Crossing the Ethical Rubicon:From Private to Public SectorJames ChanosKynikos AssociatesSt. Hilda‟s CollegeUniversity of Oxford26 January 2011
“Alea iacta est” – Point of No Return?• In Roman tradition, if a general crossed the Rubicon he became a private traitor to the Republic• No clear ethical Rubicon in the private sector• Public sector is adopting the private sector‟s mentality 2
Enron: Poster Child For Private Sector Fraud• 2001: Enron was the largest corporate fraud in history – Inflated profits – „Mark to model‟ – Special Purpose Entities („SPEs‟)• “Smartest guys in the room” „My personal belief is that Enron stock lacked a moral compass is an incredible bargain at current – Related party transactions prices, and we will look back a couple of years from now and see the great – Insiders selling personal opportunity that we currently have.‟ stock while touting the company‟s stability Kenneth Lay, CEO, September 26, 2001 3
Enron Fallout: Strong Public Sector Response• Incisive congressional hearings with testimonies from key participants• Successful Enron prosecutions initiated almost immediately• July 30, 2002 - Sarbanes Oxley passed by Congress, to change rules of “the game” – Attempt to end the previous „hands off‟ regulatory framework – Immediate private sector pushback 4
2002-2006: Next Moral And Financial Crisis Takes Shape• Fannie and Freddie: A home for all Americans – Subprime/near prime debt growth – 40 percent of new mortgages in 2006 (9 percent in 2001) – securitized by inflated housing – „Prices in aggregate never fall‟• SEC‟s 2004 rule change lifts leverage for five largest investment banks per their request „American consumers might benefit if• Breakdowns in lending oversight lenders provided greater mortgage product by investors, rating agencies, and alternatives to the traditional fixed-rate mortgage.‟ regulators Alan Greenspan, Federal Reserve Chairman, February 23, 2004 5
Fool‟s Gold: Regulatory Arbitrage of Structured Finance• Tranching magically transformed risky assets into “AAA”• Rating agencies provided necessary “AAA” blessing• Pension accounts reaching for higher “AAA” yield provided the necessary demand• Wall Street (as usual) provided the supply through its originate and distribute model• Moved lending from regulated banks to unregulated asset backed market• Global Structured Investment Vehicles („SIVs‟) spread the cancer worldwide 6
Early Accounting Scandals: Foretelling of Ethical Lapses• Fannie Mae accounting controversy „…[it‟s findings] are serious and raise doubts concerning the validity of previously reported financial results, the adequacy of regulatory capital, the quality of management supervision, and the overall safety and soundness‟ OFHEO discussing report, September 23, 2004 „Some people seem to be of the belief that if you manage your company with an eye to the accounting results, that that is somehow a suspicious activity.‟ Franklin Raines, Fannie Mae CEO, Slate, October 7, 2004• AIG sued by New York Attorney General „The irony of this case is that AIG was a well-run and profitable company that didn‟t need to cheat. And yet, the former top management routinely and persistently resorted to deception and fraud in an apparent effort to improve the company‟s financial results.‟ Elliot Spitzer, May 26, 2005 7
1st Half 2007: Warnings Sounded…First Cracks Appear• FASB 157 tightens “fair value” accounting standards, requires more disclosures; banks worry about impact on balance sheets• April 2, 2007 - U.S. sub-prime lender New Century Financial files for bankruptcy• April 16, 2007 - G7 Ministers „We suspect the problem in the sub- meeting prime area is just the tip of the iceberg – Hedge funds warn: „worry for the mortgage market as a whole. For about the regulated banks‟ all practical purposes, the sub-prime market is in the process of shutting „Faced with a financial system that down.‟ few people seemed to understand David Shulman, Senior Economist, anymore, the G8 did nothing.‟ University of California Los Angeles Fool’s Gold, Gillian Tett 8
2nd Half 2007: Wall Street Sees Problems…But Keeps Dancing• Some Wall Street firms take positions to limit risk from extreme events• Bear Stearns hedge fund exposed to subprime mortgages undergoes crisis• Exposed firms around the globe began to teeter (IKB, Northern Rock, Countrywide)• But biggest banks continue to „When the music stops, in terms of liquidity, things will be complicated. But as long as the dance to the music music is playing, you‟ve got to get up and dance. We‟re still dancing.‟ Charles Prince, Citigroup CEO, July 9, 2007 9
2007-2008: Northern Rock Saga• Poster child for UK residential lending bubble – 14% growth in 2006; 13% UK market share – Reliance on wholesale funding – Exposure to subprime and self-certification lending• Northern Rock plows ahead despite warning signs in early 2007 – First half mortgage lending increased 47% – UK mortgage market share spiked to 19% `It is likely to take the outside world a little time to understand our developing strategy, but you can be assured the outlook for Northern Rock remains very positive.„ Adam Applegarth, Northern Rock CEO, July 25, 2007• September 14, 2007 - “Run on the Rock” `This standing facility is of course only extended to – Northern Rock received liquidity support businesses that are sound but face a temporary facility from the Bank of England liquidity problem.‟ – First UK bank run since Victorian era Adam Applegarth, Northern Rock CEO, September 14, 2007• February 22, 2008 - Northern Rock nationalized 10
2007: Despite Warnings Public Officials Look the Other Way• March 23, 2007 - NY Fed‟s Geithner: „We do not have the capacity to monitor or control concentrations of leverage or risk outside the banking system.‟• March 28, 2007 - Treasury Secretary Paulson tells Congress subprime problem „appears to be contained‟• May 17, 2007 - Current Federal Reserve Chairman Bernanke: „…we believe the effect of the troubles in the subprime sector on the broader housing market will likely be limited, and we do not expect significant spillovers from the subprime market to the rest of the economy or to the financial system.‟ 11
Bear Stearns: First Shoe to Drop „Bear Stearns balance sheet, liquidity, and capital remain strong…‟ Alan Schwartz, Bear Stearns CEO, March 12, 2008• Over leveraged balance sheet exposed by the market• Asset/liability funding mismatch magnified balance sheet stress• Federal Reserve negotiates weekend fire sale of Bear Stearns• Federal Reserve also forced to JP Morgan Pays $2 a Share for Bear Stearns guarantee $30 billion of toxic Bear New York Times, March 17, 2008 Stearns‟ assets 12
Public Officials‟ Response to Bear Stearns Implosion• Regulators refuse to recognize true cause• Regulatory blame game – Short sellers set up as scapegoat – Hedge funds demonized as the „real risk in the system‟• Regulatory response reflects blame shift – HBOS successfully pressured FSA to investigate „Bear Stearns capital, and its broker-dealers capital, exceeded supervisory standards. short sellers in April 2008 Counterparty withdrawals and credit denials, – First short-selling restrictions resulting in a loss of liquidity - not inadequate capital - caused Bears demise. „ in US, July 2008 Christopher Cox, SEC Chairman, March 20, 2008 13
Lehman Brothers: An Early Greek Tragedy• Vocal marketplace critics of Lehman dismissed by company and regulators• Lehman management steadfastly denied problems „I am the one who ultimately signs off and Im comfortable with our valuations at the end of our second quarter. We have always had a rigorous internal process.‟ Richard Fuld, Lehman Brothers CEO, June 16, 2008 „We don‟t feel that we need to raise that extra amount. Our capital position at the moment is strong.‟ Ian Lowitt, Lehman Brothers CFO, September 10, 2008• September 15, 2008 – Lehman Brothers filed for bankruptcy „Unbeknownst to the investing public, rating agencies, government regulators, and Lehman‟s board of – Implied hole in balance sheet north of directors, Lehman reverse engineered the firm‟s net $150 billion…2x Enron‟s! leverage ratio for public consumption.‟ Examiner’s Report, March 11, 2010 14
Public Officials Scramble to Limit Lehman Fallout• Global short selling regulations enacted arbitrarily• Major investment banks converted to bank holding companies by Federal Reserve – Optics: Tighter regulation „… to address dollar funding pressures – Reality: Access to the worldwide, we announced a significant expansion of reciprocal currency arrangements Federal Reserve balance with foreign central banks, including an sheet approximate doubling of the existing swap lines with the European Central Bank and the Swiss• Federal Reserve uses its National Bank and the authorization of new swap facilities with the Bank of Japan, the Bank balance sheet to liquefy the of England, and the Bank of Canada.‟ world Ben Bernanke, Federal Reserve Chairman, September 23, 2008 15
AIG Bailout: Credit Disaster Stopped (CDS)• AIG sold plausible deniability to Wall Street – Largest seller of credit protection for structured finance vehicles – Enabled Wall Street to claim „it was hedged‟• AIG regulators incapable of monitoring growing risk• AIG: The Emperor‟s New Clothes „AIGFPs models…when coupled with their conservatively structured transactions provide AIG with a very high level of „It is hard for us, without being flippant, to comfort.‟ even see a scenario within any kind of realm Martin Sullivan, AIG CEO, December 05, 2007 of reason that would see us losing one dollar in any of those transactions.‟• Less than a year later, US Federal Joseph Cassano, AIG Financial Products CEO, Government undertook $182 billion August 2007 bailout of AIG 16
Mixed Message From Private Sector Regarding Public Sector Bailout…Say What?• General Electric (‘GE’) • Ford Motor„Late Monday morning, General Electric CEO Jeff „Companies are taking drastic measures to preserveImmelt called to tell me that his company was their finances – not just the big banks, but alsohaving problems selling commercial paper.‟ companies like General Electric and Ford.‟Hank Paulson, US Treasury Secretary, September 8, 2008 Hank Paulson, US Treasury Secretary, September 18, 2008„We have no issues funding ourselves.‟ „Ford is asking for access to up to $9 billion in bridgeKeith Sherin, GE CFO, September 25, 2008 financing, but reiterated that it hopes to complete its„We really see the CP market improving right now. transformation without accessing the loan shouldWe have had no problems with our own CP, but I Congress agree to make the funds available.‟ Ford Motor Company Press Release, December 2, 2008think we have just taken this issue off the table forinvestors.‟ Ford Bailout Money Unnecessary, Company SaysJeff Immelt, GE CEO, October 10, 2008 Associated Press, December 10, 2008„Jeff Immelt had come to my office on the 16th to „We dont want to borrow any more money. We havemake the case that the FDIC should guarantee GE sufficient liquidity to fund our transformation plan, …Capital‟s debt issues… “We are the ones out there our business is in a relatively good shape.‟making the loans that the banks aren‟t, and we need Alan Mulally, Ford CEO, January 25, 2009help,” Immelt said.‟Hank Paulson, US Treasury Secretary, October 16, 2008 – Tapped Federal Reserve CP facility 14 times for $15.9 billion from October 2008 to June 2009Note: Hank Paulson quotes are provided from his book, On the Brink: Inside the 17 Race to Stop the Collapse of the Global Financial System.
Government Officials Move to „Calm‟ Crisis• TARP rammed through Congress in October 2008 – $700 billion Treasury slush fund – Eventual use of TARP funds differed from initial justification• Overt or quasi-nationalization of large banks around the globe (Citigroup, Bank of America, Lloyds/HBOS, RBS, Dexia)• FASB pressured to change mark-to- market accounting rules „When things go well, people call me• Stress tests performed on US banks Gordon. When theyre bad, they call me – all pass! Mr. Brown. At the moment, they are• Questionable governance of quasi- calling me Gordon.‟ nationalized firms Gordon Brown, UK Prime Minister, – No AIG emails? December 22, 2008 18
Ireland: When the Luck of the Irish Finally Ran Out• „New feudalism‟ inflated property prices - housing boom and collapse leaving Irish banks awash in bad loans• Near-anarchic attitude to law and morality: “cronyism, light regulation, loose ethics”• Political and public mentality could not grasp realities „A perfect illustration of the economics of morality –• Residential housing values the absence of a sense of propriety, of restraint and of right and wrong.... Public morality...is about estimated to be worth more knowing when to stop. Nothing in Ireland told people when to stop.‟ than 3x GDP at the 2006 peak Fintan O’Toole, Ship of Fools 19
Greece: A Modern Fiscal Tragedy• A foreign investment bank may have helped hide Greece‟s obligations• Hidden fiscal deficits exposed the extent of leverage• Market reacted swiftly by increasing the funding cost for Greece• Papandreou government punished in the market and locally for being forthcoming, and attempting to solve the problem 20
EU Regulatory Response to Financial Crisis• Regulators continue to shift blame• “Speculators” blamed for rising credit costs• Hedge fund rules and regulations enacted• EU learned from US counterparts – banks‟ „It is revealing that the tests [on the Irish stress tests all successful! banks] conducted last July identified a capital shortfall of just €3.5bn. Yet less than six• European Financial months later, Irish banks required 10 times Stability Facility („EFSF‟) that amount.‟ George Osborne, UK Chancellor of the established Exchequer, January 2011 21
2010 US Financial Reforms...?• Dodd-Frank Act: – Does it solve „too big to fail‟ problem? – Can Volcker rule limit conflicts hurting clients? – Will new watchdog curb systemic risks? – Vague law – many details to be filled in 22
Modern Day Rubicon: Crisis in US Public Finance• Failure to comprehend and/or acknowledge structural fiscal problems• Unwillingness to address longer term financial obligations• Public sector employs its own convenient accounting standards• Not using GAAP-accounting to measure true obligations – Real 2010 US budget deficit quite different • Reported: $1.3 trillion • GAAP adjusted: $5.3 trillion (est.) 23
Modern Day Rubicon: EU Fiscal Crisis Not Yet Solved• Rolling credit concerns from country to country• Austerity measures not well received locally• Kicking the fiscal can down the road• Financial markets still not convinced• The EU/Euro survival at stake? 24
Modern Day Rubicon: China, The Red Rubicon• GDP targets drive economic activity, not vice versa• Real GDP versus „China GDP‟ – Questions over regional versus national GDP figures – State Owned Enterprises („SOEs‟) control 50% of industrial assets• Party officials and state-owned enterprises incentivized to maximize the „top-line‟… or „lose face‟• “GDP figures are „man-made‟ and therefore unreliable…all other figures, especially GDP statistics are „for reference only,‟ he said smiling.” – Vice Premier Li Keqiang, expected successor to Premier Wen Jiabao 25
Prescription For Solving Public/Private Ethical Lapses• Accounting standards that provide transparency – Moving all relevant assets and liabilities back on the balance sheet – Properly valuing assets and liabilities• Full and timely disclosure of any public assistance or conflict resolution• Strong legal response to hold “cheats” accountable• Vigilant guardianship of the public purse 26
Thank You Again, St. Hilda’s College and the University of Oxford
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