Satyam - what were the lenders thinking?

I remember once having a very serious look at a particular (non-US) mortgage lending operation owned by Citigroup. I came from a banking culture where the first question you asked someone who wanted a loan was "why?"

Citigroup lent money in this operation purely against assets.

It was a great place to go if you wanted to borrow money no questions asked. It was "asset based lending".

Margin loans are always "asset based lending". You borrow against seemingly good security and they sell the security if the collateral isn't sufficient. Nobody asks you what you want the money for.

But perhaps they should. At least sometimes...

The broad outline of the Satyam fraud was that B. Ramalinga Raju produced fake accounts - with fake profits. The auditor however didn't pick up the fake accounts because the fake accounts accorded with actual cash flows.

The actual cash had to come from somewhere. It was injected by B. Ramalinga Raju and he obtained it by margining his shares.

He margined his shares for a billion dollars. A billion. Its a lot of money to just about anyone in the world.

And because they were margin loans nobody asked what he was doing with them.

But think about this rationally. Was he borrowing a billion dollars to spend? Well he didn't seem to live that lifestyle - and besides it probably really is impossible to spend that much.

So - presumably he was borrowing to invest...or so the bankers thought. The bankers should have asked for collateral - even secondary collateral - against what he was investing in.

But because it was a margin loan they didn't think to ask!

If only they had asked what B. Ramalinga Raju wanted a billion dollars for? No good answer probably means that there was no good reason to lend the money.


J

Auditors - a follow up...

This is strange – but anyone that thinks that markets necessarily get the right outcome is just plain wrong.

There is consensus amongst my readers that the big 4 accounting firms have little to recommend them.  They are bureaucratic, expensive, not particularly responsive to small customers and not particularly competent.  Frauds get through them rather frequently so they should not even give comfort.

There is a strong view (not a majority – but too strong to be ignored) that they are better for marketing purposes, and a view held by some that using a big 4 firm lowers my litigation risk.  

The case for using a big 4 firm comes down to the view that they are well known and appealing to clients but my competent one-state audit firm is not well known and is hence unappealing...

Now if Bronte Capital made its investment decisions this way we would soon be out of business.  Don’t worry about buying the best investment we can – buy the one that looks best to clients!  

But seriously the big 4 firms have a lot to answer for.  Three of them audited Madoff feeder funds and PWC has Satyam to add to its (long) list of distinctions.  They have between them audited all the big financials that got us into this mess – and yet – strangely – the mess that the audit world is in now is making the marketing value of a big 4 name even stronger.

This is really peculiar.  The firms that led us into this mess are the beneficiaries (at least at the moment) of the mess that they created.  This is the accounting firm equivalent of a CEO who blew up a company getting a $50 million severance.  

It stinks.

Next we are going to hear how important rating agencies are now that debt is defaulting.  Moody’s stock will go to infinity!

We are going to discuss this with our foundation clients – but the likely outcome is that we will chose the best firm rather than the name firm.  Treat this as “just another investment decision”.  [The foundation clients have a big say – and if they wish to go the other-way that is reluctantly what we will do.]

Future potential clients will just have to learn to live with that.

J

A call to sensible conservatives who still think the enlightenment was a good idea

Warning: non stock post - just my usual diatribe against people who argue from falsehoods...  

I have always admired the Alan Sokal hoax.  I thought I was a long way to the left of centre – but then I discovered post modernism.  Post modernism was a denial of the enlightenment to the extent that it denied the existence of “physical reality”.  In the post modernist dialectic no knowledge was superior to any other except the knowledge that no knowledge was superior to any other.  Your lying eyes deceived you as to facts – indeed facts were “socially constructed”.  If you are not familiar with the Sokal hoax this is the article which was published – and this is the simultaneous article exposing the hoax.  It is VERY funny.

Anyway the post-modernist position is absurd.  As Alan Sokal points out anyone who doesn’t believe in physical reality is invited to jump off his New York high-rise apartment balcony.

Now the Sokal hoax had a purpose – which was to try and reground the social sciences in reality.  Post Modernism has just about self-destructed.  Mission sort of accomplished.  

But it is not only the left that departed from reality.  One of President Bush’s senior advisors derided his critics for being “reality based”.  The putative Republican vice presidential candidate in the last election was off with the fairies on evolution.  And the right has had its fair share of climate change deniers – long on rhetoric, short on science.

One of the homes of the climate change deniers in Australia has been Quadrant Magazine – the formerly intelligent home of the literate right.  I even used to subscribe.  Quadrant has been under the editorial control of Keith Windshuttle – a historian who has made the fairly common transition from doyen of the trenchant left to doyen of the trenchant right.  He has made a career of questioning other people’s research and particularly other people’s footnotes.  Windshuttle was a personal favourite of our esteemed former Prime Minister (John Howard), and Howard was a favourite of Still-President Bush.  

Well Keith Windshuttle has been hoaxed.  It was a clever little diatribe on genetic engineering which got him – by a bogus author with a bogus argument and little heed to facts.  You can read the hoax here and the exposure here.  The hoaxer’s identity is now public too - and her politics and her motives are far too left-of-centre for my taste...  

Keith Windshuttle has a few dodgy self-defences – one being that Quadrant is not a science journal – and it should not be incumbent on him to check scientific arguments.  In which case why does he publish diatribes on the science of climate change?  

The main difference I can see between the Sokal hoax and the Quadrant hoax is that in the Sokal hoax the hoax came from the left – and its goal was to remove the vacuous end of the left so that there can be rational debate.  Sokal is an old lefty who even taught physics in Nicaragua.  The Quadrant hoax came from the left with the goal of exposing the right as vacuous.  (PJ O’Rourke – we need a clever right wing hoaxer!)

This is a chance (another one) for the right to clean up its act – and remove the vacuous elements of the right and improving discourse for everyone.  Just as Sokal’s hoax improved the quality of left-leaning debate by discrediting anti-enlightenment stupidity – can the right take up the challenge of cleaning itself up?  

In Australia a first step would be to sack Windshuttle from the editor’s position at Quadrant.  But who to replace him with?  Surely the right in the Western world still contains sufficient quality conservative intellect.  Or maybe the Bush/Howard era has shattered too many...  

Sensible conservatives who still think the enlightenment was a good idea – your time has come…

Please.  

Choice of audit firm – a request for comments from readers

We are in the process of setting up a small fund.  I don’t want to use the word “hedge fund” because we really will take positions rather than try to run a balanced book.  

And we need to choose an audit firm.  We won’t use leverage, we will be global and we intend on having proper third-party custody arrangements.  We should present low audit risk –we will pass the simple due-diligence tests which Madoff (should have) failed.  

Our current choice is a medium sized West Coast firm – a big name in San Francisco – but generally unknown outside that foggy town.  They have a professional staff of about 100 – they are not a fly-by-night three person operation.

However in the post-Madoff era the words “who is that auditor?” have a different meaning.  We are leaning towards a bigger name auditor – a big four firm.  That is a pity because our auditor has genuine expertise – we chose the partner because we like and trust him.  He will help keep us out of the many international tax problems that could befall a global fund for American partners running out of Australia.

The smaller firm in our opinion offers genuinely less risk (namely tax risk) for us and our clients and at a lower cost than a big four firm.  

So – how do people really feel about the 100 professional audit firm?  We want to use them.  Will it matter that you – our potential clients – have not heard of them?

And does it make any difference that three of the big four and the number 5 audit firms are all likely to face serious Madoff problems because they audited Madoff feeders?  It is going to be problematic for everyone now that Ernst and Young, KPMG and PWC all have a reasonable chance of failing as a result of auditing Madoff feeder funds.  (It seems that they spectacularly failed to do their job.)

This leads to another policy question: how do you build another big four (or six).  This four are all discredited!  Is there a role for an accounting firm with 200 partners capitalised with 200 million dollars?  How do you do start that sort of thing anyway?  

Hookers that still cost too much – some comments on the IMF and Latvia

This blog was early on giving a public cry on the Latvian economy.  I have the Latvian crisis to thank for a lot of my readership – it was about 50 per day until I wrote a post about the looming economic crisis in the Baltics – and illustrated the lack of competitiveness of the Baltic economy by talking about the price of prostitutes.  That single post raised my readership by over 1000 percent - and it has risen - albeit more slowly - ever since.  The post even warranted my first mention in the mainstream media – in the Estonian business press.

I guess it was subject matter.  With some cynicism I suggested that sex tourism was the main Latvian export – and if you wanted to know about the domestic competitiveness then you should look at the price of prostitutes.  The technocratic economists want to talk about “real effective exchange rates” and I just want to talk about the cost of getting laid.  Will the insanely clever PhD students out there (Claus you know I am talking about you) try to model that.  

Anyway if you really are interested in this I suggest you read the original post here…  It is (my opinion) one of the best posts on this blog – so I hope you will not think I am wasting your time.  

That said – the situation was that the Scandinavian banks – most notably Swedbank – had been funding the Latvian (and other Baltic) current account.  This was a fixed exchange rate but in an uncompetitive economy that was not accompanied by the monetary crunch that the theory would suggest because the Scandy banks (especially Swedbank) were acting as the Latvian central bank and borrowing in Euro and lending in Lats.  Locals told me that much of the lending was in Euro not Lats but the effect was the same.  The Latvian current account deficit was sustainable as long as Swedbank was guaranteeing it – and Swedbank kept its credibility.

Unfortunately in a financial crisis – and with management as inept as Swedbank – it is rather tricky to maintain credibility.  When trust in Swedbank eroded either (a) the Lat was about to get devalued massively – smashing up Swedbank either on currency risk or by making it impossible for Latvians to repay their Euro debt or (b) monetary policy – being a fixed exchange rate and an uncompetitive economy was about to re-assert itself and cause a great-depression level event in Latvia.  When Swedbank could not sterlise the current account deficit the Latvian central bank would be forced to do it causing a monetary crunch of massive proportions.

I argued that the other Baltic states were more sustainable than Latvia – Estonia being bad and Lithuania being about as unsustainable as the United States.

Well – if you haven’t been following events – they are playing out rather like my blog post.  Latvia has required an IMF bailout.  Estonia is in a rather nasty recession.  Lithuania is muddling on.  The order predicted in my original post.  

But – not in the scenario of the original post – the IMF has not required a devaluation of the Lat.  Apparently the pressure from the Scandinavian banks was large – and the Scandy governments (presumably political play-things of their banks) are large contributors to the bailout.  They have chosen a bailout with huge domestic contraction but a fixed peg.  The last time the IMF tried that was Argentina and it was eventually a disaster with the peso peg being abandoned anyway.  

There are plenty of raised eyebrows about the decision to keep the peg (see Krugman for instance) but the political economy is obvious…

First – abandonment of the peg is the most rapid way of showing the insolvency of the Scandy banks – and the Scandinavian governments are big contributors to the bailouts and – seemingly – political pawns of their banks.  

The second reason for not abandoning the peg in Latvia is that it would take about 15 seconds to decide the peg is doomed in Estonia as well – and maybe – because a trilogy is three tragedies performed in quick succession – in Lithuania as well.  

Anyway several people I admire (most notably a Fistful of Euros, Alpha Sources and also Krugman) have pointed out the obvious – that the monetary contraction that will happen will result in much lost production and loan failures anyway.  The monetary contraction however comes from the loss of credibility of the real Latvian Central Bank – Swedbank.  Once a real central bank has to give out its foreign exchange it will cause a crunch of gargantuan proportions.  

So – score this for Bronte Capital.  I admit my failures on this blog – and it is Christmas so I should indulge my successes.

As for how the bailout will work – I am with Edward Hugh of Fistful of Euros.  It is Argentina mark 2.  

And do I need evidence?  Well I have spent 15 minutes searching around on the web – and the prostitutes still cost too much (though their price seems to be declining).  If someone with first-hand experience wants to correct me then pop something (anonymously if you wish) in the comments.  

John Hempton

I have resisted pouring more scorn on the totally inept Swedbank – but I should remind people that they purchased a bank in the Ukraine early last year for USD735 million.  The bank had only 10 million of earnings – and most the 735 million was debt assumed.

They did this just in time for economic output to fall as much in the Ukraine as it did in the Great Depression in the US.  

Next time Swedbank management wants to blow half a billion I have a bridge to sell them in Sydney.  Their title will be just as good as their claim on the Ukraine!

This wouldn’t matter – but Swedbank was funding the Ukrainian current account deficit as well as the Latvian one – and when they stop the crash will be rather nasty. 

Santander also caught in the due diligence lie

The numbers are larger than at Bramdean – the lie is the same:

Intensive due diligence is vital to ensuring the integrity and sustainability of the investment process . . . Each investment undergoes lengthy and detailed scrutiny according to clearly defined manager selection criteria.

The website on which this lie was printed has been pulled.

As the FT points out it was impossible to do due diligence on your Madoff investments because Bernie did not allow it. But Santander claimed they did it as did certain other fund-of-fund businesses.

There is however much bigger consequences to Santander being caught in a lie. Santander – as do almost all English speaking banks – needs to raise money in wholesale markets.

Raising money depends on trust and as Jim Grant has just pointed out (and as this blog has pointed out several times) there is currently a “bear market in trust”.

If the trust in Santander fails then Santander fails. And that would be a very big piece of Bernie Madoff collateral damage.

J

Bramdean Alternative’s solvency problems

In my last post on Bramdean Asset Management (Nicola Horlick’s business) I suggested to Ms Horlick that she should make a statement to the stock exchange about how Bramdean Alternatives (what the website describes as the “flagship fund”) intends on funding capital calls by the private equity funds that they have invested in.

The problem of course includes that part of the money intended for capital calls was invested in Madoff Securities (via Defender – a Madoff feeder fund).  

No statement from Bradean Alternatives as how they plan to meet capital calls has been made.  In most jurisdictions a listed company has an obligation to keep the market fully informed.  However, failing a statement from Bramdean I thought I might spell the issues out.  

Almost all of this comes from the half yearly management accounts.

First the company has very substantial capital calls.  The half yearly statements detail them:

The Company was 88.8% invested at the end of the second quarter 2008. It has made commitments to sixteen underlying private equity funds and underlying specialty funds amounting to approximately US$224 million and the total amount that has been drawn-down on the commitments made is approximately US$59 million.

This is a very real problem.  The company has obligations to pay capital calls on funds it has already invested in of US165 million.  That is not chump change.

Moreover the most liquid parts of the portfolio – Madoff investments – are suddenly seriously illiquid.  Defender (a Madoff feeder) was specifically earmarked as part of a transitional portfolio – transitional because it was a place-holder for funds intended to meet capital calls.  (Fortunately however - and to give Bramdean some credit - they have raised some cash this year to meet capital calls.) 

Bramdean Asset Management thought that it was perfectly reasonable to overcommit Bramdean Alternatives: 

At 30 June 2008, the Company’s commitments to private equity and specialty funds accounted for 85.3%of its assets, representing an over-commitment of 1.22X, based on the Company’s commitments as a share of total net assets.  Any over-commitment may be managed through the Company’s cash holdings, through redemptions from the Transitional portfolio and through the use of gearing. The Company may gear by up to 25%of its net asset value, but has not employed this facility and had no debt at 30 June 2008.

In particular they thought that they could manage this by selling their “transitional portfolio” (that is Madoff), from cash holding and through the use of gearing.

Now the portfolio is down a lot since June 30.  At June 30 it was 263 million.  By October is was 220 million – and the private equity commitments were thus proportionately larger.  

Moreover they have not done spectacularly well in November and December will have wiped out the Madoff moneys (about 20 million more).  NAV is likely to be below US200 million – and the commitments to illiquid private equity type funds are over 220 million the majority of which has not been called.  Cash was about $50 million.  It will be very difficult to meet calls.

Oh, but in the June report they thought they could borrow the money to meet the capital calls.  That is what it says.  Now Nicola’s much vaunted due diligence process has been exposed as vacuous by Bernie Madoff – and the credit markets have tightened considerably – it is highly unlikely that anyone is going to lend Bramdean Alternatives money secured by the equity interest in a whole lot of 2007 private equity portfolios.  

Nicola Horlick lambasts her critics as sexist – and I admit I did call her a silly silly girl.  But capital calls are not gender specific and the cash drain and resulting insolvency is independent of Nicola’s gender.

I am sorry to say it – but Ms Horlick’s flagship fund looks like toast.  Maybe there is sufficient secondary market in the private equity funds for the fund to survive – but I doubt it.  

Maybe the capital calls will not come.  But I also doubt it.  It is however very hard to tell from the published accounts as the due date for the capital calls is not outlined.  

Moreover if they start testing the market for secondary pieces of funds applied for twelve months ago they will (at best) have to take very considerable write-downs.  The asset value of Bramdean Alternatives hardly reflects current market values on private equity investments made 12 months ago…

I consider this case more than just another piece of Bernie Madoff collateral damage.  It’s a real live case – and resolution is necessary for the restoration of trust to British Capital Markets.

What happens when this finally hits the wall?

It is not enough for the FSA to write off the looming insolvency of Bramdean Alternatives as just another credit crisis meltdown.  Bramdean made some very strong statements about how they do due diligence.  They made them in a prospectus and in annuals.  Here is the statement from the annual.  

The investment process is systematic and disciplined.  Due diligence is at its heart and around 3-4 months are typically spent analysing a potential manager, a process which includes a number of on-site visits with that manager. The process culminates in the provision of a detailed report that is then presented to and discussed at Bramdean’s Investment Committee, where a selection decision will be made on all private equity funds, specialty funds, and transitional investments. That Committee has to approve an investment unanimously before it can proceed. Where required, Bramdean will also conduct legal diligence.

Ongoing monitoring is similarly robust and includes regular reviews of market conditions and their potential effect on the underlying funds and any direct private equity investments. In response to the conclusions drawn from this process, the Investment Committee will decide whether or not to retain an investment.

There is little evidence that the statements are true (though I will take Nicola’s word for it).  Bernie Madoff famously did not let people do due diligence on him, but almost certainly Nicola – with her feminine charms was the exception.  Anyway if the due diligence was not done in the manner advertised – and moneys were raised on that basis then this is not just an unfortunate credit crisis bust but the raising of money on what look like false pretences.  But of course Nicola did the due diligence on Madoff, including several on-site visits and analysis over 3-4 months.

John Hempton

PS.  Nicola said her critics were sexist.  

Nicola wrapped the noose around her neck when she invested with Madoff.  The hangman has now pulled the lever.

It doesn’t matter one iota that the body is a woman and it is delusional to think otherwise.

PPS.  Why did I chose to pick on Nicola?  After all the last time Nicola crossed my consciousness was when she accepted a job at Australians Mutual Provident (AMP) and then did not come.  I am an Australian and Nicola Horlick is hardly a celebrity here.   A distant relative of mine is the chairman of the AMP - so I guess he offered her the job...

I genuinely wasn’t going to post anything.  I wrote the post with no intention of putting it up.  But then she accused her critics of being sexist – and blamed the SEC for the apparent failure to do her own homework.  That invited a response. 

And I wouldn’t have made a second post if she hadn’t changed her website.  

But as I dug I found more and more that is in the public interest.  The financial crisis in Bronte’s view will end when people learn to trust other people in financial markets – and here we had someone who had large – and potentially devastating capital calls trivialising her problems.  

This deserved a little exploration.

New World Capital Managment - a follow up...

I know my post on New World Capital Managment has nothing compared to recent frauds. But the failure to prosecute reaffirms my doubt in the integrity of financial markets. I am writing this down because restoring trust to financial markets is the key to stopping the second great depression.

The fund was run by Greg Duran under the rubric of “New World Capital Management”. There were other staff such as Tau Ngo, Jill Ballantyne, Kyung Britt and several others – but as far as I can tell these additional people were fictional. (Well one or two of them might be real...)  

Greg Duran is a real person and his career had largely been in the honourable profession of mortgage broking...  I can still find the odd phone number which he answers.

The fund had a fantastic record – with barely a down month and some months up to 66 percent returns.

At one point it was even Barclay’s top rated hedge fund globally – which, given that it was a fraud, says as much about Barclays as it does about New World.

Anyway as explained in the original post I rang their purported auditor. Spicer Jeffries confirmed that New World was a client (perhaps only a prospective client) and indicated that the claimed returns were not audited. To this day I do not understand why Spicer Jeffries did not call the police. The statement “audited by us” is the entire product of an audit firm – and failure to protect that phrase is – at best – sloppy work.

I also emailed the CEO of the purported prime broker and he reported my concerns to Gregory Duran. At best this shows shocking judgement, but my timeline indicates that it is possible that Ikon tipped off Mr Duran that he was being chased – and that Mr Duran took that opportunity to steal the rest of the funds under management. Certainly if I were filing a civil action to recover the money Ikon is a logical defendant. If a class action lawyer wishes to help out – then I will provide the emails and their date stamps.

In my original post I indicated that Gregory Duran had sucked in one New York based fund of funds. The whole rationale for a fund of funds is that they can do thorough due diligence. A fund of funds taken in by a single fraud this blatant should probably not exist. Several funds of funds will of course cease to exist post Madoff...  a fund of funds business in Madoff also should cease to exist.

I did not name the fund of funds that was sucked in as I had no desire to destroy their business. However Holding Capital Group named themselves – suing Gregory Duran to recover their own seed investment (but surprisingly not suing Gregory Duran on behalf of their clients who they also put in the fund).  [Funds of funds businesses in Madoff haven't all come out - but ashen faced silence is probably the best course of action...]

About six weeks after my first post on New World I was contacted by Neville S Hedley – and enforcement attorney at the CFTC. I thought great – the wheels of justice are slow – but at least they are turning. I spent about an hour on the phone with Mr Hedley – and Mr Hedley was familiar with many aspects of the “alleged fraud”. He left his guard down at some point – and just started referring to it as “the fraud”. When questioned on that he just said “well that is pretty indisputable” – possibly the finest judgement I have seen by anyone with any authority on this matter.

I was happy – but not for long. The problem turned out to be that whilst Gregory Duran claimed to trade futures (especially currency futures) to get these returns – there is no evidence that he ever traded anything. Because he did not actually trade Mr Hedley decided that the CFTC had no jurisdiction. Having no jurisdiction he couldn’t actually do anything and dropped the case. 

Mr Hedley said he was going to try and interest the state prosecutors (New Mexico) in the case – and he did so – but state prosecutors it seems couldn’t be bothered. I understand why prosecutors are reluctant to investigate live fraud cases – but this one is dead and the prosecution is an easy scalp.

This is just another appeal to restore integrity to US financial markets. The markets don’t work for lack of trust – and the reasons for that lack of trust are obvious to anyone who looks – this being another example.

John Hempton

Gentle understatement

The Dreier law firm closed down awful fast.  Its website is still up and there is no news on it about the firm’s liquidation.  If you ring 212-328-6111 you get the following beautifully understated message:

You have reached the office of Marc Drier.  At the present time he is not available to take your call.  If you require immediate assistance please dial zero for the operator and ask for Catherine…

The motto of the new era: live fast, die young, leave a pretty website. 

Weather and subprime mortgages

Maybe I am a little harsh on people... strange things happen.  Normal distributions are not normal.  

Paul Kedrosky has a wonderful post on river flows in San Diego.  

http://paul.kedrosky.com/archives/2008/12/17/weather_geekery.html

The weather flows are even more abnormal than mortgage pools with 30% default rates.  

The world is strange...

John Hempton