Re:Balance -- Jim Peterson

Dimon in the Rough? Jamie Gets Up and Down with the Law-Makers

Jamie Dimon called on the Washington carpet? 

The rug was royal red and plush indeed -- judged by the treatment given to JP Morgan Chase’s chief executive by the Senate Banking Committee on June 13, and by the House Financial Services Committee a week later, over the bank’s synthetic credit derivatives “portfolio hedging” debacle publicly quantified at $ 2 billion on May 10.

Dimon’s agility at alternately seducing, evading and befuddling his interrogators was a reminder of the sadly limited capability of senior law-makers to bring meaningful leadership to the complex world of global-scale finance.

It may sound like a final examination essay for a graduate-school course in Government or Policy (and my students should consider themselves duly warned), but it truly matters out in the real world.

That’s because the depressing conclusion from the Dimon hearings is that the prospects for beneficial regulatory influence are dim.

As a “teaching moment,” C-Span viewing is not for the faint of heart, nor the weak of stomach. The participants performed with the character depth of a Dan Brown novel and a virtual inability to read their staff-drafted questions.

Fawning by the Senators -- Dimon’s home-town Charles Schumer (D-NY), or Jim DeMint (R-NC) or Bob Corker (R-Tenn) -- was only matched in the lower House by the embarrassing display of incompetence -- Maxine Waters (D-Cal), Gary Ackerman (D-NY), Brad Sherman (D-Cal) and Rubin Hinojosa (D-Texas) being selected egregious examples. 

The proceedings showed no grasp among any of the players of some basic truths, starting with this pressing question:

If a bank so ostensibly well run through the financial crisis could incur a blow-up of such magnitude, what level of confidence should be reposed in the safety of institutions not nearly as robust?

Dimon’s straight-faced assertion -- that the multi-billion dollar wrong turn in his London-based derivatives portfolio was “an isolated event” -- aimed to finesse the break-down of oversight and controls at the bank’s highest level where, as he invoked President Harry Truman, “the buck stops.”

But to accept Dimon’s embrace of the solutions of industry-wide capital and liquidity requirements – facile for him, because at levels his own bank can meet -- is to ignore the fundamental lessons of large-scale catastrophe:

Namely, it is precisely those with potentially disastrous impact – whether Japanese nuclear plant siting or Italian cruise liner routings or permissible banking activities – that are most demanding of the highest degree of attention.

The sources of learning are ominous in their two messages (e.g., the late mathematician and markets observer Benoit Mandelbrot and Black Swan populizer Nassim Nicholas Taleb):

• First, financial bubbles are inflated by the aggressive huffing and puffing of bankers acting in accordance with their basic DNA, only to burst inexorably because complex systems designed and run by humans are inherently susceptible to breakdowns beyond either prediction or prevention.

• Second, the inevitable excesses of the marketplace will always outpace the efforts of legislators and regulators operating under constraints of resources, comprehension, intelligence and constituent influence.

So, because the bankers cannot be constrained from using models and other self-deceptive devices that mask or rationalize their weaknesses, what can society expect from its regulators?

Given their inability to do more than scapegoat the last outburst with show-trial hindsight rather than anticipate the next one with perception and effectiveness, a structural response must be straightforward – recognizing both that self-interested bankers will push any regulatory scheme past the point of abuse, and that the regulators themselves lack the tools to stop them.

The comparison remains apt: If hammers are allowed in the toy-room, there will be breakage by the toddlers.

It is important that “too big to fail” has no bearing. Dimon’s “London whale” could have laid on his misguided portfolio, outside the boundaries of a permissive regulatory regime, on behalf of far smaller institutions – the rogue examples include Jon Corzine at MF Global and last fall’s Kweku Adoboli at UBS, and go back to and beyond 1995 and Nick Leeson on the Singapore fringes of Barings Bank.

What it does mean is that the repeal of Glass-Steagall’s separation of investment from commercial banking has proved catastrophically costly, enabling the kiddies to run amok with their hammers.

Which, in context of the Dimon hearings’ evidence of “boys and their toys,” should be profoundly disturbing. The rules still to come under Dodd-Frank – watered down by the on-going lobbying that Dimon claimed as the bank’s “constitutional right” – leave the bankers’ undisciplined playroom wide open and effectively unsupervised. 

 

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Guest Post at the FEI Blog: When Litigation Kills the Accounting Profession -- Don't Say You Weren't Warned!

Edith Orenstein's FEI Blog is a "must read" -- a thorough and lucid map of the goings-on in Washington among the  legislators, regulators and agencies of law enforcement. I have the pleasure this week of taking up Edith's kind invitation for a guest post, while she is on vacation:

With the devilish details of the Dodd-Frank Act now to be worked out and many special interests weighing in, legislative activity in the American financial sector returns to a standstill – probably until after the elections of November 2012.

So what would bring to the forefront a topic that to most is sleep-inducing, although it keeps some few from sleep: namely, the very viability of the large accounting firms and their fragile franchise to audit the world’s global companies?

Nothing less, presumably, than an existential shock to the stability of one of the Big Four tetrapoly – an unresolvable criminal investigation or a “bad case” outcome in one of their nightmare civil cases. . . . . For the entire post, and to see the scope and quality of Edith's own work -- please see here.

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The Indian Government's Reaction to Satyam -- Marching Backwards to the Future

In what is still the global-scale financial scandal of the year -- India’s Satyam Computer Services -- the search for villainy continues to diversify.

•    Blogger Francine McKenna leads the charge (Re:The Auditors) against what she sees as a corrupting business relationship of services provided alongside PricewaterhouseCoopers, whose Indian firm did Satyam’s audits.

•    Indian regulators are publicizing their cooperation with the US SEC (here), and suggesting the imminent end to their investigations (here).

•    And the amount of impartiality expected from the Indian system of criminal justice was signaled in the July 9 statement of Corporate Affairs Minister Salman Khurshid, that “All the concerned persons have been arrested except one and prosecution has begun against the guilty" (here, and the anxious emphasis is mine).

I was recently berated by a reader for saying back in February (here), that the Indian approach of incarcerating suspects even before charges were brought did not accord with basic notions of fairness and due process. The gist of his barb was that I was being “holier than thou,” because in his view the US government bail-out of its financial institutions was the “crime of the century,” whereby the “biggest crooks in our society” have stolen $ 700 billion of taxpayer money with no benefit to “the people who have landed on the streets due to foreclosure.”

My deeply insulted critic is entitled to his position. But he is trying to pick a fight on the wrong ground. I have lived and worked outside the US long enough to recognize the risk of presumptive cross-border judgments. And history, not he or I, will judge the leadership of President Obama, Treasury Secretary Geithner and Federal Reserve Chairman Bernanke. It’s not an “either/or” proposition.

Rather, it remains that, save for those like Alan Stanford who present flight risk, and where even the now-jailed Bernard Madoff enjoyed the liberty of his apartment until the day of his guilty plea, it offends mature notions of justice to imprison white-collar accused ahead of an adjudication of their guilt.

Pass this as a quibble. It is of more importance to the evolution of the Indian environment, that the degree of insight and perception shown by Minister Khurshid ominously suggests two reasons why the only impact of Satyam on that country’s governance and regulation will be from the “law of unintended consequences.”

The first issue is attitudinal. Satyam represents India’s “Black Swan” moment, in the phrase made popular by Nassim Nicholas Taleb’s best-seller (reviewed here). It was an unexpected and highly disruptive event – about which Khurshid commits the familiar error of misperception and flawed analysis, stating that “the Satyam scam is an aberration and the events are specific to the company in question. No other scam of this nature has come to notice since then” (here).

Now that Satyam has brought it forcefully home that large-scale corporate fraud is a reality in India (and in fact was completely predictable all along, despite official denial and evasion), it is equally certain that other similar situations are gestating even now, undiscovered but waiting their own moments to emerge.

So rationalizing Satyam as unique will be to miss the inevitable crises of the future. Yet, Khurshid’s remarks indicate a simple-minded determination to replicate the ineffective reactions of his counterparts in countries elsewhere.

That is, his view that a package of new legislation and an “elaborate regulatory framework” will address “all issues” involving forgery and computer manipulations, disclosures to stakeholders and discipline of public accountants and corporate secretaries (here) simply lacks the credibility of a track record of success.

Did Sarbanes/Oxley impede the credit market implosion? Or slow down Bernard Madoff? Measured against efforts at prevention, in jurisdictions suffering decades of corporate malfeasance and failing consistently to stop the periodic eruption of fresh cycles of wrongdoing, the Indian view that effective prevention can be learned and implemented from a one-off experience is dangerously naïve.

Secondly, even less likely to act as a deterrent is Khurshid’s proposal to include the concept of shareholder class actions in a new Companies Bill (here).

Events may well outrun the Indian legislators. As announced (here), the opportunistically-named Midas Touch Investment Association seeks to launch a class action in India on behalf of 300,000 shareholders, seeking over $ 1 billion from Satyam’s directors, auditors and promoters. At the very least, this promises a two-ring circus as veteran plaintiffs’ lawyers in the already-pending US actions will eagerly protect their access to an expected honeypot of legal fees.

Lest I attract further vitriol from those taking positions on either end of the advocacy spectrum – as to whether class actions are either a vital and essential weapon for defrauded investors, or a tool of extortion and destruction held over corporate management and a menace to the entire capitalist system -- a middle course:

Decades of American experience with securities class actions would suggest caution, before introducing such a jurisprudential tool into the kit of Indian governance and enforcement. At least, the empirical observation of developed economies and markets in Europe, which have thrived without the common resort to shareholder class actions, might at least indicate that steering the Indian system in the direction of the American would invite the re-invention of a set of less than desirable problems.

An available lesson from Taleb’s “Black Swan” is the all-too-human tendency to resist learning from failure. A special version – characteristic of the political classes and fully displayed by Minister Khurshid – is the hubris of the uninformed, who in their refusal to study the lessons of history are incapable of appreciating the boundaries of their ignorance.  

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The Indian Regulators Pronounce on Satyam -- And a False Dawn is Promised

Is corporate India now vaccinated against an outbreak of white-collar financial fraud?

The great and the good of the country’s regulators would think it – taking at face value their prideful descriptions of the investigative scrutiny of scandal-ridden Satyam Computer Services Ltd.

The former chairman of the Securities and Exchange Board of India, Meleveetil Damodaran, is quoted – here -- as calling the fraud at Satyam “unique,” and “an isolated case, not reflective of the state of affairs of India Inc.”

He would say so, of course, as a current board member of Tech Mahindra, the successful bidder now grasping the handle of the poisoned Satyam chalice. But the annoying question persists: on what basis could he possibly make such an over-reaching claim?

Not from the work of the Central Bureau of Investigation, which invokes its use of “cyberforensics” – here -- in order to “uncover how in-house computer systems (at Satyam) were exploited to generate false invoices.”

Please. Spare us another exaggerated claim on behalf of the “forensics” of post-exposure inquiry.

A sewer worker can unplug a cesspool, too, if given a shovel and told – pointing to the clogged hole – “Dig here.” Admirable are the muscles involved. But the worker is not thereby qualified to engineer the waste plant, nor to monitor the flow through its twisted pipes and drains.

The forensic program to illuminate a revenue statement inflated by bogus business would start – and typically would end – with a single sharp finger pointed to the designer of the information system:

“Will you please show me the back-door technique by which alternative invoices – authorized or not – can be entered into the system? And for good measure, would not such an entry be concealed from the mainstream reporting process?”

That’s it. Not the stuff of brilliance or epiphany.

It does remain to be revealed, probably in court, whether such simple and direct questions were ever asked in the normal course of Satyam’s risk management process – under audit or otherwise. But conceiving them after the fact is hardly the matter of revelation now being publicized by the Indian regulators.

As for the excessive enthusiasm of the good Mr. Damodaran. Nassim Nicholas Taleb’s “Black Swan” presents the two lessons essential to avoid the “induction trap” into which the SEBI veteran falls headlong:

•    First, no number of observations of white swans can disprove the existence of a black one. Likewise, however superficially successful may appear the historical performance of a financial reporting and assurance structure, the past can give no comfort that a catastrophic failure will not suddenly emerge.

•    Second, the single observation of a black swan not only destroys the baseless over-confidence that the species does not exist – it must also contemplate the prospect of other like specimens. More directly, Satyam as one mega-fraud not only establishes that it can happen in India, but supports the necessary expectation that others exist, only as yet undiscovered.  

Or in more folksy terms – the first appearance of a cockroach, in a kitchen thought to be pest-free, both disproves any assumption of health-code compliance, and also reasonably alerts the chef – since vermin are not known to be solitary – to the unpleasant presence of more.

The Institute of Chartered Accountants in India, meanwhile, is off on a wild-goose-chase of its own – here and still here -- chasing after the details of the international affiliations among the only accounting firms globally established enough to participate in the delivery of audit services in a true cross-border involvement.

As if agreements as to name-sharing, letterheads and business cards had anything to do with the defalcation at Satyam. Or, either, with the provincial stature of India’s locally-biased profession – flailing away in back-footed defensiveness as it confronts the reality that it is at least a generation behind the modernization required to participate in a globalized economy.

Rather than take comfort that a black pot of India Inc has been bleached to lily white, in other words, prudent investors and gate-keepers alike would do well to view the pronouncements of naïve regulators as a symptom that the country’s environment for financial chicanery remains fertile and inviting. 

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"The Black Swan," Nassim Nicholas Taleb

I’m happy to have been an early supporter of “The Black Swan.” Not that Nassim Nicholas Taleb’s best-seller of last spring needed my contribution. Taleb explores the human inability to recognize or appreciate the likelihood or impact of extreme events. Since he has stopped giving interviews, we can only imagine his satisfaction at the graphic global demonstration of his hypotheses delivered by the blind herd behaviors during the turmoil in the credit markets that started last spring with a virus in American subprime mortgages and quickly spread worldwide.

Those willing to stand the combination of erudition, authorial attitude and quirkiness will also find his website rewarding -- here .

Book Report: A Meditation on Chance

Originally published in the International Herald Tribune on May 4, 2007

The Black Swan: The Impact of the Highly Improbable By Nassim Nicholas Taleb Random House, 292 pages

A stranger walks into a crowded bar. How does his arrival affect the customer profile?

Because of physical human limits, his presence has a trivial impact on the average age, height or weight of the patrons. But what about wealth? If the guy is Bill Gates, suddenly - on average - everyone in the place is many times a multimillionaire.

For Gates, who could have predicted it? Despite the superior technology of Apple, Microsoft enjoyed the lucky opportunity of an early lead, which it then exploited to market dominance and immense wealth creation.
To explain the serendipity of business success – the same as for casualties of war, damage from natural disasters, action in the stock markets, or even emergence of best-selling books - the traditional tools of the economist and the social scientist are not getting it.

For a meditation on the cognitive shortcomings that cause us to under-appreciate the frequency of randomized, highly improbable but severely consequential events, see Nassim Nicholas Taleb's new book, "The Black Swan." In my neighborhood bookseller it is found on the Science shelf - only because the shop doesn't have separate sections for Uncertainty, Empirical Skepticism or Epistemology.

Taleb, who has taught at the university level in the United States and was once a trader and investment manager, takes his title, and his themes, from the rare bird, unknown in the West until discovered in Australia. No number of white swan observations could disprove the existence of a black swan, although no one had ever seen one, but a single sighting destroys the conventional contention that they did not exist.

Taleb is spreading his own wings after the success of his previous book, "Fooled by Randomness." The new book concentrates on the unexpected frequency and impact of black-swan events in the world of financial markets. Expanding the observation that we are unable to predict or identify events that are exceedingly rare but deeply meaningful, he explores the collection of biases that cause us to misinterpret these events after the fact.

Taleb navigates between the metaphorical landscapes of Mediocristan - a smoothed-down domain, lacking extremes and outliers - and Extremistan, where singular events can impact the whole. Much of life occurs in the former, and Taleb does not argue otherwise. What he does illuminate is our failure to know the difference between the two realms - especially to recognize that the likes of Warren Buffett and Long-Term Capital Management populate the latter, along with 9/11 and Columbine and Virginia Tech.

There are many sources for our lapses, one being the willful ignorance of the "silent evidence," such that much human endeavor will not make an impact: The many garage inventors who, instead of becoming Bill Gates or Steve Jobs, toil forever in obscurity; in sports, the failed Cinderellas whose desperation putts and last-second shots just do not drop; the blown-up brokers and fund managers whose disappearance from the data pools of memory contribute to the inflated egos of the survivors.

Taleb also shows us the impaired vision of the game theoreticians, who seek wisdom about risk-taking from casino games, but miss the basic point: Despite the appealing stories of the occasional lucky weekend punter, the casinos always win. As Taleb points out, casino games are not random in any really interesting way. Rather, the type of risk that really threatens a casino might be that its headline entertainer would be mauled by a tiger - something unthinkable before it happened in 2003 to the illusionist Roy Horn, of Siegfried and Roy, at the Mirage in Las Vegas.

Taleb himself is a beneficiary of a black swan event: the market turmoil of October 1987, which under conventional predictive tools should not have happened. The financial success he had from astute trading strategies freed him to emulate his role models, Voltaire and Montaigne, who retired from the hubbub of commercial and political affairs to the reflective quiet of their libraries and studies.

Taleb's sources extend from the physician and philosopher Sextus Empiricus, in second century Alexandria, to the Yale mathematician Benoit Mandelbrot, guru of the field of fractal geometry, to whom Taleb dedicates his book. The elegance with which Mandelbrot generates highly complex structures out of simple mathematical rules lies at the heart of Taleb's ability to explain the extreme events that lie beyond the smooth bell curves of conventional analysis.

Taleb disavows that "Fooled by Randomness," his earlier work, was intended as a book on business and investing, and his vision for "The Black Swan" is broader still. But anyone who has read this book is unlikely to think the same way about any number of life-shaping decisions, including how resources are deployed and priorities are set, how to invest both time and treasure, what risks to absorb and which to lay off by insurance.

Along Taleb's free-flowing highway of erudition are signposts that are no less useful in the commercial world than anywhere else:

The compulsion to concoct after-the-fact rationalizations out of nearby anecdotes means that daily market analysis is at best meaningless noise.
Market strategies that are designed upon bell-curve models suffer the built-in defect of excluding the potential for wildly extreme events.
If we could predict what we don't know, it wouldn't be unknown. Better the discerning, and humble, recognition of the wide scope of our ignorance.

For these guides to a modern world both more complex and less predictable than we may believe - as well as for welcome relief from the superficiality of the typical business and investing publications - Taleb's book deserves our attention, and our thanks.