30 March 2015

Governance; Ethics and Morals versus Regulation

In London at the CRSA Forum last week (25th March 2015), once again speakers talked about the importance of the ethical foundation of leaders and companies, and as usual rubbished the need for or importance of "rules based systems" of governance or regulation . Implicit in the comments was the importance of ethics as the foundation of any successful business. Explicit were the statements "ethics are better than regulation" and "rule based systems are less effective than moral or ethics based systems".

Unfortunately, that is bollocks. There is simply too much weight placed on the idea that ethics and morals actually deliver more effective governance than rules. On the one hand, absolutely, effective corporate (and personal) governance for long term benefit needs a moral and ethical foundation. On the other, remove the rules and only the ethical or moral will comply.

Rules do not exist to stop ethical behaviour, nor to make companies profitable or unprofitable, or to ensure that a manager "earns" a bonus. Rules and regulations are enacted by governments to promote what the government of the day has determined to be desirable behaviours, and to discourage or punish those that are undesirable.

While the good news is that only 4% of CEOs may be psychopaths (Forbes "Why some psychopaths make great CEOs") that is four times the average in society as a whole. And while only a small percentage of CEOs may be psychopaths, their CFOs and FDs are under pressures of their own to ensure the numbers are right. The penalties for missing the quarterly numbers can be decidedly unpleasant (CFO.com).

"Comply or Explain", the UK reporting mantra, is held up as the alternative to rules based systems of reporting and governance. IFRS is a wonderful example of principles based reporting, yet the IFRS (International Financial Reporting Standard) still runs to over 2700 pages, excluding various national GAAP extensions to IFRS. Still, this is better than the 17,000 pages of US GAAP (Moss Adams LLP, 2009). Yet anyone who has attempted to use IFRS will find that it is as mired in rules as any GAAP. This also overlooks that so much of US GAAP is based on permutations of tax law specific to the US or to individual states. Oh, and US GAAP has been around a little longer than IFRS.

A victory for principles based reporting? Or, as a friends says "If self-reporting was the only requirement, there would be no murder".

Rules exist for a reason. They provide the boundaries beyond which behaviours are unacceptable in law and regulation, if not in culture and society. Yet to point out that principles based systems are inadequate is all it takes to be branded in favour of a rules based system, as if that is something bad.

There are good rules, and there are bad rules. Don't eat your soup with a fork is a good rule. Allowing companies to discriminate against any minority based on the presumed religion of the company is NOT a good law (and is not religious freedom).

Allowing the CEO and Chairman to be the same person in a public company is not a good principle, but it would be a good rule. Because as a principle, it can be applied or not, it is only a principle. Make it a rule, and there is no weasling around it, it is worse than bad practice (and a fine indicator that the company is being run for the enrichment of the managers and now the owners) and it would not be permitted.

Independent directors are a sound principle, and I see no need for a rule on this. An independent Audit Committee chair is a very sound principle. So sound that maybe it should be a rule.

Board effectiveness reviews? Great principle, but no, I wouldn't make them mandatory.

After all, the purpose of rules is not to over-ride good principles, sound ethics and strong morals. The purpose of rules is to limit the flexibility of those that pay lip services to good principles, or those that are not ethical or moral. Fraudsters, or just those under pressure to produces the target numbers by any means, can more easily justify bending principles, but they cannot justify bending the rules.

Indeed, I continue to say "Principles and ethical standards only apply to principled and ethical people".

06 March 2015

The GFC is not over; It might not have begun

Ever since the GFC (Global Financial Crisis) of 2008 - present, there has been a constant refrain that "no one saw this coming". That is rubbish of course.

Just as rubbish as the idea that somehow we either are out of the crisis, or that we will soon be in the clear.  All that has happened is that national governments have continued to kick the can further down the road, playing loan-shark to themselves and to each other. Greece is only one example of the fate of virtually all developed countries.

Why, and what is coming?

First Why. As a matter of principle, marketing exists as a discipline specifically to convince people to buy something (a tangible product or an idea) that may or may not actually be good for them, but the selling of which will delivery greater benefit to the seller. As a second matter of principle, wealth is invested with purpose of gaining a greater return on the wealth invested, at a return greater than the passive "parking" of that wealth in non-productive assets. Or, in simpler terms, money wants to gather more money. Or, even cruder, the Rich want to get Richer, happily at the expense of either other Rich, or at the expense of everyone else.

So, consider the investment in renting politicians and pundits as marketing spend, with the objective selling the idea (which is the product) that the amassing of wealth is both possible for anyone, and that any breaks on the amassing of wealth is a tax on the aspirations of those that are not wealthy. From this lens it is easy to accept union busting as a valid exercise, as unions by their nature act as blocks on the concentration of wealth.

Equally, economic crashes serve to undermine the increase in wealth. Therefore, it is advantageous for markets to either be reasonably stable, or to increase in value. As the wealth in markets is concentrate in the share-owning class(es), then the increase the value of markets defacto increases the wealth of the owners.

Debt as a venture capitalist tool

What is a great way to amass wealth? How about increasing a company's debt burden through the sale of bonds, and then spend a portion of that debt to "buy back" shares or pay dividends. In both cases, wealth is concentrated in the hands of the owners, while the risk and eventual debt burden is passed to the company and the owners of the bonds who carry a risk of default by a failing company.

Consider then this same tactic at national scales. The creation of new money through QE (Quantitative Easing) serves a similar function as the issuing of company debt. The national debt is increased, interest rates are suppressed, and there are limited places that "money can go" to make a return. So where does the money go? To the markets, which continue to rise on a tide of new debt. And as with the company debt, while the "dividends" in the form of increased value of the markets are concentrated, the risk is diffused across the entire population - the national "bond holders" in effect. Individual gain (the markets) balanced against socialized pain (the national debt).

After all, as the wealth is concentrated in the markets (or more accurately, in the wallets of the shareholders) the nation(s) find that the money they could have either not spent, or spent for the good of the nation, is wasted through debt repayments and reduced national investment. 

In this way the venture capitalist playbook of pumping up company debt, shifting the value from the company to the shareholders, and leaving the company and bond holders with the risk and reduced returns, is translated into national policy.

So wheres the problem?

Someday, the company must either pay back that debt, or go bankrupt. Paying that debt adds to the overall costs of the company, reducing the future potential returns. As John Mauldin in his February 24th "Thoughts from the Front Line" newsletter says "Debt is Future Consumption Denied". And that future consumption denied is as true at a company as at a national level.

So here's the problem, and the future. Governments such as Japan have proved that you can continue to produce new money for an almost infinite period of time (or for decades at least) without actually collapsing your economy. And if Japan can get away with it, certainly the United State, the UK, Europe, or almost any other government can accomplish the same scam, keeping markets afloat and continuing to concentrate wealth while diffusing the risk, and the resulting burden.

Unfortunately governments do not act in a void. And when all government are playing the same game, eventually there is no one left to buy their debt but themselves, from themselves.

Exist from QE cannot happen, because to do so will mean that the existing stock of financial capacity will be required to start paying off those corporate (oops, national) bonds. And borrowing money from yourself only works if the only person you are paying is yourself.

The next crisis, the real one

Various writers have been predicting that 2012, 2013, 2015, 201x will be the year that Japan effectively goes under. I don't know when it will happen, but it will.

Greece, currently under the thumb of the loan sharks of the Troika, will "file for bankruptcy" and leave the Euro. That is a given. When? I don't know, but my prediction is May 2015, through a weekend of new laws on the creation of the New Drachma. The playbook already exists, and Varoufakis's (the Greek Finance Minister) goal with the extension is not to actually capitulate to Berlin and Brussels, but to manage the Grexit to Syrisa's schedule, not to be forced into an exist at with Berlin and Brussels in control.

Grexit is the future, so watch it closely. It is the future of the West (and much of the East). As ugly as the Grexit will be, Greece will be back, and in a few years it will actually be a growing, vibrant economy again. Greeks will come home.

The rest of the central bankers will cower in fear of the lynch mobs and continue to pump money, while the wealthy continue to rent politician and marketeers to sell the concept of perpetual aspiration. Money will continue to be printed. But national investment will falter, fear will continue to stalk the land, and the wealth will continue to trust in the gated community and private security.

The moment central banks attempt to raise rates, the markets will collapse, therefore interest rates will be artificially held down. Raise rates and governments will need to spend more of their limited budgets on interest payments, taking budget from other national spending priorities, or increasing borrowing (against themselves again). Yet to admit that they cannot raise rates will confirm the trap that the banks are stuck in. So they will continue to hint, and might even, once, raise rates, only a little, before dropping them again.

The debt bubble will burst, and massive wealth will be destroyed, and the suffering will be terrible. For five or even ten years.

And yes, we'll have years of people writing that we could not have predicted this, and that no one saw it coming. And that is, and will be rubbish.

But the sun will come out again.