In a matter of first impression in Puerto Rico, and applying Delaware law, District Judge Gustavo Gelpi dismissed all the claims against 11 defendants, all of whom were the most senior executives at Westernbank, formerly Puerto Rico’s second largest bank. Westernbank, a $10 billion bank with hundreds of branches scattered throughout the island, was closed by the FDIC in 2010 for reasons unrelated to the lawsuit.
The derivative lawsuit, brought by a shareholder of the bank, alleged that the majority of the board of directors and senior management purposely ignored the warning signs of a massive, $200 million structured fraud initiated against the bank’s asset based lending division by a significant client of the bank. The shareholder claims included breach of fiduciary duties as officers and directors of the bank, waste of corporate assets, unjust enrichment, Sarbanes-Oxley violations, and violations of numerous Puerto Rican statutes.
Attorneys Carlos F. Concepcion, Manuel A. Rodriguez and Scott A. Burr, and Forensic Investigator and CPA Francisco Gomez, assisted the Special Litigation Committee of the board of directors in determining the viability of multiple derivative claims initiated against the bank’s officers and directors.
The investigation involved a review and analysis of over 100,000 documents related to the fraud and interviews of nearly 40 bank officials, directors and officers with knowledge of the events leading to the fraud. The Committee’s report, a nearly 200 page single-spaced report detailing its factual and legal analysis, was ultimately filed with the court along with the Committee’s motion to terminate or otherwise dismiss the case. The factual investigation also required detailed analysis of Westernbank’s internal control systems and their remediation that resulted from nearly a dozen third-party reports and analysis.
The overwhelming amount of fraud occurring and uncovered in South Florida, including mortgage, banking, securities, and regulatory fraud demands at least a cursory analysis of the personalities and behavior that typify these fraudsters. Stanford, Rothstein, Freeman, Tolz, etc., are merely the tip of a very large iceberg penetrating South Florida.
I am often asked to explain, or even justify, criminal behavior, not merely for the sake of curiosity, but to prevent being swindled by these schemers. We believe that if we can understand the criminal mind, we can identify their attributes and prevent from getting swindled. Unfortunately, the pathology of crime is far more complex than we dare imagine.
There are two ways of preventing a fraud from occurring. One technique is quantitative, and involves the use of sophisticated due diligence to ferret out the fraud or any inconsistencies in the fraudster’s “stories”. These quantitative techniques take the form of pre-investment financial due diligence, background checks, verification of financial history with third-party sources, current customer verification, etc. These quantitative techniques are typically performed before investments are made and throughout the history of the investment. Unfortunately, very little of these techniques are actually performed, witness the Madoff scandal. Here, very little, if any, investigative due- diligence was ever performed, and even when it was, the SEC summarily dismissed it.
The second technique, the subject of this article, is far more complex and qualitative. It involves understanding and profiling the criminal pathology as a means of detecting potential firestorms later. This subtle technique involves profiling the types of personalities that might be inclined to commit criminal fraud.
We have witnessed the hubris of endless cycles of war and conquest that have characterized the Roman, Greek, British and Spanish empires, and more recently, the German Reich and the Soviet Union. Nearly every continent and empire has held unbridled power briefly, but none has been able to hold it for long. The Romans succeeded chiefly because of the relative weakness and tribal instincts that characterized their vanquished enemies, but even they were ultimately defeated by their own demons and internal failings.
These failings were principally characterized by an inability to recognize the unsustainable nature of their societies and the economic models on which they were premised. Marching vast armies through multiple continents became economically and politically unsustainable for the Roman Empire, which entrusted its unceasing demands for territory and power to professional armies that would spend years abroad and far removed from the Roman homeland. The German Army would march its Panzer units abroad for years, virtually requiring that these specialized army units reposition themselves as occupiers, rather than conquistadors.
Meanwhile, the local populace, ignorant of the back-breaking cost of these armadas, continued to cheer the endless conquests and territorial expansion of their homelands. Nationalistic fervor and pride, bordering on nihilistic self-approbation, continued unabated. No sacrifice was required, no penalty or tax was paid for this unceasing expansion, until virtually the end of their empires. The populace was ultimately deluded into a vision of guilt-free expansion, politically and economically, that required no excessive or burdensome levy on their current lifestyles.
Predictive modeling, the process by which a model is created or chosen to try to best predict the probability of an outcome, has lost credibility as a forecasting tool. Overly simplistic models have failed to account for the sheer complexity of human interaction and the degree to which most people behave irrationally. Most predictive economic models presume that people behave rationally most of the time, a premise which is terribly flawed but which serves as the intellectual foundation of many current economic models (See the Wall Street Journal article on this issue, here).
Predictive modeling has seeped into nearly every facet of our decision-making. It has been the cornerstone for most economic models for decades, and lately it has even attempted to predict consumer behavior. Companies like Amazon use predictive modeling to determine what consumers will purchase, and even suggest purchase alternatives based on what other consumers have purchased after reviewing the same item that the consumer initially looked at.
These models are quite good at predicting outcomes provided that the input variables, or human choices, are extremely limited. Thus, Amazon’s ability to predict what a consumer might purchase after having reviewed a particular item on its website is quite good, because the range of inputs and variables necessary to make that prediction is low.
Those are the years to which the Great Recession has propelled South Florida’s economy. In a series entitled Economic Time Travel, The Miami Herald, here, and here, recently provided evidence of the stark reality that many businesses and consumers face.
The Herald study tracked 60 different monthly indicators, from revenue generated by hotels, building permits, home re-sales, unemployment, cargo volume, taxes, and many others, all weighted based on their relative importance to the economy as judged by economists, analysts and industry leaders.
Collectively, the Great Recession sent the South Florida economy back to 2002. Individually, many sectors have fared much worse, such as commerce and the overall business climate. The jobs market slid back to levels unseen since 1998. Only tourism and trade, two sectors that support lower level, service sector jobs, have prospered and bounced back.
60 economic indicators can’t be wrong about what we’ve all intuitively felt for a few years: we’re crawling backwards, not forwards economically. Our standard of living, earnings and our purchasing power have declined significantly, yet prices continue to march forward. Commodity prices have surged, and gas is poised to surpass the record levels reached in 2008. Nearly every family has been directly or indirectly affected by this economic malaise.
The utter contempt that Jackson Memorial Hospital’s managing board, the Public Health Trust, and the Miami-Dade County Commission, have displayed for the residents of Miami-Dade County and the Jackson health system has reached a new high.
The Miami Herald reports, here, that the treasurer of Jackson Health System’s governing board noted this week that cash is getting “dangerously low” and that major cost cuts may be needed. Currently, Jackson will likely end the month of January with only 16.7 days of cash on hand. Hospital’s median day’s cash on hand is closer to 90 days cash, making Jackson’s days cash on hand ratio abysmal, and a true operating emergency.
Additionally, Jackson experienced a 7 percent drop in patient revenue, a material and significant decrease to any business entity. The impact on Jackson, though, is pronounced, given its already weakened financial condition and its primary mission of serving the uninsured.
Jackson’s real problems are the result of institutional ignorance and complacency. This author was briefly involved in the nomination process to sit on the Public Health Trust, and met with a panel of Miami-Dade County commissioners, Florida legislators, Public Health Trust members, and other important local politicians.
In an ominous warning to other, post-industrial developed economies, Japan seems mired in an economic straitjacket decades in the making. A majority of its younger workers are unable to find permanent, regular jobs, and feel increasingly marginalized. Instead, Japan’s corporate structure is geared towards protecting its aging population and bloated pension systems.
A recent article in the New York Times, here, highlights the individual distress felt by its young workers. Amazingly, this has resulted in a “brain-drain” of highly educated Japanese to other countries and threatens to stunt economic growth for generations. This generational inequality is partly to blame for Standard & Poors recent downgrade of Japan’s sovereign debt.
Last year, nearly 45% of young workers held “irregular” jobs, akin to contract labor in the United States. These jobs offer low pay, no benefits, and no pension. Only 56.7% of university seniors received job offers in 2010, an all-time low.
The graying of Japan and its reluctance to undertake the structural changes necessary to include young adults in its economy is producing a new, “lost generation” of disenfranchised youth. These second-class citizens will endure a rapidly-declining standard of living and a widening gulf between the “castes”.
The cultural ethos prevalent in Japan encourages conformity and obedience. Japan’s economic engine thrived on this ethos and their ability to mold university graduates to the firm’s culture. This allegiance to the firm produced a robotic, nearly mechanical worker whose primary goal was the maximization of firm profits and revenue growth.
Unfortunately, this ethos is obsolete, and Japan’s near absolute reliance on this standard has stunted the growth of individualism and entrepreneurship. Japan has few initial public offerings, and Japanese entrepreneurs primarily skew older.
As the current year fades and the new year begins, a trend continues to emerge in our society that is every bit as damaging as the economic fraud that has nearly plunged our country into another depression.
This fraud, which I’ve dubbed emotional deceit, is the constant betrayal of mutual trust and respect that has seeped into nearly every corner of our personal lives. The resulting emotional upheaval leaves a trail of destruction so bitter and permanent that it threatens our social and moral fabric.
What are some of the signs and symptoms of emotional deceit in society? The betrayal by Wall Street of any sense of decency, the lack of moral courage, and the demise of corporate values are all examples, and continue to shred our economy.
What occurred on Wall Street didn’t merely shock the economy into near-depression, but it ripped the veneer from the socially accepted notion that some level of decency and good-will existed between the participants in this free-market experiment. It doesn’t, and it never will, again.
Everyone’s on their own, adrift within their own, tiny life-boat. Our grand economic experiment now shifts from one of growth for all to a relentless search for economic survival and subsistence.
On a much deeper level, though, emotional deceit has seeped into the very fabric and essence of our personal relationships. The deep mistrust and cynicism that characterizes the economy and its participants now also pervades our personal relationships.
Current financial reporting practices often produce fictional and sometimes aberrant statements that are misleading if not outright fraudulent. For example, consolidated financial statements are traps for the unwary, hiding and masking transactions through Byzantine group structures and idiosyncratic consolidating techniques.
Consolidation procedures require that inter-group transactions be eliminated when the financial statements of the group are consolidated, on the theory that this procedure eliminates transactions between the group that are not at arm’s length and which may in fact be shams. But consolidation accounting has another, less obvious yet insidious result – it purposely conceals and buries subsidiary information within the group's consolidation, hiding both the enlightening and damaging aspects of subsidiary performance within the whole.
Consolidation accounting purports to represent the economic activity of a group of legally separate and unique entities under the fictional mantra of the group, relying on economic form over legal form and financial substance. They conceal data that might normally be available to users of financial statements, and may serve to hide data from shareholders and creditors that is damaging or otherwise disparaging.
Data not found in unconsolidated financial reports mysteriously appear in consolidated statements under the guise of economic substance, yet bear little relation to real-world substance and the individual, disaggregated accounts of the subsidiary. This theory of aggregation is contrary to the norms found in GAAP – that of full disclosure and careful consideration of an entity’s viability as a going concern.
Prevailing consolidation techniques ignore the legal and financial implications that the aggregated assets and liabilities are neither owned nor made available to the group. This group mentality encourages users and readers of financial statements to view the entities of the consolidated group as virtual branches of the parent, again creating a dangerous fiction rendering the financial statements less meaningful. The grandest of these fictions, though, is the assumption engendered by consolidation accounting that profits and losses of the subsidiary entities will pass through to the parent entity through dividend payments.
Our financial reporting system is under siege as never before. Corporations are under intense pressure from shareholders to meet or exceed earnings targets. Globalization continues to relentlessly compress profit margins. The response from many companies has been dramatic: radically reduce expenses by slashing services, wages and benefits, raise prices whenever possible, and employ accounting gimmicks and sleight-of-hand to manipulate earnings whenever these measures fall short.
These gimmicks, some quite elaborate, have resulted in a string of accounting failures and corporate scandals. Accounting failures have become rampant and more pervasive, undermining the credibility of the accounting profession and the inherent reliability of the financial reporting model as an evaluative tool in shaping investor confidence and awareness.
The financial statements, which include both quantitative and qualitative information, purport to transmit the financial data of an entity or group of entities into a prescribed format that stakeholders of that entity can use as a means of evaluating the financial health and viability of that entity. Financial statements must be able to accurately and faithfully convey the economic substance of a transaction, over a period of time, and as of a given date.
Financial information presented in these statements must be capable of accurate comparison to financial statements of other entities. These other entities may or may not be within the same industry as the target company, and the financial statements must convey the economic substance of the transaction rather than merely the economic form of it.
The SEC claimed that from 2001 to 2007, New Jersey claimed to have set aside funds to pay for pension benefits, when no such funds had been made available or earmarked. According to the SEC, New Jersey engaged in an accounting fiction to make it appear that the funds existed. The SEC also claims that this accounting illusion allowed New Jersey to sell $26 billion worth of state bonds to unsuspecting investors, who were never made aware of the magnitude of the state’s pension troubles.
New Jersey’s public pension fund is one of the largest in the country, and its chronic underfunding can potentially undermine future budgets by requiring significant redistributions from the operating budget to service its pension obligations. According to the SEC, the state treasurer repeatedly certified that the pensions were being funded according to the plan, which was never true. Interestingly, though, the SEC chose not to pursue charges against the treasurers who certified the misstatements or other professionals and auditors who reviewed them.
A recent article in the Wall Street Journal, here, highlights how accounting manipulation has increasingly become the tool of choice for dealing with a souring economy. Regulators, the Federal Reserve, the Treasury, and those with clearly vested interests have largely failed in their efforts to stimulate the broader economy. The one remaining tool in the toolbox, though, remains their most potent: create more fiction and re-write those facts which are inconvenient.
“Extend and pretend” has become de rigueur at banks and other financial institutions, financial sleight-of-hand which masks bad loans by purportedly modifying loan terms or providing repayment assistance. These modifications prevent the need to immediately write-down the loans or fully reserve for them. By forestalling these write-downs, banks avoid further destruction of their capital positions, which have been decimated by the economic firestorm.
Many of these loan modifications are shams, and are not designed to protect the commercial project’s viability. Instead, these bogus loan modifications ensure that banks maintain the loan as performing assets and prevent further weakening of their capital.
As the FDIC grapples with an uncertain economy, spurious loan modifications and the fictitious balance sheets they create may purposely delay efforts to close many of the 1000 or so troubled banks that are projected to be shuttered by the FDIC in the next few years. Efforts to delay these closings will, in turn, postpone the FDIC’s own financial Armageddon and taxpayer bailout.
Anton Valukas, of Jenner & Block, discovered Repo 105 while investigating Lehman’s collapse and detailed its use in his report, here. Repo 105 was the artful term used to denote the accounting device through which Lehman manipulated and managed its financial statements, which involved temporarily removing billions of dollars of assets from Lehman’s balance sheet at the end of each quarter. This gimmick reduced Lehman’s leverage ratios, which were crucial to maintaining its required favorable ratings from the principal ratings agencies, and ultimately, to maintaining investor and counterparty confidence.
Lehman ultimately failed for a variety of reasons, including its increasing inability throughout the crisis to securitize and distribute its subprime mortgage originations and its countercyclical growth strategies of using its own balance sheet to acquire assets for long-term investment. These proprietary investments were principally concentrated in three areas: commercial real estate, leveraged loans and private equity. Most of these asset areas would soon implode as the financial crisis expanded.
These countercyclical investment strategies “consumed more capital, entailed more risk, and were less liquid than Lehman’s traditional lines of business.” Ultimately, as the result of these investment strategies, Lehman desperately needed to raise cash, was unable to sell most of these highly illiquid investments at desirable prices and was forced to turn to massive accounting manipulation to temporarily reduce its balance sheet “solely for the purpose of the firm’s public financial reports.”
If there was ever any doubt that the US housing market was being artificially supported by the federal government, new statistics dispel this. A recent Bloomberg article, here, highlights how dependent the US housing market has become on federal assistance.
Fannie Mae and Freddie Mac, already financial wards of the state, may ultimately require $1 trillion dollars in federal bailout funds. This sobering statistic belies the very notion that the US housing market operates as an efficient, free-market enterprise, and that housing values are based on arms-length transactions.
The fact is, the housing market is currently anything but arms-length or free-market. Gross price valuation distortions have occurred within many asset classes in the last 10 years, including commercial and residential real estate. These distortions occurred for many reasons, but were primarily due to the near freefall of credit standards that now threaten our banking system. Easy money distorted prices, and now threatens the survival of hundreds, if not thousands, of banks.
Fannie and Freddie own or guarantee 53 percent of the nation’s $10.7 trillion in residential mortgages, and have sold $1.4 trillion in mortgage-backed securities to the Federal Reserve and the Treasury Department since the crisis began. The liabilities assumed by the housing giants remain off the federal balance sheet, an accounting fiction that grossly underestimates the government’s long-term debt exposure.
Michael Lewis' article in Vanity Fair, here, is a short tease for his new book, The Big Short, which exposes how Michael Burry, a hedge fund manager, accurately predicted the housing debacle far in advance of the actual crisis. The Vanity Fair article reveals how Burry single-handedly outmaneuvered Wall Street’s elite, and how this success has not ingratiated him to those he took to task.
Burry, a Stanford educated physician, is undoubtedly very smart, but this is not why Burry was able to see what others could not. It is Burry’s questioning, contrarian nature that led him to perform substantial due-diligence into an assumption that others had taken for granted: that housing was on an epic, sustained run that would never cease.
Burry’s story is a tale of two unique, if interrelated, phases. The first phase involved Burry’s tenacious slog through a thicket of documents, prospectuses and textbooks, looking for clues to the impending disaster and performing bank credit analysis on the home loans that he was analyzing, the same analysis that should have been performed by the issuing banks, but wasn’t. The second phase, convincing Wall Street to create financial products so that he could short the market, was pure genius.
Michael Burry’s analysis of the housing market and his conclusions are due primarily to his dogged due-diligence, pure and simple. This effort was nothing short of herculean in scope but otherwise unremarkable and tedious, and was the product of Burry’s tireless review of thousands of documents. Once completed, though, this due-diligence provided Burry the platform for the unshakeable faith in his ability to detect patterns and draw conclusions from within the housing bubble, and ignore the conventional and usually mistaken wisdom of crowds.
Common wisdom is that short sellers, those market participants attempting to capitalize on the misfortunes of individual stocks, manipulate or shape negative information to their benefit. The study, reviewed here in the New York Times, and published here, reveals that short sellers are merely very astute and perform a very high level of due diligence. These "informed traders" do not merely time the markets and information, and therefore, obtain unfair advantages over other market participants. Rather, short sellers perform effective due diligence and often prognosticate future failure or scams.
The researchers looked for evidence that short sellers' informational advantages were due to timing, and looked for evidence of abnormal short selling ahead of news events in the U.S. over the 2005-2007 period. They found no such patterns, and noted that the "ratio of short sales to total volume is nearly constant around news events." The researchers actually found that "there is a significant increase in short selling AFTER the news event" which indicates that the short sellers are trading on publicly available information.
Niall Ferguson, the Laurence Tisch Professor of History at Harvard University, has written a profound analysis of the destruction of empires for the journal Foreign Affairs, reprinted here. Ferguson posits that an empire's slide into chaos is abrupt and disruptive, rather than gradual and cyclical, as traditionally thought. Historically, scholars seemed unified around the notion of gradual decline and phased transitions:
Ferguson suggests that the cyclical nature of destruction as a theory of empire collapse is fundamentally flawed. Empires are complex societies, delicate social, cultural and economic systems that operate fluidly, organically, and in a state of delicate stasis. Sudden, often small events or circumstances, such as those described by Nassim Taleb in The Black Swan, can disrupt this equilibrium and create a crisis of such magnitude that the entire organism collapses.
It is these “proximate triggers” that we must be concerned about, that can cause wide-spread conflagration and destruction of complex systems. Small inputs to these systems can “produce huge, often unanticipated changes – what scientists call the amplifier effect.” “When things go wrong in complex systems, the scale of disruption is nearly impossible to anticipate.”
Following the Pew Center's Trillion Dollar Gap report on the pension crisis, The New York Times reports, here, that states continue to purposely distort their expected rates of return to prevent their already large pension funding shortfalls from growing steeply. Significantly, states are also concentrating greater portions of their assets in a riskier range of investments, such as commodity futures, junk bonds, foreign stocks, deeply discounted mortgage-backed securities and margin investing in an effort to seek higher returns.
The outright inflation of expected rates of return on pension assets, often pegged at over 8 percent, allows governments to diminish their annual cash contributions to the plans, but ultimately succeeds only in deferring the pain to later years. The fiction of inflated returns on pension assets temporarily closes the funding shortfall and allows governments to ease their current budgetary constraints, but fails to address the fundamental urgency of the crisis: that pensions and retiree health care benefits are grossly underfunded.
Taxpayers have, for decades, been induced into believing that unfunded pension plan increases were painless methods of increasing employee pay, especially pay for unionized workers. Deferring the pain has left state and local governments with a massive, unfunded liability, though, and could bankrupt many state governments.
The report, published by the Pew Center on the States highlights the chasm between the promises made to government employees throughout the last three decades and the stark choices that will have to be made to pay for these benefits in the coming decades. These choices will exacerbate tensions between state government stakeholders, their citizens and employees.
The gap is roughly divided into two benefit components, pension costs and health care benefits. These benefits will increase steeply over the next few decades and will burden states and local governments with very difficult choices, namely, whether to dramatically raise new revenue by increasing the tax burden or slash services to their constituents, or a combination of both.
The New York Times, reports here, that cities hit hardest by the collapse of the real estate bubble face significantly more distress in the coming years, as the federal government gradually removes the massive subsidies that have prevented a complete collapse of the residential real estate market, and with it, the economy. To the extent that the real estate market is functioning at all, it "is doing so only because of the emergency programs, which have pushed down interest rates on mortgages and offered buyers a substantial tax credit."
Notably, that aid has included the following:
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