Compliance: Productive Role in the Meltdown?

November 25th, 2008

What was compliance’s role in the financial market meltdown?  In short, ambivalence.  After all, compliance professionals’ key responsibility includes transactional advice and monitoring.  Compliance professionals serve on risk and governance committees and often have the ear of the general counsel. 

 

At a recent SIFMA CL conference in New York City, David DeMuro, the former head of Compliance for Lehman Brothers, noted that he was sitting in a product conference and the head of mortgage securities was discussing new product developments.  DeMuro said that the scheme seemed questionable, but he did not understand the issues well enough to promote a substantive objection. This has been an unfortunate refrain.  Compliance professionals missed an opportunity to advise management to take a second look at questionable business practices, practices that ultimiately had a negative impact on so many financial firms..  In my view, the problems stem from the fact that Compliance is paid to get along with the business.  Compliance officers become managing directors if the business people like them and can get along with them.  Thus, in the absence of hard reasons not to approve a transaction (i.e. specific regulations), Compliance will not raise a hand, perhaps on concern that they might be labeled difficult.

 

If they had raised a concern, it probably would have been focused on these areas:

 

Valuation:  Firms like Lehman were valuing the securities at levels that did not make sense, particularly to the market.  The CFO, whose job it is to be the independent arbiter into his process was either not independent, not competent, or both.  Compliance’s obligation to ensure independence – adherence to policies and procedures – was not constructive.  The problem was not limited to Lehman, but befell many financial firms.

 

New Business Review:  So what were these new business committees thinking?  Creating products to lend to subprime borrowers or selling insurance on portfolio without adequate reserves were only two of the business initiatives that went through this committee.  Was this considered best practices or did this adhere to the firm’s policies and procedures.  Should Compliance have raised an issue?

 

Adherence to Firm Policies: Companies have policies as to what type of security can be sold to certain clients.  In fact, some clients differentiate industries and maturities. Some have specific suitability issues. There is evidence that many of these policies were ignored.  In some cases, clients gave a verbal waiver trying to take advantage of a rising market.  Unfortunately, verbal waivers are not sufficient and Compliance should have been at the forefront of preventing this behavior.

 

The days of listening and nodding at management meetings appear to be over.  Compliance must move to the forefront to be true to its mandated role.  I believe the best way to accomplish this is to develop a series of best practices that are universally accepted;  FINRA or the Investment Advisor / Investment Company equivalent (SEC?) could and perhaps should mandate not only rules, but also a series of best practices for compliance professionals.  With these practices in hand, compliance professionals can fall back on industry practices without being concerned by business led retribution.

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The New Regulatory World; Better for Customers

November 4th, 2008

I was listening to NPR on Friday morning and heard a report entitled “How Credit Default Swaps Spread Financial Rot.”  Something in the report made me pause.  When questioned about blame, a financial risk analyst noted that while financial firms had no intention of causing world financial problems, there was also no intent to regulate these financial vehicles.  Of all the regulatory bodies, at least 30 regulating the financial markets in the US, Its hard to imagine that no one regulated a private security transaction that linked the entire financial world in a convoluted daisy chain.  As mentioned in the piece, the demise of one small institution in a remote part of the world could cause a chain reaction to take down the entire financial system.  That’s why world governments are racing to stem the tide and recapitalize the banks.

 

So why was this problem not identified and resolved years ago?  First, the US regulations are antiquated.  Most were developed in response to the financial panic of the late 20s and early 30s.  Second, the general political movement over the last 25 years has been to reduce regulation.  Regulation was viewed in the context of unnecessary paperwork or the famous Pentagon mandated $3,000 toilet seat.  So regulators became declawed and began to focus on issues like data archiving and storage media.  While this can be important at times, the issues associated with read-only CDs seemed to eclipse the issues surrounding CDS (credit default swap).  Add to that the fact that some agencies focus on specific rules (e.g. FINRA) instead of prudential regulation.  For instance, the SRO (self-regulatory organization) that regulates the brokerage industry, FINRA, examines institutions based on a rule book and a checklist.  That’s why the SEC/FINRA did not step in when the CDS stench started to emanate from 237 Madison (Bear Stearns). The agency said that it was not its job.

 

John Bogle, the legendary former CEO of The Vanguard Group, has recently written a book entitled “Enough.”  He noted that financial firms are enamored by numbers which he says  can be very deceiving.  He cited the quarterly earnings per share announcement as the most financial engineered number that a company presents; one only has to read the recent Fortune Magazine article on GE to understand Mr. Bogle’s point.  He said that most of the important risk characteristics cannot be measured: character, integrity, moral conduct.  Given the amount of fees that go into the pockets of senior executives and financial professionals, the public is owed a fair understanding of the risks before it invests. 

 

As David Sobel from Abel Noser likes to point out, the prospective financial regulation modernization initiatives will undoubtedly ensure that both the firms and the individuals at these firms will be liable to ensure that the public is fairly treated.  Regulations will be prudential and targeted.  The rules and regulations will become part of the day to day process at financial firms.  To get a glimpse into what the man on the street thinks about more regulation at this time, I remember a meeting I was in about 6 years ago, right after Sarbanes-Oxley was put into law.  The UBS attorney was upset at the intrusive nature of the law and how much extra work it would cost her.  A member of the group commented that this was the price to pay for malfeasance.  He said that as an investor, he felt much more comfortable with financial statements now that the CEO had to sign his or her name. 

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The Financial Crisis: The Role of Compliance

October 29th, 2008

By now I think it is clear that the results of credit mess will be a revised, sustainable business model and process transparency.  In a recent OP-ED in the NY Times, SEC Commissioner Christopher Cox lamented that the lack of transparency in the Credit Default Swap (CDS) market has “trapped the large financial institutions in a web of transactions. This has created systemic risk that is particularly serious in the current stressful economic environment, contributing to a gravitational pull that stands to drag everyone down.”

 

I believe the CDS problem has a principle cause: a lack of transparency to market participants, to senior management, to investors and regulators.  This is the product of the lack of a formal market and insufficient financial disclosure. 

 

First of all, the securities are privately negotiated and traded. In 1998, Commodity Futures Trading Commission put forth a proposal that would have effectively moved many derivatives into a market environment such as the way commodities and futures are managed and regulated.  Most market followers cite Robert Rubin, the Treasury Secretary under President Clinton and Alan Greenspan, the Chairman of the Federal Reserve for blocking the 1998 proposal.

 

Secondly, these securities were not required to be disclosed on the balance sheet.   In an article discussing the Enron problem, Gretchen Morgenson described off balance sheet vehicles, such as CDS, this way, “The trouble is, while more companies are relying on off-balance-sheet methods to finance their operations, investors are usually unaware that a company with a clean balance sheet may be loaded with debt — until it is too late.

 

“One intent of these structures is to try to move debt off the radar screen so that companies appear less financially leveraged than they actually are,” said Scott Sprinzen, co-chairman of the corporate bond rating criteria committee at Standard & Poor’s.   Derivatives are typically off balance sheet items because they do not represent actual cash instruments.

 

 So It appears to me the best way to restore and maintain order in the financial markets is to restore transparency: implement rules and processes to make financial transactions apparent to its constituencies.  While the strengthening of accounting rules and the improvement of regulatory institutions will help facilitate this, I would like to focus on the Compliance Department’s role in restoring and maintaining transparency and ultimately order.

 

Since these transactions and the resulting disclosures were in fact legal and ethical, Compliance cannot be directly blamed for the problems that have caused the crisis.  In a recent speech at the NSCP conference in Philadelphia, Lori Richards noted that “perhaps the most important thing you can do as a compliance professional is to remind firm employees of their obligations to investors - for an adviser, the fiduciary obligation to clients, and for a broker, the obligation to follow just and equitable principles of trade. These obligations must continue to motivate and inform the way that the firm interacts with clients, customers, and investors.”  She continued, “In the current credit crisis, the SEC has been aggressively working to police the markets, and to ensure that the “rules of the road” for public companies and market participants include full disclosure to investors and promote healthy capital markets. While a small agency (only 3,800 staff), the SEC packs clout through its experienced and dedicated staff.”

 

In the next installments, I will begin to review the needed changes in the compliance capability to support to orderly restoration of the financial system.

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A Panic, A Crash, a Potential Silver Lining

October 12th, 2008

The historic drop in the stock market appears to be the combination of a panicked credit market and an unsettling realization that assets in this country, and perhaps around the world, are overpriced.  In addition, the leverage that has been allowing the unsustainable consumer consumption has come to an abrupt end; this can imply a reduced baseline for economic activity.  In other words, the capacity for producing cars or houses or computers or other durable goods may be overstated.  That is why the prices of GM and Ford stock are significantly down and why the market cannot seem to find its equilibrium. 

The credit market is besieged by the lack of transparency of the financial institutions balance sheet.  Mortgage derivatives are so pervasive and, given the drop in the housing prices, no one knows which banks are solvent.  This is constraining bank to bank lending which allows business to fund gaps in accounts receivables and other short term cash needs.  Add to this the free fall of certain commodities like oil and gas, and the financial market is certifiable mess.

The resulting “ruckus” appears to be insurmountable.  Every short-term idea seems to fail or at least not stem the panic.  But I would argue that while the decline is steep and painful, it is exactly what our country and our economy needs.  Prior to this event, our lifestyle was unrealistic and, more importantly, unsustainable.  Just consider that 2 bedroom apartment selling in NYC for $2.5 million or the beautiful house on your block that got torn down to give way for a 10,000 square foot McMansion.  Perhaps we should consider the $250,000 initiation for the country club in Purchase, NY.  The clear price/ value imbalance was fueled by the unbelievable amount of leverage in the system which leads to excessive demand for houses and cars as well as luxury items that put many of these goods beyond the reach of families.  Congress was pushed to lower borrowing standards to help families purchase these goods which further exacerbated the situation and gave us one very serious hangover.  What politicians couldn’t or wouldn’t say, the market said pretty forcefully. 

The silver lining in all of this is a sensible economy.  The salary gap for the highest and lowest paid employees will contract, consumption will be reasonable and prices will approximate value.  While the contraction will be painful, the positive impact on our country will be profound.  We will begin to experience a lower trade deficit, a stronger dollar, oil prices will contract to historical levels ($20-30 per barrel), housing prices will be affordable.  Moreover, regulation will become sensible, designed to achieve ethical, sustainable corporate behavior.  No longer will we allow financial institutions to tell the government how they should be regulated. 

Next week, I will describe characteristics of the new regulatory environment.

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Genesis of the Financial Crisis: Unsustainable Financial Transactions

October 2nd, 2008

I was drawn to an article in the NY times on Sunday written by Gretchen Morgensen entitled, “Behind Insurer’s Crisis, Blind Eye to a Web of Risk.”   Ms. Morgensen discusses the geneses of the credit default swap and notes how AIG became one of the focal points for the product.  The tone moves from sad or devastating as it chronicles the fall of one of the most admired global companies, AIG, to the sublime when she notes that Goldman Sachs held $20 Billion dollars of AIG obligations.  In short, if AIG met a Lehman fate, then Goldman, Morgan Stanley and probably a number of admired financial companies would be severely hindered.  With the way the capital markets are constraining capital raising, the remaining financial institutions that the public can join may be limited to Bank of America, JP MorganChase  or Citibank. 

Morgensen has become the conscience of the mortgage meltdown.  As the financial community was downplaying the global impact of the housing slide, she was highlighting the troubles in areas like Jacksonville, Florida.  I happened to meet April Charney at a recent SIFMA conference.  She is an attorney with Jacksonville Legal Aid, a source for Ms. Morgenson and someone who has been working to assist people who have lost or are in danger of losing their homes.  Her basic issue with the financial community is their unsustainable strategies, their programs to wring the last dollar out of unsuspecting families knowing full well that these strategies were rife for long-term failure.  While she admits that the public was greedy, she directs her ire at the financial institutions who she felt had the responsibility for taking an ethical and long term approach for their activities.  She laments that it was the short term perspective that dominated the operating style of most financial firms that caused the rampantly irresponsible behavior. 

Next week, I will give some perspective to this “unsustainable” financial behavior.

 

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