The Firm: The Story of McKinsey and Its Secret Influence on American Business (38 page)

The long road of McKinsey helping lead bankers astray had actually started years earlier. As Mellyn pointed out in his follow-up to
Financial Market Meltdown, Broken Markets
, McKinsey banking practice lion Lowell Bryan was the go-to consultant for bankers in the 1980s. At the time, Mellyn argued, McKinsey was urging an industrial competitive strategy model on what had become a cozy regulated utility.
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The result, which
did
work for a time, ultimately led to a complex and costly bank model in which bankers were pushed to actually create demand for credit rather than merely providing it, with the result that, over time, they moved farther and farther into questionable credits. “It is hard to generate more demand for credit among creditworthy borrowers,” observed Mellyn, “so as we have seen time and again in banking’s roller-coaster history, lenders began to inch farther and farther out [along] the risk curve.” The process continued for years until the collective risk taking blew up in the banks’ faces.

This was McKinsey losing the forest of reality in the analytic glory
of its trees—with the result that it had rubber-stamped a banking industry strategy that was strikingly similar to the one that had brought down Enron. Except this time, the consultants helped inflate a bubble not just in a single stock but also in the entire global economy. “The ways of lending money safely are simple, obvious, and admit no variation,” wrote Mellyn.
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And yet McKinsey was helping all its large banking customers depart from that principle—focusing them on sales and marketing above all else—with predictably disastrous results.

McKinsey also prodded its biggest customers along with a fear mongering reminiscent of its bogus idea of a “war for talent.” This time around, it was “extreme competition.” A 2005 paper published in the
McKinsey Quarterly
said that top companies in any industry faced a 20 to 30 percent chance of losing their leadership positions within a five-year period. This risk had apparently tripled in just a single generation.
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The implied solution: get a consultant to show you the way forward.

Here was one way: make as many loans as possible, package them just as quickly, and sell them out the back door to credulous institutional investors. In the meantime, load your balance sheet with unprecedented amounts of leverage in order to juice returns. The U.S. investment banks, for example, jacked their leverage—defined as the ratio between financial assets and the difference between financial assets and liabilities—from just over twenty-five times in 2003 to nearly thirty-five times in 2008.

Interestingly, the McKinsey Global Institute was doing substantial research of its own on developments in the global financial markets during the boom years, and it had reached conclusions that stood in opposition to the strategies of the firm’s largest financial clients. “Like the rest of the world, we failed to have a full grasp of what was happening in the lead-up to the financial crisis,” said Diana Farrell, “but we were beginning to sound a drumbeat about the degree of leverage
in the economy.”
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MGI created a unique global database and captured a concept called “financial deepening,” which indicated that it wasn’t enough to look at individual institutions; a true understanding could come only from a systemwide analysis. MGI noted that financial assets were equal to global GDP in 1980, rose to two times in 1990, and rose to three times in 2000. “We were probing and understood this was important and worth ringing the bell on,” explained Farrell. “But we did not fully understand that it was unsustainable.”

What was acceptable to McKinsey—and its competitors serving many of the same financial institutions at the time—was that the profits of the financial services sector were skyrocketing, from 15 percent of U.S. corporate profits in 1980 to 41 percent in 2007. And so what its consultants told their clients was not necessarily the same thing Farrell suggested had been concluded at MGI. According to the
New York Times
, in 2007, in an engagement meant to evaluate the risks in General Electric’s finance unit, McKinsey told its client that money from countries with trade surpluses—such as China and Middle Eastern oil producers—would provide a buffer for the increased lending and leverage for the foreseeable future.
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That advice could not have been more wrong.

Perhaps in karmic reward for its contribution to the bubble, McKinsey lost money on its own investments in the aftermath. The value of McKinsey’s Supplemental Retirement Plan declined by 21 percent in 2008, shedding $780 million out of a total of $3.8 billion at the start of the year. When it came to investments, the firm’s bust-era results could be as spotty as some of its advice. What’s more, McKinsey could be as gullible as any other investor: The firm lost $193.5 million in the Petters Group Ponzi scheme. On the other hand, McKinsey did manage to benefit from investment banks’ and hedge funds’ rigging of the CDO game, as it had investments in the Magnetar hedge funds, creators of the now-infamous “Magnetar trade.”

Swiss bank UBS hired McKinsey to help it decide whether or not to enter the leveraged buyout market for midsize companies in 2002. But McKinsey and UBS’s own board dithered over the notion until 2006, when the best idea was to
exit
middle-market LBOs. “I looked at one of my colleagues and asked him, ‘How do we stop this?’ ” related a former executive of UBS. “He told me that it would take me three years to do so. People thought UBS was risk-averse at the time. I’d say they were decision-averse. They couldn’t pull the trigger without letting McKinsey study something for a year or more.

“What drove me crazy was that McKinsey
knew
how screwed up UBS was,” continued the executive. “They knew it. But when I asked them why they didn’t tell the CEO in Zurich or the board of directors, I already knew the answer: telling them would put McKinsey’s job in jeopardy. And that would cut off the $8 million to $10 million they made from us on that single project.” The complaint leads to an important question, which is whether or not Wall Street firms have any business hiring six-month consultants to tell them how to set strategy. If you’re making cars or selling soup, you may have a longer lead time; but trading securities is not conducive to six-month analysis. This is arguably the reason Goldman Sachs has for so long set itself apart from the competition. The company has people who make decisions. They make calls that would have taken UBS two years to consider.

Since pretty much every bank of importance had hired McKinsey, you had fifty companies in the mid-1990s focused on the same thing—global strategy—at the exact same time.
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The same was true ten years later, raising an interesting issue of systemic risk. While the firm’s fingerprints were once again nowhere to be found in the detritus of the real estate collapse, its consultants had been advisers to many of the companies that both inflated the bubble and collapsed as a result of it. Whatever the specific advice to specific clients, McKinsey had once
again failed to give them the best advice of all, which was to go in the direction of less, not more. That makes the value of the advice
it did give
incidental at best, and destructive at worst.

What was McKinsey’s response to the crisis? In October 2008 it opened a Center for Managing Uncertainty, headed by Lowell Bryan. This was the same Lowell Bryan who had developed a formidable U.S. banking practice by recommending the same thing to one U.S. bank after another. There was a joke in the New York banking practice: “We will do branch bank network
rationalization
and keep doing it in bank after bank until the banks have cut too far and the pendulum swings the other way, at which point we will then do a bank branch network
expansion
study and look for ways for organic expansion, acquisitions, and so on, until the pendulum swings again. Rinse. Repeat.” Repeat studies of the same kind are the consulting world’s cash cows. You don’t need to create selling documents or work documents. Just fill in the frameworks with the client’s data and do the same thing you’ve done before, thereby reaping the benefits of the simplest of equations: Low Cost = High Margins.

In 2009 the consultants began urging governments to tackle “whole-government transformation”
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to deal with the credit crunch, with the consultants as trail guides on that journey. Oliver Jenkyn, who headed McKinsey’s retail banking practice during the moment of the industry’s worst excesses—in both mortgage and credit card lending—was hired by Visa in August 2009 as its head of strategy and corporate development. Failure to advise properly once again proved no impediment to further engagement.

In 2009 Edward Liddy, CEO of flailing insurance giant AIG, hired McKinsey to help sort out its multibillion-dollar mess—perhaps because of the goodwill the firm earned while working for him at Allstate. AIG referred to the engagement as Project Destiny. But the consultants failed to gain their usual purchase on the company, a remarkable
failure considering the utter crisis that AIG was experiencing at the time. “AIG had workout specialist AlixPartners and McKinsey,” recalled a consultant who also spent time at the insurer. “The Alix guy kept telling management that McKinsey was working in a theoretical vacuum. Alix was the M*A*S*H hospital, McKinsey was the brain surgeon who had no business being in a M*A*S*H hospital.” That made McKinsey expendable when AIG’s situation became increasingly acute: Liddy’s successor, Robert Benmosche, promptly canned the consultants upon taking over as CEO in mid-2009.

Remarkably, McKinsey didn’t see much of a falloff in its business as a result of the global economic downturn. Revenues, which had flat-lined in 2003 at $3 billion, kept growing right on through the financial crisis, hitting $6 billion in 2008. By that point the firm had eighty-two offices around the world and more than fifteen thousand employees.

In 2007, at the firm’s partners conference in Singapore, Davis and Michelle Jarrard presented the findings from an internal study of just how the firm had gotten sideswiped by the dot-com bubble. The dot-com boom and bust, which had affected just 5 percent or so of the world economy, hit McKinsey hard. Given the resultant financial squall in Silicon Valley, New York, London, and Scandinavia—McKinsey strongholds—that wasn’t so much of a surprise. But the financial crisis, which hit some 60 percent of the world economy, barely left a scratch. That was due at least in part to Davis and Jarrard focusing the firm on internal controls as well as traditional client development.

McKinsey found itself facing new questions, though. And one, in particular, began showing up in a number of different guises. Was the
firm now so successful—and so big—that it was running the risk of becoming what it had long warned clients against becoming themselves: a hidebound bureaucratic organization that had lost the spark of its youth?

In 2007 Google knocked McKinsey out of the number one spot on the Universum MBA student ranking of preferable employers, a spot the consulting firm had held for the previous twelve years. This was certainly due in part to Google’s astounding success, but McKinsey had outlasted any number of pretenders to its throne over the previous decade.

In 2009
Fortune
named McKinsey the fourth-best company in the United States for producing leaders, after IBM, Procter & Gamble, and General Mills. This was no small honor, but also a comedown from the era when McKinsey was viewed as the preeminent creator of leaders the world over. That same year, Google retained the top spot over McKinsey in the Universum survey, a position it maintained through 2012. Adding insult to injury, the annual Glassdoor list of best places to work in 2012—a ranking created entirely from employee reviews—had Bain & Company (number one) placing
ahead
of McKinsey (number two) for the fourth year in a row. Google is one thing, but such success by a
direct competitor
is another. According to the website Poets & Quants, in 2011 McKinsey was still the single largest recruiter of MBAs from top schools.
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Whether quality has kept up with quantity is an open question.

By 2009 McKinsey was attracting a very different crowd, according to some. “It felt deadening,” said one person who worked in a support role for the firm. “Of course, it might not have felt that way to all those MBAs, engrossed in their charts and their teams. They were people who went to good schools but who weren’t very intellectual. They were very successful grinds.

“I think the fundamental problem at McKinsey is that they have
no real product,” she continued. “What do you do when there’s nothing there? You commoditize things that other people consider part of life, like personality and intelligence. You turn them into ‘units.’ They objectify basic human ideas and force them into ‘workflows’ and ‘dichotomies’ and ‘frameworks.’ These are not intellectuals. They are institutional people. They are people who spent a lot of time in the library memorizing things. They may talk of their new ‘framework,’ but it’s not like it’s an electric car or something.”

The firm tried to continue what was an increasingly transparent illusion of exclusivity. The annual corporate charity run sponsored by JPMorgan Chase requires a company logo on participants’ T-shirts. In 2009 there was substantial (and preposterous) internal debate about whether or not McKinsey should decline because of the requirement.

More important, McKinsey was now large enough that the possibility of questionable behavior—by both current employees and alumni—began rising coincidentally. In 2007 Chinese police detained twenty-two people in a bribery investigation related to equipment orders that had made its way into McKinsey’s own procurement division. Upon investigation, it turned out that two McKinsey employees had taken $250,000 in bribes from four equipment suppliers.
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And in 2008 Deustche Post CEO and McKinsey alumnus Klaus Zumwinkel resigned in disgrace after getting caught evading some $1.5 million in taxes and appearing on television in handcuffs.