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The Leak on WikiLeaks – Regulators Knew About Risks That Led to Financial Fallout

Thursday, December 2nd, 2010

While I cannot predict what WikiLeaks will leak about some major banks, I have a hunch that one of the revelations might be from a special New Constructs report provided to the Senate Banking Committee’s Subcommittee on Securities, Insurance, and Investment in late October 2009.

In that report, we revealed that regulators – if they were paying attention – would have seen that many Wall Street firms were engaging in alarming levels of credit derivatives (aka credit default swaps or CDS) activity. For example, the notional value of Bank of America’s (BAC) credit derivatives contracts at the end of 2007 was over $3 trillion and 5328% greater than the $57 billion at the end of 2001. For American International Group (AIG,) the notional value of its credit derivatives contracts at the end of 2007 was $562 billion and 447% greater than the $126 million at the end of 2001. It is a wonder that Bank of America was able to survive the financial crisis without the same level of bailout/takeover by the US government experienced by AIG given that BAC’s credit derivative exposure was so much greater. Perhaps, WikiLeaks will offer some insight into how that happened?

The growth in exposure to credit derivatives was so high that anyone paying attention would have noticed. So, either the regulators knew and chose to do nothing about it (i.e. Bernie Madoff) or they simply were not paying attention (i.e. Enron, WorldComm etc).

The point is not that regulators missed or ignored clear and obvious early warning signals of the impending financial fallout that occurred years later. The point is that they seem to miss these signals quite often.

None of this surprises me given my expe­ri­ence work­ing with the SEC, Sen­ate Bank­ing Com­mit­tee, FDIC, Sen­a­tor Corker, and the Con­gres­sional Over­sight Panel. My pre­sen­ta­tions to them focused how to improve the integrity of the cap­i­tal mar­kets most effi­ciently by imme­di­ately fill­ing holes in the cor­po­rate finan­cial report­ing sys­tem. I high­lighted sev­eral major breaches of finan­cial dis­clo­sures that had gone unde­tected and remain uncor­rected by the SEC. For exam­ple, over the last 5 years we found 10 com­pa­nies whose income state­ments do not add up cor­rectly and 20 com­pa­nies in the last 11 years whose bal­ance sheets do not bal­ance. For more exam­ples, see the Cor­po­rate Finan­cial Dis­clo­sure Trans­gres­sions report I sub­mit­ted to the SEC and the Sen­ate Bank­ing Com­mit­tee. What you read in that report will sur­prise you.

In my humble opinion, our regulatory framework (before and after overhaul) is woefully ill-equipped to find, track and address the financial machinations constantly invented on Wall Street and in corporate America.

As I stated in Private Sector to the Rescue, “Given that our abil­ity to trust polit­i­cal lead­ers is low, we must rely more than ever on pri­vate enter­prise to lead our soci­ety.”

Investors can speak louder than all politicians and regulators combined with how they allocate their research spending and how they make their investment decisions. In other words, you must decode Wall Street Propaganda and make sure you know the financial ins-and-outs of the stocks you buy and sell. There is no short-cut to success or the hard work required to analyze Financial Statements and the Financial Footnotes to determine the true economic earnings of companies. But the benefits can save your…

In short, there is no substitute for “doing the diligence.” Watch your back when investing in this market because no one else is watching it for you.

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3 Comments

  1. varadha says:

    Terrific, yet simple analysis. I’ve always been a fan of ROIC as a measure of capital efficiency and believe that no size/growth outperformance can replace the quest for efficiency.

    Sort of like a big gas guzzling v8 that needs ever increasing gallons of fuel to keep its engine running

  2. David says:

    But Angie’s $90 per user acquisition cost is going to go away. That’s what their approach probably is. How would their outlook be if that $90 cost dropped down to a total cost of $3 per user?

  3. David:

    That would be great, but cost per user acquisition is not something that’s very easy for a company to fix. ANGI can slash their marketing budget to the bone, but then they would stop acquiring new members. They would probably lose members in fact, as their membership renewal rate is at ~75% and declining. If they cut marketing expense by ~95% as you seem to be suggesting, ANGI might be able to eke out 1 year of slight profits, but they would start shedding members and losing money very quickly. ANGI’s only hope is to keep its marketing budget high and hope it can reach the scale and brand awareness to be able to sustain its business while scaling back marketing costs enough to turn a profit. The fact that ANGI’s revenue growth is slowing down even as its marketing costs keep increasing makes it very unlikely it will achieve that goal.

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