Wall Street Law Blog

A Catch-22: Fraud and Financial Risk Management (from the Wall Street Law Blog Greatest Hits Collection)

CAN YOU PROVE THE CAUSE OF OUTCOMES THAT DON'T HAPPEN...

- OR - 

WHAT IS AN OUNCE OF PREVENTION WORTH ANYWAY?  

Who among us isn't a sucker for a company that can make us money and has a firm-wide commitment to superior, disciplined risk management?  Profitable and safe, what could be better?  

But how can you - as an outsider - really confirm that a company does practice sound risk management?  Or even that a company gives risk management a second thought?  

Hmmmm...

  

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Claims of quality risk management are hard to disprove most of the time because good risk management is about prevention (i.e., keeping bad things from happening).  By nature, preventative actions are fertile territory for fraudsters.  Why? Because, in the absence of a negative outcome, claims of success or quality based on preventative measures are often very hard to disprove.

If you did not get the flu this past winter, was it because you got a flu shot or because you weren't exposed to the influenza virus?  If you are in a car accident and escape injury, is it because your Jeep has anti-lock brakes, air bags, and the latest whiplash resistant seatbelts or would you have walked away from the crash without all the state-of-the-art safety features?  Who the hell knows?
Before the "Great Recession," financial services companies could - and did - win investor trust by falsely touting their supposed high quality risk management systems.  But, as the failure to contract flu does not prove the effectiveness of a flu shot, the absence of evident risk management failures (like catastrophic losses) is not proof of high quality risk management.

On the other hand, if you DO get the flu, you have pretty clear evidence that your flu shot was a waste of time and money.  And if a financial institution DOES suffer catastrophic losses, that is certainly a hint that a firm's purported "best in class" risk management systems may not have been so good after all...

Investment Banks in Moving Business? Not quite.

Securities fraud, 10b-5: 

Material Misrepresentation, 

a textbook example.

• WALL STREET BANKERS SAID THEIR COMPANIES WERE IN 'THE MOVING BUSINESS, NOT THE STORAGE BUSINESS.'  NOT QUITE.

Translation?  For so many years, investment banks thrived by transferring risky assets off their balance sheets as fast as they could.  During the housing and credit bubbles, Bear Stearns, Lehman Brothers, Merrill Lynch, Morgan Stanley and others entered the storage business in a big way.  Then, one by one, the investment banks died.

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• Intermediary Role Abandoned

For the majority of its successful run, the Wall Street investment banking model was based on a simple rule. Investment banks were NOT investors. They were intermediaries. They brought sellers and buyers together. This means that investment banks did not hold risky securities on their balance sheets any longer than was absolutely necessary. In "Wall Street-speak," i-banks liked to say they were in the moving business, NOT the storage business. 

During the credit / housing bubble, most of the former investment banks got into the storage business in a big way. They drank their own cool aide, buying high risk mortgage-backed securities, cdos, and related instruments for their own proprietary trading accounts. The investment banks stopped acting as intermediaries, and started acting as buyers and sellers. This was one of two major reasons why Bear Stearns, to cite one example, wound up with a balance sheet clogged with illiquid toxic waste. 

The other reason Bear Stearns ended up with a huge volume of mortgage-backed securities and related products was greed. Bear Stearns was so determined to milk every penny of profit from the bubble that it built up a massive inventory of mortgages to feed into its securitization machine. When the market froze, Bear Stearns was stuck with tons of loans. Bear Stearns also had a huge portfolio of mortgages it securitized but could not sell before demand for mortgage-backed securities completely disappeared. In short, Bear Stearns was left holding the bag. 

The principle of risk transference required the former investment banks to get rid of virtually all securities (except securities that are considered "cash equivalents") as rapidly as possible. Once the investment banks got rid of the mortgage-backed securities they produced - and collected fat fees - they no longer had to worry about default. The risk of default would be fully transferred to investors. On Wall Street, this is how it was supposed to work. At some point, the enormous fees from acting as an intermediary were insufficient to satisfy Wall Street executives. If Wall Street had stayed in the moving business, the meltdown of the investment banks would have been far less severe. Instead, investment banks violated their cardinal rule. They got into the storage business in a big way, and we all are paying the price.