Do We Need Big Banks?

Humans can’t handle more than 150 relationships. It’s a throwback to our caveman past – when tribes exceeded 150 people, bonds of trust started to weaken and no one really knew what was up.

Big banks in New Zealand have thousands of employees and hundreds of thousands of customers. Big banks in the US have tens of thousands of employees and millions of customers. No one really knows what is going on because there are so many people involved in the banking sector.

Back in the olden days, before I was born, you used to have a relationship with a bank manager. When you went to apply for a loan, he knew your banking history, probably your parents and your grandparents too. If you were applying for a farm loan he’d have a decent knowledge of your farming ability.

This meant that the distance between savers and borrowers was small. Relationship banking meant knowing your customers, knowing the local community and knowing that if someone had good character they were likely to pay the bank back eventually.

Back in the olden days, there was also a lower incidence of bad behaviour. Defrauding banks still happened, but it was a lot harder than it is today. Because communities were smaller, the social shame effect could be used to lower the likelihood of default.

This is all in stark contrast to how the banking sector functions today. Credit approval is granted based on points and complicated models that evaluate a potential borrowers prospects.

Putting aside the role that fancy models played in the collapse of Long Term Capital Management, the NASDAQ technology collapse, the housing boom and rise of sub-prime, the derivatives on sovereign debt and even domestic housing developments, the big banks today have enormous distance between the savers and the borrowers.

In any system, when you centralise decision making, you lose knowledge at the coal face that matters. In his essay The Use of Knowledge In Society, F A Hayek argued that the reason central planning failed was because a committee couldn’t make price decisions for every single actor in an economy.

Central planning in the banking system is represented by centralised credit approval systems. They use fancy models that use crap models like “Value at Risk” because the regulators, who know very little about the real world, have mandated that those models are the true representation of the risk a bank is exposed to.

Dispersed knowledge applies just as much as the private sector as it does in the public sector. Dozens of local bank managers making subjective decisions is likely to be more stable than a centralised credit approval system.

The conceit, of course, is that a model is a simplification of reality. It is made up of assumptions, can disregard potentially relevant factors as “not useful” and applied to situations it really shouldn’t be.

Big banks in New Zealand today are walking blind through a minefield. Their loan default models are based on past default rates. Their “worst case scenario” stress testing models forget that the “worst case scenario” is always worse than the last worst case scenario before that!

We don’t really need big banks because the arguments they use to justify their existence, like they provide payment networks and the like, are redundant in the 21st century. They are a utility, the flash offices I see in Wellington belonging to big banks offends me deeply.

They should be as boring as water companies. Not some sexy, profitable, lavish executive pay with no clawbacks for imposing systemic risks on everyone else nirvana. The big banks have to go if we want any return to a realistic distance between savers and borrowers.

Ross Asset Management Cash Flow 2000 to 2012

“It was not the financial elite, [it] was ordinary New Zealanders who are working hard and have saved money,” he said.

I am pleased to read that there are rumblings of net winners having money clawed back from the Ross Asset Management scheme.

In the recovery of assets in the Madoff scheme, Irving Picard has pursued “net winners” who received more from the scheme than they put in. He has achieved several substantial settlements, notably the estate of Jeffry Picower and the NY Met owners who used Madoff like a checking account.

The comment by investor Bruce Tichbon that his group of investors want to limit the fees charged by receivers and liquidators is entertaining.

The cost of recovering funds from fraud is high due to the need for forensic accounting experts and civil suits against “net winners”. Many of the transactions over the past few years could qualify as voidable preference, meaning the liquidator can claw them back.

The process will also take years to wind down. There are no quick resolutions to situations like this. You can’t just get a court order one month and have the “net losers” bank cheques the next.

We are yet to hear back from the Serious Fraud Office on whether charges will be laid against David Ross.

But by representing the cash flows identified by PWC in its report to the High Court graphically, we can see how these schemes work:

The net difference over the 12 year period, which excludes activity before 2000, is -$15,774,673.59. But over $303 million was contributed to the scheme and almost $290 million withdrawn. Management fees accounted for almost $30 million dollars.

The onset of the global financial crisis seems to have set the unwinding of David Ross into motion. A substantial increase in withdrawals along with a major reduction in contributions rapidly altered the mathematics here.

It’s clear that although management fees of $30 million were a factor in the collapse of the scheme, they are dwarfed by the mathematics. It’s simply not possible to keep adding substantial investors to finance the withdrawals of other investors in a global financial crisis where people are cautious about investing outside of lower risk assets.

I am extremely concerned that anti-money laundering rules didn’t pick up on really odd cash flow patterns like this. I hope the FMA will use this occasion to instruct the commercial banks to identify high cash cash flow patterns like we saw above.

The “unusually large” number of brokerage accounts held by RAM and its associated entities are also major red flags. If you have hundreds of millions of dollars under management, maintaining accurate performing reporting over a handful of accounts is difficult enough – dozens of accounts would require a substantial back office operation.

With respect to overseas asset recovery, if a substantial portion of the management fees has been transferred offshore best of luck to PWC in getting any of that back.

This is going to be one of the most interesting cases to come out of the global financial crisis in New Zealand. The fact that nobody has done serious due diligence does not bode well for any notion that investors are capable of managing their own money without enormous investment in education and financial literacy.

Red Flags And Ross Asset Management

The report by High Court appointed receivers PWC regarding Ross Asset Management makes for sober reading. In the wake of several ponzi schemes being uncovered as the global financial crisis led to more withdrawals than contributions, we have to think carefully about the enormous red flags that presented themselves when it came to Ross Asset Management.

Brian Gaynor wrote in the Herald:

Investors deposited funds with RAM, assets were purchased and sold on their behalf and held by RAM. The investment performance of these funds was reported by RAM without any independent verification or audit. RAM clients had their own individual portfolio and, as a consequence, could have widely differing investment returns.

As he notes, this was exactly the same structure employed by Bernie Madoff. The cash flowed into a single account and back out again when withdrawals were requested. The PWC receivers have identified just $10.2 million out of a supposed $449.6 million in assets under management. The cash flow analysis in the PWC report makes for sobering reading.

When you think about due diligence on potential investments, the Ross Asset Management proposition sets off multiple sirens. The lack of independent verification of returns, the use of an accountant who shared the same address as the firm, the absence of an independent custodian and maintenance of client records in a single Access database are just the tip of the iceberg.

There was quite a disturbing interview on Radio New Zealand where the poor lady involved had all of her savings with David Ross. It is clear that Ross Asset Management was operating on the down low, relying on referrals and word of mouth.

With the high average account balance of around $500,000 many investors would have been wholesale investors / accredited investors. That means lower disclosure is required and filing prospectuses with the FMA isn’t necessary.

It’s clear that having $500,000 to invest is not sufficient evidence of an ability to manage your own wealth. An enormous amount of reading and careful thinking needs to be done before writing a cheque to anyone – let alone to an asset management firm that operated completely outside standard practice.

Since the collapse of MF Global it has been clear that you are an unsecured creditor to any investment firm you have an account with. Every single dollar of your wealth is at risk – your term deposit, your bonds, your shares, your derivatives trades – they all require ongoing monitoring and tough questions being asked of the people you’re dealing with.

When the most clued up fund managers in the world regularly clear different types of trades through different prime brokers to reduce the counter-party risk involved, that’s a clear signal to ordinary investors that breaking up where you put your money is the bare minimum of risk reduction you can do.

I am surprised that accountants performing the foreign investment fund tax calculations for investors in Ross Asset Management didn’t double check shareholdings via the registry. How could you file accurate tax returns reporting foreign capital gains and dividends without double checking the relevant share registries?

I will follow the development of this case with interest. Because Mr Ross was an “Authorised Financial Advisor”, it will be interesting to see whether more background investigation will be conducted to see if other AFAs are running investment funds of this magnitude on the side and outside the regulatory framework the FMA oversees.


Book Review: A Matter Of Principle By Conrad Black

A Matter Of Principle By Conrad Black

My interest in the Conrad Black case was sparked by an article that appeared last year in Vanity Fair. I quickly forgot it, but when the disgraceful interview conducted by Jeremy Paxman appeared on my YouTube recommended list I was keen to explore the Conrad Black case in more detail. Jeremy Paxman was completely uninformed and came across as a numpty.

According to the initial trial by media, Conrad Black was an entitled, pompous corporate thief in the vein of Kenneth Lay or Dennis Kozwolski. He had stolen hundreds of millions of dollars from shareholders and deserved a life sentence in US prison whilst forfeiting all of his worldly possession.

While you have to take the words of a convicted “criminal” with some caution, the case of Conrad Black and the availability of court judgments on the internet enable the reader to perform “due diligence” on the case he makes for his innocence.

At first skeptical, I am now convinced that he was the victim of a terrible persecution. It all started when a non-shareholder and former SEC chairman Richard Breeden filed a 13D form with the SEC.

It set in motion a series of events where people who had no business interfering in the private affairs of Hollinger were able to cause shareholder losses of more than US$2 billion dollars.

These hangers-on even paid themselves millions of dollars with Hollinger’s money after taking it hostage. Tens of millions of dollars was wasted on high priced lawyers who couldn’t do much more than demand payment in advance from Conrad Black and his fellow defendants.

The corporate governance crew were able to greenmail, bully and intimidate the other directors into allowing a full-blown investigation of Conrad Black and his business partner David Radler’s “wrongdoing”. They included a former Chairman of the SEC and numerous powerful lawyers who cared more about getting paid than getting to the bottom of whether or not fraud had been committed.

It turned out David Radler really was a crook. He took the coward’s way out with plea bargain, serving up Conrad Black on a platter. The actual turn of events, which can be independently verified with a few hours Google searching, was completely different from the Murdoch media narrative.

Conrad Black very clearly sets out how the plea bargain process works – in exchange for false testimony, you can bargain with the prosecutors to save your own skin. In terms of game theory it makes perfect sense. For non-sociopaths it is morally repugnant behaviour.

One of the reasons that Conrad Black was so misrepresented in the media was that he refused to plea bargain with the US Justice behemoth.
For his insolence, the FBI seized the proceeds of a New York apartment sale. They had no claim to it but stopped $10 million from going to his defence lawyers.

Although convicted on “honest services” grounds and for obstruction of justice, Conrad Black didn’t back down. His appeal to the Supreme Court led to the “honest services” clause being struck out and very stern comments on how the original judge should review his reasoning in the case.

The author of the “honest services” conviction was Richard Posner of the Chicago 7th Circuit Court of Appeal. Black rails against Posner’s megalomania and refers to his reputation on the bench for a lack of attention to detail.

The case against Conrad Black had shrunk from an enormous alleged fraud to a handful of technicalities. But despite the Supreme Court effectively overturning his convictions, Posner ignored them and issued another judgment that still incorporated the unconstitutional “honest services” nonsense.

In order to save face for the US Department of Justice, the SEC and the greenmail corporate governance activists his sentence in Federal prison was reduced to 42 months in 2010. He had to serve another 7 and a half months before he could be released.

His time in prison wasn’t completely in vain. In this book Conrad Black clearly explains how US justice is not justice at all. He rails against the plea bargaining system, civil asset forfeiture, intimidation of witnesses and the implausibly high success rate of US prosecutors.

He talks about how upskilling in prisons is non-existent, why there are major incentives for prison populations to keep on growing and with his signature style mounts a convincing argument that the entire US justice system now operates on the basis of “guilty until proven innocent”.

If Conrad Black was not a multi-millionaire with the willingness to fight and the financial capacity to do so, he was facing a life sentence for a vendetta by corporate governance greenmailers.

The cost of this injustice has been the destruction of a career, the destruction of more than $2 billion in shareholder wealth and the enormous cost incurred by the SEC, DoJ and FBI in hounding Conrad Black for almost a decade.

This book completely altered my thinking on the role that corporate governance plays in public companies. The ability for an outsider to essentially hold an entire company hostage and bill it for the privilege shocks me.

The real world evidence of regulatory capture, rent seeking, miscarriage of justice, abuse of due process, judicial over-reach and a whole plethora of other abuses makes A Matter Of Principle a solid read for anyone interested in how the US justice system can pummel even an entrenched member of the 1%.