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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Racing to Avoid a Crash: On the Track -- On the Street

There’s a stack of final papers in my Risk Management course – and an apero on the sunny terrace of the neighborhood café, to ease the grading process.

And a fond wish for one more class session, to dissect last weekend’s lesson in the disastrous consequences of bad risk assessment and choice-making under high-stress competitive conditions.

It happened at Sunday’s Indianapolis 500. Rookie driver JR Hildebrand had a comfortable lead going into the final lap. But instead of riding easily to victory, he attempted a high pass of a slower car on the very last corner, crashed into the wall, and slid his wreck to a second-place finish – passed by the doubtless astounded Dan Wheldon, on whom Hildebrand’s error of judgment and the fickle gods of fate bestowed a gift beyond imagination.

Aggressive, brave or foolish – the high cost of immature enthusiasm under “win or crash” analysis is not rare. Recall the Olympic gold medal that snowboarder Lindsey Jacobellis threw away on her final run at Turin in 2006, with her ill-advised showboating stunt attempt on the last bump.

My class of MBA and Finance students focuses on lessons from highly-consequential decisions, especially in failure situations – drawn from many fields into the worlds of commerce and professional services, where most will eventually work, and where senior leaders charged with risk responsibility have performed so poorly over the last four years.

From Hildebrand’s split-second choice – now part of racing lore and a life-long mark on his career record, they would take at least these two:

First, the skills and energy of the young are to be recognized and respected; a new hot-shot does command attention and can achieve greatness, whether in sport or government or a trading room. But as events at Indy showed, the converse is no less valid. Beginner’s luck is no substitute for seasoned strategy, and those surviving to accumulate the scars of experience bring wisdom that tempers rash choices.

Provided Hildebrand does learn his risk/reward lesson, in other words, he is not likely to repeat it.

Therein lies learning for business and financial disciplines, still struggling past the recent crisis. The tragically short time horizon of the designers of exotic derivatives, and the exclusion from the quants’ risk models of events beyond their recollection, created the conditions for the crushing impact of events erroneously thought to be unforeseeable.

The second lesson from Hildebrand’s choice-making looks at the structure of his decision matrix: a binary choice -- “try to pass” or “lay off” -- but with alternative and different benefits and detriments for each.

The consequences of playing safe and cautious were in his favor: there was no downside, as he was at no risk of being overtaken, and to cruise safely meant a checkered flag.

In choosing to charge the corner, on the other hand, he had negligible upside – he was already holding a dominant lead – while, as events proved, the downside of being unsuccessful was catastrophic.

(Take note, of course, that the calculation could alter dramatically – if, for one case, he was trailing and needed a last-minute pass to advance, or if he was tightly shadowed and at risk of losing his lead.)

The metaphor extends, readily enough:

Should an investment manager double down on a losing strategy, which unless reversed will bankrupt his fund? Or should the size of his positions be controlled along the way, so that no single exposure could threaten his entire firm’s survival?

Should an entrepreneur put all his capital at risk to start a new venture? To a retiree in reasonable comfort, the upside is limited, but the hazard of a failed and penurious old age is real; while to a new graduate with a long view, fortune favors seizing the greatest number of jackpot opportunities.

The under-appreciated risk-assessment obligation, all of this should suggest, lies in deliberate attention, usually overlooked, to the alternative choice: the action foregone, the rejected Plan B, the road not taken, the decision not to charge ahead.

To a rookie Indy driver with his hair on fire and his foot to the floor, this would all seem abstract, bloodless and pedantic. But it should feel otherwise to a risk officer whose strategic control over a floor of stoked-up traders is his bank’s best hope for survival through the next bubble.

Because my students are more likely, post-graduation, to steer companies and to run portfolios, than to drive turbocharged racing cars, the sorry case of JR Hildebrand’s impetuous mis-chance will keep a place in my curriculum.

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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.

 

Disintegration of the Big Four Audit Firms? As They Tell the House of Lords, "We Don't See That on the Horizon"

The epitaph for the private delivery of audit services to the world’s large global companies was written in London on November 23.

During its generally amiable ninety-minute stumbling around the topic of auditor concentration – available here and observed on here and here -- the House of Lords Economic Affairs Committee queried the invited heads of the Big Four, “You do share the general unease about the fact that it could be Four coming down to Three?”

For the quartet’s response, the senior partner of Deloitte’s UK firm, John Connolly, contributed this entry to the lexicon of the self-deluded: “I don’t see that on the horizon at all.”

Which will go down next to the grim valedictory of Citigroup’s Chuck Prince in July 2007, that “as long as the music is playing . . .we’re still dancing,” only months before his forced departure, or – closer to home – PCAOB chairman William McDonough’s concession in September 2005 that among the regulators, “None of us has a clue what to do if one of the Big Four failed.”

Although memorable language would not be expected from a “numbers guy,” Mr. Connolly’s invocation of an empty horizon has real resonance.

Military comparisons are inevitable – and instructive. General Custer did not foresee danger from the invisible Indians. The American forces at Pearl Harbor were heedless of the approaching Japanese. And to Hitler, the beaches of Normandy were both well-defended and bare of Allied threat.

While in this decade’s uniquely impactful if unforeseen event, nineteen Saudi thugs with box cutters in their backpacks begat a world-wide season of terror, destruction and disruption, the effects of which have altered history.

As with these examples, and the grievous lessons that emerge only in the hindsight of the short-sighted, Mr. Connolly’s handicap is the limit on his vision – because a clear view of a blank horizon is of little value if the surveyed circumference extends no farther than arm’s-length.

I am indebted to my friend Shyam Sunder at the Yale School of Management for the Sanskrit folk tale of koopa mandooka – the “frog in the well”, which lives in blinkered comfort so long as confined within the boundaries of his closed little world.

But should he venture forth, the perils of the world outside are unknown. It may indeed be a paradise, full of succulent insects and comfortable lily pads and luscious companions with which the frog can disport and sire entire populations of little tadpoles.

Or, it may be a hell of deadly predators – voracious snakes and hawks and sharp-toothed fish. Or a searing desert beyond the fringes of the oasis, where a clueless frog will be pan-seared in minutes.

Unless informed and prepared, the frog in the well has no way to differentiate a prosperous future from one of mortal danger.

And the consequences of his ignorance are just as fatal as those of being wrong.

Here’s what the Big Four leaders might have said, in answer to the Lords’ call:

“We not only share your unease. We are terrified for the survival of our firms – not so much for our generation, who if fortunate may hope to ease soon into retirement, but for the future of a profession that depends for its sustainability on the talent and commitment of our younger personnel.

“Our ability to provide valuable assurance remains important to the capital markets. But it must evolve beyond the binary choice, whether or not to pronounce “true and fair” -- a choice exposed in the banking crisis by our delivery of unqualified audit reports on soon-to-fail institutions as not only unresponsive but affirmatively dangerous.

“Yet we are shackled to obsolete reporting by regulatory requirements confining us to an unhelpful commodity product. What is needed is no less than a fundamental re-structuring, under which:

• “Supplanting the current report form which no longer serves a useful purpose, we could tailor our reports to the real needs of particular users.

• “Our ability to deploy a full range of services would include access to the expertise of non-audit personnel to achieve more sophisticated performance and improved quality.

• “The interests of investors would be reasonably supported by government oversight, enforcement and protection such that our reporting would not create liability exposure of a magnitude that would destroy us.”

They might have said that. But they didn’t. For want of a vision extending to that far but visible horizon, a golden opportunity was allowed to pass. 

 

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The House of Lords Looks at the Role of Auditors: And Then Everyone Went for Tea

 Here’s a good way to increase the chances for satisfaction: start with very low expectations.

That was my approach, anyway, in dialing up the broadcast by Parliament TV of the House of Lords Economic Affairs Committee session of November 23, billed as a look at concentration in the audit market and the role of the auditors in the financial crisis -- here.

As a soporific, it was a decent substitute for televised football as a way to sleep off the after-effects of the Thanksgiving feast – watching the heads of the Big Four practices in the UK bat away slow-pitch questions that ranged from the naïve and misinformed to the incomprehensible.

Plainly, the intractable challenges to the viability of the large-company audit model are at no risk of being solved at the hands of the British legislators, whose depth of inquiry ran the gamut of complexity from A to B.

Examples:

• “Are you happy” with the degree of market concentration? Well, what’s not to like -- although it can hardly be admitted, when the Big Four control the entire large-company audit market with no prospect of competition.

• What about a threat to withdraw from the audit market? Oh, not us, your lordships – audit is at the very core of what we do!

• If that’s so, “are you uneasy” that the large firms would go from four to three?

• With a straight face, “we don’t see that on the horizon.” Of course not – while at the same time conceding that although the events of the credit crisis were “unprecedented,” there are “lessons to be learnt” for everyone.

Sometimes the unthinkable does happen – as the events of the last three years have made clear. So where was their lordships’ follow-up question: 

What would you do – what would any of us do – if despite your intentions, one of the firms incurred what was described with wonderful British euphemism as an “Andersen moment”?

And for this, there was no suggestion of an answer from either side of the tables. 

In the middle third of the proceedings, their nobilities were able to become better informed, if not wiser, as their invited guests gave a concise run-down of the irrelevance to audit concentration of a list of unachievable ideas -- namely:

• Break-up of the Big Four would add nothing to global-scale competition, since – against the breadth required because 80% of the revenue of FTSE 100 companies is generated outside the UK -- the resulting fragments would lack scale, coverage and investment capability.

• The current restriction on scope of services to audit clients – where last year no FTSE 100 company paid consulting fees to its auditor – is claimed to be working well: an assertion which, considering the unsolved nature of the survivability threat, means that if the current environment represents success, what would failure look like?

• The arguments for joint audits or mandatory rotation founder on the examples of degraded quality – the likes of Parmalat in Italy and BCCI in the UK itself.

• And the howler of the day: if audit is “implicitly a form of insurance,” why does that industry not ride to the rescue? – a proposition so discredited that even the committee chair hastened onward.

The hearing wound down to a clearly rehearsed and well-choreographed five pm break for tea, but not without an “Alice in Wonderland” go-round on the question of the auditors’ issuance of unqualified opinions in the months before the failures of such British institutions as Royal Bank of Scotland, HBOS and Northern Rock.

At the assertion that the auditors actually “performed well” in light of the complex events of 2007 and 2008, adjectives such as “astonishing” and “misleading” were tossed around both in the hearing and amongst subsequent commentators – here.

But why should anyone be surprised?

The pointed observation by one of the Big Four that the auditor does not assess the risk of a business, but renders a report in identical language, whether the leverage of the enterprise is 100 times or none at all – starkly contrasted with a plea from the questioners that an assessment of the “dangers" in a business is precisely, if simplistically, the assurance sought by a wishful user community.

In that context, the fact that the technical reporting requirements were satisfied, to avoid a going-concern qualification – if only through closed-door communications with the Bank of England and the Financial Services Authority – finally exposes the raw insufficiency of the current audit model.

As was equally the case in the 1980’s when the American auditors trailed the emerging catastrophe among the savings-and-loans, the profession lacks satisfactory tools when the regulatory regimes put them to the choice -- whether to qualify their opinions and generate a self-fulfilling prophecy of disaster, or to rationalize a demonstration of the emptiness of the report that constitutes their core product.     

If that much could be taken as established once for all, before everyone went off for tea, then unlike the case with most such posturing displays, the day was not a complete waste.

 

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Goldman's Settlement with the SEC, and the Fragile Future of the Fabulous Fab

Even in the depths of summer, the settlement agreed last month by Goldman Sachs to resolve the charges of the US Securities and Exchange Commission relating to “Abacus,” the toxic subprime mortgage-based derivative, attracted howls of antagonism.  

A reader here called it “total joke” and “a blatant PR splash by the SEC.” Among the bloggers, plaintiffs’ lawyer Jake Zamansky addressed his constituency in high dudgeon, about “letting Goldman off the hook” for “a measly $ 550 million without admitting any wrongdoing”(here). Andrew Ross Sorkin in the New York Times focused on Citigroup’s own $ 75 million SEC settlement (here), but included Goldman’s deal in pointing out that corporate fines come ultimately out of the pockets of shareholders of the offender, not the responsible senior executives.

There’s certainly no need to plead for Goldman. It deftly submitted to an early-stage punishment it could readily afford to bear, from a government agency apparently lacking the stomach for a protracted battle and therefore signaling significant anxiety about its case on the merits.

There are limited options for punishing a corporation – money fines, behavioral monitoring, or the ultimate loss of its right to exist. As only the abstract, legislatively chartered sum of its corporeal parts – directors, managers, employees, shareholders and customers – a corporation is an existential construct that cannot be imprisoned, flogged or otherwise subjected to more personal sanctions.

So for starters, no responsible authority has suggested that the financial sector either in the US or globally would be better off if Goldman had been punished to the point of extinction.

Instead, times have changed. Arthur Andersen disintegrated in 2002 under the Justice Department’s Enron-related indictment – the avoidable and unnecessary result of a series of tragic-comic tactical blunders on both sides. Since then, federal prosecutors in America have treated the financial services sector with the delicacy of Oscar Wilde’s maxim that “a gentleman never hurts anyone’s feelings – unintentionally.”

Consider by contrast the future fate of Fabrice Tourre – the Goldman wheelman on the Abacus deal, who having missed the settlement bus, is now left for road kill.

Did he seek to participate along with the company’s settlement, only to be left as the sole remaining defendant? My calls to his lawyer elicited no response. And the SEC itself never comments on pending litigation. But as reported on August 9, the SEC staff did disclose to the federal court in New York that “very preliminary” settlement talks with Tourre had occurred (here).

It would be inverted logic for the agency to claim a notch on its battle-axe for the $550 million result against the company, yet to view Tourre as such a significant player that it would refuse to negotiate with him. He is simply too small a minnow in the Goldman pool, compared to the big fish the SEC did not even charge, starting with chief executive Lloyd Blankfein and president Gary Cohen.

On the other hand, if Tourre was at the settlement party but could not find the exit under virtually any penalty that left him at liberty, either he or his counsel deserves a whack. Tourre faces a long haul of pre-trial depositions and document production, costly in both funds and emotion. Even with Goldman footing the financial bill, the grind on an individual opposing the forces of government is eventually crushing to the spirit.

Callow and over-stated enthusiasm for his defense position would be no great surprise, but a defendant’s stubborn pride that he was an innocent under venal superiors is a commodity whose value depreciates with the extended duration of a prosecution.

That is, Tourre is a dead man in the industry no matter what. There is now a record against him that includes Goldman’s concession of “mistakes” – although not liability or culpability. Tourre will therefore lose his motions for early extinction of the charges.

So any later settlement window will only open just before a trial, when the SEC will have its engines humming and when an outcome must be worse than anything Tourre could have negotiated at an earlier stage.

Outsiders’ criticisms should only be offered with great care. But it says here that Tourre’s spanking by the SEC is inevitable – so the sooner he bends over, the better.

 

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Lessons in Risk Management: A Hierarchy of Learning from Ignorance

The seemingly indestructible baseball legend Satchel Paige asked, “How old would you be, if you didn’t know your age?” *

I’ve worked during this summer vacation to review and refresh the syllabus of my MBA-level course in risk management and decision-making, where the related question is, “How smart can you be, if you don’t know your own ignorance?”

At its core, the course seeks to identify potentials for success, from the lessons of failure. Recent weeks have provided an abundance of “teaching moments”:

• Tony Hayward’s long-postponed but inevitable defenestration as CEO of BP – another demonstration that public perception of a tone-deaf executive’s culpability will prevail – incidentally inflicting major collateral harm to what had been an advancing discussion on the benefits of splitting the roles of corporate chairman and chief executive.
• By contrast, Goldman Sach’s achievement of a speedy and affordable settlement of the SEC’s suit over a toxic subprime mortgage-based derivative product, for the relative pittance of $550 million. Love or despise the “vampire squid” – Goldman will survive and thrive in no little part for its ability to maintain both calm and quiet under pressure, keeping beneath the flame-throwing and appreciating the benefit of avoiding additional fueling of the short-lived news cycle.
  
• The release by WikiLeaks of a massive volume of raw documentation from the Afghanistan war. The trove will be well-combed by future historians, but even on a superficial reading of the official manipulations, naïveté and mendacity, the fundamental lessons remain unlearned -- from China, Algeria, Viet Nam and Afghanistan itself -- that short of annihilation, no level of mighty foreign military technology will prevail in a house-to-house conflict against forces able to blend seamlessly into a village-level local population.

Thinking with students about these scenarios, with special concern for the availability of awareness and action in time to actually affect an outcome – that is, before the inflection point at which a threat tips over to become a disaster – there emerges a kind of hierarchy of learning opportunities. Consider: 

• As the last of the helpless dinosaur population dwindled around the tar pits, while tiny furry mammals disported at their feet, the combination of climate change and evolution reduced their survival chances to zero.
• Innocent species lacking defensive measures were equally doomed – including those wiped out by humans, from carrier pigeons to the great whales.
  
• Human societies also innocent in their ignorance have doomed their viability – whether the Easter Islander destroying their only timber sources to replace their great canoes, or the Greenland settlers unwilling to adopt the diets and hunting techniques of the natives (see Jared Diamond’s “Collapse,” 2005).
• Further up the ladder of chargeable responsibility is the blinkered denial built into herd behavior – no better exemplified than by the last-gasp claim of Citigroup’s Chuck Prince in the summer of 2007, that, “As long as the music is playing, you’ve got to get up and dance.”
  
• And finally – or at least to stop just short of conduct warranting indictment – there is the evidently deliberate and self-interested exploitation of the credulous, wrought by Goldman and its now-isolated foot soldier, Fabrice Tourre, in designing a financial derivative with characteristics maximizing its likelihood of failure.

As I would like my students to learn from such an array, in daily life no less than in the classroom, the ability to avoid the next problem is measured by the capacity to take heed from the last. 

*My review last May of Larry Tye's delightful biography of Paige is here. 

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Goldman Sachs and the Fabulous Future of Fabrice Tourre

Is there a future at Goldman Sachs for Fabrice Tourre? The self-styled “fabulous Fab” was the only individual clipped as co-defendant in the suit by the Securities and Exchange Commission over Goldman’s late 2006 flogging of the exotic financial derivative Abacus, a credit default obligation based on a portfolio of toxic subprime mortgages.

Tourre is now safe-housed in London -- Goldman having evidently taken the strategic decision to keep their erstwhile wonder-boy clasped in close embrace for the duration of its legal exposures. 

For which, by contrast, compare the unpleasant consequential exposures for Société Générale, whose rogue ex-trader Jérôme Kerviel’s just published tell-all, “L’Engrenage, Mémoire d’un Trader”, re-ignites the early 2008 agony of his multi-billion euro infliction; or Arthur Andersen’s ready disavowal and jettison of Enron engagement partner David Duncan, before its own flame-out in 2002.

It would be inductively flawed for Tourre to assume continued enjoyment of his employer’s long-term hospitality. Thanksgiving turkeys, fattening in luxury through the autumn, learn to their dismay of the radical adjustment in their life-style when the farmer’s late-November strategy brings down the axe. Equally, Tourre’s useful life at Goldman is tied entirely to the resolution of its concerns with law enforcement.

So, being well-advised, he should expect to become chum for the sharks either as part of a settlement or directly thereafter.

Unless of course he can prove his present value by re-programming the energy with which he hawked the Abacus product to Goldman’s ready market of credulous believers. 

And how? The British bookmakers have already captured the odds-making on the survival prospects of the Tory/Lib Dem coalition. This year’s action on the NCAA basketball tournament is over. And the consequences of BP’s blown well in the Gulf of Mexico are priced into existing petroleum futures.

Other exotic alternatives? Given the volatility of emerging information about the organized church, arising from Chile to Germany, what about “clerical futures,” tied to the predicted tenure and turn-over of a portfolio of Catholic bishops, or the likelihood of Episcopal schism based on gay ordinations?

Or perhaps a wager on the total first-year sales volume of Apple’s iPad – directly tied to the roll-out of the device itself rather than the prosaic proxy of AAPL’s stock price?

Or here: our cultures now encourage wagers on the duration of life itself, through life insurance, viatical settlements and reverse mortgages -- and pre-nuptial agreements are increasingly used to manage the business side of romantic associations. Do the investment bankers’ innovators not see an unexploited niche market for financial products tied to the durability of marital contracts?

A full range of investment opportunities should be available. A customized wager on the likelihood of the neighbors’ break-up would require frequent re-pricing, depending on the level of loud arguments and broken crockery. By contrast, standardized trades could be tied to the five-year intervals celebrated in the etiquette books – call them “anniversary futures,” denominated wood, tin, pearl, silver, and golden, and priced accordingly.

The records of the domestic courts would also make historical data available to underpin trading opportunities in “marriage pools” -- say, by parish or profession or income level -- with divisions into tranches and risk ratings differentially assigned and priced. 

Consider the risk-disclosure language in the offering documents: triple-AAA ratings for the likely fidelity of a group of unadventurous stay-at-home actuaries – or junk-level assessment for the ten-year prospects of wander-lustful professional golfers or soccer players or elected officials.

These ideas might generate a certain reticence among portions of the investor community. Betting against the probity of the local clergy might infringe some sensitivities. Hard-core adherents to the sanctity of life-long vows might be uncomfortable taking bear positions. But no more so than the occasional unease with the role of short-sellers in the equities markets – recalling that nobody actually forced Goldman’s clients to buy those doubtful-looking CDO’s.

A host of small details would remain to be worked through – whether insider status would extend to clergy or divorce lawyers, for example.

But these are small concerns, and “the Fab” has time on his hands. 

Unless, being smarter than a turkey, he is already busy trading the over/under on his departure date.

 

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How Dangerous is the Two-Billion Dollar Suit Against PwC Over Iceland's Glitnir Bank? The Answer is Blowin' in the Wind

Especially for PricewaterhouseCoopers, the bad news out of Iceland just won’t let up.

First it was the October 2008 collapse of the country’s entire banking system – including its three largest banks – and the departure of their former leaders for congenial places of refuge.

 Then it was the volcano with the unpronounceable name, closing airports world-wide in a demonstration that it is not nice to disregard the forces of nature.

 And on Wednesday came the announcement of a two-billion-dollar lawsuit, brought in New York by the winding-up board of Reykjavik-based Glitnir against its former chairman, chief executive and other leadership, lead investor Jon Asgeir Johannesson, and its auditors PwC -- here.

 It’s an updated reprise of the hitchhikers’ bumper sticker from the 1970’s: “Cash, ash or crash – nobody rides for free.”

 (Okay, for those who don’t remember the original – here.)

 Although asset-freezing orders were apparently issued out of the High Court in London affecting Johannesson’s real estate holdings, those among the individual defendants presently outside the reach of the American or Icelandic legal systems poured scorn on the proceedings – here.

 Bombastic posturing from sheltered jurisdictions will cut no ice with the litigation process in America, however, and PwC itself issued the predictably bland statement (here) about standing by its opinions.

 Well it should, because the days are over when litigation arising out of the non-English countries could be disregarded as trivial, disrespected as the works of immature jurisdictions where outcomes were negotiable against a backdrop of mutual accommodation and inconsequential impacts.

 Instead, PwC faces a real lawsuit (for the complaint, here), in a real court – Manhattan’s New York Supreme – brought on behalf of the bank’s creditors and advised by Steptoe & Johnson and Slaughter & May – real lawyers who know their billions from their millions. Nor, any more than any of the other Big Four accounting firms, does PwC have the resources to absorb a ten-figure litigation blow (here). 

 So the proceeding is mightily more serious for PwC than a few days of flight delays. The Glitnir proceedings show yet again that the world of life-threatening auditor litigation has become as borderless as the skies of global air travel.

 Blowing smoke is not going to make this one go away.   

 

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The Future of Goldman Sachs: Sound, Fury, and the Human Appetite for Risk

 

If correctly read, the thermometer on the temperature of the body politic suggests that the public fever of the last weeks on the SEC’s charges against Goldman Sachs has broken.

A reader expressed her cooled reaction to Goldman’s design of an exotic, tradable mortgage-based product on which the shorts and longs were symmetrically affected: “Why not – after all, that’s what they do!”

It’s not just Warren Buffett's avuncular cheerleading at the Berkshire Hathaway shareholders’ meeting in Omaha, however directly interested, or the related embrace of the mainstream media (for both, see the NYT’s Andrew Ross Sorkin on May 3, here).

More, the brevity of public attention proves again Samuel Johnson’s 18^th century observation that “nothing focuses the mind like a hanging” – whether the present dependent subject is the British Parliament, BP’s oil containment efforts or the Greek noose around the neck of the Euro.

As it moves off-screen, Goldman’s future does not depend on the usually attenuated inter-connections between Main Street and Wall Street. It will lie, rather, in the hands of law enforcement officers, whose reputation enhancement will incline them to nick off a pound of flesh or two and move on to resolution; legislators ready to take up other posturings; and, especially, clients and trading partners whose self-interest will be well served by Goldman’s robust survival.

Which, the more I ponder, is as it must be.

Populist outrage at the business model behind Goldman’s esoteric designs always lack emotional coherence – the unease of those uninformed and unfamiliar with the operation of complex financial products showing again that a little information can be worse than none at all.

As the behavioral academics say, it’s very much to do with how the issues are framed.

For one example: conventional reaction would likely be negative in response to an opinion poll, “Would you support wagering on the length of a human life?”

Yet that is the entire basis for the life insurance industry, which – no less than Goldman’s Abacus product – is in the long run (costs, time value and enterprise profits included) a zero-sum proposition. Large pools of underwriters’ capital wager on the uncertain but ultimate timing of the inevitable mortality of those on whom the bets are made.

And a broad range of legitimately insurable interests are required – it only being frowned upon to allow, for example, the sole care-giver of a fragile elder to take a large policy for his own benefit.

Likewise, while the disconnect between aspirations and responsibilities played no small part in the foundational irrationality of the credit crisis, ownership of a family home has been widely promoted as a virtue. Meanwhile, despite the faint odor of disrepute not unlike that sometimes attached emotionally to short sellers in the equities markets, a niche market for reverse mortgages develops, by which the home equity of aged owners is bought out under pricing based on lifetime occupancy and actuarial expectancy tables.

Even at the personal level, the comparison has always been striking between motorcycle riders in America – who dutifully keep to their lanes although exercising a libertarian right to ride bare-headed – and those in France, for whom helmet compliance is inviolate but so is the chance to careen around traffic and down the dividers.

All of which shows that variations in risk appetites are pervasive, ranging from the ubiquity of casinos and lotteries to the cultural variations in personal safety judgments to the stream of innovations in mitigation techniques – whether product safety devices or hedging derivatives.

So while the particulars of Goldman’s innovations would, and will, outstrip the comprehension of its outsiders – beyond the atavistic spasms of short-term insult at the sheer amounts of money involved – its fundamental instincts are no different from those broadly inherent in the animating principles of human society in general.

In other words, they are part of us.

 

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Valuing Goldman's Next Sh*tty Deal: How About a Little Wager?

  The race is not to the swift, nor the battle to the strong.

-- Ecclesiastes 9:11

But that’s the way to bet it.

--Damon Runyon

 A reader has just asked how, under a cascade of falling knives, Goldman Sachs might shelter itself?

 Media coverage of last Thursday’s Senate hearings tip-toed around the use by Subcommittee on Investigations Chairman Carl Levin (D.-Mich.) of the internal nomenclature of the “sh*tty deals,” like pedestrians in sandals on my dog-infested Paris street.

 The odor of the entire sordid proceedings was unrelieved by the insistence of more punctilious editors on asterisks and euphemisms, nor was the dignity of America’s upper legislative chamber improved.

 Goldman confronts a quartet of threats, of which only the latter two will be serious:

•  The Senate’s orgy of finger-pointing is now old news, supplanted by the BP oil spill, the Times Square car bomb and the British elections.
•  The eventual financial services legislation to emerge from the Congress will be pernicious and misguided, but no less survivable by Goldman than by any other banks.
•  The SEC’s suit over the subprime-mortgage-backed product designed and sold at the behest of hedge fund manager John Paulson, and the potentially broader and more crippling criminal investigation by Justice, will resolve in due course.
•  And, ultimately, there will be a franchise value effect of the verdict to be rendered by the court of public opinion.   

 In reaction to the reader’s query, Goldman might well re-deploy the energy and creativity of its SEC co-defendant, the young hot-shot Fabrice Tourre. The self-styled “fabulous Fab” is now evidently side-lined in its London office – under the classically sound tactical decision to keep him on board rather than throw him overboard into the waiting jaws of the sharks of law enforcement.

 That is, Tourre as a pitchfork veteran around the Goldman sh*t-pile should see the threats to Goldman’s franchise value as both a challenge to new product development and an opportunity to generate both revenue and rehabilitation.

 Namely:

 The street already sponsors talk of a settlement between Goldman and the SEC, which will affect the company’s now-depressed stock price. But why would a simple office pool on the outcome be the only bet? Rather than pursue the mundane approach of speculation in either GS itself or its vanilla options, a creative derivatives engineer would build a whole suite of investment products tied to the timing and cost of the resolution.

 The simplest tradable derivative would be on the straight-dollar over/under of the SEC settlement – the likelihood of a litigated defense victory being as much an unimaginable outlier as, say, the industry’s prior assessment of the collapse of LTCM, Bear Stearns or Lehman Brothers.

 Those interested in handicapping the competing litigation capabilities of the SEC and Goldman’s counsel could test their assessments in the marketplace. Also, Goldman is said to be facing potential legal expenses of up to $100 million – certainly enough to set up a special fund whose performance would be tied to the cubic volume of the court filings.

 Those believing that Goldman is Satan reincarnate rather than the Lord’s messenger could take faith-based bear positions on the outcome, while those cynics who profess skepticism that politics underlie the SEC’s case would do the opposite.

 As for the more threatening criminal proceedings, opportunities arise to speculate on the stability of Goldman’s reputational capital. With the Fab’s proven ability to spin gold out of subprime sh*t, it would be child’s play to devise a “reputational index” that could be traded long or short – perhaps tied to the firm’s movement in league tables or deal flow.

 Subsidiary products could handicap the odds on the most likely individual candidates to be thrown under the litigation bus -- including (probably in inverse order) CEO Lloyd Blankfein, COO Gary Cohn, CFO David Viniar, and the soon-to-be dispensable Mr. Tourre himself.

 What is critical for Goldman, of course, is to capture for itself not only the hedging opportunities but also the vigorish on all this activity, rather than leave anything at the table for the competition.

 Having the inside track on the timing of litigation developments, costs and strategies would seem to require scrupulous care not to be seen as arbitraging its privileged position or trading under conflicting interests. But if its claim to sponsor’s neutrality in the original CDO deal is given credence, Goldman should have nothing to worry about.

 

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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 SEC's New Rule 201 on Short Sales: Taking a Bear Position on Over-Regulation

(Paris, France) – Second thoughts on first impressions: a revisiting of my early disdain (here) for amended Rule 201 of the U.S. Securities and Exchange Commission – a new restriction on short selling that imposes an “uptick rule” – a circuit breaker that would be triggered by a one-day stock price drop of ten percent or more.

The reflective mood may itself have been triggered by my vernal equinox relocation to this European base, for the spring and summer – with possible impact on my publication schedule, but also a refreshed exposure to perspectives on this side of the Atlantic.

(At this point, it would be obligatory for mainstream media to pause for a white-bread definition of short selling and a summary of the SEC’s rule. Happily in an evolved environment, all that is needed is this link to the SEC’s release of February 24, which in turn leads to Chairman Mary Schapiro’s speech, and the supporting staff paper – to all of which the curious are referred for details.)

I have observed the debate on short sales restrictions to be binary and polarizing – that, as with handgun control or gay marriage or abortion rights, coherent but non-negotiable views reside at the ends of the spectrum, with compromising positions difficult to articulate inside the black-or-white extremes.

Events over the last two years leave me less sure. On the one hand, it’s hard to generate much sympathy for the special pleading of John Mack of Morgan Stanley, or of Lehman’s Dick Fuld before its September 2008 collapse – especially with the recent release of the Proustian-length exposition by bankruptcy examiner Anton Valukas (here). 

Nor, in pursuit of honest symmetry, is there any popular sentiment for reining in the pernicious speculative effects of upside exuberance. Imagine the vitriol that would be poured on a regulatory rule imposing a “downtick rule” before buying a stock experiencing a daily uplift of ten percent.     

And yet, even the ursaphobic are deserving of respect – some days, the bear really does eat you.

Which leads to the hard and subtle question: how much regulation is the right amount?

And there, I suggest, the SEC’s “10% price drop” is a filter with much too large a mesh.

As its staff paper spells out, on an average day from 2001 to 2009, a 10% trigger would have hit some 4% of covered securities – and nailed some 1.3% even during an interim period of supposed low volatility.

For a sympathetic but skeptical observer, government interference at the two-sigma level is just way too much. 

Not least, the administrative burdens on both market participants and the regulatory agencies themselves will be enormous, yet with no more than SEC's repeated say-so on the benefits to broad-based legitimate activity, while consuming energy and resources better deployed to the real problem cases.

Many examples demonstrate that where a sector’s violations emerge from a very small part of the population, enforcement efforts that are imposed universally achieve only massive waste and minimal effect -- where targeted programs would be more effective at far less cost and disruption: 

• Most modern automobiles are essentially clean and non-polluting; the bulk of vehicle emissions come from a very small number of “dirty” cars and trucks – which can be effectively identified by mobile, low-cost “drive-by” monitors rather than broad and expensive inspection programs.
• Recall the Clinton-era imposition on personal charitable donations, requiring useless acknowledgement letters that have done nothing but stuff files and eat up time, paper and postage while adding no benefit to IRS tax enforcement.
  
• Transportation “security” in the post – 9/11 era has reduced the effectiveness and civility of air and rail travel at every level, all to the anxiety and unease of the general public -- but at the imposition of full body pat-downs and loss of gels and toothpastes, has failed to identify dangerous shoes and underwear – when contrasted with the nearly-invisible (and when well-used) highly-focused intelligence.

And closest to the subject, as I asked recently (here), what good has been accomplished by all the expenditure of corporate and agency time and budgets required under the Sarbanes/Oxley law – ostensibly functional for six full years as of the undeterred collapse of Lehman Brothers and the worldwide financial markets oscillations that followed?

Recent research brings forth the learning that the causal factors for the types of problems cited above are not uniformly spread through a population, but cluster within a small sub-set of the whole – a proposition that calls for dramatic re-engineering of law enforcement and regulatory policy.

A good place to start would be with short-sale limits calibrated to the really impactful – not 4% per average day, but perhaps 4% per year – situations that would be recognizably dramatic, readily identifiable and agreed as worth attention on a consensus basis, while generally leaving alone both the markets’ longs and shorts.

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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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