Chris Flowers Tracks Financial Services in the U.S. & Japan: 1999, 2009 & 2019

October 15, 2009

Speaker:
J. Christopher Flowers, Chairman & Chief Executive Officer, J.C. Flowers & Co. LLC

Presider:
Jun Makihara, Chairman, Neoteny Co., Ltd.; Director, Japan Society

Christopher Flowers of private equity firm J.C. Flowers & Co. visited Japan Society to talk about the state of the financial world and to discuss what we can learn from the past as we begin to recover from a global crisis of harrowing proportions.

On the Wednesday before the extraordinary weekend of September 14 and 15, 2008, Mr. Flowers was in Tokyo attending a board meeting of Shinsei Bank. He was called out to speak with a senior Bank of America official, who asked him to return immediately to the U.S. to work on a potential joint bid for Lehman Brothers.

"At seven am on Thursday morning we convened with the Bank of America and with Lehman Brothers at the lawyers' offices and started due diligence. By Thursday evening it was already clear, both to ourselves and to the Bank of America, that a deal could only be done with financial assistance from the U.S. government. Among other things, Lehman had over $30 billion of commercial real estate assets, which were worth far less than their carrying value, and this was only one of many problems."

"I was surprised by this. I had gone through the summer of 2008 in the aftermath of the Bear Stearns situation thinking that Lehman ought to be okay."

"On that same Thursday evening I received another call, this time from a senior official at AIG, and he asked me to meet with the CEO, Bob Willumstad, of AIG for lunch the next day. And I said, 'Why is that?' And he said, 'The liquidity situation at AIG is critical, and AIG needed to make a deal that very weekend.' I was astounded by this. I could see that this was shaping up to be a very busy weekend indeed."

On Friday, Treasury Secretary Hank Paulson made it clear both in public statements and in private conversations that no government aid for Lehman would be forthcoming.

That same day, Mr. Flowers was handed a one-page cash flow forecast for AIG that showed the company would run out of cash the following week. "This was Friday. Wednesday was negative $6 billion. And I was, again, astounded."

"I remember in this meeting mentioning the word bankruptcy, and the folks from AIG said, 'Well, why are you being so alarmist?' And I said, 'Okay. Fine. I won't mention the word bankruptcy, but I can assure you that if you do not pay these people their $6 billion on Wednesday they're going to be very, very upset.'”

The group put in a call to Warren Buffett, "but in the end he was not interested in bailing out AIG." Heading back to his office, Mr. Flowers called German insurance company Allianz, and by Saturday Allianz people were in New York looking at a potential joint bid for AIG with J.C. Flowers.

Meanwhile, on Saturday morning "I met with the people at the Bank of America, and they took me aside and they said that they had been called by Merrill that very morning, just to make life interesting, and that the Bank of America wanted to make a deal to buy Merrill, and that they preferred that to Lehman Brothers, and they wanted to do it that weekend. So, it was now Saturday. They wanted to do that by Sunday."

Later that morning, Mr. Flowers met with Mr. Paulson and New York Fed chief Tim Geithner at the Fed's offices in lower Manhattan to discuss Lehman. "It was pretty clear that our requirements would not be met, and that we weren't going to do a transaction with Lehman that weekend, or ever."

"As I was leaving this meeting I asked Hank if he was paying attention to AIG. And he said, 'Well, not really.' So, I had with me the piece of paper I got the day before with AIG's cash flow, and I said, 'Hank, let me show you this thing.' And he said, 'Oh, my God.'"

"AIG I think had contacted the Federal Reserve on Friday to talk about their problems, but understandably Paulson and Geithner and the other top officials had been so busy with Lehman they had not yet really had time to grapple with AIG. And of course one of the things that made this the cataclysmic weekend is that it wasn't just Lehman; it was that AIG was the next thing behind that and so forth, so it all stacking up together was really starting to make things look very, very bleak indeed."

On the Sunday, Allianz and J.C. Flowers made a joint bid to invest in AIG for $10 billion. AIG turned down the offer, and indeed "the management of AIG regarded our offer as a profound insult."

"The events of that weekend set in the motion the most harrowing period in the financial market since the 1930s," Mr. Flowers continued. "And it is my personal opinion, although I don't think is the official version--it is my personal opinion that if the government had wanted to save Lehman that weekend, they could have done it, and they had the power to do it. And I would note that indeed they saved AIG a day or two later. But I also think that if it hadn't been Lehman, probably sooner or later some other company would have blown a gasket and they would have ended up in the same place."

Comparing his experiences with Japan and Long-Term Credit Bank a decade earlier, Mr. Flowers said that although in both cases the banks suffered from having too many bad loans, the Japanese banks had liquidity--"the right side of the balance sheet was fine." And the troubles in the Japanese banks happened very slowly. "What took a year and a half in Japan" with LTCB "was taking a weekend by late 2008 in the U.S. By the way, trying to do these deals in a weekend is not a very good recipe to get a thoughtful result."

"I have been through many downturns over the last 30 years, and this is how it has always worked: banks get in trouble because their assets are no good. But the aftermath of Lehman was completely different. And what you had there was excellent companies with good assets, for example, Goldman Sachs and General Electric, to name two, which came very close to going bankrupt purely because of a liquidity panic."

As 2008 came to a close, J.C. Flowers had investments in banks in the U.S., Japan, the Netherlands, Germany, Russia, India and Taiwan, and Mr. Flowers spent a good deal of time in Japan, where "in my opinion the Japanese authorities did a particularly good job." And "Japanese financial institutions did not need any liquidity support beyond normal Bank of Japan activities--whereas special liquidity support programs were necessary just about everywhere else, including the United States, Germany and Britain, to name three."

"Many, many factors, institutions and individuals are to blame, and it's not just one or a few that should be singled out. But high on the list, in my opinion, would be the rating agencies," Mr. Flowers said. Lenders were sloppy; borrowers were guilty of "feckless optimism." Regulators "could have done a better job," but "I don't think that is a very important factor" because no country appeared to do better than others because of its regulatory regime.

"That weekend in September 2008 was a profound watershed event for financial services and for the world economy," he said. Going forward, Japan has great advantages: it's the world's second-largest economy, it has the second-largest financial services sector and "it is conveniently located in Asia, the locus of much future growth." To succeed as a global financial center and a leading financial center in Asia, "it needs to embrace a pluralism beyond what Tokyo currently has on offer." This extends to the language of business; in Europe, Deutsche Bank, UBS and Credit Suisse all use English, which "might not sound like much, but I think that's actually a metaphor" for a shift in attitude that "could also help Japan address its demographic issues by permitting perhaps more effective immigration."

One clear outcome of the crisis will be that banks must hold more capital, which in Mr. Flowers' view "basically makes sense; and parenthetically, Japanese banks tend to be on the low end of capitalization on a worldwide basis." Value will shift away from securitization-based models, which will take a long time to become reliable again, and towards deposit-taking and insurance models.

Leaving aside the possibility of a major event such as a sovereign default or the bursting of a bubble, Mr. Flowers said, his own view, consistent with those of most observers, is "that business really is starting to pick up and improve, and that we will have enough stability. We are back in the kind of downturn that I'm used to, where we have seen this movie before; we know what has to happen. The forces of the market are going to work, and the economy will slowly start to pick up."

***
Questions from the audience followed:

Do you think the agencies that rated those instruments AAA had a clue what was in these packages?

Over time, the agency models "became increasingly divorced from judgment," agreed Mr. Flowers. But "I assume that that is not going to be the next problem. That problem is going to get corrected. It will be some different problem that screws this up next time."

Do you agree with some who say that the crisis was caused in part by excess liquidity in the system, and that the government-sponsored entities played a role as well, particularly in the mortgage market?

On the first of these, "at the sort of granular level where we operate, or the anecdotal level," Mr. Flowers said, "we just kind of see what's going on in front of us," and "it didn't look that way to me." On the second, "plenty of countries in the world don't have a Fannie Mae and Freddie Mac and have a perfectly effective, functioning mortgage market, and so they seem like a big mistake to me frankly, and a contributor to the problem."

Can you elaborate on the prospects for Japanese financials? Their core profitability is already lower than their U.S. counterparts, and with new rules forcing them to lower their leverage even further, there will be a much wider gap.

"Price, the great equalizer, is one factor to take into account," Mr. Flowers responded. "I do think good Japanese companies with a good Japanese economy will be good investments."

Does looking at our experience give you a different view of the Japanese bailouts in 1998?

One big difference is that "the crisis in Japan 10 years ago was basically in Japan and not in the entire world. The crisis this time was in the entire world," Mr. Flowers said.
"The other thing is Japan never felt like a liquidity crisis really at all.... Japan 10 years ago reminds me more of a deep recession in the U.S. than it does of what happened in September 2008."

Could you talk about the regional and smaller community banks in the U.S. that are still closing down every day, 100 now so far, maybe more?

"U.S. banks are in for a pretty unpleasant couple of years," peaking in 2010 or 2011--"I would guess there will be 500 before we're done," meaning a 5 percent failure ratio, he said. "That's 95 percent that will get through." The FDIC and other regulators "have set forth a bunch of rules that offer us some opportunities to invest, and where they do offer us opportunities to invest we would like to do that."

As an investor, what do increased capital requirements imply about reduced profitability? Where do you see new lines of business that will compensate for that extra capital?

"If you look at Goldman Sachs, where I spent 20 years, over say the last 30 years, its business has been completely radically transformed from what it was then to what it is now, but the ROE has hardly moved in that time period," and the same is true in banking generally, Mr. Flowers said. "So, what I really think is you kind of need an ROE for the system to work, and that the rest of the system will adjust for that ROE to be available."

Shinsei's profitability has been hurt by government restrictions in the consumer finance area. What do you think was the reason that you might have miscalculated the risk in this investment?

Shinsei bought consumer finance company APLUS before the change in consumer finance regulations, which "was quite unexpected by us," Mr. Flowers said. "Of course if we had known that the rules would change we would not have paid the price we paid for APLUS in the first place."

"We also bought Lake, a consumer finance company, from General Electric, but it's important to note that in that case we have absolutely no gray-zone exposure, because we have been indemnified by GE." Of three big consumer finance companies "we have the only one with no gray zone, the only one that is wholly owned by a bank with bank-cost funding, and an opportunity to integrate a retail consumer finance service offering to retail customers around Japan, which is unique."

Are the so-called toxic assets still on the books a threat to the stability of the financial system? What do you think of Treasury's yet-to-be-launched program to help banks dispose of these assets?

They're not a threat to stability but "I do think it affects the recovery, though, because I think the banking sector will be weighed down by these problems for the next couple of years."

"If you have some crummy asset, collecting it out might well be the best thing to do, rather than sell it and take a big loss--the bid-ask spread and the uncertainty and so forth. So, I don't think that" the Treasury program "will make much difference."

Private equity gets criticized for excessive leverage, for relying too much on layoffs, and for having a short-term focus. Do you continue to think private equity is a viable business model?

I do. Notably, it offers "a very keen focus on a company's performance, and the ability to act on it, especially in a time of crisis." Leverage problems aren't unique to private equity, and in fact those in subprime and commercial real estate and elsewhere are much bigger. As for time horizons, "we have been at Shinsei Bank now for nearly 10 years and have no intentions of disposing of our stake any time soon," and there are many other quite long-term investments the firm has made.

What do you see as the most interesting investment opportunities for your firm looking forward?

In financial services, the U.S. "has been all turned upside down, and as a result there are many opportunities here," as witness the FDIC-assisted deal his firm did with IndyMac, now OneWest Bank, and including life, property and casualty insurance as well, Mr. Flowers replied.

--Katherine Hyde