Alternative investments, the cases which have been discussed in section 6, are essentially structured derivatives deals, with leveraging and plenty of risk. Many are designed by hedge funds and marketed by banks to their clients. However, the name hedge fundis a misnomer, because what they really do is to speculate.
There are also companies which are hedge funds but masquerade under a differ- ent label.
The bankrupt Enron was a hedge fund with a gas pipeline on the side.8 Italy’s also bankrupt Parmalat was a hedge fund under cover of dairy products.9In both cases, the window dressing was regulated, the huge gambles which took place in the background (carefully hidden from public eyes and supervisory scrutiny) were not. In neither case was the real size of the hedge fund side known, even in approximate figures of recognized gains and losses. Under these conditions the practice of leverage can take very large dimensions.
The leverage of hedge funds is typically a medium two-digit number; 50 is not unheard of. But there are exceptions. Before it crashed in September 1998, Long Term Capital Management (LTCM), also known as the Rolls-Royce of the hedge funds featuring a couple of Nobel prize winners, had an exposure of $1.4 trillion with a capital of $4 billion; this means a leverage of 350 or 35 000%.10
LTCM’s exposure is an extreme event, but even when some hedge funds say that their leverage is ‘only’ 10 or 15 times their capital, they usually fail to account for the fact they are mostly running on bought money and that their derivatives trades significantly add to the leverage factor. Neither is LTCM the only hedge fund which went down the tubes. This happens quite often, particularly in the aftermath of financial events which make the speculators’ bets unravel.
For instance, a major financial event came on 5 May 2005, when Standard &
Poor’s downgraded to junk $453 billion in outstanding debt of General Motors
and Ford Motor Corporation. On Wall Street, some analysts said that General Motors crisis is:
● A national disaster for Corporate America, and
● It could actually detonate the world financial-monetary system because too many leveraged funds are overexposed to GM’s and Ford’s debt.
In the aftermath of this unprecedented downgrade, stock markets and bond mar- kets suffered massive losses, particularly so after traders pointed to evidence of severe problems at several large hedge funds, as direct consequence of GM’s and Ford’s woes. The hedge funds mentioned in this respect included GLG Partners, Bailey Coates, Cromwell Fund, Marin Capital, Highbridge Capital, Sovereign Capital, and Asam Capital Management.
London-based GLG Partners had $13 billion under management, and it was listed as the largest hedge fund in Europe, and second largest in the world. On 10 May 2005, GLG issued a statement that ‘All the funds are fine and we have no concern.’ The market however was sceptical, and the same was true of the hedge fund’s investors.
Also London-based Bailey Coates Cromwell Fund, established in July 2003, had
$1.3 billion in capital plus another $2 billion in bank credits. Euro-Hedge, a pri- vate entity that tracks European hedge funds, suggested that by early June 2005 the capital of Bailey Coates imploded to $635 million. On 20 June management announced the fund’s immediate liquidation.
California-based Marin Capital Fund was set up in 1999, raising $1.7 billion in capital. Its specialty was credit derivatives, a risky business.11The hedge fund made big bets with GM debt, lost out with the S&P downgrading, and mid-June 2005 management decided to liquidate the fund. (This is by no means the only gambler who bet on GM debt and lost.)
As was stated at a financial conference, Highbridge Capital wrote a letter to investors on 10 May 2005 noting: ‘It is our understanding that recent volatility in the structured credit markets is apparently related to the unwinding of an unprof- itable collateralized debt obligation (CDO) tranche correlation by one or more par- ties. …’ CDOs relieve banks of some of their credit risk by transferring it to entities who buy them – like insurance companies, pension funds, and hedge funds.
A year earlier, in 2004, Highbridge was bought by JP MorganChase. It is therefore part of a bigger group, as well as proof that commercial and investment banks own
unregulated hedge funds. Sovereign Capital, a British hedge fund, is closely linked to Lazard Brothers. This fund is heavily involved in East Asian markets, and news of the possibility of its collapse caused panic among Asian bankers and investors.
These are no rare exceptions. According to Merrill Lynch, about 17 percent of Deutsche Bank’s clients in its debt sales and trading business are hedge funds.
When the bank was named as one of the victims of the GM/Ford fall-out, the bank’s chief financial officer claimed that his institution’s exposure is fully col- lateralized. However, according to its own 2004 Annual Report, Deutsche Bank at 2004 end held derivatives positions, mostly interest rate derivatives, of a nom- inal volume of $21.5 trillion. In terms of real money, under stress market condi- tions, this is double the GDP of the Germany economy.12
Aman Capital Management, which has been based in Singapore, has reportedly lost most of its investors’ money. Established in 2003 by UBS and Salomon Brothers derivatives traders, Aman aimed to be the flagship hedge fund of South- East Asia. By the end of March 2005, however, Aman’s capital had shrank to
$242 million, and the hedge fund subsequently suffered new large derivatives losses, leading to a late June 2005 announcement that:
● The hedge fund is no longer trading, and
● Management will distribute whatever is left of the capital to investors.
Because what they do not have in capital they make it up in loans, particularly from the banking industry, one of the main issues that worries many experts, as well as the regulators, is the pyramiding of borrowing. Hedge funds borrow to bet on the market.
● Funds of funds, which through banks commercialize the hedge funds products to retail customers, also borrow and hold leveraged positions.
● Individuals who buy alternative investments borrow to invest in funds of funds; they are the ultimate suckers.
All this amounts to highly geared bets whose outcome is technical, obscure, and subject to the whim of markets. Critics are rightly concerned by the fact that, moreover, the hedge funds’ and funds of funds’ fee structure encourages their managers to borrow aggressively. Such fees are often calculated on the basis of all the ‘managed’ money: equity plus debt. As a result,
● More borrowing means more pay, and
● This is an enormous conflict of interest.
‘It is a house of cards,’ says one London fund of funds manager. ‘Each level of debt amplifies the rest – and that is hard to manage.’13Regulators who tried their hand in bringing some sense of risk control into the runaway hedge fund indus- try got fired by the politicians instead of being thanked for their efforts.
A recent case is that of William Donaldson, founder of Donaldson Lufkin Jenrette the investment bank (he sold it some years ago to Crédit Suisse for $11.8 billion, a high price), former president of the New York Stock Exchange (NYSE), and until recently chairman of the Securities and Exchange Commission (SEC), the American regulator. At a 1 June 2005 press conference, announcing his early res- ignation, Donaldson made it clear:
● He was forced to leave SEC, and
● The primary issue of contention was his effort to regulate hedge funds.14 In Europe, as in the United States, the regulation of hedge funds is a political issue which goes nowhere, because of strong headwinds blowing from embed- ded interests. On 13 June 2005, Gerhard Schrửder, the German Chancellor, gave a keynote address at an economic policy congress of his Social Democratic Party (SPD). In this he said that governments are obliged to protect the freedom and the stakes that have been achieved through regulations. What Schrửder essen- tially targeted was the:
● Short-term engagement of some hedge funds in Germany
● Criteria under which they operate, and interests they serve.
Schrửder said that the government wants stable financial markets, and that is why it needs transparency of hedge funds’ wheeling and dealing. This has essen- tially been a call about internationally unified minimum standards for hedge funds, as well as measures for the improvement of transparency on the oil mar- kets (another big gambling field of hedge funds). But after these fireworks noth- ing has happened, and the destruction of the global economy continues unabated.
Notes
1 Basel Committee on Banking Supervision, ‘Supervisory Guidance on the Use of Fair Value Options under IFRS’, Consultative Document BIS, July 2005, Basel.
2 With the exception of those held to maturity according to management intent(see Chapter 1).
3 Eskil Ullberg, ‘A Risk Management Approach to the Cost of Capital – Great Challenges for Business, Insurance and Regulators’, Geneva Association, Progress, No. 41, June 2005.
4 D.N. Chorafas, The 1996 Market Risk Amendment: Understanding the Marking-to-Model and Value-at-Risk, McGraw-Hill, Burr Ridge, IL, 1998.
5 D.N. Chorafas, The Management of Bond Investments and Trading of Debt, Butterworth-Heinemann, London, 2005.
6 D.N. Chorafas, Alternative Investments and the Mismanagement of Risk, Macmillan/Palgrave, London, 2003.
7 D.N. Chorafas, Wealth Management: Private Banking, Investment Decisions and Structured Financial Products, Butterworth-Heinemann, London and Boston, 2006.
8 D.N. Chorafas, Corporate Accountability, with Case Studies in Finance, Macmillan/Palgrave, London, 2004.
9 D.N. Chorafas, The Management of Equity Investments, Butterworth-Heinemann, London, 2005.
10 D.N. Chorafas, Managing Risk in the New Economy, New York Institute of Finance, New York, 2001.
11 D.N. Chorafas, Credit Derivatives and the Management of Risk, New York Institute of Finance, New York, 2000.
12 EIR, 27 May 2005.
13 The Economist, 12 June 2004.
14 EIR, 17 June 2005.
Part 2
Implementing IFRS
6
Project Management for Implementation of IFRS
1. Introduction
The study, and adoption, of new standards, like IFRS, which present a phase- shift from long-established thinking, policies, and procedures, calls for a most significant intellectual effort. This is true with nearly all modern business prac- tices, from globalization to technology, which require that more intellectual effort is organized around the problem to be solved, rather than at the side of tra- ditional functions such as production, marketing, lending or administration.
The implementation of IFRS calls for a well-organized project with budget, timetable, quality of deliverables, and follow-up. From planning to execution, this effort requires project management principles, including the making of design reviews. This is the subject of the present chapter, which aims to present the reader with:
● Critical issues confronting an important project
● Specific references to the application of IFRS, and
● Approaches to a successful implementation process and its control.
Starting with the fundamentals, the first crucial question concerning any impor- tant problem is: ‘What’s the problem?’ With IFRS, the salient problem is the phase shift from accounting methods based on accruals, which have become almost a second nature, to new accounting principles with which most account- ants have no experience. Fair value is an example.
Once this issue of change of standards is overcome, the next salient problem comes up: ‘What’s the aimed at solution to the problem?’ The answer is more realistic pricing of assets and liabilities, given that a fast-changing, globalized, dynamic market economy has made book value nearly irrelevant.
Still another crucial query is: ‘Which are the most important factors entering into this problem?’ The critical factors are not one or two, but several. The foremost is conceptual change, precisely because of the phase shift to which reference has been made. The next is intensive training in the new accounting principles, fol- lowed by the rules of project management which will define:
● Resources to be committed
● Timetables to be respected
● Costs to be incurred, and
● Results to be expected from the implementation.
All this is written in the understanding that IFRS will impact many areas of the company’s business beyond the accounting and finance operations, but at the same time there will be opportunities presented by IFRS. To capitalize on these opportunities, it is important to identify the key differences, between old and new systems, make an accounting policies review, see where methods might have common elements, and change reporting approaches including consolida- tion processes and IT support.
Sure enough, there will be changes to the way management information is pre- sented, regarding both form and content (see Chapter 8). Other changes will affect internal communications for employees and board members, as well as external communications for stakeholders and other users of financial state- ments. All this should be an integral part of project management for IFRS.
Most certainly, crucial company functions like internal and external audit, risk management, and the internal control system will be affected. The way to bet is that IFRS will have short- and long-term impact on the way profit and loss is cal- culated, the balance sheet’s content, and damage control activities. In short, it will affect:
● Control systems
● Compliance tests
● Liaison with regulatory authorities.
In turn, all this will have an after-effect on human resources, from recruitment of staff with IFRS experience, to the revision of performance incentives. And infor- mation systems, too, will need changes from functional specifications to busi- ness usage requirements. Some people look at all these references as ‘problems’, but in reality they are opportunities.