Financial derivatives


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  • A Brief Guide to Financial Derivatives
  • Computer Fraud
  • Systems Auditing in a Paperless Environment, by Howard A. Kanter, Ed.D., CPA Equity Funding: Could It Happen Again?“ by David R. Hancox, CIA, CGFM
  • Financial derivatives

    1. 1. Define investment goals and constraints Identify investment alternatives Choosing the best alternatives Portfolio construction Portfolio execution Portfolio evaluationPortfolio Portfoliorevision hedging
    2. 2. Overview Definition of Financial Derivatives Common Financial Derivatives Why Have Derivatives? The Risks Leveraging Trading of Derivatives Derivatives on the Internet An Apologia for Derivatives The Dark Side of Derivatives
    3. 3. Definition of Financial Derivatives A financial derivative is a contract between two (or more) parties where payment is based on (i.e., "derived" from) some agreed-upon benchmark. Since a financial derivative can be created by means of a mutual agreement, the types of derivative products are limited only by imagination and so there is no definitive list of derivative products. Some common financial derivatives, however, are described later. More generic is the concept of “hedge funds” which use financial derivatives as their most important tool for risk management.
    4. 4. Repayment of Financial Derivatives In creating a financial derivative, the means for, basis of, and rate of payment are specified. Payment may be in currency, securities, a physical entity such as gold or silver, an agricultural product such as wheat or pork, a transitory commodity such as communication bandwidth or energy. The amount of payment may be tied to movement of interest rates, stock indexes, or foreign currency. Financial derivatives also may involve leveraging, with significant percentages of the money involved being borrowed. Leveraging thus acts to multiply (favorably or unfavorably) impacts on total payment obligations of the parties to the derivative instrument.
    5. 5. Common Financial Derivatives Options Forward Contracts Futures Stripped Mortgage-Backed Securities Structured Notes Swaps Rights of Use Combined Hedge Funds
    6. 6. A. Risk and Rewards of D More leverage  Market efficiency Less transparency  Risk sharing and transfer Dubious accounting  Low transaction costs Regulatory arbitrage  Capital intermediation Rising CP exposure  Liquidity enhancement Hidden systemic risk  Price discovery Tail-risk future  Cash market exposure development Weak capital  Hedging tools requirements Zero-sum transfer tools  Regulatory savings
    7. 7. OptionsThe purchaser of an Option has rights (but not obligations)to buy or sell the asset during a given time for a specifiedprice (the "Strike" price). An Option to buy is known as a"Call," and an Option to sell is called a "Put. "The seller of a Call Option is obligated to sell the asset tothe party that purchased the Option. The seller of a PutOption is obligated to buy the asset.In a “Covered” Option, the seller of the Option alreadyowns the asset. In a “Naked” Option, the seller does notown the assetOptions are traded on organized exchanges and OTC.
    8. 8. Forward Contracts In a Forward Contract, both the seller and the purchaser are obligated to trade a security or other asset at a specified date in the future. The price paid for the security or asset may be agreed upon at the time the contract is entered into or may be determined at delivery. Forward Contracts generally are traded OTC.
    9. 9. Futures A Future is a contract to buy or sell a standard quantity and quality of an asset or security at a specified date and price. Futures are similar to Forward Contracts, but are standardized and traded on an exchange, and are valued daily. The daily value provides both parties with an accounting of their financial obligations under the terms of the Future. Unlike Forward Contracts, the counterparty to the buyer or seller in a Futures contract is the clearing corporation on the appropriate exchange. Futures often are settled in cash or cash equivalents, rather than requiring physical delivery of the underlying asset.
    10. 10. Stripped Mortgage-Backed Securities Stripped Mortgage-Backed Securities, called "SMBS," represent interests in a pool of mortgages, called "Tranches", the cash flow of which has been separated into interest and principal components. Interest only securities, called "IOs", receive the interest portion of the mortgage payment and generally increase in value as interest rates rise and decrease in value as interest rates fall. Principal only securities, called "POs", receive the principal portion of the mortgage payment and respond inversely to interest rate movement. As interest rates go up, the value of the PO would tend to fall, as the PO becomes less attractive compared with other investment opportunities in the marketplace.
    11. 11. Structured Notes Structured Notes are debt instruments where the principal and/or the interest rate is indexed to an unrelated indicator. A bond whose interest rate is decided by interest rates in England or the price of a barrel of crude oil would be a Structured Note, Sometimes the two elements of a Structured Note are inversely related, so as the index goes up, the rate of payment (the "coupon rate") goes down. This instrument is known as an "Inverse Floater." With leveraging, Structured Notes may fluctuate to a greater degree than the underlying index. Therefore, Structured Notes can be an extremely volatile derivative with high risk potential and a need for close monitoring. Structured Notes generally are traded OTC.
    12. 12. Swaps A Swap is a simultaneous buying and selling of the same security or obligation. Perhaps the best-known Swap occurs when two parties exchange interest payments based on an identical principal amount, called the "notional principal amount." Think of an interest rate Swap as follows: Party A holds a 10-year $10,000 home equity loan that has a fixed interest rate of 7 percent, and Party B holds a 10- year $10,000 home equity loan that has an adjustable interest rate that will change over the "life" of the mortgage. If Party A and Party B were to exchange interest rate payments on their otherwise identical mortgages, they would have engaged in an interest rate Swap.
    13. 13. Swaps Interest rate swaps occur generally in three scenarios. Exchanges of a fixed rate for a floating rate, a floating rate for a fixed rate, or a floating rate for a floating rate. The "Swaps market" has grown dramatically. Today, Swaps involve exchanges other than interest rates, such as mortgages, currencies, and "cross-national" arrangements. Swaps may involve cross-currency payments (U.S. Dollars vs. Mexican Pesos) and crossmarket payments, e.g., U.S. short-term rates vs. U.K. short-term rates.
    14. 14. Rights of Use A type of swap is represented by swapping capacity on networks using instruments called “indefeasible rights of use”, or IRUs. Companies buying an IRU might book the price as a capital expense, which could be spread over a number of years. But the income from IRUs could be booked as immediate revenue, which would bring an immediate boost to the bottom line. Technically, the practice is within the arcane rules that govern financial derivative accounting methods, but only if the swap transactions are real and entered into for a genuine business purpose.
    15. 15. Combined Derivative Products The range of derivative products is limited only by the human imagination. Therefore, it is not unusual for financial derivatives to be merged in various combinations to form new derivative products. For instance, a company may find it advantageous to finance operations by issuing debt, the interest rate of which is determined by some unrelated index. The company may have exchanged the liability for interest payments with another party. This product combines a Structured Note with an interest rate Swap.
    16. 16. Hedge Funds A “hedge fund” is a private partnership aimed at very wealthy investors. It can use strategies to reduce risk. But it may also use leverage, which increases the level of risk and the potential rewards. Hedge funds can invest in virtually anything anywhere. They can hold stocks, bonds, and government securities in all global markets. They may purchase currencies, derivatives, commodities, and tangible assets. They may leverage their portfolios by borrowing money against their assets, or by borrowing stocks from investment brokers and selling them (shorting). They may also invest in closely held companies.
    17. 17. Hedge Funds Hedge funds are not registered as publicly traded securities. For this reason, they are available only to those fitting the Securities and Exchange Commission definition of “accredited investors”—individuals with a net worth exceeding $1 million or with income greater than $200,000 ($300,000 for couples) in each of the two years prior to the investment and with a reasonable expectation of sustainability. Institutional investors, such as pension plans and limited partnerships, have higher minimum requirements. The SEC reasons that these investors have financial advisers or are savvy enough to evaluate sophisticated investments for themselves.
    18. 18. Hedge Funds Some investors use hedge funds to reduce risk in their portfolio by diversifying into uncommon or alternative investments like commodities or foreign currencies. Others use hedge funds as the primary means of implementing their long-term investment strategy.
    19. 19. Why Have Derivatives? Derivatives are risk-shifting devices. Initially, they were used to reduce exposure to changes in such factors as weather, foreign exchange rates, interest rates, or stock indexes. For example, if an American company expects payment for a shipment of goods in British Pound Sterling, it may enter into a derivative contract with another party to reduce the risk that the exchange rate with the U.S. Dollar will be more unfavorable at the time the bill is due and paid. Under the derivative instrument, the other party is obligated to pay the company the amount due at the exchange rate in effect when the derivative contract was executed. By using a derivative product, the company has shifted the risk of exchange rate movement to another party.
    20. 20. Why Have Derivatives? More recently, derivatives have been used to segregate categories of investment risk that may appeal to different investment strategies used by mutual fund managers, corporate treasurers or pension fund administrators. These investment managers may decide that it is more beneficial to assume a specific "risk" characteristic of a security.
    21. 21. The Risks Since derivatives are risk-shifting devices, it is important to identify and understand the risks being assumed, evaluate them, and continuously monitor and manage them. Each party to a derivative contract should be able to identify all the risks that are being assumed before entering into a derivative contract. Part of the risk identification process is a determination of the monetary exposure of the parties under the terms of the derivative instrument. As money usually is not due until the specified date of performance of the parties obligations, lack of up- front commitment of cash may obscure the eventual monetary significance of the parties obligations.
    22. 22. The Risks Investors and markets traditionally have looked to commercial rating services for evaluation of the credit and investment risk of issuers of debt securities. Some firms have begun issuing ratings on a companys securities which reflect an evaluation of the exposure to derivative financial instruments to which it is a party. The creditworthiness of each party to a derivative instrument must be evaluated independently by each counterparty. In a financial derivative, performance of the other partys obligations is highly dependent on the strength of its balance sheet. Therefore, a complete financial investigation of a proposed counterparty to a derivative instrument is imperative.
    23. 23. The Risks An often overlooked, but very important aspect in the use of derivatives is the need for constant monitoring and managing of the risks represented by the derivative instruments. For instance, the degree of risk which one party was willing to assume initially could change greatly due to intervening and unexpected events. Each party to the derivative contract should monitor continuously the commitments represented by the derivative product. Financial derivative instruments that have leveraging features demand closer, even daily or hourly monitoring and management.
    24. 24. Leveraging Some derivative products may include leveraging features. These features act to multiply the impact of some agreed-upon benchmark in the derivative instrument. Negative movement of a benchmark in a leveraged instrument can act to increase greatly a partys total repayment obligation. Remembering that each derivative instrument generally is the product of negotiation between the parties for risk-shifting purposes, the leveraging component, if any, may be unique to that instrument.
    25. 25. Leveraging For example, assume a party to a derivative instrument stands to be affected negatively if the prime interest rate rises before it is obliged to perform on the instrument. This leveraged derivative may call for the party to be liable for ten times the amount represented by the intervening rise in the prime rate. Because of this leveraging feature, a small rise in the prime interest rate dramatically would affect the obligation of the party. A significant rise in the prime interest rate, when multiplied by the leveraging feature, could be catastrophic.
    26. 26. Trading of Derivatives Some financial derivatives are traded on national exchanges. Those in the U.S. are regulated by the Commodities Futures Trading Commission. Financial derivatives on national securities exchanges are regulated by the U.S. Securities and Exchange Commission (SEC). Certain financial derivative products have been standardized and are issued by a separate clearing corporation to sophisticated investors pursuant to an explanatory offering circular. Performance of the parties under these standardized options is guaranteed by the issuing clearing corporation. Both the exchange and the clearing corporation are subject to SEC oversight.
    27. 27. Trading of Derivatives Some derivative products are traded over-the-counter (OTC) and represent agreements that are individually negotiated between parties. Anyone considering becoming a party to an OTC derivative should investigate first the creditworthiness of the parties obligated under the instrument so as to have sufficient assurance that the parties are financially responsible.
    28. 28. Mutual Funds and Public Companies Mutual funds and public companies are regulated by the SEC with respect to disclosure of material information to the securities markets and investors purchasing securities of those entities. The SEC requires these entities to provide disclosure to investors when offering their securities for sale to the public and mandates filing of periodic public reports on the condition of the company or mutual fund. The SEC recently has urged mutual funds and public companies to provide investors and the securities markets with more detailed information about their exposure to derivative products. The SEC also has requested that mutual funds limit their investment in derivatives to those that are necessary to further the funds stated investment objectives.
    29. 29. Selling of Financial Derivatives Some brokerage firms are engaged in the business of creating financial derivative instruments to be offered to retail investment clients, mutual funds, banks, corporations and government investment officers. Before investing in a financial derivative product it is vital to do two things. First, determine in detail how different economic scenarios will affect the investment in the financial derivative (including the impact of any leveraging features). Second, obtain information from state or federal agencies about the brokers record.
    30. 30. Derivatives on the Internet In the past several years, trading of financial derivatives has become an active Internet e-commerce focus, with EnronOnline as among the most active sites. Leaving aside assessment of the reliability of e-commerce trading sites, the following are valuable sites for keeping track: For quick news bites, the best sources are maintained by some of the major financial news organizations: Bloomberg Online The Associated Press Bridge Financial
    31. 31. Derivatives on the Internet One very quick and easy analysis of developments in overnight markets and identification of key issues in todays markets is Marc Chandlers commentary: For Canadian news, there are two national newspapers, The National Post and The Globe And Mail Internationally, The New York Times, South China Morning Post, The Washington Post The Financial Times
    32. 32. Derivatives on the Internet Risk measurement methodology can be found at J.P. Morgans Credit Suisse First Boston CreditRisk+ site The Global Association of Risk Professionals The Treasury Management Association (USA) The Treasury Management Association of Canada CIBC Wood Gundys School of Financial Products
    33. 33. An Apologia for Derivatives Derivatives are not new, high-tech methods. Derivatives are not purely speculative or leveraged. Derivatives are not a major part of finance. Derivatives are of value to companies of all sizes. Derivatives are tools to meet management objectives. Derivatives reduce uncertainty and foster investment. Derivatives can both reduce and enhance risk. Derivatives do not change the nature of risk. Derivatives reduce, not increase systemic risks. Derivatives do not call for further regulation.
    34. 34. The Dark Side of Derivatives Six examples will be used to illustrate some of the perils, especially ethical perils, in use of financial derivatives: Equity Funding Corporation of America (1973) Baring Bank (1994) Orange County, California (1994) Long Term Capital Management (1998) Enron (2001) Global Crossing (2002) Each of them represented an effort to use financial derivatives to produce inflated returns. Two cases were proven to be frauds. Two appear to have been innocent of fraud. Two are still to be seen. Each was a major financial catastrophe, affecting not only those directly involved but the world at large.
    35. 35. Derivative Products OTC Derivative Markets Exchange Traded Derivatives $128 trn notional $29 trn notional $ 5 trn market value $700 trn turnover US: 35% EU: 34% JP Morgan Chase Chicago 28% Asia: 25% $ 27 trn Eurex 14% Euronext Non-Financials SGX 70% $ 20 trn BM&F 62% KSE/KOFEX (relative size may be misleading) 40% annual growth ratesInterest InterestFX G-DebtEquity Key Driving Factors Equity-IndexCom  Capital flows StocksCredit  Leverage ComOther  Risk Management FX  Liquidity  Transaction Costs Sources: BIS (June 2002) ; FIBV (Dec 2001)
    36. 36. The Steps on the Primrose Path A B C D E F 1 deregulation x 2 wish to have stock price go up x ? x x x 3 use of stock options as incentives x x x x x 4 use of hidden borrowing x ? x x x 5 use of financial derivatives in risky gambles x x x x x x 6 consulting by auditor on use of derivatives x ? x x x x 7 use of deceptive accounting to hide risks x x ? x x 8 acquiescence of auditor in deception x ? ? ? 9 use of fraudulent entries to support deceptions x x ? ? 10 use of hidden partners x ? 11 move from individual fraud to corporate fraud x ? ? 12 connivance of auditor in fraud x ? ? 13 use of a Ponzi scheme to continue fraud x ? ? 14 profiting before the collapse x x x(A) Equity Funding, (B) Baring Bank, (C) Orange County,(D) Long Term Capital Management, (E) Enron, (F)Global Crossing
    37. 37. Equity Funding Corporation of America The insurance funding program The first scam The next scam The really BIG scam The final scam The house of cards collapses The fallout from Equity Funding An analysis of the causes The Lessons Learned
    38. 38. The insurance funding program - 1 Equity Funding Corporation of America was founded in 1960. Its principal line of business was selling "funding programs" that merged life insurance and mutual funds into one financial package for investors. The deal was as follows: first, the customer would invest in a mutual fund; second, the customer would select a life insurance program; third, the customer would borrow against the mutual fund shares to pay each annual insurance premium. Finally, at the end of ten years, the customer would pay the principal and interest on the premium loan with any insurance cash values or by redeeming the appreciated value of the mutual fund shares. Any appreciation of the investment in excess of the amount paid would be the investors profit.
    39. 39. The insurance funding program - 2 The company had a huge sales force. The thrust of the salesmans pitch to a customer was that letting the cash value sit in an insurance policy was not smart; in fact, the customer was losing money. The customer was encouraged to let his money work twice by taking part in the above deal. The development of such creative financial investments was a trademark of Equity Funding in the early years of its existence. After going public in 1964, Equity Funding was soon recognized across the country as an innovative company in the ultraconservative life insurance industry.
    40. 40. The insurance funding program - 3 This kind of leveraging of dollars is a concept used by sophisticated investors to maximize their returns. They use an asset they already own to borrow money in the expectation that earnings and growth will be greater than the interest costs they will incur. However, its a concept that is fraught with risks for the investor and should not be promoted by an ethical company without fully informing the investor of the risks. Even so, there was nothing illegal or even immoral about the basic concept. Indeed, it was a captivating idea, except it didnt make enough money for the company or its executives. So some executives—led by the president, chief financial officer and head of insurance operations—got a little more creative with the numbers on their books.
    41. 41. The first scam "Reciprocal income“ Preparing to take the company public in 1964, there was concern that its earnings were too low. To correct this "problem", the owners decided that Equity Funding was entitled to record rebates or kickbacks from the brokers through whom the companys sales force purchased mutual fund shares. The resulting income, called "reciprocal income" was used to boost 1964 net income for Equity Funding. So the fraud apparently began in 1964 when the commissions earned on sales of the Equity Funding program were erroneously inflated.
    42. 42. The next scam Borrowing without showing liability In subsequent years, to supplement the reciprocal income so as to achieve predetermined earnings targets, the company borrowed money without recording the liability on its books, disguising it through complicated transactions with subsidiaries. The fraud expanded in 1965, when fictitious entries were made in certain receivable and income accounts. By 1967, revenues and earnings of Equity Funding had increased dramatically, and the stock price rose accordingly. Equity Funding began to take over other companies, and it became critical to maintain the price of the stock of Equity Funding so it could be used to pay for the companies being acquired.
    43. 43. The Really BIG Scam Reinsurance Fictitious policies Forging files
    44. 44. The Final Scam Killing off the policy holders
    45. 45. The computer makes it possible Although there were a number of other aspects to the fraud, the computer was used because the task of creating the bogus policies was too big to be handled manually. Instead, a program was written to generate policies which were coded by the now famous, or rather, infamous, code "99". When the fraud was discovered in 1973, about 70% of all of the companys insurance policies were fake.
    46. 46. The failure of the auditors
    47. 47. The house of cards collapses
    48. 48. The fallout from Equity Funding Accounting and auditing practices Insider trading The aftermath of Equity Funding
    49. 49. An analysis of the causes The Management Ethics and integrity of management and employees Managements philosophy and operating style The Auditors Lack of independence of the auditors Lack of professional skepticism of the auditors External impairments to the audit
    50. 50. The Management The ethics and integrity of management and employees Managements philosophy and operating style
    51. 51. The Auditors The independence of the auditors Professional skepticism of the auditors
    52. 52. The Lessons Learned
    53. 53. Baring Bank Bankruptcy Barings Bank was established in London in 1763 as a merchant bank, which allowed it to accept deposits and provide financial services to its clients as well as trade on its own account, assuming risk by buying and selling common real estate and financial assets. In early 1980, Barings set up brokerage operations in Japan. With its success in Japan, Barings decided to expand to Hong Kong, Singapore, Indonesia and several other Asian countries. By 1992, Barings subsidiary in Singapore had a seat on the SIMEX, but did not activate it due to lack of expertise in trading futures and option contracts.
    54. 54. Nick Leeson: both Front and Back Four months later Barings decided to activate its SIMEX seat. They appointed Mr. Nick Leeson as the general manager and charged him with setting up the trading operations in Singapore and running them. Mr. Leeson was in charge of both the front office and the back office. An important task in brokerage business, particularly in the settlement side, is uncovering and dealing with trading errors, which occur when the trading staff misread or mishear an instruction or a broker misunderstands a hand signal. When errors occur, brokerages book the losses or gains into a computer account called an "error account". For Mr. Leeson, errors recorded were sent to the home office in London and deducted against Mr. Leesons branch earnings.
    55. 55. Account 88888 Account 88888 was started when a phone clerk sold 20 contracts instead of purchasing them. Mr. Leeson was unable to do anything about it until the next trading day because the market rose 400 points. That next trading day, Leeson established account 88888 and created fictitious transactions to cover up the error. Over the next few months Leeson hid some 30 large errors in account 88888. He relaxed his attitude towards errors, and when an important customer brought an error to Leesons attention, he simply put the error into account 88888 without any further investigation.
    56. 56. The Collapse As the market moved, errors in account 88888 changed in value, and a $1 Billion loss was generated by open positions in account 88888. As the account grew bigger, margin calls also got bigger. London approved these large margin calls because of the large profits Leeson was posting. Barings’s problems arose because of serious failure of controls and management within Barings.
    57. 57. Orange County BankruptcyOn December 6, 1994, Orange County in Californiabecame the largest municipality in U.S. history to declarebankruptcy. The county treasurer had lost $1.7 billion oftaxpayers money through investments in derivatives.The bankruptcy resulted from unsupervised investmentactivity of Bob Citron, the County Treasurer, who wasentrusted with a $7.5 billion portfolio belonging to countyschools, cities, special districts and the county itself.
    58. 58. Orange County—History In 1994, the Orange County investment pool had about $7.5 billion in deposits from the county government and almost 200 local public agencies (cities, school districts, and special districts). Borrowing $2 for every $1 on deposit, Citron nearly tripled the size of the investment pool to $20.6 billion. In essence, as the Wall Street Journal noted, he was "borrowing short to go long" and investing the dollars in derivatives—in exotic securities whose yields were inversely related to interest rates.
    59. 59. Orange County—Period of SuccessThus, Citron invested in financial derivatives and leveragedthe portfolio to the hilt, with expectations of decreasinginterest rates. As a result, he was able to increase returns onthe county pool far above those for the State pool.Citron was viewed as a wizard who could painlessly delivergreater returns to investors. The pool was in such demanddue to its track record that Citron had to turn downinvestments by agencies outside Orange County.Some local school districts and cities even issued short-termtaxable notes to reinvest in the pool (thereby increasingtheir leverage even further).
    60. 60. Orange County—the collapse The investment strategy worked excellently until 1994, when the Fed started a series of interest rate hikes that caused severe losses to the pool. Initially, this was announced as a “paper” loss. Citron kept buying in the hope interest rates would decline. Almost no one was paying attention to what the treasurer was doing and even fewer understood it— until the auditors informed the Board of Supervisors, in November 1994, that he had lost nearly $1.7 billion. Shortly thereafter, the county declared bankruptcy and decided to liquidate the portfolio, thereby realizing the paper loss.
    61. 61. The Role of the Brokerage NY Times, June 3, 1998, Wednesday Merrill Lynch to Pay California County $400 Million Merrill Lynch & Co agrees to pay $400 million to settle claims that it helped push Orange County, Calif, into 1994 bankruptcy with reckless investment advice; 17 other Wall Street securities houses and variety of other companies that sold risky securities to county-run investment pool are expected to settle similar suits; county, which lost over $1.6 billion in high-risk investments, could end up recovering $800 million to $1 billion; its financial condition has improved sharply; table on status of some major suits and criminal probe.
    62. 62. The Underlying Causes The immediate cause of the bankruptcy was Citrons mismanagement of the Orange County investment pool. However, he would not have been driven to strive for such high rates of return on the pool—nor would he have been able to invest as he did—had it not been for the fiscal austerity in the state that began with Proposition 13. That citizen initiative, and several subsequent initiatives, severely limited the ability of local governments to raise tax revenue. Recognizing the extreme fiscal pressure these initiatives placed on county governments, the state loosened its municipal investment rules—allowing treasurers, for the first time, to use Citrons kind of strategy.
    63. 63. Orange County is not Unique Orange County provides dramatic warning of the dangers of that kind of investment strategy and should deter others from following the same path. But the conditions and resulting imperatives that drove the county to gamble with public funds remain. The demand for smaller government, tax limits, and local autonomy continues, and many municipalities may find the specter of financial collapse looming—especially when the economy takes its next downturn. These conditions exist, to a greater or lesser degree, in counties across the state and nation, which makes the Orange County bankruptcy especially significant.
    64. 64. What needs to be done? Local governments need to maintain high standards for fiscal oversight and accountability. As noted in the state auditors report following the bankruptcy, a number of steps should be taken to ensure that local funds are kept safe and liquid. These include having the Board of Supervisors approve the countys investment fund policies, appointing an independent advisory committee to oversee investment decisions, requiring more frequent and detailed investment reports from the county treasurer, and establishing stricter rules for selecting brokers and investment advisors. Local officials should adjust government structures to make sure they have the proper financial controls in place at all times.
    65. 65. What needs to be done? State government should closely monitor the fiscal conditions of its local governments, rather than wait for serious problems to surface. The state controller collects budget data from county governments and presents them in an annual report. These data should be systematically analyzed to determine which counties show abnormal patterns of revenues or expenditures or signs of fiscal distress. State leaders should discuss fiscal problems and solutions with local officials before the situation reaches crisis stage.
    66. 66. What needs to be done? Local officials should be wary about citizens pressures to implement fiscal policies that are popular in the short run but financially disastrous over time. Distrustful voters believe there is considerable waste in government bureaucracy and that municipalities should be able to cut taxes without doing harm to local services. Local officials need to do a better job of educating voters about revenues and expenditures. State government should also note that there are no checks and balances against citizen initiatives that can have disastrous effects on county services. Perhaps legislative review and gubernatorial approval should be required for voter-approved initiatives on taxes and spending.
    67. 67. Long Term Capital Management Long Term Capital Management (LTCM), run by the former head bond trader and vice chairman of Salomon Brothers, a former vice chairman of the Federal reserve, and two Nobel Prize-winning economists, leveraged almost $5 billion into a $100 billion portfolio full of derivatives, a 20/1 leverage ratio. The results obviously were spectacular while LTCM’s strategy worked, and were equally spectacular and disastrous when it didn’t. Few of LTCM’s investors and perhaps none of its lenders were aware of the magnitude of this fund’s gambles.
    68. 68. Long Term Capital Management If, as they say in the mutual fund literature, “past results are not indicative of future performance,” how should one go about evaluating a hedge fund? As with any other investment portfolio, the key is to understand the types of investments it currently owns, the overall strategy of the manager, and the tactics the manager intends to use or avoid. Getting answers to these questions is not only due diligence, but common sense. An article in the Financial Economists Roundtable (by Myron Scholes, one of the winners of the 1997 Nobel Prize for Economics and a principal in LTCM), alludes to risks in derivatives markets, but concludes that "there is no evidence the activities of these (derivatives) dealers pose a significant systemic risk".
    69. 69. The Near Bankruptcy and Bail-Out What happened at Long Term Capital Management? In 1998 it came close to going bankrupt! Only pressure from the U.S. federal government saved it. In Fall 1998, a bail-out of LTCM was arranged. Illustrious Wall Street institutions were cajoled into putting up $3.5billion to avert its bankruptcy. Time Magazine has a very rewarding article about the glaring inconsistency of this policy. eg Asian financial institutions must pay the penalty for taking too much risk, but very rich American investors will be bailed out.
    70. 70. Long Term Capital Management The New York Times has some great analysis. Check out the extraordinary leverage of the fund, and a piece about John Meriwether, fallen genius of LTCM and ex Salomon trader. (book: Liarss Poker) This article contains a naive fallacy from a Salomon Brothers veteran discussing roulette "because it is a mathematical certainty that red will come up eventually". Do these people really believe that? I would like to bet my entire capital leveraged by 20 times that it isnt a mathematical certainty! Any takers?
    71. 71. Long Term Capital Management 9/23/98 Prescient article from CNBCs David Faber about rumors of Long Term Capital Management bailout. 9/29/98 Banks Near Final Accord on Investment Funds Rescue 10/1/98 In 4 1/2 hours of testimony, Federal Reserve Chairman Alan Greenspan defended the bail out of LTCM. LTCMs failure threatened “substantial damage,” he said. 10/2/98 Rumors of an emergency Fed Meeting to discuss liquidity issues related to Long-Term Capital Management spooked the market. Comment from the Fed: "As a matter of policy, we dont comment on these things". Interesting...
    72. 72. Long Term Capital Management 10/5/98 MSNBC Columnist James O. Goldsborough has a great article about LTCM, and the high volume, high risk strategies. It repeats the roulette doubling up analogy. 10/8/98 The Secret World of Hedge Funds 10/10/98 In Archimedes on Wall Street, Forbes Magazine gives a good overview of what LTCM attempted to do. Good comparison of John Meriwether to Archimedes. Financial genius is a short memory in a rising market 10/15/98 Alan Greenspan cut interest rates by another quarter point. A surprise move, as it was outside the regular FOMC meeting. What does Alan Greenspan know that we dont?. Could there be more hedge fund exposure?
    73. 73. Long Term Capital Management Recommends Hedge Funds : Investment and Portfolio Strategies for the Institutional Investor (The Irwin Asset Allocation Series for Institutional Investors)-buy now from Amazon.comThe story of the 1929 stock market crash. Back then it was Investment Trusts and highly margined investors, this time highly leveraged Hedge Funds...?
    74. 74. Long Term Capital Management An interesting place to start researching hedge funds is the Hedge Fund Association. The Associations aim is to educate the investing publics and legislators misperceptions of hedge fund volatility and risk. So why were investors in LTCM bailed out? Could the absence of the capital injection have resulted in a chain reaction of failures?
    75. 75. Enron Bankruptcy The Start as a Gas Pipeline Company in 1985 Deregulation Enron Finance in 1990 Enron’s Overseas Energy Projects Enron Communications and Internet Structure Enron Online and Internet Brokering Enron and the Market in Broadband The Catches—one after another! The Collapse Enron and E-Mails Lasting Trail The Fallouts
    76. 76. Gas Pipeline Company in 1985 In 1985, Kenneth Lay, using proceeds from junk bonds, combined his company, Houston Natural Gas, with another natural-gas pipeline to form Enron. From that start, the company then moved beyond selling and transporting gas to become a big player in the newly deregulated energy markets by trading in futures contracts. In the same way that traders buy and sell soybean and orange juice futures, Enron began to buy and sell electricity and gas futures.
    77. 77. Deregulation In the mid-1980s, oil prices fell precipitously. Buyers of natural gas switched to newly cheap alternatives such as fuel oil. Gas producers, led by Enron, lobbied vigorously for deregulation. Once-stable gas prices began to fluctuate. Then Enron began marketing futures contracts which guaranteed a price for delivery of gas sometime in the future. The government, again lobbied by Enron and others, deregulated electricity markets over the next several years, creating a similar opportunity for Enron to trade futures in electric power.
    78. 78. Enron Finance in 1990 In 1990, Lay hired Jeffrey Skilling, a consultant with McKinsey & Co., to lead a new division—Enron Finance Corp. Skilling was made president and chief operating officer of Enron in 1997. Even as Enron was gaining a reputation as a "new- economy" trailblazer, it continued—to some degree apparently against Skillings wishes—to pursue such stick-in-the-mud "old-economy" goals as building power plants around the world.
    79. 79. Enrons Overseas Energy Projects Enron’s energy projects sprouted in places no other firm would go but appear not to have earned it a dime. With operations in 20 countries, Enron Corp. set out in the early 1990s to become an international energy trailblazer. Enron launched bold projects in poverty-ravaged countries such as Nigeria and Nicaragua. It set up huge barges—with names like Esperanza, Margarita and El Enron—in ports around the world to generate power for energy-starved cities. Enrons international investment totaled more than $7 billion, including over $3 billion in Latin America, $1 billion in India and $2.9 billion to develop a British water-supply and waste-treatment company.
    80. 80. Enrons Support from the U.S. The U.S. government has been a major backer of Enrons overseas expansion. Since 1992, Overseas Private Investment Corp provided about $1.7billion for Enrons foreign deals and promised $500million more for projects that didnt go forward. The Export-Import Bank put about $700 million into Enrons foreign ventures. Both agencies provide financing and political- risk insurance for foreign projects undertaken by U.S. companies. Enron enlisted U.S. ambassadors and secretaries of State, Commerce and Energy to buttonhole foreign officials on Enron’s behalf. It cultivated international political connections, recruiting former government officials and relatives of heads of state as investors and lobbyists.
    81. 81. Enrons Incentives to Risk Like other parts of Enrons vast operation, its international division was fueled by intense internal competition and huge financial incentives. Executives pocketed multimillion-dollar bonuses for signing international deals under a structure that based their rewards on the long-term estimated value of projects rather than their actual returns. The system encouraged executives to gamble without regard to risk.
    82. 82. Enrons Overseas Boondoggle In reports to investors, the company played down or obscured what analysts and others saw as inevitable losses. But in an interview with academic researchers in 2001, Jeffrey K. Skilling, who then was chief operating officer, conceded that Enron "had not earned compensatory rates of return" on investments in overseas power plants, waterworks and pipelines. Skilling said the projects had fueled an "acrimonious debate" among executives about the wisdom of its heavy foreign investments.
    83. 83. Enrons Overseas Partnerships An internal investigation released this month showed that two foreign projects, in Brazil and Poland, were entangled in Enrons off-the-books partnerships, accounting devices controlled by then-Chief Financial Officer Andrew S. Fastow that shielded huge debts from investors. Those arrangements allowed Enron to present a more optimistic report to investors. Other partnerships also were involved: “Whitewing”, with interests in Turkey, Brazil, Colombia, and Italy; Ponderosa, with interests in Brazil, Colombia, and Argentina.
    84. 84. Enron Communications January 21, 1999: “Enron Communications, Inc., introduced today the Enron Intelligent Network (EIN), an application delivery platform … that will enhance the company’s existing … fiber-optic network to create next generation applications services. The EIN brings to market a reliable, bandwidth-on-demand platform for delivering data, applications and streaming rich media to the desktop. “The Enron Intelligent Network architecture is based on a unique approach to networking through distributed servers … that supports the development and maintenance of distributed applications across network environments.”
    85. 85. Enron Communications “In November 1999, Enron Communications (as a wholly owned subsidiary of Enron) joined with Inktomi Corporation in a strategic alliance in which the Inktomi Traffic Server cache platform was to be integrated into the Enron Intelligent Network. The objective was to offer high quality network performance and bandwidth capacity to support broadband content distribution and e-business services. The integration of Inktomis caching software into the Enron Intelligent Network was to enhance the ability of Enron Communications to seamlessly and selectively push content to the desktop while handling massive volumes of high bit rate network traffic in a scalable manner.”
    86. 86. Enron Communications About Inktomi: ”Inktomi develops and markets scalable software designed for the worlds largest Internet infrastructure and media companies. Inktomis two areas of business are portal services, comprised of the search, directory and shopping engines; and network products comprised of the Traffic Server network cache and associated value- added services. Inktomi works with leading companies including America Online, British Telecom, CNN, Excite@Home,, Intel, NBCs Snap!, RealNetworks, Sun Microsystems, and Yahoo!. The company has offices in North America, Europe and Asia.”
    87. 87. EnronOnlineEnronOnline was launched Nov. 29, 1999.“EnronOnline offers customers a free, Internet-based system for conducting wholesale transactionswith Enron as principal.”“EnronOnline is your best tool for trading energy-relatedproducts and other commodities quickly, simply andefficiently. Our Web-based service combines real-timetransaction capabilities with extensive information andcustomization tools that increase your knowledge of whatshappening around the world-even as it happens.EnronOnline sharpens your sense of the marketplace tomake you a more knowledgeable trader.”
    88. 88. EnronOnline “No matter what commodity you want to buy or sell, youre almost certain to find a live, competitive quote on EnronOnline. We cover markets all over the world including gas, power, oil and refined products, plastics, petrochemicals, liquid petroleum gases, natural gas liquids, coal, emission allowances, bandwidth, pulp and paper, metals, weather derivatives, credit derivatives, steel and more. EnronOnline covers almost every major energy market in the world. And were not sitting still. Were adding new markets and new products all the time.” An ironic example of "Trading Markets": Credit Risk Management Tools, including Bankruptcy Swaps
    89. 89. EnronOnline Claims Real-Time Pricing Fast, Free, Secure Execution Price Limit Orders Option Contracts Market News and Quotes Industry Publications Weather Insights Complete Customization Capabilities
    90. 90. Brokering (?) over the Internet Note that Enron served NOT just as a broker but as a Principal—an active participant in transactions.
    91. 91. Enron High-bandwidth Venture December 3, 1999: "Cutting the red ribbon for bandwidth commodity trading, high-bandwidth application service company Enron Communications Inc. Friday introduced its new approach to bandwidth." "This is Day One of a potentially enormous market," said Jeff Skilling, Enron president and chief operating officer. He compared the present inflexible agreements for pre-set capacity amounts to pre-reform "oil contracts in the 1970s, natural gas contracts prior to 1990 and electric power contracts prior to 1994." May 2, 2000: “Enron Corp. announced today the expansion of EnronOnline to include products for the purchase and sale of bandwidth capacity.”
    92. 92. Enron Broadband Trading Strategy The Purpose: Effect on Enron Stock Prices The Technique Step 1. Sell to an affiliated partnership Step 2. Set an internal value on the sale Step 3. Sell from one partnership to another Step 4. Act as underwriter for the sale The Lack of Substance The Beginning of the Collapse The Collapse
    93. 93. The Catches—one after another! Acting as Principal in transactions! Failing really to make money Creating trading shell companies Acting as partner in transactions! Playing games with financial reporting Being Greedy
    94. 94. The Collapse Sudden announcement of losses in Oct 2001 File for bankruptcy in Dec 2001 Bankruptcy Congressional Investigations began in Dec 2001 Attempted destruction of documents
    95. 95. Enron and E-Mails Lasting Trail It is almost impossible to hide transactions: Paper records at the source Local computer system records Internet communication records Recipient records Paper records at the destination
    96. 96. End of Enron’s Overseas Energy Program In mid-February 2002, Overseas Private Investment Corp., which backed many of Enron’s overseas energy projects, moved to stem its $1-billion Enron exposure by canceling $590 million in loans to the company, once one of its largest clients. Enron had missed deadlines for OPIC requirements in financing projects in Brazil, an OPIC spokesman said. OPICs decision shifted more of the burden for the troubled projects from the U.S. government to Enrons creditors, lenders and partners.
    97. 97. The Fallouts of Enron Collapse On the Workers Reduction in force by 6,000 workers Effects on their retirement accounts On the Stock Market Effects of “sophisticated accounting” Effects on Internet-related stocks Effects on Communications-related stocks On the Accounting Profession Effects of conflicts-of-interests: Combining Auditing & Consulting On the Halls of Government Effects on Energy Policy-Making Effects on Political funding
    98. 98. Effects on the Accounting ProfessionBiggest Accounting FirmsThe accounting industry is dominated by the aptly named Big Five, followed by muchsmaller firms whose client lists includes mainly mid-size and small companies. 2001 U.S. U.S. Total 2001 global revenue Partners U.S. Staff revenue (billions) (billions)PricewaterhouseCoopers $8.1 2,784 43,134 $19.8Deloitte & Touche 6.1 2,283 28,992 12.4Ernst & Young 4.5 1,934 22.526 9.9Andersen 4.3 1,620 27,788 9.3KPMG 3.2 1,471 17,577 11.7BDO Seidman . 0.4 306 2,054 2.2Grant Thornton 0.4 272 2,962 1.7McGladney & Pullen 0.2 493 2,530 1.6Source: Public Accounting Report
    99. 99. March 15, 2002. The Los Angeles Times, page A1U.S. Indicts Enron Auditor Over ShreddingAndersen faces an obstruction of justice charge after failing to reach a pleaagreement with prosecutors.By Edmund Sanders and Jeff Leeds, Los AngelesTimes Staff WritersWASHINGTON -- Federal prosecutors Thursday hit accounting firm Andersenwith a criminal indictment for allegedly orchestrating the "wholesale destruction"of tons of Enron Corp. documents, raising new doubts about Andersens survival.The one-count indictment is the first of what Justice Department officials hintedcould be a string of criminal charges arising from the collapse of energy giantEnron, which filed for Chapter 11 bankruptcy protection Dec. 2 amid an accountingscandal.Reacting swiftly to the indictment, the government today suspended Enron Corp.and Andersen from entering into new federal contracts.
    100. 100. March 15, 2002, New York TimesAndersen Charged With Obstruction in Enron InquiryBy Kurt EichenwaldWASHINGTON, March 14 — In the first criminal charge ever brought against amajor accounting firm, Arthur Andersen has been indicted on a single count ofobstruction of justice for destroying thousands of documents related to the Enroninvestigation, the Justice Department announced today.The indictment, handed up by a grand jury last week and unsealed today, describesa concerted effort by Andersen to shred records related to Enron in four of thefirms offices, in Houston, Chicago, London and Portland, Ore. It was the firstcriminal charge stemming from the governments investigation of Enrons collapsein December."Obstruction of justice is a grave matter, and one that this department takes veryseriously," Larry D. Thompson, deputy attorney general, said at the JusticeDepartment. "Arthur Andersen is charged with a crime that attacks the justicesystem itself by impeding investigators and regulators from getting at the truth."
    101. 101. Global Crossing Bankruptcy January 29, 2002: “Global Crossing Ltd, which spent five years and $15 billion to build a worldwide network of high-speed Internet and telephone lines, files for bankruptcy after failing to find enough customers to make network profitable; had attracted many notable business and political figures, including Democratic National Committee chairman Terry McAuliffe, former Pres George Bush, Tisch family and former ARCO chairman and big Republican fund-raiser Lodwrick Cook.” This is the largest bankruptcy of a telecommunications company.
    102. 102. The History Global Crossing was formed in 1999 from a merger of a Bermuda-based fiber-optic cable company with a local U.S. telecom company. In the ensuing years, it developed a 100,000-mile global network of fiber-optic cables—including links that traverse the Atlantic Ocean—linking more than 200 cities in 27 countries in the Americas, Asia and Europe. It was regarded as one of the most promising of the new generation of telecom companies that sprang up in the late 1990s, and had secured a stock market value of $75bn.
    103. 103. The History While it incurred more than $12bn debts, its assets are believed to be worth nearly $24bn, almost twice as much as its debts. About mid-2000, things began to turn sour for the telecom industry. Optimistic network operators had completed huge infrastructures just as a nationwide economic slowdown curtailed corporate spending for such services. That left not only Global Crossing but other network companies with insufficient revenue to pay the massive debt they had accumulated to build their costly networks. In fact, Global Crossing has never reported annual profit since its creation, and by the first quarter of 2001, cash was running short.
    104. 104. Accounting Practices Global Crossing then entered into swaps with other networks, using indefeasible rights of use, or IRUs. Global Crossing would buy an IRU and book the price as a capital expense, which could be spread over a number of years. But the income from IRUs was booked as current revenue. Technically, the practice is within the arcane rules that govern financial derivative accounting methods, but only if the swap transactions are real and entered into for a genuine business purpose.
    105. 105. Allegations disputed But there was the possibility that these transactions were not for legitimate business purposes and indeed were potentially fraudulent. Such concerns are a direct result of the revelations about misleading accounting methods used by the failed energy trader Enron. Global Crossing has said it will launch an independent probe of its accounts (by a company other than Anderson). "Recent happenings in the industry have brought a lot of attention to accounting," a spokesman said (but without mentioning Enron). Global Crossing has said it will look into allegations of impropriety by a former employee.
    106. 106. The Former Employee At the center of the controversy is Joseph Perrone, the companys former executive vice president of finance and former outside auditor. For 31 years he had been an auditor and partner with the Big Five accounting firm Arthur Andersen & Co. By the time he joined Global Crossing in May 2000, Perrone was intimately familiar its operations, having directed Andersens work in connection with Globals 1998 initial public offering, which raised about $400 million. Though it is common for outside auditors to jump ship and go in-house at the companies they audit, Perrones move was unusual because he was so highly placed at Andersen.
    107. 107. The Incentives To lure Perrone from Andersen, Global Crossing offered him a $2.5-million signing bonus on top of a base salary of $400,000 and a target annual bonus of $400,000, according to SEC filings. Perrone also received 500,000 Global Crossing stock options, along with shares in its sister company, Asia Global Crossing Ltd., which were to vest over a three-year period. Perrone also is chief accounting officer at Asia Global Crossing. This all piqued the interest of SEC officials, who questioned whether Perrones hiring "impaired" Andersens independence. Ultimately, the SEC was satisfied that Andersen "met the requirements for independence."
    108. 108. The Incentives “Chairman Gary Winnick could lose control if bankruptcy plan is accepted, but the blow would be softened by stock deals that reaped him more than $730 million. Company shares traded for more than $60 as recently as March 2000. They have now fallen more than 99 percent, to 13.5 cents, in over-the-counter trading after being de-listed by the New York Stock Exchange.
    109. 109. THE END