Tag: The Economist

Dodd-Frankenstein

You would expect that a publication with a libertarian tilt like The Economist would not look favorably at the Dodd-Frank Wall Street Reform and Consumer Protection Act. They call it Too big not to fail. Being The Economist, the article argues with the facts on its side.

  • Dodd-Frank: 848 pages
  • Federal Reserve Act of 1913: 32 pages
  • Glass-Steagall act: 37 pages
  • Sarbanes Oxley: 66 pages

“The scope and structure of Dodd-Frank are fundamentally different to those of its precursor laws, notes Jonathan Macey of Yale Law School: “Laws classically provide people with rules. Dodd-Frank is not directed at people. It is an outline directed at bureaucrats and it instructs them to make still more regulations and to create more bureaucracies.”

It’s not a matter of more regulation. The focus should be on better regulation. Much of Dodd-Frank is just tacked on because it had the momentum to become law. I’m pretty sure extractive minerals had nothing to do with the financial crisis. But Section 1502 of Dodd-Frank requires public companies to make extensive disclosures on the use of conflict minerals in their supply chain.

There are some good things. An unregulated derivatives market was a bad thing. Although, I’m not sure they are getting the regulations right in the new regulated derivatives market.

The test will be the next financial crisis. I assume one will come. Inevitably there will be an oversupply of capital in some area of investment and investors will run in to trouble. Companies will be in trouble, consumer will be in trouble, and investors will be in trouble. Will Dodd-Frank succeed in reducing that likelihood and reducing the impact? Only time will tell.

Telling the Truth During Earnings Calls

Is the CEO or CFO lying during the quarterly earnings call? How can you tell?

David F. Larcker and Anastasia A. Zakolyukina of the Stanford Graduate School of Business turned to the rich data set of quarterly calls and subsequent financial restatements. After studying Q&A sections of transcripts of hundreds of calls with CEOs and CFOs, the researchers then looked to see whether financial statements being discussed were substantially restated at some point after the call. If they were restated, Professor Larcker and Zakolyukina (a PhD student at the school)  reasoned that the executive had been “less than candid.”

They found that answers from deceptive executives:

  • have more references to general knowledge
  • fewer non-extreme positive emotions
  • fewer references to shareholders value and value creation
  • use signi significantly fewer self-references, more third person plural and impersonal pronouns
  • more extreme positive emotions
  • fewer extreme negative emotions
  • fewer certainty and hesitation words

Their performance is only 4% to 6% better than a random guess. So it’s statistically significant, but not determinative.

Sources:

Taxonomy and Compliance

Compliance often has to deal with a great big piles of data. When tackling a big pile of data, it helps to organize the data into a taxonomy. The taxonomy helps with analysis.

Of course, just by choosing the nodes in the taxonomy you are influencing the view of the data.

I was struck by how hard it is to work with a taxonomy in a recent article in the Economist: In Quite a State. The article looked at the many different lists of countries in the world and the many different ways of defining a country.

The US Department of Homeland Security offers 251 choices when you apply online for a visa-free entry. That list includes Bouvet Island, uninhabited Antarctic volcanic island belonging to Norway in the South Atlantic.

Hotmail offers a menu 242 countries/regions when you register an e-mail account. The United Nations has 192 member states.

One of the most interesting examples is Taiwan or Chinese Taipei. During the days of the Cold War many countries recognized Taiwan as a separate country because it was the non-communist regime exiled from China. Now that mainland China has become an economic titan, only 23 countries have formal diplomatic ties with Taiwan.

I am always struck by the treatment of Taiwan during Olympics, when their athletes walk behind a generic Olympic flag instead of the traditional Taiwan flag.

Adding an item or deleting an item to a taxonomy affects your view of the underlying data and affects the prominence of that item. It’s hard to “flag” a problem if it is not properly identified.

The Economist: Special Report on Financial Risk

This week’s The Economist has an excellent special report: The Gods Strike Back.

The title comes from Peter Bernstein’s Against the Gods:

“The revolutionary idea that defines the boundary between modern times and the past is the mastery of risk: the notion that the future is more than a whim of the gods and that men and women are not passive before nature.”

The report contains these stories:

For me, when looking for blame, I tend to focus on the rating agencies. As the report points out, the raters were paid by the the issuers not the purchasers of the securities. That results in a misalignment of interests. Of course, they may have just gotten wrong.

Looking at the chart below you have to be impressed by how spectacularly wrong they were:

Hopefully, we will learn some lessons from the financial crisis. We should have learned by now that the next crisis will be caused by something different so we need to be able to recognize and deal with the unexpected.

The Economist Special Report on Social Networking.

“An astonishing amount of time is being wasted on investigating the amount of time being wasted on social networks.”

I love reading The Economist because of lines like that. The January 28 issue has a special report on social networking. (The cover image is Steve Jobs dressed like Moses with his new tablet)

“Another [report], by Nucleus Research, an American firm, concluded that if companies banned employees from using Facebook while at work, their productivity would improve by 1.5%. This assumes that people would actually work rather than find some other way to pass the time they have to spare. In the same vein, perhaps companies should also ban water coolers and prohibit people sending e-mails to their friends. The assumption that firms can block access to the networks altogether is also rather heroic. Some employees now have web-enabled smart phones, so trying to stop them from surfing their favourite sites will be another waste of time.”

What is different about Web 2.0?

“All this shows just how far online communities have come. Until the mid-1990s they were largely ghettos for geeks who hid behind online aliases. Thanks to easy-to-use interfaces and fine-grained privacy controls, social networks have been transformed into vast public spaces where millions of people now feel comfortable using their real identities online.”

As is typical with The Economist, the report is straight forward and full of facts. There is none of the hyperbole of the social media snake oil salesman.

This special report will examine these issues in detail. It will argue that social networks are more robust than their critics think, though not every site will prosper, and that social-networking technologies are creating considerable benefits for the businesses that embrace them, whatever their size. Lastly, it will contend that this is just the beginning of an exciting new era of global interconnectedness that will spread ideas and innovations around the world faster than ever before.

The stories in the special report:

Iceland’s Meltdown

iceland-flag

With all of the focus in the United States on the collapse of Bear Stearns, AIG, Lehman Brothers, and Merril Lynch, we may be a bit myopic in not noticing other issues around the world. Iceland stands out as a country that has really run into trouble. As Michael Lewis wrote in Wall Street on the Tundra: “Iceland instantly became the only nation on earth that Americans could point to and say, ‘Well, at least we didn’t do that.’”

The collapse has been so big that Iceland is abandoning its own currency to join the European Union. Until the collapse, Iceland had little interest in joining the EU. They do want the bureaucrats in Brussels messing with their fishing. Iceland put some excellent regulatory controls on fishing that have lead to stable fish populations and rich fishermen.

They failed to do the same with their financial system. They ended up having fisherman quitting the sea to engage in currency trading.

There are lots of lessons to be learned from a compliance and risk management perspective.

Legend has it that Joe Kennedy cashed out of the stock market when his shoeshine boy gave him stock tips. Maybe a warning sign should be fishermen engaging in currency trading. We saw similar events in the U.S. as people quit their jobs to be real estate entrepreneurs. I heard a success story from an acquaintance who told of buying a house for 100, putting in 10 and selling it for 120. I didn’t have the heart to tell him that house prices has risen by 15% during that same time frame. A rising market makes everyone look like a genius.

As Michael Lewis points out “One of the hidden causes of the current global financial crisis is that the people who saw it coming had more to gain from it by taking short positions than they did by trying to publicize the problem.” You saw that with Iceland’s collapse and you saw that with the collapse in the United States. The most publicity shined on Goldman Sachs for its profits in September 2007 made from shorting mortgage positions. I am sure that there were quite a few mortgage originators who knew they were peddling garbage. But they had no incentive to stop the income coming from origination fees.

The three biggest banks in Iceland, a country of only 310,000, made loans totaling over 850% of Iceland’s Gross Domestic Product.  Only 1/5 of the loans were in Iceland’s currency. They instead borrowed from their banks in cheaper currencies such as yen and Swiss francs. To compare, the balance sheet of Britain’s banking system was at 450% of GDP and the US at 350%. Clearly, carrying too much debt is a problem. Especially when their are few alternative sources of capital besides more debt.

Iceland’s debt load increased from 200% of GDP in 2003 to almost 1000% in 2008. That is an enormous growth curve. Even steeper than the rise of housing prices in the United States.

Economic cycles are part of human nature. We overbuy into good times and oversell in bad times. It easy enough to look back a few years to the Dot-Com bubble focusing on market share and eyeballs at the expense of the bottom line.

See:

When Markets Turn

The EconomistThe Economist ran a special report on the future of finance last week. One item caught my eye – When Markets Turn: A Parable of How Modern Finance Can Go Wrong. The story looks back at the collapse of the Long-Term Capital Management in 1998. The article puts some of the lessons of that funds collapse to the current collapse of the credit markets.

They identify the theory put forth by Mr. Soros on “reflexivity.” Once people come to believe that an economic theory is true, they over invest in that economic theory. “Once people come to believe that house prices never fall, they will buy too much property—and house prices will fall. When they believe that shares always do well in the long run, they will buy too many shares—and the market will do badly for years.”

Relexivity makes financial markets more dangerous than the casinos. “The numbers on a roulette wheel never change, but markets offer no guarantee that yesterday’s odds will be the same tomorrow.”

Facebook and Airlines

British Airways and Virgin Atlantic both ran into trouble when their employees posted nasty remarks about their customers on Facebook. This raises the question about whether the companies did enough to educate their employees about the proper use of social networking.

See:

From Burden to Benefit: Making the most of regulatory risk management

The Economist Intelligence Unit published an executive briefing: From Burden to Benefit: Making the most of regulatory risk management (executive summary) (full report .pdf).

It is an irony of modern business that regulation, a concept designed to reduce risk by protecting the interests of corporates, customers and society at large, has itself become one of the most serious risks that companies face. From dealing with unfamiliar regulatory frameworks in overseas markets to scanning the environment for new threats, regulatory risk management has become a time-consuming and costly activity that demands board-level engagement and a rigorous approach.

According to the report, two-thirds of respondents say the biggest problem that hinders their company’s ability to manage regulatory risk is “complexity of the regulatory environment.”

On the positive side, most said they had strong capabilities dealing with regulatory risk. But the big weakness, was the problem of dealing with multiple regulatory environments, both domestically and internationally, and juggling multiple projects.

Thanks to Leon of SOX First for pointing out the report: Compliance Challenges.

Bribery and Corruption Have Become Endemic in Russia

The Economist ran a special report on Russia. The article that caught my eye was Grease My Palm. In looking at the scope of the problem in Russia, the articel cites the corruption market being estimated at $300 billion, which is about 20% of Russia’s GDP. INDEM (a Russian NGO) says 80% of all Russian businesses pay bribes.

It makes you wonder how any U.S. business can being doing business in Russia without violating the FCPA.