Saturday, April 21, 2012

Root cause of the GFC: systemic failure in fiduciary trust/duty

Watching a Lateline interview with a British politician last night on the British Leveson Inquiry into the behaviour of the Murdoch media, crystallised my thinking on the root cause of the GFC:
A systemic failure in both fiduciary duty in the global financial community and a concomitant failure in governance and oversight by the regulators, public service and politicians.

The New Oxford American Dictionary defines "Fiduciary" as:
involving trust, esp. with regard to the relationship between a trustee and a beneficiary
Princeton's Wordnet defines "Fiduciary Duty" as:
the legal duty of a fiduciary to act in the best interests of the beneficiary.

The critical piece for me in the Lateline interview was that the politicians driving one of the most important Inquiries in recent times let their personal fears override their duties as representatives of the Public:
... Rebekah Brooks [chief executive], who rejected our invitation [to give evidence] on three occasions ... but the committee then decided not to invite Rebekah Brooks, [seen as surprising] ... And I think it is very clear now that the individual fears that committee members felt led to them ... basically losing the will to do that.
The GFC did not arrive unheralded nor without the involvement of many actors through the whole investment "food-chain".

  • The front-line sellers of retail "sub-prime" loans that lied, deceived and failed to disclose to victims what they were actually buying, especially A.R.M.'s (Automatically Resetting Mortgages: a low-rate "honeymoon" period (2-3%?) before repayments were increased to the underlying rate (12-15%?).
  • The churning of these sub-prime loans as if they were prime-quality loans by Banks through the Mortgage Underwriting houses, Freddie Mac and Fannie May and those underwriters accepting high-risk loans as low-risk.
  • The "repackaging" of sub-prime loans from the Mortgage Underwriters as CDO's (Collateralised Debt Obligations) without fully disclosing or properly insuring the embedded risk, instead using CDS's (Credit Default Swaps).
  • The complete operational failure and dereliction of duty by all Ratings Agencies in declaring these packaged "toxic loans" in CDO's backed by CDS's to be the lowest risk asset possible, AAA-rating.
  • The relentless, high-pressure wie-spread sales of these complex instruments to inappropriate and uninformed consumers, with extraordinary levels of deception, misleading statements and since documented, complete fabrication and wilful dissembling (lying).

But it could only have happened if there was not only widespread failure of agents Fiduciary Duty to investors, but also criminal behaviour.
There were a slew of interlocking system failures that were necessary to translate the "zero-cost" money being thrown around by the US Federal Reserve into systemic rorting (fraudulent gaming of the system) - and none of them was ethical, moral or legal.

The GFC was fuelled by an seemingly infinite pool of zero-cost money being used to "stimulate" the US economy after the "Dot Boom" became the "Dot Bust" circa 2000.

There were many schemes to take this money and convert it into "high return, safe vehicles".
The contradiction inherent, returns are the inverse of safety (higher rates of return compensate for higher risk), went unnoticed, unchallenged and generally uncommented, except towards the inevitable collapse.

Yet, despite, the massive consequences of the GFC, the "socialisation" of the crystallised losses, which for decades will haunt the mug punters, or average taxpayers paying for these bailouts through their governments, nothing has substantially changed. More importantly, almost nobody has gone to jail.

Many banks and financial institutions declared record profits (and hence record internal bonuses), the year after they were bailed-out by the very people they were again relentlessly gouging - the average taxpayer.

There is a fundamental inversion at work in the financial and managerial world that the regulators and legislators have been ignoring for the last 30-40 years:

  • CEO's and fund-managers/investment advisors want all the upside of ownership, and none of the downside. They want a large fraction of any gains when the market goes up, and suffer nothing when it goes down. They can bankrupt a company an/or destroy all your investment, and still demand a bonus, let alone compensate the owners for their reckless, irresponsible behaviour.
  • Institutional Investors, in the form of Banks, Insurance companies, Retirement Funds/Investment houses give their small, anonymous investors all the downside of ownership and little or none of the upside. Risk is transferred from the Institution to the Individual investors, while they retain all or most of the benefits when the markets improve. The small investor, often forced into compulsory investment, takes all the losses of the gambles and speculation by the Institution, whilst being charged a fixed percentage of their assets and a proportion of "excess gains".
This state of affairs is consistent with the causation of the GFC and stems from a very simple thing:
Politicians, and hence Regulators and Government Bureaucrats, confuse CEO's and Institutional Investors with Owners, when they are merely employees or agents.
How I can prove these assertions:

  • The GFC was inevitable from the documents released or surfacing afterwards.
  • CEO, 'senior management' and Board salaries have spiralled upwards at a compound rate of 30%pa since ~1975, without any comment, constraint or Inquires by Governments worldwide.
    •  while real wages of employees have remained static or declined since ~1985, and
    • "big business" especially continues it outrageous calls for "more flexible working arrangements" from those employees to "lower costs" and "increase productivity" when decades of decline in real wages show that none of the savings and improved profits are passed onto those long-sufferring employees.
  • Institutional Investors and Governments still pass wide-scale losses onto the general public, who were not responsible for the decisions, had no control and no 'internal information'.
  • The unemployment rate is most countries is (very) high, but those people out of work, receiving lower "benefits" and paying higher taxes are exactly not the people who created the GFC.

Then there are the many studies into "Mergers and Acquisitions" of large, publicly owned companies.
They all say the same thing, despite the very expensive and detailed "Due Diligence" processes, the vast majority of Mergers not only fail to create value, they destroy substantial amounts of owner value, which is ultimately the small, anonymous investors funding Institutional Investors.

A case in point from my field (I.T.):
Unisys (UIS): Formed from the 1986 merger of Burroughs and Sperry/Univac (numbers 2 and 3 in turnover and CapEx behind IBM), not only never became #1, but has declined four-fold in share value and declined from $10.5B revenue/year and 120,000 employees to $5Bn/year and 30,000 employees in 2010.
It was never going to be a good idea due to the radically different, and incompatible, corporate cultures and that there were no great synergies in their product lines, rather the reverse, they were direct competitors in most of their markets.

Yet the deal was struck and The Great New Giant Company was formed.
Within two years, the extent and scale of value destruction to both brands was obvious, and in a rational world would've been cause for a rapid demerger and unwinding of the still incomplete "integration".

Yet this didn't happen. The Board, the CEO and all the "management team" kept resolutely destroying the company. Now, decades on, it is a mere shell of its former self, and both brands struggle. Both organisations were successful, growing and sound before the merger. The market or "externalities" didn't change significantly at the time, rather the reverse, IBM grew its business very well for the next 5 years.

At the very least, the CEO and senior management team should've been placed "on notice" by the Board at the end of the first year when they comprehensively missed all their targets, and summarily sacked after the second year when the value destruction and failure to grow was incontrovertible.

Why didn't this happen, and why wasn't the Board sacked for a gross dereliction of duty? Institutional Investors are the majority shareholders and have a general policy of "we don't interfere". It's almost like they don't care about protecting their small, anonymous contributors from the downside...

Those who caused all this carnage at Unisys, the active destruction of shareholder value and the massive opportunity losses from both brands failing to keep growing, have never been held to account or suffered dire economic or civil penalties for their actions and inaction.

The resulting questions are:

  • Who pursued and benefited from the Merger? Presumably the two Boards, CEO's and combined "senior management team". Those who stayed got bigger salaries and bonuses, those who left got their "golden parachutes" (outrageously generous severance packages unavailable to the rank-and-file workforce).
  • Why was this massive market failure not investigated nor pursued by Regulators and Legislators? I guess because nobody that mattered complained. No Institutional Investor would complain ("we're uninvolved"), nor did they act on behalf of their plethora of small investors, rather handing them back a slightly smaller dividend without explanation.
It seems that Politicians, those we have elected to represent us against the more powerful, have become the captives of Big Business (CEO's and Boards) and servants of Media.

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