Re:Balance -- Jim Peterson

Accounting for Subprime -- Scoring the Scorekeepers

This audit season the skeletons just refuse to stay in the closets. Latest this month, but far from last, are AIG’s $4 billion loss estimate increase and Credit Suisse’s $2.85 billion write-down in its asset-backed securities.

Both examples read directly on a question put by a friend and regular reader -- a business school professor in Paris: “How much of the subprime thing is related to the accounting?”

Not that she needs my help with a lesson outline for her MBA students. But having been a guest in her classroom, I’m happy to offer. If I were teaching her class, I’d get there in three steps:

At the level of human behavior, subprime in its origins was first about the disconnect between incentives and risks: the mortgage originators took their fees immediately, but repackaged and laid off the future stream of payment obligations. Then the bankers, abetted by the ratings agencies, gamed the credit rating system by pushing untestable valuation models onto their credulous customers.

Second, as after-effect, subprime is now about legal responsibility. With the filing of new investor lawsuits back to Enron-era levels (for which, see the helpful running count being kept by the D&O Diary,here ),  the roster of defendants includes not only the banks and mortgage companies, but also the three dominant credit rating agencies and, at last count, three of the Big Four accounting firms.

But third, with the global harm extending from villages in the Norwegian Arctic to counties in rural Florida to bush hamlets in Australia, we should go back to basics: accounting principles and methods for the recording and reporting of transactions are as old and pervasive as trade itself.

As soon as commerce moved beyond one-to-one barter, conventions were required to quantify such inherently judgmental issues as the hazard of re-payment in future periods, the time value of money to change hands at a later time, or the transfer of performance to a third-party.

So viewed, subprime and the credit market turmoil are all about the accounting, and nothing else. Fundamentally flawed assessments were made – whether out of venality or ignorance – about the quantification, timing and transferability of the risks associated with uniquely complex financial derivatives, and the collapse in their values as knowledge and experience eventually caught up.

So the accounting for mortgage-based assets and their off-spring should be seen as a proxy for the reckoning of financial reality in all aspects:

For a family buying its first home with an adjustable-rate mortgage, the expense entry for housing cost changes from rent to mortgage payment. Its balance sheet now has an asset, the house, with the associated mortgage debt as a liability. When a depressed housing market erodes any equity, and the payment escalates beyond the family’s means, the accounting confirms the reality – red ink and foreclosure.

An investment bank that sponsored and sold exotic tranches of financial products now has the task of re-assuming them back onto its balance sheet and marking their value to a collapsing market rather than a discredited black-box model, which means filling the accounting holes. Costly new rescue capital, opportunistically supplied to the likes of Citi and Merrill, Northern Rock and the monoline insurers, may provide a lifeline but dilutes or even destroys the prior shareholders.

As for investors – whether an individual shareholder of the banks or a pension or retirement fund that bought the exotic products – their losses may not yet be realized for accounting purposes, unless they have sold out the positions, but they can plainly feel the real-world loss of wealth, and unsurprisingly are taking advice from the plaintiffs’ lawyers.

As shown already by AIG and Credit Suisse, the accounting challenges pinpointed by the professor are fraught both for the financial institutions and also for any investor who heard the siren song of higher rates and traded off for unknown future risks.

That’s because the more candor and rigor are brought to this year’s audit process, the more stark will be the ultimate concession that the valuation models on which subprime was built were creatures of myth and unreality. And therein lies a ghastly liability implication -- that the well-controlled and smoothly operating systems required under Section 404 of the looming Sarbanes-Oxley law simply weren’t there.

In the end, to wrap up for the good professor’s class, the quality of accounting is an effect, not a cause – the level of its virtue and integrity is observable in a mirror held up to commercial society.

Or as first put in the early 1970’s by cartoonist Walt Kelly’s swamp philosopher, Pogo the possum, “We have met the enemy, and he is us.”   

Credit Rating Agencies -- Submerged by Subprime?

A pal of mine in Washington, keeping watch on the legislators and regulators, is asking what to name his pied-a-terre, with its balcony facing the nation’s capitol.

With a familiar old blame game now roiling in the credit markets, we’re suggesting he call the place “Déjà Vu.”

It’s not only Enron all over again for the beleaguered banks that wrapped up and sold the exotic mille-feuilles of debt securities concocted out of subprime mortgages. It’s even more ominous for the three dominant credit rating agencies – Standard & Poor’s, Moody’s and Fitch – under scrutiny for their own multiple and well-compensated roles.

To summarize: this trio advised on the creation and design of these complex instruments. They then proceeded to issue their ratings on the same paper, which was peddled around to hedge funds, local government cash managers, and institutional investors worldwide. The ratings – required by the offerors to be of defined grades -- were carefully couched as “opinions” strictly limited to credit risk. Yet they were viewed by the purchasers not only as measuring expected credit loss, but as proxies for over-all investment quality. That is, they were issued under a “but-for” test: no rating meant no deal.

But reality eventually intruded: no established markets meant that nobody really had a clue about the value of these one-off instruments – not the buyers, not the issuers who paid for the ratings, and not the ratings agencies themselves.

Any wonder at the intensity of the heat? With cries of “conflict of interest” ringing loud, the ratings agencies are assailed across the globe, from EU markets commissioner Charlie McGreevy to the Attorneys General of Ohio and California. And along with the issuing banks, they are being named in lawsuits by their own shareholders and investors as well.

Should any of this feel surprising? Whatever the defensive spin and the persistent denial of the deepening conditions of adversity, problems yet to ripen mean that we are not yet even approaching what Winston Churchill termed the “end of the beginning.” Still to come in the next year or so:

•    Upward interest rate re-sets on the subprime mortgages themselves, ballooning the homeowners’ payments and default rates and deepening the gloom in the housing sector.

•    Legislators’ tinkering for the sake of the poor homebuyers, with uncertain but real effects on the value of the investment portfolios where the mortgages came to reside.

•    Exposure during this audit season of the still-hidden skeletons in the closeted portfolios of the institutional investors who are still exploring and discovering their exposures.

•    Further blood-letting in the executive suites, as the blown-up careers of Merrill’s Stan O’Neal, Citigroup’s Chuck Prince and Bear Stearns’s Jimmy Cayne foretell a parade of CEO sacrifice.

•    And finally, several more rounds of loss provisions – witness the $24 billion at Merrill and the three-stage total of $18 billion at UBS -- as the subprime debt-holders struggle, along with their auditors and lawyers, to supplant their discredited valuation models and mark their positions to market reality. 

Eventually these will play out. But dozens of new lawsuits already disprove the claim of the academic scorekeepers, that the post-Enron dip in the case-count represented a systemic cleansing of the corporate stables. The bad old days are indeed here again – Sarbanes-Oxley was never to be a one-time fix for corporate financial misbehavior.

Ratings agencies confronting their antagonists have historically invoked the virtually sacred American right of free speech. But the security blanket of the First Amendment must be feeling threadbare, limited as is its coverage to the journalistic role of publicizing ratings data at no cost to the end-using consumers.

Rather, critics point to the three large ratings agencies’ cartel control of the sector, their allegedly corrupting consulting practices and client-based fee structures, their opaque opinions, and above all their inability, under market stress, to foresee or prevent their clients’ financial debacles.

The agencies themselves are touting a menu of fixes, from Moody’s proposal to replace letter ratings with numbers – arguably no more than a switch from illiteracy to innumeracy – to massive downgrades of mortgage-backed securities with knock-on effects for other debt portfolios and the entire bond insurers speciality, to the blame-the-user invocation by Standard & Poor’s of more “investor education.”

But should the ratings agencies feel confident of dodging the bullets? Two lessons in history suggest not. First, the closely analogous model of the auditors’ participation in the securities marketplace has brought them to grief, with multi-billion dollar litigations threatening their very survival. Second, both plaintiffs’ lawyers and legislators, inspired by Sarbanes-Oxley, will pick on proximate targets. That’s where they will both fix the blame and aim their fire.

So once again, the phrase “It’s different this time” can be chiseled on the gravestones of those who speak it. In fact, it’s the same all over again.

Ethics in Corporate Leadership -- Teachable or Not?

Last week it was my pleasure -- and challenge -- to be a guest speaker in a top business school’s MBA class in leadership. The students’ energetic focus on corporate “tone at the top” suggested that with some minor fixes to the dates, this column retains its currency today. 

Ethics Training Needs Reality

Originally published in the IHT on July 28, 2006

This column is dedicated to an honest and hard-working couple who lived across the street from where I grew up.

The husband had retired after a hard blue-collar career for one of the pipeline companies that became Enron. When the company failed and he lost his pension and health care, they were forced onto the dole and died in penury.

In July 2006, the month that the bell tolled for Kenneth Lay, Enron's disgraced chief, this important question came up on my radar: Can personal ethics really be taught in the corporate environment?

A large professional trade group, whose members deal with financial information for investors, was rolling out a major new ethics training effort. Yet it remains apparent that the teachability of ethical behavior is still an important challenge. Companies take on an annual crop of new and inexperienced employees, even while virtue has remained in short supply - from Enron's downfall in 2001 through the 2006 uncovering of widespread backdating of stock option prices.

On the plus side, this project is large, competent and high-minded. It features leading university academics, the latest in snazzy video and graphics in a CD-based curriculum and flexible delivery from self-teaching to small- group seminars.

But here's the rub: In the history of corporate training, no one has ever flunked an ethics course.

With such obvious and squeaky- clean training scenarios as the bonus- driven salesman putting pressure on his credulous client and the agonized junior staff member blowing the whistle on a morals-challenged superior, not even the Lays and Jeff Skillings could miss earning honors marks.

Could it be otherwise? It's baby steps for baby feet to announce and administer a course flagged by unmistakable signs and guideposts. You might as well put pilot trainees in a simulator programmed for level flying in clear sunshine, and then expect them to land a jumbo jet with a double engine failure in a midnight thunderstorm.

Two suggestions could move the instruction beyond the novice level.

The first - based on the reality- driven models actually used for pilots, firemen and emergency room doctors - would embed issues of fraud, irregularity and dubious ethics on an unspecified and unannounced basis, directly into the mainstream training on which global companies spend fortunes annually. Trainees would then have the stimulus and the satisfaction of teasing out the problems for themselves.

Just as physical training issues are calibrated for complexity, so could those in a corporate setting. Important issues abound: Where is the line between good client service and an inappropriate incentive? How far can accounting rules be bent before they are broken? What is the balance between the benefits of booking a contract in an early fiscal quarter and the incompleteness of the paperwork needed to satisfy the auditors?

These and dozens of other real-world issues comprise the case-by- case experiences that arise every day. But there they come with the pressures of market performance and individual career development, and not beribboned in lofty conclusions delivered by highly compensated fly-by consultants with their soft-science doctorates.

Second, in addition to the challenge of shaping the classroom to something like quotidian reality, a company that is truly committed to doing well by doing good must deliver the right tone at the top.

And that in turn means that the true educational moments come from both the formal and the casual messages coming out of the executive suites. No amount of preaching from a human resources department can realign a company's meandering moral compass.

From the misplaced vision leading to Arthur Andersen's collapse in 2002 to the dubious stock sales by senior executives at EADS while the Airbus 380's delivery timetable was deteriorating, staff and management can and do, for better or worse, evaluate with clarity and precision the truthfulness quotient embodied in the messages being sent by their bosses.

If, instead of a fatal heart attack in the luxury of Aspen, Lay could have pulled off a modest but conveniently disabling illness, he might have finished his felonious career by cheating even his jailers. But despite Enron's reputation for coming up with uniquely creative deals, St. Peter at the Pearly Gates had the harsh message that at least one earthly futures contract can be neither hedged nor laid off to an undisclosed third party.

Despite Shakespeare's plangent reminder that "we owe God a death," the misery wrought by Lay's cupidity on my neighbors and thousands of others leaves my sympathies for him no deeper than my belief in his protestations of both innocence and piety.

Only when ethics training is properly framed by the principles of leaders consistently delivering both the walk and the talk, will all the expenditure on courses and software and fancy diplomas be justifiable. Of course, at that point, if the messages were credibly delivered as part of everyday business life, the extra spending would be redundant, unnecessary and more productively directed elsewhere.

Societe Generale -- Of Internal Controls and Risk Management

Published in the IHT on February 1, 2008 (here)

SocGen: When Risk Management Fell Asleep at the Switch

Since the first story is seldom the whole story, it will take time and police work to get to the bottom of the €4.82 billion euros in financial trading losses racked up by the French bank Société Générale in unwinding unauthorized positions taken by a trader, Jérôme Kerviel.

Will Kerviel emerge as an evil genius disguised as a 30-something slacker? The ring leader of a clever gang of financial scamsters? Or, more likely, an average-to-dull employee who exploited the weaknesses of his employer's systems and the credulity of his overseers?

The answer to the question "How did he do it?" appears routine enough. Kerviel's exploits seem not very different from those of the wrong-way traders who have popped up like mushrooms in the back offices of trading institutions from Barings to Sumitomo to Allied Irish Bank to Penn Square.

The scenario is almost always the same: An early burst of irregular but winning trades, motivated by bonus envy or simple testosterone, later spirals the wrong way - briefly matched by a daisy chain of falsified counterdeals and an accelerating but ultimately futile concealment of old losses covered by new ones.

The more demanding question - "How did he get away with it?" - will become answerable only through SocGen's accountability to investigators; to President Nicolas Sarkozy of France, who is not amused; and to its shareholders.

Outside auditors have been summoned. But since there is no forensic process so banal as the after-the-fact sweeping of the dust off the wrong-doer's trail, the interesting question they will likely not address is this: "Where were the curious, persistent and demanding managers ahead of the wreck?"

It's too early to tell, but enough is knowable to suggest that a relative of Inspector Clouseau was seconded to the risk management and compliance function of the hapless bank.

My first and best mentor in the scrutiny of financial fraud made a point of extending his inquiry beyond the immediate problem. Called to investigate an irregularity in one corporate corner, he would search for other possible outbreaks. Instead of assuming a system to be foolproof, he would speculate about ways to stress-test it for vulnerabilities.

He had a first principle: Any system of recording and reporting transactions is suspect. As a product of human design and operation, it is vulnerable not only to simple error but also to deliberate subversion.
In the SocGen situation there are some basic risk management tools, implicated by Kerviel's apparent mode of operating.

First is the vacation rule: Everyone who processes transactions should be taken off his desk at intervals, so that a chain of successive falsifications, if one exists, can be discovered and broken. This has been an article of faith since long before it became the centerpiece of a landmark 1976 U.S. Supreme Court decision in the Hochfelder case. That case dealt with the right to sue under the securities laws, but it started as a dispute over the application of a simple tool in internal control: the realization that an employee who never takes a vacation may be hiding something.

A low-level French employee who declines to take his vacation entitlement is already an extraordinary anomaly, enough that Kerviel's superiors should have gone on immediate and full alert. As Kerviel himself acknowledged to French police investigators, "It's one of the elementary rules of internal control. A trader who doesn't take any days off is a trader who doesn't want to leave his book to another."

A second risk management premise is that you don't net positions before quantifying risk. The exposure in a portfolio with €50 billion euros of puts and €49 billion of calls is emphatically not limited to €1 billion. At least since the Continental Vending case in the 1960s, where criminality was charged over the improper offset of accounts receivable against payables before setting a reserve, "netting" has been recognized as a recipe for concealed disaster.

Especially in a trading environment, combining the ostensible effects of "buys" and "sells" subverts the very essence of safeguarding against the possibility that one leg or the other might somehow go wrong - or even, as here, be falsified altogether.

A third is that back-office compliance cannot be only a little bit broken. Whether Kerviel was known to take irregular trading positions as far back as 2005, as he says, or only starting in 2006, as the investigator suggests, either one indicates a tolerance at SocGen for a back-office error rate greater than zero. But as the effect of financial leverage in Kerviel's dealings makes clear, there is no such thing as small or controlled leakage in a commodities operation.

Back-office compliance does not work to the same margin of error as, say, audited financial statements, which need only be stated fairly within the broadly judgmental range of "materiality" - or, in laymen's terms, "close enough." For systems capable of going awry to the tune of billions of euros, that level of tolerance for error cannot pass a credibility test.

Finally, and indicative of the SocGen attitude of mind, is the report that Kerviel talked his way out of an external alert by producing falsified documents by way of excuse. Once the red flag is raised, going to the target himself for an explanation suggests a box-ticking mentality that is out of place in a compliance function.

"Rogue trader" is probably too colorful an epithet for Kerviel. For the functionaries in SocGen's risk management, "asleep at the switch" probably doesn't go far enough.