Saturday, May 3, 2014

Honest Brokers Need Not Apply

In a world wracked with crises of confidence in the capital markets, I am puzzled by the dereliction of accountability in the realm of advocates, “independent” rating agencies, and advisors.  In his critical inquiry written in 2009, Université de Montréal’s Professor Stéphane Rousseau details the extensive contribution Credit Rating Agencies had in the conditions leading to the Global Financial Crisis of 2007-2008.  While rating agencies wilfully ignored evidence of credit quality erosion in favor of propping up phony investment grade ratings on financial products, they have borne no meaningful liability for the catastrophic effects of their neglect.  And while Rousseau and others comment on the massive financial harm done by this market failure, he provides little evidence to suggest that meaningful steps will be taken to address the massive conflicts of interest or user complicity in the environment that creates a dearth of comprehensive transparency.

Now it doesn’t take a degree in economics to figure out that issuer-pays models of credit rating have an inherent conflict.  If investors were truly free to opt in or out of purchasing “investment grade” products, for example, then competition for asset quality may be a countervailing force to hold rating efforts in check.  However, in a world where pensions, insurance companies, banks, and other asset managers are required to hold assets with certain ratings, the notion that there is a market force to hold originators or raters accountable is laughable.  Furthermore, with central banks and sovereigns complicit in issuing bonds that need to preserve the illusion of being “safe”, the ability for true qualitative rating to flourish is a phantasmal illusion.

But here’s the trouble with trying to solve the honest broker problem:  the public is passively or wilfully ignorant of basic financial literacy and thereby neither knows the questions to ask nor the ability to discern the veracity of the answers provided by ‘experts’. 

Let me offer a few examples. 

A country just announced that it is investing public funds into the development of a mining operation within its borders.  It is investing about $120 million into a project – not the publicly traded company allegedly running the project.  For its $120 million, it stands to receive (according to the optimistic interpretation of the agreement) 30% of the economics of the project (an unincorporated joint venture) – not equity in the publicly traded holding company.  During the same time the country was being encouraged to use public funds to invest in the JV, the company raised about ¼ of the amount in an issuance of commons shares for which one of its largest shareholders received a fee of C$2 million.  That’s right, a shareholder got paid to invest in common equity while the country from whom resources will be taken was told to pay for the privilege of getting a minority stake in the venture.  Now, the kicker is the following.  It would be reasonable to expect that a 30% stake of a venture sold for $120 million would mean that the venture must be worth about $400 million, right?  Wrong.  Contemporaneous with the country’s investment, the public markets priced the entire corporation at $224 million.  Oh, and another point.  When the public company bought the license to the project it claims to be worth around $400 million, it paid about $13 million in 2006.  Since then, it’s lost nearly $90 million with no reasonable revenue on the horizon.  Is the company’s auditor PricewaterhouseCoopers to blame for this perplexing market-defying transaction?  Probably not.  Is the country’s finance minister or asset manager to blame for getting terms far worse than the company’s own shareholders?  Probably not.  Is the company preying on market ignorance within the country?  Absolutely.  Would the country or the company’s auditor make different decisions if they were informed of all the facts?  Most certainly.

A high net worth investor has close to $1 billion.  For years, his assets have been the siren for “asset managers” and “private wealth managers”.  Using hundreds of pages of charts, graphs and disclaimers, investment professionals have desperately tried to convince him – for a fee – to allocate funds to partnerships that promise returns or market risk mitigation.  And, once allocated, performance has not matched the modeled returns.  Their explanations are reminiscent of cartoons depicting court advisors and astrologers who express their interpretations of omens and entrails with sufficient generalities to explain either accuracy or fallacy with equal confidence.  All the while, quantifiable risk and return, a measurable (and measured) phenomenon, is ignored in the clamor of professional opinions and explanations.  The illusion of brand credential costs this investor at least $10 million each quarter (for which he pays a few hundred thousand dollars) but is never explicitly recognized.  Is the investor’s staff culpable for this lost performance?  Probably not.  Should the principal be an expert in all global investment products?  Probably not.  Are the paid advisors preying on the product and performance ignorance of the investor?  Absolutely.  Would the investor and his staff make different decisions if they were fully informed of all the facts?  Most certainly.

In both of the examples above, the common denominator of predatory abuse is one party’s willingness to exploit a lack of knowledge while all those being abused are kept in the mists of uncertainty and ignorance.  In both of the examples above, the damaged parties have been informed of the wilful harm perpetrated on them and, in both examples, they have been incapable of responding due to the perception that, in the absence of their own competence or qualifications, it’s safer to go with a branded name than becoming fully informed and acting in enlightened self-interest. 

Which leads me to a rather important question.  Why is it that ‘victims’ of financial abuse are willing to expose themselves to predators even when fully informed of the harm they’ll face?  Whether its pension managers, resource-laden countries, or high net worth investors, the ‘honest broker’ is rejected in favor the consensus predator promoter.  Post-2008 no rating agency suffered Arthur Andersen’s post-Enron criminal fate.  Why?  Because their patrons still are benefiting from their dubious negligence.  Following decades of “resources curse” awareness heads of state and finance ministries still fall for the same illiquid ‘partnership’ deals that let public investors enrich themselves while countries are rife with poverty and corruption.  Why?  Because intimidation of power by corporate and capital elite is more powerful than the will of leaders to defend their citizens.  Despite persistent non-performance and sub-par performance, high net worth individuals continue to cede their stewardship to proven incompetence.  Why?  Because wealth, beyond manageable measure, debilitates those who confidently made it.  And in any of these eco-systems, where is the truth welcome?  Regrettably, nowhere. 

But in each of these cases, it is my contention that the problem actually arises from a deeper paradox.  Those who don’t welcome the truth may merely be evidencing a deep insecurity into the nature of why they’re sitting on such excessive opportunity.  The pension manager may be overwhelmed with the sense of responsibility to those whose funds are entrusted to him or her.  The head of state may be ill-equipped to steward the resources within a nation’s border.  The financially wealthy may doubt their entitlement to the excess that a market transaction placed in their hands.  In each of these instances, the rejection of transparency, truth and honesty may be a protection against the ultimate truth that cannot be confronted – that the steward suffers from a sense of inadequacy or confidence.  Therefore, one of the great opportunities facing those who value transparency and ethical, accountable markets, may be to care for and engage the steward, not the perceived asset, and in so doing, emancipate them from the burden of inordinate, unwelcome responsibility.  Maybe we need a bit less empirical honesty and a bit more compassionate collaboration with those to whom much has been entrusted.


  1. (reposted from LinkedIn) - David, I think our methods might mesh, as your conclusion certainly matches mine, that "Maybe we need a bit less empirical honesty and a bit more compassionate collaboration with those to whom much has been entrusted."

    What I'm running into on the UNEP FI risk assessment team is a strong reluctance to include the financial risk of a business's exposure to CO2 produced as a result of paying the people it uses to operate or provide other essential services. It's by far most business's largest exposure to climate change risks, embedded in the goods and services that business people rely on. If a CO2 tax, (or market energy cost spike), didn't raise a business’s costs, it would certainly shrink its consumers’ demands for their product. That’s the path of financial disaster I see coming.

    I've had a good chance to present the problem to the group, along with the accounting method that would give investors a complete picture of the environmental risk exposures their businesses face. Still, no one is acknowledging that it is indeed a major hidden financial risk that should be the principal duty of our team to expose and advise the financial community about.

    It seems to confront the dilemma, you may have come across, that economics does not categorize the people who run and provide essential services to a business as part of the operations of a business, as crazy as that sounds to me. So the consumption that brings them to work with the needed skills to do the job is not counted as a business impact on the environment, even though the business provided the money and consumed the services.

    As I see it that share of the money from the business is what is exchanged for the "value added" that business people provide, and it has environmental impacts as a cost of operating the business. That's the very same as for the money paid for the technology, and it's environmental impacts. So, from "nature's view" shouldn't they both be counted the same way, as part of the investor's risk exposure?

    I think it would give investors better information to have the total GHG risk exposure accounted for, whoever takes responsibility for it. Otherwise wouldn't we be stuck just lying to investors due to the inconvenience of rethinking the accounting method presently being used? It's an institutional problem to change accounting methods, but technically easy to count the impacts of human services as "average" per unit of GDP, until someone objects and offers more data.

  2. From C. Ansboro

    Very thought-provoking.

    In the 2 examples given, were the parties who rejected the information and assistance offered not offered this help in a deeply compassionate way? What could have been done differently?

    Is the point that a different mindset from the beginning might have created more opportunities?

    One can do one's best to communicate from the heart to "create a listening", and ideally let go of attachment to specific results. Perhaps the person on the receiving end just isn't ready.

    Regardless of the reason for someone's response, it's a delicate balancing act to provide information and perspective, yet not exert pressure. It's all the more challenging when someone truly believes they
    understand what is in someone else's best interest.

    1. Catherine, as the perpetrator of said interventions I'm not well positioned to opine on my sensitivity. That said, while I have sought compassionate engagement, my delivery is often surgical and empirical. As a result, I believe that, as the messenger, I may have weakened the message.

      I am aware of this balancing act most definitely and seek to hold myself to a higher standard. That's a work in progress on my side.


Thank you for your comment. I look forward to considering this in the expanding dialogue. Dave