Sometimes financiers get it right and perform a valuable public service

The world of high finance sounds rather like a zoo. It’s not only the bulls and bears of the stock market, or the hawks and doves that flock around the central banks.

Investment banks are “vampire squids”. Hedge funds are “locusts”, speculating against decent companies and entire countries until they collapse into bankruptcy.

Jordan Belfort, the drug-addled conman who pushed dodgy stocks of hopeless companies on poor Americans in the 1990s, styled himself as the “Wolf of Wall Street”.

And there is, sadly, a lot of truth in such stereotypes. Finance is often parasitic on the real economy and predatory in its behaviour towards clients and customers.

But critics and reformers should also recognise when some financiers do not conform to this negative characterisation; and to acknowledge when the industry performs a broad public service.

The first people who recognised that something was financially awry at the giant outsourcing firm Carillion were not regulators. They weren’t civil servants. They certainly weren’t the company’s auditors. Nor were they the firms’ bankers or passive asset managers, who invested in Carillion on behalf of pension funds and insurance companies.

It was hedge funds. Their research on the company revealed that Carillion was paying its suppliers very late – a classic sign of possible financial distress. They also noticed that Carillion was piling up large amounts of off-balance sheet debt. Hedge funds such as Marshall Wace and CapeView Capital started taking substantial short positions in Carillion (betting on the share price falling) as early as 2013. If only ministers, who continued bunging large public contracts to the firm right up until its demise, had been similarly on the ball.

The hedge funds didn’t kill Carillion – its incompetent management did that. The hedge funds were effectively sounding a warning, albeit one that wasn’t heeded by enough people.

The classic image of “sell-side” analysts working for stockbrokers and investment banks is that they are hopelessly compromised, tailoring their views on the prospects of firms to please their existing (or potential future) corporate clients, rather than to serve the interests of actual investors.

It’s often true – but not always. Two years ago another outsourcer, Capita, was riding high in the stock market, its share price at £ 11, and was widely approved of across the City. But one analyst at the stockbroker Panmure Gordon, Michael Donnelly, broke with the consensus and cautioned clients about the sustainability of the business based on his own reading of the company’s data. Last week Capita’s share price fell below £ 2 and the new chief executive admitted that the company had, in fact, been appallingly run for years. Donnelly’s warning was vindicated.

Purple Bricks is one of the new breed of online estate agents. Managers have claimed they successfully sell around 90 per cent of the properties they handle within 10 months – a comfortingly high proportion for homeowners thinking of paying the roughly £ 1,000 flat up-front fee for its services. But Anthony Codling, an analyst for the investment bank Jefferies, said in a note last week that his own research (ploughing through Land Registry data) suggested Purple Bricks is actually only selling around half of the properties on its books in that time, which is in line with the rest of the estate agent industry. The share price of the company, which is in the midst of an international expansion, sank in response.

Purple Bricks has rejected Jefferies’ data, although it hasn’t released their own to rebut it. But the point here is not the truth of any particular view on a company’s finances or growth prospects, but one pertaining to the kind of behaviour we want from asset managers and financial analysts. These are instances of financiers ignoring the rubber stamps of auditors, brushing aside the confident assertions of company executives, going against the herd, and performing their own, original, research.

This is also what the small band of hedge fund managers profiled in Michael Lewis’ The Big Short did with regard to US “sub-prime” mortgage loans that fuelled the disastrous international credit bubble before 2008.

The economist John Kay, who wrote an official review of equity markets for the Government in 2012, recommended that asset managers should have deep knowledge of and regular engagement with the managements of the companies in which they invest. This will involve digging out inconvenient facts.

“Obtaining better information about companies is essential to the efficiency of markets and society,” he says.

The many critics of finance are quite right. The sector unquestionably needs wholesale reform. The wolves and vampire squids must be defanged. But high finance is not going to disappear, at least not while ordinary people have savings and pensions that they want to be invested in decent companies with reasonable growth prospects.

As well as getting justly angry at finance’s many abuses, we need to have a vision of what we want the sector to be and the socially useful job we ultimately want financiers to perform. The past month has given us some signposts.

#JohnKay #PurpleBricks #hedgefunds #Carillion #Capita

The charmed life of these failed auditors and accountants without accountability

Based on a quick inspection of the books, there doesn’t seem to be a great deal of accountability demanded from the British auditing profession.

In March 2017, the giant audit firm KPMG signed off on the annual accounts of the construction giant cum-outsourced services provider Carillion, saying they gave a “true and fair view” of the state of the company’s affairs.

For this work, KPMG received a fee of £1.4m. This followed £1.4m of fees recouped the year before. In fact, KPMG had been Carillion’s auditor every year since it was founded in 1999. You don’t need to be an accountant to work out that that adds up to a very lucrative client relationship.

But in July 2017, just four months after the annual accounts emerged, Carillion announced to the stock market that its contracts to provide services were worth a remarkable £ 845m less than they had previously been valued on its books.

That bad news shattered Carillion’s share price and, ultimately, led to the collapse of the entire company earlier this month, dumping pensioners into the official state-run lifeboat scheme, leaving tens of thousands of employees facing redundancy and forcing civil servants to scramble to pick up hundreds of dropped contracts to provide school dinners, maintain prisons and a host of other services.

How did KPMG not identify this massive overvaluation of contracts? Was it because they took Carillion’s estimates at face value? If that’s the case, what’s the point of the external audit? Are the auditors merely called in to rubber stamp what the company tells them? Moreover, KPMG was not the only auditor of Carillion’s numbers. 

Its 2016 report relates that it had a special “internal” auditor too, in Deloitte, with which it worked even more closely than with KPMG. So why didn’t Deloitte pick up on the dodgy contract numbers? When two blue-chip auditing firms apparently can’t detect a near £1bn overvaluation of assets (financial difficulties that many hedge funds without access to Carillion’s books had apparently identified since they were placing big bets on the stock price going down) there’s a problem.

There’s nothing unusual about these spectacular auditing failures. KPMG signed off on the books of HBOS multiple times in the years before the bank’s bad loans eventually blew it apart in 2008. The auditor was even invited to investigate allegations of excessive risk-taking from an internal HBOS whistleblower, Paul Moore. It dismissed them. Indeed, all the UK’s big banks were thoroughly audited before their balance sheets tore like tissue paper before a tsunami during the 2008-09 financial crisis.

The Financial Reporting Council, which after intense political pressure was brought to bear, announced this week that it will investigate KPMG’s performance over Carillion. Yet the lessons of experience of this regulator are anything but encouraging.

Previous probes by the FRC have produced nothing but clean bills of health for auditors. “In nearly every major financial scandal we’ve had since the financial crisis, the FRC decides none of its charges have done anything wrong,” notes Jim Armitage, city editor of the Evening Standard. Worse, these rulings come with no reports or published evidence, making a mockery of the FRC’s claims to “promote transparency”.

Many have pointed out that such indulgence in the face of failure might have something to do with the fact that the board of the FRC is dominated by former auditors and the big corporate customers of auditors.

Perhaps it’s naive to imagine it could be otherwise given the need for professional experience in such a body. Yet the plain fact is that this model of self-regulation for this industry has failed.

The life of an auditor seems to be a charmed one. You pick up large fees for “checking” the books of your client. But when the company collapses you don’t share any of the financial pain or blame. 

Yet what is the point of audit without accountability? It’s no use to shareholders. It’s no use to employees and pensioners of the company. It’s no use to other stakeholders, such as suppliers and customers. The only value, at least the only value that’s discernible from a glance at the dismal past decade, is to the senior managers of the client firm and, of course, to the auditors themselves.

#KPMG #FinancialReportingCouncil #Deloitte #accountancy #Carillion #audit

The British elite’s cult of the amateur and the damage done by ministerial churn

Boris Johnson caused one of his regular commotions last week when, through the medium of “friends”, he offered his cabinet colleagues some unsolicited advice on how much extra money ought to be funnelled to the struggling National Health Service.

When asked about the intervention, the magisterial rebuke from the Chancellor Philip Hammond was simply to point out: “Mr Johnson is the Foreign Secretary.”A good point. What on earth has health spending got to do with him?

Yet, on reflection, perhaps it’s not such a powerful point. For, speaking statistically, Johnson might easily have actually been installed as Health Secretary or even Chancellor in the recent reshuffle, given the regularity with which government ministers are reassigned and recycled for reasons entirely unrelated to their experience or competence.

Or Home Secretary. Or Education Secretary. Or indeed any other of the cabinet jobs. Perhaps it’s not so outrageous for Johnson to interject himself onto another minister’s turf in such an environment of predictable flux.

The Institute for Government report sets out the depressing picture of ministerial churn in its latest annual report on Whitehall. Since 2010 we have had six different justice secretaries and six culture secretaries. Over that time the minister in charge of the Department for Work and Pensions has changed five times.

At junior level the churn is even more extreme. After the most recent reshuffle almost 40 per cent of junior ministers were new to their position. Since the June 2017 general election that proportion rises to 70 per cent. Every single minister at the Cabinet Office was changed in January. At the Ministry of Justice three out of four were fresh. This is a farcical rate of churn.

It’s hardly original to argue that this chopping and changing of ministers, usually for purely political reasons, is a ridiculous approach to government. It may not even be getting any worse – John Reid occupied eight different cabinet jobs in eight years under Tony Blair – but the inordinate strain put on the Whitehall system by Brexit preparations re-emphasises what folly it is.

“Ministers barely get up to speed on their responsibilities before moving on,” Sir Richard Mottram, a former permanent secretary at the Cabinet Office, told the Financial Times.

Imagine trying to become familiar, in a hurry,with universal credit, or prisons, or outsourcing, to cite just three of the complex crises currently facing the Government. How well is that job likely to be done? How good are the decisions taken likely to be?

And it’s more than just a matter of competence: it undermines accountability too. “They cannot be held responsible for their actions because they have long since moved on before the consequences become clear,” says Sir Richard.

What we have here is the British elite’s cult of the amateur, a reflection of the entirely unfounded conviction that no relevant experience or substantive training are necessary for someone to do a senior job, just a “first-class brain” and a capacity for bluffing.

Educationalists, industrialists and economists bemoan the chronic neglect of vocational education and skills training in Britain, certainly relative to our European peers. Yet perhaps we shouldn’t be particularly surprised by it. If top politicians don’t believe they personally need any form of training, why should they believe anyone else needs it? Why should the unskilled be interested in skills?

This is as a systemic problem and the media is, alas, a major part of the problem. The press, particularly the broadcast media, cover government reshuffles essentially as entertainment; breathless “who’s up, who’s down” soap operas.

It never seems to occur to newspaper editors and TV producers to invite academic experts on governance to give their opinion on whether reshuffles in themselves are a good idea or not. Readers and viewers are left with the impression that this is simply how government works. The dysfunction is normalised.

Former special advisers such as Dominic Cummings and Nick Timothy gripe about the Whitehall civil service and its supposed institutional resistance to the beneficent reforms of their ministers. Those reforms may, or may not, be beneficent. Civil servants may, or may not, be unduly resistant to reforms. 

Yet such critics might care to reflect on the fact that it is the civil service that keeps the wheels of government and administration turning through the turmoil of ministerial personnel churn. Fix that problem and complaints about the public servants who actually keep the show on the road might deserve a hearing.

#cabinetsecretaries #reshuffles