Market Commentary: Manifest Absurdity

 

Greensill

Today’s FT reported on Lex Greensill’s testimony to Parliament’s “Treasury Committee” as follows:

He insisted that his company’s lending was supported by real assets, although he admitted that up to 20 per cent of the group’s lending last year was based on “future receivables”.

If you’re like me, you probably had to stifle a guffaw on the conflation of “future receivables” with “real assets”.

But if you think a bit more, perhaps in the current environment it’s not so far fetched.

Even sober financial analysts and commentators, including some at the FT, have identified crypto currencies as a new “investable asset class”.

In terms of “real assets” are future receivables any less real than Bitcoin, Dogecoin, or their like? 

I think not.

If that isn’t a sign of irrational exuberance, I’m not sure if there is any sign.

Fairness impels me--note the choice of that verb—to mention that today Jemima Kelly did opine in those very same salmon-colored pages that crypto currencies were a “joke” and shouldn’t be taken “seriously”.

Ark Innovation – Springs a Leak

The FT reported that Ark had lost one-third of its value since its February “high”.

I’d make the same comment I did regarding Tesla’s loss of value.

More accurately, the price is down by one-third.

Value is intrinsic. Price is a market phenomenon.

Also a shout out to Lex, for noting that:

Data from Morningstar illustrate the pitfalls. More than two-thirds of thematic funds outperformed the broad MSCI ACWI index in the year to end March. But go back five years and that drops to below a third. One-fifth of thematic funds did not even survive. Over a decade, just 4 per cent outperformed. As themes go, this one does not inspire much confidence.

Middle Eastern Democracy – Kurdistan Style

Today’s FT “Long Read”--as its actual length discloses it is apparently designed for those with ADD--discussed authoritarianism in Kurdistan.

Not only was I was surprised and deeply shocked to learn that Jeffersonian democracy was not flourishing in Kurdistan. 

But also that corruption was rampant indeed.

Who would ever have thought?

As pointed out in the article, much of the silence on these two topics has to do with geopolitical “considerations”.

So much for making the world safe for democracy or fighting corruption.

At least I suppose one can take comfort that no one has proposed Kuridstan for NATO membership. 

 At least not yet!

Market Commentary: Greensill -- The Critical Difference between Insurance and a Guarantee and Why It Matters

 

An Unhappy Outcome

Since I haven’t seen anything on this topic in re Greensill, I thought I’d offer a few thoughts on how the fundamental difference between (1) a guarantee of payment and (2) an insurance policy affects the Greensill “situation”. 

And how it might motivate actions by participants in this unhappy event.

The difference between these two instruments is frequently misunderstood, including by supposed finance professionals. Hopefully, this post will fill in any extant knowledge gaps.

A guarantee of payment (as opposed to a guarantee of collection) is a legally binding obligation by the guarantor to make payment to the guaranteed party if the debtor does not make a scheduled payment. Proof of the debtor’s non payment is generally fairly “easy” to make. Usually then the guarantor makes payment without undue delay.

An insurance contract is a legally binding obligation by the insurance company to pay the policyholder if the policyholder submits a valid claim.

Keep those last two words in mind. 

The insurance company reviews the policy conditions, the insured’s (or policyholder’s) actions, and makes the initial determination of the validity of the claim. Some policyholders have been known to complain that such assessments seem to move at a glacial pace.

As that should imply, the insurance company has more legal defenses against payment than a guarantor. And its payment is not as fast given the time to review the claim.

The insurance policy spells out the conditions for validity.

For example, in obtaining the policy, did the policyholder make a material misrepresentation or fail to disclose material information that would reasonably have caused the insurance company to refuse to write the policy? In such a case the entire policy is invalid.

Did the policyholder fail to take reasonable steps to prevent the loss?

For example, if he left his Maybach unlocked with the key in the ignition and his insurance company knew this fact, they would likely decline the claim for theft.

If she routinely stored gasoline in her villa and filed a claim for fire damage and the insurance company knew this fact, the result would be the same.

Did the policyholder take reasonable steps to mitigate damages?

When the fire broke out, did she call the fire department? Or just let the villa burn down?

If his trade counterparty was in financial difficulty and he should have been aware, did he shorten payment terms, ask for collateral, lower his credit limit for aggregate outstandings?

There may also be other specific policy exclusions: strike, riot, civil commotion, actions of political entities, foreign exchange controls, etc.

We can therefore expect that Tokio Marine and other insurance companies will be carefully reviewing their obligations under any outstanding policies on Greensill related debt. 

I saw in today's FT (23 March) that Tokio Marine had opined that the policies might not be valid. 

Today (2 April) the FT reported that Grant Thorton acting as administrator for Greensill had been unable to verify certain invoices underpinning loans to Liberty Commodities - part of Mr. Gupta's group.  

Actually, the article says that several firms whose names appeared on invoices denied any commercial relationship with Liberty.  You can guess that this means that any "insurance" on these invoices is invalid.

One would of course have to review the actual policies and the respective governing laws to determine the defenses the insurance companies might have.

But I wonder if it’s possible that policies issued in excess of underwriting limits might be one? 

Part of that might turn on whether Mr. Brereton was working for Greensill (as an insurance broker) or for Tokio Marine (as its employed underwriter).

As well one can imagine Credit Suisse fund managers' angst over the difference between insurance and a guarantee as well as potential liabilities that might arise from potential "defects" in disclosures in selling documents vis-a-vis disgruntled clients whose attorneys will be going over said documents carefully.

Keep up to date on developments.  

The FT continues to follow the Greensill saga with an interesting article on Mr. Brereton earlier this week.

Wirecard - Great Moments in Regulatory Oversight

 

Wachsam sein --immerzu

On 10 December Mr. Naif Kanwan, executive director for enforcement and market monitoring at Apas, the Federal Republic’s audit “watchdog”, gave testimony at German parliamentary hearings on Wirecard.

Olaf Storbeck has an absolutely delightful (though ultimately disturbing) account on that testimony which appears in the print edition of Friday’s FT (where else?)

Let’s run through the quotes. AA’s commentary in italics.

“My impression was: somebody is on the case, has been looking at the allegations and came to certain conclusions.” He added that this “subconsciously influenced my thoughts about the matter”. 

One reading of this quote is that it is an admission that the apparently aptly named naif was not on the case. And saw little reason to disturb himself. George will do it. 

Perhaps as well, that Mr. Naif’s investigations are conducted based primarily on the operation of the subconscious. If you will, a Freudian approach to regulation. Hence the picture above. The subconscious, as I hope you know, is more active during sleep.

Alternatively, it could just be an attempt to create an excuse. Feigned faulty memories or low intelligence are often proffered to “explain” failures.

Asked if he believed in early 2019 that FT journalists colluded with short sellers, Mr Kanwan pointed to BaFin’s ban and criminal complaint. “These moves were in line with such a picture,” he said.

Indeed, it is certainly well known-at least in certain circles-that short sellers are a nefarious bunch always up to no good bad mouthing fine companies. And that short sellers have never ever pointed out fraud before regulators woke up.

Equally that there really haven’t been any cases of external auditors missing or colluding in accounting irregularities.

It’s also well known that major financial newspapers don’t take action against columnists that collude with short sellers, particularly when a major regulatory agency lodges a criminal complaint.

Shame on you, FT! 

Especially since this also happened with NMC – though to be fair in that case no criminal charges were lodged.

He acknowledged the watchdog at the time was unaware of earlier allegations against Wire-card raised by short sellers in 2016 in the so-called Zatarra report. That only changed in October 2019 after the FT published internal Wirecard documents pointing to a concerted effort to fraudulently inflate sales and profits.

One (at least AA) expects a watchdog to “wachsam sein immerzu” to quote the old song from the East. Though AA admits that he may be ignoring the possibility of “repressed memories”.

As a positive comment, I’ve heard--and not just from short sellers or financial journalists--of a communications service called the “internet” which I am assured allows one to follow news, conduct searches, etc. 

They say it’s quite useful.

I am even also told that one  can set up “alerts” to be advised of news on a particular topic, company, etc. without having to take an active steps –other than setting up the alerts.

Remarkable if true.

On that latter point, he did note: 

 “As a lesson learned, we have improved our press monitoring.”

лучше поздно, чем никогда!

Corporate Fraud Part 2 -- An Alternative Proposal for Enchancing Detection

Abu Arqala Publishes His Proposal

In the previous post, I expressed some concerns about a proposal to combat corporate fraud.

Saying that a particular solution seems unworkable or difficult to implement isn’t really of much utility.

Don’t tell me what can’t be done. Tell me what can.

The point is to outline a possible solution.

What then is AA’s alternative? What is to be done?

To start we have to accept that just as with corporate misgovernance there is no financial equivalent of hydroxychloroquine that is a sure cure. 

Because fraud is not just equivalent of a bad “flu”, financial or otherwise, and won't just go away in July or some other month, we do have to take action.

To that end I offer this alternative proposal which seeks to use existing structures to enhance current risk disclosures and promote risk-based auditing.

A key goal is turning auditors’ attention and action away from what appears to be a sole focus on policies, internal processes and controls, and pieces of paper.

As the old joke goes, if it isn’t written down, it doesn’t exist for an auditor.

The real risk with that mentality is the converse.

If an auditor has a piece of paper—a confirmation, a copy of a contract, etc.--the existence of an asset or liability or a business relationship is a proven fact.

The steps I’m proposing would not mean that auditors would abandon examining adherence to financial reporting and accounting standards, reviewing internal controls and processes for adequacy, nor performing many paper based audit activities, including confirmations, nor issuing opinions on those matters.

Because the majority of companies do not engage in major fraud, that current audit work provides needed information to a wide range of third parties, e.g. shareholders, other investors, lenders, business partners, etc. And so it should continue.

If a company is fraud free, an investor is still going to want to know if the company is following accepted accounting principles, has proper accounting systems and internal controls, has documentary evidence to back up transactions, etc. That it uses reasonable assumptions when valuing hard-to-value assets.

One doesn’t want to invest one’s money with or make a loan to an honest but incompetent or disorganized company.

So my proposals are designed to leave those aspects of auditing in place but enhance the extent of auditors’ work.

First, emphasize the need for auditors to identify if the company has any serious or unusual risks in its business model or practices, including unusual vulnerabilities.

If such risks are found, require that they are disclosed in a clear form in a company’s audited financial statements.

When those risks are pose substantial or unusual vulnerabilities, auditors should include these in the “key audit matters” section of their audit opinion. That would require that they discuss the existence and materiality of such “matters”; describe the additional audit work they have performed to address them; and their resulting assessment on that matter.

If they don’t reach the level of a “key audit matter”, they should be noted and addressed/focused on in the audit plan. 

The goal is not to come up with a laundry list of every potential risk factor similar to a bond or stock offering memorandum which is primarily a CYA or more accurately a CYLE (cover your legal exposure) exercise for the underwriting/offering banks and the issuer. 

All business are subject to a variety of risks.

The point is to identify those risks or vulnerabilities that are not obvious and have a material impact. 

This will become clearer in the post to follow where I outline this “point” applied in actual cases or hypothesize how it might have been applied at Wirecard or Hin Leong Trading.

Second, require that auditing procedures be scaled to risk of an individual asset, liability, etc.

For example, one should not use the same method to verify bank deposits of Euros 1.9 billion that one uses to confirm a USD 100,000 receivable. 

What are these two principles designed to achieve?

The first is designed to alert market participants, lenders, and regulators of vulnerabilities and dependencies that could have a material affect on the company’s health. To raise a red flag. 

That's important because fighting fraud is not the sole job of one group any more than corporate governance is. 

What that means is that for this aspect of point one to work someone out there has to be "listening".  If the "flag" is missed, the chances of uncovering the fraud decrease. 

It is also intended to cause the auditor to focus on a class of risks that seem often to be overlooked at least in some cases. 

That serves as the "back-up" if no one is listening.

Auditors are already required to assess a company’s risks and then develop a specific audit plan of work to ensure appropriate audit work is done on these areas. So this is a reminder with emphasis of this existing requirement.

But if they don’t focus on this latter class of risks, there is a real danger—as perhaps evidenced by some recent fraud cases—that they will not undertake the work they should have to address these issues.

The second is designed to "force" auditors to scale audit work to risks.

What’s the relation to fraud?

As I noted in an earlier post, many but not all types of fraud necessarily require the overstatement of assets. 

We’re most concerned with major frauds that threaten the viability of a company that is the reason for risk based scaling of audit work.

At first blush, this may sound like a good proposal. Or at least that's what I tell myself.

But it is not a panacea. There are no 100% solutions.

Why?

As to reliance on large numbers of market participants reacting to alerts (the first point), if you’ve read this blog before, you know I have little faith in the mythology of efficient markets.

Not no faith. Just a slight bit more than I have in the “Power Ponies”.

Admittedly, I’m banking on a very small number of market participants to read, understand, and then take action on any red flags raised by disclosure of these sort of business risks.  

That being said, just a few persistent sharp investigative (but probably underpaid) journalists at the FT played a major role in uncovering NMC and Wirecard

.

But, the effectiveness of this point doesn't just rely on those sort of market participants.

Widening auditors' risk focus and thus getting them to adjust their audit focus and work should also contribute to detection, particularly because they have access to detailed company financial information that other market participants don't.

But neither of these two intended goals will result in fraud detection all the time.

That’s the reason for the second point.

That’s why it’s in some respects more important than the first. 

Enhanced audit work. Moving beyond the tick-the-box approach to one that is based on risk. The more risk the more work required.

Why is that important?

As I’ve argued, “fiddling” with the income statement requires “fiddling” with the balance sheet pretty much dollar for dollar.

Major fraud requires major fiddling.  

If audit procedures disclose that assets are overvalued or non existent, it’s very good sign that the income statement has been overstated and income is non existent. And vice versa.

There are other cases of fraud that might be detected by enhanced audit work to confirm the existence of an asset or its carrying value.

Some examples.

Knowingly exchanging one asset for another of lesser or of no value.

Or, as happened at Hin Leong Trading, selling inventory without recognizing the sale in the accounts.

Failure to recognize the financial impact of a “good” transaction that has gone bad. A receivable associated with a legitimate sale turns out to be uncollectable. An asset purchased in good faith goes “south”. But there is no charge to the income statement or to equity.

Harder to detect frauds would be inflating expenses to take cash out of the firm. For example, overpaying for goods or services actually received. Or paying for non existent services.

Note in the second part of the previous sentence I’ve eliminated “goods”. It’s much easier to determine that an asset doesn’t exist, than it is that a service wasn’t performed. Or performed in full.

Enhanced audit procedures should lead to discovery of some and perhaps even many of those frauds, primarily those likely to have a material adverse impact on the company. 

Smaller amount items are likely to remain undetected. 

All well and good, you might say. But what about other cases of fraud like NMC where billions of US dollars in liabilities were not recorded in the financials.

Indeed.

These are extremely difficult to detect.

The “first line” of defense is the auditor’s confirm from lenders or providers of funds. This is not ironclad because auditors do not send confirms for each and every loan or other asset of the lender. 

If clever people are perpetrating the fraud, they may arrange a fraudulent reply to the confirms.  

One might hope that as part of annual credit reviews, lenders and other providers of funds look to see if their debt is reflected in the borrower's financials.  They have the details that generally should enable them to identify their debt, e.g., rate, tenor, currency in the absence of their name in the financials.

Banking on "hope" is a endeavor with limited probabilities of success.

Other difficult to detect frauds involve hard-to-value assets, e.g., non listed investments, or real estate. 

Slight changes in assumptions can result in large changes in value. If stock analysts have trouble accurately valuing listed securities, it’s unlikely that accountants or even forensic accountants will fare better.

Enhanced audit work (my second point) does not provide an airtight solution. It does, however, raise the odds of detection.

That means that at best my proposal will not detect all fraud, but it might result in more fraud being detected than currently.

In a post to follow, I’ll detail how both steps have been applied and might have been applied at Wirecard and Hin Leong.  The latter by drawing on my legendary powers of 20/20 hindsight.