Economic historians who, 50 years hence, write about events of our times will probably say that the 1997 crisis in East Asia was the first of many bubbles that burst in the second half of the decade of the 1990s, with the IMF running to the rescue with ready cash. By contrast, the salvage of Long Term Capital Management (LTCM) in September/October 1998 was undertaken by the Federal Reserve of New York, through brokerage, using the hedge fund’s stakeholders as lenders of last resort.
Like any other company, hedge funds fail, and the way to bet is that the more leveraged they are the greater is the likelihood they will lead themselves to bank- ruptcy. Chapter 1 has presented several examples of hedge fund failures in 2005, but the best of all still remains LTCM which, in its time, was known as the Rolls- Royce of hedge funds.
Central banks do not have to do hedge fund bailouts, because these are not reg- ulated entities. All bailouts are signs that lenders want their money back even if they have to put up more capital. When the payout is done with taxpayers’
money it poses two main problems:
● The moral hazard as a forerunner to other rescues, and
● The fact that those who made the mess walk away with their capital intact, or nearly so.
As billion dollar losses multiply, the banking system is discovering that it can- not maintain its current level of loan-making activity to the hedge funds and to corrupt or inefficient sovereigns. Knowledgeable people on Wall Street have also been worried about a longer-term aftermath. In 1998, the magnitude of LTCM’s exposure and its underline high leverage were seen as the reason why the New York Fed had no choice but to organize the rescue of the hedge fund, as Dr Alan Greenspan made clear in his testimony to Congress:
● Ifthe fund went bust, and its positions were liquidated in a firesale
● Thenthe panic would have turned the banks’ trading bets into a nightmare.
Since derivatives and other leveraged instruments are revalued daily through value-at-risk, the banks can become technically insolvent rather quickly. Moreover, the very sharp fall of LTCM’s capital increased the risk that lenders might seize its assets, even if these were insufficient to meet its obligations.
The salvage operation the Fed put together took a leaf out of J.P. Morgan’s book.
In 1907 the great financier had gathered fellow bankers at his office at 23 Wall Street to stem the stock market panic. There was, however, a difference. The 1907 market panic was public news, while as a result of the secrecy associated to hedge funds, as the news of LTCM’s troubles spread,
● Most banks assumed that other hedge funds, too, held huge loss-making positions that might have to be unwound, and
● The market’s nervousness was made worse by rumours that several invest- ment banks, too, were on the verge of going bust.
In fact, some analysts pointed out that the September 1998 collapse in the dollar/yen exchange rate was probably due to forced liquidation of positions.
This was done by both banks and hedge funds because they had borrowed in yen (where interest rates were rock bottom) and invested the proceeds in dollars. To avoid this rush, the consortium put together by the Fed gave itself three years to unwind the LTCM portfolio. The target was an orderly liquidation on the hypoth- esis that:
● Volatility would subside and global markets would recover sufficiently during the 3-year time frame
● While interest rates would move in the consortium’s favour, allowing it to cut its losses and even make a profit.
Correctly, nobody hoped that it would be possible to change things appreciably in the short term, as dealers were sitting on large inventories of securities acquired from LTCM and they, too, liked to unload. That made it harder to sell many of the securities that LTCM held, particularly so at a time when financial institutions were shrinking their balance sheets and reducing risk capital.
● Less risk capital means fewer purchases of financial assets, and
● The result is that, for some time, highly leveraged assets are no longer in favour.
Also negative has been the fact that commercial and investment banks in the consortium that provided the salvage money were betting on the same hypothe- ses LTCM had done and went wrong – for instance, on the assumption volatility would subside and yields on junk bonds would converge with US Treasuries.
Only the best-managed institutions who make up their own mind and don’t fol- low the crowd of speculators have a chance of avoiding LTCM’s blunders.
Because of arrogance, lack of coordination, poor foresight, and absence of an enterprise risk management system, practically everything had gone wrong at the
‘Rolls-Royce of hedge funds’, starting with the way the fund was run.
The CEO and his partners were unable to appreciate that a nervous market will flee from risky investments into safe Treasuries. Yet, this happened during August 1998, a month and a half prior to LTCM’s collapse. Neither did they show an understanding of the fact that, historically, risky securities plunge at once.
When the blow-up approached, and risk management models flashed red, LTCM could not unwind its positions as quickly as its partners had assumed. With rising volatility, market liquidity dried up faster than LTCM’s top brass had expected12 – which is also a major management failure in foresight and in governance.
Had LTCM been pushed into bankruptcy and its net positions, first estimated at
$116 billion, then at roughly $200 billion, and finally at $1.4 trillion, been liquidated, the markets would have been sucked into a maelstrom. Since the mis- calculation of interest rate trends had been one of the fund’s undoings, a further rush to the safety of Treasuries would have made liquidating the LTCM positions all but impossible.
One of the lessons to be drawn from the LTCM debacle is that many people who handle money don’t quite know how to calculate risk and return – or don’t care to do so. Instead of sanctioning the pseudoscientists and their huge leverage of exposure, LTCM’s chief executive and his associates seem to have prompted them to do more of the same.
As everybody in business should appreciate, ‘doing more of the same’ is the negation of management oversight. This is another lesson to be learned from the failure of Long-Term Capital Management. Prudence advises that the board should approve investment strategies, trading policies, portfolio objectives, and gearing initiatives which lead to diversification of risks. The board and CEO should also assure that all of these moves are consistent with the institution’s:
● Financial condition
● Risk profile, and
● Risk tolerance.
It is the responsibility of the board to establish limits on aggregate trading, lever- aged loans, investment and exposure amounts, defining the types of permissible
investments and their tolerances. The board and CEO should moreover assure there is an adequate system of internal controls with:
● Appropriate checks and balances, and
● Clear audit trails regarding business operations.
These bullets are two of the pillars on which an enterprise’s risk management should rest. The Fed has not said so explicitly, but the board, CEO, and senior management should also understand the tools and methodology being used in bet- ting, as well as the hypotheses being made and the risk(s) these might involve. It is good to be innovative in finance, but not everything new is sound – particularly ifit is untested, or done lightly for novelty’s sake; and ifrisk management is looked at as a bother rather than as a life-saver.
Notes
1 D.N. Chorafas, After Basel II: Assuring Compliance and Smoothing the Rough Edges, Lafferty/VRL Publishing, London, 2005.
2 Robert J. Schoenberg, Geneen, Norton, New York, 1985.
3 D.N. Chorafas, Stress Testing: Risk Management Strategies for Extreme Events, Euromoney, London, 2003.
4 D.N. Chorafas, Implementing and Auditing the Internal Control System, Macmillan, London, 2001.
5 D.N. Chorafas, Modelling the Survival of Financial and Industrial Enterprises: Advantages, Challenges, and Problems with the Internal Rating-Based (IRB) Method, Palgrave/Macmillan, London, 2002.
6 D.N. Chorafas, Reliable Financial Reporting and Internal Control: A Global Implementation Guide, John Wiley, New York, 2000.
7 D.N. Chorafas, Economic Capital Allocation with Basel II: Cost and Benefit Analysis, Butterworth-Heinemann, London and Boston, 2004.
8 Insurance Economics, No. 52, July 2005.
9 D.N. Chorafas, After Basel II: Assuring Compliance and Smoothing the Rough Edges, Lafferty/VRL Publishing, London, 2005.
10 D.N. Chorafas and Heinrich Steinmann, Expert Systems in Banking, Macmillan, London, 1991.
11 D.N. Chorafas, Agent Technology Handbook, McGraw-Hill, New York, 1998.
12 D.N. Chorafas, Understanding Volatility and Liquidity in Financial Markets, Euromoney Books, London, 1998.
17
The Role of the Audit Committee
1. Introduction
In many companies, the Board of Directors has several ongoing committees:
Audit, Finance, Corporate Governance, Compensation, Technology, and more recently Risk Management, being among the most common. Because of malprac- tice and other events regarding audit-related weaknesses in corporate gover- nance, many of them quite serious, the Audit and Finance committees became prominent and the range of their responsibilities expanded.
A recent document by the Basel Committee on Banking Supervision had this to say about the need that board directors pay personal attention to the entity’s auditing activities: ‘The Committee presumes that large, internationally active banks will have an audit committee … responsible for providing oversight of internal and external auditors; approving their appointment, compensation and dismissal; reviewing and approving audit scope and frequency; receiving audit reports; and assuring that management is taking appropriate corrective actions in a timely manner to address:
● Control weaknesses
● Non-compliance with policies
● Laws and regulations, and
● Other problems identified by auditors.’1
In principle, both the Audit and Finance committees should consist of directors who have no financial or personal ties to the company. They should also meet standards established by the New York Stock Exchange for independence of opinion and of decisions. In addition, at least a couple of each committee’s mem- bers should have accounting and/or financial management expertise.
To perform their functions in an able manner, members of the Audit Committee should meet with the company’s management periodically during the year, to consider the adequacy of internal controls (see Chapter 16), assure that objectiv- ity of financial reporting is always observed, and examine the outcome of stud- ies by internal auditing. Such findings should be discussed with:
● The company’s independent auditors, and
● Appropriate company financial and auditing personnel
An important mission of the Audit Committee is to elaborate with the company’s management and independent auditors the processes used for certification of finan- cial statements, particularly certification made by the company’s chief executive
officer and chief financial officer. As will be recalled, this is required by the Securities and Exchange Commission (SEC) and the Sarbanes–Oxley Act of 2002 (see Chapter 10) in connection to the company’s filings with SEC.
Another vital function of the Audit Committee is that of recommending to the Board of Directors the appointment of independent auditors for the company, or a change in current appointment. This is typically done after reviewing the per- formance of the certified public accountants firm, and its independence from the company’s management.
Nobody, however, said that Audit Committees cannot be manipulated, at least up to a point. When this happens, it reduces to nothing its role of external financial oversight. Martin Taylor, a British businessman who sits on five boards in five different countries, recalls one American Audit Committee that used to meet after the figures that it was supposed to scrutinize had already been released.2 Contrary to the mission performed by the Audit Committee, the role of the Finance Committee is focused on the budget, management of assets and liabili- ties, evaluation of cash flow, and verification of intrinsic value of the firm. All appropriations beyond a certain threshold, as well as the budgetary process as a whole (see Chapter 9), should be under the control of this committee. The same is true of the firm’s financial policy.
The Corporate Governance Committee usually has several functions, including recommending to the Board of Directors nominees for election as senior execu- tives and independent directors of the company; making recommendations to the board as to matters of corporate governance, including management control; eval- uating policy issues, and recommending changes when and where necessary.
The Sarbanes–Oxley Act of 2002 requires companies to have procedures to receive, retain, and treat complaints made by third parties regarding accounting, internal controls, or auditing matters. Also to allow for the confidential and anonymous submission by employees of concerns regarding questionable accounting or auditing issues. Depending on the problems brought to light, this may involve both the Auditing and Corporate Governance Committees.
An integral part of the functions of the Compensation Committee is that of admin- istering management incentive compensation plans; establishing the compensa- tion of officers; and reviewing the compensation of directors. The Corporate Governance and Compensation Committees often jointly consider qualified can- didates for directors suggested by shareholders.
A major risk to good governance is that the Compensation Committee can be packed. A survey by the New York Timesfound that in 420 out of a selection of 2000 large American public corporations, the board’s Compensation Committee, which determines the CEO’s pay, included relatives or people with ties either to the boss or to the company. This represents more than 20% of all sampled cases and therefore it is not an exception but a trend, and a matter that should deeply concern Audit Committees.
Basel defines the role of the Risk Management Committee as being that of pro- viding oversight of activities by senior executives in managing credit, market, liquidity, operational, legal, compliance, reputational and other risks of the insti- tution. According to the supervisors, this role should include receiving from sen- ior management periodic information on:
● Risk exposures, and
● Risk control activities.
The objective of the Technology Committee is to assure that in terms of the tech- nology it uses, and the investments which it makes, the company is ahead of the curve; or, at least, at state of the art with the best technology money can buy.
Long years of experience in technology have convinced me that the Audit Committee should commission audits by independent consultants on the level of technology the company uses and its effectiveness. Slippages should not be allowed to happen, because pretty soon they develop into a falling behind in technology in a big way, with a severe effect on competitiveness.