The ERM Current™

The criminal investigation into the accounting practices at AIG is progressing and the focus is none other than Joseph Cassano, former head of the Financial Products group that brought AIG to its knees.  Here is what the Wall Street Journal reported yesterday.

Federal prosecutors are also focusing on a December 2007 investor presentation in which Mr. Cassano said write-downs tied to the swaps had reached an estimated $1.6 billion. Authorities are looking at whether Mr. Cassano should have disclosed to investors that the figure would have been higher by several billion dollars if not for the aid of a value adjustment known as “negative basis,” according to people familiar with the matter. Several months later, when AIG disclosed that its auditor, PriceWaterhouseCoopers, found a “material weakness” in its accounting of the swaps, it said it would abandon the adjustment, according to company filings.

Had it not been for the identification of a material weakness by the auditors, who knows how long it may have taken to properly disclose the losses.  At this point, it looks like Mr. Cassano deserves to be bunkmates with Bernard Madoff.

Risk Management can be only as effective as a company wants it to be, as evidenced by the continuing saga of American International Group (“AIG”).  The Wall Street Journal reported last week that certain high level executives who may have had a hand in limiting access of key risk management personnel remain on the job.  AIG’s Chief Risk Officer, Robert Lewis, was at the center of the discussion since he is responsible for AIG’s Enterprise Risk Management program.  Here’s what the WSJ had to say.

AIG’s outside auditor and a regulator raised concerns months before the bailout about the ability of AIG’s risk management to monitor what was going on in some units.

At an AIG board-committee meeting in January 2008, AIG’s auditor, PricewaterhouseCoopers LLP, “expressed concern that the access” Mr. Lewis’s department and other top AIG executives had into the financial-products unit, AIG Investments and other subsidiaries. Access “may require strengthening,” according to minutes of the meeting released by Congress last fall.

Two months later, the federal Office of Thrift Supervision, which regulated AIG’s financial-products unit, sent a letter to the company, also released by Congress. OTS said the unit “was allowed to limit access of key risk control groups while material questions relating to the valuation of the [swap portfolio] were mounting.”  The OTS said those “control groups” included Mr. Lewis’s department.

At a congressional hearing last week, Rep. Gary Peters (D., Mich.) asked AIG Chief Executive Edward Liddy, “Where was the risk management of your company? Where was the failure of your own internal risk-management procedures?”

Mr. Liddy responded, “We had risk-management practices in place. They generally were not allowed to go up into the financial-products business.”

Selective risk management within a company is a recipe for disaster.  Any area that is deemed “off-limits” should be a gigantic red flag for both senior management and the board of directors. 

Today’s post leaves one speechless, both literally and figuratively.  In the figurative sense, few words can describe the ever increasing amounts of money that the US Government is pouring into financial institutions such as AIG.  Literally, there is not much more to say beyond what Barron’s Bob O’Brien has to offer in his video post,  AIG Becoming a Money Pit?.

Last week, former US House Speaker Newt Gingrich wrote an opinion in the San Francisco Chronicle renewing the call for a repeal of the Sarbanes-Oxley Act of 2002 (“SOX”).  Mr. Gingrich’s basic premise is that SOX went too far in regulating corporate governance and at the same time did nothing to prevent the collapse in financial markets.  As many others have complained in the past, Mr. Gingrich says that SOX is too costly and is preventing companies from going public.  Mr. Gingrich cites a $4.36 million cost per company from a recent Financial Executives International (“FEI”) survey.  However, he fails to mention this figure is for the largest of companies (those with a market value greater than $700 million) and is out of date.  The most recent FEI survey figure for the largest companies is actually lower ($3.8 million) and for smaller companies that he is referencing in his IPO argument, the average cost is just over $600,000.  

Now, let’s compare that to the updated “rescue” package for AIG.  Just this week, the package was increased to $150 billion.  That’s right – billion with a “B”.  And, as for the claim that SOX did nothing to prevent AIG’s woes, it actually helped bring the woes to light.  It was the external auditor’s disclosure of a material weakness in AIG controls (a SOX requirement) over credit default swap valuations that first held AIG management accountable and led to the departure of the CEO.  

Lastly, Mr. Gingrich says that SOX is driving companies overseas.  Well, if that is the case, then the “rescue” packages are certainly serving as a great incentive for companies to come back to the US.  Now, companies are lining up to receive US taxpayer money.  Those companies that do not want to be held accountable when accessing capital through public markets are probably better off in other markets.  SOX is not the problem – it is the “rescue” packages that need to be repealed.

Yesterday, the US House Committee on Oversight and Government Reform had quite a session receiving testimony from those involved in events leading to the massive bailout of American International Group (“AIG”).  Of particular concern was a letter from Joseph St. Denis, an AIG accounting policy expert that had been hired, as he explained, “as part of an entity-wide effort to address material weaknesses by AIG’s external auditor”.   Unfortunately, Mr. St. Denis could not participate in this effort because he was restricted from reviewing the area with the highest risk – accounting for credit default swap derivatives.  

Mr. St. Denis resigned from AIG after serving just over a year due to restrictions placed on him by senior executives. After surfacing many legitimate issues, he was demoted even though he had received a stellar performance rating only a few months before.  Then, according to Mr. St. Denis, he was prohibited from reviewing the very area that led to AIG’s ultimate demise.  Joseph Cassano, head of AIG’s Financial Products group, was the executive responsible for the valuation of AIG’s Super Senior Credit Default Swap portfolio and the same executive who made the following statement to Mr. St. Denis:

“I have deliberately excluded you from the valuation of the Super Seniors because I was concerned you would pollute the process.”

The improper valuation of this portfolio led to another material weakness in 2007 and ultimately led to AIG’s death spiral.  Meanwhile, Mr. Cassano retired from AIG earlier this year and continues to receive $1 million per month in consulting fees from AIG.  In the words of famous musician Mark Knopfler, I think this is a clear case of “punishing the monkey while letting the organ grinder go free”.  Your thoughts?

Click here to read Joseph St. Denis’ letter to Congress