By: Ronald D. Struck                                                                     February 1992

REALISTS FOCUS ON TIMING

 “Realists” are neither optimists nor pessimists. They know that markets swing back and forth between conditions that justify optimistic and pessimistic outlooks.  They continually analyze changing market conditions to identify the appropriate timing for, and degree of, optimism or pessimism.

 In November 1991 I wrote an optimistic opinion that 1992-93 would prove to be an excellent time to acquire real estate.  To demonstrate that I am a Realist, that these were not the ravings of another perpetual optimist, here’s what happened when I wrote a pessimistic opinion about the outlook for 1989.

In late 1988, the real estate and high-yield securities markets were booming - almost euphoric.  At that time, I was the chief financial officer of FarWest Savings, a $5 billion savings & loan.  In November 1988, I submitted my strategic financial plan for 1989, which addressed the projected external environment and recommend key operating strategies, to the vice-chairman for presentation at the upcoming meeting of the board of directors

Among other things, the plan focused on two key potential risks for 1989.  First, new restrictive risk-based capital regulations were likely to be passed by the regulators, which would be highly onerous for a large portion of FarWest’s assets, especially its high-yield securities, and could significantly reduce FarWest’s return on capital.  Second, the real estate, transportation, and defense microeconomic sectors in Southern California could weaken substantially, producing an economic downturn that would hamper FarWest’s ability to generate profits from traditional residential mortgage lending activities.  Either factor could have a serious negative impact on FarWest; both simultaneously could be disastrous.

Strategies were recommended to address these major risks, however they would require major changes in FarWest’s operations.  First and foremost, strategy called for the sale of FarWest's high-risk assets, especially its high-yield securities, before the end of the first quarter 1989.  Secondly, growth should be limited, the portfolio adjusted to a low-risk profile, and, for the course of 1989, FarWest should operate in a very conservative manner.  While these actions may have been tough pills to swallow in the short-term, I felt they would enable FarWest to safely ride out the gigantic storm that was looming on the horizon, coming out of it as one of the stronger, more competitive, surviving institutions.  Because of its strength at that point, FarWest could efficiently resume a growth strategy, including acquiring other institutions that didn’t weather the storm as well.

The president, also a Realist, was in full agreement with my outlook.  The vice-chairman & CEO wasn’t.  He said it was “outlandishly conservative and reflected a lack of the entrepreneurial spirit the bank needed in order to achieve its growth objectives”.  The vice-chairman, in my opinion an “Unrealist,” was driven by emotions, basing his outlook upon optimistic factors that he HOPED might happen, and ignoring the risk factors that could happen.  He enjoyed being in the high-risk asset arena, and was convinced nothing would occur in 1989 that would interfere with his ability to significantly expand this area and thereby materially increase profits.  He felt that the then booming economy would continue throughout 1989, and beyond.  And, if new capital regulations were passed, regulators would permit S&Ls to “grandfather in” their existing portfolios.  He was so optimistic that he planned to obtain approval from the board of directors to raise new capital in order to quickly and significantly increase investments in high-risk assets, primarily high-yield securities and merchant banking transactions (transactions under which FarWest took a leading principal investment position in corporate equity or debt).

I was going to be out of town when the first board of directors meeting for 1989 was scheduled and the 1989 strategic plan reviewed and approved.  In preparation for the meeting, the vice-chairman told me that he didn’t want anything presented that would “unduly” concern the board members about his capital/expansion plan.  The vice-chairman asked that I rewrite my views and present a new more optimistic overview that would support his expansion objectives.  I refused, indicating that he should prepare his own optimistic views and strategies and present them together with the ones produced by my division.  If we disagreed so-be-it, but as senior officers of the institution we had a fiduciary responsibility to apprise the board of key factors that could impact the institution.

The vice-chairman became furious.  He felt was my pessimistic outlook was poppycock and would unnecessarily negatively influence the board.  So, while I was out of town, he had an alternative, optimistic overview prepared by my staff, identified me as the author, and presented it to the board.  When I returned from my trip I discovered what he had done, immediately voiced my very strong objections, and indicated that the board should be immediately apprised that the strategic plan they were presented reflected the vice-chairman’s views, not mine. Needless to say, the vice-chairman didn’t agree.  In fact, soon thereafter, he discovered he didn’t need my services at all any longer, or for that matter those of the president (who had continued to support my views), and he fired us both in February 1989.

Hindsight gives a twenty-twenty view of the cost when an emotional Unrealist is in charge.  During the first half of 1989, under the guidance of the vice-chairman, FarWest pursued a very aggressive growth plan, adding enormous amounts of high-yield securities and exotic commercial real estate loans to an already very high-risk portfolio.  Then, the new risk-based capital regulations were passed, with no grand-fathering provisions, and FarWest’s high risk-based weighted assets, especially their high-yield securities, plummeted in value.  About the same time, as my plan had projected, the economic cycle shifted dramatically and rapidly downward, virtually eliminating the institution's ability to engage in residential mortgage lending activities at a profit.  For year-end 1989, FarWest reported losses of over $100 million.  They struggled to get back on their feet in 1990 but it was to late.  In September 1990, the vice-chairman was forced to resign, and in early 1991 FarWest was taken over by the regulators and put into receivership.

Unfortunately for FarWest, in 1988 I was right when, as a Realist, I went against the prevailing optimism and sent up red flags warning of significant downside risks in the market.  Had the vice-chairman not been an emotional Unrealist, or at least permitted a discussion and full evaluation of a potential downturn for 1989, FarWest might still be in existence today.  In fact, it might even have become one of the strongest financial institutions around.

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