This blog aims to provide - in part - a morphology of sin - and alas like the loss-of-virginity and relationships that ensue - it is complicated.
Not everybody always sees it that way. Felix Salmon posted about "The Return of Obvious Graft" which is about three financial crimes and how simply he sees them. I quote:
It’s almost comforting to find a spate of financial scandals which involve simple, easy-to-understand illegal and unethical behavior, after all these years rummaging around in synthetic mezzanine collateralized debt obligations and the like. Three have particular salience right now:
(i) The Congressional insider-trading scandal. Spencer Bachus is the poster boy here: one minute he was getting highly confidential briefings from Hank Paulson and Ben Bernanke on the parlous state of the economy; the next he was loading up on contract options on Proshares Ultra-Short QQQ, a synthetic ETF designed to maximize profits when the stock market falls, and which is emphatically for day traders only.
(ii) Olympus, which now seems to have channeled more than $2.5 billion to yakuza crime syndicates, including the country’s largest, the Yamaguchi Gumi.
(iii) MF Global, which increasingly looks as though it stole money in customer accounts.
I am surprised that Felix - who is a bit of an aficionado of this sort of stuff - should boldly state that these three involve "involve simple, easy-to-understand illegal and unethical behavior". Felix is - I think - wrong about all three. In the second case I think Felix's error is important because it has investment implications.
Congressional trading scandals
The congressional trading scandal is simple enough - I can't think of any way in which is ethical for someone like Spencer Bachus - who is elected to represent a broad electorate - to use information that he gains as a representative to trade against the same people. Conflict of interest springs to mind. The problem is - as the article Felix links indicates - that the behavior probably isn't illegal. It should be. I don't disagree with Felix's sentiment here - just the fact of illegality is not clear.
The Olympus scandal is alas much harder. I spent about eighteen (almost continuous) hours recently looking at Olympus. I wish the story was as simple as Felix indicates because you would buy the stock with your ears pinned back. If the story was that $2.5 billion were simply stolen then you would have a business that could generate $2.5 billion (which makes it a very valuable business) and the looting would likely stop now. If the story was as simple as Felix says you would buy the stock as the business will continue to be highly profitable and the stock has cratered.
But Felix's story isn't even the official story now. The official story is that Olympus made some very large (albeit genuine) trading losses over a decade ago. It hid them. And hid them. And hid them. And its books did not balance so the hiding involved many senior staff. Then after many years (and towards the end of the careers of the malefactors) they sought to bring the books back into balance. So they jigged up some large fake acquisitions and paid a couple of billion for them. The money however was not looted - it was recirculated to fill the hole in the balance sheet from the trading losses.
If that story were true you would still probably buy the stock because that is still a story about a very profitable underlying business that will probably retain its profitability and a stock that has cratered.
Alas I am not sure even that story is true. At the core of Olympus is an amazingly profitable medical devices business. It makes gastrointestinal endoscopes - devices you stick you know where - and look for colorectal cancer. These devices are also used in operations. Stated revenue for this segment was 355 billion yen and operating profit was 69 billion yen. Put this in dollars because I don't think in yen - that is $4.6 billion in revenue and $890 million in operating profit. That is a lot of profit and a lot of revenue from peering where the sun don't shine.
My fear was that was too much profit. I could not convince myself that this business should be as profitable as all that. An alternative hypothesis occurred to me - which was that Olympus was sharply overstating the profit of its core medical devices business. Over time their accounts would then shift from reality - possibly by cumulatively more than a billion dollars. So some day they would chose to fill the hole (just as they supposedly filled the hole on the hidden trading losses). And then they did the fake acquisitions.
If my alternative hypothesis is correct then the case for buying Olympus stock evaporates. What you have is a cratered stock and a business that had been fraudulently overstating profits for years. And it has a lot of debt.
The underlying low-level-of-profitability hypothesis is more consistent with the debt load.
Olympus just isn't as simple as Felix makes out - and the differences have investment implications. If only it were simply looted.
What happened at MFGlobal is not clear. There is no question that client cash is missing - but there is some doubt as to whether it was "stolen" or whether something else happened to it.
A US based broker-dealer (though not broker-dealers in other jurisdictions) is obliged to keep client assets (usually securities) separate from firm assets. Usually this means that client assets which are not required to be pledged to support client balances are kept in a client segregated account. Client assets are allowed to be pledged but only to a low multiple (usually 1.4 times) the client balance and then only to support client obligations. In other words client assets can be pledged if the clients are leveraged.
Client cash is also meant to be segregated under similar terms. The problem is that client cash is not kept as cash - that is it is not bits of paper sitting in vaults. Client cash is kept as people usually keep cash - in bank deposits when it is small in volume and maybe in short dated government securities when it is large in volume. Brokers have always been allowed to buy government securities as a use of client cash.
If they held Euro cash then they would presumably be allowed to buy Euro government securities (and in Europe now that means German Bunds).
Robert Lenzer in Forbes suggested (and possibly with good evidence) that the cash was held as Italian, Greek and Spanish government bonds - possibly longer dated. These are Euro government bonds held against Euro cash - which would be OK if it were US Government bonds against US cash. But in Europe its a problem: European governments can't print the Euro so they are not riskless and the assets were long dated. In which case MF Global may have legally speculated with client money. This is not the simple, easy-to-understand illegal and unethical behavior of Felix's blog post - rather a glaring policy loophole. Moreover Lenzer suggests that MF Global actively lobbied to keep the loophole open.
Still I am not even sure of the Lenzer story. There is a story doing the rounds in Asia (meaning I have heard it from multiple sources) that Deutsch Bank and/or Goldman Sachs got the client assets - the client assets were posted as collateral maybe for client positions and maybe for MF Global's own positions. And the bulge-bracket guys snitched it.
Now if it were clearly marked as client collateral and DB or GS snitched it then the big-boys would be involved in theft. But if were not clearly marked as or somehow DB and GS were not informed that it was client collateral then DB and GS would be entitled to grab it. And if they grabbed client collateral then alas it is not there for the clients.
So it is a real question as to what collateral was posted to whom and who snatched it. That will be litigated for a long time - and a malicious - or for that matter a not-guilty party at MF Global is likely to tell the jury that they posted the collateral to Goldman Sachs and clearly told Goldies it was client collateral and that Goldman Sachs pinched it anyway. It may be a simple crime - but a simple defense - and one that many people would find intuitively appealing - is that Goldman Sachs et al, not MF Global, stole the money.
All I am saying is that Felix has picked yet another three which do not meet Felix's criteria of "simple, easy-to-understand illegal and unethical behavior". Financial crime - like any morphology of sin - is complicated. Almost always.
Thanks for a thoughtful article. I had a similar train of thought on Olympus - although I came out thinking the margins were 'possible'. Surgical device companies, Baxter springs to mind, have EBITDA margins north of 20%, but I'm no expert in this area.
As a side note, despite Japanese companies' general reputation (of being ethical, highly moral - at least my perception). There has been a history of accounting fraud to cover losses and maintain the facade of a well-run profitable company. My general sense is this is generally not for personal gains (there is always some), but more cultural in nature - hard to explain. So your analysis seems to fit... just a thought.
John, can you please elaborate on your concerns regarding Olympus's profitability?
What red flags do you see?
The problem I had was that I could not dismiss the possibility that the profit of the core business was fudged upwards. If I am going to walk straight into buying a fraudulent company I want to have a big edge when I buy it.
The company has flat too much debt to really have a business that profitable in a mature industry - but that is not really a red-flag - well it is - but its not a strong one.
I wanted to be more comfortable... maybe I had demands for comfort just a little too high.
If the client money went to Goldman Sachs there should be a paper trail indicating what the money was and what it was being pledged for. As soon as MF Global failed to identify the funds as belonging to clients in my opinion a crime was committed for which the responsible parties should go to prison for a very long time - unless the client account agreements permitted intermingling and/or use by MF Global of client cash balances as though they were loans from the clients to the MF Global.
Not certain here, but since insider trading rules are ill-defined in the US, it comes down to what the SEC or DOJ will prosecute -- here's an article on the topic:
Not that I expect anything to happen, but it would be possible to see a lot of the congressional insider trading stop with one or two cases filed by the DOJ.
There has been quite a lot of mention (by CME amongst others) of MF Globals' "sloppy" accounting practices which make it difficult to identify where the missing funds are.
I contend that the firm's accounting was deliberately sloppy to make the malpractice both harder to detect whilst in use and harder for anyone to apportion blame in the event that it was ever detected. I believe Corzine and others will attempt to use this as their first line of defence should they be charged with fraud.
To refer to their actions as exploiting a loophole misses the core tenet of what they did and IMO sounds apologist. These people took a calculated punt using other peoples money and lost it. If they won and their bets were made good then they walked away with excess profits for themselves and if they lost then it was someone elses problem..
Whilst the law may technically enable them to "invest" in shortnterm government securities, only an idiot can fail to see the difference between buying, for example, 2 year US treasuries and a 10 yr BTP.
I strongly suspect that Corzine will have the financial resources to defend himself for longer than the creditors and customers of MF Global can prosecute him and he will serve no jail term for his actions, if indeed he is ever even charged with a criminal act.
Quite frankly, the whole affair is both repugnant and demonstrates the depths to which the US financial system has sunk.
70% of acquisitions destroy shareholder value. I'd always thought the extra 20% came from the fact that companies do not usually willingly sell themselves for less than they're worth.
But now I wonder. Maybe that means 20% of acquisitions are exercises in hiding past malfeasance.
I very much suggest reading Mr. Jesus Huerta de Soto's "Money, Bank Credit and Economic Cycles" in regard to the client funds at MF Global.
I attempt to simplify: The confusion between "client funds" and "client loans to the bank" immanent in our fractional reserve banking system is a violation of traditional Roman law.
The violation of a basic principle of law will lead to misery in the long run. After the MF Global disaster no thinking investor can feels safe about anything he does not have physically in his hands. Everything is called into question and our modern system cannot run without trust.
There needs to be a deep reform at the roots in our legal and financial system to restore confidence and the rule of law and it may require radically simplifying and reasserting elemental rights, like a bank depositor's rights to "his money, placed with a custodian for his use, not the custodians. Otherwise he would have given the bank a loan."
How complicated is this? He didn't just own shares, he bought some...
Why isn't he in Jail?
In September 2008, Goldman Sachs received permission from the Fed to become a bank holding company and get access to loans from the Fed while Stephen Friedman, then chairman of the New York Federal Reserve’s board of directors, owned shares in Goldman Sachs and sat on its board of directors. The Fed gave Friedman a waiver from its conflict of interest rules but did not consult with the board nor did it publicly disclose the affiliation.
SF is not in jail because he rec'd a waiver from the Fed to add to his GS holdings. EZpz.
"The official story is that Olympus..."
No: The Olympus story is that Olympus....
"So they jigged up some large fake acquisitions and paid a couple of billion..."
Incorrect: The acquisitions were real; Olympus is claiming the payments were faked.
see this reuters article about what probably happened at MFG. just like AIG being short unlimited amounts of CDS contracts was perfectly legal, MFG could borrow from margin accounts to prop. invest. risk management was the problem, not legality.
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