Archive for the ‘Accounting Standards’ Category

An Indictment of the Financial Sector

Thursday, January 27th, 2011

The purpose of the traditional blue-ribbon government panel has to been to study a serious problem and issue a report with vague explanations of causes and mushy policy prescriptions. The new report from the federal government’s Financial Crisis Inquiry Commission is a refreshing exception to the rule.

In the place of such nebulous prose, the 600-page-plus document is filled with pointed analyses of who did what wrong when. In other words, it names names. The FCIC acknowledges that it needed to delve into arcane subjects such as securitization and derivatives, but the report’s preface states:

To bring these subjects out of the realm of the abstract, we conducted case study investigations of specific financial firms—and in many cases specific facets of these institutions—that played pivotal roles. Those institutions included American International Group (AIG), Bear Stearns, Citigroup, Countrywide Financial, Fannie Mae, Goldman Sachs, Lehman Brothers, Merrill Lynch, Moody’s, and Wachovia. We looked more generally at the roles and actions of scores of other companies.

To get a sense of the scope of the rogues’ gallery of financial players, take a look at the report’s index, which, interestingly, is not in the official PDF but can be found on the website of the publisher that is issuing the commercial version.  There are dozens of entries for specific firms and even more for specific individuals. Goldman Sachs and Lehman Brothers, for instance, each have listings for about 40 different pages.

The FCIC does not just mention names; it assigns responsibility and soundly rejects the notion—expressed at commission hearings by major financial industry executives—that the crisis came as a complete surprise:

The crisis was the result of human action and inaction, not of Mother Nature or computer models gone haywire. The captains of finance and the public stewards of our financial system ignored warnings and failed to question, understand, and manage evolving risks within a system essential to the well-being of the American public.

It is satisfying that the report acknowledges the culpability of figures in both the private and the public spheres. Along with Wall Street villains, it fingers government institutions and officials, especially those with regulatory responsibilities:

The sentries were not at their posts, in no small part due to the widely accepted faith in the self-correcting nature of the markets and the ability of financial institutions to effectively police themselves. More than 30 years of deregulation and reliance on self-regulation by financial institutions, championed by former Federal Reserve chairman Alan Greenspan and others, supported by successive administrations and Congresses, and actively pushed by the powerful financial industry at every turn, had stripped away key safeguards, which could have helped avoid catastrophe.

Figures such as current Fed Chairman Ben Bernanke, former Treasury Secretary Henry Paulson and former SEC chair Christopher Cox are singled out for making misleading statements in 2008 about the gravity of the situation just before the crisis erupted. The report goes on to state:

Our examination revealed stunning instances of governance breakdowns and irresponsibility. You will read, among other things, about AIG senior management’s ignorance of the terms and risks of the company’s $79 billion derivatives exposure to mortgage-related securities; Fannie Mae’s quest for bigger market share, profits, and bonuses, which led it to ramp up its exposure to risky loans and securities as the housing market was peaking; and the costly surprise when Merrill Lynch’s top management realized that the company held $55 billion in “super-senior” and supposedly “super-safe” mortgage-related securities that resulted in billions of dollars in losses.

Finding that “a combination of excessive borrowing, risky investments, and lack of transparency put the financial system on a collision course with crisis,” the FCIC cites the high leverage ratios at the leading investment banks and the fact that “the leverage was often hidden—in derivatives positions, in off-balance-sheet entities, and through ‘window dressing’ of financial reports available to the investing public.”

The report continues: “When the housing and mortgage markets cratered, the lack of transparency, the extraordinary debt loads, the short-term loans, and the risky assets all came home to roost. What resulted was panic. We had reaped what we had sown.” One chapter, covering the explosion of risky financial instruments such as collateralized debt obligations is entitled “The Madness.”

Perhaps most damning is the FCIC’s finding of a “systemic breakdown in accountability and ethics” that “stretched from the ground level to the corporate suites.” For example, the report cites the case of the subprime lender Countrywide (later taken over by Bank of America):

As early as September 2004, Countrywide executives recognized that many of the loans they were originating could result in “catastrophic consequences.”  Less than a year later, they noted that certain high-risk loans they were making could result not only in foreclosures but also in “financial and reputational catastrophe” for the firm. But they did not stop.

All in all, the FCIC report paints an incriminating picture of the U.S. financial industry as well as the government regulators and private entities such as credit rating agencies that are supposed to put some checks on the unbridled pursuit of profit. In fact, the document in many ways reads like a criminal indictment. We would all be better off if some actual prosecutors pursued these leads.

Note: The report, dominated by a section of more than 400 pages endorsed by a majority of commissioners, also contains a 125-page dissent from the minority as well as 80 pages of endnotes. But that’s not all. The document indicates that it is not the sole repository of what the FCIC found:

A website—www.fcic.gov—will host a wealth of information beyond what could be presented here. It will contain a stockpile of materials—including documents and emails, video of the Commission’s public hearings, testimony, and supporting research—that can be studied for years to come. Much of what is footnoted in this report can be found on the website.

A critical researcher’s dream.

Using Financial Reform to Promote Deregulation

Thursday, April 29th, 2010

Growing public rage over Wall Street misbehavior has snapped the Senate out of its lethargy on financial reform. Amid the get-tough posturing, however, the impulse to lighten the regulatory “burden” on business has not completely disappeared.

When Senate Republicans unveiled their alternative approach to reform on April 26, buried in the document was a provision that called for less rather than more regulation. The GOP proposal would make smaller publicly traded companies exempt from a key provision of the Sarbanes-Oxley Act (Sarbox, for short), the corporate accountability law enacted in 2002 in response to the accounting scandals at companies such as Enron and WorldCom.

The provision in question, Section 404, requires firms to maintain a system of internal controls to ensure the integrity of their financial statements, which must include an audited assessment of the adequacy of those measures. A breakdown in such controls is an invitation to financial fraud.

Senate Republicans would like to provide an immediate exemption to companies with a market capitalization of $150 million or less and would instruct the Securities and Exchange Commission to explore the possibility of setting the cutoff even higher. The SEC has already delayed implementation of the Section 404 requirement for smaller firms, and it convened a business-dominated advisory committee that recommended consideration of Sarbox relaxation for firms with market capitalization up to $787 million. The Commission, however, has refused to create a permanent exemption.

Truth be told, it is not just Republicans who are pushing the exemption idea. The financial reform bill that passed the House in December contains a Section 404 small-business exemption that was proposed – against the wishes of Financial Services Committee Chair Barney Frank – by Democrat John Adler along with Republican Scott Garrett, both of New Jersey. The amendment passed with the blessing of the Obama Administration, with White House Chief of Staff Rahm Emanuel personally lobbying members of the Committee on its behalf.  Senator Dodd, however, did not include a small-business exemption in his financial reform bill.

The Sarbox small-firm carve-out may win some friends in business circles, but it entails serious risks. Chief among them is that the exemption could serve as a stepping stone to further weakening or abolition of the entire law.

This is more than a remote possibility. Republicans make no secret of their distaste for Sarbox in general and have used this as a theme in criticizing the Dodd bill. South Carolina Senator Jim DeMint called that bill “Sarbanes-Oxley on steroids,” adding: “Like Sarbanes-Oxley, it is reactionary legislation that’s more likely to hurt U.S. businesses than reform the financial system.” A recent Wall Street Journal editorial denounced Dodd’s bill as “a souped-up version of the Sarbanes-Oxley bill of 2002 – that is, a collection of ill-understood reforms whose main achievement will be to make Wall Street even more the vassal of Washington.”

Congress is not the only arena where Sarbanes-Oxley is under assault. The U.S. Supreme Court is expected to rule soon on a challenge by the rabidly anti-regulation Competitive Enterprise Institute to the legitimacy of the Public Company Accounting Oversight Board, which was created by Sarbox by regulate public accounting firms. Some legal observers believe that a high court ruling against the Board could lead to the demise of Sarbox in its entirety.

Even if this dark scenario does not come to pass, does it make sense to loosen the controls on smaller firms? Fraudulent behavior is hardly unknown among public companies of modest size. In fact, such companies have long been used as vehicles for criminal enterprises. A 1996 Business Week investigation found that “substantial elements of the small-cap market have been turned into a veritable Mob franchise, under the very noses of regulators and law enforcement.”

Lately, the focus has been on the sins of the financial giants, but that’s no reason to dilute oversight of smaller players. Now’s a time for tightening regulation across the board.

Getting Companies to Come Clean About Risks

Thursday, July 24th, 2008

In 1982 building materials producer Johns-Manville filed for bankruptcy, overwhelmed by a rising tide of lawsuits brought by workers crippled from exposure to the company’s most infamous product: asbestos insulation. The Manville litigation and Chapter 11 filing caught many investors off guard because the company, despite knowing the risks of asbestos for decades, did not disclose the potential consequences to shareholders. The episode is one of the most egregious cases of corporate irresponsibility in U.S. history.

Unfortunately, Corporate America did not learn the lesson of the asbestos debacle. Many companies—from cigarette manufacturers to investment banks involved with subprime mortgages—have failed to fully inform investors of potential liabilities. They have been able to do so, in large part, because of lax accounting rules.

That could now change. The entity that sets the rules—the Financial Accounting Standards Board—is currently working on the first modifications since 1975 to its disclosure guidelines, known as FAS Statement No. 5, regarding “loss contingencies.” The problem is that FASB is considering revisions that some advocacy groups consider too weak.

The Investor Environmental Health Network (IEHN), “a collaborative project of investment managers that tracks product toxicity issues,” has just issued an appeal for interested parties to submit comments urging FASB to adopt stricter standards for Statement No.5. The comments are due by August 8.

Specifically, the IEHN is concerned that the revision of Statement No. 5, while requiring companies to report maximum possible loss, has three significant loopholes. These would allow companies to skirt the new rules if the company claims that the risks are only remotely likely and would not be resolved within the next year, or if it claims that the disclosure would be “prejudicial.” Also, the new rules would apply only to legal liabilities, not asset impairments (such as the risk that a company’s property might be destroyed by flooding related to climate change).

As Sanford Lewis, who serves as counsel for IEHN, puts it in an e-mail message to me: “For Enron, subprime lending and asbestos, the unifying theme is that management treated these severe-impact issues as only ‘remotely likely’ to hurt their companies. Now FASB wants to make some of these ‘remotely likely’ issues discloseable, but only if the issue is expected to be resolved within a year. Yet issues such as these typically take many years, if not decades, to be resolved. Investors need to know about them now, not right before the financial catastrophe hits.” (See his video on the issue here.)

Stricter accounting rules might not prevent risky behavior on the part of corporate executives, but they would increase the odds that investors would know about those risks before it was too late to bail out—or pressure management to clean up its act.