May 27, 2010
Interesting title huh, read on you will see how this relates to Bill Ackman.
Introduction & Excerpt (Via Harvard Law School On Corp Governance)
In the paper, Inefficiencies in the Information Thicket: A Case Study of Derivative Disclosures During the Financial Crisis, I provide an empirical examination of the effect of enhanced derivative disclosures by examining the disclosure experience of the monoline insurance industry in 2008. Conventional wisdom concerning the causes of the Financial Crisis posits that insufficient disclosure concerning firms’ exposure to complex credit derivatives played a key role in creating the uncertainty that plagued the financial sector in the fall of 2008. To help avert future financial crises, regulatory proposals aimed at containing systemic risk have accordingly focused on enhanced derivative disclosures as a critical reform measure. A central challenge facing these proposals, however, has been understanding whether enhanced derivative disclosures can have any meaningful effect given the complexity of credit derivative transactions.
Like AIG Financial Products, monoline insurance companies wrote billions of dollars of credit default swaps on multi-sector CDOs tied to residential home mortgages, but unlike AIG, their unique status as financial guarantee companies subjected them to considerable disclosure obligations concerning their individual credit derivative exposures. As a result, the experience of the monoline industry during the Financial Crisis provides an ideal setting with which to test the efficacy of reforms aimed at promoting more elaborate derivative disclosures.
Overall, the results of this study indicate that investors in monoline insurers showed little evidence of using a firm’s derivative disclosures to efficiently resolve uncertainty about a monoline’s exposure to credit risk. In particular, analysis of the abnormal returns to Ambac Financial (one of the largest monoline insurers) surrounding a series of significant, multi-notch rating downgrades of its insured CDOs reveals no significant stock price reactions until Ambac itself announced the effect of these downgrades in its quarterly earnings announcements. Similar analyses of Ambac’s short-selling data and changes in the cost of insuring Ambac debt securities against default also confirm the absence of a market reaction following these downgrade announcements.
Click Here To Read: A Tribute To Bill Ackman: Inefficiencies In Derivative Disclosures
May 7, 2010
Abstract:(Via SSRN)
Thorsten Beck
Professor, CentER, European Banking Center, Tilburg University
Ross Levine
Brown University – Department of Economics; National Bureau of Economic Research (NBER)
Alexey Levkov
Brown University – Department of Economics
Journal of Finance, Forthcoming
We assess the impact of bank deregulation on the distribution of income in the United States. From the 1970s through the 1990s, most states removed restrictions on intrastate branching, which intensified bank competition and improved bank performance. Exploiting the cross-state, cross-time variation in the timing of branch deregulation, we find that deregulation materially tightened the distribution of income by boosting incomes in the lower part of the income distribution while having little impact on incomes above the median. Bank deregulation tightened the distribution of income by increasing the relative wage rates and working hours of unskilled workers.
Additional Implications (via Harvard Corp Governance Blog)
We find that removing restrictions on intrastate branching tightened the distribution of income by increasing incomes in the lower part of the income distribution while having little impact on incomes above the median. This finding is robust to an array of sensitivity analyses. We find no evidence that reverse causality drives the results. Moreover, the impact of deregulation on income distribution varies in a theoretically predictable manner across states with distinct economic, financial, and demographic characteristics at the time of deregulation. These findings support the view that branch regulation in the United States restricted competition, protected local banking monopolies, and impeded the economic opportunities of the relatively poor.
We also present evidence that the impact of branch deregulation on income inequality is an indirect one. There is no evidence that branch deregulation reduces inequality by boosting incomes of the self-employed or by increasing educational attainment. Rather, the effect of branch deregulation on income inequality is driven by a reduction in inequality between skilled and unskilled workers and a reduction in income inequality among unskilled worker. In addition, we show that the relative wages and the relative working hours of unskilled vis-à-vis skilled workers increased significantly after branch deregulation. This is consistent with branch deregulation leading to a greater demand for labor that falls disproportionally on lower-skilled workers who therefore see both their working hours and their wage rates increase.
Click Here To Read: Big Bad Banks? The Winners and Losers from Bank Deregulation in the United States
May 1, 2010
Sounds like a stalemate..
Excerpt (Via Harvard Law On Corp Governance)
In our paper, we examine the effect of securities class action settlements on targeted firms. Private suits have long been championed as a necessary mechanism not only to compensate investors for harms they suffer from financial frauds but also to enhance the deterrence of wrongdoing. But many critics have claimed that there a hidden dark side to the successful prosecution of a securities class action. In this paper, we shed light on these issues by examining whether the revelation of earlier misstatements, the initiation of private suit, and the payment of a substantial settlement, weaken the defendant firm so that the firm is permanently worse off as a consequence of the settlement.
We find that defendant firms that settle securities class actions experience no significant declines in sales opportunities as a result of the lawsuit and settlement, but do experience a reduced level of operating efficiency while the lawsuit was pending (but not after it is settled). Most significantly, we also observe that defendant firms experience liquidity problems post-settlement and worsening Altman Z-scores (and a greater propensity to file bankruptcy) during that time period as well. Beginning with the filing of the class action, firm share prices are punished to the extent that investor returns do not recover.
We conclude that there is something in our results for both sides of the debate regarding the effects of securities litigation. One side could point toward our findings as evidence that the litigation is not a zero sum game for wrongdoers where only the insurer pays. On the other hand, others would claim that settlements, if not the entire litigation process, are a menace because they drain funds from the corporation that could better be directed toward strengthening its financial position.
Click Here To Read: Lying and Getting Caught: An Empirical Study of the Effect of Securities Class Action Settlements on Targeted Firms
April 25, 2010
Dear Readers,
I’m exceptionally proud to introduce you to Fraud Girl, our new Sunday columnist. She will write about all things corp governance, fraud, accounting, and business ethics. To give you some background (and although I can not reveal her identity). Fraud girl recently visited me in Chicago for the Harry Markopolos presentation to the local CFA. We were incredibly lucky to meet with Mr. Markopolos and enjoyed 3 hours of drinks and accounting talk. Needless to say Fraud Girl was leading the conversation and I was trying to keep up. After a brainstorm session I persuaded her to write for us and teach us about wall street screw-ups.
So watch out, shes smart, witty, and passionate about making the world a better place. I think Sundays just got a lot better…
-Miguel
Founder of SimoleonSense
P.S. For Questions or Comments: Reach fraud girl at: FraudGirl [at] simoleonsense.com
Regulators, Ignore the Masses — It’s Your Responsibility
Men in general judge more by the sense of sight than by the sense of touch, because everyone can see but only a few can test feeling. Everyone sees what you seem to be, few know what you really are; and those few do not dare take a stand against the general opinion, supported by the majesty of the government. In the actions of all men, and especially of princes who are not subject to a court of appeal, we must always look to the end. Let a prince, therefore, win victories and uphold his state; his methods will always be considered worthy, and everyone will praise them, because the masses are always impressed by the superficial appearance of things, and by the outcome of an enterprise. And the world consists of nothing but the masses; the few have no influence when the many feel secure.
-Niccolo Machiavelli, The Prince
Why are Machiavelli’s words so astonishingly prophetic? How does a 500 year old quote explain contagion, bubbles, and Ponzi schemes? Do financial decision makers consciously overlook reality or do they merely postpone due diligence? That is the purpose of this series — to analyze financial fraud(s) and question business ethics.
Recent accounting scandals i.e. Worldcom, Enron, Madoff, reveal a variety of methods for boosting short term performance at the expense of long run shareholder value. WorldCom recorded bogus revenue, Enron boosted their operating income through improper classifications, and Madoff ran the largest Ponzi scheme in history. Sure these scandals were unethical, deceived the public, and made a ton of money. But what is the most striking similarity? Each of these companies was seen as the golden goose egg; an indestructible force that could never fail. Of course, the key word is “seen”, regulators, attorneys, financial analysts, and auditors failed to see reality. But why?
Fiduciaries are entrusted with protecting the public and shareholders from crooks like Skilling, Pavlo, and Schrushy. An average shareholder lacks the knowledge and expertise of a prominent regulator, right? Shareholders don’t perform the company’s annual audit, review all legal documentation, or communicate with top executives. No, shareholders base their decisions off information that is “accurate” and “meticulously examined”.
Unfortunately in each of these instances regulators failed to take a stand against consensus and became another ignorant face in the crowd. “Everyone sees what you seem to be, few know what you really are; and those few do not dare take a stand against the general opinion”. Who are the few that really know who these companies are? The answer should be evident. What isn’t clear is why these cowardly few are in charge of overseeing our financial markets.
When Auditors Look The Other Way
A week ago, I came across this article: Ernst & Young defends its Lehman work in letter to clients. I chuckled as I was reading it, remembering Roxie Hart from the play Chicago shouting the words “Not Guilty” to anyone who would listen. Like Roxie, the audit team pleaded that the media was inaccurate. In recording Lehman’s Repo 105 transactions, they claimed compliance with GAAP and believed the financial statements were ‘fairly represented’. But, fair reporting is more than complying with GAAP. Often auditors are “compliant” while cooking the books (a mystery that still eludes me). In this case, the auditors blatantly covered their eyes and closed their ears to what they must have known was deliberate misrepresentation of Lehman Brother’s financial statements.
We will explore the Lehman Brothers fiasco in next week’s post…but here’s the condensed version. Days prior to quarter end, Lehman Brothers used “Repo 105” transactions, which allowed them to lend assets to others in exchange for short-term cash. They borrowed around $50 Billion; none of which appeared on their balance sheet. Lehman instead reported the debt as sales. They used the borrowed cash to pay down other debt. This reduced both their total liabilities and total assets, thereby lowering their leverage ratio.
This was allegedly in compliance with SFAS 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities that allowed Lehman to move the $50 Billion of assets from its balance sheet. As long as they followed the rules, auditors could stamp [the] financial statements with a “Fairly Represented” approval and issue an unqualified opinion.
Clearly in this case complying was unethical and probably illegal. Howard Schilit, the author of Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports, once said, “You [the auditor] work for the investor, even though you are paid by someone else”. He insists that auditors should look beyond the checklists and guidelines and should instead question everything. Auditors are the first line of defense against fraud and the shareholders are dependent upon the quality of their services. So I ask again, with respect to Lehman Brothers, were the auditors working for the investors or where they in the pockets of senior management?
What can we do?
An admired value investor believes in a similar tactic for confirming the honesty of companies. It’s known as “killing the company”, where in his words, “we think of all the ways the company can die, whether it’s stupid management or overleveraged balance sheets. If we can’t figure out a way to kill the company, then you have the beginning of a good investment”. Auditors must think like this, they must kill the company, and question everything. If you can’t kill a company, then (and only then) are the financial statements truly a fair representation of the firms operations.
There was no “killing” going on when the lead auditing partner said that his team did not approve Lehman’s Accounting Policy regarding Repo 105s but was in some way comfortable enough with them to audit their financial statements. This engagement team failed in looking beyond SFAS 140 and should have realized what every law firm (aside from one firm in London) was stating; that the accounting methods Lehman Brothers used to record Repo 105s were a deliberate attempt to defraud the public.
So I repeat: Ignoring reality is not an option. Ignoring the crowd, however, is an obligation.
See you next week….
-Fraud Girl
For Questions or Comments: Reach fraud girl at: FraudGirl [at] simoleonsense.com
March 25, 2010
Click Here To Read: The Most Influential People In Corporate Governance
Introduction (via Harvard Law School Forum on Corp Governance)
A review of the most recent Directorship 100 list – a list of the most influential people in corporate governance put together each year by Directorship magazine – indicates that individuals affiliated with Harvard Law School and its Program on Corporate Governance play a central role in the corporate governance landscape.
The Directorship 100 list includes such well-known figures as President Barack Obama, Chairman Barney Frank, SEC Chair Mary Schapiro, activist investor Carl Ichan and Goldman Sachs CEO Lloyd Blankfein. The Forum was pleased to learn that the list includes thirty-four individuals who are (i) HLS faculty and fellows, (ii) Members of the Advisory Board of the Program on Corporate Governance, (iii) Guest Contributors to the HLS Forum, and/or (iv) Harvard Law School grads. The “Harvard Thirty-Four” are as follows (for HLS alums, the year in parenthesis refers to graduation year):
Click Here To Read: The Most Influential People In Corporate Governance
March 6, 2010
Great paper by one of Buffett’s favorite CEOs, Roberto Goizueta, ex-Chairman and CEO The Coca-Cola Company.
Click Here To Read: Robert Goizueta-Why Shareowner Value?
Introduction (via Roberto Goizueta)
At The Coca-Cola Company, our publicly stated mission is to create value over time for the owners of our business. Of course, there are plenty of other missions upon which a company could focus: serving customers; pursuing philanthropy; providing the highest quality of products and services; creating jobs and job security.
But I would submit that in our political and economic system, the mission of any business is to create value for its owners. In the wake of huge layoffs at certain companies, this idea has been vilified by many critics, and doubt has arisen in the minds of many business leaders about their purpose. This is incredibly dangerous to the companies whose leaders doubt their purpose and to the society that those companies serve. So why is creating shareowner value the right mission for our businesses? There are three basic answers to this question:Increasing shareowner value over time is the job society demands of us.Increasing shareowner value enables us to contribute to society in meaningful ways. Focusing on creating value over the long term keeps us from acting short-sighted.
Good Quotes (via Roberto Goizueta)
“The greatest contributions we make to society come not because we do good deeds, but because we do good work.”
“We must remain focused on our core duty: creating value over time.”
Click Here To Read: Robert Goizueta-Why Shareowner Value?
February 23, 2010
Will the new SEC rule help or hurt. It’s hard to say from a personal bottom-up point of view risk management comes from temperament and resistance to institutional imperatives and psychological influences. Anywho, perhaps this is the next best thing.
Click Here To Read: Who’s Minding Risk? SEC’s new proxy-disclosure rule
Introduction (via CFO.com)
Monday-morning quarterbacks pinned the blame for the financial crisis largely on excessive risk taking, particularly at large financial institutions. Subsequent calls for regulatory reform have increasingly included nonfinancial companies and their boards, which critics accuse of having been lax in overseeing risk management.
Now, the Securities and Exchange Commission is requiring companies to describe in their proxy statements how the supervision of risk is distributed among their boards and board-level committees. Approved in December and effective on February 28, the rule is part of a package of rules intended to improve disclosures regarding executive compensation that may foster risky behavior.
By prompting companies to define their board members’ responsibilities for overseeing risk, the disclosure could reveal inefficiencies. You could have a situation where the compensation committee, the audit committee, and potentially a risk committee are all addressing similar areas related to risk, says Mark Plichta, a partner at Foley & Lardner. “[Board members] need to understand the boundaries of who is doing what. There are a lot of gray areas and areas for overlap.”
But the disclosure could also show, as a recent survey suggests, that some companies delegate responsibility for overall risk management to the audit committee. That duty, some experts maintain, should be reserved for the board of directors.
Because audit committees tend to straddle the line between overseeing financial-risk management and process, they are sometimes pressed to look at other types of risks as well. (The New York Stock Exchange requires listed companies’ audit committees to periodically review the processes for handling risk exposures.) According to a survey of board members and senior executives by KPMG’s Audit Committee Institute, 18% of audit committees are primarily responsible for overseeing strategic risk, and 58% oversee IT security and privacy risks.
Click Here To Read: Who’s Minding Risk? SEC’s new proxy-disclosure rule
February 23, 2010
Click Here to Read:Are Incentive Contracts Rigged by Powerful CEOs?
Introduction (via Harvard Law)
In our paper Are Incentive Contracts Rigged By Powerful CEOs?, which is forthcoming in the Journal of Finance, we argue that powerful CEOs induce their boards to shift the weight on performance measures towards the better performing measures, thereby rigging the incentive part of their pay. The intuition is developed in a simple model in which some powerful CEOs exploit superior information and lack of transparency in compensation contracts to extract rents. The model delivers an explicit form for the rigging of CEO incentive pay along with testable implications that rigging is expected to (1) increase with CEO power; (2) increase with CEO human capital intensity and uncertainty about a firm’s future prospects; and (3) negatively impact firm performance.
Findings (via Harvard Law)
The findings have important policy implications. A direct solution to rigging would be to require more explicit disclosure of ex ante incentive pay contracts. The argument that poor disclosure is justifiable given firm concerns about leaking competitive information and difficulty in recruiting executives strikes us as overstated and self serving. It is, therefore, reassuring to note regulatory efforts in this regard, with the SEC sending letters to 350 companies in 2007 critiquing the way they described the pay of their top executives. Even in the absence of better disclosure, the good news from our paper is that contract rigging might be reduced in other ways as well. Our results suggest that policies that increase the independence of boards may be effective in reducing contract rigging by powerful CEOs. In addition, rigging may be moderated in firms with stronger governance along other dimensions.
Click Here to Read:Are Incentive Contracts Rigged by Powerful CEOs?
