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Control Fraud

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“The money power preys on the nation in times of peace, and conspires against it in times of adversity. It is more despotic than monarchy, more insolent than autocracy, more selfish than bureaucracy. It denounces, as public enemies, all who question its methods or throw light upon its crimes.”

- Abraham Lincoln

Control Fraud

James Galbraith mentions in a comment the very useful concept of “control fraud” introduced by William K. Black, see e.g. When Fragile becomes Friable: Endemic Control Fraud as a Cause of Economic Stagnation and Collapse (pdf),

Individual “control frauds” cause greater losses than all other forms of property crime combined. They are financial super-predators. Control frauds are crimes led by the head of state or CEO that use the nation or company as a fraud vehicle. Waves of “control fraud” can cause economic collapses, damage and discredit key institutions vital to good political governance, and erode trust…

Economic theory about fraud is underdeveloped, core neo-classical theories imply that major frauds are trivial, economists are not taught about fraud and fraud mechanisms, and neo-classical economists minimize the incidence and importance of fraud for reasons of self-interest, class and ideology.

Neo-classical economics’ understanding of fraud is so weak that its policy prescriptions, if adopted wholly, produce strongly criminogenic environments that cause waves of control fraud. Neo-classical policies simultaneously make control fraud easier and more lucrative, dramatically reduce the risk of detection and prosecution by maximizing “systems capacity” problems, and encourage crime by making it easier for fraudsters to “neutralize” the social and psychological constraints against deceit and fraud. Thus the paradox: neo-classical economic triumphs produce tragedy…

William K. Black is also the author of the book The Best Way to Rob a Bank Is to Own One.

William K. Black:

Environmental “Control Frauds”

“Control fraud” has specific implications useful to the study of conservation finance. Both public control frauds (“kleptocracies”) and some private control frauds pose special dangers to the environment. Kleptocrats loot “their” nation. The direct effects of kleptocracy on the environment are severe. The head of state (and often his cronies) will approve developments that enrich him regardless of the harm to the environment. The government he controls will help the cronies evade any domestic or international laws designed to protect the environment, e.g., by issuing false certificates of the origin/nature of products. Kleptocrats are also autocrats, so the leader will use the state to suppress environmental protests.

The indirect effects of kleptocracy also harm the environment. Kleptocrats’ policies lead to widespread poverty, endemic corruption among lower-level government officials and reduced social trust and cohesion. Indeed, kleptocrats often follow the old colonial practice of “divide and conquer” — favoring one ethnicity or region over others. This can produce chronic armed conflicts that harm the environment. Even if there is no armed conflict the indirect effects mean that there is no effective environmental protection and increased pressure by poor citizens to exploit resources even when doing so overwhelms resources that could have been renewable.

Private control frauds often target the environment. Whenever a company can gain a competitive advantage by acting in an unlawful manner, e.g., by disposing of toxic wastes in a river instead of in the appropriate (but far more expensive) toxic waste disposal center a “Gresham’s law” style dynamic arises. (Gresham’s law: “bad money drives good money out of circulation” during hyperinflation. Note: George Akerlof used this metaphor appropriately in his seminal explanation of “lemon’s markets.” Note that examples he gives in that article are all variants of another type of control fraud — those that target the consumer.) Thus, environmental control frauds have two victims — the public and honest competitors. Unless the government effectively detects and punishes environmental control frauds the dynamic can ultimately lead to environmental control fraud becoming endemic. In the case of international disposal of toxic wastes, companies search for nations with weak regulation (or kleptocrats). National and international regulatory/enforcement efforts are essential to reduce this perverse economic incentive to engage in environmental control fraud.

William K. Black
Executive Director, Institute for Fraud Prevention
Associate Professor of Economics and Law, UMKC

Rob Henderson:

The next big control fraud exposure is actuarial fraud within the insurance industry – an industry that works closely with state bankers and capital markets to influence share prices and loot pension funds.

A Failure of Corporate Governance By James Kwak

A failure of corporate govermance is the part of control fraud...

(I’ve gotten several great articles forwarded to me via email by readers. It may take a few days to do them justice. Here’s one.)

In the great consensus of the past twenty years, government regulation was unnecessary because the free market provided better tools for constraining private companies. One force was the market, idealized by Alan Greenspan, who believed that counterparties could even police effectively against fraud. The other force was shareholders, who would punish managers for acting contrary to their interests. The market would prevent companies from abusing their customers, while corporate governance would prevent them from abusing their shareholders.

For those who still believe in the latter, McClatchy has a good (though infuriating) article on what went wrong on Moody’s, the bond rating agency that, we previously learned, responded to warnings about the toxic assets it was rating by . . . firing the people making the warnings. In the words of an executive on a Moody’s risk committee:

“My question the whole time has been, ‘Where the hell has the board been?’ I would have expected, sitting where I was, that I would have got a lot more calls from the board. I got none of that.”

Another Moody’s executive added, “There was no (corporate) governance at the firm whatsoever. I met the board, I presented to them, and it was just baffling that these guys were there. They were just so out of touch.”

The story that Kevin Hall tells about Moody’s has been told many times before. Board members often serve at the pleasure of the CEO, who controls who receives the perks of board membership. The result is often, but not always, boards that rubber-stamp the decisions of the CEO and his or her inner circle. Court precedents make it difficult to hold board members personally liable for anything, and companies buy liability insurance for their board members just in case. As Lynn Turner, former chief accountant of the SEC, said to McClatchy, “I personally think until law enforcement agencies start holding these boards accountable, . . . you’re probably not going to get a lot of change.”

This is why I am skeptical of proposals to, for example, increase the number of independent board members. There’s nothing wrong with it, but I think it betrays a certain amount of naivete over what independent board members actually do.


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Old News ;-)

[Oct 13, 2011] "Benford's Law and the Decreasing Reliability of Accounting Data"

And it's just one more reason for investors to beware....
October 12, 2011 | Economist's View

This is from Jialan Wang:

Benford's Law and the Decreasing Reliability of Accounting Data for US Firms, by Jialan Wang: ...[T]here are more numbers in the universe that begin with the digit 1 than 2, or 3, or 4, or 5, or 6, or 7, or 8, or 9. And more numbers that begin with 2 than 3, or 4, and so on. This relationship holds for the lengths of rivers, the populations of cities, molecular weights of chemicals, and any number of other categories. ...
This numerical regularity is known as Benford's Law, and specifically, it says that the probability of the first digit from a set of numbers is d is given by

In fact, Benford's law has been used in legal cases to detect corporate fraud, because deviations from the law can indicate that a company's books have been manipulated. Naturally, I was keen to see whether it applies to the large public firms that we commonly study in finance.
I downloaded quarterly accounting data for all firms in Compustat,... over 20,000 firms from SEC filings... (revenues, expenses, assets, liabilities, etc.).
And lo, it works! Here are the distribution of first digits vs. Benford's law's prediction for total assets...

Next, I looked at how adherence to Benford's law changed over time, using a measure of the sum of squared deviations of the empirical density from the Benford's prediction...
Deviations from Benford's law have increased substantially over time, such that today the empirical distribution of each digit is about 3 percentage points off from what Benford's law would predict. The deviation increased sharply between 1982-1986 before leveling off, then zoomed up again from 1998 to 2002. Notably, the deviation from Benford dropped off very slightly in 2003-2004 after the enactment of Sarbanes-Oxley accounting reform act in 2002, but this was very tiny and the deviation resumed its increase up to an all-time peak in 2009.

So according to Benford's law, accounting statements are getting less and less representative of what's really going on inside of companies.The major reform that was passed after Enron and other major accounting standards barely made a dent.
Next, I looked at Benford's law for three industries: finance, information technology, and manufacturing. ... [shows graphs] ... While these time series don't prove anything decisively, deviations from Benford's law are compellingly correlated with known financial crises, bubbles, and fraud waves.

And overall, the picture looks grim. Accounting data seem to be less and less related to the natural data-generating process that governs everything from rivers to molecules to cities. Since these data form the basis of most of our research in finance, Benford's law casts serious doubt on the reliability of our results. And it's just one more reason for investors to beware....

[Aug 04, 2010] Hey Rube, Here's Why Your Lawmakers Ignored All Those Calls and Faxes

Jesse's Café Américain

"The financial industry has spent $251 million on lobbying so far this year as lawmakers hammered out new rules of the road for Wall Street, according to the latest lobbying reports compiled by a watchdog group."

Money Talks. And money in the hands of the man who is sitting in the offices and standing in the halls of Congress is an effective tool for buying the influence and the laws that you want.

Political campaign financing reform, including stricter limitation of direct contributions by special interests to targeted lawmakers, is at the heart of it.

Does the First Amendment cover soft bribery? That is how they will spin it.

Goldman Sachs has the right to express its opinion to your congressman, while wrapping it in a thick rolls of hundred dollar bills, charged to expenses, and paid for by you.

And while it is a nice cushion, $251 million is small potatoes compared to the real payoff in jobs and speaking engagements with huge stipends, consulting fees, and sinecures after leaving office. And that is on top of their fat pensions and cadillac benefits.

Corporatism is the parternship of big business and government. And in the organizational state, the individual (that's you Mr. Potato Head) is irrelevant. Except for comic relief, someone to be played for the fool, the emotional plaything of paid pundits and party politics. Someone whom they can whip into a frenzy, who really enjoys the show.

Yeah boy, we'll show those new crooks a thing or two, and vote the old crooks back in November. Especially the ones that make no bones about being in it for the money and the power, and appeal to the worst in us with stereotypes and caricatures. That will teach Washington something about us.

You bet it will.


CNN
Wall Street's lobbying pricetag: $251 million
By Jennifer Liberto
August 2, 2010: 2:08 PM ET

WASHINGTON (CNNMoney.com) -- The financial industry has spent $251 million on lobbying so far this year as lawmakers hammered out new rules of the road for Wall Street, according to the latest lobbying reports compiled by a watchdog group.

The financial sector spent more than any other special interest group from April through the end of June -- a whopping $126 million, according to the Center for Responsive Politics' latest estimates. Wall Street banks, as well as insurance and real estate firms, hiked the amount they spent on lobbying by 12% in the second quarter compared to the same period last year.

"Financial reform certainly drove Wall Street lobbying efforts," said Dave Levinthal, spokesman for the Center for Responsive Politics. "Even as the economy remains beaten and bruised, with some financial institutions continuing to struggle, most banks and securities houses found it in their budgets to hire lobbyists - and lots of them."

In the first half of 2010, Goldman Sachs spent $2.7 million, just $100,000 shy of the total the firm spent on lobbying in all of 2009. The firm's reports to the federal government said it lobbied Treasury, White House and the Commodity Futures Trading Commission, as well as Congress...

There was plenty of evidence of financial sector lobbying throughout in the period leading up to final passage of the Wall Street reform bill last month.

In June, during the final 20-hour meeting of the panel to reconcile differences between the House and Senate reform bills, lobbyists suddenly packed a congressional office meeting room a bit after midnight, as lawmakers started tackling the final details of making derivatives more transparent. In hallways, they cornered House members who serve on the Agriculture Committee, in particular.

In late May, JPMorgan Chase chief executive Jamie Dimon made calls to a couple of lawmakers who were expected to be named to the conference panel.JP Morgan Chase spent $3 million on lobbying in the first half of the year, about the same as in 2009, according to the Center.

While the financial sector was active, other industries also dug deep into their wallets to talk to lawmakers. Despite the fact that the health care bill passed in March, the Center said health firms spent nearly as much as Wall Street firms did in the second quarter, $125 million. So far this year, the health care industry has spent $267 million on lobbying.

Overall, all lobbying totaled $1.78 billion in the first half of the year, up 7.5% in from the same six months in 2009. If it continues at that pace, 2010 will be a record year for lobbying, according to the Center for Responsive Politics.

However, fewer lobbyists are pounding the pavement, as the number of lobbyists dropped 5% compared to the same period in 2009.
Posted by Jesse at 9:48 AM

Is The SEC Still Working For Wall Street " The Baseline Scenario

"The money power preys on the nation in times of peace, and conspires against it in times of adversity. It is more despotic than monarchy, more insolent than autocracy, more selfish than bureaucracy. It denounces, as public enemies, all who question its methods or throw light upon its crimes."
- Abraham Lincoln

"If the American people ever allow private banks to control the issue of their money, first by inflation and then by deflation, the banks and corporations that will grow up around them, will deprive the people of their property until their children will wake up homeless on the continent their fathers conquered."
- Thomas Jefferson

"When plunder becomes a way of life for a group of men living together in society, they create for themselves in the course of time, a legal system that authorizes it and a moral code that glorifies it."
- Frederic Bastiat – (1801-1850) in Economic Sophisms

"The world is governed by very different personages from what is imagined by those who are not behind the scenes."
- Benjamin Disraeli, first Prime Minister of England

"It is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning."
- Henry Ford

"We are on the verge of a global transformation. All we need is the right major crisis and the nations will accept the New World Order."
- David Rockefeller

"The drive of the Rockefellers and their allies is to create a one-world government combining super capitalism and communism under the same tent, all under their control…. Do I mean conspiracy? Yes I do. I am convinced there is such a plot, international in scope, generations old in planning, and incredibly evil in intent."
- Congressman Larry P. McDonald, 1976, killed in the Korean Airlines 747 that was shot down by the Soviets

"Give me control of a nation's money and I care not who makes its laws."
- Mayer Amschel Bauer Rothschild

"If the people were to ever find out what we have done, we would be chased down the streets and lynched."
- George H W Bush

"Needless to say, the President was correct. Whatever it was he said."
- Donald Rumsfeld, February 28, 2003

"Tell a lie loud enough and long enough and people will believe it."
- Adolph Hitler

Where was Moody's board when top-rated bonds blew up McClatchy

As the bottom fell out of the housing market and complex mortgage-backed securities began tanking in 2007, a strange thing happened at Moody's Investors Service, one of the largest firms that rate bonds for the risks they pose to investors.

Moody's blue-ribbon board of directors stopped receiving key information from an internal committee that was supposed to keep the board informed of risks to the company, a McClatchy investigation has found.

Instead, the ad hoc risk-management committee suddenly disappeared, precisely at the time when the board and management should have been shifting to higher alert as the financial world began quaking.

As McClatchy reported last year, the credit-rating agency had been handing out Triple-A grades like candy for Wall Street mortgage securities that were backed by pools of home loans that turned out to be junk.

When the global financial crisis deepened in 2007 and the integrity of bond ratings came under attack, the captains of industry on the Moody's board seldom asked tough questions, according to former Moody's executives who made presentations to the board.

That's important, because the legislation to overhaul financial regulation that's now moving through Congress aims to empower ratings-agency boards by requiring a direct line of communication between the company officials who police for risks and the boards. It's not clear whether that would have made any difference at Moody's.

The findings of the new McClatchy investigation not only call into question the value of the new regulatory approach lawmakers are drafting; they also help underscore the widespread criticism that many corporate boards practice crony capitalism rather than independence.

"My question the whole time has been, 'Where the hell has the board been?'" said a former Moody's employee who was on the disbanded committee. The employee spoke on the condition of anonymity at the advice of a lawyer, fearing future litigation. "I would have expected, sitting where I was, that I would have got a lot more calls from the board. I got none of that."

Several former Moody's executives who made presentations to its board as the financial crisis emerged in 2006 and 2007 described the board members as incurious, saying they seemed to be there primarily to enjoy the perks and prestige of board membership. The former executives all demanded anonymity on the advice of their lawyers.

Moody's board members receive $75,000, $95,000 or $115,000 a year for the six or eight meetings they attend, depending on whether they hold leadership positions, plus $115,002 every year in annual restricted stock.

Moody's dominated the ratings for "structured finance" products - securities backed by pools of loans that are packaged together and provide a monthly income stream to investors.

The structured finance division powered Moody's revenues past the $1 billion mark in 2002, and past $2 billion in 2006. The company's stock price soared nearly six-fold between 2001 and 2007, from $12.70 to $72, which created a huge windfall for its largest shareholder, billionaire investor Warren Buffett.

The board, however, apparently had few questions on the way up - or later, on the way down, a former Moody's officials said.

"There was no (corporate) governance at the firm whatsoever. I met the board, I presented to them, and it was just baffling that these guys were there. They were just so out of touch," another former high-level Moody's executive said.

Board members are supposed to protect shareholders, from individual investors such as Buffett to institutional firms that invest the retirement contributions of American workers.

McClatchy also has learned that during this time, as concerns grew about the ratings of complex mortgage-backed securities, two Moody's executives reached out to the company's largest shareholder, Buffett, to warn him of problems.

Buffett's firm, Berkshire Hathaway, based in Omaha, Neb., owned about a fifth of Moody's shares then. It remains the largest shareholder at around 13 percent last year. A Berkshire spokeswoman declined to comment, but a former Moody's employee who reached out to Buffett said the investment guru responded that he was a "hands-off" investor.

McClatchy sent detailed questions twice to Moody's, which recently upgraded McClatchy's debt rating one notch to Caa1 from Caa2; both ratings are considered non-investment, or "junk" grade. Moody's declined to comment for this story, taking issue with McClatchy's use of anonymous sources.

Moody's officials said the comments from former employees provide just a snapshot, not a complete view of the board's activities, but the company refused to provide any detail about what board members did or said during the time in question, and three board members contacted separately declined comment.

At issue is an ad hoc risk committee that was abolished shortly after a management shake-up resulted in the controversial appointment of Brian Clarkson as Moody's president and operating chief in August 2007.

Clarkson was elevated by Raymond McDaniel, Moody's chief executive and the chairman of its board, because of the huge profits coming from the structured finance division.

That division worked closely with Wall Street investment banks such as Bear Stearns, Goldman Sachs and Lehman Brothers to rate mortgage-backed securities.

Big institutional investors such as pension funds and endowments can purchase only top-rated securities, so Wall Street firms desperately needed the blessing of Moody's or its competitors, Standard & Poor's and Fitch.

A McClatchy investigation late last year revealed how Clarkson moved structured finance executives into Moody's top regulatory and compliance positions, seemingly a conflict of interest. The changes also resulted in the firings or departures of numerous executives who'd questioned either the methodologies Moody's was using to rate the complex securities or the risks it was taking.

One veteran who left the company was Chester Murray, the executive in charge of international operations. He headed the ad hoc committee that met quarterly to advise the board on potential threats. After Murray left Moody's in December 2007, the panel never met again, even as the problems in the housing market gave way to what by September 2008 became a near meltdown of global finance. Clarkson announced his retirement months earlier, in May 2008.

Moody's officials wouldn't discuss the ad hoc committee.

"Either the board knew that the risk management committee had been disbanded or they didn't," a former executive said. "If they did know, the question is why they did nothing about it. If they didn't know, it's hard to escape the conclusion that Ray (McDaniel) hid the committee's disbandment from the board, since as board chairman he certainly knew that it had been disbanded."

Moody's rejected requests for McDaniel to comment on the committee or the activities of the board.

"You raise a good question," said Lynn Turner, a former chief accountant of the Securities and Exchange Commission who's criticized the failure of ratings agencies to see the risks in the failed Houston energy giant Enron Corp., which collapsed in late 2001. "I personally think until law enforcement agencies start holding these boards accountable, the point you're raising is probably right on target, and you're probably not going to get a lot of change."

Moody's wasn't alone in making big profits from structured finance and wildly inaccurate bond ratings, and S&P and Fitch suffered similar losses of revenue and reputation when the bottom fell out. Fitch is a privately held company, and S&P is owned by publishing giant McGraw-Hill. After the crisis, both engaged in deeper house cleanings than Moody's did, replacing their top executives.

Moody's chief McDaniel remains on the job, with board support. He was awarded almost $7.38 million in salary and compensation in 2007, the year things fell apart; $7.56 million in 2008 as markets tanked; and $5.4 million last year.

He has his job despite embarrassing October 2008 revelations from the House of Representatives Committee on Oversight and Government Reform. It made public portions of a McDaniel board presentation in October 2007, in which he acknowledged pressure from Wall Street investment banks to give favorable ratings and confided that "at times, we drink the Kool-Aid."

At that same hearing, Jerome Fons, a former Moody's managing director of credit policy, told lawmakers "the deterioration in standards was palpable," adding that managers "turned a blind eye to this, did not update their models or their thinking and allowed this to go on."

Stung, Moody's announced weeks later that it had named Stanford University Finance Professor Darrell Duffie, a well-regarded academic, to its board. Duffie was given a seat on the board's audit and compliance committee.

Reached recently by phone in California, he declined to discuss what transpired before his arrival, but he suggested that corrective steps are being taken by all major rating agencies, including Moody's.

"I'm quite optimistic myself that the rating of structured products is something that can be done well in the future, and that the agencies are positioned to do it well," Duffie said.

Board members are often business icons, sought for the reputational luster they bring rather than expertise in the business of the companies on whose boards they sit.

"The problem is (that) staffing boards often is like decorating a Christmas tree. You get people who are good ornaments, with luster. The question is, do they have the skill set to help the company add value?" said David Nadler, an expert in corporate governance for consultant Oliver Wyman in New York.

The Moody's board includes Henry McKinnell Jr., a former chief executive of pharmaceutical giant Pfizer. He heads the board's governance committee and left Pfizer in 2006 with a "golden parachute" valued at $180 million.

The Moody's audit committee, which oversees compliance, is headed by John Wulff, the retired chairman of chemicals giant Hercules Inc. and a former chief financial officer of Union Carbide Corp. Also on that committee is Basil Anderson, vice chairman of office supplies retailer Staples Inc. until his retirement in 2006 and a former chief financial officer of the Campbell Soup Co.

Former Florida Republican Sen. Connie Mack, who sat on the Senate Banking and Finance Committees, also is on the board. Now an influential Washington lobbyist, Mack retired from Congress in 2000.

The big fish is Robert Glauber, the former head of the National Association of Securities Dealers, a Wall Street self-regulatory body. He was a Treasury undersecretary from 1989 to 1992.

That Glauber allegedly asked so few questions in this turbulent period bothered some who presented to the board.

"He's just the nicest guy, but he was not asking tough questions or digging deeply into what was going on," one former executive said. "That was my impression. I liked him. He had an interesting career, but there was no questioning."

A voice message left for Glauber requesting comment wasn't returned.

Several former Moody's executives said the only tough questions came from board member Nancy Newcomb, a retired senior officer for risk management at Citigroup.

They also described Mack as incurious. He declined comment, citing board duties.

"Senator Mack is another easygoing guy . . . but these people had very little understanding of the nature of the business, how things worked," said a former presenter to the board. "They never walked the floors and talked to the staff. They got the 90,000-foot view of the firm that was highly filtered."

That's what experts feel needs to change on corporate boards.

Unless board members know how their companies operate, they might not ask tough questions.

"Ultimately, a more effective board might have caught what was going on and intervened with management. We don't know," Nadler said. "You can ask the question 'Where was the board?' But the answer could be in a lot of different places."

Because rating agencies earn money from the very people they're rating, there's an inherent conflict of interest. Corporate governance experts think that should mean even greater transparency on their boards.

"I think shareholders deserve some of the fundamentals of how their board is structured and working," Nadler said.

The new legislation contemplated by Congress would expand the number of "independent" members on ratings agency boards and require greater disclosure of potential conflicts of interest and methodology. Moody's and its competitors have already taken steps, albeit after the fact, to make ratings methodology more transparent.

In proxy statements Moody's filed with the SEC in 2006, 2007 and 2008, there's no mention of any action or concerns raised by the board. Annual reports also make no mention of board concerns.

However, the recently filed proxy statement, covering 2009, describes a new risk panel that seems to reinstate some functions of the former ad hoc committee.

The only action the board appears to have taken concerning what went wrong at Moody's was disclosed in the proxy statement to investors for 2008. The board recommended against a failed shareholder proposal from the Massachusetts Laborers' Pension Fund to create an independent chairman for the Moody's board.

The move was aimed at McDaniel, who also serves as board chairman, but it won only 30 percent of the proxy votes. The issue is up for a vote again at the April 20 annual meeting, this time brought by England's Legal & General Assurance (Pensions Management) Ltd.

It's also unclear what the audit committee felt about the departure of experienced audit and compliance executives, who were replaced by colleagues from the structured-finance division.

Months after he became president, Clarkson appointed Michael Kanef, who managed a group in charge of rating asset-backed securities, to be the chief regulatory officer overseeing the compliance staff. Compliance officials began reporting to the people they'd been policing.

According to congressional testimony last year, Kanef forced out Scott McCleskey, the chief compliance officer at Moody's, in September 2008 and replaced him with David Teicher, a structured finance executive with no compliance background. A lawyer with some compliance experience has since replaced him.

"If I had been on that board, as soon as this change was made I would have said, 'What is this person's background?' I would have gone ballistic then and there," said one former Moody's executive who briefed the board.

Read more: http://www.mcclatchydc.com/2010/04/02/91419/where-was-moodys-board-when-top.html#ixzz0kiL2hjtZ

A Failure of Corporate Governance By James Kwak

(I've gotten several great articles forwarded to me via email by readers. It may take a few days to do them justice. Here's one.)

In the great consensus of the past twenty years, government regulation was unnecessary because the free market provided better tools for constraining private companies. One force was the market, idealized by Alan Greenspan, who believed that counterparties could even police effectively against fraud. The other force was shareholders, who would punish managers for acting contrary to their interests. The market would prevent companies from abusing their customers, while corporate governance would prevent them from abusing their shareholders.

For those who still believe in the latter, McClatchy has a good (though infuriating) article on what went wrong on Moody's, the bond rating agency that, we previously learned, responded to warnings about the toxic assets it was rating by . . . firing the people making the warnings. In the words of an executive on a Moody's risk committee:

"My question the whole time has been, 'Where the hell has the board been?' I would have expected, sitting where I was, that I would have got a lot more calls from the board. I got none of that."

Another Moody's executive added, "There was no (corporate) governance at the firm whatsoever. I met the board, I presented to them, and it was just baffling that these guys were there. They were just so out of touch."

The story that Kevin Hall tells about Moody's has been told many times before. Board members often serve at the pleasure of the CEO, who controls who receives the perks of board membership. The result is often, but not always, boards that rubber-stamp the decisions of the CEO and his or her inner circle. Court precedents make it difficult to hold board members personally liable for anything, and companies buy liability insurance for their board members just in case. As Lynn Turner, former chief accountant of the SEC, said to McClatchy, "I personally think until law enforcement agencies start holding these boards accountable, . . . you're probably not going to get a lot of change."

This is why I am skeptical of proposals to, for example, increase the number of independent board members. There's nothing wrong with it, but I think it betrays a certain amount of naivete over what independent board members actually do.

Where was Moody's board when top-rated bonds blew up McClatchy

As the bottom fell out of the housing market and complex mortgage-backed securities began tanking in 2007, a strange thing happened at Moody's Investors Service, one of the largest firms that rate bonds for the risks they pose to investors.

Moody's blue-ribbon board of directors stopped receiving key information from an internal committee that was supposed to keep the board informed of risks to the company, a McClatchy investigation has found.

Instead, the ad hoc risk-management committee suddenly disappeared, precisely at the time when the board and management should have been shifting to higher alert as the financial world began quaking.

As McClatchy reported last year, the credit-rating agency had been handing out Triple-A grades like candy for Wall Street mortgage securities that were backed by pools of home loans that turned out to be junk.

When the global financial crisis deepened in 2007 and the integrity of bond ratings came under attack, the captains of industry on the Moody's board seldom asked tough questions, according to former Moody's executives who made presentations to the board.

That's important, because the legislation to overhaul financial regulation that's now moving through Congress aims to empower ratings-agency boards by requiring a direct line of communication between the company officials who police for risks and the boards. It's not clear whether that would have made any difference at Moody's.

The findings of the new McClatchy investigation not only call into question the value of the new regulatory approach lawmakers are drafting; they also help underscore the widespread criticism that many corporate boards practice crony capitalism rather than independence.

"My question the whole time has been, 'Where the hell has the board been?'" said a former Moody's employee who was on the disbanded committee. The employee spoke on the condition of anonymity at the advice of a lawyer, fearing future litigation. "I would have expected, sitting where I was, that I would have got a lot more calls from the board. I got none of that."

Several former Moody's executives who made presentations to its board as the financial crisis emerged in 2006 and 2007 described the board members as incurious, saying they seemed to be there primarily to enjoy the perks and prestige of board membership. The former executives all demanded anonymity on the advice of their lawyers.

Moody's board members receive $75,000, $95,000 or $115,000 a year for the six or eight meetings they attend, depending on whether they hold leadership positions, plus $115,002 every year in annual restricted stock.

Moody's dominated the ratings for "structured finance" products - securities backed by pools of loans that are packaged together and provide a monthly income stream to investors.

The structured finance division powered Moody's revenues past the $1 billion mark in 2002, and past $2 billion in 2006. The company's stock price soared nearly six-fold between 2001 and 2007, from $12.70 to $72, which created a huge windfall for its largest shareholder, billionaire investor Warren Buffett.

The board, however, apparently had few questions on the way up - or later, on the way down, a former Moody's officials said.

"There was no (corporate) governance at the firm whatsoever. I met the board, I presented to them, and it was just baffling that these guys were there. They were just so out of touch," another former high-level Moody's executive said.

Board members are supposed to protect shareholders, from individual investors such as Buffett to institutional firms that invest the retirement contributions of American workers.

McClatchy also has learned that during this time, as concerns grew about the ratings of complex mortgage-backed securities, two Moody's executives reached out to the company's largest shareholder, Buffett, to warn him of problems.

Buffett's firm, Berkshire Hathaway, based in Omaha, Neb., owned about a fifth of Moody's shares then. It remains the largest shareholder at around 13 percent last year. A Berkshire spokeswoman declined to comment, but a former Moody's employee who reached out to Buffett said the investment guru responded that he was a "hands-off" investor.

McClatchy sent detailed questions twice to Moody's, which recently upgraded McClatchy's debt rating one notch to Caa1 from Caa2; both ratings are considered non-investment, or "junk" grade. Moody's declined to comment for this story, taking issue with McClatchy's use of anonymous sources.

Moody's officials said the comments from former employees provide just a snapshot, not a complete view of the board's activities, but the company refused to provide any detail about what board members did or said during the time in question, and three board members contacted separately declined comment.

At issue is an ad hoc risk committee that was abolished shortly after a management shake-up resulted in the controversial appointment of Brian Clarkson as Moody's president and operating chief in August 2007.

Clarkson was elevated by Raymond McDaniel, Moody's chief executive and the chairman of its board, because of the huge profits coming from the structured finance division.

That division worked closely with Wall Street investment banks such as Bear Stearns, Goldman Sachs and Lehman Brothers to rate mortgage-backed securities.

Big institutional investors such as pension funds and endowments can purchase only top-rated securities, so Wall Street firms desperately needed the blessing of Moody's or its competitors, Standard & Poor's and Fitch.

A McClatchy investigation late last year revealed how Clarkson moved structured finance executives into Moody's top regulatory and compliance positions, seemingly a conflict of interest. The changes also resulted in the firings or departures of numerous executives who'd questioned either the methodologies Moody's was using to rate the complex securities or the risks it was taking.

One veteran who left the company was Chester Murray, the executive in charge of international operations. He headed the ad hoc committee that met quarterly to advise the board on potential threats. After Murray left Moody's in December 2007, the panel never met again, even as the problems in the housing market gave way to what by September 2008 became a near meltdown of global finance. Clarkson announced his retirement months earlier, in May 2008.

Moody's officials wouldn't discuss the ad hoc committee.

"Either the board knew that the risk management committee had been disbanded or they didn't," a former executive said. "If they did know, the question is why they did nothing about it. If they didn't know, it's hard to escape the conclusion that Ray (McDaniel) hid the committee's disbandment from the board, since as board chairman he certainly knew that it had been disbanded."

Moody's rejected requests for McDaniel to comment on the committee or the activities of the board.

"You raise a good question," said Lynn Turner, a former chief accountant of the Securities and Exchange Commission who's criticized the failure of ratings agencies to see the risks in the failed Houston energy giant Enron Corp., which collapsed in late 2001. "I personally think until law enforcement agencies start holding these boards accountable, the point you're raising is probably right on target, and you're probably not going to get a lot of change."

Moody's wasn't alone in making big profits from structured finance and wildly inaccurate bond ratings, and S&P and Fitch suffered similar losses of revenue and reputation when the bottom fell out. Fitch is a privately held company, and S&P is owned by publishing giant McGraw-Hill. After the crisis, both engaged in deeper house cleanings than Moody's did, replacing their top executives.

Moody's chief McDaniel remains on the job, with board support. He was awarded almost $7.38 million in salary and compensation in 2007, the year things fell apart; $7.56 million in 2008 as markets tanked; and $5.4 million last year.

He has his job despite embarrassing October 2008 revelations from the House of Representatives Committee on Oversight and Government Reform. It made public portions of a McDaniel board presentation in October 2007, in which he acknowledged pressure from Wall Street investment banks to give favorable ratings and confided that "at times, we drink the Kool-Aid."

At that same hearing, Jerome Fons, a former Moody's managing director of credit policy, told lawmakers "the deterioration in standards was palpable," adding that managers "turned a blind eye to this, did not update their models or their thinking and allowed this to go on."

Stung, Moody's announced weeks later that it had named Stanford University Finance Professor Darrell Duffie, a well-regarded academic, to its board. Duffie was given a seat on the board's audit and compliance committee.

Reached recently by phone in California, he declined to discuss what transpired before his arrival, but he suggested that corrective steps are being taken by all major rating agencies, including Moody's.

"I'm quite optimistic myself that the rating of structured products is something that can be done well in the future, and that the agencies are positioned to do it well," Duffie said.

Board members are often business icons, sought for the reputational luster they bring rather than expertise in the business of the companies on whose boards they sit.

"The problem is (that) staffing boards often is like decorating a Christmas tree. You get people who are good ornaments, with luster. The question is, do they have the skill set to help the company add value?" said David Nadler, an expert in corporate governance for consultant Oliver Wyman in New York.

The Moody's board includes Henry McKinnell Jr., a former chief executive of pharmaceutical giant Pfizer. He heads the board's governance committee and left Pfizer in 2006 with a "golden parachute" valued at $180 million.

The Moody's audit committee, which oversees compliance, is headed by John Wulff, the retired chairman of chemicals giant Hercules Inc. and a former chief financial officer of Union Carbide Corp. Also on that committee is Basil Anderson, vice chairman of office supplies retailer Staples Inc. until his retirement in 2006 and a former chief financial officer of the Campbell Soup Co.

Former Florida Republican Sen. Connie Mack, who sat on the Senate Banking and Finance Committees, also is on the board. Now an influential Washington lobbyist, Mack retired from Congress in 2000.

The big fish is Robert Glauber, the former head of the National Association of Securities Dealers, a Wall Street self-regulatory body. He was a Treasury undersecretary from 1989 to 1992.

That Glauber allegedly asked so few questions in this turbulent period bothered some who presented to the board.

"He's just the nicest guy, but he was not asking tough questions or digging deeply into what was going on," one former executive said. "That was my impression. I liked him. He had an interesting career, but there was no questioning."

A voice message left for Glauber requesting comment wasn't returned.

Several former Moody's executives said the only tough questions came from board member Nancy Newcomb, a retired senior officer for risk management at Citigroup.

They also described Mack as incurious. He declined comment, citing board duties.

"Senator Mack is another easygoing guy . . . but these people had very little understanding of the nature of the business, how things worked," said a former presenter to the board. "They never walked the floors and talked to the staff. They got the 90,000-foot view of the firm that was highly filtered."

That's what experts feel needs to change on corporate boards.

Unless board members know how their companies operate, they might not ask tough questions.

"Ultimately, a more effective board might have caught what was going on and intervened with management. We don't know," Nadler said. "You can ask the question 'Where was the board?' But the answer could be in a lot of different places."

Because rating agencies earn money from the very people they're rating, there's an inherent conflict of interest. Corporate governance experts think that should mean even greater transparency on their boards.

"I think shareholders deserve some of the fundamentals of how their board is structured and working," Nadler said.

The new legislation contemplated by Congress would expand the number of "independent" members on ratings agency boards and require greater disclosure of potential conflicts of interest and methodology. Moody's and its competitors have already taken steps, albeit after the fact, to make ratings methodology more transparent.

In proxy statements Moody's filed with the SEC in 2006, 2007 and 2008, there's no mention of any action or concerns raised by the board. Annual reports also make no mention of board concerns.

However, the recently filed proxy statement, covering 2009, describes a new risk panel that seems to reinstate some functions of the former ad hoc committee.

The only action the board appears to have taken concerning what went wrong at Moody's was disclosed in the proxy statement to investors for 2008. The board recommended against a failed shareholder proposal from the Massachusetts Laborers' Pension Fund to create an independent chairman for the Moody's board.

The move was aimed at McDaniel, who also serves as board chairman, but it won only 30 percent of the proxy votes. The issue is up for a vote again at the April 20 annual meeting, this time brought by England's Legal & General Assurance (Pensions Management) Ltd.

It's also unclear what the audit committee felt about the departure of experienced audit and compliance executives, who were replaced by colleagues from the structured-finance division.

Months after he became president, Clarkson appointed Michael Kanef, who managed a group in charge of rating asset-backed securities, to be the chief regulatory officer overseeing the compliance staff. Compliance officials began reporting to the people they'd been policing.

According to congressional testimony last year, Kanef forced out Scott McCleskey, the chief compliance officer at Moody's, in September 2008 and replaced him with David Teicher, a structured finance executive with no compliance background. A lawyer with some compliance experience has since replaced him.

"If I had been on that board, as soon as this change was made I would have said, 'What is this person's background?' I would have gone ballistic then and there," said one former Moody's executive who briefed the board.

Read more: http://www.mcclatchydc.com/2010/04/02/91419/where-was-moodys-board-when-top.html#ixzz0kiL2hjtZ

Much Ado About Nothing $23B: Goldman Sachs Bonus

By Barry Ritholtz - October 14th, 2009,

Its time for the quarterly hand-wringing amongst the populace regarding the over-sized bonuses at Goldman Sachs. This Q, its a mere $23B.

The focus on the bonuses of top performing traders and investment bankers is misplaced. There are many, many things to be upset about regarding the financial sector - but bonuses are not one of them.

We live in a capitalist system, where there are going to be winners and losers. Its not fair, but it is how it is. You can complain about it, but it is all but pointless. Feel free to pursue a millionaire's tax of 1% on every who earns more than $1m - a super top tier - to pay for health care reform or whatever you want. (Best of luck with that!)

Every few years, we lament overpaid athletes, musicians, movie stars. Bruce Springsteen is going to make $100 million+ this year on tour. While you can complain about it, ask yourself how many people can fill 50,000 seat arenas 200 night a year at $100 a pop. Lebron James, Peyton Manning, and others justify their salaries by generating massive revenue and profits for their employers.

So too it is with Goldman Sachs and others.

The traders who throw off the most profits, the bankers that generate the most lucrative deals are worth tens of millions to their "team owners." That is how it is, and it is unlikely to ever change.

What should you be upset about?

• Paying people in year one for risks that last years or decades;

• The "privatized gains, socialized losses" of the current system;

• Dramatically reduced competition in the Banking sector;

• The idea that "Too Big To Fail" is now an official policy of the United States;

• The "gifting" of $100s of billions of dollars to mismanaged banks that should have been allowed to fail in a controlled fashion;

• Bank lobbyists preventing any sort of credible regulation from passing;• Goldman Sachs wresting $19 billion from AIG;

• The absurd and poorly thought out $750 billion TARP plan;

• The suspension of mark-to-market allowing banks to hide losses and not accurately disclose their bad assets;

• The outsized influence Banks have on Congress and Goldman Sachs has within the Executive branch.

There are plenty of things to be upset about these days. Top performers earning huge paydays at the biggest firms is not one of them . . .

Previously:
Looking at Wall Street Pay (August 1st, 2009)
http://www.ritholtz.com/blog/2009/08/looking-at-wall-street-pay/

Why Financial Reform Died: "Banks Run Congress" (October 12th, 2009)
http://www.ritholtz.com/blog/2009/10/why-financial-reform-died-banks-run-congress/

What's Wrong With Billionaire Fund Managers? (April 16th, 2008)
http://www.ritholtz.com/blog/2008/04/whats-wrong-with-billionaire-fund-managers/

Single Best Investment in History = 258,449% (October 12th, 2009)
http://www.ritholtz.com/blog/2009/10/single-best-investment-in-history-258449/

Derivatives Lobby Corrupts Congress (October 12th, 2009)
http://www.ritholtz.com/blog/2009/10/derivatives-lobby-corrupts-congress/

Total Campaign Contributions/Lobbying by TARP Recipients (October 12th, 2009)
http://www.ritholtz.com/blog/2009/10/total-campaign-contributions/

Top Hedge Fund Earners (March 25th, 2009)
http://www.ritholtz.com/blog/2009/03/top-hedge-fund-earners/

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