FINANCIAL CONTROL: ECONOMIC RATIONALES, FINANCIAL CRISIS FAILURES, CONTINUING RISKSPresentation to GHBERStephen V. Arbogast, Executive ProfessorC.T. Bauer College of BusinessUniversity 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 andbalances” that:

1. Compensate for human ethical weakness2. Provide necessary support to individuals of integrity who are

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:1. Ethics, Reporting, Conflict of Interest, Anti-Trust Policies2. Internal Control Procedures

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

3. Internal Audit & Business Practices Committee

However, Financial Control is really about CultureNot 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

1. Do it right every time – and do it first2. It’s a Team Game - Everyone must buy in3. You can and will continuously improve4. You are what the data says you are

• 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:1. Preventing Theft and Management ‘s Agency Behavior2. Avoid Claims, Judgments, Lawsuits, Damages3. Avoid Disrupting Normal Business & Implementing Strategy

• Positive Contributions:1. Preserve Accurate Information to run the Business2. Establish Accountability within Management Team3. Create a Culture of “Continuous Improvement”

Four Stories to Illustrate

I. Esso Thailand’s Refinery Expansion & “Maintenance Parts Runners”

II. Andy Fastow’s Non-Recourse Financing for Enron

III. Exxon Chemical’s Capital Reappraisals and Forecasting Biases

IV. Exxon’s “Continuous” Unit Cost Reductions – “Above Field”

Wall Street has not been a Financial Control Model: Financial/Ethics Crises Since 19851.1985-88: 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:1. Chase Manhattan2. Chemical Bank3. Manufacturers Hanover4. Marine Midland5. Irving Trust6. Bankers Trust7. Texas Commerce8. Bank of America (Nations Bank)9. Bank One10. Mellon11. First Chicago12. State Street13. Fleet14. First Union15. Riverside

• Investment Banking:1. Dillon Read2. Kuhn Loeb3. Salomon Brothers4. First Boston5. Shearson6. Paine Webber7. E.F. Hutton8. Dean Webber9. Smith Barney10. Drexel Burnham Lambert11. Kidder Peabody

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

1. Acquire asset pool2. Reconfigure to resemble bond payments, provide lender security interest3. Get Rated as IG4. Price to Sell at Discount (Higher Yield) vs. “Straight Debt”

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 –1. Making markets – and reading flow of buying/selling2. Mining information from trading clients3. Mining information from banking clients4. Inventing securities clients/counterparties can’t understand or price

• By 1993 Goldman Sachs has 500 “Proprietary Traders,” a $100 billion balance sheet and is leveraged 50/1

What’s Wrong with Proprietary Trading from a Governance & Controls perspective?• Core franchises not valued for service to clients but for information to

be mined and used, and as trading “counterparties” to out-trade

• This creates built in conflicts of interest –• Are you working for your client or yourself?• Powerful temptations not to protect private information useful to traders• Exploitation of “dumb money” means looking for clients you can victimize

• Hard to practice good financial control when don’t really want to consider all the issues involved in your core business model• Do I really want to consider conflict of interest in this deal?• Joke at Goldman – “If you have a conflict, we have an interest.”

• Last Point – Traders, as key rainmakers, become politically dominant• Trading a zero sum game that have to win at every year to succeed as managers

Where Does this Lead – Exploitation of Client, Weak Financial Control – Goldman’s Abacus deal• Goldman client John Paulson speculates against subprime mortgage

market in 2007 – Goldman decides to copy his trades

• Late in 2007, Paulson asks GS to ‘construct’ a security consisting of ‘sure to fail’ mortgage securities so Paulson can speculate against it• The catch: GS must sell the security to other clients• Can it tell them of Paulson’s involvement and sell the security?

• Goldman’s actions, reviewed by its Mortgage Capital Committee• Don’t tell buyers about Paulson’s picking the mortgages or betting against them• Copy Paulson in betting against the mortgage market even more• Result #1 – Paulson makes $1 billion and buyers lose same; GS wins big too• Result #2 – SEC sues GS, collecting record $550 M fine

Where does this lead II? Lehman Brothers Repo 105

• Lehman leveraged 40+/1, holding huge subprime mortgage and other speculative positions – market and Rating Agencies notice, criticize

• Lehman resorts to Repo 105, removing $50 billion of assets from balance sheet at quarter end via ‘Repurchase Agreement’ loans it books as sales• Top management in the know: “We have to get off this drug” Bart McDade

• Matthew Lee, Senior VP for balance sheet reporting, writes to CFO:• “I have become aware of certain conduct and practices…that I consider to possibly

constitute unethical or unlawful conduct.”• Lee is ‘downsized’ a month later & never works again in the industry• Lehman fails 3 months later due to unsustainable leverage vs. impaired assets

J.P. Morgan scandals, 5 years after Financial Crisis, show problems not fixed• London ‘Whale’ trading losses not reported accurately or disclosed to

Morgan Board timely• $900+ M SEC fine agreed to by Morgan

• West Coast energy market manipulation• Morgan to sell its utility assets, exit the business

• Manipulation of ethanol RINs market – just now being investigated

• Morgan now committed to ‘correcting’ controls issues, after leading industry opposition to new regulatory requirements, Volcker Rule

Who was the Winner in the Financial Crisis

• Wells Fargo Bank• No controls issues or trading losses• Didn’t need a bail out• Took over Wachovia, a valued franchise, at low price

• Wells’ recipe: stick to core business, good controls, long term focus• Minimal securities trading, investment banking

• Wells however, provides the most valuable social function in finance –credit in good times and bad• Didn’t have to ‘de-leverage’ in 2008

Poor Controls Lead to Overleverage, then Deleveraging - How does De-leveraging kill an Economy?

• Consider Bank X, leverage 40/1 like Lehman and GS• $400 billion in assets, $10 billion in capital

• Bank X now has $2 billion in trading losses• At 40/1 ratio, remaining $8 billion capital can only support $320 billion in assets• How does Bank X adjust?

1. Sell $80 billion in assets immediately at whatever price it can get2. Raise new capital3. Stop all new loans

• When this happens at multiple banks, two things follow:1. Banks stop lending to each other2. Credit dries up for the ‘Real Economy’ Great Recession

How then to Get a Safer, Well Controlled Finance Industry that Serves the Real Economy?• Existing + recent regulations not enough

• Don’t strongly discourage “big trading” model• No solution for too big to fail• Can’t count on controls when deep conflicts of interest undisturbed

• The needed solutions:1. Strong Volcker Act or similar version of Glass-Steagall2. Clear disclosure of derivative positions, counting them against capital ratios, and

disclose commercial bank financing of investment banks & hedge funds3. Strong enforcement of securities laws, SOX certification, Board Audit Cmte.

Independence 4. If Auditors report major differences with management to Board Audit Cmte., as

required by SOX, cannot be fired for X period ‘except for cause’

Questions?