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Corporate Governance and Financial Health

16414033-abstract-word-cloud-for-corporate-governance-with-related-tags-and-termsThree years ago I did some work for an independent credit rating agency utilizing a quantitative methodology to determine financial health of corporations.  Dr. Patrick Caragata founder of the firm conducted a study of 200 TSX listed firms with high CGI ratings (Governance Metrics International).   Dr. Caragata was seeking to determine the correlation of Corporate Governance (CG) and financial health.  His findings revealed that “CG ratings failed to indicate when a company was in poor health 75% of the time.  In fact, they wrongly identified 32% of weak companies as being highly rated on GMI.”

Dr. Caragata also extended his model to use financial health score as an early warning signal for a listed company’s share price.  KMV, established ratings agencies, Altman’s Z Score were also determined as lagging predictors of share price.  Dr. Caragata’s research on bond pricing and CDS where better predictors of financial health momentum and ultimate predictors of share price but still failed to correlate financial health score as an early warning signal for share prices.  The problem that the model continually encountered was that valuation always exhibited a bias towards share price (market momentum)  not financial health score.  The determination of a “fair value” based on historical spreads of financial health score and share price was overly and overtly price sensitive. Perhaps a signal of an inefficient market?  This was particularly true for bubble stock anomalies and commodity sensitive equities.

Purveyors of Business Process Management (BPM) suggest that listed practitioner’s of BPM trade at a 15% premium to non-practitioners.  I wonder if its marketing boast.  Though BPM is not CG;  it does speak to having CG excellence in the corporate DNA.   A cultural commitment   to sound practices create valuation premiums and sustainable business models.  That’s the message well managed companies consistently deliver as a central theme of their value proposition.  Integrating sound practices and CG excellence into the corporate culture does create valuation premiums because it suggests an intentionality of business process deeply wedded to the enterprise mission.

I believe the radical reconfiguration of Wall Street offers a telling example of incongruity of good CG practitioners and financial health.  It was always a self evident truth that Wall Street firms that folded or transformed into commercial banks were probably some of the best rated CG enterprises.  CG excellence can do nothing to save an enterprise with a structurally flawed business model.  Though CG excellence does presuppose a board of directors in tune with the vicissitudes of the market; who would have thought that we would be looking at the extinction of the global investment banking business?  Merrill Lynch, Morgan Stanley, Lehman Brothers, Bear Stearns and the mighty Goldman Sachs were walking dinosaurs with flawed unsustainable business models?  All either folded, were acquired or became FDIC insured commercial banks.  I still can’t believe it but it’s true.  The world is being turned upside down.

Sum2 is a firm believer in coupling quantitative and qualitative risk measures to maintain operational excellence to build a healthy sustainable enterprise.  Effective CG alone cannot assure financial health.  It  must be a critical pillar of the governance, risk and compliance (GRC) triad.

When we speak about the principles of good governance, how about the original dissertation on the ideal of governance excellence.  Seemingly an insistence on an honest evaluation of reality to determine what is good is all it takes.  Its really that simple.

Visit the blog Risk Rap and the Allegory of the Cave post on FAS 157:

Sum2 welcomes the opportunity to speak with partners who share our passion for GRC excellence.

originally published 6/12/13

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June 12, 2013 Posted by | Bear Stearns, business continuity, credit crisis, Credit Redi, culture, FASB, operations, risk management, sound practices, sustainability | , , , , , , , , , , , , , , , , , | Leave a comment

$700 Billion is a lot of Guacamole!

paulsonAn article in today’s  Forbes online entitled Trouble with TARP,  reports a growing concern by the Congressional Oversight Panel (COP) about the effectiveness of the $700 billion program.  The COP reports that the effectiveness of the program is difficult to determine due to lack of transparency of how funds were spent.  The COP report also states that the absence of any reporting guidelines for TARP participants impedes effective oversight.

The 145 page report starts with a retelling of the extreme conditions confronting the banking sector as the credit crisis exploded last autumn.  It also outlines the choices confronting regulators, legislators and industry executives as the crisis deepened.  We were led to believe by Treasury and Federal Reserve officials that the global banking system was in imminent  danger of collapse.  Nothing less then immediate and drastic measures taken by sovereign government officials and industry executives would prevent the catastrophic consequences of global economic carnage.  The report makes it clear that these market conditions were so extreme that regulators were navigating through uncharted waters.  Any remediation measures taken had little historical precedence to guide actions.  Hence Paulson was given carte blanche to handle the crisis with unprecedented latitude and executive facility.

As this blog reported earlier this week, the TARP was originally designed to acquire troubled assets from banking institutions.  TARP funds were earmarked to purchase mortgage backed securities and other derivatives whose distressed valuations severely eroded capital ratios and stressed banks balance sheets.  Hank Paulson later shifted the strategy and decided to inject TARP funds into the banks equity base.  This has done wonders for the shareholders of the banks but troubled assets remain on the banks balance sheet.  As the recession continues,  unemployment, home foreclosures, SME bankruptcies and the looming problem with commercial mortgage backed securities  (CMBS) are placing a new round of added strain on the banking system.

The TALF program is designed to draw private money into partnership with the government to acquire troubled assets from banks.  So far the program has received a tepid response.  I suspect that the principal factors inhibiting the expansion of the TALF program are numerous.  Chief among them is the inability of FASB to decide upon valuation guidelines of Level III Assets.  Banks holding distressed securities may also be reluctant to part with these assets because they have tremendous upside potential as the economy improves.

The COP also questioned the effectiveness of TARP because stress tests were only conducted on 19 banks.  The report states that additional  stress tests may be required because the previous tests failed to account for the length and depth and length of the recession.   Community banks are also of concern.  They face a perfect storm in challenging macroeconomic conditions.  Of particular concern is commercial real estate loans.  Many economists are concerned that high rate of loan defaults in commercial loan portfolios pose great threats to the community banking sector.

Though interest rates remain low due to the actions of the Federal Reserve,  lending by banks still remains weak.  SME’s are capital starved and bankruptcy rates are quickly rising.  SME’s are critical to any economic recovery scenario.  A strong SME sector is also crucial for a vibrant and profitable banking system.  Perhaps a second round of TARP funding may be required to get more credit flowing to SME’s.  If banks start failing again it would be devastating.  The Treasury and the Federal Reserve don’t have many bullets left to fire  because of all the previous expenditures and a waning political will of the people to continue to fund a systemically damaged banking system.

Risk: banks, SME, economy, credit, market

You Tube Video Music: Billie Holiday with Lester Young, Pennies from Heaven

August 13, 2009 Posted by | banking, credit crisis, economics, FASB, Paulson, real estate, recession, regulatory, SME, TALF, TARP, Treasury, Uncategorized, unemployment | , , , , , , , , , , , , , , , , , , , , , , , , , | Leave a comment

A Taxing Situation

irs-and-capitol1President Obama announced his intention to curb the use of offshore tax havens for multinational corporations.  The Treasury Department is looking to raise tax revenues and believes that by closing the use of offshore tax shelters it will be able to raise over $200 bn over the next ten years.  According to the New York Times,  firms like Citibank, Morgan Stanley, GE and Proctor and Gamble utilize hundreds of these type structures to shelter revenue from being taxed by the IRS.  It has effectively driven down the tax rates these companies pay and has been a key driver in maintaining corporate profitability.

This move should come as a surprise to no one.  The Treasury Department needs to find sources of tax revenues to cover the massive spending programs necessitated by the credit crisis and the global economic meltdown.  The TARP program designed to revitalize banks has  expenditures that amounted to $700 bn.  Amounts pledged for economic recovery through EESA, PPIP and ARRA will push Treasury Department expenditures targeting economic stimulus projects and programs to approximately $2 tn.  These amounts are over and above routine federal budget expenditures that is running significant deficits as well.

The planned move by the Treasury Department to rewrite the tax code may be an intentional effort to close budget deficits but it also represents a significant rise in tax audit risk.   For the past two years the IRS has been developing a practice strategy and organizational assets to more effectively enforce existing tax laws.  Private sector expertise, practices and resource has significantly out gunned the IRS’s ability to detect and develop a regulatory comprehension of the tax implications of the sophisticated multidomiciled structured transactions flowing through highly stratified and dispersed corporate structures.  The IRS is looking to level the playing field by adding to its arsenal of resources required to engage the high powered legal and accounting expertise that corporate entities employ.

The IRS has hired hundreds of new agents  and has developed risk based audit assessment guidelines for field agents when examining corporations with sophisticated structures and business models.  As such investment partnerships, global multinational corporations and companies utilizing offshore structures can expect to receive more attention from IRS examiners.

The IRS had developed Industry Focus Issues (IFI) to be used as an examination framework to guide audit engagements for sophisticated investment partnerships and  Large and Mid-size Businesses (LSMB).  The IFI for LSMB has developed three tiers of examination risk.  Each tier has comprises about 12 examination issues that will help examiners focus attention of audit resource on areas the agency considers as high probability for non-compliance.  Clearly the audit risk factors risk

To respond to this challenge, Sum2 developed an audit risk assessment program to assist CFO’s, tax managers, accountants and attorneys conduct a through IFI risk assessment.  The IRS Audit Risk Program (IARP) is a mitigation and management tool designed to temper the threat of tax audit risk.   A recent survey commissioned by Sum2 to measure industry awareness of IFI risk awareness indicated extremely low awareness of tax audit risk factors.

Sum2’s IARP helps corporate management and tax planners score exposure to each IFI risk factor.  It allows risk managers to score the severity of each exposure, mitigation capabilities, mitigation initiatives required to address risk factor, responsible parties and mitigation expenses. The IARP allows corporate boards and company management to make informed decisions on tax exposure risk, audit remediation strategies, arbitration preparation and tax controversy defense preparation.

The IARP links to all pertinent IRS documentation and information on each tax statute and IFI audit tier.  The IARP links to pertinent forms and allows for easy information retrieval and search capabilities of the vast IRS document libraries.  The IARP also has links to FASB to have instant access to latest information on accounting and valuation treatments for structured instruments.

The IARP is the newest risk application in the Profit|Optimizer product series.  The Profit|Optimizer is a enterprise risk management tool used by SME’s and industry service providers.

The IARP is available in two versions.

The IRS Audit Risk Program for investment partnerships (IARP)

Buy it on Amazon here: IARP

The Corporate Audit Risk Program (CARP)

Buy it on Amazon here: CARP

Sum2’s Audit Risk Survey results are here: IFI Audit Risk Survey

You Tube Video: Chairman of the Board, Pay to the Piper

May 6, 2009 Posted by | business, CPA, EESA, FASB, hedge funds, IARP, IRS, NP, private equity, risk management, Sum2, Tax, Treasury | , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , | Leave a comment

IRS Audit Risk Survey: Final Results

tax-returnSum2 is please to report the final results of the IRS Audit Risk Survey for Fund Managers. Sum2 has commissioned the survey to determine financial services industry awareness and readiness for IRS audit risk factors. The survey sought to determine industry awareness and readiness to address IRS Industry Focus Issue (IFI) risk exposures for hedge funds, private equity firms, RIAs, CTAs and corporations using offshore structures.

Survey Background

Due to the pressing revenue requirements of the United States Treasury and the need to raise funds by recognizing new sources of taxable revenue; hedge funds, private equity firms, CTA’s and other corporations that utilize elaborate corporate structures, engage in sophisticated transactions and recognize uncommon forms of revenue, losses and tax credits will increasingly fall under the considered focus of the IRS.

Since 2007 the IRS began to transition its organizational posture from a benign customer service resource to a more activist posture that is intent on assuring compliance and enforcement of US tax laws. Specifically the IRS has invested in its Large and Mid-Size Business Division (LMSB) to enhance its expertise and resources to more effectively address the tax audit challenges that the complexity and sophistication of investment management complexes present. The IRS has developed its industry issue competencies within its LMSB Division. It has developed a focused organizational structure that assigns issue ownership to specific executives and issue management teams. This vertical expertise is further enhanced with issue specialists to deepen the agencies competency capital and industry issue coordinators that lends administrative and agency management efficiency by ranking and coordinating responses to specific industry issues. IRS is building up its portfolio of skills and industry expertise to address the sophisticated agility of hedge fund industry tax professionals.

To better focus the resources of the agency the IRS has developed a Three Tiered Industry Focus Issues (IFI). Tier I issues are deemed most worthy of in depth examinations and any fund management company with exposure in these areas need to exercise more diligence in its preparation and response. Tier I issues are ranked by the IRS as being of high strategic importance when opening an audit examination. This is followed by Tier II and Tier III focus issues that include examination issues ranked according to strategic tax compliance risk and significance to the market vertical. Clearly the IRS is investing significant organizational and human capital to address complex tax issues of the industry. The IRS is making a significant institutional investment to discover potentially lucrative tax revenue streams that will help to address the massive budget deficits of the federal government.

Survey Results

The survey was open to fund management executives, corporate treasury, tax managers and industry service providers. CPAs, tax attorneys, compliance professionals, administrators, custodians and prime brokers were also invited to participate in the study. The survey was viewed by 478 people. The survey was completed by 43% of participants who began the survey.

Geographical breakdown of the survey participants were as follows:

  • North America 73%
  • Europe 21%
  • Asia 6%

The survey asked nine questions. The questions asked participants about their awareness of IFI that pertain to their fund or fund management practice and potential mitigation actions that they are considering to address audit risk.

The survey posed the following questions:

  • Are you aware of the Industry Focus Issues (IFI) the IRS has developed to determine a fund managers audit risk profile?
  • Are you aware of the organizational changes the IRS has made and how it may effect your firms response during an audit?
  • Are you aware of the Three IFI Tiers the IRS has developed to assess a funds audit risk profile?
  • Are you aware of how the Three IFI Tiers may affect your audit risk exposures?
  • Have you conducted any special planning sessions with internal staff to prepare for IFI audit risk exposures?
  • Has your outside auditor or tax attorney notified you of the potential impact of IFI risk?
  • Have you held any special planning meetings with your outside auditors or tax attorneys to mitigate IFI risk?
  • Have you had meetings with your prime brokers, custodians and administrators to address the information requirements of IFI risk?
  • Have you or do you plan to communicate the potential impact of IFI risk exposures to fund partners and investors?

Survey highlights included:

  • 21% of survey participants were aware of IFI
  • 7% of survey respondents planned to implement specific strategies to address IFI audit risk
  • 6% of survey respondents have received action alerts from CPA’s and tax attorney’s concerning IFI audit risk
  • 26% of survey respondents plan to alert fund investors to potential impact of IFI audit risk

Recommendations

Sum2 believes that survey results indicate extremely low awareness of IFI audit risk. Considering the recent trauma of the credit crisis, sensational fraud events and the devastating impact of last years adverse market conditions; fund managers and industry service providers must remain vigilant to mitigate this emerging risk factor.

These market developments and the prevailing political climate surrounding the financial services sector will bring the industry under heightened scrutiny by tax authorities and regulatory agencies. Unregulated hedge funds may be immune from some regulatory issues but added compliance and disclosure discipline may be imposed by significant counter-parties, such as prime brokers and custodians that are regulated institutions.

Market and regulatory developments has clearly raised the tax compliance and regulatory risk factors for hedge funds and other fund managers. Issues concerning FAS 157 security valuation, partnership domiciles and structure, fund liquidation and restructuring and complex transactions has increased the audit risk profile for the industry. Significant tax liabilities, penalties and expenses can be incurred if this risk factor is not met with a well considered risk management program.

In response to this industry threat, Sum2 has developed an IRS Audit Risk Program (IARP) that prepares fund management CFOs and industry service tax professionals to ascertain, manage and mitigate its IRS risk exposures within the Three IFI Tiers. The IARP provides a threat scoring methodology to ascertain risk levels for each IFI risk factor and aggregates overall IFI Tier exposures. The IARP uses a scoring methodology to determine level of preparedness to meet each of the 36 audit risk factors.

The IARP helps managers to outline mitigation actions required to address audit risk factors and determine potential exposures of each risk. The IARP calculates expenses associated with mitigation initiatives and assigns mitigation responsibility to staff members or service providers. The IARP links users to issue specific IRS resources, forms and documentation that will help you determine an IFI risk relevancy and the resources you need to address it.

The IARP will prove a valuable resource to help you manage your response to a tax audit. It will also prove itself to be a critical tool to coordinate and align internal and external resources to expeditiously manage and close protracted audit engagements, arbitration or litigation events. The IARP product is a vertical application of Sum2’s Profit|Optimizer product series.

The Profit|Optimizer is a C Level risk management tool that assists managers to uncover and mitigate business threats and spot opportunities to maintain profitability and sustainable growth.

The IARP product is available for down load on Amazon.com.

The product can also be purchased with a PayPal account: Sum2 e-commerce

Sum2 wishes to thank all who anonymously took part in the survey.

If you have any questions or would like to order an IARP please contact Sum2, LLC at 973.287.7535 or by email at customer.service@sum2.com.

April 20, 2009 Posted by | compliance, CPA, CTA, FASB, hedge funds, IARP, IRS, legal, NP, private equity, regulatory, risk management, Tax, Treasury | , , , , , , , , , , , , , , , , , , , , , , , , , , , , , | 5 Comments

Level Three Sinks Lower at GS

Interesting piece at CFO Magazine concerning fair value deterioration of Level Three Assets at Goldman Sachs during the month of August. Goldman Sachs reports that valuation of Level Three Assets dropped by 13%. It would be interesting to understand the impact of this collateral erosion had on GS’s largest counter-party AIG?

Was this the trigger that precursors the radical interventionist moves by the Treasury to purchase a controlling stake in AIG?

This insight will become most constructive as the Treasury begins its purchase program of toxic level three assets. Hammering Hank has hired Neel Kashkari one of his mentees from GS to head up the repurchase program. Mr. Kashkari is said to be a quantitative wiz kid and a real life rocket scientist to buy Level Three Assets from GS and other banks and create and manage a portfolio of toxic assets on behalf of the American taxpayers.

The CFO article can be viewed here.

You Tube Video: Goof Troop Level Three

Risk: collateral valuation, counter-party default,

October 8, 2008 Posted by | banking, credit crisis, EESA, FASB, TARP, Treasury | , , , , , , , , , | Leave a 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 | , , , , | 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 | , , , | Leave a comment