Audits and Auditors

I would like to recommend to the readers of this post the column by Jennifer Hughes in the Financial Times this morning. The title of the article is “Lehman Case Revives Dark Memories of Enron”: http://www.ft.com/cms/s/0/c9516dea-3792-11df-88c6-00144feabdc0.html.

The issue at hand is the relationship between a firm and its external auditors. The reason for the attention given to this issue by Hughes is the examination of the collapse of Lehman Brothers by Anton Valukas. Although not a major thrust of the review, questions did arise in the study concerning the role of Lehman’s external auditor Ernst & Young in the accounting practices adopted by the firm.

Ernst & Young began auditing Lehman Brothers in 1994 and two Lehman of Chief Financial Officers came from this external auditor. One, David Goldfarb, joined Lehman in 1993 and became CFO of the firm in 2000. The other, Chris O’Meara, joined Lehman in 1994 and was the CFO from 2004 to 2007. It was under Goldfarb that the accounting policy with respect to “Repo 105” transactions was developed.

To Hughes, this brought up memories of the accounting relationship between Enron and the external auditing firm Arthur Andersen. Again, a very close relationship had been established between the two organizations and many Andersen staff worked for Enron over the years.

I am not out to just criticize the accounting profession and the good and proper working relations that exist between many companies and their external auditors. However, the relationship between companies and their auditors can become too cozy and can present the opportunity to do things with company books that are, let’s say, not quite what the owners would like them to pursue.

My interest in this relationship comes from my experience as a senior executive, including President and CEO, of several publically traded banking companies. Each case was a turnaround situation.

In such a situation it is vital to get the accounting books in order and presentable to shareholders and the investment community for their close scrutiny. Internally, it is good to have “fresh eyes” to perform such a review. In a troubled institution it is problematic to have the same people, from inside as well as from outside the organization, performing this exercise. The first reason for this, of course, is that these same people watched the organization become troubled and they have a self-interest in defending the status quo. This is neither good for the company nor the shareholders and, thus, certainly not good for the executives hoping to turn-around the firm.

But, this pointed me to the problem that the financial controls that had existed were not sufficient for the company or for the executives in charge to prevent the firm from collapsing into a troubled institution. So, either the work was not getting done adequately or the executives that had been in charge did not want the work to get done adequately. Either way, the situation was not a good one for the institution or the shareholders.

It became my rule that any organization in which I was the CEO would put the job of external auditor out for bids in the fifth year of an engagement. I felt this was necessary for me to keep on top of what was going on in the organization and to have “fresh eyes” review the books and the accounting procedures on a regular basis. Furthermore, doing this periodically encouraged the openness and transparency on the part of the employees that I believed was necessary for the shareholders and the investment community.

This “rule” of mine may have been a little severe, but I was doing turnarounds at that time and the tighter time schedule seemed important to me then. Perhaps a seven year turnover of external accountants would be better, except in cases where the CFO of the company happens to be a former employee of the accounting firm doing the external auditing.

Hughes mentions in her article that Italy, among other countries, have limits on audit firm tenure. There the length of time allowed is nine years. Other countries require that the “lead partner” from the accounting firm be changed every five years. Also, there are rules about hiring individuals from the external auditing firm, rules that require a “cooling off” period for anyone joining an audit client.

To me, this requirement seems of particular importance to banks and other financial institutions. Yes, the banks are examined by the regulators and this should provide a check on what banks are doing. But, this is not enough in my mind.

When I was a bank President and CEO, I wanted the bank to have stricter requirements on what it did than the regulators. The reason is that I wanted the company to control the position of the bank and not the regulators. This also applied to the safety and soundness of the bank. That is why I wanted to ensure that the external auditors were truly independent of me and the staff of the bank. Having the external auditor “turnover” on a regular basis was one way to help achieve this goal. To my mind, any CEO that has the best interests of his/her shareholders in mind would want this to be the case.

I know that this is not the case of all CEOs in all industries. That is why some regulation of company/external auditor relationships is important. This is true especially for the commercial banking industry. Any regulatory reform that is passed should have some statement about the presence of an external auditor and the regular replacement of external auditors. This is a first round effort to insure the safety and soundness of the banking system and should, if it existed, ease some of the burden placed on the examination efforts of the regulatory agencies. It is a part of the openness and transparency that should be required for all companies, but especially for those related to banking.

I know that there is little academic research, as Hughes reports, connecting “audit, or auditor tenure, and the quality of the work.” I know that most situations and people work out well. I know the value that hiring someone familiar with your books is a “good thing” because of the complexity and sophistication of accounting practices today.

Still, I always wanted to be on top of things and continually have “fresh eyes” looking over the operations and the books. I always wanted to be challenged to do things in the best way possible. I always wanted people to push me to do better. Openness and transparency never bothered me. To me, performance always went back to how well you executed your game plan and not on how much trickery or deception you needed to win.

To me, it all comes back to fundamentals and ability. If you lack one or the other or both…I guess you need to rely on other means, like “cooking the books”, to come out on top.

Banking, Banks, and the President: Defining the Issues

The side that wins the political battles is usually the one that presents the issues in such a way that the “public” responds to this presentation and goes with them rather than with the “other side.”

There is an election coming up next year and the campaigning has already begun. The battle: whether or not the Democrats are going to be able to maintain a large enough majority in Congress to control the action in Washington, D. C. Already, the Democrats are looking back over their shoulders to 1994 mid-term election and their loss of control of Congress at that time. And, they are scared.

The way to operate in politics is to “frame” important issues in such a way that they will resonate with a majority of the electorate. It takes time for specific issues to “take hold” with the public so the framing effort must be started well in advance of the election. The process of “framing” is moving ahead, full steam.

The economy is obviously going to be an issue. How it is framed will determine the result. It appears that the banking industry is going to play a big role in how the discussion on the
economy evolves. The battle lines: Main Street versus Wall Street. The issues: an unemployment rate of 10% and an underemployment rate at 17-18% versus lots of taxpayer money to bail out the banks and the subsequent profitability of the big banks. A further issue: people losing their homes through foreclosure versus the payment of large bonuses by the big banks to their executives.

Sure the meeting between the President and the heads of the major banks in the United States was a great photo op. But, what did the photo op turn into? Let me just say that a headline like “Bankers Put Obama on Hold” accompanied by a picture of the President at his desk holding a phone does not create a very favorable image of the bankers (see the article by Andrew Ross Sorkin in the New York Times: http://www.nytimes.com/2009/12/15/business/15sorkin.html?_r=1).

Paul Volcker, former Chairman of the Board of Governors of the Federal Reserve System, is still a hero to many people, myself included, and is perhaps the most respected person in finance in the world today. He stated very bluntly in West Sussex, England this week that the bankers just didn’t get it. Great headlines!

In debates like this it doesn’t always matter who is right and who is wrong. We have seen over and over again that in economics, identifying the cause and effect of an economic situation is so difficult and the lags between the cause and the effect are so long, that explaining a situation to the public in terms that they understand is almost impossible.

Here I am specifically writing about the run-up to the financial collapse of 2008. To me the causes of this collapse go back to the almost 50 years of inflationary finance perpetrated by the United States government, Republican and Democratic alike, on the American people. This includes the huge deficits run up by the federal government since 9/11 and the inexcusable monetary ease that kept real interest rates negative for two to three years in the 2002-2005 period. The financial bubbles that resulted in housing and the stock market this decade produced the conditions that led to the subsequent events.

An economy with an inflationary bias is ideal for the evolution of financial innovation. It is ideal for leveraging up the balance sheet. It is ideal for assuming more and more risk.

It is difficult, however, to explain this cause and effect to the public.

Financial innovation looks like greed run amok. Assuming more and more risk looks like greed run amok. And, excessive amounts of leverage looks like greed run amok.

But, what about the government policy makers that created the incentives that made financial innovation valuable? What about those that contributed to the inflation that made high degrees of leverage worthwhile and edgy risk taking more attractive?

The connection is very difficult to put into sound bites and win the hearts and minds of voters.

In terms of financial regulation? My belief is that banks, especially the big banks have moved beyond the recent financial collapse. Congress and the regulators are always fighting the last war. The goal of Congress and the regulators is to not let the events of 2008 and 2009 happen again.

Guess what? The events of 2008 and 2009 will not happen again. The banks have moved beyond that. The reformed regulations will probably hurt the smaller banks much more than the larger banks. The smaller banks are still the ones dealing with the past, the questionable commercial real estate loans, the residential mortgages that are in arrears or are not paying at all, the consumer credit, the credit of state and local governments and so on and so on.

But, the big banks. They are already into 2010 and 2011 and beyond! More on this in another post.

This is why the banking industry must be careful at this time. In a real sense, Volcker is right; the bankers just don’t get it!

They can’t afford to look as if they are making the President look silly. They can’t afford to make themselves look like they are “fat cats.” Whoops, that is what the President called them Sunday night and it is all over the country. The bankers can’t afford to look as if they are staunchly against regulation reform. The bankers can’t look like they don’t care about mortgage foreclosures, or small-business loans, or getting people back to work.

The issues are being “framed” right now. The bankers cannot put themselves in a position to be characterized as “Scrooge” while the Obama administration comes on as “Tiny Tim.”

The Upcoming Banking/Financial Regulation

New financial regulation is on the horizon. As with the health care program, the Obama administration is providing very little unified leadership as to where it really stands and, as a consequence, there is a multitude of plans being tossed out into the air. There is, more or less, a Treasury plan, an FDIC plan, a Barney Frank plan, a Federal Reserve plan and so on and so on.

Where we will end up is anyone’s guess right now. At present, no real leader has emerged. Just like the health care debate.

From what I have seen I am not very comfortable. As is usual, the politicians sense a “popular” issue with the public. “Something must be done!” is the cry. But, as is typical, the politicians, in my mind, are fighting the last war.

There are three topics that seem to be missing in every discussion about new regulation or re-regulation.

First, how does one control and/or penalize “bad” monetary and fiscal policies that can lead to financial stress and a breakdown of the system? How do we overcome the economics of mis-directed presidential administrations? How can we keep the Federal Reserve and the Treasury Department under control when their policies are coming from the likes of Alan Greenspan, Ben Bernanke, Paul O’Neill, Jack Snow, and Henry Paulson?

The actions of the federal government impact the whole country. The actions of the United States government impact the whole world. What the government does changes the incentives in the whole system, how people conduct their lives and their businesses.

Yes, individuals did wrong and took advantage of other people. Yes, corporations and other organizations did not perform prudently. But, they did not create the environment in which such behavior became profitable.

I don’t care what regulations are put into place, when your government, year-after-year, creates trillions of dollars in debt and the monetary authorities keep interest rates at ridiculously low levels for extended periods of time you are going to change incentives and create opportunities for people to take advantage of the system and other people and organizations.

Second, if finance is fundamentally just information, how does one really control and regulate financial innovation? One of the things we have learned about information and the spread of information is that it cannot be controlled. It is easy to take “information” off-shore. It is easy to transform “information” into different forms and into different organizational structures. The world of the future will consist of more and more financial innovation and not less. And, this innovation will happen somewhere because it is easily transported to anywhere in the world, if necessary. And, in real time!

Third, the best regulation is that which emphasizes “processes” and not “outcomes.” We need regulatory systems that produce openness and not secrecy. We need economies that do not contribute to a covering-up of transactions whether it be for tax or flows of funds purposes (see the Financial Times, “Leading Economies Blamed for Fiscal Secrecy”: http://www.ft.com/cms/s/0/ea9f6964-c57a-11de-9b3b-00144feab49a.html) or whether it be for deals (see the Financial Times, “Trading in European ‘Dark Pools’ leaps Fivefold since the start of the year”: http://www.ft.com/cms/s/0/a43d96f0-c74e-11de-bb6f-00144feab49a.html).

Controls, prohibitive restrictions, price limits, artificial scarcities all lead to “black markets” whether the products and services are goods or whether they are just information.

Strict regulations aimed at “outcomes” just tend to drive people and organizations into areas that are less controlled and that are more opaque, less transparent. Is this what we want?

Our rules and regulations should help provide efficiencies and reduce the costs of information to the public. These rules and regulations will not stop individuals and organizations from taking too much risk or from possible financial dislocation. However, the more everyone knows what is going on, in my mind, the better off everyone will be. Also, the economic and financial system will operate better and the swings will be more incremental movements rather than discrete jumps.

Of course, my concerns are not popular with politicians for two reasons. The first is that the voters want to see something tangible done by the government. Developing rules and regulations that are meant to achieve “outcomes” are something that can be bragged about, even if they don’t work very well. Trying to explain that finance is another form of information and that financial innovation cannot really be controlled is difficult to do when the public sees all the perks and benefits that are associated with financial wealth.

The second reason is that politicians have difficulty claiming that government might be the root cause of the problem, especially when they have been a part of that government. Those that govern very seldom support the argument that government might be a cause of difficult times because government is so often looked upon as the solution to the problems we encounter, especially when the problems are of national or international scope.

We are going to get some new regulatory structure and that regulatory structure will, over time, prove to be insufficient to achieve what people hope that it will achieve. The last major change in regulatory structure was enacted in the 1930s. It took until the latter part of the 1990s to eliminate almost all of that structure. Millions and millions of dollars were spent over that 60-70 years to get-around that regulatory structure. Also, much brain-power was devoted to escaping the constraints.

My guess is that it will take a lot less time to get around the regulatory structure that is now under construction. The reasons for this prediction are the three topics that I mention above. In fact, one could argue that the government is doing a pretty good job right now, while you read this post, of conforming to the issue raised in first of the topics.