Legislative ignorance went a long way to try and outrun the gravitational force of the unwind. But its time is growing nearer. The NY Times Economix blog, authored by Simon Johnson, addresses the landscape and inherent necessity:

In particular, informed sentiment has shifted against continuing to allow very large banks to operate in their current highly leveraged form, with a great deal of debt and very little equity. There is increasing recognition of the huge and unfair costs that these structures impose on the rest of the economy.

The implicit subsidies provided to too-big-to-fail companies allow them to increase compensation by hundreds of millions of dollars. But the costs imposed on the rest of us are in the trillions of dollars. This is a monstrously unfair and inefficient system, and sensible public figures are increasingly pointing this out.

The NYT blog illustrates the obvious prescription….heavy downsize. Kill the current debt funded model (where tax revenues repay the creditors of failed banks and their leaders) and impose hefty equity capital requirements (so much that it’s not profitable to be above a size with risk manageable by humans). Banks are federally funded stewards of economies and commerce. They’re not governments.

On cue, Jamie Dimon lent a hand with the unwind by pouring ample ammunition into the pockets of his critics.

A recent blog by TheCoporateCounsel.net raised the obstacles of politics and funding as impairments that handcuff the SEC’s capacity to execute its mission. The piece reminded me how long this fight has been waged. I can recall it being topical when I arrived at the agency in 1990.

At that time, Drexel Burnham was collapsing, S&L’s were disappearing as a tranche of our banking system (as a result of their post-dereg binging on commercial lending) and LBO’s were beginning to blow up widely. Operating margins & cash flows could not service their debt costs, let alone pay down principal.

Securities markets and the financial sector had just come through a decade that transformed them. Risk, the pricing of it in existing and newly developed securities, and development of markets to actively trade these securities became pillars of the new era.

At the time, funding oversight operations to secure capital markets with a fee on capital from those markets looked like common sense. Still does. It was the most sensible bureaucratic act I had ever witnessed. Significant, since I recall witnessing no other sensible bureaucratic acts.

The argument against the SEC at any point in the last two decades isn’t whether it’s necessary. The critique would be on execution. This argument can’t be had without the issues raised in thecorporatecounsel.net’s blog. If you won’t allow the agency to fund itself and perform within those financial parameters, and you make the agency hostage to the carnival of politics, you are not going to get consistent, objective and effective execution of it’s mission - investor protections.

Looking at the cost to the markets for funding the agency’s operations makes the case for its existence transparent. Filing fees are the SEC’s funding stream. They were and are truly fractional. During my tenure they were expressed as a fraction, such as 1/29th of 1% of the offering value (i.e. 0.00034). Today they’re expressed as cost per million of the offering. Currently, $114 per $1,000,000 of capital offered. Seriously. The common underwriter’s take from the same offering collects $70,000 per million, give or take $10,000 per million. “Shadow” costs reflected in legal and accounting fees related to being public remain paltry, relative to the costs to investors of being naked re: market oversight.

Just the presence of the agency, with sufficient funding, staffing and enforcement powers, deters the vast amount of risk that is inherent in unregulated markets. The effectiveness at shutting down the remainder rests in allowing the agency the full benefit of the funding it raises. Freeing it from the personal and institutional political interests that attach to it from the congressional budgeting process can only improve its capacity to perform oversight of the capital markets and secure the aimed for protections of investors.

Simon Johnson authored a piece carried in the NY Times Economix blog last week. It was shocking for its good news and the good sense it illustrated re: rulemaking around securing the US monetary system against the baked in risk carried by the four horseman and their brethren.

The drafters of the Dodd-Frank financial reform law got an important thing right. Despite fierce pushback from the banks …the legislators communicated a key new intent: megabanks must be able to fail, and the Federal Deposit Insurance Corporation should be in charge of that liquidation process.

Mr. Johnson keenly points out the FDIC’s strategic advantages for the role:

The F.D.I.C. was an inspired choice for this role, because it is less captivated by the “magic” of Wall Street and less captured by its money and influence than any other group of officials.

The F.D.I.C. has also long been in the business of shutting down banks while limiting the damage to taxpayers, although it did not previously have complete jurisdiction over the largest banks when they got into trouble. It could only deal with those parts that had federally insured “retail” deposits, and this turns out not to be where the biggest problems have occurred in recent times.

The FDIC also built substantial confidence in their role and process by making their decision process transparent. The methods are illustrated admirably by Mr. Johnson.

The developments being shepherded by the FDIC re : wind down of a massive institution that fails and making it clear that such an institution can fail and can be wound down safely, represent genuine and infinitely beneficial change from the current and unworkable banking industry and oversight practices.

There are legitimate reasons that legitimate companies opt for RM’s. Underwriter cost of an IPO is at the top of the list. However, the history of RM’s is ripe with tales of the illegitimate. In recent times, the brand of RM that focused on bringing PRC (People’s Republic of China) entities public has emphasized the sordid characters and deals that are emblematic of regulator concerns surrounding the format. The Times ran this piece on The New York Global Group, which facilitated RM’s with PRC entities and is now the subject of the FBI’s interest.

Historically, these transactions have also been sold as “blank check” deals and SPAC’s (special purpose acquisition corp). The first form of blank checks I was involved with was while on staff of the SEC in the 90’s. They were often solicitations for limited funds ($5m or less) by an ownership interest with a very opaque business plan. Around 2005 this model was upgraded to include a roster of seasoned professional management and investors, where larger sums were being sought ($100m +). Again, there was no definitive business plan. The accumulated brand power of the gathered backers was supposed to be direct evidence of how great an idea would be developed…eventually…and you could get in before that was clear to anybody.

A bit later these were modified and became SPAC’s. This rendition of the RM was selling that same notion that its “best of breed” roster of management and investor power would seek out the best investment opportunities, choose one from that robust lot, and fund it with the SPAC’s money, that public investors would already have fronted to the SPAC. That money was being held in essential escrow and earning a risk free return, until the opportunity of great fortune was found by the best-of-breed consortium. If a period of time elapsed with no pot of gold found (e.g. 18 months), it would be returned to the investors.

The blank checks and SPAC’s were one of the canaries in the coal mine telling anyone who was watching that the big fall of finance was coming. That there could be so much liquidity being funneled to unfocused and indeterminate business plans, based on nothing more than the short term reps of a too large roster of players, was hint enough. This lesson was not learned well, as the aforementioned piece in the NY Times illustrates.

The right business model can use the RM as a step transaction toward public funding. The shell company’s ownership usually agrees to a merger because they want a liquid exit from their position. The operating company doesn’t get any new capital. They won’t have basis for a major index listing either, unless their asset/equity tests etc. already qualify them. The value is if they have a business model and operating level that can benefit from a public capital raise further down the road.

As money and margin became institutions and drove global business plans over the last two decades (private equity, sovereign wealth funds, Goldman-Morgan-Lehman axis etc), rather than invention and product/service development, the allocation of capital became concentrated and narrow. It wound up in “sure things” that could deliver the golden fleece - the 20% return - that also covered the heavy fees charged by those that managed the funds.

“Sure things” are often staples societies need to live…energy, housing, food, health care. Out of this capital allocation and concentration of investment, global societies did not get measurably better or more efficient energy infrastructure, housing markets, food supply and distribution and least of all, reliable, affordable, quality health care. What we have gotten is more expense and less supply.

The theory of a free market to allocate capital efficiently breaks down in the execution. Liquidity got concentrated in the hands of financial engineering. From that there came a waterfall of ways to hedge, go short and go long any sure thing. But there did not come an allocation of capital that fostered invention and development of the ideas that secure economies and reward wise investors.

Money flowed swiftly to few sources. It did not flow freely and steadily throughout the broad range of global demand’s needs. It’s how you get a locked up, debt-ridden global economic train that cannot produce any steam to carry itself forward.

Above all, money must be in constant motion, from investors’ hands to borrowers’ ideas to labor’s pocket to merchants’ cash registers. This loop is essential and fundamental for forward economic motion. A strategy of investing in sure things concentrates capital in scant few places that rely on societies suffrage to generate return to a limited investor base. This loop is detrimental to global economic motion and it’s the one we’ve got.

Their chance began in 2004, when the annual increase in housing values of 25% or more were taking place in a wage environment that saw 1 - 2% annual increases (incomes fund mortgages…). The credit rating triumvirate responded by drunkenly endorsing all quality of securities with housing underlying them, good and bad. Transaction based fee revenue is a powerful toxin.

Now they ask investors to respect their “downgrades” of sovereigns which took on the burden of the failed housing backed securities held by domestic banks, the ones the credit agencies ambitiously endorsed. It’s all but common knowledge that there has not been a AAA rated sovereign for many years. They all owe each other, in one form or another, via sovereign debt or through their banking systems (thus, even Germany has the risk) . The credit agencies are the last to know.

When the clock struck midnight on September 15, 2008, an old debt came up for reckoning. Since then, a great deal of posturing and manipulating of due dates by sovereigns, banks and corporations has pushed the reckoning out as best it could. Like gravity, the reckoning of the profligate and reckless global spend that occurred over a decade will have its way. At that point, there can be a renewal of growth and development. But nobody wants to pay.

Sovereign debt holders whine that they are due full value and if they don’t get it, they’ll not provide the free market capital that is the force behind global business. Where are they going to go? Where will they put their capital instead? They are as beholden to invest in the sovereigns & their markets as the sovereigns themselves are. It is economics 101. You can allocate, choose one over another, but the whole is a closed loop.

If the sovereigns suffer, so shall private capital. And the whimsy that Asia, China specifically, will be their investment of choice is laughable. China cannot establish its own currency as a reserve because it lacks the integrity of economics and politics that are the legs of a reserve currency. No one trusts it as a reserve…gold will tell you this. Add that its economy cannot act as a consumer of the world’s goods & services, only as a provider…and you have a sovereign that would tip along with all others.

An old spend waits to be reckoned. The rollovers and extensions are near expired. The losses will be shared by taxpayers and creditors alike…gravity will have its way. From that, the next phase of growth can find its footing.

The FT piece highlights the UK PWC matter came under the jurisdiction of a “soft” regulator who has oversight obligations for more than one professional discipline. Further, it was necessary to convene a tribunal comprised of parties who are not actively engaged in the oversight and discipline of the audit function on a daily basis.

The AADB (Accountancy and Actuarial Discipline Board ) cannot decide on its own penalties, however; instead, it has to convene a tribunal of three to five people that decides whether or not to uphold its case.

The FT piece also indicates the tribunal had significant concerns there was dialog and bargaining between PWC and the AADB, resulting in a compromised action:

The tribunal also criticised the AADB for not pursuing any individual PwC auditors.
It alluded to the possibility of a deal between the AADB and PwC in which the auditor co-operated in return for keeping partner names out of the public eye.

Another instance highlighting the canyon that exists in current global practices on the subject of sovereign auditor oversight involves the Shanghai office of D&T and its friction with the SEC, as illustrated by the CorporateCounsel.net’s blog:

The hearing will also highlight tensions between the SEC and Chinese issuer and auditor regulators who have failed to reach a written agreement on mutual assistance in securities investigations and supervision of audit firms despite talks during the summer of 2011. This sets the stage for either resolution of those tensions through negotiation or increased conflict between the two regulatory systems with unknown consequences for issuers and auditors in both capital markets.

The need for the audit is fundamental and common to all jurisdictions…assurance. The investor must be able to confidently rely on the financial statements and be assured of their accuracy and fairness in order to make an informed decision. Without the audit, there would be no tangible basis to rely on the financials or management’s representations re: the financials.

October 1929 gave birth to the mandatory audit in the US through enactment of the Securities & Exchange Acts. A definitive auditor oversight function was empowered through the PCAOB out of the larger Sarbanes-Oxley legislative process. The result is a single point of rulemaking, oversight and disciplinary action, focused on auditors of public companies.

Assurance is a generic need, common to all investors. It’s uniformly applicable across all jurisdictions. Yet the authority of the auditor and the oversight of their practices is not. If there are to be a single set of reporting principles and they are to be applied and interpreted consistently across all jurisdictions (i.e. “convergence”), it’s reasonable to conclude the authority and oversight of the auditor will need to be just as consistent. Otherwise, the consistency that is established at the standards level is lost at the assurance level.