Risk Rap

Rapping About a World at Risk

Intellectual Capital Deflation

balloonBearingPoints Chapter 11 filing represents a watershed type event.

The filing by the global consulting firm BearingPoint puts it on life support or at the very least in an intensive care unit. BearingPoint the bulge bracket consulting firm that was spun off from KPMG due to regulatory mandates concerning the separation of accounting and advisory businesses is in serious trouble. It has been struggling under a mountain of debt and the bankruptcy filing will give the firm protection from creditors while it seeks to reorganize its business.

BearingPoint’s filing is an interesting metaphor about the deflation of intellectual capital.  Ideas, creativity, knowledge, productivity and innovation are some of the words that that we closely associate with intellectual capital.  Once we may have even thought this form of capital to be immune from the vicissitudes of the banality of markets.  I surmise that the recent business cycle exposes that idea as based more in our narcissistic prejudices then the cold objective realities of efficient markets.  As we witnessed radical capitalism’s continued drive of extreme rationalization through monetization we discovered the price of anything but seriously lost sight of the value of everything.

During the 1990’s I remember always being impressed and astonished by the reports of the rising productivity of the American workforce.  Year in year out the rising productivity was the proud boast and confirmation of American managerial brilliance.  But today that claim looks spurious at best.  Rethinking this proclamation may reveal this was accomplished not by brilliant management innovation but by outsourcing operational functions to subsistence based economies; and some artful balance sheet wizardry that aligned business performance ratios to maximize shareholder returns; particularly senior managers whose stock options were critical design considerations as to how those ratios were engineered.  Indeed if productivity is a proxy for innovation, the productivity of  American capitalism was outpacing the most aggressive predictions of Moore’s Law.  True technology contributed to massive gains in productivity but in many ways was an economic rent seeking agent that enabled a flawed economy to sustain itself through over leveraged economic and misdirected intellectual capital.

Today we are confronted with the evaporation of massive social wealth that the IMF estimates to be almost $4.1 trillion in the financial service sector.  I suspect a good portion of this value was carried on the balance sheet as good will.  And anyone that has been living close the plant earth the past couple of years can attest to how the good will of corporations has been severely discounted.  Perhaps this wealth never really existed and as the saying goes “you can’t lose what you never had”.  We can take comfort in that and perhaps we can look on the bemused folly of central governments eagerly trying to stimulate economic growth to levels of our recent unsustainable past.  I must admit that my sympathies and conviction stand with the Keynesian but I am beginning to wonder if they are chasing the long tails of ghostly economic shadows cast by AIG’s worthless CDS franchise.  Once considered a revolutionary innovation cooked up by the finest minds of the capital markets financial engineers are now perplexing conundrums wrapped in a riddle and remain valuation Level Three FAS 157 mysteries.

To be sure intellectual capital deflation is a huge subject.  I must also admit that this blogger lacks the time, skill and brain power to elucidate and articulate the numerous nuances and depth this assertion deserves and requires.  I guess we could sum it up in a sound bite like the “dumbing down of America” but I believe that merely addresses the race to the bottom marketers skillfully cultivated to gobble up a greater portion of that ever fickle and fluid market share pie.  In a way the deflation we speak of turns this dumbing down on its head and now claims the purveyors of fine ideas and clever tactics devised by the corporate marketing geniuses who were able to enrich themselves by conceiving the brilliant plans to convince us to buy so they can sell as much useless junk to as many people as possible.

The monetization of intellectual capital by incorporated consultants are increasingly becoming inefficient.  New technologies that are enablers of strategic thinking has large consultancies disappearing into the computing cloud.  Large bull pens of gray matter are inefficient as innovation in small firms are more efficient purveyors of thinking large to solve small problems or thinking small to solve larger problems. The large corporate dinosaurs that protected bloated bureaucracies enmeshed in group think stasis increasing showed an inability to be agents of innovation.  They boldly proclaimed best practices to justify and position themselves in the executive office but now that the large corporations have been decapitalized their value creation mantras dissipated as markets capitalization fell.

In appears that the bulge bracket firms viability were dependent on knowledge transfer initiatives to underdeveloped economies to support outsourcing; and rent seeking business models dependent on regulatory mandates of Sarbanes Oxley, GBLA, COBIT, EURO conversions, Basel II, Y2K, PATRIOT ACT, HIPAA, FISMA etc etc. Their business models profited from significant business drivers of the past two decades the reallocation of capital to emerging markets and the guarantee of market protection due to governmental regulatory mandates.  In both instances value creation from the deployment of intellectual capital proved to be unsustainable.

Consider the financial services industry and hedge funds.  Hedge funds claim to offer uncorrelated investment products but most of the hedge funds performance fell in lock step with the market index averages.  Investors pay premiums to participate in absolute return strategies offered by hedge funds.  Fund managers make the claim of absolute returns based on their superior insights that their intellectual capital confers on their investment strategies.  Last year that claim was demolished to devastating effect.

Newspaper publishers are also experiencing a decline in the portfolio value of their intellectual capital.  But many believe that it is more of  a question of their antiquated business model and once they figure out how to Googlize their business model to sufficiently monetize its intellectual capital shareholders will once again be rewarded with an appreciation in its investment and the true value of their intellectual capital will be realized.

The markets are dramatically changing. Today the question is not so much about ideas and strategy its a question of execution. Just as in the recent past it was about raising capital and acquiring assets now its about making informed capital allocation decisions and liquidity. Its true you need the target to shoot at but you also need munitions, a good scope with adjusted cross hairs and a gun. The value proposition of consultants is quickly becoming marginalized.

Its a poor business model. It scales poorly, its racked with inefficiencies, its built on protected markets and knowledge segregation. Now that those barriers are falling and more and more MBAs are out of work the value of this form of intellectual capital continues to fall.

Consultants all to often are beholden to their process biases. They find it difficult to get out of the box and routinely ask their engagements to climb into the box with them. That said it is an absolute necessity that business redefines its business model to address current market realities. It needs to do so with dispassionate dispatch and it needs to create a unique value proposition that differentiates the brand and adds identifiable alpha in an expanded value delivery chain.

Its a big challenge that many professional services firms need to confront. Our firm went through that transition 6 years ago. We went from a strategic sound practices consulting firm to a product creation and marketing firm dedicated to the commercial application of sound practices. For Sum2 creating value was a very different value proposition then delivering value. The need to build equity in our business was our principal concern. Building and marketing tangible product value is how you create a sustainable business model.

Corporations are becoming disenthralled of their self perceived cleverness. Many believe that major investments in applied intelligence create a culture of insularity that hedges all risks and builds enterprise value. In the past it allowed executives to hide behind a wall of opaqueness. They bought the best and brightest minds from our esteemed business schools convinced that this treasure of intellectual capital would protect them. They believed the digital blips of risk models to be sparkling Rosetta Stones containing the secrets that unlock the mysteries of effective risk management, value creation and business sustainability. The codified results of these algorithmic exercises are revered as holy Dead Sea Scrolls that offers the protection of an supernatural mojo. This is the thinking of a bankrupt brain trust.

You Tube Video: Nena, 99 Luft Ballons

Risk: Group Think, sustainable business model, value creation

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April 24, 2009 Posted by | banking, bankruptsy, Basel II, business continuity, economics, FASB, investments, media, risk management, Sum2 | , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , | 1 Comment

Existential Valuation

Charles Ponzi

Many pundits blame the banking crisis on people taking out mortgages they could not afford. I place it at the feet of the investment banks that funded the sub-prime mortgage products.

Michael Lewis’s book Liars Poker details how Salomon Brothers business exploded during the late 1980’s as the mortgage market began to grow. Salomon Brothers since acquired by Citigroup was an early innovator in the creation and sales of mortgage backed securities (MBS). Without MBS the necessary funding that fueled the exponential growth of mortgage finance, construction, home finance lending and equity lines of credit could not exist.

This innovation drastically altered the nature of the banking industry. Bank’s at one time loaned out money from their own capital. But this changed with the advent of MBS type products. Structured products allowed local banks to access funding from many sources and changed banks into credit channels that marketed credit products financed by third parties. Since it wasn’t their capital at risk, risk management and due diligence suffered.

The great innovation of MBS was that it added leverage to the credit markets. As investment banks and buy-side investors grew rich on the cash flows provided by MBS the investment banks began to invent new financing products. CMOs, CLO’s, ABS securitized cash flows and other exotic derivatives like CDS came onto the scene to provided investor protection in the event of a counter-party default. These products levered up the debt positions of corporations, consumers, investors and governments. It created an economy overly dependent on an unsustainable credit marketing industry. As is the case with all Ponzi schemes, as the low man on the totem pole began to default on the usurious rates charged for sub-prime loans the entire house of cards collapsed.

As leverage in the credit markets grew to fantastigorical levels these non-market traded products became more sophisticated and esoteric. These products were structured to address investment requirements of institutional investors. Since they were non-exchange traded securities sold directly to investors the ability to value these securities was exceedingly difficult. As the market developed further the Financial Accounting Standards Board (FASB) had to create rules and asset classifications of these securities so that they could be properly valued for reporting purposes. FASB solution was to classify these assets as Level Three.

See May 17 Risk Rap Post on FAS 157

Herein lies the rub for these Level Three assets. Maybe the dismal science can wave a magic wand and make these assets double in value, disappear or perhaps quarantine these securities in accounting purgatory waiting for better times and future Treasury Secretaries to offer absolution and full redemption for the past sins of our fallen Masters of the Universe.

But just because we say it ain’t so bad don’t make it so good. The Basel II global banking guidelines for capital adequacy insist on transparency on asset quality. The world central bankers have agreed on a formal regulatory methodology to determine asset valuation, solvency conditions, collateral management practices and acceptable ratios of economic and regulatory capital requirements necessary to protect against defaults in the credit markets. What a thought! The US banking industry should stop dragging its feet on its adoption and start implementing the recommended strict disciplines it advocates to protect the solvency of our banking system.

No more voodoo economics, asset valuation slight of hand or accounting convention tricks and balance sheet gymnastics. We need fiscal disciplines, transparency and accountability based on sound economic and generally accepted accounting principles. We need to develop an economic infrastructure that is based on the creation of value and equity not an economy based on creation of collateral and deepening debt.

Music: Cab Calloway and the Nicholas Brothers Jumpin Jive

Risk: bank solvency, pariah nationhood, FASB, Basel II

October 2, 2008 Posted by | banking, credit crisis, FASB, jazz | , , , , , , , , , , , , , , , , , , , | Leave a comment

Pennies from Heaven

Morgan Stanley and Goldman Sachs have changed their charters and are now bank holding companies. I believe this was necessary for Goldman and Morgan Stanley to have access to Federal bailout money in the newly proposed bank workout plan.

Paulson insists that we must move with great dispatch. I get nervous when these types of transactions occur with such velocity that I have a hard time understanding the value proposition. After all, if me and my countrymen are being asked to belly up to the bar and put $1Trillion into the game I want more of an understanding then believing Chris Dodd has seen the horror if we don’t act and it ain’t pretty.

Couple of questions:

Does this allow Goldman Sachs and Morgan Stanley to purchase commercial banks? Will Goldman and Morgan be opening up S&L’s and local community banks? If that is the case should we allow them to take over the management of the banking system considering their poor track records of managing investment banks? A disturbing characteristic of our managed economy is that the more colossal the failure the greater reward is bestowed.

Second question is a small technicality. Paulson’s suggestion to segregate good bank assets and bad bank assets centers around FAS:157 Level Three Assets. If the current holders of these assets cannot value them now, how will the Treasury acquire them from the failed banks and at what value will they carry them on their books? We should also assume that since the US Treasury will want to sell these assets how will it know its getting a good price or “fair value” when it liquidates its position?

Will Level Three assets be used as collateral for the new bank holding companies capitalization requirements? If these assets are not performing now, how can we assume these assets will perform in times of “real economic duress” to meet defaults in the future?

Level Three Assets are principally the CLO, MBS and Credit Default Swaps (CDS) that lie at the root of this crisis. If they functioned as they should, all credit risk should have been hedged out of the system and we should not be experiencing this economic crisis because of insurance CDS provided. Seems to me that the CDS were more snake oil then insurance. If they didn’t work when they were needed (see AIG) why would the US Treasury think there will be a market for them in the future?

Will the investment banks and financial engineers who enriched themselves on the creation and sales of CDS instruments be required to return the money they earned in commissions on the sale of this worthless junk?

Just asking.

Music: Billie Holiday with Lester Young: Pennies from Heaven

Risk: bank, managed economy, bank capitalization,

September 22, 2008 Posted by | banking, credit crisis, FASB, jazz, Paulson, TARP | , , , , , , , , , , | Leave a comment

FAS 157: Allegory of the Cave

In Plato’s magnum opus, The Republic, he devotes a chapter to Socrates’ discourse with his young student Glaucon. Socrates uses an allegory to explain the difference between truth and appearances. The Allegory of the Cave has remained a powerful philosophical metaphor and cornerstone of metaphysics. It outlines how the human perception of reality can be at odds with and diverge widely from what actually is true and good.

The cave is a controlled environment where humans are held captive. The only light they are allowed to see is from a dimly lit fire that casts shadows of images on a far wall. Enclosed in darkness save the faint projections, their inability to see the source or understand how those images appear to their senses gives them the perception that the shadows of things that they see are in fact the real things themselves. It’s not until the cave’s captives are brought out into the light of day that they are able to see that the shadows are only a poor reflection of a manipulated truth.

Socrates’ lesson to young Glaucon, whose name is very close to glaucoma, serves as a proper metaphor to understand the debate concerning FAS 157 and the concept of Fair Value.  For the uninitiated, the issue of Fair Value under FAS 157 addresses how to determine the “value” of securities held in investment portfolios. FAS 157 provide guidelines for three categories of valuation methodologies. Large banks and brokerage firms are increasing the reclassification of their assets using Level 3 methods. The valuation and projected cash flows from assets such as CMOs, CDOs, CLO, and Credit Default Swaps are being derived by sophisticated computer models developed by each firms in-house risk management group. Many of these risk models failed to perceive and detect the melt down in the credit markets that so far has led to $100 billion in balance sheet write downs for the large investment and money center banks. Socrates allegory is similar to the models developed by bank risk managers. These “black box proprietary applications” shines light on the Level 3 assets to determine an approximation of market value. It’s a self created reality of a risk manager’s perception of an assets value.

So what.

Esoteric stuff to be sure but the debate concerning this issue is most relevant to understanding how the current credit crisis evolved, how banks, brokerage firms and hedge funds value and trade securities, how risk mangers make informed decisions concerning risk tolerance and how industry and governmental regulators determine weather a bank is sufficiently capitalized to remain solvent.

The political fallout from the Bear Stearns shotgun wedding is yet to be played out. Main Street wants some relief for mortgage defaults and Wall Street feels that the Fed reacted too quickly and is resisting additional regulation and market intervention into the workings of the capital markets.

Pervasive credit and macroeconomic risks are still present in the global capital and debt markets. Mortgages, municipal finance and commercial paper markets were the first wave of credit market dislocations. Credit card receivables, student loans and other securitized asset classes may pose some acute challenges for our central bankers, accountants, regulators and risk managers in the not to distant future.

Once we emerge from our caves Socrates’ quote to young Glaucon become most prescient. Said Socrates, “And if they were in the habit of conferring honors among themselves on those who were quickest to observe the passing shadows and to remark which of them went before, and which followed after, and which were together; and who were therefore best able to draw conclusions as to the future, do you think that he would care for such honors and glories, or envy the possessors of them? Would he not say with Homer, Better to be the poor servant of a poor master, and to endure anything, rather than think as they do and live after their manner?”

Thank you Socrates. I waited 30 years to use this knowledge that Dr. Choi excitedly taught me in Introduction to Western Philosophy as a freshman at William Paterson College in 1974. Now that we have experienced the light may we never have to slip into darkness again?

Music Video: War, Slippin Into Darkness

Risk: credit, regulatory, accounting, banking, market, risk management

May 18, 2008 Posted by | banking, credit crisis, FASB, hedge funds, jazz, movie, philosophy | , , , , , , , , , , , , , , , , , , , , | 1 Comment