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Chief Financial Officer Duties
When formulating a financial plan and financial policies for his firm the financial manager will find the following outline useful.
I. GET AN UNDERSTANDING OF THE FUNDAMENTAL CHARACTERISTICS OF THE FIRM AND ITS OWNERS.
A. What are the fundamental characteristics of the firm?
1. Cyclicality or stability of sales
2. Effect of sales changes on profits
3. Growth trend--rate and stability
4. Effect of sales changes on cash flow
5. Capital structure--debt-equity ratio
B. What financial policies may the financial manager change; within what limits must he operate?
1. Company will be judged by industry norms
2. Limitations posed by family ownership
3. Resolution of conflicts among desire for growth, conservative debt policy, dividend payout ratio, aversion to dilution, and maintenance of good market price for stock
4. Dividend policy--the greater the certainty and regularity of dividends, the more important the dividends
C. Industry Characteristics
1. Analysis of the nature of the risks facing the company
2. Typical capital structure in the industry
II. LONG TERM FINANCIAL PLAN
An effort should be made to project the image of the company ten years into the future--its financial characteristics and probable growth and need for funds.
The following issues may arise:
1) Dividend policy for a growth company;
2) Appropriate size and frequency of new stock issues;
3) Pricing new issues and rights--(not necessary when seeking new stockholders and capital and present owners do not plan to increase their investment.);
4) Significance of a) earnings per share and b) return on aggregate dollar investment in a growth company;
5) Selecting an investment banker or venture capital firm (May as well start at the top and work down.) and new stockholders, deciding when to go national (Small issue precludes national distribution.);
6) Effect of debt on risk to common stockholders.
[See "Debt Trips up Hinckley, Venerable Maker of Yachts" in the N.Y. Times 10-9-09 linked below.]
III. CAPITAL STRUCTURE AND DEBT FINANCING
The financial manager may have to deal with several different problems related to debt in the firm's capital structure. He must be aware of the importance of analyzing terms and restrictions in terms of current market conditions--no terms are per se fair or unfair--and developing a bargaining strategy, i.e., deciding which terms are least and which are most desirable or critical, with which to approach negotiations. In that way concessions may be secured on provisions most important to the company. The manager may want to consider the possibility of using warrants as incentive financing in recognition of situations in which, in reality, part of the debt funds should be considered equity.
Another important issue is one of the proper debt proportion and the question of how quasi debt items such as guarantees of customers' obligations should be regarded. Standards which may be considered in determining the proper debt proportion include: 1) The one-third rule of thumb; 2) Comparison with similar companies; 3) Cash flow stability; 4) Comparison of ROI (return on investment) with the cost of capital, i.e., the margin of earnings over interest. Cash flow relationships are more important in determining the appropriate amount of debt than the balance sheet percentage.
The SEC uses special criteria and reasoning in judging the capital structures of public utilities. The criteria for approval of a public utility's debt issue include 1) reasonably adapted to the security structure of the issuer and other companies in the holding company system; 2) Reasonably adapted to the earning power of the firm; 3) Is the particular issue necessary or appropriate to the economical and efficient operation of the firm; 4) Are the fees and other remuneration in connection with the issue reasonable? 5) Terms and conditions not detrimental to the interest of the public; and 6) Comparability to industry norms.
IV. COST OF CAPITAL
The need to measure the cost of capital arises in the course of analyzing alternative methods of financing. The following basic considerations are useful for this analysis are: 1) The purpose of the investment--e.g., increased efficiency or expansion?; 2) The likely effect on the market price of the company's stock; 3) The current financial condition of the company; 4) The effect of the market price of the stock on the cost of capital--should be considered if at some point in the future it is likely that the company must go to the equity market.
Present value analysis is useful for analyzing future cash flows. The following assumptions are built into present value analysis: 1) You are interested only in the unique effect of each alternative method of raising capital on future cash flows of the company; 2) Assumptions relating to which time intervals are critical; 3) Acceptance of a hurdle rate. Long time periods increase uncertainty and cast some doubt on the validity of the analysis. A good alternative is to assign residual values to assets at the end of five or 10 years instead of pushing your analysis way out into the future. As to the appropriate hurdle rate of return, it is wise to use a range of rates and to use higher ones when future uncertainty is high.
A weighted average cost of capital method attempts to take into account both present and future costs of capital. This cost is computed by applying current costs of the different forms of capital to the relative percentages of each form in the company's "ideal' capital structure.
Return on investment (ROI) calculations should 1) Take into account the tax consequences of different investments; 2) The economic life of the investment; 3) Be based on incremental cost and revenue figures.
In a company that has ruled out all sources of funds other than retained earnings 1) An argument can be made for maintaining a fairly large cash balance, and 2) An appropriate hurdle rate is the company's historical return on investment. For many projects ROI is a minor factor in the investment decision. The role of the investment in the corporate strategy must also be considered. For example, for a public utility, reliable service is often a paramount criterion.
The financial manager should endeavor to develop explicit financial policies for the company including emphasis on management's obligation to the company's stockholders.
Company financial policies include the payment of dividends on common stock--whether to pay dividends and how much to pay out. In some situations the dividend is sacred, and financial policy should be designed so as not to jeopardize the dividend. The common dividend should be considered akin to a fixed charge. Issues should be carefully timed to coincide with company cash flows. The desirability of pre-paying sinking fund payments is questionable. Retaining the funds preserves flexibility.
Financial models can be used to gain a better feel for the inter-relationships among major variables which must be taken into account; 2) They can give an idea of which estimates are critical to the results so that the most sensitive areas may be concentrated on; and 3) They can provide a useful representation of the business environment. However, it is difficult to agree on assumptions about stockholder desires and behavior.
VI. MANAGEMENT'S OBLIGATION TO STOCKHOLDERS
How sensitive should management be to stockholders' demands? Should company financial policy be designed to fit present stockholders' needs or should it be designed around the needs of the company because of the nature of its operations and its industry, with the end in mind of attracting investors who approve of this policy. There is no pat answer to this question. One must search for the Golden Mean, i.e., be sensitive to the owners of the company who, after all, are taking the risk, yet you must devise sensible policies in line with the nature of company goals and environment. A question to be asked is what promotes the interest of the stockholders over the forseeable future? Examples of management considerations include 1) The tax consequences of available alternatives; 2) The effect of each alternative on the market price of the stock. With a little effort management should be able to convince the stockholders to support a sensible financial policy.
What’s surprising, though, is how willing regulators have been to allow the proliferation of phony-baloney financial reports and how keenly investors have embraced them. As a result, major public companies reporting results that are not based on generally accepted accounting principles, or GAAP, has grown from a modest problem into a mammoth one.
NYTimes 4-24-16 Gretchen Morgenson: According to a recent study in The Analyst’s Accounting Observer, 90 percent of companies in the Standard & Poor’s 500-stock index reported non-GAAP results last year, up from 72 percent in 2009.
Regulations still require corporations to report their financial results under accounting rules. But companies often steer investors instead to massaged calculations that produce a better outcome. [Gretchen Mongenson's article is linked below.]
VII. OPERATING PROBLEMS AND ISSUES
Significant savings can be realized by analyzing cash collection and disbursement procedures. For a big company it generally pays to decentralize the collection and set up receiving banks. Bankers can be willing and helpful in improving cash collection efficiency.
VIII. VALUATION AND MERGERS
There is no intrinsic value for a security. The purpose for which the value is being determined must be considered. The statutory trend is toward market value methods. One way to regard the stockholder is as an investor to whom the obligation is fulfilled if it is made possible for him to shift to a comparable investment in a similar company. However, there is still (1960) a large body of legal opinion that theoretical liquidation value is more appropriate.
In the case of mergers one must be aware of a possible effect of knowledge of the impending merger on the recent market price. Tax considerations are often a major factor, e.g., the use of the sale of assets method in order to enable the re-depreciation of assets. Non-financial considerations are often critical, e.g., what happens to employees and officers. If steps are taken far enough in advance management can often prevent a take-over.
IX. ADUJUSTMENTS AND REORGANIZATIONS
The Securities and Exchange Commission requires that the plan be 1) Fair; 2) Feasible; and 3) Have a reasonable chance of success. Reorganization plans are often based on the relative bargaining power of the various groups. Nevertheless, these interests must be rationalized to the satisfaction of the SEC.. They like the use of capitalized future earnings. It may be best to combine interests into as few groups as possible. What is offered to each group must bear a close relationship to the market value of what they currently have.
X. STOCKHOLDER AND OTHER INTERESTS
In real life many managers do not feel the same moral obligation to stockholders and the public as is considered desirable in academic and responsible business circles. Often managements do not recognize their responsibility to all stockholder groups. In particular the holders of "preferred" stock. This conflict can easily occur when a company deals in its own securities. Management should carefully examine the nature of its obligation to serve the interests of all stockholders and observe the the principle of full disclosure and prior notification when trading in its own securities. And management should avoid situations where its personal interest conflicts with those of stockholder groups. Finally, it's obligation to company employees and the public should not be overlooked. Antisocial behavior is not justified in the name of serving the interest of the company's stockholders, and certainly is not in order to line the pockets of the company's CEO and other managers.
[Submitted May 16, 1960 to Professor Pearson Hunt's Financial Management Course, Harvard Business School. Professor Hunt marked the paper "very good."]
ADDENDUM NOVEMBER 2009:
Recent events have put the spotlight on several issues on which the CFO is responsible for or is likely to be called upon for guidance:
1. The dangers of too much leverage on the balance sheet have been made apparent in the banking industry, the auto industry and in private equity deals where excessive borrowing following takeovers has imperiled a number of companies.
2. Various ethical and legal issues such as insider trading and backdating and re-valuing stock options.
3. Executive compensation.
4. Corporate governance issues such as the composition and role of the board of directors and the rights of common stockholders.
NYTimes 4-26-16 "The Quiet War on Corporate Accountability"
- Log In - The New York Times
Last year, FASB released a proposal that could make it easier for corporations to withhold important financial information from shareholders. This could put the economy at greater risk of
NYTimes 4-24-15 "Fantasy Math Is Helping Companies Spin Losses into Profits" Gretchen Morgenson
- Log In - The New York Times
A recent study said 90% of S&P companies reported non-GAAP results last year, up from 72% in 2009. Rules require reports under accounting rules, but companies often steer investors to massaged numbers.
Professor Pearson Hunt
Pearson Hunt Obituary
- Pearson Hunt remembered - October 2002 - Alumni Bulletin - Harvard Business School
Find a friend, find a job, or find out more about the latest HBS research. Access a wealth of tools and resources exclusively for HBS alumni.
1-17-12NYTimes "Dell's Ups and Downs with Options" by Floyd Norris
- Dell’s Ups and Downs With Options - High and Low Finance - NYTimes.com
Dell has spent more on share repurchases than it earned throughout its life as a public company, and most of those repurchases were at prices well above current levels, benefiting Dell executives more than long term shareholders.
7-11-12NYTimes--"The Spreading Scourge of Corporate Corruption" Eduardo Porter
- The Spreading Scourge of Corporate Corruption - NYTimes.com
The misconduct of the financial industry no longer surprises most Americans, and trust in big business overall is declining. We should be alarmed.
9-4-12NYTimes--"The Man Behind Facebook's I.P.O. Debacle" Andrew Ross Sorkin
- David Ebersman, the Man Behind Facebook's I.P.O. Debacle - NYTimes.com
The company's chief financial officer badly misjudged demand for Facebook's I.P.O., and will be under pressure until the stock rebounds.
6-28-12NYTimes--Jamie Dimon Gets an "Unsatisfactory" from Professor Hunt
- JPMorgan Trading Loss May Reach $9 Billion - NYTimes.com
As JPMorgan has moved rapidly to unwind the position in credit derivatives, internal models at the bank have recently projected losses of as much as $9 billion.
6-27-12 ProPublica "How Shareholders are Hurting America" Jesse Eisinger
- How Shareholders Are Hurting America - ProPublica
Corporations don't plan for the long-term. Blame economists, business professors and corporate governance do-gooders, says professor Lynn A. Stout, Cornell Law School.
6-8-12NYTimes--Accounting Backfired at MF Global
- MF Global Case Exposes Weakness in Accounting Rules - NYTimes.com
Trustees trying to unravel what happened at MF Global have focused on one technique, allowed under current accounting rules, that allowed the firm to buy bonds and book immediate profits.
4-9-11nytimes---CEO Incentive Pay Leads to Cooking the Books and Screwing the Shareholders
- Enriching Executives, at the Expense of Many - NYTimes.com
Albert Meyer, a money manager, sees some international companies as models of pay practices that show more respect for shareholders than similar American companies do.
- Enriching Executives, at the Expense of Many - NYTimes.com
Albert Meyer, a money manager, sees some international companies as models of pay practices that show more respect for shareholders than similar American companies do.
5-12-11NYTimes EDITORIAL--"Wall Street Held Accountable"
- Wall Street, Held Accountable - NYTimes.com
The conviction of a major hedge fund manager comes at a moment of distrust in the markets.
4-8-11NYTimes--Floyd Norris--How Secrecy Undermines Audits
- Sarbanes-Oxley Audit Reforms Undermined by Secrecy - NYTimes.com
Disciplinary actions against audit firms can remain secret for years, so investors have no way of identifying companies that may be using inappropriate accounting practices.
3-30-NYTimes Floyd Norris--Repo Men Exposed?
- Repo Men, Exposed? - Floyd Norris Blog - NYTimes.com
When is a repo a fraud? The S.E.C. is trying to find out.
3-30-10 NY Times--S.E.C. Looks at Wall Street Accounting
- More flakey accounting on Wall Street?
The S.E.C. said on Mon. it had started an inquiry into about two dozen financial companies to determine whether they followed accounting practices similar to those recently disclosed in an investigation of Lehman Bros., i.e. the use of "repos."
11-7-09 NYTIMES--Insider Trading is a Murky Legal and Ethical Issue
- What is insider information, anyway. A murky ethical and legal question.
Switchboards at law firms have been lighting up in recent weeks as hedge fund managers and technology executives deluge lawyers with one question: What information is safe to share, in case the feds are listening?
The End of the Financial World as We Know It Michael Lewis & David Einhorn NY Times 1-4-09
7-22-10NYTimes--Dell Settles SEC Accounting Fraud Case for $100 Million
- Dell Settles SEC Accounting Fraud Charge for $100 Million
Dell agreed to pay $100 million to settle civil charges by the S.E.C. that its executives used fraudulent accounting tricks to make it appear that the computer maker was meeting Street earnings estimates. Michael Dell agreed to pay a $4 million fine.
GM Dire Outlook, Cash Crisis, Katie Merx in the Detroit Free Press 7-3-08
GM's and Chrysler's descent into bankruptcy and bailout in the spring of 2009 is a good example of the peril resulting from too much debt on the balance sheet of a company in a cyclical, highly competitive industry.
[Unfortunately, the link to Katie Merx's article in the Detroit Free Press is dead.]
4-17-07 NYTimes Hedge Funds Serve as Giant IRAs for Hedge Fund Managers
9-11-09 Floyd Norris "Accountants Misled the World Into Crisis, and It Could Happen Again
- High and Low Finance - The Accountants Misled Us Into Crisis - NYTimes.com
Is this an accounting-led recession? Banks masked their inadequacies, and now argue that revealing their weakness will make the situation worse.
Private Equity Firms Gobble Up Public Companies
Enron, the Supreme Court and Shareholders on the Brink by Ben Stein NYTimes 4-29-07
Chief Financial Officer--wiki
Floyd Norris on the Issue of Off Balance Sheet Items NYTimes 2-29-08
High & Low Finance
Why Surprises Still Lurk After Enron
- By FLOYD NORRIS Published: February 29, 2008
Should we blame the accountants?Surprises multiplied as the subprime problem of 2007 grewinto the credit disruption of 2008. It is one thing to have a bank report losses because some of the loans on its balancesheet went bad. That is part of the business of banking. It is something else, however, for a bank to report a multibillion-dollar loss from taking some risk that had never been mentioned in its financial statements.
Haven't we seen this movie before, involving a company called Enron? Didn't Congress pass a law requiring that the problem of off-balance-sheet mysteries be solved? "After Enron, with Sarbanes-Oxley, we tried legislatively to make it clear that there has to be some transparency withregard to off-balance-sheet entities," Senator Jack Reed, Democrat of Rhode Island and chairman of the Senate securities subcommittee, said this week. "We thought that was already corrected and the rules were clear and we would not be discovering new things every day."Senator Reed has sent letters to the Securities and Exchange Commission, as well as to the Financial
Accounting Standards Board, which sets United States accounting rules, and the International Accounting Standards Board, which does the same for most of the rest of the world,asking detailed questions about what went wrong and how it should be fixed. Getting together answers to his questions could provide the S.E.C. with a road map to determine where the rules failed, as well as where companies failed to apply the rules properly.
One rule that needs scrutiny now - called 46-R - was passed after Enron. Essentially, it says companies can keep "variable special purpose entities" off their balance sheets if they conclude that the bulk of the rewards, and risks, lie with others. But companies are supposed to evaluate those estimates regularly, and change the accounting if the conclusions change. A risk that seemed remote last year can seem all too real now, and that explains a lot of the surprising write-offs.
Suddenly, losses are booked. Investors learn that a company has taken a risk only after the risk has gone bad. That should not happen. The rules require that companies make some disclosures about off-balance-sheet vehicles even if they do not put them on their financial statements. They should discuss factors like the nature of the risk they face and the maximum loss that is possible.But those disclosures have often not been made, or have been made in such a general way as to be meaningless. The S.E.C., and perhaps the Congress, should ask some companies to explain their earlier lack of disclosures. They will hear that companies thought the amounts involved were unimportant - "not material" in the jargon of accounting. They may find out that some managements did not understand all the risks that were being taken. And they may find that some companies failed to disclose risks that they should have disclosed.
The 2007 annual report of the State Street Corporation, a Boston bank, is a model of what disclosures should be, in laying out the risks of some special purpose entities it set up to hold assets. Those entities, known as conduits, borrowed money to pay for the assets, with State Street promising to come up with the cash if the conduits could not find other lenders.In the report, State Street explains why it has not taken any write-off on those conduits, which contain $28.8 billion in what the bank believes to be high-quality assets. It can avoid consolidation because other investors would suffer the first $32 million of losses - about one-tenth of 1 percent of the assets. After that, State Street would be on the hook. But State Street says its model indicates defaults on the underlying assets will not cost that much.So long as the conduits stay off its balance sheet, State Street does not have to adjust them to reflect the market value of the assets in the conduits. But if State Street ever concludes that defaults are likely to be a little higher - say $100 million, only three-tenths of a percent of assets - it will have to put the assets on its balance sheet. And if it does that, it will have to write them down to market value. At the end of last year, State Street estimates that market value was about $850 million below face value. Had it been forced to consolidate the conduits, that loss would have been posted, leaving a write-down of about $530 million after taxes. About 40 percent of the bank's 2007 profits would have vanished.As those assets eventually came due, State Street might have been able to recoup some or all of those losses if there were few defaults. But that could happen years later.The basic strategy with these conduits was to borrow at lower short-term commercial paper rates and lend at higher long-term rates. That has long been one way banks make money, and sometimes lose it if credit markets move in the wrong direction.
This accounting rule let those risks vanish from the balance sheet because somebody else would suffer the first one-tenth of 1 percent of losses if any of the securities went bad. A rule that allows that to happen needs revision.
At least State Street investors now know about those risks, and have an explanation of why State Street thinks the market value of those assets is unreasonably low. Investors in many other banks, including some that have taken big write-offs, know much less about the risks those banks face.There are many other issues in bank accounting, some stemming from the nature of market value estimates.
JPMorgan Chase pointed out this week that it has taken reserves of 4.9 percent against the value of the leveraged loans on its books - twice that of some of its competitors.Maybe that means JPMorgan's loans are not as good, but maybe it means that other banks are simply using more optimistic estimates. In a market where there are observable market values, the S.E.C. might want to ask how such disparities come to exist. There are no perfect accounting rules, and forcing banks to consolidate everything might be unreasonable. But banks should have done more to let investors know the nature of the risks that were being taken. If the accountants had forced better disclosures, it is at least possible that managements would have spent more time evaluating the risks they were taking, and then made wiser business decisions.
Floyd Norris comments on finance and economics in his blog
COMMENT: Floyd Norris is the lead financial writer for the N.Y. Times. He's one of the best in the business, in my opinion. Norris and Gretchen Morgenson both are strong advocates for the rights of investors as was Professor Pearson Hunt.
Wall Street, Run Amok
By BEN STEIN Published: April 27, 2008
You don't really need to find out what's going on.
Just leave well enough alone......
You don't really want to know just how far it's gone. Just leave well enough alone... .- Don Henley, "Dirty Laundry"
YOU may well be asking yourself, as I have asked myself, how on earth did the credit crisis on Wall Street become such a catastrophe? How did all of the mechanisms operated by the mind-bogglingly well-paid men and women of the Street go so wrong that we saw a major investment bank, Bear Stearns, essentially disappear? How did Wall Street firms of ancient lineage take such immense losses that they made banks clam up on lending - at great risk to the economy? Weren't fail-safe devices in place to guard against risk? Weren't government watchdogs there to make sure that catastrophes could not happen? Weren't ratings agencies on the job to police what was going on in the canyons of Lower Manhattan?
To paraphrase Dr. Evil in the "Austin Powers" movies: "How about ‘no,' Scott?" Anyone who cares about this disaster would be extremely well advised - and I'd underline "extremely" as often as possible - to read a speech on the matter that was given on April 8 by a genius investor named David Einhorn at a Grant's Interest Rate Observer event. Mr. Einhorn runs Greenlight Capital, a successful hedge fund. He also isn't an infallible observer of human lapses and regulatory failures - he invested in and briefly served on the board of New Century, a subprime mortgage lender that later went bust amid accounting problems. (When I sought his response, Mr. Einhorn said he did not want to comment on New Century or on his essay.)
Yet his speech so well explains what went wrong in the financial debacle that it's frightening. Here is my CliffsNotes version of it.
First, Maestro Einhorn points out that the fellows who run big investment banks have a strong incentive to maximize their assets and leverage themselves into deep trouble because their pay is a function of how much debt they can pile on. If they can use relatively low-interest debt to generate slightly higher returns, the firm earns more revenue and executive pay increases. Often, an astonishing 50 percent of total revenue goes to employee compensation at Wall Street firms.
NOW, you may ask, what kind of assets were they acquiring with that debt? Well, sometimes, as with Bear Stearns, the leveraged assets are mostly government agency debt, which used to be regarded as fairly safe. Sometimes, as Mr. Einhorn notes, those portfolios also hold stocks, bonds, loans awaiting securitization, and pieces of structured finance deals. They also hold heavy exposure to derivatives that have stunning risk profiles and can produce astounding losses in bad circumstances. They might also contain real estate assets and have exposure to private equity deals.
In other words, they can hold some scary "assets." What do they hold as capital against such risks? You would think it would be cash or Treasury bonds, wouldn't you? But no.Under an interesting set of rules promulgated by the Securities and Exchange Commission in 2004, called
"Alternative Net Capital Requirements for Broker-Dealers That Are Part of Consolidated Supervised Entities," the amount of capital that had to underlie assets was reduced substantially. (Mr. Einhorn rightly says that this set of rules should have been called the "Bear Stearns Future Insolvency Act of 2004.")
Through the act, the S.E.C. - acting as one of Wall Street's chief regulators, mind you - also allowed such things as "hybrid capital instruments" (much riskier than cash or Treasuries), subordinated debt (ditto) and even deferred return of taxes, to be counted as capital. The S.E.C. even allowed the banks to hold securities "for which there is no ready market" as capital. "These adjustments reduced the amount of required capital to engage in increasingly risky activities," Mr. Einhorn says. In response to Mr. Einhorn's critique, an S.E.C. spokesman told me that these changes could theoretically lower capital, but that the agency has seen no evidence that that has, in fact, occurred. But Mr. Einhorn has even more troubling observations. He says the S.E.C. also allowed broker-dealers to set their own valuations on assets and liabilities that were hard to value. And broker-dealers could assign their own creditworthiness ratings to counterparties in complex derivatives transactions when those counterparties were otherwise unrated.
In a word, Mr. Einhorn says, the S.E.C. told Wall Street to police itself to save on regulatory costs, while not bothering to "discuss the cost to society of increasing the probability that a large broker-dealer could go bust."
A result of all this, he says, was as follows: "The owners, employees and creditors of these institutions are rewarded when they succeed, but it is all of us, the taxpayers, who are left on the hook if they fail. This is called private profits and socialized risk. Heads, I win. Tails you lose. It is a reverse-Robin Hood system."
And when it all went kaput during the Bear Stearns debacle, the likable chairman of the S.E.C., Christopher Cox, said that the system was fine and needed no immediate repairs. Of course, Henry M. Paulson Jr., the Treasury secretary, is calling for merging the S.E.C. with the easygoing Commodity Futures Trading Commission, in the financial equivalent of setting off a Doomsday Device.
The S.E.C. told me that all of its actions were helpful to investors and that no one could have prevented the Bear Stearns collapse because it was caused by liquidity issues, not capital issues. My respectful response is that if Bear were thoroughly well capitalized, why would liquidity issues come up at all?
There is much more in Mr. Einhorn's speech about how dramatically understaffed the ratings agencies are in assessing risk on Wall Street and how even the biggest ratings agencies largely allowed the Street to rate itself.
The big ratings firms, according to Mr. Einhorn, do not even bother to assess the major investment banks' portfolios because they change so often. It looks to me as if the inmates are running the asylum. One truth, that deregulation is sometimes a good thing, has been followed down so long and winding a road that it has led to an immense lie: that deregulation carried to an extreme will not lead to calamity.
To think that people of this mind-set are in charge of the finances of the nation that is the cornerstone of world freedom is terrifying. Mr. Einhorn may well have done us a service of great value.
Ben Stein is a lawyer, writer, actor and economist. E-mail: email@example.com.
6-2-08 Secret Life of a Deal at Dow
- Skullduggery at Dow
Dow Chemical and two fired executives settle lawsuits over secret $50 billion take-over attempt.
Einhorn Address on Credit Crisis April 2008
- David Einhorn on Credit Crisis
David Einhorn, hedge fund president and manager gives his views on the causes of the current economic crisis. April 2008.
David Einhorn wiki bio
- David Einhorn
David Einhorn author of "Fooling Some of the People All of the Time," manager of hedgefund Greenlight Capital.
CPA Bookkeeper's Website--reading a balance sheet
- CPA Bookkeeper's Website--Reading a Balance Sheet
Be sure to check for special off-balance sheet items!
Greenspan Admits His Mistake
Remarks by Alan Greenspan at Federal Reserve Bank of Chicago on International Finance May 7, 1998
Excerpt wrt dangers of leverage:
What is becoming increasingly clear, and what is particularly relevant to this conference, is that, in virtually all cases, what turns otherwise seemingly minor imbalances into a crisis is an actual or anticipated disruption to the liquidity or solvency of the banking system, or at least of its major participants. That fact is of critical importance for understanding both the Asian and the previous Latin American crises. Depending on circumstances, the original impulse for the crisis may begin in the banking system or it may begin elsewhere and cause a problem in the banking system that converts a troubling event into an implosive crisis.
The aspects of the banking system that produce such outcomes are not particularly opaque.
First, exceptionally high leverage has often been a symptom of excessive risk-taking that left financial systems and economies vulnerable to loss of confidence. It is not easy to imagine the cumulative cascading of debt instruments seeking safety in a crisis when assets are heavily funded with equity. Moreover, financial (as well as nonfinancial) businesses have employed high leverage to mask inadequate underlying profitability and did not have adequate capital cushions to match their volatile environments.
Second, banks, when confronted with a generally rising yield curve, which is more often the case than not, have had a tendency to incur interest rate or liquidity risk by lending long and borrowing short. This has exposed banks, especially those that had inadequate capital to begin with, to a collapse of confidence when interest rates spiked and capital was eroded. In addition, when financial intermediaries, in an environment of fixed exchange rates, but still high inflation premiums and domestic currency interest rates, sought low-cost, unhedged, foreign currency funding, the dangers of depositor runs, following a fall in the domestic currency, escalated.
Third, banks play a crucial role in the financial market infrastructure. A sound institution can fend off unexpected shocks. But when they are undercapitalized, have lax lending standards, and are subjected to weak supervision and regulation, they have become a source of systemic risk to both domestic and international financial systems.
Fourth, recent adverse banking experiences have emphasized the problems that can arise if banks, especially vulnerable banks, are almost the sole source of intermediation. Their breakdown induces a marked weakening in economic growth. A wider range of nonbank institutions, including viable debt and equity markets, can provide important safeguards of economic activity when the banking system fails.
Fifth, despite its importance for distributing savings to their most valued investment use, excessive short-term interbank funding, especially cross border, may turn out to be the Achilles' heel of an international financial system that is subject to wide variations in financial confidence. This phenomenon, which is all too common in our domestic experience, may be particularly dangerous in an international setting. I shall return to this issue later.
Finally, an important contributor to past crises has been moral hazard, that is, a distortion of incentives that occurs when the party that determines the level of risk receives the gains from, but does not bear the full costs of, the risks taken. Interest rate and currency risk-taking, excess leverage, weak financial systems, and interbank funding have all been encouraged by the existence of a safety net. The expectation that national monetary authorities or international financial institutions will come to the rescue of failing financial systems and unsound investments clearly has engendered a significant element of excessive risk-taking. The dividing line between public and private liabilities, too often, has become blurred.
Here's a link to the full text of Greenspan's address:
Measurement of Financial Leverage in the Presence of Environmental Liabilities Relating to Superfund Sites
NY Times 10-10-09 "Debt Trips up Hinckley, Venerable Maker of Yachts"
- Debt Trips Up Hinckley, Venerable Maine Yacht Maker - NYTimes.com
Hinckley Yachts, known for beautiful sailboats and sleek powerboats, lost business when the economy faltered, but debt made its problems even worse.
Pension Accounting Rules Are Flawed
The current (2007-09) financial crisis and recession have reinforced the validity of the views of advocates of pension accounting reform and even called into question the underlying concept of defined benefit pension plans. The concept of privately funded pension plans is doubtful because, too often, the beneficiaries of many of the plans outlive the corporations or other organizations responsible for funding the plans. The problem of beneficiaries outliving the plan sponsors is exacerbated by flawed, inadequate accounting and funding rules for the plans.
In 2005, former SEC chairman, Arthur Levitt, Jr., in a Wall Street Journal op-ed and in testimony before Congress called for putting an end to "Potemkin pension accounting, pointing out that "over the past three decades we have allowed a system of pension accounting to develop that is a shell game, misleading taxpayers and investors about the true fiscal health of their cities and companies--and allowing management to make promises to workers that saddle saddle future generations with huge costs." Unfunded pension liabilities of the S&P 500 companies were estimated at $218 billion and unfunded liabilities of state and local governments at $700 billion. As of May 2009, auto sector pensions alone were underfunded by $77 billion.
Claims against the Pension Benefit Guaranty Corporation have skyrocketed. Levitt predicted that the "hole" in PBGC funding could reach $100 billion, putting a strain on the Treasury exceeding the massive Savings and Loan bailout by in the 1980s. Levitt believes reform is imperative for regulatory incentives and accounting rules that encourage public and private employers to make promises that can't be kept. He proposes reform in three areas:
1. Bring transparency and honesty back to pension accounting. Currently there is too much subjectivity and outright guesswork. The real economic liability of a company's pension plan and the true value of the assets that will be used to meet the obligation are often not reflected on the balance sheet. Rather they are hidden in undecipherable footnotes permitted by current accounting rules. The rules also permit pension accounting to rely on unrealistic assumptions about expected returns on the funds' investments for the next 30 or 40 years. According to Levitt the "smoothing" of assets and liabilities allows companies produces deceptive financial statements which artificially boost earnings and, too often, enhance executive compensation. These bogus figures also reduce the companies' contributions to the Pension Benefit Guaranty Corporation.
2. Investors and pensioners deserve relevant and understandable information from pension plans about their fiscal health and operations, not impenetrable financial statement footnotes. This should start with lifting the shroud of mystery around discount rates used to compute the present value of pension obligations and, thus, the size of the liability or asset reported. For too long companies have played with various variables to devise a rate that helps them recalibrate retirement plan assets and liabilities in order to manage earnings. And many unions have been willing victims, trading current wage increases for unrealistic pension promises. And too many accountants and actuaries, the professionals who are supposed to be the watchdogs, have given their seals of approval to these phony transactions.
3. The situation in state and local government pension plans is even worst than in corporate plans. Not only are the unfunded liabilities moving toward $1 trillion, but the accounting standards lag behind that of American corporations. Weakened disclosure rules fail to reflect accurately the assets and liabilities of public pension plans; alternative actuarial procedures are allowed that can be abused to lower report costs; and the current rules fail to provide citizens and elected officials with a clear picture of what claims these programs will be making on future tax revenues. Too often, public pension officials and government finance officers resist moves to greater transparency. Unrealistic pension assumptions are getting an increasing number of cities and states into economic difficulty.
Principal source: Arthur Levitt Op-ed in the Wall Street Journal, November 10, 2005.
Deeds comment: In addition to the above issues pointed out by Arthur Levitt there is another conceptual flaw in defined benefit pension plans: Too often the employee beneficiaries outlive the companies upon whom they are relying for benefits. The employers disappear in bankruptcy or through acquisitions leaving behind under-funded pension funds. A lack of portability of defined benefit pension plans is another serious flaw in defined benefit pension funds as fewer employees remain for their entire career with a single employer. Even if their pension has vested after 5 or 10 years the benefit they receive years later is eroded to a pittance by inflation.
N.B.: There are serious issues with 401k and IRAs as well which prevent many of these plans from delivering promised or expected retirement benefits. They are: 1. Low participation rates; 2. Inappropriate investments; 3. Excessively high administrative costs; 4. Excessive mutual fund fees and trading costs; 5. Mutual fund conflicts of interests and abusive practices; and 6. Lack of a competent, independent, objective source of advice for plan participants.
Pension Accounting Reform Ducks Just When Investors Need It
- The Accounting Onion: Pension Accounting Reform Ducks for Cover Just When Investors Need It
The backdrop for today's post is the present dive in stock prices at the same time the Federal Reserve is trying to stimulate the economy by decreasing interest rates. What I'm fixin' to describe is how it will -- and...
7-22-08 Mercer on Pension Accounting Reform
- Pension Accounting Reform
If FASB touches the income statement, CFOs will reach for the Valium. FASBs pension review could wreak havoc with reported earnings. The change could dwarf the impact of the company's core business and render the income statement useless.
12-1-10FreePress--Delphi Books Cooking Trial
A former Delphi executive who settled accounting fraud charges said that his former boss, J.T. Battenberg, CEO, was not closely involved in a decision to report a $237-million warranty claims payment to General Motors as a pension adjustment.
March-April 2011 Harvard Magazine " Integrated Reporting A Revolution in Corporate Reporting"
- Robert Eccles on the benefits of integrated reporting | Harvard Magazine Mar-Apr 2011
Integrated reporting gives stakeholders information about the sustainability of a corporations business. Eccles has written a case about Southwest Airlines transition to an integrated report, as well as three books on corporate reporting...