Part II: The Failure of the American Social Contract Will Cause Profound Upheaval

The American Social Contract was the social and financial backbone for much of the economic progress made by America in the last 60 years. Its destruction will lead to the eventual and inevitable erosion of the middle class and meaningful prosperity for generations of future workers. The consequences of this disruption are profound.

As the middle class is slowly carved out and flattened, economic demand will continue to decrease, leading to stagnant and stalled economies. Monetary policies by central banks, which have traditionally primed the economic pumps through targeted interest rate cuts at key moments of crisis, have become largely irrelevant. These policies, which have rescued nearly every recession in the last 60 years, will become increasingly impotent. Currently, with interest rates in negative territory throughout the world, central bank monetary policies have been rendered ineffective in creating aggregate demand, the real culprit of the decades-long stagnation in Japan and most Western economies.

And economists are perplexed because the current cycle is unlike any they’ve ever witnessed. Keynesian intervention, long favored by the Democratic elite has, at one time or another throughout the last 60 years, been successfully applied to modern recessions to alleviate them. But most recently, monetary policy aimed at improving the economy following the Great Recession has largely failed to kick-start aggregate demand.

Supply-side fiscalists, the favored Republican Band-Aid to nearly every economic ailment, stresses that fiscal policy alone is enough to induce the expansion of businesses, which in turn would ultimately spur growth. This model, proposed and implemented by many Republican presidents, has markedly failed to remedy the country’s economic malaise, as overcapacity continues to plague most manufacturing countries.

Both remedies have failed to mitigate economic contraction, as the United States has steadily reduced overall tax rates for the last 30 years (fiscal, supply-side intervention), and interest rates have remained at historic lows for at least 10 years (monetary, Keynesian intervention), yet overall aggregate demand has remained stalled and barely budged.

The inevitable result of decreased economic demand and pervasive central bank interest rate manipulation are frequent asset bubbles. Interest rate manipulation has severely skewed asset allocation incentives in the United States, creating massive pricing bubbles in the stock market and real estate markets and among many other asset classes affected by this manipulation.

Banks and other traditional financial repositories have been stripped of any meaningful ability to provide investors with healthy returns on their invested assets, and these investors have turned to other investment vehicles for their funds. This outcome has driven up the value of these alternative investments to unrealistic valuations. These valuations have become meaningfully divorced from their inherent, income generating potential, and instead are based on fear and irrational expectations.


Category: The Economy
Part I: The History of the American Social Contract and Why it Failed

The American Social Contract has failed, and with it the moral justification that generations of Americans accepted in order to educate themselves, marry, raise families, build businesses, retire and pass the torch to each successive generation of workers. The contract itself was deceptively simple and plain, but breathtaking in its sweep of moral, financial and cultural imperatives: the youth of our country were expected to reasonably educate themselves and prepare themselves for the responsibility of adulthood and their place in America’s economic engine, in return, the American workplace would provide a haven for these skills, successively greater pay and responsibility, and sufficient security and income with which to bankroll an early retirement.

This compact, though, has turned into a Faustian deal. No longer are successive waves of well-schooled young adults strutting into a secure world with nearly guaranteed jobs. They are being increasingly told there is no place for them at the table; instead, they’re on their own. Ill equipped to compete with each other let alone with their much older siblings, they feel betrayed.

In order to understand the failure of the American Social Contract, it is important to first understand how it came into being and became the driver for most of America’s post World War II economic expansion. After World War II had lifted the nation from the ravages of the Depression, it was this implicit contract that guaranteed the loyalty of successive generations of workers to corporate America. This bi-lateral understanding between the corporate aristocracy and the governed ensured a steady stream of educated and industrious workers eager to improve their lives over each preceding generation.

America, the only economic giant largely unscarred by the ravages of World War II, became the world’s financial and economic engine, driving much of the developed world’s innovation and manufacturing. America innovated, created, supplied and manufactured much of the economic output required by a post-industrial world-order, suffered from little overseas competition and assumed the mantle of technological giant and innovator.


Category: The Economy
Thursday, 20 August 2015 23:28

Amazon, America's Dystopian Workplace

Amazon’s workplace culture is an Orwellian edifice filled with sabotage, subterfuge and fear

As a technology and retail giant and forebear to the internet’s gilded age, Amazon was founded on the marriage of relentless technological innovation to volume driven discount pricing, and has brutally and efficiently eliminated vast categories of retailers, industries and product categories along the way. The retail carnage induced by Amazon has resulted in the closing of thousands of brick-and-mortar stores and even many “category killers”, but saved American consumers untold millions throughout the years. But, in a biopic reminiscent of the Grapes of Wrath, Amazon’s post-Orwellian dystopia was laid bare in an epic piece this week by the New York Times, here.

The Time’s Jodi Kantor and David Streitfeld systematically portray Amazon as a soul-crushing, often brutal workplace more akin to Orwell’s “1984” rather than an enlightened, creative twenty-first century workplace, complete with its own thought-police, doublethink, Inner Party, Outer Party and Proles. Even the headline banner within the Time’s piece suggests a highly toxic workplace environment and nineteenth century vestige rather than that of a free-wheeling, free-thinking paragon of collaborative synergy. The article notes that the “company is conducting an experiment in how far it can push white-collar workers to get them to achieve its ever-expanding ambitions.”

What Kantor and Streitfeld brilliantly exposed was the amazing deception occasioned on an unsuspecting public and consumer, who for years has been accustomed to Amazon’s cheery and nearly zealous religious idolatry of its brand and image. The Land of Oz is revealed as a mere, nineteenth century sweatshop and cult, its unsuspecting victims the tens of thousands of young-ish workers, most with advanced degrees, who have been brainwashed to drink the kool-aid brewed by resident sociopath and psychopath Jeff Bezos, Amazon’s CEO.

The Bezos minions, called “Amabots” by fellow Amazonians, are encouraged to “become one with the system”. This is eerily reminiscent of Star Trek’s dystopian Borg Collective, which enforced the complete loss of individual identity to the greater “mother ship” and its goals and objectives.


Category: The Economy
The American medical system is perhaps the largest, "free-market" fraud being perpetrated on an otherwise, unassuming populace. This parasitic model continues to undermine our business competitiveness.

If I described a market with little to no transparency in its pricing mechanism, purposeful price manipulation, extraordinary barriers to entry created by market participants themselves, little competitive bidding, severe influence peddling by lobbyists and pricing that has no relationship to the underlying costs, I would essentially be describing a market severely manipulated by anti-competitive cartels and likely subject to antitrust regulation by federal and state authorities.

In fact, these characteristics describe the institutionally corrupt and highly manipulated “free-market” of the American medical system. In a series of articles published by the New York times, here, here, and here, the Times outlined the dirty secrets characterizing this purportedly free market system, and the severe disparities in costs to the consumer between the United States and the rest of the world.

As outlined below, what emerges is a portrait of an institutionally corrupt medical cartel that purposely distorts pricing, making meaningful evaluations between providers nearly impossible. Rather than going down, as prices invariably do as markets become commoditized, medical costs in the United States typically escalate over time.

Medical manufacturers dole out hundreds of millions of dollars annually for consulting, royalties and other activities to physicians in an effort to buy loyalty. The Justice Department has, in the past, accused medical manufacturers of paying kickbacks, and has assessed hundred of millions of dollars in fines.

While the government targets overt fraud perpetrated by criminals on the Medicare and Medicaid entitlement programs, it has failed to even acknowledge the presence of the institutional fraud that has been “baked” into the system by the pharma-medical device complex. As a result the United States has the highest medical costs of any established country, and essentially subsidizes the entire world, most of which has enshrined cost constraints and price caps into their medical systems.

The United States has long refused to acknowledge that price constraints, enacted by every major first-world country, are necessary and vital in controlling costs. Instead, the pharma-medical device and insurance industry complex continues to advocate and push for “denial-of-care” or service limitations as the primary tool in controlling costs. Denial of care has essentially become the only cost cutting tool available in the arsenal, while medical cost inflation continues unabated. The federal government has consistently refused to intervene directly, as Medicare has never negotiated directly with manufacturers, but offers instead all-inclusive payments for surgeries to hospitals to prompt them to bargain harder for better prices.

The extreme undesirability of imposing price constraints and caps on medical devices and drugs reflects the quaint notion that the American medical system is somehow a “free-market” and market driven. As the Times illustrated, the entire system is essentially manipulated and pricing is artificially inflated through coercive intrusion and pricing irregularities.

Category: The Economy
America continues to slog through the same path as our Roman ancestors, as it allows institutional forces from within to destroy what forces from without could not destroy

Fraud takes many forms, oftentimes it is disguised and deeply embedded within the cultural, economic or social systems that most take for granted. Other times, fraud is overt, specific and perpetrated by outside forces. The police, our local and federal governments, private investigators, or internal audits target the obvious, non-institutional frauds, whether personal, financial, social or economic.

Examples of these overt frauds are criminal activity, Medicare fraud, insurance fraud, personal infidelity, or the failure of corporate governance. These types of fraud, though, are relatively easy to detect and spot, and are generally correctable given sufficient remedial activity. Institutional fraud, on the other hand, is pervasive and endemic to our society.

History often repeats itself, and from it America can divine its future, or at least one version of that future. A brief history lesson will highlight the perils of ignoring deep institutional fraud domestically and the risks associated with it. The Roman Empire concerned itself with empire building, marching vast armies for years through conquered territories, but ignored the institutional decay that was ossifying the Roman homeland. Ultimately, it was not merely enemy armies that collapsed the empire, but the collapse of economic, social and moral structures deep within the empire.

Likewise, the United States continues to project formidable military and economic strength abroad, and is perceived as a protector of Western values and cultural institutions. This role protects the oligarchic military industrial complex and the enormous profits derived from these missions, but much like the Romans ignores the enormous costs and social impacts inherent in maintaining this infrastructure. The Chinese, much like the barbarians that faced the Roman armies, threaten to broach our economic and military borders not because of advanced technology or superior skill, but because of sheer brute strength and population size.

Similarly, the German Wehrmacht, the most formidable military machine ever assembled, was overwhelmed by waves of Russian divisions in World War II.  In spite of possessing advanced technology and brilliant military tacticians, the Germans were slaughtered by waves of Russian soldiers, even as Germans killed 20 Russians for every slaughtered German. Both China and Russia currently have a near endless supply of labor, both militarily and economically, with which to rout American interests in the very near future.

Why is this history lesson critically important to us at this juncture? Because, as a nation facing some steep challenges economically, socially and culturally, we have chosen to ignore the deep institutional fraud that is fraying our homeland institutions. Instead, we continue to see risks only abroad, and ignore the destruction of our own homeland. These risks will consume us long before the Chinese or Russians have imposed their will.


Category: Wall Street Fraud
Saturday, 07 July 2012 05:11

You Know That I'm Not Easy Featured

Inside the Mind of a Pathological Narcissist, an Emotional Fraudster

Hey. Recognize me? I am the person who rebuilt your self-esteem, the one who became your soul mate. We were so compatible, you and I, we seemingly had everything in common. We feasted, entertained, and had meaningful and deep conversations among us. Our time together was a matter of urgency, with not a moment to waste. We needed to be together, constantly and continually. I called you repeatedly, sometimes 15 times daily. I built you up when you were down, and offered confidence when you doubted. I sparked your interest when you were bored and breathed excitement into your daily routine.

We slept together on our first date, careless and carefree, looked each other in the eyes that morning, and laughed through the afternoon at our careless abandon. I made you feel needed, wanted, protected, necessary, loved, and euphoric. I listened to you, sparked your interest, felt your pain, and made you feel alive. I was your inspiration and your role model, the one you aspired to emulate, the one who made you glow.

I brought you into my family, thrust my son upon you, and you felt alive. He bonded with you quickly, so much so that you nearly appeared to be his natural father. To the world, we were a real family, and I convinced you that you were a great father. My boy adored you, worshipped you, and emulated you. I made sure that you and he quickly adapted to each other and cared deeply for one another.

I made you feel young again, in love, carefree and passionate. We enjoyed much fun together early in our relationship. We danced, ate, partied and drank, all in the guise of love and seduction. I appeared to care, and learned to mimic your emotions. I observed you carefully, and mirrored your feelings, always careful to reflect back an empathic and supportive mate. Our sexual abandon made you feel wonderful and creative, and I complied with every one of your wishes, knowing how important this act was to you. You were exhilarated at my youthful imagination and energy. I mimicked compassion, caring, affection, emotion and tenderness, and reflected back your needs.


Category: Financial Fraud
Monday, 10 October 2011 22:53

A Matter of First Impression

In a matter of first impression in Puerto Rico, and applying Delaware law, District Judge Gustavo Gelpi dismissed all the claims against 11 defendants, all of whom were the most senior executives at Westernbank, formerly Puerto Rico’s second largest bank. Westernbank, a $10 billion bank with hundreds of branches scattered throughout the island, was closed by the FDIC in 2010 for reasons unrelated to the lawsuit. 

The derivative lawsuit, brought by a shareholder of the bank, alleged that the majority of the board of directors and senior management purposely ignored the warning signs of a massive, $200 million structured fraud initiated against the bank’s asset based lending division by a significant client of the bank. The shareholder claims included breach of fiduciary duties as officers and directors of the bank, waste of corporate assets, unjust enrichment, Sarbanes-Oxley violations, and violations of numerous Puerto Rican statutes.

Attorneys Carlos F. Concepcion, Manuel A. Rodriguez and Scott A. Burr, and Forensic Investigator and CPA Francisco Gomez, assisted the Special Litigation Committee of the board of directors in determining the viability of multiple derivative claims initiated against the bank’s officers and directors.

The investigation involved a review and analysis of over 100,000 documents related to the fraud and interviews of nearly 40 bank officials, directors and officers with knowledge of the events leading to the fraud. The Committee’s report, a nearly 200 page single-spaced report detailing its factual and legal analysis, was ultimately filed with the court along with the Committee’s motion to terminate or otherwise dismiss the case. The factual investigation also required detailed analysis of Westernbank’s internal control systems and their remediation that resulted from nearly a dozen third-party reports and analysis.

Category: Financial Fraud

The overwhelming amount of fraud occurring and uncovered in South Florida, including mortgage, banking, securities, and regulatory fraud demands at least a cursory analysis of the personalities and behavior that typify these fraudsters. Stanford, Rothstein, Freeman, Tolz, etc., are merely the tip of a very large iceberg penetrating South Florida.

I am often asked to explain, or even justify, criminal behavior, not merely for the sake of curiosity, but to prevent being swindled by these schemers. We believe that if we can understand the criminal mind, we can identify their attributes and prevent from getting swindled. Unfortunately, the pathology of crime is far more complex than we dare imagine.

There are two ways of preventing a fraud from occurring. One technique is quantitative, and involves the use of sophisticated due diligence to ferret out the fraud or any inconsistencies in the fraudster’s “stories”. These quantitative techniques take the form of pre-investment financial due diligence, background checks, verification of financial history with third-party sources, current customer verification, etc. These quantitative techniques are typically performed before investments are made and throughout the history of the investment. Unfortunately, very little of these techniques are actually performed, witness the Madoff scandal. Here, very little, if any, investigative due- diligence was ever performed, and even when it was, the SEC summarily dismissed it.

The second technique, the subject of this article, is far more complex and qualitative. It involves understanding and profiling the criminal pathology as a means of detecting potential firestorms later. This subtle technique involves profiling the types of personalities that might be inclined to commit criminal fraud.



Category: Financial Fraud
Saturday, 27 August 2011 06:18

The Guy in the Gray Range Rover

The US has begun a long slog into the cycle of decay and vacuum of leadership that characterizes all great empires whose suns are fading.

We have witnessed the hubris of endless cycles of war and conquest that have characterized the Roman, Greek, British and Spanish empires, and more recently, the German Reich and the Soviet Union. Nearly every continent and empire has held unbridled power briefly, but none has been able to hold it for long. The Romans succeeded chiefly because of the relative weakness and tribal instincts that characterized their vanquished enemies, but even they were ultimately defeated by their own demons and internal failings.

These failings were principally characterized by an inability to recognize the unsustainable nature of their societies and the economic models on which they were premised. Marching vast armies through multiple continents became economically and politically unsustainable for the Roman Empire, which entrusted its unceasing demands for territory and power to professional armies that would spend years abroad and far removed from the Roman homeland. The German Army would march its Panzer units abroad for years, virtually requiring that these specialized army units reposition themselves as occupiers, rather than conquistadors.

Meanwhile, the local populace, ignorant of the back-breaking cost of these armadas, continued to cheer the endless conquests and territorial expansion of their homelands. Nationalistic fervor and pride, bordering on nihilistic self-approbation, continued unabated. No sacrifice was required, no penalty or tax was paid for this unceasing expansion, until virtually the end of their empires. The populace was ultimately deluded into a vision of guilt-free expansion, politically and economically, that required no excessive or burdensome levy on their current lifestyles.


Category: The Economy
Can human behavior be accurately predicted, or is it too complex and nuanced to quantify and discern through  modeling?

Predictive modeling, the process by which a model is created or chosen to try to best predict the probability of an outcome, has lost credibility as a forecasting tool. Overly simplistic models have failed to account for the sheer complexity of human interaction and the degree to which most people behave irrationally. Most predictive economic models presume that people behave rationally most of the time, a premise which is terribly flawed but which serves as the intellectual foundation of many current economic models (See the Wall Street Journal article on this issue, here).

Predictive modeling has seeped into nearly every facet of our decision-making. It has been the cornerstone for most economic models for decades, and lately it has even attempted to predict consumer behavior. Companies like Amazon use predictive modeling to determine what consumers will purchase, and even suggest purchase alternatives based on what other consumers have purchased after reviewing the same item that the consumer initially looked at.

These models are quite good at predicting outcomes provided that the input variables, or human choices, are extremely limited. Thus, Amazon’s ability to predict what a consumer might purchase after having reviewed a particular item on its website is quite good, because the range of inputs and variables necessary to make that prediction is low.

Category: The Economy
Tuesday, 12 April 2011 16:33

The New Normal

Jobs: 1998, Commerce: 1999, Housing: 2002, Tourism, 2005, Mood: 2003.

Those are the years to which the Great Recession has propelled South Florida’s economy. In a series entitled Economic Time Travel, The Miami Herald, here, and here, recently provided evidence of the stark reality that many businesses and consumers face.

The Herald study tracked 60 different monthly indicators, from revenue generated by hotels, building permits, home re-sales, unemployment, cargo volume, taxes, and many others, all weighted based on their relative importance to the economy as judged by economists, analysts and industry leaders.

Collectively, the Great Recession sent the South Florida economy back to 2002. Individually, many sectors have fared much worse, such as commerce and the overall business climate. The jobs market slid back to levels unseen since 1998. Only tourism and trade, two sectors that support lower level, service sector jobs, have prospered and bounced back.

60 economic indicators can’t be wrong about what we’ve all intuitively felt for a few years: we’re crawling backwards, not forwards economically. Our standard of living, earnings and our purchasing power have declined significantly, yet prices continue to march forward. Commodity prices have surged, and gas is poised to surpass the record levels reached in 2008. Nearly every family has been directly or indirectly affected by this economic malaise.

Category: The Economy
Wednesday, 02 February 2011 17:25

Jackson's Institutional Incompetence

Miami-Dade County's Jackson Memorial Hospital is Adrift in a Sea of Incompetent Executive Management

The utter contempt that Jackson Memorial Hospital’s managing board, the Public Health Trust, and the Miami-Dade County Commission, have displayed for the residents of Miami-Dade County and the Jackson health system has reached a new high.

The Miami Herald reports, here, that the treasurer of Jackson Health System’s governing board noted this week that cash is getting “dangerously low” and that major cost cuts may be needed. Currently, Jackson will likely end the month of January with only 16.7 days of cash on hand. Hospital’s median day’s cash on hand is closer to 90 days cash, making Jackson’s days cash on hand ratio abysmal, and a true operating emergency.

Additionally, Jackson experienced a 7 percent drop in patient revenue, a material and significant decrease to any business entity. The impact on Jackson, though, is pronounced, given its already weakened financial condition and its primary mission of serving the uninsured.

Jackson’s real problems are the result of institutional ignorance and complacency. This author was briefly involved in the nomination process to sit on the Public Health Trust, and met with a panel of Miami-Dade County commissioners, Florida legislators, Public Health Trust members, and other important local politicians.

Category: Financial Fraud
Friday, 28 January 2011 22:24

The Land of the Falling Sun

Post-Industrial Japan’s Developing Caste and Generational Inequality are Strangling Younger Workers 

In an ominous warning to other, post-industrial developed economies, Japan seems mired in an economic straitjacket decades in the making. A majority of its younger workers are unable to find permanent, regular jobs, and feel increasingly marginalized. Instead, Japan’s corporate structure is geared towards protecting its aging population and bloated pension systems.

A recent article in the New York Times, here, highlights the individual distress felt by its young workers. Amazingly, this has resulted in a “brain-drain” of highly educated Japanese to other countries and threatens to stunt economic growth for generations. This generational inequality is partly to blame for Standard & Poors recent downgrade of Japan’s sovereign debt.

Last year, nearly 45% of young workers held “irregular” jobs, akin to contract labor in the United States. These jobs offer low pay, no benefits, and no pension. Only 56.7% of university seniors received job offers in 2010, an all-time low.

The graying of Japan and its reluctance to undertake the structural changes necessary to include young adults in its economy is producing a new, “lost generation” of disenfranchised youth. These second-class citizens will endure a rapidly-declining standard of living and a widening gulf between the “castes”.

The cultural ethos prevalent in Japan encourages conformity and obedience. Japan’s economic engine thrived on this ethos and their ability to mold university graduates to the firm’s culture. This allegiance to the firm produced a robotic, nearly mechanical worker whose primary goal was the maximization of firm profits and revenue growth.

Unfortunately, this ethos is obsolete, and Japan’s near absolute reliance on this standard has stunted the growth of individualism and entrepreneurship. Japan has few initial public offerings, and Japanese entrepreneurs primarily skew older.


Category: The Economy
Wednesday, 08 December 2010 23:44

The Pain of Deceit

Our national, economic betrayal is merely a symptom of much larger, personal betrayal

As the current year fades and the new year begins, a trend continues to emerge in our society that is every bit as damaging as the economic fraud that has nearly plunged our country into another depression.

This fraud, which I’ve dubbed emotional deceit, is the constant betrayal of mutual trust and respect that has seeped into nearly every corner of our personal lives. The resulting emotional upheaval leaves a trail of destruction so bitter and permanent that it threatens our social and moral fabric.

What are some of the signs and symptoms of emotional deceit in society? The betrayal by Wall Street of any sense of decency, the lack of moral courage, and the demise of corporate values are all examples, and continue to shred our economy.   

What occurred on Wall Street didn’t merely shock the economy into near-depression, but it ripped the veneer from the socially accepted notion that some level of decency and good-will existed between the participants in this free-market experiment. It doesn’t, and it never will, again.

Everyone’s on their own, adrift within their own, tiny life-boat. Our grand economic experiment now shifts from one of growth for all to a relentless search for economic survival and subsistence.

On a much deeper level, though, emotional deceit has seeped into the very fabric and essence of our personal relationships. The deep mistrust and cynicism that characterizes the economy and its participants now also pervades our personal relationships.


Category: The Economy

Current financial reporting practices often produce fictional and sometimes aberrant statements that are misleading if not outright fraudulent.  For example, consolidated financial statements are traps for the unwary, hiding and masking transactions through Byzantine group structures and idiosyncratic consolidating techniques.

Consolidation procedures require that inter-group transactions be eliminated when the financial statements of the group are consolidated, on the theory that this procedure eliminates transactions between the group that are not at arm’s length and which may in fact be shams. But consolidation accounting has another, less obvious yet insidious result – it purposely conceals and buries subsidiary information within the group's consolidation, hiding both the enlightening and damaging aspects of subsidiary performance within the whole.

Consolidation accounting purports to represent the economic activity of a group of legally separate and unique entities under the fictional mantra of the group, relying on economic form over legal form and financial substance. They conceal data that might normally be available to users of financial statements, and may serve to hide data from shareholders and creditors that is damaging or otherwise disparaging.

Data not found in unconsolidated financial reports mysteriously appear in consolidated statements under the guise of economic substance, yet bear little relation to real-world substance and the individual, disaggregated accounts of the subsidiary. This theory of aggregation is contrary to the norms found in GAAP – that of full disclosure and careful consideration of an entity’s viability as a going concern.

Prevailing consolidation techniques ignore the legal and financial implications that the aggregated assets and liabilities are neither owned nor made available to the group. This group mentality encourages users and readers of financial statements to view the entities of the consolidated group as virtual branches of the parent, again creating a dangerous fiction rendering the financial statements less meaningful. The grandest of these fictions, though, is the assumption engendered by consolidation accounting that profits and losses of the subsidiary entities will pass through to the parent entity through dividend payments.

Category: Financial Fraud
Tuesday, 31 August 2010 22:08

Earnings Management: An Academic Primer

Our financial reporting system is under siege as never before. Corporations are under intense pressure from shareholders to meet or exceed earnings targets. Globalization continues to relentlessly compress profit margins. The response from many companies has been dramatic: radically reduce expenses by slashing services, wages and benefits, raise prices whenever possible, and employ accounting gimmicks and sleight-of-hand to manipulate earnings whenever these measures fall short.

These gimmicks, some quite elaborate, have resulted in a string of accounting failures and corporate scandals. Accounting failures have become rampant and more pervasive, undermining the credibility of the accounting profession and the inherent reliability of the financial reporting model as an evaluative tool in shaping investor confidence and awareness.

The financial statements, which include both quantitative and qualitative information, purport to transmit the financial data of an entity or group of entities into a prescribed format that stakeholders of that entity can use as a means of evaluating the financial health and viability of that entity. Financial statements must be able to accurately and faithfully convey the economic substance of a transaction, over a period of time, and as of a given date.

Financial information presented in these statements must be capable of accurate comparison to financial statements of other entities. These other entities may or may not be within the same industry as the target company, and the financial statements must convey the economic substance of the transaction rather than merely the economic form of it.

Category: Financial Fraud
Tuesday, 31 August 2010 21:40

Those Pesky Pensions

In a sign that the looming pension battles continue unabated, the New York Times reported, here, that the Securities and Exchange Commission accused the State of New Jersey of securities fraud and claimed that it had not been properly funding public worker’s pensions, while claiming it had. The SEC settled its suit with New Jersey by issuing a cease-and-desist order, and no penalties were imposed.

The SEC claimed that from 2001 to 2007, New Jersey claimed to have set aside funds to pay for pension benefits, when no such funds had been made available or earmarked. According to the SEC, New Jersey engaged in an accounting fiction to make it appear that the funds existed. The SEC also claims that this accounting illusion allowed New Jersey to sell $26 billion worth of state bonds to unsuspecting investors, who were never made aware of the magnitude of the state’s pension troubles.

New Jersey’s public pension fund is one of the largest in the country, and its chronic underfunding can potentially undermine future budgets by requiring significant redistributions from the operating budget to service its pension obligations. According to the SEC, the state treasurer repeatedly certified that the pensions were being funded according to the plan, which was never true. Interestingly, though, the SEC chose not to pursue charges against the treasurers who certified the misstatements or other professionals and auditors who reviewed them.

Category: The Economy
Balance sheet fiction continues unabated, as evidence mounts that banks are creating bogus loan modifications to avoid having to write down loans and destroy capital.  

A recent article in the Wall Street Journal, here, highlights how accounting manipulation has increasingly become the tool of choice for dealing with a souring economy. Regulators, the Federal Reserve, the Treasury, and those with clearly vested interests have largely failed in their efforts to stimulate the broader economy. The one remaining tool in the toolbox, though, remains their most potent: create more fiction and re-write those facts which are inconvenient.

“Extend and pretend” has become de rigueur at banks and other financial institutions, financial sleight-of-hand which masks bad loans by purportedly modifying loan terms or providing repayment assistance. These modifications prevent the need to immediately write-down the loans or fully reserve for them. By forestalling these write-downs, banks avoid further destruction of their capital positions, which have been decimated by the economic firestorm.

Many of these loan modifications are shams, and are not designed to protect the commercial project’s viability. Instead, these bogus loan modifications ensure that banks maintain the loan as performing assets and prevent further weakening of their capital.

As the FDIC grapples with an uncertain economy, spurious loan modifications and the fictitious balance sheets they create may purposely delay efforts to close many of the 1000 or so troubled banks that are projected to be shuttered by the FDIC in the next few years. Efforts to delay these closings will, in turn, postpone the FDIC’s own financial Armageddon and taxpayer bailout. 

Category: The Economy
The bankruptcy examiner’s report in the bankruptcy of Lehman Brothers is a portrait of accounting manipulation and fabrication that stands next to Enron as the epitome of structured financial statement fraud.

Anton Valukas, of Jenner & Block, discovered Repo 105 while investigating Lehman’s collapse and detailed its use in his report, here. Repo 105 was the artful term used to denote the accounting device through which Lehman manipulated and managed its financial statements, which involved temporarily removing billions of dollars of assets from Lehman’s balance sheet at the end of each quarter.  This gimmick reduced Lehman’s leverage ratios, which were crucial to maintaining its required favorable ratings from the principal ratings agencies, and ultimately, to maintaining investor and counterparty confidence.

Lehman ultimately failed for a variety of reasons, including its increasing inability throughout the crisis to securitize and distribute its subprime mortgage originations and its countercyclical growth strategies of using its own balance sheet to acquire assets for long-term investment. These proprietary investments were principally concentrated in three areas: commercial real estate, leveraged loans and private equity. Most of these asset areas would soon implode as the financial crisis expanded.

These countercyclical investment strategies “consumed more capital, entailed more risk, and were less liquid than Lehman’s traditional lines of business.” Ultimately, as the result of these investment strategies, Lehman desperately needed to raise cash, was unable to sell most of these highly illiquid investments at desirable prices and was forced to turn to massive accounting manipulation to temporarily reduce its balance sheet “solely for the purpose of the firm’s public financial reports.”

Category: Financial Fraud
The US housing market remains on federal life-support as recognition of the government’s housing liability will wreck its balance sheet

If there was ever any doubt that the US housing market was being artificially supported by the federal government, new statistics dispel this. A recent Bloomberg article, here, highlights how dependent the US housing market has become on federal assistance.

Fannie Mae and Freddie Mac, already financial wards of the state, may ultimately require $1 trillion dollars in federal bailout funds. This sobering statistic belies the very notion that the US housing market operates as an efficient, free-market enterprise, and that housing values are based on arms-length transactions.

The fact is, the housing market is currently anything but arms-length or free-market. Gross price valuation distortions have occurred within many asset classes in the last 10 years, including commercial and residential real estate. These distortions occurred for many reasons, but were primarily due to the near freefall of credit standards that now threaten our banking system. Easy money distorted prices, and now threatens the survival of hundreds, if not thousands, of banks.

Fannie and Freddie own or guarantee 53 percent of the nation’s $10.7 trillion in residential mortgages, and have sold $1.4 trillion in mortgage-backed securities to the Federal Reserve and the Treasury Department since the crisis began. The liabilities assumed by the housing giants remain off the federal balance sheet, an accounting fiction that grossly underestimates the government’s long-term debt exposure.

Category: The Economy
Page 1 of 3