Friday, December 26, 2008

FASB Blinks On 'Mark To Market' Methodology At Last

Earlier this week, the Wall Street Journal published an article reporting on FASB's late, halting steps to modify 'mark to market' accounting for financial sector firms- banks and life insurers.

In the piece, the Journal reporters wrote,

"Accounting watchdogs are fast-tracking an effort to provide a small dose of "mark-to-market" relief for financial firms, as banks and life insurers continue grappling with deteriorating investment holdings.

The Financial Accounting Standards Board last week began steps to loosen a rule regarding when financial firms must book losses on a narrowly defined subset of lower-rated mortgage-backed securities, commercial-backed securities and certain other structured securities.

For those financial firms that hold the relatively small group of securities at issue, managements and their auditors would have more leeway to put off a potential write-down that would clip net income. That could help bolster their regulatory capital.

The possible rule revision falls far short of what banking and insurance executives were seeking because they wanted relief that would give them greater leeway in valuing a wider range of securities. But it illustrates how aggressive they have become in trying to stave off paper losses. Analysts are still trying to figure out which companies might own the particular securities at issue."

Unfortunately, the move seems to be coming as far too little, too late. If, some fourteen months ago, FASB had allowed performing securities to be marked at their economic value, rather than the instantaneous trading value, which might be zero, much of the last year's carnage could have been avoided.

However, by waiting too long, intangible losses became tangible writedowns, which restricted credit, investment and, eventually has led to a reduction in real economic activity.

Talk about the tail wagging the dog....

Thursday, December 25, 2008

Fraudulent Conveyance In The Madoff Case

In today's earlier post, I referred to the general consensus that many withdrawals by clients from Madoff's accounts in the last six years are subject to seizure, as being fraudulently conveyed by Madoff to those investors.

Apparently, due to recent rulings in the Bayou fund fraud of a few years ago, investors cashing out of a Ponzi-type scheme are not really withdrawing their profits, but, according to a court ruling, taking stolen funds.

Here's what I don't understand. Suppose you invest $5MM with Madoff. And suppose by the time you do, he's totally running a Ponzi scheme. There just isn't really anywhere near the oft-quoted "$50B" in the various accounts.

If you are sent account statements over a period of years stating that you now have, say, $10MM in your account with Madoff, and you choose to take your original stake off the table, and play with 'house' money, how are you fraudulently taking other people's money?

After all, you did give Madoff $5MM. You are certainly entitled to recover your original investment, aren't you?

I can see where withdrawals above the original investment could be seized for pro rata distribution. But not the original investment. That was your money. If you were fortunate enough to take it back, and sufficient funds were available to allow that, how did you take it from anyone else?

Death In The Madoff Case

Wednesday's Wall Street Journal carried the now-widespread news of Thierry Magon de La Villehuchet's suicide.

The French banker was bereft at the losses of his and his clients money in Madoff's scheme.

It's a sad thing, to be sure. But here's what I don't understand.

Villehuchet was said to be working non-stop on 'recovering' funds from the fraudulent investment scheme.

Just how did he plan to do that, when everyone with a brain knows that nobody will be getting any recovery anytime soon. And, if anything, it appears that, due to legal precedent, any investors who withdrew funds in the past six years may be required to return that money as having been fraudulently conveyed.

You could be doing all the work you wanted on trying to get some money returned, but you're not going to be successful.

More likely, the banker was simply overcome with dread at the realization that he had lost $1.5B of blue-chip client, and his own, money in Madoff's fraud.

Wednesday, December 24, 2008

American Express: That's No Bank!

Now we have yesterday's announcement that the TARP will be unfurled to cover $3.39B of American Express assets. CIT is also in for $2.33B.

According to the Journal article,

"Both CIT and AmEx need stable funding sources to make loans to businesses and consumers, but the credit crunch has made raising funds in public markets expensive."

No kidding!

But neither of these firms are part of the deep, crucial web of bank deposits and monetary system. They are simply standalone credit companies.

We had private sector excess which led to the TARP. Now we have the TARP itself going to excess.

If ever there were two firms which should be shotgun-merged with some other companies, or simply closed, via Chapter 11, these two are them.

Ken Chenault should be fired, on the way to American Express' acquisition by a commercial bank, or the sale of its profitable pieces to other firms.

To some extent, with the decline of the travelers check business, the very raison d'etre of AmEx has evaporated. Its former perfect funding/lending hedge is gone.

So, evidently, should the firm.

Tuesday, December 23, 2008

The Wisdom Of John Thain's Job Choice

Back in late October of 2007, I wrote this post discussing whether John Thain would take the top job at Merrill Lynch, as Stan O'Neal was being cashiered. I wrote, regarding Thain,

"Why would a senior executive who has run part or all of Goldman Sachs need to prove himself running a less-robust financial services business model with less talented personnel?"

It was inconceivable to me that anyone with a record of accomplishments, as Thain had at Goldman and the NYSE, and a good job, would be remotely interested in being Merrill's CEO. To do so, it seemed to me, would be a triumph of ego over common sense.

After Thain took the Merrill job, I wrote this post, providing more detail for my reasoning that he would eventually dump the retail side and try to recreate Goldman Sachs,

"No, I think it's safe to say Thain will ditch the current form of Merrill, and build a securities sector firm with the best features, in his opinion, of Goldman, Blackstone, and other private equity/hedge fund firms.

Goldman's time is not yet finished as the premier public investment bank. Thain will do well to incorporate large parts of its culture, senior executives, and business mix at Merrill."

Given that Thain had actually jumped from a relatively secure position as NYSE CEO to head troubled Merrill, I figured that, in time, he'd spin the retail side off, realizing that it is a dying business. Instead, he'd probably recreate something with which he was familiar- the Goldman Sachs model.

Finally, in this recent post, about eleven months after the first linked post, I opined,

"Second, I bet John Thain wishes he'd stayed at the NYSE and never been tempted by the wreckage Stan O'Neal left behind. Too much damage, not enough time. Who'd have guessed that Thain would be out of a job before Vikram Pandit at Citigroup?"

Several of my friends think that Thain couldn't lose in taking the Merrill job. That, like I wrote in this post almost exactly one year ago, people like Gerstner, Ryan and Pandit 'can't lose' for taking such CEO billets.

I suppose Thain might be viewed that way, but, personally, I think Thain made a major mistake. So great that, in simply asking to be paid for doing a decent job piloting the wrecked firm into the arms of BofA, rather than go bankrupt or be seized, he drew a huge amount of scorn and derision.

Already, he is seen not as having done yeoman's work at Merrill, but, simply ended by turning greedy when he requested a $10MM bonus for his efforts.

Now he is reportedly out of the running to ever succeed Ken Lewis.

Before Merrill, Thain was viewed as a capable co-head of Goldman, and a very successful CEO at the NYSE, fundamentally changing the firm in the wake of Dick Grasso's ugly exit.

Now, Thain is also remembered for gulling investors in December and the first quarter of 2008 to put money into the disintegrating brokerage firm, then claiming they didn't need to raise any more capital. To me, Thain is tarnished by some of what he did early on at Merrill, and for even leaping into the mess. I think it smacks of too much ego and too little perspective on the unfolding disaster that was in process a year ago.

Maybe I'm alone in this view, but I think Thain's time at Merrill has diminished his reputation and raises questions about his judgment.

Monday, December 22, 2008

More On Bernie Madoff's Fraud & Its Reprecussions

I wrote a prior post concerning the Bernie Madoff investment fraud last week, here.

Since last Tuesday, more stories have circulated detailing the enormity of the losses among many wealthy individuals, charities, trusts, and institutional funds.

Daniel Henninger of the Wall Street Journal offered a comparison between Madoff's spreading scandal and a recent off-broadway play, "The Voysey Inheritance." It's an interesting reflection on the response of people to such large, outright fraud.

However, I wrote in my prior post,

"I guess, for me, the most amazing stories in the Madoff mess are those once-wealthy people who failed to diversify, and basically gave all of their wealth to Madoff to invest. I don't know the details of Madoff's operation, but, from my time as a registered fund manager, I know that there are safeguards required to prevent the easy looting of client assets in cases like this.

For instance, in the case of private accounts, a custodian institution is usually used. It's not clear if such an arrangement was in force for Madoff's clients. Another typical safeguard is a quarterly statement of holdings in individual accounts.

If these were not used, it shows incredible gullibility on the part of so many wealthy people. If they were, it suggests that Madoff had a lot of help, since these would have been fraudulent statements."

We don't yet know the extent of help and complicity that Madoff had with his scheme, with the probable exception of his wife. But as I discussed this matter with friends in the investment business this weekend, we all agreed that, to concoct and maintain such detailed records of fraud for so many individual accounts, Madoff must have had quite a bit of assistance.

It's inconceivable that Madoff's confederates or minions would have thought nothing of hand-entering so much portfolio position data each quarter, rather than it being generated from existing position statements driven by custodian or brokerage account statements.

To me, the key observation, which I read in the Journal last week, was that an outside analyst had done a sort of 'back of the envelope' calculation to determine that Madoff's portfolios, according to estimates of the assets he ran being in the tens of billions of dollars, must have had trading activity exceeding the entire market for various index puts or calls. Additionally, experienced clients seemed to think nothing of the fact that blue chip equities showed no decline in prices earlier this year, although they were key to the alleged strategy.

This smacks of convenient denial of reality by so many clients. The suspension of disbelief, and a desire to simply believe that unbelievably good, and not just consistently, but uniformly constantly good results, were real.

As I reviewed the mechanics of Madoff's scheme of undisclosed numbers of individual accounts, rather than a single, explicitly-spotlighted fund, with my partner, my belief that Madoff had long ago discovered loopholes that I, too, observed earlier this decade grew significantly.

The most important element of his fraud, without question, was the lack of independent custodial inventory reports of financial assets held in accounts for clients. I can't emphasize enough that this alone left every one of Madoff's clients vulnerable.

Coupling this with a curious lack of diversification, a/k/a greed or stupidity, and you have the recipe for disaster among so-called 'sophisticated' investors.

Many years ago, during the WPPSS bond collapse, I read articles in the Wall Street Journal detailing the loss of entire life savings of many very average Americans. People had actually invested entire retirement accounts into just this one instrument, only to see it fail utterly and become worthless.

At the time, I posited a very personal belief that, for most people, simply reaching retirement with their principal intact is probably better than average performance. Never mind the 10% annual S&P average return, or something more like 3-6% if someone invested in a mix of assets and traded heavily.

Just staggering across the financial finish line with what you saved, while avoiding egregious market downturns, frauds, and other widespread investing pitfalls, was probably an exceptionally good performance.

Madoff's clients now add substantial evidence for my viewpoint. How many once-wealthy Americans having millions of dollars of accumulated financial assets are now simply bankrupt? Or nearly so, with almost nothing to show for decades of successful careers?

And all of this....all of it...would have been minimized, if not totally avoided, had each and every investor insisted on receiving a regular asset inventory report from an independent custodian. This would have prohibited false claims of asset ownership, or required an entire custodian's business to be in league with Madoff.

I don't believe any more regulations will prevent a repeat of this type of periodic investment fraud. There are plenty of safeguards required by current regulations. But nobody can prevent a person from simply throwing caution to the winds, trusting in a manager, and his 'special' inner client circle, without any objective, confirming evidence.

As I described to my friends over coffee on Saturday, you can run hundreds of individual investment accounts as an unregistered investment manager. Sure, the legal maximum is between 15 and 30. But so what?

If you choose your clients carefully, and never let on that you actually have hundreds of them, and they don't all meet, who would know? If none complain to the SEC, why would that agency bother you?

If, as in a proper Ponzi scheme, you cash out any disgruntled investors, so they have nothing to take to the SEC by way of losses or evidence of malfeasance, there's simply no way of being discovered.

It's a lot like being shot by an illegal firearm. Sure, we have complicated laws restricting lawful access to these weapons. That only means you are more likely to be shot and/or killed by an unlawfully-obtained weapon, rather than a lawfully-obtained and carried piece. You won't be less wounded, or dead.

And more laws won't actually prevent illegal guns from existing. Nor illegal investment management schemes, either.