St hilda rubicon_final

James Chanos Kynikos Associates St. Hilda‟s College University of Oxford

26 January 2011

Crossing the Ethical Rubicon: From Private to Public Sector

“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”

lacked a moral compass

– Related party transactions

– Insiders selling personal

stock while touting the

company‟s stability

3

„My personal belief is that Enron stock

is an incredible bargain at current

prices, and we will look back a couple

of years from now and see the great

opportunity that we currently have.‟

Kenneth Lay, CEO, September 26, 2001

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

• Breakdowns in lending oversight

by investors, rating agencies, and

regulators

5

„American consumers might benefit if

lenders provided greater mortgage product

alternatives to the traditional fixed-rate

mortgage.‟ Alan Greenspan, Federal Reserve Chairman,

February 23, 2004

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

meeting

– Hedge funds warn: „worry

about the regulated banks‟

„Faced with a financial system that

few people seemed to understand

anymore, the G8 did nothing.‟ Fool’s Gold, Gillian Tett

8

„We suspect the problem in the sub-

prime area is just the tip of the iceberg

for the mortgage market as a whole. For

all practical purposes, the sub-prime

market is in the process of shutting

down.‟ David Shulman, Senior Economist,

University of California Los Angeles

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

dance to the music

9

„When the music stops, in terms of liquidity,

things will be complicated. But as long as the

music is playing, you‟ve got to get up and

dance. We‟re still dancing.‟ Charles Prince, Citigroup CEO, July 9, 2007

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%

• September 14, 2007 - “Run on the Rock”

– Northern Rock received liquidity support

facility from the Bank of England

– First UK bank run since Victorian era

• February 22, 2008 - Northern Rock nationalized

10

`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

`This standing facility is of course only extended to

businesses that are sound but face a temporary

liquidity problem.‟ Adam Applegarth, Northern Rock CEO, September 14, 2007

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

guarantee $30 billion of toxic Bear

Stearns‟ assets

12

JP Morgan Pays $2 a Share for Bear Stearns New York Times, March 17, 2008

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

short sellers in April 2008

– First short-selling restrictions

in US, July 2008

13

„Bear Stearns' capital, and its broker-dealers'

capital, exceeded supervisory standards.

Counterparty withdrawals and credit denials,

resulting in a loss of liquidity - not inadequate

capital - caused Bear's demise. „ Christopher Cox, SEC Chairman, March 20, 2008

Lehman Brothers: An Early Greek Tragedy

• Vocal marketplace critics of Lehman

dismissed by company and regulators

• Lehman management steadfastly denied

problems

• September 15, 2008 – Lehman Brothers

filed for bankruptcy

– Implied hole in balance sheet north of

$150 billion…2x Enron‟s!

14

„I am the one who ultimately signs off and I'm

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

„Unbeknownst to the investing public, rating agencies,

government regulators, and Lehman‟s board of

directors, Lehman reverse engineered the firm‟s net

leverage ratio for public consumption.‟

Examiner’s Report, March 11, 2010

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

–Reality: Access to the

Federal Reserve balance

sheet

• Federal Reserve uses its

balance sheet to liquefy the

world

15

„… to address dollar funding pressures

worldwide, we announced a significant

expansion of reciprocal currency arrangements

with foreign central banks, including an

approximate doubling of the existing swap lines

with the European Central Bank and the Swiss

National Bank and the authorization of new

swap facilities with the Bank of Japan, the Bank

of England, and the Bank of Canada.‟ Ben Bernanke, Federal Reserve Chairman,

September 23, 2008

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

• Less than a year later, US Federal

Government undertook $182 billion

bailout of AIG

16

„AIGFP's models…when coupled with their

conservatively structured transactions

provide AIG with a very high level of

comfort.‟

Martin Sullivan, AIG CEO, December 05, 2007

„It is hard for us, without being flippant, to

even see a scenario within any kind of realm

of reason that would see us losing one dollar

in any of those transactions.‟ Joseph Cassano, AIG Financial Products CEO,

August 2007

• Ford Motor

Mixed Message From Private Sector Regarding Public

Sector Bailout…Say What?

• General Electric (‘GE’)

17

„Late Monday morning, General Electric CEO Jeff

Immelt called to tell me that his company was

having problems selling commercial paper.‟ Hank Paulson, US Treasury Secretary, September 8, 2008

„We have no issues funding ourselves.‟ Keith Sherin, GE CFO, September 25, 2008

„We really see the CP market improving right now.

We have had no problems with our own CP, but I

think we have just taken this issue off the table for

investors.‟

Jeff Immelt, GE CEO, October 10, 2008

„Jeff Immelt had come to my office on the 16th to

make the case that the FDIC should guarantee GE

Capital‟s debt issues… “We are the ones out there

making the loans that the banks aren‟t, and we need

help,” Immelt said.‟

Hank Paulson, US Treasury Secretary, October 16, 2008

„Companies are taking drastic measures to preserve

their finances – not just the big banks, but also

companies like General Electric and Ford.‟ Hank Paulson, US Treasury Secretary, September 18, 2008

„Ford is asking for access to up to $9 billion in bridge

financing, but reiterated that it hopes to complete its

transformation without accessing the loan should

Congress agree to make the funds available.‟ Ford Motor Company Press Release, December 2, 2008

Ford Bailout Money Unnecessary, Company Says Associated Press, December 10, 2008

„We don't want to borrow any more money. We have

sufficient liquidity to fund our transformation plan, …

our business is in a relatively good shape.‟ Alan Mulally, Ford CEO, January 25, 2009

– Tapped Federal Reserve CP facility 14 times

for $15.9 billion from October 2008 to June 2009

Note: Hank Paulson quotes are provided from his book, On the Brink: Inside the

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

• Stress tests performed on US banks

– all pass!

• Questionable governance of quasi-

nationalized firms

– No AIG emails?

18

„When things go well, people call me

Gordon. When they're bad, they call me

Mr. Brown. At the moment, they are

calling me Gordon.‟ Gordon Brown, UK Prime Minister,

December 22, 2008

Ireland: When the Luck of the Irish Finally Ran Out

„A perfect illustration of the economics of morality –

the absence of a sense of propriety, of restraint and

of right and wrong.... Public morality...is about

knowing when to stop. Nothing in Ireland told

people when to stop.‟

Fintan O’Toole, Ship of Fools

19

• „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

• Residential housing values

estimated to be worth more

than 3x GDP at the 2006 peak

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‟

stress tests all successful!

• European Financial

Stability Facility („EFSF‟)

established

21

„It is revealing that the tests [on the Irish

banks] conducted last July identified a capital

shortfall of just €3.5bn. Yet less than six

months later, Irish banks required 10 times

that amount.‟ George Osborne, UK Chancellor of the

Exchequer, January 2011

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

25

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

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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