Re:Balance -- Jim Peterson

Coincidence, Causation and Apple's Stock Price: Further Lessons from the UBS Dress Code

My MBA students in Risk Management study closely the hazards of conflating coincidence and causation – at best mis-leading, and at worst, acutely dangerous.

But sometimes it’s so delicious, we could only wish it so.

Last Monday, with a focus on the never-ending debate over international accounting standards based on general principles or detailed rules, I made sport of the 43-page employee dress code published in December by Swiss bank UBS (here), believing that professional guidance based on the former is definitely preferred.

And the very next day – mirabile dictu – UBS stood down (here), with a sheepish retreat to “what is important” – evidently still, the modest requirement to dress in the bank’s official colors of black, white and red (here).

This was not the grand capitulation to public opinion shown by The Gap, when it hastily withdrew its misbegotten new logo last October (here). But it makes the important point that normative behavior can be modified by non-coercive societal influence – rather than under the heavier hands of legislatures or law enforcement.

I dare not claim a causal relationship between my digs at UBS and its hasty retrenchment – no more, for that matter, did my criticism of PwC’s loopy new logo (here) stimulate a re-think on its part.

A far better case for the caution not to over-weigh coincidence lay in last week’s storm of activity around the stock price of Apple Inc. On consecutive days, January 17 and 18, CEO Steve Jobs announced an indeterminate medical leave, and the company released estimate-smashing results for 2010 – revenues up 71% and net income up 78%.

The pundits’ cacophony went in all directions, following Apple’s closing the prior Friday at an all-time high of 348. Monday’s US market holiday gave a whole extra day for the uncertainty-mongers to stir the pot.

As they did. The ride began with Tuesday’s early trading down at 326, driving back up to close the day at 340 – if only temporarily. Punters in options saw short-dated 320 puts that had closed Friday at 54 cents explode briefly to $ 5, while those betting on a quick recovery could “buy the dip.”

Then during the week, while the major indices were basically flat, both those positions were trashed; Apple peaked back above 348 on Wednesday, doing for any skittish bears, and then slumped to close at 326 on Friday the 21^st, doing the same to itchy-fingered optimists. 

It took the week for events to shake out. Apple’s roller coaster fell out of the technology news, supplanted by the board shake-up at HP (here) and Google co-founder Larry Page’s emergence to sole leadership out of the triumvirate with Sergey Brin and Eric Schmidt (here).

On Monday the 24^th the stock was back to 337, and as things stand on Tuesday it has cheerily closed above 341, looking again at its pre-tumult high.

From the perspective of long-term Apple investors (a group to which I belong, by the way), viewing a price chart over a year or even a month, the price moves over the week are an inconsequential hiccup. But to those caught in a flurry of zero-sum trades, there were real effects.

How would they have divined the reasons and the lessons?

Just as primitive peoples lit bonfires and beseeched the gods of the solstices to return the sun, mistakenly believing themselves both responsible and successful, athletes maintain their winning streaks through locker-room rituals and lucky amulets. Investors too invoke their models and their charts as if to be convinced that their decisions are guided by design and intelligence rather than the randomness of fortune.

Both those shorting Apple on Jobs’s health news and those who bought the company’s future in the narrow trough are congratulating themselves on their insightfulness and perspicacity. While those taking the opposite (and losing) positions – in both directions – are equally wringing their hands that some undetectable malign external forces – surely not their own fault – conspired to sabotage their investment strategies.

All of which goes to confirm yet again, that a hubristic over-confidence unable to differentiate skill from random luck is a dangerous substitute for the humility to appreciate that the market, like life itself, is too complex to be predictable.

Still, it would be nice if someone from UBS would call up and say, “thank you.”

 

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Accounting Standards: Rules or Principles? Lessons From the UBS Dress Code

Goldman Sachs has snatched from its US clients the windfall chance to front-run Facebook's IPO, by limiting access to the potential of its $1.5 billion special-purpose fund to foreigners -- while professing no influence from the fuss-budgets at the SEC (here). So it seems a good time to ask:

Should regulatory compliance and accounting standards be expressed as detailed codes of precisely-drawn rules? Or as broadly-articulated principles?

There are lessons to be taken from the 43-page dress code issued by Swiss bank UBS in December (here).

The debate needs help: endless, pointless and fruitless, it feeds the conclusion that much-touted but never progressed “convergence” between international accounting standards and country-level codes in Europe, the UK and the US is as distant, elusive and unlikely as ever.

Popular reaction is that only a Swiss mentality could perpetrate the obsession at UBS, with its meticulous prescriptions on suit fabrics, cosmetic colors, collar points and hair care both facial and cranial.

Although, a dress code did appear late in my own corporate life – no less ridiculous but also raising non-trivial dissonant issues about the boundaries and effectiveness of guidance.

I was the senior member and titular head of a team based in Paris – an expatriate American amongst colleagues from the major European countries. To a man and woman, all were immensely talented and hard-working. They were also urbane, stylish and beautifully attired.

Global headquarters in the US published its requirements for the new “business casual.” It was only six single-spaced pages, compared to the fulsome 43 pages of UBS – but who’d have expected better from the sartorially challenged Americans?

It went into gruesome detail on necklines and sleeve styles and degrees of elasticity; it proscribed denim and gym gear and athletic branding; and it forbade flip-flops and open toes and footwear of any aerobic provenance.

On a given day, probably one-third of our Paris team would have been out of compliance. But, making their own individual decisions about skirt lengths, or pantyhose in July, or whether to match an Armani T-shirt with a differently-branded suit, my young charges were always impeccably turned out and appropriate for client premises and boardrooms anywhere.

For the purpose, they were capable of proper judgments under the lightest of guidance. At our annual group party our solicitor from Edinburgh was elegant in his formal tartan kilt, dirk and sporn – but for court he was always in proper dark grey suit. On warm spring days the length of limb on display among our lanky cadre of legal assistants was a substantial percentage of their average 1.8 meters – but they all donned decorous trouser suits when the visiting firemen arrived from America.

Which has what to do with the challenge of setting international accounting standards? The answer starts with the extent of mutual trust and confidence shared by a community seeking for mutually-acceptable guidance and limits.

Our Europeans rightly expressed derision and ridicule for the US code, just as most of the world feels for the pathetic efforts of UBS, because of our expectations for what was important: discipline, dedication and execution of first-quality work. Under broad principles of professionalism and good taste, their public face was virtually one of self-regulation.

Whereas if constrained by punctilious trivialities, they would have wasted both their morale and my goodwill, along with countless hours of productive time, on manipulation of the rules in rebellious search for boundaries and exceptions.

It’s no different with financial reporting standards and regulations. History teaches that bright-line limits are pushed to excess by the creative and the aggressive: the depreciation lives of mainframe computers in the 1970’s, the elastic retained ownership requirements for special-purpose entities exploited by Enron in the 1990’s, the investor limits skirted by Facebook under the counsel of Goldman Sachs.

It is the human condition that some deviance from codes of behavior is inevitable – society decides the amount, by voting its willingness to allocate resources to law enforcement and sanctions.

The range across cultures can be vast – from the de facto legalization of recreational drugs in urban America at one end, to the use of flogging in Singapore to punish the consumption of fast food on the public streets.

At the extreme, drunken driving among teen-agers could be eliminated: raise the driving age to 25 and impose capital punishment on first offenders. No less, accounting manipulations could be wiped out – by outlawing commercial transactions in more than one currency or that fail to settle for cash within 48 hours.

But the compromises required of society would never go so far. Instead, the certainty of occasional lapses and excesses is accepted. Limits are broadly defined, and enforcement mechanisms are calibrated -- for both better andworse -- in both the capital market’s use of financial information and the fashion decisions of a business office.

Judged by my experience in the latter, a global environment is far more seemly and operates with more success without the heavy hand of excess regulation.

That will soon be learned, I wager, in the halls of UBS. Whether the new leaders of the Financial Accounting Standards Board and the International Accounting Standards Board will agree is a matter of greater doubt.

 

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The Audit Model Is Broken -- "Re:Balance" Has Its Third Birthday -- And The Message Hasn't Changed

And lo, it came to pass in the dark time of winter, that there was a grand convergence. All the scribes did their scribbling, and the soothsayers said their sooths, and the stars came into alignment. There was loud wailing, and an anguished chorus sang in unison, and a great outcry was heard in the land:

“The model is broken.”

All the major voices of concern over the unsustainable state of the financial reporting and audit model sang the same year-end theme.

For the academics, Dave Albrecht was most terse (December 15):

“The audit model is broken.  Everybody knows it. … Therefore, financial reporting is broken.”

The best critic of the dysfunction in reporting standards, Tom Selling, said (November 9):

“none of the (proffered) solutions fix the root causes of the problems with the auditing profession…. the sad irony is that nobody is as happy as they could be with the current state of affairs.”

Expect to hear from a plaintiffs’ lawyer? Jake Zamansky obliged (January 5) with a shout-out for Andrew Cuomo’s suit against Ernst & Young over the repo accounting at Lehman Brothers:

“Lehman Bros’ actions, and Ernst & Young turning a blind eye to them, stink to high heaven. … As the financial and subprime crisis unfolded, where were the auditors who were the “gatekeepers” charged with protecting shareholders?”

Francine McKenna could be counted on – re-cycling a prior piece (also January 5):

“I’ve said throughout the subprime crisis that morphed into the financial crisis that fraud played a role and the auditors were, at least, negligent and potentially complicit in that fraud."

On the UK side of the Atlantic, both Ian Fraser (December 21) and Richard Murphy the next day resurrected the 2008 interview in which Charlie Munger likened the state of accounting to a “sewer” and asserted that:

“a majority of the horrors we face would not have happened if the accounting profession were organized properly.”

And the ever-opinionated Dennis Howlett rang in (on the solstice itself):

“Francine, myself and others have for years been saying that audit is broken….(O)ne thing that any self respecting professional must look at and wonder. What the hell is going on with our profession?”

So what’s to make of this convergent outbursting? First, the chorus may be louder, but the lyrics are not new.

“Re:Balance” celebrates its third birthday this month – with my thanks and appreciation to all those who do me the privilege of their interest and involvement. From its earliest days, the message has been consistent; in its first month (here), I took up a reader’s question: “How much of this sub-prime thing is related to the accounting?”

As I put the answer then, and still today:

“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.”

But attention goes back much further, to this blog’s antecedent, my column in the International Herald Tribune in Paris – where in April 2002, in my second piece,* I warned that, “what has been absent is a debate on how much longer the audit function, as it has been known for 150 years, can survive in its present form:”

“Companies will push the ‘rules’ of accounting beyond the edge. And unless the corporate audit changes in nature and in value, the Big Four auditing firms – down from the Big Eight in the last dozen years – will read their own obituaries well before another dozen.”

This is where Charlie Munger and those who focus their spleen only on the auditors go astray, and do real harm to the potential for constructive debate.

Munger has his history wrong, despite being closer than all of us to the Victorian-era birth of the audit function. Independent audit – voluntarily created by company owners -- was not born to bear a “public duty,” but acquired that appliqué in the decades after it saw off government take-over in England in the 1860’s and America in the 1930’s.

As a consequence, he gives an inappropriate pass to the central parties – the issuers and other players who really like the system as it is.  Which is understandable, because Munger as wheel-man for the legendary Warren Buffett is, unlike the average investor or shareholder, a member of that very circle who give no respect or regard to audited financial statements, precisely because of their ability to both grasp and exploit the inadequacies and obsolescence inherent in today’s model.

It’s as if – using Munger’s “sewer” analogy – blame for an antiquated and overflowing drainage system were inflicted not on the engineers and designers responsible for its shortcomings, or the politicians who refuse support for the renewal of the public works, but on the subterranean workers in boots and gloves, struggling in futility to shovel against a tide of dark and filthy muck.

As I put it three years ago:

“In the end, … 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.”   

 

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* No available reference, I am sorry to say. The New York Times as sole owner of the IHT has managed not only to suck both the soul and the circulation out of that once-vibrant resource that served the overseas Anglo community so long and well, but also to consign its web archive to the same closed and inaccessible limbo to which the newspapers themselves are rapidly headed.

 

Holiday Gifts in Bernie Madoff's Bankruptcy: A Widow Does Her Bit -- and the Banks Will Too

 Holiday gifts arrived early in December for the circle of players around the wreckage that was Bernie Madoff. There are several lessons.

First, the widow of Madoff’s ur-client Jeffrey Picower redefined the landscape of civil forfeitures by agreeing with Madoff trustee Irving Picard to turn over an astonishing $7.2 billion – said to be her late husband’s entire take from a 35-year relationship (here).

Second, Picard himself dumped sacks of coal and lawsuits into the stockings of the Madoff enablers – notably including Unicredit, JPMorgan Chase, UBS and HSBC – charging them with notice of Madoff’s irregularities even while profiting from their proximity as custodians, administrators and managers of the monies fed to him by investors (the FT’s December series is well summarized here).

The former is of interest at least as a matter of social behavior and norm-setting. The latter will have reverberations with effect on the relationships between banks and other intermediaries and their own gate-keepers, including their auditors.

Barbara Picower faced this dilemma: She could have spent the rest of her own life defending against Picard’s suit, fighting uphill to protest the conduct and virtue of her spouse – who, charitably accepting her own claim of innocent ignorance of Madoff’s scheming, confronted the plainly demonstrable character evidence of his propensity to cheat at golf (a favorite post with readers from March 2009 is here).

Or – presumably able to live in adequate comfort on her bequest from Jeffrey of $ 200 million, and thus dramatically re-calculating the magnitude of a “widow’s mite” – she could launder her own status with a dramatic gesture of civility and largesse.

Secular sainthood is seldom so available – and with nary a hungry day either.

The noblesse of the widow Picower has made life less pleasant for Madoff’s other A-list clients. Those like Picower, close enough to finger the tattered edges of his moral fabric, are now forced to choose. They can oppose Picard’s claims to claw back their ill-gotten returns, under the shadow of the widow’s precedential capitulation. Or they can join the settlement queue – although not cushioned by the generous inheritance she enjoys, and to be seen only as belated converts, never to enjoy the halo effect she obtained as first-mover.

Depending on his trawl through Madoff’s client list, Picard is now working on a shortfall of some $10 billion. Of that, it says here that he will extract on the order of $ 1 billion from HSBC alone – precisely on account of the roadmap to its liability provided by the due-diligence engagements performed for the bank by KPMG in 2005 and 2007 and roundly ignored. It’s a plaintiff’s dream and an evidentiary nightmare for the bank that, prediction suggests, HSBC will pay handsomely to keep far away from a trial.

There’s more here, though: The KPMG engagements are a roadmap not only to what was done for its client, but to what could have been done for the other enablers targeted by Picard. Therein will lie a tale for the courts – and another set of eight or nine-figure contributions eventually to reach Picard’s collection basket.

But now for the broader questions: What if HSBC had taken KPMG’s work to heart. Or the other banks and feeder funds had engaged credible due diligence by their advisers on accounting, auditing and controls? Madoff’s pyramid would have been toppled before it reached pedestrian levels.

Suppose by extension, while we are at it, that Lehman Brothers had asked E&Y for a critical study of the exposures lurking in its use of repo derivatives to window-dress its balance sheet? And actually acted on it?

Or that Daniel Bouton at Société Générale had re-deployed a portion of his bank’s costs of external audit to give actionable scrutiny to the corrupted back-office operation that was so expensively exploited by rogue trader Jérôme Kerviel?

Or that AIG had given credence to a state-of-thinking study of the non-correlated nature of the inter-connected structure of the global CDO market?

Instead of the risk management possibilities of available but unavailed sources of wisdom, these institutions continued to subscribe to the one-page, bog-standard commoditized reports that regulators require from auditors – to be ignored in good times, because they convey no value regarding non-problematic operations, and useless for the detection and prevention of catastrophic events in bad. 

It’s a closed and obsolete system as bankrupt as Bernie Madoff himself. In the entire cast of characters, Barbara Picower emerges so far as the best of the whole sorry lot.

 

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