9/11 to 7/11 - Destruction of Towers

There is such an eerie similarity in the numbers, not totally though, but atleast in the manner it rhymes while saying it. The memories and the macabre pictures of that terrible tragedy of September 11th 2001 are far too vivid to be forgotten in a hurry. The death and destruction to innumerable families, and more critically, the realization of vulnerability, to a nation that for a moment stood stunned in silence, virtually sent shivers down the spine of public consciousness all over. The crumbling of the Two World Trade Towers overnight was as much symbolic of dangers that lurked around for the strongest of civilizations, as it was a paralyzing moment of truth, for those who lost their near and dear, all in a jiffy.

The month of September 2008 has brought about another similar disaster this time on the global financial sector. The seven eleven represents the financial disasters in USA that has caused a financial tsunami leading to a global meltdown - the filing bankruptcy applications by financial giants under Chapter Seven and Eleven of US Bankruptcy laws.

The Nine-Eleven tragedy was on account of fundamental extremism this time it is fundamentally due to financial extremism. Both the tragedies happened in an economy that had supreme confidence in systems that was replete with jargons and acronyms! It is classic case of supreme confidence to the sub-prime to the submerged!

The collateral damage that these events have brought on the system the world-over is enormous. Typical of the nine eleven tragedy – though it was the Twin Towers that fell, other edifices symbolizing the psychology of confidence of people in the U S also fell. It was also followed by a traumatic period of insecurity for the entire world. Likewise, the bankruptcy of a couple of major entities in the U S would carry far-reaching implications to the entire monetary apparatus of the world, leaving behind it ,a long trail of terrible doubt and insecurity in the international financial arena.
For such of those are not upto speed on the USA bankruptcy laws, here is what it means - When a troubled business is badly in debt and unable to service that debt or pay its creditors, it may file (or be forced by its creditors to file) for bankruptcy in a federal court under Chapter 7. A Chapter 7 filing means that the business ceases operations unless continued by the Chapter 7 Trustee. A Chapter 7 Trustee is appointed almost immediately. The Trustee generally sells all the assets and distributes the proceeds to the creditors. This may or may not mean that all employees will lose their jobs. When a very large company enters Chapter 7 bankruptcy, entire divisions of the company may be sold intact to other companies during the liquidation. Fully-secured creditors have a legally-enforceable right to the collateral securing their loans or to the equivalent value, which right cannot be defeated by bankruptcy. A creditor is fully secured if the value of the collateral for its loan to the debtor equals or exceeds the amount of the debt. For this reason, however, fully-secured creditors are not entitled to participate in any distribution of liquidated assets which the bankruptcy trustee might make. On the other hand in the case of chapter 11 filing is usually an attempt to stay in business while a bankruptcy court supervises the "reorganization" of the company's contractual and debt obligations. The court can grant complete or partial relief from most of the company's debts and its contracts, so that the company can make a fresh start. Sometimes, if the business's debts exceed its assets, then at the completion of bankruptcy the company's owners all end up without anything; all their rights and interests are ended and the company's creditors are left with ownership of the newly reorganized company. Either way as far as the company is concerned it is a closed chapter!
It is time that the industry and regulators understood that it is not enough that there is an act in place but the discipline has to come through the implementation of sound processes. We are familiar with B2B – starting with the Boom to Bust of .com companies, then onto realignment of business practices on Business to Business channels but now it is time for Back to Basics!

To begin with we might as go back to what the Americans so passionately refer to as “KISS” – “Keep it Simple Stupid”. The next, it is not enough if you have SOX but it more important to have BOOTS – Build Operate Operationally Transparent Systems. In an endeavour to create technology savvy organisation we have created technology monsters! Go to any organisation and don’t be surprised if they claim that they have expert systems... As a wag once put it, an expert is someone who knows more and more about less and less until, eventually, he knows everything about nothing. The modularisation of business processes based on highly complex technology applications has meant that invariably very few people are aware of the process in its entirety. The unscrupulous are bound to exploit the information vacuum that is created in the bargain. By no stretch of imagination is one suggesting that technology does not provide controls on the contrary, sometimes, it has so many that transaction is never understood in its totality and relative implications less understood!

Though the current situation represents the collective and cumulative failure of all concerned the law makers, regulators, corporate boards, independent professionals but as the same time we need to recognise that business organisations cannot be run on based on audits, external ratings and regulatory policing but sound internal systems. The Reserve Bank of India has rightly expressed concern over excessive dependence on external credit rating agencies by lenders. The banking regulator has recently expressed apprehensions that it may not be prudent to rely only on these agencies, given the current context in the global economy. These views were expressed as recently as July 2008 and how true it has come! Take the recent cases of AIG in America where a couple of rating agencies down graded the commercial papers a couple of days before the company was taken over. It literally was the proverbial bolting of doors after the horses had bolted! To think of it, even there it was only downgraded to an A –ve which still represented an investment grade when the company was literally in the doorsteps of a run and bankruptcy. The credit rating mechanism has been truly and surely exposed as a shallow exercise in the current context. These rating organisations have got to go back to the drawing boards and reexamine their whole rating process and mechanism.

Time has come for all organisations to have critical relook at their corporate practices. It is time that organisations are run based on strong trust based value systems addressing all facets of governance, risk and compliance. One does not necessarily have to ape the west for everything, we could learn from their mistakes. Let it not represent a situation where you ape someone and get monkeys. Let us not go overboard in the name of independence. Independence is not a qualification it is a state of mind. India has a had its own share of corporate and financial scams where the quantum of monies spent on investigations and committees have in some cases far exceeded the value of the purported scam without even having identified what the problem was.

It is time to ponder, analyse, take actions, and above all create a sense of values in business dealings. It is not just the recent shocks in the financial systems, but even the not so distant happenings around the Enrons and the Andersons, that bear strong evidence to confidence going overboard, and basic discipline in systems and time tested business principles, taking a serious knock. History, they say, repeats itself, because people repeat their mistakes. Can this big price we have now paid, be an investment for a stable tomorrow? Some serious points for introspection.

Credit Rating - A crisis of confidence

If you have suddenly found the investors fidgety or moody don’t blame them for the rating standards have become poor!
Never before has any single industry come under the scanner as in recent times with financials institutions falling nine pins. The consecutive failure of the giants only indicates that more is to come in the next couple days, weeks and months. The news reports based on the data released by the Federal Deposit Insurance Corporation indicating the banks and savings institutions on the ‘problem list’ grew to 117 in the second quarter of the calendar year 2008 against 90 in the first quarter. A 30% increase in the number of potential delinquents. The information evidently is not going to go down too well in the banking and financial community not to speak of the investors or the average layman who may just be wondering as where on earth he could keep his savings. It sounds literally like the nursery rhyme written “Ringa Ringa Rosie” with every conceivable financial entity falling!
Investors, be it the institutional financial investors or the retail investors, have always derived comfort from the any external assurance like professional audit and credit rating agencies. The turn of events over the last week has dealt a body blow on the confidence levels. One definitely is intrigued by the fact that the entire international rating agencies had assigned a credit rating of AA to AIG till May 2008 and suddenly down graded it just the night before the company was taken over the federal government under the bailout package. Even the down grading was to an investment grade which raises the basic question as how could a company on verge of significant credit default and bankruptcy has an investment grade rating?!
If investors in the failed companies are still looking at heaven to obtain plausible explanations, the failed giants namely AIG, Lehman and others to follow themselves, with all their financial acumen, appear to have been done by their trust on credit-rating agencies. The main credit raters — Moody's and Standard & Poor's, Fitch had assigned AAA and AA ratings to all sorts of exotic mortgage securities and other financial without evidently understanding or communicating to layman the underlying risks involved. An average investor would be last person to know how and understand the risks in the context of a collateralized loan obligation or commercial-mortgage-backed securities.
In hindsight it appears even sophisticated investors took Moody's and S&P's assessment of companies & instruments at face value and it turned out that the agencies sailing in the same boat as that of investors - clueless! A survey, a couple of years back, of the Association for Financial Professionals revealed that about 30% of finance managers perceived the credit ratings of their own organizations to be inaccurate; about 40% perceived rating changes to be untimely.
The role of credit rating agencies has been under the scanner ever since the sub-prime crisis started making its rounds in the international financial markets. The credit rating agencies have had to put up a strong defense to deny the accusation that they gave inflated ratings to sub-prime mortgage debt and other discredited bonds in order to attract more Wall Street investment banks that have now failed. This has happened not too long back and was about the same time last year.
Going back to the case of AIG, one wonders if the rating agencies had factored into the rating assignment the key issues of the leverage that is ratio of borrowings to capital. It was the highest in comparison to its peers at 11 to 1. This has to be viewed in the context of its exposure to the credit default swaps coverage that it had extended. The entire risk management mechanism of the company evidently was skewed and this, in retrospect, did not meet the eye rating agencies. The only aspect that raises an alarm is that all the agencies have accorded the same rating. The question that begs answer is if there is a cartel on rating or the rating mechanism shallow and fundamentally flawed! Harsh questions but definitely would be crossing the minds of every affected person.
Warren Buffet the sage from Omaha and financial expert had in an interview just after the Enron saga had said that derivates like futures, options and swaps were developed to allow investors hedge risks in financial markets - in effect buy insurance against market movements - but have quickly become a means of investment in their own right. He had warned that derivatives can push companies onto a "spiral that can lead to a corporate meltdown", like the demise of the notorious hedge fund Long-Term Capital Management in 1998. The words sound likes that of Nostradamus.
The credit default swaps (CDS) one of the many weapons of mass destruction that caused the current market meltdown has evidently not been brought under the scanner by the rating companies in their assessment. How else would one account for the madness of a virtual financial time bomb? According to industry, The International Swaps and Derivatives Association, estimates in USA the CDS market has exploded over the past decade to more than roughly $58 trillion.. That is many times over the size of the U.S. stock market and far exceeds the $7.1 trillion mortgage market and $4.4 trillion U.S. treasuries market. Pardon me for my lack of mathematically knowledge - I would be happy if someone got a fixation on the number of zeros attached to these numbers! Maybe we should take the zero has no value, beyond the decimals, but in this case once the market is decimated!!
One of the allegations that surfaced in the review of the credit rating agencies conducted by the Securities Exchange Commission USA was that certain of the larger credit rating agencies abused their dominant market position by engaging in certain aggressive competitive practices. Fitch complained that S&P and Moody's were attempting to squeeze it out of certain structured finance markets by engaging in the practice of "notching" — lowering their ratings on, or refusing to rate, securities issued by certain asset pools (e.g., collateralized debt obligations), unless a substantial portion of the assets within those pools were also rated by them.
A US government staff report in the context of the failure of Enron had the following to say. “In the case of Enron, the credit rating agencies failed tus used their legally sanctioned power and access to the public’s benefit, instead displaying lack of due diligence in their coverage and assessment in their coverage and assessment of Enron. Credit rating agencies did not ask sufficiently probing questions in formulating their ratings, and in many cases merely accepted at face value what they were told by Enron officials, Rating agencies apparently ignored or glossed over warning signs, and despite their mission to make long term credit assessments, failed to sufficiently consider factors affecting the long term health of Enron, particularly accounting irregularities and overly complex financing structures” This Para would aptly summarize that nothing has really changed over the over the couple of years!
The intent is not to discredit the agencies or cast aspersions on the agencies as much to say that the process has not been addressed over the years the problems of the 2001 Enron episode have reared their ugly face yet again.
A major issue that the users have been grappling is relatively less regulatory role on the rating industry and process. The rating process has become a virtual financial black-box with little or no clarity on the methodology used in the process. The lack of transparency is something that the industry needs to desperately work on. All other independent professional assessment or assurance has clearly laid out standards, guidelines and reviews. Increased disclosure about rating processes and decision outcomes would also improve transparency in the rating process. Again the ratings have to be simplified in terms of communication rather than list of alphabets from A to Z with multiple combinations of AAA to CCC with positive and negative signs being added to compound to users woes.
It is not just a lesson for the credit rating process but for all independent professionals to get back to introspection mode and examine as to how the faith of the investing community can be restored.