1. Crossing the Ethical Rubicon:
From Private to Public Sector
James Chanos
Kynikos Associates
St. Hilda‟s College
University of Oxford
26 January 2011

2. “Alea iacta est” – Point of No Return?
• In Roman tradition, if a
general crossed the
Rubicon he became a
private traitor to the
Republic
• No clear ethical Rubicon in
the private sector
• Public sector is adopting
the private sector‟s
mentality
2

3. Enron: Poster Child For Private Sector Fraud
• 2001: Enron was the largest
corporate fraud in history
– Inflated profits
– „Mark to model‟
– Special Purpose Entities
(„SPEs‟)
• “Smartest guys in the room”
„My personal belief is that Enron stock
lacked a moral compass
is an incredible bargain at current
– Related party transactions prices, and we will look back a couple
of years from now and see the great
– Insiders selling personal opportunity that we currently have.‟
stock while touting the
company‟s stability Kenneth Lay, CEO, September 26, 2001
3

4. Enron Fallout: Strong Public Sector Response
• Incisive congressional
hearings with testimonies from
key participants
• Successful Enron
prosecutions initiated almost
immediately
• July 30, 2002 - Sarbanes
Oxley passed by Congress, to
change rules of “the game”
– Attempt to end the previous
„hands off‟ regulatory
framework
– Immediate private sector
pushback
4

5. 2002-2006: Next Moral And Financial Crisis Takes Shape
• Fannie and Freddie: A home for all
Americans
– Subprime/near prime debt
growth – 40 percent of new
mortgages in 2006 (9 percent
in 2001) – securitized by
inflated housing
– „Prices in aggregate never fall‟
• SEC‟s 2004 rule change lifts
leverage for five largest investment
banks per their request „American consumers might benefit if
• Breakdowns in lending oversight lenders provided greater mortgage product
by investors, rating agencies, and alternatives to the traditional fixed-rate
mortgage.‟
regulators Alan Greenspan, Federal Reserve Chairman,
February 23, 2004
5

6. Fool‟s Gold: Regulatory Arbitrage of Structured Finance
• Tranching magically transformed
risky assets into “AAA”
• Rating agencies provided
necessary “AAA” blessing
• Pension accounts reaching for
higher “AAA” yield provided the
necessary demand
• Wall Street (as usual) provided the
supply through its originate and
distribute model
• Moved lending from regulated
banks to unregulated asset backed
market
• Global Structured Investment
Vehicles („SIVs‟) spread the cancer
worldwide
6

7. Early Accounting Scandals: Foretelling of Ethical Lapses
• Fannie Mae accounting controversy
„…[it‟s findings] are serious and raise doubts
concerning the validity of previously reported
financial results, the adequacy of regulatory
capital, the quality of management supervision,
and the overall safety and soundness‟
OFHEO discussing report, September 23, 2004
„Some people seem to be of the belief that if you
manage your company with an eye to the
accounting results, that that is somehow a
suspicious activity.‟
Franklin Raines, Fannie Mae CEO, Slate,
October 7, 2004
• AIG sued by New York Attorney General
„The irony of this case is that AIG was a well-run
and profitable company that didn‟t need to cheat.
And yet, the former top management routinely and
persistently resorted to deception and fraud in an
apparent effort to improve the company‟s financial
results.‟
Elliot Spitzer, May 26, 2005
7

8. 1st Half 2007: Warnings Sounded…First Cracks Appear
• FASB 157 tightens “fair value”
accounting standards, requires
more disclosures; banks worry
about impact on balance sheets
• April 2, 2007 - U.S. sub-prime
lender New Century Financial files
for bankruptcy
• April 16, 2007 - G7 Ministers „We suspect the problem in the sub-
meeting prime area is just the tip of the iceberg
– Hedge funds warn: „worry for the mortgage market as a whole. For
about the regulated banks‟ all practical purposes, the sub-prime
market is in the process of shutting
„Faced with a financial system that down.‟
few people seemed to understand David Shulman, Senior Economist,
anymore, the G8 did nothing.‟ University of California Los Angeles
Fool’s Gold, Gillian Tett
8

9. 2nd Half 2007: Wall Street Sees Problems…But Keeps Dancing
• Some Wall Street firms take
positions to limit risk from
extreme events
• Bear Stearns hedge
fund exposed to subprime
mortgages undergoes crisis
• Exposed firms around the
globe began to teeter (IKB,
Northern Rock, Countrywide)
• But biggest banks continue to „When the music stops, in terms of liquidity,
things will be complicated. But as long as the
dance to the music music is playing, you‟ve got to get up and
dance. We‟re still dancing.‟
Charles Prince, Citigroup CEO, July 9, 2007
9

10. 2007-2008: Northern Rock Saga
• Poster child for UK residential lending bubble
– 14% growth in 2006; 13% UK market share
– Reliance on wholesale funding
– Exposure to subprime and self-certification
lending
• Northern Rock plows ahead despite warning signs
in early 2007
– First half mortgage lending increased 47%
– UK mortgage market share spiked to 19%
`It is likely to take the outside world a little time to
understand our developing strategy, but you can be
assured the outlook for Northern Rock remains very
positive.„
Adam Applegarth, Northern Rock CEO, July 25, 2007
• September 14, 2007 - “Run on the Rock”
`This standing facility is of course only extended to
– Northern Rock received liquidity support businesses that are sound but face a temporary
facility from the Bank of England liquidity problem.‟
– First UK bank run since Victorian era Adam Applegarth, Northern Rock CEO, September 14, 2007
• February 22, 2008 - Northern Rock nationalized
10

11. 2007: Despite Warnings Public Officials Look the Other Way
• March 23, 2007 - NY Fed‟s
Geithner: „We do not have the
capacity to monitor or control
concentrations of leverage or risk
outside the banking system.‟
• March 28, 2007 - Treasury
Secretary Paulson tells Congress
subprime problem „appears to be
contained‟
• May 17, 2007 - Current Federal
Reserve Chairman Bernanke: „…we
believe the effect of the troubles in
the subprime sector on the broader
housing market will likely be limited,
and we do not expect significant
spillovers from the subprime market
to the rest of the economy or to the
financial system.‟
11

12. Bear Stearns: First Shoe to Drop
„Bear Stearns' balance sheet,
liquidity, and capital remain
strong…‟
Alan Schwartz, Bear Stearns CEO,
March 12, 2008
• Over leveraged balance sheet
exposed by the market
• Asset/liability funding mismatch
magnified balance sheet stress
• Federal Reserve negotiates
weekend fire sale of Bear Stearns
• Federal Reserve also forced to
JP Morgan Pays $2 a Share for Bear Stearns
guarantee $30 billion of toxic Bear New York Times, March 17, 2008
Stearns‟ assets
12

13. Public Officials‟ Response to Bear Stearns Implosion
• Regulators refuse to recognize
true cause
• Regulatory blame game
– Short sellers set up as
scapegoat
– Hedge funds demonized as
the „real risk in the system‟
• Regulatory response reflects
blame shift
– HBOS successfully
pressured FSA to investigate „Bear Stearns' capital, and its broker-dealers'
capital, exceeded supervisory standards.
short sellers in April 2008 Counterparty withdrawals and credit denials,
– First short-selling restrictions resulting in a loss of liquidity - not inadequate
capital - caused Bear's demise. „
in US, July 2008 Christopher Cox, SEC Chairman, March 20, 2008
13

14. Lehman Brothers: An Early Greek Tragedy
• Vocal marketplace critics of Lehman
dismissed by company and regulators
• Lehman management steadfastly denied
problems
„I am the one who ultimately signs off and I'm
comfortable with our valuations at the end of our
second quarter. We have always had a rigorous
internal process.‟
Richard Fuld, Lehman Brothers CEO, June 16, 2008
„We don‟t feel that we need to raise that extra
amount. Our capital position at the moment is
strong.‟
Ian Lowitt, Lehman Brothers CFO, September 10, 2008
• September 15, 2008 – Lehman Brothers
filed for bankruptcy „Unbeknownst to the investing public, rating agencies,
government regulators, and Lehman‟s board of
– Implied hole in balance sheet north of directors, Lehman reverse engineered the firm‟s net
$150 billion…2x Enron‟s! leverage ratio for public consumption.‟
Examiner’s Report, March 11, 2010
14

15. Public Officials Scramble to Limit Lehman Fallout
• Global short selling
regulations enacted arbitrarily
• Major investment banks
converted to bank holding
companies by Federal
Reserve
– Optics: Tighter regulation
„… to address dollar funding pressures
– Reality: Access to the worldwide, we announced a significant
expansion of reciprocal currency arrangements
Federal Reserve balance with foreign central banks, including an
sheet approximate doubling of the existing swap lines
with the European Central Bank and the Swiss
• Federal Reserve uses its National Bank and the authorization of new
swap facilities with the Bank of Japan, the Bank
balance sheet to liquefy the of England, and the Bank of Canada.‟
world Ben Bernanke, Federal Reserve Chairman,
September 23, 2008
15

16. AIG Bailout: Credit Disaster Stopped (CDS)
• AIG sold plausible deniability to Wall
Street
– Largest seller of credit protection for
structured finance vehicles
– Enabled Wall Street to claim „it was
hedged‟
• AIG regulators incapable of monitoring
growing risk
• AIG: The Emperor‟s New Clothes
„AIGFP's models…when coupled with their
conservatively structured transactions
provide AIG with a very high level of „It is hard for us, without being flippant, to
comfort.‟ even see a scenario within any kind of realm
Martin Sullivan, AIG CEO, December 05, 2007 of reason that would see us losing one dollar
in any of those transactions.‟
• Less than a year later, US Federal Joseph Cassano, AIG Financial Products CEO,
Government undertook $182 billion August 2007
bailout of AIG
16

17. Mixed Message From Private Sector Regarding Public
Sector Bailout…Say What?
• General Electric (‘GE’) • Ford Motor
„Late Monday morning, General Electric CEO Jeff „Companies are taking drastic measures to preserve
Immelt called to tell me that his company was their finances – not just the big banks, but also
having problems selling commercial paper.‟ companies like General Electric and Ford.‟
Hank Paulson, US Treasury Secretary, September 8, 2008 Hank Paulson, US Treasury Secretary, September 18, 2008
„We have no issues funding ourselves.‟ „Ford is asking for access to up to $9 billion in bridge
Keith Sherin, GE CFO, September 25, 2008
financing, but reiterated that it hopes to complete its
„We really see the CP market improving right now. transformation without accessing the loan should
We have had no problems with our own CP, but I Congress agree to make the funds available.‟
Ford Motor Company Press Release, December 2, 2008
think we have just taken this issue off the table for
investors.‟ Ford Bailout Money Unnecessary, Company Says
Jeff Immelt, GE CEO, October 10, 2008 Associated Press, December 10, 2008
„Jeff Immelt had come to my office on the 16th to
„We don't want to borrow any more money. We have
make the case that the FDIC should guarantee GE
sufficient liquidity to fund our transformation plan, …
Capital‟s debt issues… “We are the ones out there
our business is in a relatively good shape.‟
making the loans that the banks aren‟t, and we need Alan Mulally, Ford CEO, January 25, 2009
help,” Immelt said.‟
Hank Paulson, US Treasury Secretary, October 16, 2008 – Tapped Federal Reserve CP facility 14 times
for $15.9 billion from October 2008 to June 2009
Note: Hank Paulson quotes are provided from his book, On the Brink: Inside the 17
Race to Stop the Collapse of the Global Financial System.

18. Government Officials Move to „Calm‟ Crisis
• TARP rammed through Congress in
October 2008
– $700 billion Treasury slush fund
– Eventual use of TARP funds
differed from initial justification
• Overt or quasi-nationalization of
large banks around the globe
(Citigroup, Bank of America,
Lloyds/HBOS, RBS, Dexia)
• FASB pressured to change mark-to-
market accounting rules
„When things go well, people call me
• Stress tests performed on US banks Gordon. When they're bad, they call me
– all pass! Mr. Brown. At the moment, they are
• Questionable governance of quasi- calling me Gordon.‟
nationalized firms Gordon Brown, UK Prime Minister,
– No AIG emails? December 22, 2008
18

19. Ireland: When the Luck of the Irish Finally Ran Out
• „New feudalism‟ inflated
property prices - housing
boom and collapse leaving
Irish banks awash in bad
loans
• Near-anarchic attitude to law
and morality: “cronyism, light
regulation, loose ethics”
• Political and public mentality
could not grasp realities „A perfect illustration of the economics of morality –
• Residential housing values the absence of a sense of propriety, of restraint and
of right and wrong.... Public morality...is about
estimated to be worth more knowing when to stop. Nothing in Ireland told
people when to stop.‟
than 3x GDP at the 2006 peak Fintan O’Toole, Ship of Fools
19

20. Greece: A Modern Fiscal Tragedy
• A foreign investment bank
may have helped hide
Greece‟s obligations
• Hidden fiscal deficits exposed
the extent of leverage
• Market reacted swiftly by
increasing the funding cost for
Greece
• Papandreou government
punished in the market and
locally for being forthcoming,
and attempting to solve the
problem
20

21. EU Regulatory Response to Financial Crisis
• Regulators continue to shift
blame
• “Speculators” blamed for
rising credit costs
• Hedge fund rules and
regulations enacted
• EU learned from US
counterparts – banks‟
„It is revealing that the tests [on the Irish
stress tests all successful! banks] conducted last July identified a capital
shortfall of just €3.5bn. Yet less than six
• European Financial months later, Irish banks required 10 times
Stability Facility („EFSF‟) that amount.‟
George Osborne, UK Chancellor of the
established Exchequer, January 2011
21

22. 2010 US Financial Reforms...?
• Dodd-Frank Act:
– Does it solve „too big
to fail‟ problem?
– Can Volcker rule limit
conflicts hurting
clients?
– Will new watchdog
curb systemic risks?
– Vague law – many
details to be filled in
22

23. Modern Day Rubicon: Crisis in US Public Finance
• Failure to comprehend and/or
acknowledge structural fiscal
problems
• Unwillingness to address longer
term financial obligations
• Public sector employs its own
convenient accounting standards
• Not using GAAP-accounting to
measure true obligations
– Real 2010 US budget deficit
quite different
• Reported: $1.3 trillion
• GAAP adjusted: $5.3
trillion (est.)
23

24. Modern Day Rubicon: EU Fiscal Crisis Not Yet Solved
• Rolling credit concerns
from country to country
• Austerity measures not
well received locally
• Kicking the fiscal can
down the road
• Financial markets still
not convinced
• The EU/Euro survival at
stake?
24

25. Modern Day Rubicon: China, The Red Rubicon
• GDP targets drive economic activity, not
vice versa
• Real GDP versus „China GDP‟
– Questions over regional versus
national GDP figures
– State Owned Enterprises („SOEs‟)
control 50% of industrial assets
• Party officials and state-owned
enterprises incentivized to maximize the
„top-line‟… or „lose face‟
• “GDP figures are „man-made‟ and
therefore unreliable…all other figures,
especially GDP statistics are „for
reference only,‟ he said smiling.”
– Vice Premier Li Keqiang, expected
successor to Premier Wen Jiabao
25

26. Prescription For Solving Public/Private Ethical Lapses
• Accounting standards that
provide transparency
– Moving all relevant assets
and liabilities back on the
balance sheet
– Properly valuing assets and
liabilities
• Full and timely disclosure of
any public assistance or
conflict resolution
• Strong legal response to
hold “cheats” accountable
• Vigilant guardianship of the
public purse
26

27. Thank You Again, St. Hilda’s College
and the University of Oxford

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