Will Lehman be Ernst & Young’s Enron?

That is the question everyone is asking after the publication of investigator Anton Valukas’s report suggesting that Lehman may have used an, um, unusual accounting practice — Repo 105 — to make it look as if its leverage was much lower at each quarter-end that in fact it was. The effect of this was to make it appear financially stronger than it was.

Ernst & Young arguably did not meet professional standards, both in investigating whistleblower allegations about the use of Repo 105 and in connection with the audit and review of Lehman’s financial statements, claims Mr Valukas.

reports the FT, though it also offers the surprising comment that “Accounting experts say the Lehman report will not be “an Enron” for Ernst & Young, in part because, with only four big accounting firms remaining, clients do not have many options to move elsewhere.” Oh, so that’s all right then — no matter what they may have done (if anything — and that is not established at this point), they can’t go down because there aren’t enough other auditors in the world to fill the gap.

Bad signal.

The FT have a reasonable slideshow on Repo 105 here, And there’s a pretty good explanation of the matter here by Simon Watkins of the Mail (of all sources).

Lehmans couldn’t get a US firm to sign off on the legality of the practice, so they took advice from Linklaters, who said it was doable under English law. Linkies’ comment to the New York Times’ DealBook team was standard:

The U.S. examiner’s report into the failure of Lehman Brothers includes references to English Law opinions which Linklaters gave in relation to a number of Lehman transactions. The examiner – who did not contact the firm during his investigations – does not criticise those opinions or say or suggest that they were wrong or improper. We have reviewed the opinions and are not aware of any facts or circumstances which would justify any criticism.

However, what I really love is the Lehman’s internal e-mail exchange quoted at the end of the NYT piece:

* “It’s basically window-dressing.”

* “I see … so it’s legally do-able but doesn’t look good when we actually do it? Does the rest of the street do it? Also is that why we have so much BS [balance sheet] to Rates Europe?”

* “Yes, No and yes. :)”

So, it seems to be a one-off practice to Lehman (see answer 2 above). I think E&Y are in trouble on this one.

Related posts:

1. IFRS: issues for auditors …and their carriers.  The FT carries a report (3...
2. managing cdo risks As news emerges that Merrill Lynch is posting a...

Eric Sprott has an excellent paper on the financial crisis and how we collectively appear to have learned nothing from it.

So where does this leave us for the decade ahead? In bad fiscal shape. It seems as if we’re just making the same mistakes over again, and on a far larger scale. We have passed the debt obligations of the financial system onto the governments. We have liquefied the system beyond any rational explanation, more than doubling the monetary base since the collapse of Lehman Brothers. Social Security, which was in balance in year 2000, is now underfunded by $15 trillion dollars. Total unfunded obligations of the US Government are now $104 trillion. If we add the $6 trillion of outstanding Fannie Mae and Freddie Mac debt and the $12 trillion of outstanding national debt, we arrive at a total US government debt obligation of $122 trillion. It’s a truly preposterous amount of money that will never be paid off in today’s dollars. As we wrote in our October 2009 article entitled “Dead Government Walking”, the US Government is on a trajectory to default on their obligations, and the same can realistically be said for the UK and Japan. The answer put forward by the US, UK and Japanese governments? Quantitative Easing and 0% interest rates. Have they learned nothing from the past decade?!

Indeed.
More thinking needed.

Related posts:

1. Goldman case just a distraction? Provocative but not wholly unpersuasive slant from zerohedge.Com, who...
2. 3 things wrong in the US economy There’s an interesting post from Hellasious on Sudden Debt...

Just when you thought it was all over, safe to go in the water etc, it looks like the banks are going to get hit all over again. Mrs. ReRisk has been predicting this for some time and it looks as if she is going to be vindicated.

From data compiled by DeMontfort[1] University, Savills estimate that there is £38bn of negative equity currently on investment properties but this might rise to £50bn once you factor in the drop in the underlying land values, or 25% of the entire lending book in round terms. Shopping centres are particularly badly affected, with as many as 1 in 5 capable right now of being put into receivership.

Accordingly, the banks are said to be doing what they can to keep the loans viable, even if it means only paying back the interest. The last thing they want is for the loans to materialize on their books.

But sooner or later, you have to guess that they will. One somehow doubts that anyone is squirrelling away the odd bonus payment to offset this.

Source: BBC News

Related posts:

1. Toyota D&O claims Oh dear. The train-wreck-in-slow-motion that is Toyota’s current crisis...

This article from the NYT does not make happy reading for D&O carriers.

It’s about a mortgage underwriter at WaMu, and is a telling, salutory tale (like so many that are emerging) of corporate greed and, more to the point, stupidity.

“If a loan came from a top loan officer, they didn’t care what the
situation was, you had to make that loan work,” she says. “You were
like a bad person if you declined a loan.”

One loan file was
filled with so many discrepancies that she felt certain it involved
mortgage fraud. She turned the loan down, she says, only to be scolded
by her supervisor.

“She told me, ‘This broker has closed over
$1 million with us and there is no reason you cannot make this loan
work,’ ” Ms. Cooper says. “I explained to her the loan was not good at
all, but she said I had to sign it.”

Uh-oh.

No related posts.

There’s an interesting post from Hellasious on Sudden Debt about the fundamental wrongs in the US economy (which shades over into general considerations on the American Way of Life).

His 3 facts are these:

Fact 1:
There is too much debt in the economy to be properly serviced by the
earned income generated. Total debt has doubled as a percentage of
disposable income in the past 25 years.

Fact 2: Saving has disappeared in the US. Every penny earned is consumed.

Fact 3:
There was wholesale removal of manufacturing from the economic base
after 2000 (aka China’s “miracle”). Millions of well paid jobs were
replaced by service sector jobs, many in the very low-pay area of
leisure and hospitality (waiters, chambermaids, etc.).

His conclusions are rather gloomy (basically, the end of the US as a super-power), though he does offer a way out — save more, spend less, don’t get in debt, move from consuming/servicing to producing.

The comments are thoughtful, particularly the riposte to the original post’s suggestions that we should make ’supercomputers and fuel-cells’ — might it be said that we only want to make these that to allow us the leisure time…to spend more, consume more etc etc.

Everyone has their competing theories of how we’ve got into this mess, but think we’re probably in for austere time — which may be no bad thing.

Related posts:

1. Pirates to back Citigroup? This just in on the e-mail: Somali Pirates in...
2. Doing nothing — to help the economy Re Risk goes mystical today. There’s an interesting assessment...
3. No global IMF In an article called Can the US Do An...

Two years ago, I was doing a deposition with a witness in a very long-running, very messy and very costly reinsurance dispute. It was the third time that we had been through the process, with various parties, so we were very familiar with the facts, the issues and the questions likely to be put.

Asking the questions were two warring factions, each represented by its lawyers. Faction 1 was represented by two very high-profile, top gun “name” partners from a leading US and international practice. Big hitters, with shiny white teeth (lots of them) and immaculate coiffures (discreetly checked from time to time). We’ll call them Mr S and Mr S.

Faction 2 was represented by a young guy, from a leading Wall Street firm. He was probably about two years qualified. Let’s call him Mr K.

The questions began. Mr S and Mr S had plainly arrived with a version of events and nothing we said was going to get in the way of that story. They were glib and superficial, failing properly to listen to the answers my client gave or to follow up on answers that would have taken them in a direction helpful to their case. (Bear in mind that my client was probably the key witness in a claim worth about USD500m). They took messages on their Blackberries while asking questions; they took no notes; they made snide comments about questions asked by Mr K, trying to bully him. They joked with each other. They were unimpressive.

Mr K, on the other hand, was more considered, more thoughtful and infinitely more subtle. He, too, had come with a story, but he wished to turn it over, analyse it and see whether it still stood up. He was careful, deliberate and listened intently. He entirely ignored the antics of the Messrs. S, refusing even to acknowledge their grandstanding. At the close of the session, he thanked my client for attending.

As we left, my guy turned to me and said “Those two were clowns, but the young guy was much more scary. Polite and well-mannered, but scary.” He was right.

My bet would always be on substance over form. Repeatedly, in the City, one sees Men of Froth rising to high levels. In the law, this is particularly surprising, especially if one takes the view, as I do, that a lawyer’s prime responsibility is to those instructing him. By all means aim to make money, but let that take a slight but definite back-seat to your professional duties. It’s a matter of emphasis, but an important one, I think.

There’s commercial sense to it, too. How often one sees a firm deciding to expand in a certain area, buying in a Man of Froth with a big name to lead the way, only to find after a year or so–an expensive year or so–that there was nothing beneath the foamy exterior. No clients, no income, no growth.

You have to grow these things carefully, with good people, time, diligence and patience. It’s a little like gardening.

A silver lining to this latest financial turmoil may be to bring people back to a more realistic appraisal of what actually works in business, including in the business of law.

Related posts:

1. A new form of ADR This said-to-be-true story (it’s in CNN so it must...

Excellent LRB article this week from Michael Kare, “professor of peace and world security studies at Hampshire College”[1] all about the world’s continuing, in fact growing dependence on oil – “the International Energy Agency (IEA) predicts that global consumption will rise from 86.9 million barrels a day in 2008 to 94.1 million in 2013.”

Professor Kare cites two things in particular as having exacerbated the current position.

First, the decision by the Chinese government in 1994 to make car ownership a central pillar of Chinese economic policy. The result?

Until 1994, China manufactured very few cars (in 1990, it was producing only 42,000 a year) and discouraged imports of foreign-made vehicles. But after Jiang Zemin’s State Planning Commission announced that car production was to become a ‘pillar’ of national economic development, with foreign companies invited to provide capital and knowhow, China soon became the developing world’s leading recipient of foreign direct investment. By 1998, it was making 500,000 cars a year; in 2002, it was making a million; a year later it was making two million.

…The growing availability of relatively affordable cars to China’s burgeoning middle class has also satisfied a long-suppressed desire. According to a recent US government estimate, the number of privately owned cars in China is expected to rise from 27 million in 2004 to 400 million in 2030.[emphasis added]

That’s a LOT more cars.

Second, the Bush Administration’s decision in 2001 to focus probably more heavily than ever on making the US economy dependent on oil, and foreign oil to boot.

Cheney came close to revealing his objective when he told reporters on 30 April 2001, two weeks before the NEP’s release: ‘Conservation may be a sign of personal virtue, but it is not a sufficient basis for a sound, comprehensive energy policy.’ Oil and other fossil fuels, he said, would remain America’s principal sources of energy for ‘years down the road’. To ensure this, the NEP called for increased drilling not only in the Arctic but in other protected wilderness areas, on public land in the American West, and in the outer continental shelf. Even more significant, the report openly assumed that the United States would become more rather than less dependent on imported oil, and urged the president to take a more active role in securing American access to foreign energy reserves. Of the report’s recommendations, around a third are aimed at bolstering US participation in global oil markets.

According to BP, US consumption rose by one million barrels a day over the course of Bush’s presidency while the output of domestic fields declined by roughly the same amount, pushing net imports up by two million barrels.

This isn’t just Bush-bashing, but you couldn’t make this up. It rather reminds me of the fanatical Nazi colonel, Hessler, in the Battle of the Bulge, dreaming of a future of eternal war — “Let’s make ourselves dependent on foreign oil so that we have to fight forever to secure it.” And make money doing it, of course.

In practical terms, for insurers and reinsurers, it means that the political risk landscape is changing. As the shift in focus of production shifts from North to South, so the perils change:

When the Petroleum Age began in the late 19th century, production was concentrated in the United States, Mexico, Romania and the Russian empire. This remained the case until well after the Second World War, with the US still providing half of the world’s oil in 1955. But the centre of production has moved ever southwards, to the Middle East, Africa, Central Asia and South America. Today, the US accounts for only 9.6 per cent of output; the Middle East for 30.1 per cent; Africa for 12.5 per cent and Latin America for 12.4 per cent. All told, the non-OECD countries now supply approximately three-quarters of the world’s oil.

This shift is important because most of the major developing-world producers were at one time or another ruled by the imperial powers and continue to bear the scars. Some, like Iraq, have borders that were devised by the imperial powers to meet their own needs and bear little relation to ethnic, religious or linguistic realities. Such regions are susceptible to involvement in violent struggles for regional autonomy or secession. The spoils of oil production often exacerbate these problems, by enhancing the attractions of separatism (especially if the oil fields are located in the ethnic territory involved, as in Angola’s Cabinda province or Iraqi Kurdistan) or of seizing national power (and thus taking control of the allocation of oil revenues).

This mirrors the same change in likely war scenarios that we have seen over the last 30 years, from the global block, total catastrophe nightmare to ‘limited wars’ largely played out in the Third World (and not so obviously by proxy). The leverage for the smaller players is much higher than it has been for an age (probably ever), and the scope for attack or threat of attack on points of vulnerability is enormous.

More volatility ahead. And probably higher prices, too.

See you at the petrol pumps.

[1] An unfortunate sounding title, I think.

Related posts:

1. IMF warns on global slowdown According to a report by the IMF to finance...
2. Woe, woe and thrice woe Just when the financial world is giving us severe...
3. PEMEX reform This week, the Mexican parliament will debate an energy...

[Warning: No reinsurance content]

There’s a difference between the two, of course.  Today, it rather looks as if justice took a back seat to ‘legality’ in the Lords.

First, they approved the extradition of computer hacker and self-styled ‘bumbling computer nerd’ Gary Mackinnon to the US.  Officials there are said to wish to see him ‘fry’, though on infers not literally.  Perhaps they’ll just stick to waterboarding.

Second, they find that the SFO Director, Robert Wardle, acted ‘lawfully’ in stopping their investigation into the BAE/Saudi alleged corruption affair, though Lord Bingham did have the wit and grace to say that “whether his decision was right or wrong was not at issue, rather whether it was one he was lawfully entitled to make.”  And he was, apparently.

You get the impression that they didn’t much like coming to the view they did, but then again the 5–0 verdict tends to show that they had little choice.  I wonder how the Court of Appeal got it so ‘wrong’.

Not the English legal system’s finest hour, one thinks.

Related posts:

1. Jackpot Justice The Pacific Research Institute has just released a study...
2. Crackdown offshore According to the FT today Companies based in the...
3. Limitation: A second bite at the cherry Summary Under the 1979 House of Lords’ decision in...

–Begin Daily Mail rant–

More ridiculous politically-correct nonsense from HM Government (following the Abu Qatada debacle). This time, according to the Times:

> THE Royal Navy, once the scourge of brigands on the high seas, has been told by the Foreign Office not to detain pirates because doing so may breach their human rights.

> Warships patrolling pirate-infested waters, such as those off Somalia, have been warned that there is also a risk that captured pirates could claim asylum in Britain.

> The Foreign Office has advised that pirates sent back to Somalia could have their human rights breached because, under Islamic law, they face beheading for murder or having a hand chopped off for theft.

Poor lambs.

The French showed a little more backbone recently. Their equivalent of the SBS first got the hostages freed, then went into Somalia and not only captured the kidnappers–members of the so-called “Somali Marines“–but also got the ransom monies back.

–end Daily Mail rant–

Related posts:

1. Pirates to back Citigroup? This just in on the e-mail: Somali Pirates in...

Following revelations of Mr Spitzer’s own alleged “irregular dealings” there is no little sense of satisfaction on Wall Street at his probable demise:

One might call it Shakespearian if there were a shred of nobleness in the story of Eliot Spitzer’s fall. There is none. Governor Spitzer, who made his career by specializing in not just the prosecution, but the ruin, of other men, is himself almost certainly ruined

writes the WSJ, in an article that cannot quite keep the glee out of its reporting. According to the FT “as the news broke, cheers were heard on the New York Stock Exchange floor”. I can imagine it.

Be interesting to see if he can extricate himself from this.

Related posts:

1. CDO woe In his ever-interesting blog Lars Toomre writes of big...
2. Virtual reinsurance Sometimes you wake up and find that your carefully...