“Free markets” work if there is transparency.”

 Former Investment Banker, Alain Bolea

Lies, lies, damn lies… and “free” markets.

Banks are returning to profitability; some with spectacular results like Goldman Sachs, others such as Citibank through asset sales.  Many are rushing to repay TARP funds.  We have avoided a complete melt-down of the banking system.  We hope.

Not much cheering 

      
To most observers, however, little has changed.  Banks have no incentive to reform.  The recent past seems to show they can act recklessly in boom times and avoid consequences when in trouble.  This is not completely accurate because although banks as institutions may have weathered the crisis, bank shareholders have lost all or most of their investment value. So there should be a lesson there.  But we are not hearing much from bank managements (with rare exceptions) about the change in philosophy that everyone is waiting for.

It also seems patently unfair that, when so many businesses are now forced into bankruptcy, banks and others, rating agencies in particular, who profited from the subprime excess, survive unharmed.

But will they really survive?

Is a true market correction on its way?

In July, when some banks returned to profitability, CALPERS, the largest pension fund in the world, sued rating agencies, S&P, Moody’s and Fitch.  Let the legal finger-pointing begin.  Just as investors turned against Arthur Andersen after the Enron debacle, today’s market players are turning on each other.

Of course lawsuits take a long time to come to judgment and are vigorously defended, but potential liabilities in this case are enormous if intentional wrong-doing can be proven.  Losses could easily overwhelm rating agencies.

The risk will come from what the discovery process surfaces in preparation for the lawsuit.  Can CALPERS prove rating agencies had plenty of reasons to doubt the validity of the AAA ratings they granted subprime mortgage instruments?  Judging by public statements made by Frank Raiter, a former S&P executive, I believe CALPERS will find plenty of arguments to support its claim.

As early as 2001, Raiter was fighting the loosening of credit standards to accommodate the emergent mortgage-backed business. “Compromises” were extensive, he charges, such as 1) rating securities that S&P had not examined, 2) not investing in analytical models and databases in spite of representations of doing so, and 3) failing to staff adequately to keep up with the volume of business.  (See Bloomberg article of September 24, 2008.)

There is little doubt that rating agencies responded to the coaxing and representations of the investment banks packaging the securities to be rated.   What will be found in email communications is anyone’s guess, but there will be plenty of embarrassment to go around.  Could that draw investment banks into the fray?  Will rating agencies eventually turn against the investment banks to save their own skins?  Will investors turn directly against investment banks?  These scenarios are hardly unlikely given that banks have the much deeper pockets.

Markets self-correct, but at great societal expense

Either way, many would argue that market logic is now moving toward correcting the excesses of the past.  The main players in the subprime bubble will finally bear the full consequences of their bad business practices.

Many economists, from their vantage point at 10,000 ft, will invoke the correction of market excesses (through the legal process) as proof that free markets work.   Slim consolation for those who saw their retirement funds vanish, lost their jobs, or had to sell their houses at a loss.

If this is the logic of free markets then it is a highly destructive process that hurts the many for the benefit of the few.  Whether you do nothing and let the economy collapse or rescue it, societal costs are huge.  In both cases the bill is passed on to the taxpayers with long term implications.

So how do we bolster sound business?  Can we bring higher scrutiny to bear at all times so businesses aren’t pulled into the unchallenged euphoria and unethical practices that take over when markets are bubbling up?

Free market pundits propose “Buyer Beware!” as the solution.   True, small investors, who may have suffered the most in this meltdown, could have used better judgment.   But most individual investors do not have the ability to evaluate risks and are compelled to rely on others.

Signs of trouble

Common sense is clearly required and a simple analogy may help us all stay out of trouble.   It comes from nature where fast growth rates are only found at the beginning of life or when cancer is present.  How does it relate to the world of business?  Businesses have life cycles: a venture will grow quickly at the beginning then stabilize at a slower growth rate.  If an established business or industry begins to grow much faster than the rest of the system it is in, there is an excellent chance that it has turned “parasitic,” that is growing at the expense of the healthy system.

This is the time to ask extra questions and look at how the company manages its intangibles, i.e. all the things that are not captured in its financial numbers.  How it does do business? Treat its employees? How transparent is its management? How prone to lawsuits is it?  How are its relations with suppliers?  How does it manage its environmental footprint?  Is it saying one thing and doing another?   Are there fundamental conflicts of interest in the business model?

I doubt that there is one single perfect yardstick, yet it would be refreshing if the major business media started highlighting such questions rather than cheerleading vociferously every time markets take off.

Where is the solution: free markets or regulation?

The debate is often presented as if free markets and regulation were mutually exclusive but history seems to point to a more balanced answer.  Markets that can be manipulated need to be regulated.

We live in the illusion that markets are automatically free.   If they were as free as economists like to think, business could be conducted fairly all the time: there would not be market “victims.” But the markets that economists like to talk about (where people can choose to make different decisions from the same information) are mostly an ideal state.   Too much rides on advantages that information grants.   Withholding and distorting information are still common tactics.

“Free markets” work if there is transparency.  The subprime crisis was all about distorted information, just as accounting scandals were.  The subprime market was not a free market; it may have been at its inception, but quickly became a systemic process to white-wash information.  Misleading representations were made by all parties and conveniently left unchallenged, especially by the raters.   The result was a perfect intellectual illusion: loans to borrowers with bad credit ratings can be aggregated and transformed into AAA risk securities!  Due diligence became inconvenient to the task of making money; if you suspected the answer could be a deal-breaker, it was best not to ask the question.

Regulation is of minimal comfort.  It always seems to come after the fact.  Few regulators have the foresight (to say nothing of the independence from political pressures) to anticipate and prevent problems.

Looking for a different market regulator

The opportunity for change lies in increasing transparency, in freeing the market from distortion and deception by bringing information forward in an organized manner.  More information is now available that’s not subject to manipulation by companies, can be cross-examined and become the basis for a sound examination of business practices.

The internet (and intelligent search engines) can provide the information to base truly independent ratings from objective criteria.  This intelligence will ferret out companies that do business by hiding or distorting information, say one thing and do another or pass on their liabilities and obligations to others.

Over time it will become increasingly clear that such companies are prone to melt downs and that unethical business practices are plain bad business.  INVESTORS beware indeed!  Watch for what is too good to be true and scrutinize how ethical a company is in every aspect of its business.

Alain Bolea

© 2009 Alain Bolea   All Rights Reserved

Alain Bolea was a Managing Director of Deutsche Bank Securities in New York, in charge of telecom financings, and oversaw a $3bn debt & equity investment portfolio.  In that capacity, he worked closely with the management teams of numerous companies.  Alain also served as CFO and acting COO of a Geneva-based educational organization recently acquired by US venture company, Meritas.   He has also held positions on the boards of directors of several mid-sized manufacturing and telecom companies. Alain holds an MBA from the Thunderbird School of Global Management and an MA and a Political Science Degree from the University of Lyon. Currently, Alain is a management consultant that rapidly brings management teams together around sustainable business practices built on aligning leadership, strategy, culture and process.  www.business-advisors.net

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