Saturday, 17 October 2009 22:49

Revenge of the Nerds

The greatest failure of the last two years is not the collapse of the securitized mortgage markets or the housing collapse that spawned them, but the failure of faulty risk analysis that continues to permeate the financial industry.

The financial industry became enomored of quantification modeling as a strict denominator of risk, and it largely collapsed as a result. Wall Street embraced modeling techniques that attempted to quantify risk by placing numeric valuations on the amount of risk they were holding. Wall Street investment banks, and the “quants” that wrote the programs, truly became enamored of the "simplification" of risk analysis that these models offered.

Finally it seemed, there appeared an easily understood evaluation technique that anyone could understand. Just run the “program”, and a daily benchmark would assess the entities’ risk, which was then comparable and quantifiable. These models became the Holy Grail of risk analysis on Wall Street. One such model, the VaR, or Value at Risk model, expresses risk as a number, or dollar valuation to be precise. VaR, and the hundreds of models like it, became a crutch, a lazy method of quantifying risk and compartmentalizing this part of their operation.

It also became a convenient way of transferring blame should the risks materialize. No one could, after all, shoulder blame when their “quant models” incorrectly assessed their exposure. Reliance on these models was intellectually lazy, a function of ignorance and of management's inability to perform critical analysis. It may have been unrealistic to believe that many of these Wall Street analysts, most bred as political science, history, or English majors, could realistically understand the dynamics of corporate risk and perform in-depth analysis of their firms' balance sheets or profit and loss statements.

Category: Wall Street Fraud
The collective failures of the Bernie Madoff ponzi scheme and the collapse of the real estate markets share one common thread: the unwillingness of most commercial investors to perform even basic due diligence on their asset purchases.

I'll start with Bernie Madoff's ponzi scheme. Madoff's scheme continually raised red-flags which were ignored, even by his most sophisticated clients, the feeder-funds which funneled huge sums of money into his ponzi scheme. Even a cursory examination would have revealed that his auditor was a local CPA who was housed in a tiny office. That fact alone should have sent prospective investors running for the exits.

Any individual or organization with millions of dollars to invest is surely sophisticated enough to understand that comprehensive audits of large organizations, such as Mr. Madoff's, require teams of auditors and large audit firms with the organizational background and experience to complete the audits. A two-person office, even working 60 hours a week for an entire year, likely could not have completed an audit of Madoff's organization.

Sophisticated feeder funds should have performed extensive due diligence, verifying and independently confirming trade tickets. Their failure to do this is inexcusable, given the purported "monitoring" services being provided to their clients and the fees collected. This, in addition to the most obvious flags of all: that Madoff's operation would have consumed more options than those publicly traded and purchased on a daily basis. Surely, this calculation could not have been too difficult for these sophisticated organizations. Let's not even discuss the most obvious flag of all: the near flawless, steady returns that never wavered or spiked. These "smooth" returns should have spurred current and prospective investors to dig deeper and fact-check their portfolios.

Category: Financial Fraud
Thursday, 20 August 2009 23:01

Were We Lied To?

The well-respected Center for Economic and Policy Research (CEPR), led by economist Dean Baker, has conducted an in-depth study of small business growth in the industrialized “first world”.

The study soundly debunks the myth that the United States has historically been a magnet for small-business creation due to its unfettered and unrestricted small business development policies and laws. Incredibly, the United States is actually near the bottom in every measure of small business creation. The United States has the second lowest share of self-employed workers, at 7.2%, leading only lowly Luxembourg in this category. The French economy, often the target of ridicule for its purportedly anti-free-market tendencies, is above the United States, at 9.0%. The United States also ranks poorly in other measures: it has among the lowest shares of employment in small businesses in manufacturing. These findings are dramatic, and underscore the continued destruction of manufacturing in the United States and the industry consolidation occurring as a result of big-box retailing and non-retailing enterprises. Competitively, US small businesses are traditionally unable to compete against big-box national retailers for market share, a less significant problem in other industrialized economies.

Category: The Economy
Thursday, 20 August 2009 23:00

The Next Shoe to Drop?

Jonathan Weil at Bloomberg has written a shorter but equally compelling piece that discusses the often arcane and incomprehensible world of bank asset valuation.

In a well written and simple to read commentary, Mr. Weil notes that pending FASB accounting changes, which would require quarterly disclosure of bank assets’ fair values (as opposed to historical values) could dramatically revise downward the value of bank loans on their balance sheets. In many cases, these downward valuations could effectively eliminate shareholder equity, and lead to technical insolvency for many of these banks. As Weil highlights, current FASB rules permit most banks to carry these loans on their balance sheets at historical cost under a complex regime that allows management great latitude in recognizing loan losses. Under the proposals, these loan losses would be immediately recognized and lead to lower earnings. Weil notes that the disparity between historical book values and fair market values is so great that many banks, including many of our largest institutions, might become technically insolvent, and shareholder equity destroyed. This article dramatically underscores how easily manipulated our financial statements have become, and how even in-depth analysis of these statements by supposedly “sophisticated investors” is largely meaningless as a guidepost for prospective investment decisions. Without accurate and meaningful financial reporting, the numbers might as well be written in Cyrillic for all their purported value. This change is long overdue.

Category: The Economy
Thursday, 20 August 2009 22:46

Manipulating the Markets

In a lengthy expose, Rolling columnist Matt Taibbi explores Goldman Sachs’ role and participation in every major economic cyclical expansion and bust throughout the last century.

His thesis is quite simple, that Goldman has managed to position itself to gain from every major speculative bubble this century by manipulating the regulatory structures and regimes, all with the tacit approval of our government and politicians. Goldman has managed to secure this approval by positioning its minions deep inside government and in highly influential private and public positions. The number of senior Goldman executives who occupied high level government positions or have become executives at other financial services firms is staggering: Robert Rubin, Bill Clinton’s former Treasury secretary and former Citibank chairman; John Thain, chief of Merrill Lynch; George Bush’s last Treasury secretary, Henry Paulson, who was Goldman’s CEO; Joshua Bolten, Bush’s chief of staff, and Mark Patterson, the current Treasury chief of staff. This is just the short list, and does not include dozens of other, less senior executives.

Category: Wall Street Fraud
Sunday, 09 August 2009 19:58

Audit Failures and Ratings Agencies

Why is anyone still surprised at the magnitude of the disaster that has befallen our economy? An economic collapse that resulted from the faulty analysis performed by those organizations charged with bestowing ratings on the thousands of securitized and structured finance products.

That anyone is surprised is simply amazing, given the collective failures of auditing firms in the last 20 years, and the collapse of Arthur Andersen due to the Enron audit failure. While audits of financial statements and audits of securitized products are dissimilar in many tangible respects, the rationale behind their failures is remarkably similar.

Complex financial statements and complex securitizations share one common feature: no one really understands them. Financial statements continue to be obtuse rationalizations of highly complex organizations and disparate companies, cobbled together and "consolidated" to appear as if the reporting entity was one, giant, unified company, rather than a series of companies that may or may not have little in common. This "consolidated" financial report purports to "fairly represent" the financial results of the consolidated entities, while providing little in the way of unconsolidated and segregated information on the disparate companies that comprise the whole.

The audits are prepared by rotating bands of auditors who generally leave the "Big 4" after little more than 2-3 years in practice, having grown weary of the numbing nature of audits. These "experts" are charged with engaging senior management in lively discussions regarding the adequacy and materiality of their financial representations, while being tethered by the massive audit fees these engagements generate. Think there's a slight conflict of interest here? Of course there is. Senior managers have a schizophrenic need to "preserve" the client relationship while ensuring the fairness of the financial statements, a tightrope that often fails.

Category: Wall Street Fraud
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