Where There’s Sizzle . . .

A few weeks ago I was giving a speech and had included in my materials a slide that listed the companies that have suffered financially because of ethical lapses.  I explained that I was missing Bear Stearns and Lehman’s because my handouts were due before we lost those companies in the Wall Street shuffle.  A participant objected, “But you have Fannie Mae on there already!”  I explained that Fannie Mae had been on the list since 2005 because of its $7 billion accounting fraud back then.  He was stunned, “Fannie Mae had problems in 2005?”  Yes, and if we had cleaned house back then, how different Fannie, our mortgages, and perhaps our markets would look today.  ‘Tis a rare thing that a company takes us by surprise in terms of its collapse.  There are always faint signals.  And, in some cases, there was sizzle.  We failed to scout out the steak.  Bring me any company over which we are currently clicking our tongues and I will show you that the signals of “Trouble Ahead!” were there.

Check out AIG.  Here’s a list of the goings-on before we had the government takeover:

1.  In 2006, the SEC filed enforcement actions against AIG, General Re, five General Re executives, and AIG executives for a sham transaction entered into to pump up AIG’s reserves even as General Re took away a $5 million fee for a meaningless exchange.  The clear message on the insufficiency of the reserves from this desperate move was apparently not taken to heart.  AIG settled up, the five General Re executives, including its CFO, were convicted.  But AIG would muddle along for another 2 years with the Wall Street Journal insisting (and even offering former CEO Hank Greenberg a platform for railing) that the federal government was wrong and that it should have just left Greenberg in charge. Heaven help us if he had stayed.

Here’s a safety tip:  When a company is fooling around with phony transactions to pump up reserves, you might want to keep an eye on that company or at least its reserves.

2.  In 2006, AIG restated its earnings by $4 billion.  The AIG board removed Greenberg in 2005.  Greenberg fought back.  Safety tip #2:  Even if Greenberg did everything right, a closer look at a company with this level of dysfunction would not be out of line.  Even if, as Greenberg himself and others allege, that “it’s the accounting rules!” doing us in, it was worth a look-see. Heck, had we looked more closely back then, we might have debated openly the accounting rules and the trouble that was lying in wait for us.

3. Jeffrey Greenberg (son of Hank) was the CEO of insurance broker Marsh &  McLennan (MMC) when that company ran into a little legal difficulty with fixing the market, i.e., steering clients to certain companies in order to avoid the nastiness and rigor of competition.  That followed a settlement by Putnam (an MMC subsidiary) for its mutual fund fees  and Mercer, another MMC subsidiary, for its role in the Dick Grasso (former head of the NYSE) pay debacle.   Putnam also settled up charges that it was working with Mercer for client referrals.  Safety Tip #3:  There was a continual swirling of legal issues around the Greenbergs.  Even if the regulators did not have their legal case (all of the issues raised were settled without admissions by the companies), there was enough coziness here to make those who believe in transparency and competition to be concerned.   

Check out Fannie:

1.  In 2004, Franklin Raines, then-chairman of Fannie Mae, was hauled before Congress for hearings on his and other Fannie executives’ compensation packages and how exactly those multi-million-dollar pay packages were computed.  There were questions about Fannie’s accounting at that hearing.  Yet, the outrage was directed at the compensation.  The accounting practices were glossed over with great ease. Safety Tip #4 — Wwhen large pay packages hang in the balance, check into the accounting that permits their award to the very executives who sign off on that accounting.  

2.  In October 2005, the OFHEO (oversight agency for Fannie and Freddie) issued a blistering report that indicated the management of Fannie Mae was engaged in everything from cookie jar accounting to underreporting losses from derivatives.  Officials who met with then-chairman Franklin Raines indicated that if a piece of paper represented accounting rules and their interpretation, Fannie was not even on the page.  Yet, except for the removal of Raines, the same management team remained in place.  COO Daniel Mudd became interim CEO.  Bad move.  Safety Tip #5:  You might want to rid the company of the management team that was involved in accounting fraud and earnings manipulation. 

3.  In October 2005, Fannie admitted its valuation of its mortgages was wrong.  So wrong, in fact, that Fannie Mae had to issue a $1.1 billion restatement.  Safety Tip #6:  You might want to get on the market implications of the country’s biggest mortgage purchaser being wrong in its valuation techniques.  Note:  The restatement came exactly three years before the market melt-down and the government takeover of Fannie. 

4.  In September 2004, Fannie and the SEC discovered that Fannie’s CFO was dumping his stock options.  Safety Tip #7:  When officers of a company are bailing out, you might want to take a closer look. 

5.  In September 2004, the OFHEO issued a report that indicated there was “a culture of mismanagement” at Fannie.  Safety Tip #8:  Whe an oversight agency tosses terms such as mismanagement about, you may need to take a closer look at the books, records, and, well, the management. 

6.  In 2001, a Fannie employee threw down the flag on Fannie’s accounting practices.  The employee was flatlined in Fannie. By 2002, employees joked about Fannie’s accounting practices.  Safety Tip #9:  Talk to employees. They know what’s happening.  Reassurances from executives are not always insightful.  Fannie’s restatement in 2005 because of the accounting issues would be about $7 billion, give or take a few hundred million.

7.  In February 2004, Alan Greenspan testified before Congress that Fannie could not hedge against a financial crisis and that there was an “implied subsidy” assumed in Fannie that was holding it up, and nothing more.  Safety Tip #10:  When Greenspan warns you . . . well.

The clear point is that we were not without warning.  Just because we don’t like the bad news, or because no one has broken the law does not mean that there are not ethical issues, in everything from accounting choices to the culture, that are sowing the seeds for financial collapse.