FINANCIAL CONTROL: ECONOMIC RATIONALES, FINANCIAL CRISIS FAILURES, - PowerPoint PPT Presentation

FINANCIAL CONTROL: ECONOMIC RATIONALES, FINANCIAL CRISIS FAILURES, CONTINUING RISKS Presentation to GHBER Stephen V. Arbogast, Executive Professor C.T. Bauer College of Business University of Houston October 2, 2013

A Story: Richard Bowen debates whether to “Write to Rubin” • November 2007: Richard Bowen, Chief Underwriter in Citigroup Real Estate lending, drafts e-mail to Citi Chairman Robert Rubin • “The reason for this urgent email concerns breakdowns of internal controls and resulting significant but possibly unrecognized financial losses existing within our organization.” • Citi representing to buyers of RMBS that mortgage credit files are complete and underwritten according to policy, when 40-60% are not; recently 80% non-compliant • Purchased mortgage pools don’t meet Credit policy criteria, yet are sold as compliant • Buyers, including Fannie Mae & Freddie Mac, may “put back” failed securities due to false representations, exposing Citi to $ billions in losses • Feeling had exhausted internal processes, Bowen sent Rubin the email • Never heard back; shortly thereafter persuaded to leave Citigroup • Citi would remain non-compliant into 2011 • Bowen not alone – similar stories at Lehman, Merrill, AIG, Moody’s, etc.

Discussion Topics • Financial Control: Popular perception vs. role in long term success • Economic Rationales for Financial Control • Why Chronic Controls Breakdowns on Wall Street ? – A Tale of Change in Business Models • The Problem is Not Fixed – Post-Crisis Cases • What Still Needs to be Done

Financial Control: Popular Perception vs. Role in Long Term Success • Popular perception of financial control is of burdensome rules and procedures constraining how one does business • Internal Audit: slightly less popular than root canal • However, financial control turns out essential to long term success • Culture of honesty, where employees don’t cheat or steal • Information/data integrity: report what happened, or what want folks to believe? • Effective risk management: identify what could go wrong and control for it? • These values, practices don’t ensure success, but firms are almost certain to fail, sooner or later, without them • Do contribute greatly to long run strategy implementation

Business Ethics and Financial Control (or, what is a DOAG?) Financial Control: a structure of “checks and • balances” that: Compensate for human ethical weakness 1. Provide necessary support to individuals of integrity who are 2. facing unethical behavior Financial control works by: • • Setting expectations that ethical behavior is required • Narrowing the scope for unethical behavior • Raising the risks of discovery and punishment • Training employees in proper practice/procedure • Protecting Employees reporting Unethical Activities!

What Exactly is Financial Control? There is formal Financial Control that incorporates: • Company Policies • Internal control procedures; e.g. opening/closing Bank Accounts • Trained resources to discover unethical practices • System to adjudicate ethics cases, administer discipline • Examples of Financial Control Elements: • Ethics, Reporting, Conflict of Interest, Anti-Trust Policies 1. Internal Control Procedures 2. Delegation of Authority Guide (DOAG)  Capital Budget Manual – what’s required to receive funds for investment  Financial Control Manual – e.g. what’s required to open a bank account  Internal Audit & Business Practices Committee 3.

However, Financial Control is really about Culture Not Rules • Effective Controls are “In the Line” – Meaning accepted widely as Management’s top responsibility (along with safety) • Management teams successful over the long run have determined that mindset underpinning controls/safety also critical to good operations Do it right every time – and do it first 1. It’s a Team Game - Everyone must buy in 2. You can and will continuously improve 3. You are what the data says you are 4. • The rewards – a culture with: • Accountability • Data integrity • Steadily improving results

How Financial Control Contributes to Long Term Strategy Success – The 6 Economic Rationales • Managements often underestimate Financial Control’s contributions • Preventive Contributions: Preventing Theft and Management ‘s Agency Behavior 1. Avoid Claims, Judgments, Lawsuits, Damages 2. Avoid Disrupting Normal Business & Implementing Strategy 3. • Positive Contributions: Preserve Accurate Information to run the Business 1. Establish Accountability within Management Team 2. Create a Culture of “Continuous Improvement” 3.

Four Stories to Illustrate Esso Thailand’s Refinery Expansion & “Maintenance Parts I. Runners” Andy Fastow’s Non-Recourse Financing for Enron II. Exxon Chemical’s Capital Reappraisals and Forecasting Biases III. Exxon’s “Continuous” Unit Cost Reductions – “Above Field” IV.

Wall Street has not been a Financial Control Model: Financial/Ethics Crises Since 1985 1. 1985-88: Levine/Boesky/Milken Insider Trading 2. 1985-90: S&L Fraud/Collapse 3. 1996-98: “Subprime I” 4. 1997-2001: DOT Com Bubble – Fraudulent Investment Research 5. 1997-2001: Corporate Accounting Scandals – Enron/WorldCom & Enablers 6. 2007-2008: Subprime II Predatory Lending, Horrific Security Ratings, Bank Accounting Frauds & Client Exploitation 7. 2009-Present: Madoff, Stanford, LIBOR rigging, J.P. Morgan “London Whale”

Why Has Wall Street Become Serial Scandal Generator – Why not before 1985? • Requires an understanding of Finance Industry competitive dynamics • Commoditization of Traditional Banking • Emergence of New business models based on risky assets & proprietary trading • These new business models involve practices antithetical to good governance, control, disclosure • Even risk management, which banks deem critical, eventually is undermined • These problems are systemic & likely will continue until trading model is reined in – current regulations helpful, but not sufficient • Let’s now explore how banking governance and control became fundamentally unsound

The Commoditization of Banking • 1970 – Banking’s Core Franchises ► Commercial Banking: Take deposits, issue CP/CDs, term loans to business, retail ► Investment Banking: Design, Underwrite, Syndicate Capital Market issuance for fee • Typical Investment Bank economics: ► Underwrite a $500 M bond offering ► Commit $100 M capital for 2-5 days ► Collect $3.5 M fee • By 1985, these franchises had commoditized:

By 1985, Banking is under Pressure • Commercial Banking: ► Major corporate clients move borrowing to capital markets ► Entry by European, Japanese universal banks ► Short term rates climb astronomically – so does cost of funds! • Investment Banking: ► Clients move from “relationship” to auction ► Competition from foreign banks not subject to Glass-Steagall Act ► Fixed commissions end • Result – great pressure on banking margins (disguised by recession) • Response: Commercial banks press to enter Investment banking ► Massive industry consolidations; survivors “Go Public” ► Bankers “innovate” to create new franchises

Banking’s “Book of the “Dead” ( A Partial List) • Commercial Banking: • Investment Banking: Chase Manhattan Dillon Read 1. 1. Chemical Bank Kuhn Loeb 2. 2. Manufacturers Hanover Salomon Brothers 3. 3. Marine Midland First Boston 4. 4. Irving Trust Shearson 5. 5. Paine Webber Bankers Trust 6. 6. Texas Commerce E.F. Hutton 7. 7. Bank of America (Nations Bank) Dean Webber 8. 8. Bank One Smith Barney 9. 9. 10. Mellon 10. Drexel Burnham Lambert 11. First Chicago 11. Kidder Peabody 12. State Street 13. Fleet 14. First Union 15. Riverside

One Banking Response: Innovation + Securitization • Innovation: Creation of New Securities & Markets: • Asset-Backed Securities (IG Credit Rating + Higher Yield) • Credit-Card Receivables • Auto Loans • Student Loans • Residential & Commercial Mortgages • Auction Rate Preferred Stock (Equity at Cost of S.T. Debt) • Junk Bonds (Non-IG Debt at Small Premium) • Securitization: Converting Non-liquid assets to Marketable Securities • Steps in Securitization Acquire asset pool 1. Reconfigure to resemble bond payments, provide lender security interest 2. Get Rated as IG 3. Price to Sell at Discount (Higher Yield) vs. “Straight Debt” 4.

Structuring Mortgage Securities to Gain AAA

Second Response: Proprietary Trading • Use Investors capital + borrowed funds to speculate & trade • Original version: smart trading, based on research • Results in massive losses - Bankers Trust fails, GS loses $100 M/month in 1993 • Second version: trade by exploiting information advantages from – Making markets – and reading flow of buying/selling 1. Mining information from trading clients 2. Mining information from banking clients 3. Inventing securities clients/counterparties can’t understand or price 4. • By 1993 Goldman Sachs has 500 “Proprietary Traders,” a $100 billion balance sheet and is leveraged 50/1