fact, if the government does not follow sound financial principals, it can be expected that incentives will change and it will become more beneficial, at least for a while, for the rest of the community to become less disciplined as well.

In the current campaign for the Presidency, both candidates are presenting programs that lack any appearance of fiscal or monetary discipline. The talk is about tax cuts, universal health coverage, and other programs that resonate with the electorate. This is not unexpected. As a historical example, Bill Clinton ran on such a platform in 1992. Fortunately, after becaming President, he had an advisor that argued that these programs would just have to wait until the government got its fiscal affairs under control and saw the value of the dollar strengthen. And fortunately, Bill Clinton listened to this advisor.

The question is, does either of the candidates have such an advisor at the present time? And, if so, will that candidate listen to the advisor once he becomes the new President? In my view, financial discipline will have to be re-established at some time. The the ultimate question is: when will it be done?