Compliance in 2008 - Same As Last Year or a Change For the Better?
During this season, people spread best wishes for the New Year to each other. But what can we anticipate in the forthcoming 12 months? Looking back over the recent past, we could reflect on what issues the financial services industry and, to some degree, corporations learned to appreciate with regard to their fiscal and reputational cost in 2007.
There are no edicts governing progress. Each organisation holds its future in its own hands, to develop or demolish. It is always an uphill crusade but who would have it otherwise? The evolution of processes will never grant immunity from challenges. Problems, crisis and difficulties have been emergent too.
What changes have there been in financial crime cases in previous years? Not much really. On 13 July 2006, three UK bankers – Giles Darby, David Bermingham and Gary Mulgrew; known in the UK as the NatWest Three, and in the US as the Enron Three, were extradited to the US on charges relating to a transaction with Enron Corporation in 2000 when they were working for the City of London firm Greenwich NatWest. On 28 November 2007, they pleaded guilty to wire fraud and are due to be sentenced on 22 February 2008. They are still in the US and by the time they are sentenced they will have been there for 18 months.
The allegation was that the three engaged in a corrupt deal with Andrew Fastow, CFO of Enron, whereby they would persuade Greenwich NatWest to sell its stake in a Cayman Islands investment company at a fraction of its real market value to a small company controlled by Fastow. The stake was then sold to Enron at its true value, and the difference was split between Fastow, Fastow’s assistant Michael Kopper, and the three of them. The three bankers netted £1.1m (US$2.3m) each, while Fastow and Kopper made a significantly larger sum.
One man, the former owner of London’s Daily Telegraph newspaper, surrendered his Canadian citizenship to become Lord Black of Crossharbour, a peerage granted to him by the UK government. By the by, Crossharbour is a stop on the London Docklands Light Railway near to the offices of the Daily Telegraph. Black has just received a prison sentence of six and a half years in Chicago for fraud and obstruction of justice over his conduct and stewardship of his company Hollinger. Canadian-born Conrad Moffat Black (born 1944) gained fame as an international press baron whose newspapers’ daily circulation of 4.5 million was a total surpassed only by Rupert Murdoch and the US Gannett chain.
These scandals are not new by any means. 1934 saw France and her government embroiled in a financial and political scandal that shook the country and the government. Serge Alexandre Stavisky, a swindler associated with the municipal pawnshop of Bayonne, sold huge quantities of worthless bonds. Despite a shady past he had connections with many people in responsible positions. Faced with exposure in December 1933, he fled but was discovered by the police in Chamonix where, depending on your political view, he either committed suicide or was murdered by the police. The political rightists alleged that Stavisky had been murdered to protect influential persons connected with him. Edouard Daladier, the premier, used force to repress bloody riots staged in Paris by extremists but he too had to resign as a result.
Mercifully, neither the actions of the NatWest Three nor Conrad Black brought rioters onto the streets or toppled prime ministers, but their actions did have a negative consequence on peoples’ basic trust in those responsible for the good stewardship of companies and management of investments. Regrettably, 2007 was to see a profound and more damaging exposure of what could be considered questionable business behavior that had significantly grave ramifications for financial institutions, brokers, corporates and, worst of all, the general public who invest or receive services from them.
The sub-prime mortgage financial crisis of 2007 was caused by the abrupt rise in home foreclosures that started in the US during the later part of 2006 and within a year had developed into a global financial crisis. Easy credit, combined with the assumption that house prices would continue to appreciate, also encouraged many sub-prime borrowers to obtain adjustable rate mortgages that should have been easily recognised as unaffordable after the initial low cost incentive period.
With house prices now depreciating in many parts of the US, refinancing has become difficult, leaving many homeowners with higher payments than they had expected or could afford. Some homeowners, following the recommendations from constant advertising, had been using the increased property value encountered in the earlier housing bubble to refinance their homes with lower interest rates and take out second mortgages against that added value and using the funds for consumer spending. This practice was frequently and constantly advertised in the media as releasing ‘your’ money. It has repeatedly been described as ‘predatory lending’ during this crisis. The basis was that between 1997 and 2006, US home prices had generally increased by well over 110%.
Of the variety of factors considered, investor appetite for mortgage-backed securities (MBS), and the tendency of rating agencies to assign investment-grade ratings to MBS, loans with a high risk of default could be originated, packaged and the risk readily transferred to others. In addition to considering higher-risk borrowers, lenders have offered increasingly high-risk loan options and incentives to them. One example is the interest-only adjustable-rate mortgage (ARM), allowing the homeowner to pay only the interest but not principal during an initial period. A ‘payment option’ loan is another example in which the homeowner can pay a variable amount, but any interest not paid is added to the principal. An estimated one-third of adjustable rate mortgages originated between 2004 and 2006 had ‘teaser’ rates below 4%, which then increased significantly after an initial period, in some cases doubling the monthly payment.
Many banks, mortgage lenders, real estate investment trusts and hedge funds supported this and invested, suffering considerable losses as a result of defaults in mortgage payment or mortgage asset devaluation. In the past few weeks since 21 December 2007, major international financial institutions had recognised sub-prime-related losses in excess of US$80bn. Other companies and mortgage lenders from around the world have filed for bankruptcy.
Would a thorough audit reveal how many sheds, outhouses, trailers and tents had substantial loans granted against them based on unknown, fanciful and definitely unchecked valuations? Is it possible that in the frenzy of trying to seize as much of the perceived business as possible, fraud may have become involved?
So far two sub-prime lenders, an online bank, a securities firm, a mortgage lender and an investment fund have filed for bankruptcy. Nine international investment banks, 11 retail banks, a re-insurance company and even the Freddie Mac and Fannie Mae mortgage organisations in the US have had to write down the values of their loans. Senior management has not escaped unscathed, as the CEOs of Merrill Lynch and Citigroup found when they were forced to resign within a week of each other.
An additional and unforeseen problem about to materialise is the impending mass retirements of those born just after World War 2, the so-called ‘baby boomers’. It is anticipated that many of them have insufficient savings for their retirements and are relying on the apparent increased values in their property to fund retirement; some of those values have all but disappeared to become very negative indeed.
So what caused this fiasco? If designing risk products with the intention of passing the risk on to others in the industry at a profit is good business then what is knowingly selling those products onto customers who, with a little due diligence on the part of the marketer, could easily be recognised as never having a hope of affording them?
Everyone in the financial services industry knows they are required to know their customers. What went wrong? Could it be that some in the financial institutions are more focused on the race to be the highest in profits at the expense of all, rather than considering the good of the customer which is manifested in the strength of the stock and therefore the strength of their reputation.
Know your customer (KYC) has been scattered to the winds. Governments are talking of finding cash to bail out the foundering lenders, foreign cash injections are miraculously being discovered for them but the customer, who is not by any means, guaranteed to be a totally innocent party in all these issues, is left to struggle. What price the future for some of them?
Who designed these products and what were their thought processes behind them except perhaps a novel profit generating achievement? Governments are the regulators and should exercise their duty of care to determine exactly where the responsibility lies, As we saw earlier from the NatWest Three, Conrad Black and the 1934 Stavisky scandal, deceit can be clothed in many costumes and a person who gains by selling what is no more than false hope to the ill informed brings disgrace on a vital and indispensable international industry. Each designer of these problematic creations should keep in mind that at some point they might well become victims of their own concepts.
If hindsight is an exact science and history always repeats itself, what can we expect in 2008? The skeptic will say “more of the same” while the idealist will say “it will be better.” What will the realist expect? Probably a mixture of both, that in itself is a step in the right direction. The anthems of modern commerce are; know your customer, know your employee and know your business. They must be adhered to and continue to be the guiding principles of enterprise.
Integrity and candor in business should be distinguishing characteristics not attributes of legend. Success in business is not the culmination of a competition between principles and ruin with neither the victor. Achievement in business requires education, dedication and plain hard work; there is no mystery to that. Perhaps KYC should be extended from know your customer to know your conscience.