Wednesday, December 31, 2008

Principles Based Standards

A major debate between the U.S.'s "generally accepted accounting principles (GAAP)" versus the international community’s "international financial reporting standards (IFRS)" is the difference between the U.S. focus on "bright light" standards as contrasted with the U.K.’s (among others) focus on "principles-based" standards. The U.S. "bright light" criteria is sort of like "see how far you can get away with something before you get caught" while the U.K. "principles-based" criteria is more like "you know the difference between right and wrong."

A major reason the U.S. will have major difficulty implementing the IFRS "principles-based" accounting standards is that American business today seems to have no principles.

Of course, there are exceptions, but doesn’t it seem as if, right now, there are way too few Ethical Leaders in positions of power and responsibility at American corporations and way too many Bernie Madoffs?

Citigroup CFO Gary Crittendon was quoted in the Wall Street Journal as saying that his bank "was forced" to put "hard-hit collateralized debt obligations" back onto its books in 2007. What is he saying?

There were lousy mortgage loans out there in the marketplace: sub-prime, Alt-A, Interest Only, Principle-Only, Option Adjustable Rate Mortgages, just to name a few. His company’s leadership bundled thousands of these loans together and created credit derivative obligations (CDOs) -- securities backed by the loans. The leadership sliced and diced the CDOs to create the impression of higher risk-higher returns, for which they could charge higher fees. They created special purpose entities (SPEs or special investment vehicles, SIVs) that essentially were limited liability partnership which they moved off of Citigroups’ books, even though they were really Citigroup's investments. Citigroup reaped the benefits of investment in those SIVs by speculators who were convinced by Citibank financial managers that the company had perfectly modeled the risks such that the value of the secruties would grow infinitely and forever. Citigroup sold the CDOs into the naïve pension fund investment market, the even more naïve charitable investment marketplace, and the even more naïve international investment marketplace. Executives like CFO Crittendon took in major bonuses for many months.

Life for Citigroup was good as long as Alan Greenspan kept interest rates at 1% after Wall Street went into a catatonic state following September 11, 2001. Ultimately, interest rates adjusted: adjustable interest rates on mortgages, by definition, adjust up when the Fed ups the Fed rate. Duh! Home speculators (flippers) and owners could no longer support higher mortgage payments, so many defaulted on the loans.

The securities (CDOs) which had been backed by weak real estate mortgages were no longer delivering the streams of expected interest and principle payments. The foreclosed properties reverted to bank owned real estate (REO), and the CDOs secured by those properties now had to be re-valued. Now Citigroup et al. had these overvalued SPEs or SIVs off their books. The choice was walk away from them, as Lehman Brothers did, and let the bankruptcy courts battle it all out at fractions of pennies on the dollar OR bring them back on the books and try to figure out how to re-value them while staying in business.

That’s what’s called "being forced" to meet the obligations you created in the first place.

Citigroup, Wachovia, Merrill Lynch, Washington Mutual didn’t ever ask "What is the principle, here?" Maybe they asked, "How long can we play this game before the interest rates change?" or maybe they asked, "How long before we get caught?"

After awhile, don’t all of these operations begin to sound the same:

  • Mortgage brokers being paid fees by investment banks to bring them large volumes of NINJA ("no income, no job applicant") loans so they could produce mortgage backed securities, credit derivative obligations and synthetic CDOs that could be sold to unsuspecting third-party buyers.

  • Appraisers being paid to inflate home appraisals to increase the value of the loan to be securitized and sold through CDOs to third-party investors.

  • Credit ratings agencies being paid by insurance companies and investment brokers to artificially inflate the ratings on debt issuances and securities in order to help them charge third-party investors higher prices for apparently safe investments.

  • Stock researchers being paid by investment brokers to produce positive stock analyses and recommendations so as to inflate the valuations on IPOs.

  • Insurance firms paying kickbacks to brokers to incent them to send them only preferred customers.

  • Options backdating: CFOs artificially altering the grant dates of options back to the date during the quarter that provided the most preferential stock value in order to maximize executive compensation based on options grants.

  • Artificial tax shelters: auditors advising clients facing large potential capital gains to invest in tax shelters established exclusively to enable those clients to avoid capital gains taxes.

    Doesn’t it all begin to look a lot like a Barnum & Bailey Circus Side Show, a Snake Oil Salesman’s Convention, or a PTL Revival Tent? Where are the "principles?" Where are the ethics in this church? Maybe that’s the problem: we’ve become so enamored of the financial side-show that we’ve lost sight of the message. We’ve gone back to caveat emptor -- the buyer better look out for him or herself because Shylock is out to scam them.

    The principle, today, is fraud. What is in this deal for me, now, rather than what are the consequences, the externalities, of my actions over the long term? Who cared what was the larger impact of these speculative SIVs on the marketplace and on other people?

    How do we undo this mess? It’s like asking: How do we get steroids out of professional sports? How do we get drugs out of the entertainment industry? How do we get fraud out of our financial markets?

    The freshness which followed from the Yellowstone fires of some years ago offers us some insight into the opportunities that could be gained from today’s financial tragedies. In medicine, if one valve is blocked sometimes letting that path stay as it is, while opening up a fresh new route, can create new and healthier circulation. The same happens in the brain as dead neurotransmitter paths are replaced by alternative mental circuitry.

    Proposals to seed 20 to 50 new banks nationwide offer us the opportunity to find principled-leaders and re-build a healthier financial economy. Other proposals suggest that firing the chief executive officers and presidents of our top 200 firms might be another sound idea.

    The principle being embraced here is that we have to stop protecting the idiots and the status quo that got us to where we are today. It’s like trying to save the dinosaurs. It goes against the natural order of things. We really need to purge a lot of the sick members of our financial community.

    Looking across our financial landscape, our banking entities have become behemoths that are too big to endure in a society that increasingly demands personalized attention and fine-tuned products and services.

    In a principles-based economy, I would expect to see a lot more people in leadership who actually cared about the consequences of their actions on their firms, their industry and their society. Maybe that explains why "principles-based accounting" is having such a difficult time finding traction in these here United States of America.
  • Friday, December 26, 2008

    Tough Love FSA-style

    In 2006, New York City Mayor Michael R. Bloomberg and New York Senator Charles E. Schumer commissioned a study that led to their recommendations in January 2007, entitled: Sustaining New York’s and the US’ Global Financial Services Leadership.
    See the 142-page study reprinted here.

    Three core recommendations were summarized as follows:

    1. It’s all SOX’s fault: "First, our regulatory framework is a thicket of complicated rules, rather than a streamlined set of commonly understood principles, as is the case in the United Kingdom and elsewhere. The flawed implementation of the 2002 Sarbanes-Oxley Act (SOX), which produced far heavier costs than expected, has only aggravated the situation, as has the continued requirement that foreign companies conform to U.S. accounting standards rather than the widely accepted -– many would say superior -– international [principles-based accounting] standards."

    2. It’s the lawsuits: "Second, the legal environments in other nations, including Great Britain, far more effectively discourage frivolous litigation."

    3. It’s the lack of immigrant visas: "Third, -- we are at risk of falling behind in attracting qualified American and foreign workers [and] fewer American students are graduating with the deep quantitative skills necessary to drive innovation in financial services."

    Bloomberg and Schumer’s primary argument was that "The British are competing! The British are competing!" They said Wall Street was losing out to better competition from the U.K., with its principles-based accounting standards and its simplified one-regulator oversight -– the Financial Services Authority (FSA).

    Now, in December 2008, comes this very same "simplified regulator," the FSA, the U.K. counterpart to a super-Securities and Exchange Commission (SEC), with tough new proposals to strengthen their regulations and oversight of most British financial services markets, exchanges, and firms. I wonder if Bloomberg and Schumer really want a U.S. version of what the FSA is proposing. It looks promising.

    The FSA’s statutory objectives are four-fold: (1) to maintain confidence in the financial market, (2) promote public awareness, (3) secure appropriate consumer protections, and (4) reduce financial crime.

    Under their "approved persons regime" (under authority of the Financial Services and Markets Act 2000), the FSA has the power to interview, vet, and monitor the performance of directors and executives at financial services entities. They can even prevent unqualified persons from taking a position of "significant influence" at a financial institution or compel a company to oust an un-approved person.

    In December 2008, the FSA proposed changes to its regulations of individuals with a "significant financial influence" on a firm as well as those individuals who deal with customers (or the property of customers).

    FSA describes "controlled functions" (levels of employment/service within regulated entities) ranging from CF1 through CF30, where the first 29 are positions of "significant influence:" CF1 is a director, CF2 is a non-executive director, CF3 is a chief executive officer, and C29 is a "significant management function." CF30 is the "customer function."

    In response to an internal audit and review of its own oversight of the Northern Rock bank failure, FSA proposed a Supervisory Enhancement Programme both to strengthen its existing principles-based regulation and to ensure, more proactively, that the board and executives of firms discharge their responsibilities.

    "The FSA is seeking to ensure that all directors and senior managers understand their regulatory obligations, have relevant experience and carry out their roles with integrity . . . [and] where a significant influence holder shows incompetence or dishonesty, we will consider enforcement action against him or her."

    Isn’t that interesting? Wouldn’t we like to have such authority over the 211 companies in which the U.S. Treasury and, by extension, the U.S. citizens, now own equities as a result of our TARP investment strategy?

    Shelia Nicoll (Director of FSA’s Retail Firms Division) spoke before an FSA conference in September, discussing the types of issues that might arise during the FSA’s on-site visits and interviews with a senior management team, executive and non-executive directors. She said firms could expect the FSA would review such issues as:

  • "whether you, and your fellow Non-Executives, have a good oversight of the risks facing your firm;
  • how effective the controls are within the firm;
  • the adequacy of the firms infrastructure, including whether the firm's people know which legal entity within a group they are actually operating; and
  • what controls there are in place to ensure that business is conducted properly with customers and markets."

    That looks surprisingly like Sarbanes-Oxley (SOX) Section 404 internal controls terminology. SOX required that executives affirm by their signatures that they understood the documentation they submitted to the SEC. The FSA explicitly expects key executives to understand the risks and to challenge business decision-making that might place the firm in jeopardy.

    "One of the main ways we try to ensure high quality governanjavascript:void(0)ce is through approving and holding to account those individuals who undertake governance functions. . . we will be seeking to hold more individuals accountable… [because] action against individuals has a much greater impact in terms of deterrence than action against firms."

    Wow, I wonder what Bloomberg and Schumer think about them apples?
  • Thursday, December 25, 2008

    TARP Accountability

    It is astounding that we give greater media attention to the Inaugural Parties and a search for the Whitehouse Puppy than we give to the financial meltdown of our economy.

    U.S. Treasury Secretary has ensured that Wall Street had a wonderful, wonderful Christmas this year.

    A total of $350 billion so far has gone to banks ($247 billion to 210 financial institutions), to American International Group ($40 billion), and to unfreeze consumer credit markets ($20 billion). President Bush (not Treasury!) announced that the government (probably Treasury) would provide a $13.4 billion loan to General Motors and Chrysler with another $4 billion promised for February (even though the Treasury has less than $2 billion left). American Express received commitments for $3.39 billion and CIT Group for $2.33 billion, after they became bank holding companies. Treasury provided, from the Capital Purchase Program under TARP, another $2.8 billion investment to 49 banks on 12/19/2008 and $1.9 billion to 43 other banks on 12/23/2008, the same day the Fed approved GMAC to convert from a privately-held investment entity to a bank holding company.

    To keep track of the Fed’s approvals of bank holding companies, go to
    Fed press page.

    To keep track of all the money Treasury has invested in the financial marketplace on your behalf, see ProPublica’s Bailout Bucks to Banks page.

    On December 19, 2008, Treasury Secretary Paulson went back to the trough to ask Congress to authorize the remaining $350 billion in TARP funds. Before we give him any more money, there are a few people asking him, "What did you do with the money we already gave you?" Unfortunately, we are not getting a lot of answers.

    The GAO issued a damning report on TARP dated December 2, 2008: Troubled Asset Relief Program: Additional Actions Needed to Better Ensure Integrity, Accountability and Transparency: (GAO-09-161). See GAO TARP Report.

    Those recommendations are being ignored.

    Harvard Finance Professor Elizabeth Warren, currently head of the Congressional Oversight Panel, issued a first report asking Treasury to explain its TARP strategy: Questions About the $700 Billion Emergency Economic Stabilization Funds: The First Report of the Congressional Oversight Panel for Economic Stabilization (December 10, 2008). See the COP TARP report.

    But of course Congress has gone home for the holidays and the New Year. Party time in DC., party time at the financial institutions and party time back home in legislative never neverland. Is there any way we could stop the Administration and the Treasury from emptying out the federal coffers before leaving office January 19, 2009?

    Friday, December 12, 2008

    The Bebchuk Solution

    On September 26, 2008, Lucian A. Bebchuk did an email blast of his working paper, A Plan for Addressing the Financial Crisis. His document (File: SSRN-id1273241.pdf) can be downloaded here.

    Bebchuk’s September recommendations would have gone far toward reconstituting our financial markets or at least address a few of the underlying causes of the financial meltdown. But his recommendations have not been heeded, and we are in a deeper financial quagmire than ever before.

    Lucian Arye Bebchuk is no slouch or hack. He is Professor of Law, Economics and Finance and Director of the Corporate Governance Program at Harvard Law School (in Cambridge, MA). He also is Research Associate at the National Bureau of Economic Research (NBER in Cambridge, MA) Research Associate at the European Corporate Governance Institute (ECGI in Brussels, Belgium). See his more recent writings here.

    There were four basic recommendations in his September paper:

    Recommendation 1. Treasury should only purchase troubled assets at fair market value.

    First, Treasury has reneged on getting rid of toxic assets and has switched to simply passing through taxpayer money to banks which also are reneging on getting rid of toxic assets. “Fair market valuations” are under attack from all sides in an effort to avoid placing bad overvalued assets in the crapper where they belong.

    Recommendation 2. Treasury should purchase new bank securities at fair market value to help under-capitalized financial institutions.

    Second, Treasury is giving out money without any monitoring of how it’s being used: whether for recapitalization, dividend distribution, or settlement of acid securities. Neel Kashkari (Interim Assistant Secretary of the Treasury for Financial Stability and Assistant Secretary of the Treasury for International Economics and Development) has said that Treasury favors monitoring through “general metrics” that look at the overall economic effects of the disbursed funds.

    Recommendation 3. Treasury should buy new bank securities through multi-buyer processes to ensure market discipline and competitive incentives.

    Third, Treasury has now written blank checks directly to 210 financial entities, many of whom didn’t want or need the money but took it because if they didn’t then other banks would do so and use the money to buy up smaller banks.

    Recommendation 4. Treasury should push financial firms to expand private capital through rights offerings to existing shareholders.

    Treasury has only pushed the public wealth down the throats of financial institutions, even letting companies continue dividend distributions – sort of a leak to private shareholders.

    The market was frozen in September, and not any better in December.

    Friday, December 5, 2008

    A Mind Is A Terrible Thing To Waste ®

    The United Negro College Funds slogan, "A mind is a terrible thing to waste," strikes me as incredibly wise, especially these days as our political idiots return home to their villages. Of course, some village idiots remain in Congress and others still have jobs at city desks, but certainly we can hope that the Big Kahunas won’t be there to push the economy around any more after January 20th, 2009.

    We are in a situation where our markets have failed, yet we continue to throw good money after bad after bad after bad. The problem is that we are financial idiots. Not simply you and me, but also the boards of directors at major financial institutions, top level managers at mortgage brokers and appraisers, and pretty much anyone who has touched credit default swaps.

    Our financial markets have failed: could it possibly be any clearer?

    Instead of using our money deposits in banks to invest in wealth-creating-business activities, our banks are hoarding money, while the federal government is giving them even more money. Instead of using our homes as residences, we are using our homes as high risk piggy banks to eke out marginal speculative returns because there are no alternative wealth-creating-business activities growing in this economy. Remember when real estate was the conservative investment option?

    How do we know that that our markets have failed? Two strong indicators affirm it. First, business has been doing business with bad people, which is called "adverse selection" -– choosing to do business with people who have no business being in the marketplace. For example, you wouldn’t sell a car to a 12 year old, would you? Well, we did.

    "Adverse selection" is a clear economic indicator that buyers and sellers in the marketplace have different information on which they are making financial choices. Prices are distorted and no longer reflect a preferred balance of underlying supply and demand. You actually DID sell a car to a 12 year old because the kid lied, he looked like an adult, and the seller in the marketplace did not care because he was getting his money from fees, which were side-deals and bets, not the price to settle in the marketplace. The market is broken because sellers keep making "adverse selections" again and again and again.

    The second indicator of a failed market is that business continues to operate recklessly, as if risk did not exist, because some Big Daddy Kahuna underwrites the losses. This is called "moral hazard" -- you can recognize it if you have kids who can’t seem to graduate from college, get a job, save money, stay away from overcharging their credit cards, and counting on their parents to keep bailing them out. Now we are seeing "moral hazard" underwritten by the US Treasury and the Federal Reserve. "Moral hazard" we have in abundance these days.

    The banks know they are protected by the political and financial subsidies from Paulson, Bernanke, et al. AIG and the insurance industry know they are protected by the same political and financial generosity. And now, the auto industry and GMAC, its own private banking system, know they can act with impunity because they can expect to be bailed out, too. Credit card companies and developers are in line with their hands out. Can landscape gardeners be too far behind?

    Not only did business sell cars to any 12 year old who came in the door, but now other business people think that selling to 12 year olds is profitable as long as the Fed keeps printing up money to back more and more risky behavior. The market is broken because now new sellers think that the marketplace (government-subsidized) approves, encourages and incentivizes more risky behavior.

    The market is broken, but there isn’t any adult intelligent enough to realize we have to stop this vicious cycle. The banks sit on the loans and infusions from the federal government, hoarding money that needs to be invested. But no action has been taken to identify who or what might be worthy of American financial investment: we keep protecting the village idiots.

    Who is trustworthy anymore? Does anyone really trust the U.S. auto industry, the entertainment industry, the publication industry, the retail sector, or the technology providers? The reality is that real estate speculation was the last gasp of a miserably broke market. The only thing America seems to be doing (regardless of whether we’re doing it well or not) is waging war against the rest of the world.

    The federal government is taking no action to alter the imbalanced information asymmetry in the marketplace. We are doing nothing to develop a derivatives clearinghouse that might properly value toxic securities. Only the FDIC and a few small nonprofits are trying limited short-term strategies to pressure mortgage renegotiations for small groups of subprime borrowers. There is no long-term strategy being developed that might address the causes of the bigger scale problems of stopping the glut of Alt-A, Option-ARM, Interest-Only, Principle-Only loans that were used by "flippers" to speculate in the real estate marketplace (the 12 year olds). There is no effort in Congress to repeal the stupid laws they passed to "de-regulate everything, so the financial industry can play." There is no effort to publicly compel banks and former investment houses to take back onto their balance sheets those "special investment vehicles" which were the equivalent of un-regulated, un-supervised, un-backed IPOs that allow investment banks to divert real money from productive uses and shareholder investments into phony assets with now negative returns to equity. There is no effort to publicly compel insurance companies to increase their capital requirements to match the level of risk actually incurred by credit default swaps speculation.

    The real reason that there is no substantive effort to address the underlying problems of this failure of the financial markets is that there is so little understanding of the financial markets today, especially by those legislators who so willingly passed lobbyist-written bills that generated so many of these problems. Some of those bills are so complex and sophisticated that there is no way your congressman or mine could possibly have pulled it off. Our Congress is broken -– just examine everything that is included in each subsequent bill being passed and you’ll see we do not have legislation, we have AS-IS FOR-SALE-CHEAP: American Assets and Values.

    Our media, newspapers, radio, television talking heads, and (even worse) our Internet bloggersphere merely make things worse by repeating bits and pieces of data without any concrete understanding of the financial concepts or consequences. The Wall Street Journal came out, around the time of TARP, with a two page spread of their boxes "explaining everything about the subprime crisis" -– everything, of course, except the subprime crisis. It looked surprisingly like the same two page spread of boxes that explained the "Enron crisis."

    There is only one person I trust to explain this financial quagmire in which we’ve found ourselves: that’s Salman Khan, founder of Khan Academy. His credentials include an MBA from Harvard Business School, a Masters in electrical engineering and computer science, a BS in electrical engineering and computer science, and a BS in mathematics from the Massachusetts Institute of Technology. Even more important, Sal Khan knows how to explain complex subjects by tapping both the right and the left brain and by using whiteboard demonstrations as a knowledge delivery vehicle. His Credit Crisis web page video segments on YouTube describe sophisticated financial issues with great clarity using straight-forward balance sheet and income statement examples.

    Oh, that the SEC would require such explicit documentation of its regulated entities.

    See his 27-module explanation of the Credit Crisis at: khanacademy.org/#Credit Crisis

    Frankly, I wish every single American journalist would be required to pass a test showing that they understand his explanations of the difference between mortgage-backed securities and credit derivative obligations, since no American journalist today seems to know what either of them are, let alone how they differ from credit default swaps. They all seem to spit out this jargon as if it were spaghetti from a bad frat party.

    On October 2, 2008, Sal Khan reported on a recommendation by Todd Plutsky, a friend from Harvard, for the U.S. to consider founding 20 to 50 new national banks as a strategy for fixing the failed financial market. See: A Possible Solution.

    CNN interviewed Khan on October 10, 2008: CNN video with the text version at:
    CNN text.

    David Leinweber, of University of California at Berkeley’s Haas Business School, Center for Innovative Financial Technology, came out November 10, 2008 with a formal proposal co-authored with Sal Khan:
    New Banks Initiative.

    The Wall Street Journal picked up on the idea briefly November 25, 2008:
    WSJ article.

    Not a word has been uttered since Thanksgiving. Let’s hope that the Obama financial advisors are looking seriously at this proposal which clearly tosses out the financial industry’s village idiots and their strategies to sell to 12 year olds.