Re:Balance -- Jim Peterson

Regulating Derivatives: After SEC vs. Goldman Sachs, Can You Keep Them Down on the Farm?

Whether and how to regulate the financial institutions’ creation and trading of exotic derivatives? Who should be enabled, or barred? Are there some so complex or toxic they should be banned? And critically – who thinks that Senator Dodd and his cohorts in the US Congress can sort it out?

I go back to the lessons on the farms of my youth.

It was an unvarying ritual: every evening, when the chores were done, my grandparents would convene to listen to the market reports, over the bakelite Philco that had pride of place on the kitchen table.   

It was especially important, when their feeder calves were ready for market, to have the daily cattle prices from the stockyards of Chicago and Omaha and Sioux City – because their timing had to strike a delicate balance. A driver and his truck had to be engaged. But commit to ship too early, and the animals would be under-prepared. Yet the risk of delay, for possible price moves, meant the possibility of being wrong, plus the dual impacts of extra feed costs and a loss of quality due to over-finishing.

By the time I was old enough to spell “cattle futures,” my astute grandfather was, through his commodities broker, hedging the on-the-hoof financial exposures that were out fattening in his feedlot – mitigating the random forces not only of market volatility but also pasturage and herd diseases and freight costs and all the malign hazards of a family farm.

What of his counter-parties? On the other side of his trades may have been Iowa Beef or McDonalds, or more likely a pure speculator – the zero-sum nature of derivatives trading made no difference to him.

The derivatives markets have known forever that at the end of the chain, some end user converts pork bellies to bacon and Brent crude to aviation fuel and even some of the gold into jewelry. But it doesn’t care. Grandpa’s fatted calves wound up as steaks and roasts and hamburgers, but trading regimes have never limited derivatives participation to packing houses and restaurant chains. Rather, a multitude of positions have evolved by way of options and futures, longs and shorts, insurance and hedges. 

And it’s equally true throughout the financial markets, where product innovation is one of capitalism’s articles of faith. Equity ownership in a single company begat the assembly of portfolios -- in turn democratized into managed mutual funds. From which it was no long step to the massively popular index funds, and thence to tradeable positions on the indices themselves.

Wagers of all varieties became available, on the movement of the S&P 500 or the FTSE 100, or sub-indices sliced and diced to the customized needs of the players big enough to ask. And the model is not only very far removed from actual ownership in the original underlying stocks – it bears considerable resemblance to the concoction by Goldman Sachs of a shortable product only distantly related to the houses temporarily occupied, before foreclosure, by the original subprime borrowers.  

Society has similarly concluded that the only requirement to sit at a gaming table is a stack of chips. The house will happily offer a chance to play, and to accept the money of the unsuccessful, without requiring proof of aptitude, or a working knowledge of the odds of filling an inside straight or bringing home an exotic roll of the dice.

Such dark pools of manipulated information as dog tracks and jai alai are allowed, for the entertainment of the tourists and the fleecing of the credulous. And local governments themselves peddle lottery tickets to the masses, against odds that would make a card shark blush.

In his hard-shell Methodism, Grandpa would never have set foot in a casino – he’d have scorned the frivolity and, more to the point, would have shunned an activity so far out of his capacity to comprehend and manage.

But allowed to live under his own principles, he’d have given taciturn tolerance to those engaged in legal if obtuse gambles.

Raised on the working end of a plowline and a pitchfork, and through a life driving a tractor and pitching bales of hay, Grandpa cultivated understatement and restraint -- along with an annual abundance of corn, beans and beef -- and never used two words when one sufficed.

His snort of derision would have been a wordless editorial -- “fool, to play a game you don’t understand.” But his own hard work and intelligent self-reliance would have respected the inevitability of creative innovation.

Rather than let a bunch of posturing politicians dictate or constrain his investment choices, he’d have let the markets decide which financial products proved their value, measured his risks, and taken his own advantage.

And so should we. 

 

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The SEC Strikes Goldman Sachs -- Now Will Goldman Strike Out?

As the great baseball umpire Bill Klem said, about whether a pitch was a ball or a strike:

“It ain’t nothin’ ‘til I call it.”

Which, as a lesson in political science, is being taken to heart by only some of those holding forth on the April 16 charges of fraud lodged by the Securities and Exchange Commission against Goldman Sachs and one of its employees (here), alleging misstatements and omissions in the structure and marketing of a synthetic collateralized debt obligation tied to residential mortgage-backed securities.

The SEC’s enforcement director, Robert Khuzami, dealt a high fastball -- avoiding complexity in packaging his advocacy for public soundbite-scaled consumption (here):

“The product was new and complex but the deception and conflicts are old and simple.”

Goldman itself played its defensive position the same way, but to different effect (here). Its terse one-liner fouled off the pitch: “We are disappointed that the SEC would bring this action related to a single transaction in the face of an extensive record which establishes that the accusations are unfounded in law and fact.”

Give Goldman points for a sense of reality, recognizing both that the judicial process will be unaffected by public posturing, and that the court of public opinion itself will not be in a mood for hand-wringing.

For it remains a mystery what inspires any claim to credibility by the typical spinners of over-played corporate protestations, when initial impassioned pleas of innocence give their inevitable way to plea bargains and outsized settlements to “put it all behind.” 

Meanwhile, the purple clouds of “I told you so” commentary from the bloggerati are as noxious as the volcanic spews from Iceland, and should only be dispersed as rapidly into inconsequence. 

Not least, the self-righteous are – as customary – conflating an initial law enforcement complaint with an adjudicated conclusion. Consider:

• ·      Much as public opinion had convicted O.J. Simpson of his wife’s murder, before his trial, the jury found otherwise – and he remained at large until the outbreak of his predictable recidivism.
• ·      It was financial and structural weakness that felled Arthur Andersen, not its indictment – remembering that procedural flaws in its conviction led to the Supreme Court’s reversal, but with no element of vindication or rehabilitation.
• ·      Even the now-jailed Bernie Madoff was presumed innocent (although charged) until the entry of his guilty plea, and entitled to bail and at least a measure of his liberty.

Respect for due process requires a measured recognition that the SEC case is at the top of the first inning – though there may well be further cases, additional claimants and private claims as well (see Kevin LaCroix’s always helpful D&O Diary). 

But Charlie Green also has it right, at Trust Matters. That is, if as Charlie suggests, the SEC’s case “resonates easily with Main Street as also being unethical,” and as corrosive to credibility, motives and trust, then the capital markets community will hold Goldman accountable for the state of its franchise in ways that the judicial process can never address.

A final constituency is yet to be heard from, about we should worry. Eight years ago, when the collapse of Enron was trailed by WorldCom, a stampeded Congress inflicted Sarbanes/Oxley and its massive demonstration of the law of unintended consequences.

Given its head, a legislature bent on retribution against the financial services sector is capable of twinning up the bankruptcy examiner’s report on Lehman Brothers (see here) with the SEC’s complaint against Goldman.

In which case, anxiety should run very high.

Because the result, in Bill Klem’s terms, will most likely be a wild pitch.

 

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The Valukas Report on Lehman Brothers: Sarbanes/Oxley's Credibility Takes a Dive

A host of hard questions lurk within all nine volumes and 2200 pages of the report by Lehman Brothers examiner Anton Valukas, released on March 11 (here) – which finds in its executive summary (here) that the company “painted a misleading picture of its financial condition.”

One of them, directed at anyone still harboring the belief that the Sarbanes/Oxley law of 2002 has had a beneficial effect on corporate governance and financial reporting: “Ready to change your mind?”

A lengthy list of potential defendants are teed up as targets for “colorable claims,” for actionable balance sheet manipulations using accounting techniques described in internal e-mails as having no substance, but serving only the purpose of reductions in Lehman’s balance sheet. 

Along with the apologists among the advocates of Sarbox’s efficacy, they will be heard to argue that its aspirations did not extend to the likes of Lehman’s financial machinations – a perspective begging this further question:

How can a regulatory program of the scope of Sarbox be justified, for the cost and complexity it inflicted on public companies and their gatekeepers -- most of whom would have been legitimately law-abiding even if left entirely alone -- while failing to identify, deter and capture the truly outstanding global-scale malefactors?

More simply put, if Sarbox didn’t have an impact on Dick Fuld and Lehman, what possible good has it wrought?

I’ve been in retreat this last week, reading the final papers of my MBA students in Risk Management – a bright and engaged group writing on recent case studies in the failures of risk modeling, assessment, comprehension and regulation.

Their examples cover the three years from the collapse of the Bear Stearns real estate funds, down to Toyota’s recent spiraling loss of both quality control and reputational stature. Even ahead of the Valukas report, it’s a target-rich environment, constantly replenished by the steady supply of newly-displayed examples of human venality, folly and frailty.

Among our course goals is the search for effective regulatory tools by which to shape improved policy-making and enforcement – a particularly challenging proposition, given the manifest inability of bureaucrats and elected officials to escape their inbred limitations of vision and effectiveness.

Depending on the importance of the issues at hand, how much enforcement should be imposed, and at what cost? 

Choices can be as coercive and heavy-handed as a polity will support and enforce. Taken to extremes, for example, teenage drunken driving could be eliminated: all that would be required is to raise the age of licensing to 25, and to impose automatic, non-negotiable twenty-year prison sentences on first-time violators.

Unthinkable, of course. Society is no more prepared for such draconian steps than it is to impose capital punishment on balance sheet manipulators or insider traders or even Ponzi schemers.

At the looser end of the enforcement spectrum, behavioral norms can be largely left to society’s level of tolerance for its own inconvenience. New Yorkers collectively agreed years ago, for example, that recreational marijuana was deemed to be de facto legitimate, thereby literally changing the atmosphere of Central Park. Likewise, no amount of patrolling will affect the dog-minding habits of Parisians, until they decide to alter the customs of a lifetime.

In the same way, the hindsight revelation of the Valukas report is that the inability of Sarbox to reach global-scale problems shows the futility of legislation so politically anodyne that it passed the US Senate by a vote of 96-0. 

The problem is one of closing the gap, between the level of deviance that society will stand and the amount of burden that it will pay for.

That is, a program of airport security will lack credibility, if so broadly applied as to deprive ordinary citizens of their ability to carry a bottle of wine or a tube of toothpaste, but that fails to identify terrorists whose deadly threat is limited only by their inept inability to detonate their shoes or their underwear.

Sarbanes/Oxley suffers the same defect: if it could not detect and deter an “outlier” on the scale of Lehman, then what beneficial effect can its proponents claim it has accomplished, by imposing an intrusive system of box-ticking on the vast bulk of corporate registrants?

As laid out in Richard Thaler and Cass Sunstein’s 2008 book, “Nudge,” which outlines such minimally-intrusive approaches as automatic enrolment options in voter registration, organ donation and retirement savings plans, the challenge to long-term incentives – whether in personal diets or corporate financial disclosure – is the compelling immediacy of short-term rewards. 

Which means it should be no surprise either that the rewards for the purveyors of subprime mortgages and exotic securities were dissociated from the risks of later implosion, or that compensation for executive leadership should be tied to measures based on the latest quarterly results.

Or, depressingly, that the time frame for political reaction to pressing public issues is no longer than the calendar for the next election.    

 

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The Risk of Crashing on a Slippery Slope: Bankers and Lugers on Parallel Tracks

A Risk Management class of bright, perceptive MBA students devoted their meeting this weekend to Olympic sports – scrutinizing the death on February 12 of Georgian luger Nodar Kumaritashvili, who lost control on the last curve of the world’s fastest track at the Whistler Sliding Centre and crashed into a steel pillar.

The students’ usual focus is on the manifold failures in risk identification, appreciation and evaluation over the last three years. They look to specify and learn from such displays of bias, error and miscomprehension as Jimmy Cayne’s loss of control of the real estate funds of Bear Stearns, the confession by Ramalinga Raju of a multi-billion dollar fiction in the accounts of Satyam Computer Services, and Akio Toyoda’s tone-deaf bungling of the world’s largest vehicle recalls.

What they found was a set of questions with compelling resonance for the financial crisis:

• ·      Was a fatal crash the result of an overly aggressive and under-trained youngster, turned loose in a competitive environment beyond his skills and capabilities?
•  ·      Was there a simple but overlooked design flaw in the structure – in Vancouver, an unpadded steel pillar squarely in the path where a loss of control would eject the 90 mph victim of a small but highly consequential mistake?
• ·      Or did the designers who pushed the limits of knowledge and technology compromise the need for safety to the desire for high-speed achievement, failing to recognize that traditional measures of safety were outmoded and insufficient?

Just like the world’s tightly-linked capital markets, the Whistler track is wonderfully designed for success. Its users describe it as challenging but thrilling – the demands are huge, as are the rewards.

But like any other advanced and sophisticated device designed and operated by humans – whether a space shuttle or a nuclear reactor or this decade’s leading-edge array of exotic financial instruments -- a luge track is subject to the non-zero possibility of catastrophic error.

Even the engineers of the most prosaic highways, who strive to improve both safety and overall speed, are mindful of speeders who will test their design limits. Where pressing the outside limits of speed and safety is the very goal of the participants – recall the Olympic motto: “Citius, Altius, Fortius” – it is hollow and unresponsive to the point of irresponsibility to claim that the track is "relatively safe" (here).

As elsewhere, average performers disappear into the obscurity of the crowd. Outliers achieve prominence in two ways, both beyond the boundaries of ordinary expectations:

At the Games, one athlete wears a gold medal and salutes his national anthem from the victor’s podium. But at the opposite tail of the performance curve, the one who crashes earns only a memorial wreath and a home-town funeral.

In the marketplace, where the gold-medal outlier may be Warren Buffett, the opposite tail is populated by the likes of Dick Fuld of Lehman, Fannie Mae’s Franklin Raines and Countrywide’s Angelo Mozillo.

There is one huge difference between the “failure study” of the Whistler designers – who promptly lowered the luge start, re-shaped the fatal curve and padded the unfortunately-located steel pole – and the finger-pointing scapegoaters of Washington and London and Brussels.

Namely, every failure in the engineering field is an opportunity for learning – even if belated. Thanks to the iceberg, the Titanic’s design was no long the model for generations of at-risk ocean liners. Nor, after 9/11, would high-rise towers ever copy the World Trade Center.

But in the politically-motivated bickering over the allocation of blame for the financial markets’ debacle, by contrast, there is not even a civil forum in which to ask the pertinent questions – much less make progress on a search for answers. 

Which, as I remind my Risk Management students, invokes the observation on learning of the 5^th century BC playwright Aristophanes:

Youth matures

Immaturity is outgrown

Ignorance is curable by education

Only stupidity is forever

 

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Measuring Corporate Stewardship by the Century -- A Lesson from the Oak Groves

"I know a bank where the wild thymes blow" --

    Oberon, Shakespeare's "Midsummer Night's Dream," II,i

A few words further (after these of November 10th and 17th), on corporate stewardship, and the ability to assess management's commitment to long-term sustainability.

The context is the measure of dysfunctionality in the dialog, with Lloyd Blankfein’s year-end bonus at Goldman Sachs expected to establish a compensation benchmark for the entire financial services sector.

Despite his vilification for both Goldman’s off-message diversion of $500 million to the aid of small businesses, and his own tone-deaf joke about “doing God’s work,” there is no other banking CEO being publicly fitted for a halo. And his company’s record is compelling, even though unless poor Blankfein suddenly develops the political savvy to foreswear all pay for this year, he is going to catch media hell no matter what take-home figure he tries to justify.

To take a long step back in history, consider the vision, commitment and behavior of the great canal-building companies of Victorian England.

These innovators not only joined with the newly-constructed railroads in making possible the Industrial Age, by achieving the first inland transport break-throughs in human history – re-writing the limits of bulk and speed that had been constrained by the capacity of an ox-cart and the pace of a horse and rider.

Knowing that the great oaken beams and timbers in the intricate gates of their lock systems would eventually require replacement, the canal developers had the foresight to plant groves of oak saplings around the huts of the lock-keepers – not for the shade and the aesthetics, but to assure a ready supply of mature trees when needed, many decades into the future.

That their legacy is now picturesque rather than practical owes only to the unforeseeable over-taking of technologies based on electricity, internal combustion, silicon and rocketry.

But sadly, it is no less unthinkable that their modern successors – the chief executives of the large airlines or trucking companies – or their counter-parts in banking, industry and professional services -- should invest and manage for their future based on such long-range planning.

Instead, there is a disconnection between managements’ incentives and long-term sustainability strategies -- as laid out by the guru of game theory, Bruce Buena de Mesquita, in his provocative and challenging new book, “The Predictioneer’s Game.” (For reviews, see the book's website. For the lite version, see his September 28 appearance on John Stewart’s Daily Show.)

His chilling example is the loss of vision of the Arthur Andersen leadership in the period leading up to the Enron debacle:

As he puts it -- under the grim caption, “Incentivizing Ignorance” (pages 116 et seq.) -- Andersen’s senior management “helped foster their own demise by not erecting a good monitoring system to protect their business from the misbehavior of their audit clients,” chiefly because ”Andersen’s most senior management genuinely did not seem to understand the risks they were taking.”

And why? Because as he puts it, “costly litigation … would not be settled until ten or so years after the initial prediction of risk.” But by that time “the engagement partner who brought in the business in his early to mid-fifties was retired and enjoying the benefits of his pension.”

Which creates the disconnection: by then, “the money for the defense was coming out of the pockets of future partners,” so “the financial incentive to know was weak indeed.” 

Recent years have shown the pervasively destructive influence of short-term incentives – from the exploding volumes of unsustainable subprime mortgages, to the proliferation of incomprehensibly risky financial instruments, to the current stripping of seasoned employees for the sake of expense reductions -- putting at risk the retention of expertise and capacity as the economic cycle turns.

It’s a sorry statement on leadership that Lloyd Blankfein is one of the few left standing, when so many short-visioned leaders have been shown unwilling to show the kind of commitment to maintenance and stewardship of the 19^th century canal builders.   

 

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Why the Bankers' Models Failed in Crisis: A GPS Program is Not the Same as Real Traffic

Lost, trapped and at risk of a serious crash.

That could very well describe the participants in the financial markets turmoil of the last two years. Instead it was my experience last Saturday afternoon – as an anxious and helpless rear-seat passenger during a frustrating hour fighting the exit traffic after a major college football game.

Autumn weekends in America are given over to exotic rituals. Cult-like herd behavior, irrational devotion to long-odds causes, microscopic analysis of esoteric game plans, prayerful invocations of last-minute rescues, and the frequently-literal intoxication of victory and defeat -- all the ways that bankers and investors behave during the routine work-week are migrated on Saturdays to tail-gate barbeques and stadium hoopla.  

Among a hundred thousand fans choking the bottle-necks of the parking lot, our driver was hopelessly conflicted. We were trying in futility to drive against the overwhelming flow toward the tollway. Normal daily street patterns were closed against us, and stern patrol officers blocked our turnings and waved off our intentions.

Trying at the same time to cope with the double distractions of his co-pilot working a cell phone and the urgently artificial voice of the dashboard GPS that insisted we should be taking forbidden routings, he also faced the threatening reality of aggressive crossing traffic at each frustrating intersection.

The recent banking and credit markets crisis was perfectly reflected in our dilemma: ordinary daily transaction flow was overwhelmed by an exceptional one-time event – an unruly horde in single-minded escape mode had nowhere to go – and an on-board warning system could not comprehend the disruptive effects of events beyond its programming.

The disconnection for the driver between the seductive directions of the GPS, to plunge into the systemic dysfunctionality of the streets, would perhaps have resembled the state of market unreality, going back to Jimmy Cayne’s dislocation as the presumptively risk-managed real estate funds of Bears Stearns spun into collapse.

Think of a traffic-guidance system as a risk management tool, in other words: it can start as an aide – but becomes a dependence -- and then an addiction. However luxurious the vehicle, it is a dangerous instrumentality when the driver’s ability to reckon direction has atrophied under commitment to a model that seizes up under stress.  

In short – as the data loaded in a GPS cannot imagine or replicate a post-game traffic jam, neither can a triple-A rating or a quantitative calculation of daily ValueAtRisk hope to capture the no-exit entrapment of an interlinked portfolio of subprime mortgage-based securities.

There are three further comparisons – one being the common and universal nature of the predicament. Equally pinned in the single-lane mess were the limousines of the VIP alumni, the high-end sports vans of the tail-gaters, and the boisterous bus-loads of drunken end-zone fans – all were as captive as Citi’s Chuck Prince and the feckless vision he imposed on the entire industry in July 2007, to keep dancing “as long the music is playing.”

Also, with every state trooper and traffic monitor devoted to prodding the crowd on its way out of town, the overload on law enforcement was evident. Marauding gangs could have been looting the Food King or emptying the town’s ATM’s – while the over-stressed constables echoed the SEC’s paralysis during the banks’ disintegrations or its curbside blinking at the predations of Bernie Madoff.

And finally: dispersion of the congestion was inevitable, and we eventually broke free. Accelerator down at last, our driver was excited: “Full speed at last,” he crowed.

“Yes,” said the still-befuddled navigator from behind his map. “Unfortunately, we have no idea which way we’re going.”

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A Scandal Erupts in Islamic Finance: The Algosaibi / Saad Dispute -- And is Anyone Surprised?

An exchange of lawsuits escalated late last month between Saudi Arabia’s Algosaibi family companies and the Saad group’s Maan al-Sanea.

Misappropriations rising to $10 billion are claimed, based on an alleged series of foreign exchange transactions in a workers’ remittance unit, by which riyal-for-dollars deals were rolled over and diverted through the use of forged documents and phony confirmations (here).

At the end of last week, a court in the Cayman Islands even presumed to order a worldwide asset freeze against al-Sanea (here) – an exercise of jurisprudential hubris worthy of the Grand Duchy of Fenwick in Peter Seller’s 1959 “Mouse That Roared.”

So another prediction promptly comes good: my call on June 8 – here – that “accounting scams pose risks to Sharia finance.”

From allegations in a New York court filing, the basics of my predictions are confirmed:

•    With lawsuits proliferating in the US and the UK, by bankers exposed on the debt securities of both sides of the Saudi feud, another multi-national financial scandal spreads across a borderless world of disputes.

•    The securities of both the Saad group and the Algosaibis – “sukuk” in the Sharia-compliant terminology – are trading at default levels, despite the demand for compliance with Islamic law, that repayment be assured by way of especially-designated collateral.

•    And so, as the spiritual basis for Islamic finance is overcome by the victims’ drive for secular accountability, the illusory pretense that “we’re different” and “it’s not done that way here” give way again, in the Gulf as it has elsewhere throughout history, when the veils of naïveté and denial are torn away.

One aspect yet to emerge from the Islamic dust-up is the finger-pointing at the gatekeepers. With aggressive advocates now driving claims that the string of unfulfilled financial commitments extended over four years, it is to be expected that the questions will be pursued: “Where were the lawyers?” and “Where were the auditors?”

Which will make for ominous times among the professionals.

The July 11 criminal conviction of Chicago lawyer Joseph Collins, for his role in the transactions by which now-jailed Refco chief Philip Bennett fleeced his shareholders and investors, puts a darkened color to the on-going civil litigation exposure of both lawyers Mayer Brown and accountants Grant Thornton.

And it appears that David Friehling, held out as Bernie Madoff’s long-time auditor, is in negotiations for a criminal plea deal – although in context of the 150-year sentence dealt out to Madoff himself, a deal would seem unlikely unless it spares Friehling the greater part of the maximum 105 years he faces.

For an informative if unsurprisingly defensive apologia for Mr. Collins, from a fellow lawyer, see here.

The Collins conviction may signal a new era of exposure for the bar, considering that their brethren among the accountants have been unsuccessful for years in selling the “pure heart – empty head” defense. The lawyers have long relied on their client privilege and a jealousy-guarded “duty of advocacy” behind which to manufacture and supply the tools of felonious monkey business. But if the duties and accountability of the two professions are seeming to converge, as the Friehling negotiations and the Collins verdict would suggest, the lawyers’ pain will be palpable.

Meanwhile -- from Refco to Madoff to Saad/Algosaibi, commodities options to Ponzi-style fictions to Sharia-based forex -- the repetitive pattern of window-dressed accounts that serve to conceal the predations of the principals -- facilitated or over-looked by those chargeable with detection and prevention oversight – continues to roll around the globe.

And only one thing is knowable for certain: the latest Saudi mis-adventure – immediate proof that Islamic finance is no more virtuous or scandal-proof than its Western equivalents – will not be the last.

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The Old Is New Again, Part II -- Accounting Scams Pose Risks to Sharia Finance

When a felon's not engaged in his employment
Or maturing his felonious little plans
His capacity for innocent enjoyment
Is just as great as any honest man's.

 -- Gilbert & Sullivan, “Pirates of Penzance”

When I wrote recently of the likely recurrence of old-fashioned accounting scams – here – based on non-existent assets and fictitious transactions, I promised to put up my own candidate as the sector ripe for eruption.

It’s this: the already huge and rapidly growing market for financial products and services based on Islamic law – Sharia – which is closing in on $1 trillion in size, targeted at Muslim customers comprising one-fifth of the world’s population, and predicted to expand at ten to twenty percent a year (here, here).

It can be safely predicted that market pressures, competitive greed and misaligned incentives will breed scandals in Sharia-based finance – going well beyond the large if simple issues of non-performance already seen in the suspension of debt payments by Kuwait’s Investment Dar as majority holder in carmaker Aston Martin, and the missed debt payments and cross-defaults of Global Investment House (here and here).

Why? And how, if they can be predicted, can they be prevented?

There are two drivers: the prospect that the bursting of the “shadow banking” bubble will bring a general global return to more traditional asset-based financing structures, and the certain cycles of re-emergent white-collar rascality.  

Koranic principles prevent the charging of interest or the assumption of undue risk. Sharia-based financiers are therefore inhibited in using derivatives or other hedging contracts, short selling, insurance in the Western sense or other risk-mitigating techniques.

Instead their financings involve the sharing of risks and rewards – exemplified by “sukuks” -- structured offerings of asset-based securities, with the “buyer” entitled to a “rent” based on a participation in underlying tangible property, and “murabahas” – financing commitments involving a “profit rate” rather than an interest payment.

Well enough, so far: boards of Islamic scholars vet and approve each transaction for compliance with Sharia principles as applicable, country-by-county. But what the resulting imprimatur – the “fatwa” -- does not do is extend to either up-front due diligence or on-going audit work to assure the fundamental bona fides of the transaction.

And right there lies the hazard. Islamic finance is a fermenting laboratory experiment for the cultivation of schemes and irregularities: a sector big enough to attract new and eager players, out-sized growth potential, modest size and limited talent and experience among the current participants, and cultural incentives to grow in competition against foreign non-believers.

History should teach that the incentives to gain or hold market share, or to stretch the level of transaction risk for the sake of enhanced volume and returns, open the door to irregular behavior on the part of individuals acting under stress -- no less for a Sharia-based sukuk than for a real estate investment trust or a field of oil wells.

One certainty is that the recurrence of financial frauds is no respecter of either piety or theology. The ecumenical scope of exploitive scandals ranges from the 1982 discovery of Roberto Calvi – “God’s Banker” – hanging dead under Blackfriars Bridge in London even as his Banco Ambrosiano suffered multi-billion lire holes in its balance sheet – to the disgraced fall of Christian evangelists Jim and Tammy Bakker – to Bernard Madoff’s looting the community of his Jewish friends and golf partners. 

And the pressures are only amplified where a sector is going through dramatic and rapid growth, with a stretching of experience and resources, increased transaction costs in lieu of interest-based revenue, and the ever-present temptation to minimize the red flags of risk in favor of the satisfaction of aggressive targets.

And so – Sharia transactions involving profit participations based on shared interests in presumably real assets raise exposures of the old-fashioned variety, namely the “sales” of assets that are inflated or fictitious – with variations on the shell-game devices used throughout history to evade due diligence and to fool the auditors.

Among the incisive comments on my last piece on likely audit threats were these:

•    One reader had the anxiety-raising concern that a gremlin may yet emerge in the securitized residential mortgage market, beyond the issues of bad credit and poor collateral – a portfolio of entirely fictitious houses or borrowers. The accuracy of his concern was promptly confirmed not only by the SEC’s broad charges of mortgage-related fraud against the Countrywide team led by CEO Angelo Mozilo (here), but by criminal charges over a New York scheme based on unbuilt buildings, fictional addresses and bogus appraisals (here).

•    And another, a regulator, had the reminder that beyond all the weaknesses in audit sampling, lies the ever-present threat of “shadow” control structures, designed and run for the pure purpose of evasion and manipulation.

Regulators, gate-keepers and systems of justice in Western traditions have been caught unprepared and flat-footed, all too often. Whether their counterparts in the emerging Sharia environment can somehow do better – despite an absence of history, tradition or experience – remains to be proved.

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Spreading the Wealth: Manure Exchanges as a Model for Fertilizing the Green Shoots

To have a real chance at saving the banks, the policy wonks need to get out of town a little more – beyond the urban cinch of the Washington Beltway or the City of London.

If they would shed their bankers’ grey suits and cordovans for a weekend in rubber boots and overalls, they’d learn that to nourish the “green shoots” of economic recovery – optimistically foreseen in mid-March by Federal Reserve Chairman Ben Bernanke – they need to spread some fertilizer around.

Even as potential buyers of toxic financial assets are balking at committing their funds, and bankers themselves are reluctant to sell troubled assets into the rescue programs, models for success are in place all over America -- literally at the grass roots.

These are the Manure Exchange programs – sponsored by soil and water conservation districts around the US, from Virginia and Illinois and Wisconsin down to Texas and up to Washington and Oregon.

Their mission, to quote this example from the Pacific Northwest, is to “bring gardeners searching for free organic fertilizer in contact with livestock owners that have excess composted manure.”

Just as the toxic asset programs aspire at the national level to scrub the ordure from the balance sheets of the troubled banks, the barn-cleansing function of the Manure Exchanges is to “remove the composted manure from farms that do not have the acreage to adequately utilize its nutrients.”

Symmetrically, toxic asset investors who seek opportunities to acquire troubled assets at attractive prices resemble the “gardeners and landowners searching for sources of local, free, organic fertilizer.”

And while classical literature does not reveal whether Hercules had the appropriate waste-disposal permits when he hosed out the stables of King Augeas, the Manure Exchanges achieve a two-fold sustainability dividend, by “enhancing the natural environment while protecting … cultural, social and economic values.”

No fees are charged under the Manure Exchange programs, thus aligning financial incentives in ways the banking industry could well study. And administration is simplicity itself: farmers who “wish to share their manure” – how delicately put is that – need only sign up with details of times and places for available pick-up.

Just as subprime mortgage portfolios were sliced by type, the rural raw material is divided out by degree of ripeness – fresh or composted – and categorized by livestock of origin – horse, pig, goat or llama.

Here lies a business opportunity for the rating agencies: Moody's or S&P could, by employing the agricultural expertise of a local Four-H student or Future Farmer, learn to divide and rate the piles into separately graded tranches.

Arbitrage opportunities also abound – a vegetable gardener’s need for cattle waste being tradable against a farmer’s excess of chicken droppings.

In the rural programs’ composting guidance -- which prescribes turning and aeration to convert raw excrement to richly nutrient gardening material, bucolically praised as “evenly textured and crumbly like soil” -- there even lies a solution to the financial markets’ inability to solve its asset valuation and recording issues.

That is, just as with a portfolio of distressed mortgage securities, Mark-to-Manure accounting would clearly require the write-down of a wagonful of untreated horse poop. But with time, patience, and diligent wielding of a pitchfork, those willing to hold their noses and tend the heap to maturity will stay the course and realize the benefits of Marking-to-Compost.

There is one serious disclosure issue with the Manure Exchanges, although it pales in comparison to the black-box opacity of the now-failed markets for exotic financial derivatives – namely, the explicit warning that without conducting tests “to determine weed seed viability,” the output should be assumed simply to be “raw organic material.”

Oh, would that Bear or Lehman or Merrill had been so candid: “If it looks like sh*t and smells like sh*t, buyers should assume it is sh*t.”

Foot-dragging bankers, holding back from participation in the “yes, we can” spirit of the White House’s new occupant, should take inspiration from the exuberance of the program in Jackson County, Oregon: where else could a composted pile of horse manure be re-packaged as “a great way for gardeners and landscapers to find black gold!”  

There is an obvious program title: the Community Recovery Asset Plan.

It’s a stirring patriotic call. President Obama should don a baseball cap in eco-friendly John Deere green, enlist Al Gore and Barney Frank, and march arm-in-arm to the offices of Treasury Secretary Geithner and Fed Chairman Bernanke, to demand:

“Hey, pull on your boots and gloves. Get out there and start shoveling.”

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Once and Future Accounting Schemes -- What Will They Think Up Next?

       

"Everything old is new again ...."
                -- Peter Allen

To pull off the next large accounting scam – or, more virtuously, to try to prevent it – where would we look?

This always-pertinent question has global dimensions, with criminal charges now lodged against two Price Waterhouse partners in India – see here – for their alleged complicity in the fraud perpetrated at Satyam Computer Services Ltd. under the leadership of CEO Ramalinga Raju.

Those inclined to heed memory and history as guides for the future will find familiar the recited bad deeds by which the Satyam accused are now answerable to the Indian courts:

• Bogus invoices for customer work never performed lay at the heart of the mid-‘80’s house of cards known as ZZZZ Best.
• Inflated rolls of non-existent employees echo the ledgers of fictitious insureds a decade earlier at Los Angeles-based Equity Funding.
• Shadow businesses and opaque investments recall the undrillable pools of petroleum, said to lie deep under the Canadian Arctic, sold as snake oil in the 1960’s by Bernie Cornfeld in the original version of Fund of Funds.

In a world of borderless impacts, and with the certainty that details of the Satyam criminal file will now implicate the defensibility of the investor lawsuits lodged in the United States as well as in India, it’s well to ask what new risks lie over the next hill.

Especially since, as similarly structured schemes have kept recurring with dreary regularity, decade after decade, the learning capacity of the financial gate-keepers is slight enough in fighting the last war, let alone to anticipate or prevent the next.

A starting point will be the predictable re-emergence of another rogue trader – almost routinely expected if still highly impactful – the next generation’s reincarnation of Nick Leeson at Barings or Yasuo Hamanaka at Sumitomo or Jerôme Kerviel at Société Générale.

But it’s also back to basics, in a world said to be reverting to older styles of banking and finance. In the recent era of exotic financial derivatives and black-box valuation models, the pervasive separation of deal-doing incentives from underlying transaction risks prove illusory and ultimately disastrous. Looking ahead, it can be anticipated that the next generation of white-collar schemers will unsheathe the simpler tools that have served so effectively throughout the past to entice the investors and evade the auditors.

Old memories may still spark, for example, to recall the 1960’s tanks full of “vegetable oil” in the meadows of New Jersey: collateral for the negotiable warehouse receipts issued by American Express, but actually nothing but water – a scheme that succeeded because the auditors looked from the top of the tanks at the thin layer of oil on the surface, rather than taking taps from the bottom.

Or the herds of ghost cattle, sold in fractional interests to urban investors: the livestock numbers were inflated by repeatedly cycling the same calves through the counting chutes – under the noses of the city-based audit staff who failed to prevent double-counting by the simple control of a chalk-stick mark on the forehead of each animal as it passed by.

Or the heavy-duty oil-field trucks comprising salable equipment portfolios: sensibly counted as they were scheduled through their repair and maintenance depots -- except that each one slipped past the auditors multiple times by the simple expedient of driving behind the repair shed to swap the identifying bar code on its engine block.

Or – to tie off a list that could otherwise go on a while – the allocation to investors of interests in a giant hill of Latin American coffee beans: except that under a thin layer of the real thing, the mound consisted of sand and bales of hay – undetected by the auditors too fastidious or pressed for time to drill or dig deeply enough to the core to get a legitimate sample.

All real stories – none of them all that original. But any of them will likely show up again soon, as timeless devices used to inflate the performance of money-gathering institutions basing their business on asset-based transactions.

Let the gate-keepers be warned – and the future perpetrators too. But only if the lessons of the past are learnable.     

Drop me a note if you have a candidate for an industry or a practice having special exposure. As a teaser -- I will soon take a specific look at a particular sector where I would see this aspect of risk to be both newly emergent and especially acute.

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Bankers Under Stress -- A Colloquium Questing for Relief

A graduate student in anthropology, able to have joined my field trip of last week, would have been handed an honors dissertation topic on a platter.

For two days I was with an exotic tribe – about a hundred senior-level bankers and their governmental regulators, assembled together to perform rituals and incantations in search of illumination and enlightenment about their system’s risky and uncertain future.

The proceedings were as defined as a liturgy, in obeisance to the god of regulated capitalism. Deep within the imposing temple of our region’s Federal Reserve Bank, the devout convened in an amphitheater, all arrayed in careful and attentive rows. Dressed in the prescribed vestments – uniform grey suits and sober neckties – we gathered to receive the wisdom of the high priests and seers, as they posed at the central lectern and delivered their Gospels according to PowerPoint.

Margaret Mead among the Samoans would have felt no less an outside observer. I have not been around that much cult-like behavior or arcane and exotic jargon since my last trip to South Bend, Indiana for a Notre Dame football game.

There on autumn Saturdays, they assemble reverentially in the sacred oval arena, face the Golden Dome, ingest the ritual brew, and raise their voices to shake down the thunder from the skies.

No less, the congregation of bankers were invoking Saint Ben and Saint Tim, seeking deliverance from the last two years of darkness and agony, through the magical efficacy of TARP and TARF, successful entrail-reading of the “stress tests,” and exorcism of the bedevilings known as Basel II and Mark-to-Market.

On full display were the same tensions and stress that have beleaguered minor sects throughout history, from the Huguenots and the Pilgrims to the Mormons and the Moonies. A highly-placed risk officer at one of the truly solid institutions, spotlessly innocent herself of any role in the global carnage, bemoaned her baseless demonization by friends and neighbors as a “greedy banker.”

And there was no little sense of persecution and paranoia in the manifest wish for relief from the daily howling of the uninformed critics at CNBC and the other media, whose intrusive drum-beating may well be serving only to distract and inflame an uneasy populace.

The concern is likely justified. The taxi driver who had delivered me to the meeting recognized the address. “Since you’re not a banker,” he said, “tell them that the businesses in my neighborhood are dying. They’ve got to start lending again.”

The legendary J.P. Morgan is cited for the story that it was time to become seriously worried about the markets when he was offered stock tips by his shoeshine boy. A cabbie is likewise an unlikely strategist on financial rescue plans. So the likelihood of populist street sentiment contributing to success in the current environment must be slight indeed.

Still – dim in the memory of an undergraduate lecture hall, I recall learning of the “cargo cults.” Isolated Micronesian peoples responded to the god-like appearance of airplanes dropping blessings from the skies, by re-creating avatars out of bamboo and thatch, donning head-sets carved from coconuts, and lighting bonfires to guide the expected parachutes. With these rituals they would pray for the continued benevolent intercession of the gleaming new deities -- with, it must be conceded, a conspicuous lack of results.

In today’s troubled context, the degree of resemblance is ominous. We who are non-initiate observers can do little but hope for the best. 

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