LECTURE 06

1. LECTURE 06

2. Equity Funding Corporation of America • The insurance funding program • The first scam • The next scam • The really BIG scam • The final scam • The house of cards collapses • The fallout from Equity Funding • An analysis of the causes • The Lessons Learned

4. The insurance funding program - 1 • Equity Funding Corporation of America was founded in 1960. Its principal line of business was selling "funding programs" that merged life insurance and mutual funds into one financial package for investors. • The deal was as follows: first, the customer would invest in a mutual fund; second, the customer would select a life insurance program; third, the customer would borrow against the mutual fund shares to pay each annual insurance premium. Finally, at the end of ten years, the customer would pay the principal and interest on the premium loan with any insurance cash values or by redeeming the appreciated value of the mutual fund shares. Any appreciation of the investment in excess of the amount paid would be the investor's profit.

5. The insurance funding program - 2 • The company had a huge sales force. The thrust of the salesman's pitch to a customer was that letting the cash value sit in an insurance policy was not smart; in fact, the customer was losing money. The customer was encouraged to let his money work twice by taking part in the above deal.  • The development of such creative financial investments was a trademark of Equity Funding in the early years of its existence. After going public in 1964, Equity Funding was soon recognized across the country as an innovative company in the ultraconservative life insurance industry. 

6. The insurance funding program - 3 • This kind of leveraging of dollars is a concept used by sophisticated investors to maximize their returns. They use an asset they already own to borrow money in the expectation that earnings and growth will be greater than the interest costs they will incur. However, it's a concept that is fraught with risks for the investor and should not be promoted by an ethical company without fully informing the investor of the risks. • Even so, there was nothing illegal or even immoral about the basic concept. Indeed, it was a captivating idea, except it didn't make enough money for the company or its executives. So some executives—led by the president, chief financial officer and head of insurance operations—got a little more creative with the numbers on their books.

7. The first scam • "Reciprocal income“ Preparing to take the company public in 1964, there was concern that its earnings were too low. To correct this "problem", the owners decided that Equity Funding was entitled to record rebates or kickbacks from the brokers through whom the company's sales force purchased mutual fund shares. The resulting income, called "reciprocal income" was used to boost 1964 net income for Equity Funding. So the fraud apparently began in 1964 when the commissions earned on sales of the Equity Funding program were erroneously inflated.

8. The next scam • Borrowing without showing liability • In subsequent years, to supplement the reciprocal income so as to achieve predetermined earnings targets, the company borrowed money without recording the liability on its books, disguising it through complicated transactions with subsidiaries. The fraud expanded in 1965, when fictitious entries were made in certain receivable and income accounts. • By 1967, revenues and earnings of Equity Funding had increased dramatically, and the stock price rose accordingly. Equity Funding began to take over other companies, and it became critical to maintain the price of the stock of Equity Funding so it could be used to pay for the companies being acquired.

9. The Really BIG Scam • Reinsurance • Fictitious policies • Forging files

10. The Final Scam • Killing off the policy holders

11. The computer makes it possible • Although there were a number of other aspects to the fraud, the computer was used because the task of creating the bogus policies was too big to be handled manually. Instead, a program was written to generate policies which were coded by the now famous, or rather, infamous, code "99". When the fraud was discovered in 1973, about 70% of all of the company's insurance policies were fake.

12. The failure of the auditors

13. The house of cards collapses

14. The fallout from Equity Funding • Accounting and auditing practices • Insider trading • The aftermath of Equity Funding

15. An analysis of the causes • The Management • Ethics and integrity of management and employees • Management's philosophy and operating style • The Auditors • Lack of independence of the auditors • Lack of professional skepticism of the auditors • External impairments to the audit

16. The Management • The ethics and integrity of management and employees • Management's philosophy and operating style

17. The Auditors • The independence of the auditors • Professional skepticism of the auditors

18. The Lessons Learned

19. Baring Bank Bankruptcy • Barings Bank was established in London in 1763 as a merchant bank, which allowed it to accept deposits and provide financial services to its clients as well as trade on its own account, assuming risk by buying and selling common real estate and financial assets. • In early 1980, Barings set up brokerage operations in Japan. With its success in Japan, Barings decided to expand to Hong Kong, Singapore, Indonesia and several other Asian countries. • By 1992, Barings subsidiary in Singapore had a seat on the SIMEX, but did not activate it due to lack of expertise in trading futures and option contracts.

20. Nick Leeson: both Front and Back • Four months later Barings decided to activate its SIMEX seat. They appointed Mr. Nick Leeson as the general manager and charged him with setting up the trading operations in Singapore and running them. • Mr. Leeson was in charge of both the front office and the back office. An important task in brokerage business, particularly in the settlement side, is uncovering and dealing with trading errors, which occur when the trading staff misread or mishear an instruction or a broker misunderstands a hand signal. When errors occur, brokerages book the losses or gains into a computer account called an "error account". • For Mr. Leeson, errors recorded were sent to the home office in London and deducted against Mr. Leeson's branch earnings.

21. Account 88888 • Account 88888 was started when a phone clerk sold 20 contracts instead of purchasing them. Mr. Leeson was unable to do anything about it until the next trading day because the market rose 400 points. That next trading day, Leeson established account 88888 and created fictitious transactions to cover up the error. • Over the next few months Leeson hid some 30 large errors in account 88888. He relaxed his attitude towards errors, and when an important customer brought an error to Leeson's attention, he simply put the error into account 88888 without any further investigation.

22. The Collapse • As the market moved, errors in account 88888 changed in value, and a $1 Billion loss was generated by open positions in account 88888. As the account grew bigger, margin calls also got bigger. London approved these large margin calls because of the large profits Leeson was posting. • Barings’s problems arose because of serious failure of controls and management within Barings.

23. Orange County Bankruptcy • On December 6, 1994, Orange County in California became the largest municipality in U.S. history to declare bankruptcy. The county treasurer had lost $1.7 billion of taxpayers' money through investments in derivatives. • The bankruptcy resulted from unsupervised investment activity of Bob Citron, the County Treasurer, who was entrusted with a $7.5 billion portfolio belonging to county schools, cities, special districts and the county itself.

24. Orange County—History • In 1994, the Orange County investment pool had about $7.5 billion in deposits from the county government and almost 200 local public agencies (cities, school districts, and special districts). Borrowing $2 for every $1 on deposit, Citron nearly tripled the size of the investment pool to $20.6 billion. In essence, as the Wall Street Journal noted, he was "borrowing short to go long" and investing the dollars in derivatives—in exotic securities whose yields were inversely related to interest rates.

25. Orange County—Period of Success • Thus, Citron invested in financial derivatives and leveraged the portfolio to the hilt, with expectations of decreasing interest rates. As a result, he was able to increase returns on the county pool far above those for the State pool. • Citron was viewed as a wizard who could painlessly deliver greater returns to investors. The pool was in such demand due to its track record that Citron had to turn down investments by agencies outside Orange County. • Some local school districts and cities even issued short-term taxable notes to reinvest in the pool (thereby increasing their leverage even further).

26. Orange County—the collapse • The investment strategy worked excellently until 1994, when the Fed started a series of interest rate hikes that caused severe losses to the pool. Initially, this was announced as a “paper” loss. • Citron kept buying in the hope interest rates would decline. • Almost no one was paying attention to what the treasurer was doing and even fewer understood it—until the auditors informed the Board of Supervisors, in November 1994, that he had lost nearly $1.7 billion. • Shortly thereafter, the county declared bankruptcy and decided to liquidate the portfolio, thereby realizing the paper loss.

27. The Role of the Brokerage • NY Times, June 3, 1998, Wednesday • Merrill Lynch to Pay California County $400 Million • Merrill Lynch & Co agrees to pay $400 million to settle claims that it helped push Orange County, Calif, into 1994 bankruptcy with reckless investment advice; 17 other Wall Street securities houses and variety of other companies that sold risky securities to county-run investment pool are expected to settle similar suits; county, which lost over $1.6 billion in high-risk investments, could end up recovering $800 million to $1 billion; its financial condition has improved sharply; table on status of some major suits and criminal probe.

28. The Underlying Causes • The immediate cause of the bankruptcy was Citron's mismanagement of the Orange County investment pool. • However, he would not have been driven to strive for such high rates of return on the pool—nor would he have been able to invest as he did—had it not been for the fiscal austerity in the state that began with Proposition 13. That citizen initiative, and several subsequent initiatives, severely limited the ability of local governments to raise tax revenue. • Recognizing the extreme fiscal pressure these initiatives placed on county governments, the state loosened its municipal investment rules—allowing treasurers, for the first time, to use Citron's kind of strategy.

29. Orange County is not Unique • Orange County provides dramatic warning of the dangers of that kind of investment strategy and should deter others from following the same path. • But the conditions and resulting imperatives that drove the county to gamble with public funds remain. The demand for smaller government, tax limits, and local autonomy continues, and many municipalities may find the specter of financial collapse looming—especially when the economy takes its next downturn. • These conditions exist, to a greater or lesser degree, in counties across the state and nation, which makes the Orange County bankruptcy especially significant.

30. What needs to be done? • Local governments need to maintain high standards for fiscal oversight and accountability. As noted in the state auditor's report following the bankruptcy, a number of steps should be taken to ensure that local funds are kept safe and liquid. These include having the Board of Supervisors approve the county's investment fund policies, appointing an independent advisory committee to oversee investment decisions, requiring more frequent and detailed investment reports from the county treasurer, and establishing stricter rules for selecting brokers and investment advisors. Local officials should adjust government structures to make sure they have the proper financial controls in place at all times.

31. What needs to be done? • State government should closely monitor the fiscal conditions of its local governments, rather than wait for serious problems to surface. The state controller collects budget data from county governments and presents them in an annual report. These data should be systematically analyzed to determine which counties show abnormal patterns of revenues or expenditures or signs of fiscal distress. State leaders should discuss fiscal problems and solutions with local officials before the situation reaches crisis stage. 

32. What needs to be done? • Local officials should be wary about citizens' pressures to implement fiscal policies that are popular in the short run but financially disastrous over time. Distrustful voters believe there is considerable waste in government bureaucracy and that municipalities should be able to cut taxes without doing harm to local services. Local officials need to do a better job of educating voters about revenues and expenditures. State government should also note that there are no checks and balances against citizen initiatives that can have disastrous effects on county services. Perhaps legislative review and gubernatorial approval should be required for voter-approved initiatives on taxes and spending. 

33. Long Term Capital Management • Long Term Capital Management (LTCM), run by the former head bond trader and vice chairman of Salomon Brothers, a former vice chairman of the Federal reserve, and two Nobel Prize-winning economists, leveraged almost $5 billion into a $100 billion portfolio full of derivatives, a 20/1 leverage ratio.  • The results obviously were spectacular while LTCM’s strategy worked, and were equally spectacular and disastrous when it didn’t. Few of LTCM’s investors and perhaps none of its lenders were aware of the magnitude of this fund’s gambles.

34. Long Term Capital Management • If, as they say in the mutual fund literature, “past results are not indicative of future performance,” how should one go about evaluating a hedge fund? As with any other investment portfolio, the key is to understand the types of investments it currently owns, the overall strategy of the manager, and the tactics the manager intends to use or avoid. Getting answers to these questions is not only due diligence, but common sense. • An article in the Financial Economists Roundtable (by Myron Scholes, one of the winners of the 1997 Nobel Prize for Economics and a principal in LTCM), alludes to risks in derivatives markets, but concludes that "there is no evidence the activities of these (derivatives) dealers pose a significant systemic risk".

35. The Near Bankruptcy and Bail-Out • What happened at Long Term Capital Management? In 1998 it came close to going bankrupt! Only pressure from the U.S. federal government saved it. • In Fall 1998, a bail-out of LTCM was arranged. Illustrious Wall Street institutions were cajoled into putting up $3.5billion to avert its bankruptcy.  • Time Magazine has a very rewarding article about the glaring inconsistency of this policy. eg Asian financial institutions must pay the penalty for taking too much risk, but very rich American investors will be bailed out.

36. Long Term Capital Management • The New York Times has some great analysis. Check out the extraordinary leverage of the fund, and a piece about John Meriwether, fallen genius of LTCM and ex Salomon trader. (book: Liars's Poker) This article contains a naive fallacy from a Salomon Brothers veteran discussing roulette "because it is a mathematical certainty that red will come up eventually". Do these people really believe that? I would like to bet my entire capital leveraged by 20 times that it isn't a mathematical certainty! Any takers?

37. Long Term Capital Management • 9/23/98 Prescient article from CNBC's David Faber about rumor's of Long Term Capital Management bailout.   • 9/29/98 Banks Near Final Accord on Investment Fund's Rescue   • 10/1/98 In 4 1/2 hours of testimony, Federal Reserve Chairman Alan Greenspan defended the bail out of LTCM. LTCM's failure threatened “substantial damage,” he said. • 10/2/98 Rumors of an emergency Fed Meeting to discuss liquidity issues related to Long-Term Capital Management spooked the market. Comment from the Fed: "As a matter of policy, we don't comment on these things". Interesting...  

38. Long Term Capital Management • 10/5/98 MSNBC Columnist James O. Goldsborough has a great article about LTCM, and the high volume, high risk strategies. It repeats the roulette doubling up analogy.   • 10/8/98 The Secret World of Hedge Funds   • 10/10/98 In Archimedes on Wall Street, Forbes Magazine gives a good overview of what LTCM attempted to do. Good comparison of John Meriwether to Archimedes. Financial genius is a short memory in a rising market   • 10/15/98 Alan Greenspan cut interest rates by another quarter point. A surprise move, as it was outside the regular FOMC meeting. What does Alan Greenspan know that we don't?. Could there be more hedge fund exposure?

39. Long Term Capital Management • 1bits2atoms.com Recommends  • Hedge Funds : Investment and Portfolio Strategies for the Institutional Investor (The Irwin Asset Allocation Series for Institutional Investors)-buy now from Amazon.comThe story of the 1929 stock market crash. Back then it was Investment Trusts and highly margined investors, this time highly leveraged Hedge Funds...?

40. Long Term Capital Management • An interesting place to start researching hedge funds is the Hedge Fund Association. The Association's aim is to educate the investing public's and legislators' misperceptions of hedge fund volatility and risk. •  So why were investors in LTCM bailed out? Could the absence of the capital injection have resulted in a chain reaction of failures?

41. Enron Bankruptcy • The Start as a Gas Pipeline Company in 1985 • Deregulation • Enron Finance in 1990 • Enron’s Overseas Energy Projects • Enron Communications and Internet Structure • Enron Online and Internet Brokering • Enron and the Market in Broadband • The Catches—one after another! • The Collapse • Enron and E-Mail's Lasting Trail • The Fallouts

42. Gas Pipeline Company in 1985 • In 1985, Kenneth Lay, using proceeds from junk bonds, combined his company, Houston Natural Gas, with another natural-gas pipeline to form Enron. From that start, the company then moved beyond selling and transporting gas to become a big player in the newly deregulated energy markets by trading in futures contracts. In the same way that traders buy and sell soybean and orange juice futures, Enron began to buy and sell electricity and gas futures.

43. Deregulation • In the mid-1980s, oil prices fell precipitously. Buyers of natural gas switched to newly cheap alternatives such as fuel oil. Gas producers, led by Enron, lobbied vigorously for deregulation. Once-stable gas prices began to fluctuate. • Then Enron began marketing futures contracts which guaranteed a price for delivery of gas sometime in the future. • The government, again lobbied by Enron and others, deregulated electricity markets over the next several years, creating a similar opportunity for Enron to trade futures in electric power.

44. Enron Finance in 1990 • In 1990, Lay hired Jeffrey Skilling, a consultant with McKinsey & Co., to lead a new division—Enron Finance Corp. • Skilling was made president and chief operating officer of Enron in 1997. • Even as Enron was gaining a reputation as a "new-economy" trailblazer, it continued—to some degree apparently against Skilling's wishes—to pursue such stick-in-the-mud "old-economy" goals as building power plants around the world.

45. Enron's Overseas Energy Projects • Enron’s energy projects sprouted in places no other firm would go but appear not to have earned it a dime. With operations in 20 countries, Enron Corp. set out in the early 1990s to become an international energy trailblazer. • Enron launched bold projects in poverty-ravaged countries such as Nigeria and Nicaragua. It set up huge barges—with names like Esperanza, Margarita and El Enron—in ports around the world to generate power for energy-starved cities. • Enron's international investment totaled more than $7 billion, including over $3 billion in Latin America, $1 billion in India and $2.9 billion to develop a British water-supply and waste-treatment company.

46. Enron's Support from the U.S. • The U.S. government has been a major backer of Enron's overseas expansion. Since 1992, Overseas Private Investment Corp provided about $1.7billion for Enron's foreign deals and promised $500million more for projects that didn't go forward. The Export-Import Bank put about $700 million into Enron's foreign ventures. Both agencies provide financing and political-risk insurance for foreign projects undertaken by U.S. companies. • Enron enlisted U.S. ambassadors and secretaries of State, Commerce and Energy to buttonhole foreign officials on Enron’s behalf. It cultivated international political connections, recruiting former government officials and relatives of heads of state as investors and lobbyists.

47. Enron's Incentives to Risk • Like other parts of Enron's vast operation, its international division was fueled by intense internal competition and huge financial incentives. Executives pocketed multimillion-dollar bonuses for signing international deals under a structure that based their rewards on the long-term estimated value of projects rather than their actual returns. The system encouraged executives to gamble without regard to risk.

48. Enron's Overseas Boondoggle • In reports to investors, the company played down or obscured what analysts and others saw as inevitable losses. But in an interview with academic researchers in 2001, Jeffrey K. Skilling, who then was chief operating officer, conceded that Enron "had not earned compensatory rates of return" on investments in overseas power plants, waterworks and pipelines. Skilling said the projects had fueled an "acrimonious debate" among executives about the wisdom of its heavy foreign investments.

49. The Catches—one after another! • Acting as Principal in transactions! • Failing really to make money • Creating trading shell companies • Acting as partner in transactions! • Playing games with financial reporting • Being Greedy

50. The Collapse • Sudden announcement of losses in Oct 2001 • File for bankruptcy in Dec 2001 • Bankruptcy • Congressional Investigations began in Dec 2001 • Attempted destruction of documents