Another Example of the Value of Risk Management

It seems that some financial institutions have not fully learned the lessons from past rogue trading incidents such as the ones that occurred at Societe Generale and Barings. Officials at UBS announced today that they are facing massive losses at the hands of a lone trader. Here's what BBC reported this morning.

Police in London have arrested a 31-year-old man in connection with allegations of unauthorised trading which has cost Swiss banking group UBS an estimated $2bn (£1.3bn). Kweku Adoboli, believed to work in the European equities division, was detained in the early hours of Thursday and remains in custody. UBS shares fell 8% after it announced it was investigating rogue trades. ZKB trading analyst Claude Zehnder said the news would damage confidence in UBS. "They obviously have a problem with risk management."

This is yet another example of the value of having a strong risk and control program. While it is difficult to control external events, companies can certainly implement proper internal controls to protect from massive losses such as this one.

Sarbanes-Oxley Executive Compensation Clawbacks Continue

Yesterday, the U.S. Securities & Exchange Commission ("SEC") announced another successful "clawback" of executive compensation under the Sarbanes-Oxley Act of 2002. James O'Leary, former Chief Financial Officer of Atlanta-based Beazer Homes USA, was forced to return over $1.4 million in bonus payments and stock sale profits that he made as a result of fraudulent financial reporting in 2006. What is somewhat unique about the case is the fact that the CFO was not implicated in any wrongdoing other than certifying that the financial statements were accurate. The individual who is being criminally prosecuted for the fraud is the Chief Accounting Officer who reported to the CFO during the time period in question.

“Section 304 of the Sarbanes-Oxley Act encourages senior management to take affirmative steps to prevent fraudulent accounting schemes from occurring on their watch,” said Rhea Kemble Dignam, Director of the SEC’s Atlanta Regional Office. “O’Leary received substantial incentive compensation and stock sale profits while Beazer was misleading investors and fraudulently overstating its income.”

This announcement comes on the heels of a related clawback from the CEO of Beazer Homes that totaled more than $6.4 million. Again, in this case, the CEO was not implicated in any criminal wrongdoing. The SEC's enforcement approach regarding both the CEO and the CFO in this case serve as a reminder to senior executives to ensure their annual certifications are accurate. The only way to know is to have a strong risk and control program in place. Wheelhouse Advisors can help. Visit www.WheelhouseAdvisors.com to learn more.

Lessons Learned from the Foreclosure Crisis

The recent foreclosure crisis is just another chapter in the financial meltdown that began in 2007.  As a result of the frenzy to securitize mortgage loans back in the middle of the decade, the required paperwork to foreclose on a property is difficult, if not impossible, to retrieve. Now, financial institutions are finding that the outsourced foreclosure work is faulty at best and fraudulent in many cases. Here's what the Wall Street Journal reported today.

In recent days, some lenders named in the foreclosure inquiries have said they would no longer use the services of some of these law firms for new foreclosures. Ally Financial Inc.'s GMAC Mortgage has pulled business and dispatched executives and a new team of lawyers to Florida to ensure foreclosure cases are being handled correctly, according to a person familiar with the situation.

The law firms and a Lender Processing unit, Docx LLC, which did work at a suburban Atlanta office, handled the nitty-gritty paperwork necessary to verify key document batches, including ownership transfer of a loan, known as an assignment, and the amount owed by a borrower losing his home. That paperwork processing at the law firms and lenders allegedly didn't review all information needed, such as who owned the loan or borrower financial information, the Florida attorney general claims. The Florida attorney general's office is looking at possible use of "fabricated documents" used in foreclosure actions in court, according to the attorney general.

This situation provides a few lessons in risk management. First, it demonstrates the lingering effects of poor controls when dealing with massive amounts of transactions complicated by a highly complex securitization process. Second, it also shows that the operational risks to a given company extend well beyond its walls to its outsourcing partners' ability to properly control its business.  Finally, with the crisis today clearly rooted in the actions of the past, it demonstrates the need for more forward-looking risk management programs.

Who Is Really to Blame?

Yesterday, the infamous Jerome Kerviel was sentenced to three years in prison and ordered to repay the estimated €4.9 billion that the French financial institution Société Générale lost as a result of his failed derivative trades. What is surprising to many who have weighed-in on the verdict is the fact that the sole blame for the massive losses has been placed on the young trader.  Here's one common view as reported in the New York Times.

“It’s a whitewash,” Bradley D. Simon, a white-collar criminal defense attorney at Simon & Partners in New York who specializes in securities and bank fraud, said of the verdict. “The evidence does not support absolving the bank completely,” he said. “This was a lot larger than Kerviel.”

Société Générale had admitted to management failures and weaknesses in its risk control systems. An internal audit published in May 2008 described Mr. Kerviel’s immediate supervisors as “deficient” and acknowledged that the bank had failed to follow through on at least 74 internal alerts about Mr. Kerviel’s trading activities dating to mid-2006.

While an appeal of the verdict is virtually guaranteed, the larger question remains. How can a situation like this unfortunate one be prevented in the future?  The answer certainly begins with stronger risk and control programs as demonstrated by the numerous weaknesses found at Société Générale.

Reputation Is Everything

In last month's issue of Operational Risk & Regulation magazine, Goldman Sachs' operational risk management program and its focus on reputational risk was profiled.  The article focused on Goldman Sachs' use of scenario analysis in anticipating the magnitude of reputational risk events.  Scenario analysis exercises such as these are very useful tools to increase the risk awareness within an organization.  Here is a summary of Goldman Sachs' approach.

Goldman Sachs is using scenario analysis to study reputational risk, employing operational risk expertise within its broader risk management framework, according to its global co-heads of operational risk management, Spyro Karetsos and Mark D'Arcy.  The bank says it embraces events, even those creating more reputational risk exposure than financial risk exposure, into its framework.  "Franchise value is highly important within the organisation and managing reputational risk is a by-product of that," says Karetsos, who is based in New York. "While it is not our responsibility to quantify reputational risk, there is an internal process that measures our exposure to those risks that are difficult to quantify, one of which is reputational risk."

The timeliness of this story is ironic given the potential massive impact to the bank's reputation as a result of the fraud charges levied by the Securities and Exchange Commission on Friday.  Once the announcement was made, the bank lost close to $12.5 billion in shareholder value by the end of the trading day.  Whether that loss can be overcome remains to be seen.  However, it does prove that in business, reputation is everything.

Out of Control

Yesterday, the U.S. Senate Subcommittee on Investigations conducted hearings to examine the largest bank failure in U.S. history and its role in the 2008 financial crisis.  The failure of Washington Mutual ("WaMu") was largely the result of years of increasing involvement in the mortgage-backed securities market.  Over a four year period, WaMu increased their securitizations of subprime mortgages from about $4.5 billion in 2003 to $29 billion in 2006.  Altogether, from 2000 to 2007, they securitized at least $77 billion in subprime loans.  At the same time, WaMu allowed its lending practices and controls to erode in the pursuit of greater loan production and short-term profits.  Here is a summary of the investigators' findings.

(1)   High Risk Lending Strategy. Washington Mutual (“WaMu”) executives embarked upon a high risk lending strategy and increased sales of high risk home loans to Wall Street, because they projected that high risk home loans, which generally charged higher rates of interest, would be more profitable for the bank than low risk home loans.

(2)   Shoddy Lending Practices. WaMu and its affiliate, Long Beach Mortgage Company (“Long Beach”), used shoddy lending practices riddled with credit, compliance, and operational deficiencies to make tens of thousands of high risk home loans that too often contained excessive risk, fraudulent information, or errors.

(3)   Steering Borrowers to High Risk Loans. WaMu and Long Beach too often steered borrowers into home loans they could not afford, allowing and encouraging them to make low initial payments that would be followed by much higher payments, and presumed that rising home prices would enable those borrowers to refinance their loans or sell their homes before the payments shot up.

(4)   Polluting the Financial System. WaMu and Long Beach securitized over $77 billion in subprime home loans and billions more in other high risk home loans, used Wall Street firms to sell the securities to investors worldwide, and polluted the financial system with mortgage backed securities which later incurred high rates of delinquency and loss.

(5)   Securitizing Delinquency-Prone and Fraudulent Loans. At times, WaMu selected and securitized loans that it had identified as likely to go delinquent, without disclosing its analysis to investors who bought the securities, and also securitized loans tainted by fraudulent information, without notifying purchasers of the fraud that was discovered.

(6)   Destructive Compensation. WaMu’s compensation system rewarded loan officers and loan processors for originating large volumes of high risk loans, paid extra to loan officers who overcharged borrowers or added stiff prepayment penalties, and gave executives millions of dollars even when its high risk lending strategy placed the bank in financial jeopardy.

These findings are not surprising in the aftermath of the financial disaster.  However, without significant oversight and change in the operations of financial institutions, a similar scenario will likely occur in the not too distant future.

New Task Force Established to Combat Financial Fraud

Yesterday, the Obama Administration announced the creation of a new task force dedicated to rooting out individuals who participated in fraudulent activities that led to the great financial meltdown of 2008.  The new organization is aptly named the Financial Fraud Enforcement Task Force and is composed of members from over 24 federal agencies.  It will be chaired by Attorney General Eric Holder.  Here is more on the task force from a Securities & Exchange Commission press release.

The task force, which replaces the Corporate Fraud Task Force established in 2002, will build upon efforts already underway to combat mortgage, securities and corporate fraud by increasing coordination and fully utilizing the resources and expertise of the government's law enforcement and regulatory apparatus. The attorney general will convene the first meeting of the Task Force in the next 30 days.

"This task force's mission is not just to hold accountable those who helped bring about the last financial meltdown, but to prevent another meltdown from happening," Attorney General Eric Holder said. "We will be relentless in our investigation of corporate and financial wrongdoing, and will not hesitate to bring charges, where appropriate, for criminal misconduct on the part of businesses and business executives."

While noble in its intent, this new task force faces several challenges.  First, its membership is quite large and politically unwieldy.  Second, it is made up of agencies that were charged with enforcing laws and regulations that were intended to prevent fraudulent activity from occurring in the first place.  Third, its creation falls on the heels of an unsuccessful prosecution of hedge fund managers that brought Bear Stearns to its knees.  Only time will tell if the task force can successfully achieve its mission.

Did Calamity Jerome Commit a Crime?

According to a report in today's UK Guardian, the infamous rogue trader from Societe Generale will stand trial next year to face criminal charges associated with his bad bets.  Jerome Kerviel almost brought down one of the largest financial institutions in the world by conducting a series of trades that led to losses of over $7 billion.  He argues that his actions were not criminal because the bank knew about and encouraged his trading activity until the losses began to mount.  Here is what the Guardian reports about the ongoing investigations.

The independent investigations and the bank's own internal inquiries into the scandal have found that its managers and control systems failed to operate properly and ignored warnings. A report by PricewaterhouseCoopers blamed the "culture" at the trading desk, describing it as "overheated". France's central bank has fined SocGen €4m for "serious shortcomings" in its internal controls that led to the trading losses. Kerviel's legal team is trying to go further and prove that the bank knew what was actually happening.

Employed at the bank since 2000, Kerviel worked his way up from a desk that monitors traders to a job on the futures desk, where he invested the bank's money by making huge bets on the future direction of European stock exchange prices. He is accused of causing five times the financial damage inflicted by Nick Leeson, the rogue trader who sparked the collapse of Barings Bank in 1995 with losses of £800m.

At the very least, the bank lacked the controls necessary to prohibit unauthorized trading activity as well as limit authorized trading activity.  As financial institutions and the trading operations they support become more complex, opportunities for fraud and abuse will continue to increase.  Investments in controls and monitoring technology are crucial to prevent future calamities such as this.

Criminal Failure to Disclose

The criminal investigation into the accounting practices at AIG is progressing and the focus is none other than Joseph Cassano, former head of the Financial Products group that brought AIG to its knees.  Here is what the Wall Street Journal reported yesterday.

Federal prosecutors are also focusing on a December 2007 investor presentation in which Mr. Cassano said write-downs tied to the swaps had reached an estimated $1.6 billion. Authorities are looking at whether Mr. Cassano should have disclosed to investors that the figure would have been higher by several billion dollars if not for the aid of a value adjustment known as "negative basis," according to people familiar with the matter. Several months later, when AIG disclosed that its auditor, PriceWaterhouseCoopers, found a "material weakness" in its accounting of the swaps, it said it would abandon the adjustment, according to company filings.

Had it not been for the identification of a material weakness by the auditors, who knows how long it may have taken to properly disclose the losses.  At this point, it looks like Mr. Cassano deserves to be bunkmates with Bernard Madoff.

New Wave of Regulation

As expected, plaintiff attorneys and prosecutors are gearing up for a flood of cases related to the roots of the current economic crisis - financial fraud.  However, an article in yesterday's New York Times suggests that the attorneys may have a tough time winning the cases.  

The herdlike behavior suggested that bankers were competing for business using widely shared assumptions, rather than trying to get away with a crime. It would be hard to prove that anyone broke the rules, these lawyers said, since regulations in the riskiest parts of the mortgage industry were so lax.

While the attorneys may have a difficult time, regulators will not have any problem tightening the rules.  Is your company prepared for the new wave of regulation?  Visit www.WheelhouseAdvisors.com to learn how we can help you prepare.

Reducing Expenses May Not Reduce Risk

More and more companies are looking for ways to reduce expenses and a popular method recently has been outsourcing.  While many benefits come with an outsourced relationship, so does increased risk.  Proper due diligence and carefully crafted service level agreements are essential.  However, with the recent fraud at Satyam in India, those activities may not be enough.  A recent article in CFO magazine highlights the problem. Here is a excerpt from that article.

The enormously inflated cash balances at Satyam have popped a hole in the reputation of the outsourcing market, which has grown from business offering solely tech business, to back-office work such as finance and accounting. "This has really shaken up the outsourcing industry," says Peter Allen, a partner and managing director for outsourcing advisory firm TPI. "The industry is built on relationships that imply some level of trust and confidence and integrity."

How comfortable are you with your outsourcing partner?  Have you assessed the risks with the relationship lately?  If not, Wheelhouse Advisors can help.  Visit www. WheelhouseAdvisors.com to learn more.

Corruption Across the Globe

Given the recent high profile cases of fraud and corruption in the United States and India (i.e. Bernard Madoff, Rod Blagojevich and Satyam Computer Services), a 2008 study by Transparency International is particularly enlightening (see illustration below).  In the study, the United States ranked 18th on a list of 180 countries.  Denmark, New Zealand and Sweden top the list as the least corrupt countries, with Somalia, Iraq, Myanmar and Haiti at the bottom of the list.  The authors of the study noted the following:

Whether in high or low-income countries, the challenge of reigning in corruption requires functioning societal and governmental institutions. Poorer countries are often plagued by corrupt judiciaries and ineffective parliamentary oversight. Wealthy countries, on the other hand, show evidence of insufficient regulation of the private sector, in terms of addressing overseas bribery by their countries, and weak oversight of financial institutions and transactions.

It remains to be seen what the 2009 study results will say about the United States and others.  Right now, it looks like a race to the bottom of the list.  Let's hope for improvements in corporate governance, internal controls and risk management in 2009.

Financial Fraud Knows No Boundaries

Corruption and fraud on a massive scale knows no boundaries as we discovered again in the disclosure by global outsourcer, Satyam Computer Services, Ltd.  The company's chairman orchestrated the fraud by falsifying company accounts and inflating revenue and profit figures over several years.  In addition, the cash position of the company was most recently reported at more than $1 billion - an amount that was completely false.  The Wall Street Journal reported the following:

The news prompted concerns about corporate governance and accounting standards across Indian industry, especially since Satyam was audited by PricewaterhouseCoopers and had high-profile independent directors, including a Harvard Business School professor, on its board until recently. PricewaterhouseCoopers said it was examining Mr. Raju's statement and declined to comment further. Immediate comparisons were drawn to the watershed in U.S. corporate accounting and governance standards that stemmed from the Enron crisis.

"Satyam is now India's Enron. The independence of the board was already in question, now the auditors' complicity in what seems to be a multi-year misstatement of financials will also be explored," CLSA said in a note.  The chairman of the Securities and Exchange Board of India said Wednesday the unfolding fraud at Satyam is an event of "horrifying magnitude."

Much must be done to stem the tide of corruption and fraud in the corporate boardrooms and executive suites. Our entire financial system depends on investor confidence that is quickly eroding.  Strong internal control over financial reporting is essential and can be a source of competitive advantage in an environment such as this.  Visit www.WheelhouseAdvisors.com to learn how we can help you.

Distorting Risks to Bolster Pay

As more and more begins to emerge from the collapse of our financial markets, it is becoming clear that effective risk management was severely handicapped by those looking to increase their personal compensation.   The New York Times reported this past weekend some of the egregious mortgage lending practices at Washington Mutual ("WaMu") that led to the largest bank failure in American history.   

WaMu gave mortgage brokers handsome commissions for selling the riskiest loans, which carried higher fees, bolstering profits and ultimately the compensation of the bank’s executives. WaMu pressured appraisers to provide inflated property values that made loans appear less risky, enabling Wall Street to bundle them more easily for sale to investors.  “I never had a clue about the amount of off-the-cliff activity that was going on at Washington Mutual, and I was in constant contact with the company,” said Vincent Au, president of Avalon Partners, an investment firm. “There were people at WaMu that orchestrated nothing more than a sham or charade. These people broke every fundamental rule of running a company.”

The major problem here is not that WaMu was poorly managed, but that the practices at WaMu became accepted by the mortgage industry as a whole.  Major reform is desperately needed to ensure that practices such as these are prevented from "becoming the norm" again.

Worldcom's Bernie Ebbers - Naughty or Nice?

Well, it is Christmas Eve and children across the globe are wondering if good, old St. Nick will bring them toys for being nice this year or a lump of coal for being naughty.  Add to the list former CEO of Worldcom, Bernie Ebbers, who is requesting a Presidential pardon of his 25 year prison sentence for his role in one of the largest accounting frauds in history.  His request has attracted worldwide attention.  Here's what The Telegraph in London reported:

Mr Ebbers, 67, who was sentenced to 25 years in jail in 2005 for his part in WorldCom's spectacular collapse, has applied to have that sentence commuted by President George W Bush.  He continues to serve his sentence at Oakdale prison in Louisiana, a low-security facility, from which he is due for release on July 4, 2028, when he will be aged 86.  The fraud at WorldCom led to the country's biggest bankruptcy filing in July 2002, with almost 17,000 employees losing their jobs as a result of the scheme to bury expenses and inflate revenue.

In this season of giving, Bernie should be thinking about how he can give back to the 17,000 people who were impacted by his wrongdoing rather than asking for a gift.  Let's all hope he gets what he deserves for his request - the world's largest lump of coal.

SEC "Office of One" Ignores Massive Fraud

Some of you may recall previous posts regarding the SEC's office of risk management that contained only one staffer for many years.  Well, according to the Wall Street Journal, the one person office was notified earlier this year about Bernard Madoff's massive Ponzi scheme and did nothing to investigate.  The article details the many attempts of Harry Markopolos to alert the SEC to the fraud.  Mr. Markopolos final attempt was made to the head of risk management at the SEC, Jonathan Sokobin.   Here is the account of that attempt:

Early this year, Mr. Markopolos made one last major effort after receiving an email from Jonathan Sokobin, an official in the SEC's Washington, D.C., office whose job was to search for big market risks. Mr. Sokobin had heard about Mr. Markopolos and asked him to give him a call, according to an email exchange between them.  

Mr. Markopolos also sent Mr. Sokobin an email -- with the stark subject line "$30 billion Equity Derivative Hedge Fund Fraud in New York" -- saying an unnamed Wall Street pro recently pulled money from Mr. Madoff's firm after trying to confirm trades supposedly done in his account, but discovering that no such trades had been made.  It was his last try.  He never heard back about his allegations regarding Mr. Madoff.  "I felt pretty low," Mr. Markopolos recalls.  Mr. Sokobin, through an SEC spokesman, declined to comment.

To Mr. Sokobin's credit, he did reach out to Mr. Markopolos to investigate.  However, given the size of his office, it is not surprising he could not act quicker to bring the fraud to an end.  Greater evidence is not needed to justify more investment in risk management.

Speechless

Today's post leaves one speechless, both literally and figuratively.  In the figurative sense, few words can describe the ever increasing amounts of money that the US Government is pouring into financial institutions such as AIG.  Literally, there is not much more to say beyond what Barron's Bob O'Brien has to offer in his video post,  AIG Becoming a Money Pit?.

Punishing the Monkey at AIG

Yesterday, the US House Committee on Oversight and Government Reform had quite a session receiving testimony from those involved in events leading to the massive bailout of American International Group ("AIG").  Of particular concern was a letter from Joseph St. Denis, an AIG accounting policy expert that had been hired, as he explained, "as part of an entity-wide effort to address material weaknesses by AIG's external auditor".   Unfortunately, Mr. St. Denis could not participate in this effort because he was restricted from reviewing the area with the highest risk - accounting for credit default swap derivatives.  

Mr. St. Denis resigned from AIG after serving just over a year due to restrictions placed on him by senior executives. After surfacing many legitimate issues, he was demoted even though he had received a stellar performance rating only a few months before.  Then, according to Mr. St. Denis, he was prohibited from reviewing the very area that led to AIG's ultimate demise.  Joseph Cassano, head of AIG's Financial Products group, was the executive responsible for the valuation of AIG's Super Senior Credit Default Swap portfolio and the same executive who made the following statement to Mr. St. Denis:

"I have deliberately excluded you from the valuation of the Super Seniors because I was concerned you would pollute the process."

The improper valuation of this portfolio led to another material weakness in 2007 and ultimately led to AIG's death spiral.  Meanwhile, Mr. Cassano retired from AIG earlier this year and continues to receive $1 million per month in consulting fees from AIG.  In the words of famous musician Mark Knopfler, I think this is a clear case of "punishing the monkey while letting the organ grinder go free".  Your thoughts?

Click here to read Joseph St. Denis' letter to Congress

Fannie + Freddie = Fraud

According to recent reports about investigations into the corporate governance and accounting practices at Fannie Mae and Freddie Mac, it appears that the two Government Sponsored Entities (GSEs) did not learn their lesson from improper disclosures made only a few years ago.  This is what was reported by the Associated Press yesterday.

The mortgage finance companies said Monday that a federal grand jury in New York is investigating accounting, disclosure and corporate governance issues at Washington-based Fannie and McLean, Va.-based Freddie.  Critics have long questioned the companies' bookkeeping.  Last November, for example, a Fortune magazine story said new accounting procedures at Fannie Mae masked potential losses on bad loans.  And several years ago, both Fannie and Freddie were forced to restate billions in earnings after federal regulators discovered accounting irregularities at both companies.

If we can't trust these GSEs to clean up their act and root out fraud, how can we again trust our government with $700 billion of our money to handle the very same mortgage-backed securities that ran through these corrupt GSEs?  What are your thoughts?  Please join the conversation below.

Corporate Fraud Risks Are On The Rise

In its recently released 2008 Global Fraud Report, The Economist Intelligence Unit and Kroll stated that corporations are reporting an overall 22% increase in fraud in 2008 as compared to a similar survey conducted in 2007.  The report noted that weakened internal controls and high staff turnover were the leading cause of the fraud increase.  The average company in the survey lost more than $8 million due to fraud at some point during the last three years.  Can your company afford these fraud risks and the potential impact on other areas such as public image, reputation and the resulting impact on shareholder return?  Share your thoughts below.  Also, to read more about this compelling report, click here.