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AN ECONOMIC WONDERLAND: DERIVATIVE CASTLES BUILT ON SAND

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opednews.com Headlined to H4 12/20/09

The development of financial derivatives throughout the period since the 1970s which have evolved to reduce risks to the minimum, the continued failure and bail-out of national and regional banking systems (Mexico, Brazil, Asia, Turkey) plus unpunished failures (Russia (several times), Argentina, China, Nigeria, Thailand) notwithstanding market fantasist belief in moral hazard must continue because it acts as an essential theological support for market fundamentalism and its corollary, market discipline. For market fantasists and those tending towards the left/social democratic section of the political spectrum alike, the sight of US, European and UK governments effectively nationalising major actors in their banking sector during the ongoing credit crisis heralds nothing less than the "end of capitalism".

Financial derivatives have developed since the 1970s, not merely as a counter to the risk-based functioning of capitalism and themselves weapons of mass moral hazard, but in virtual defiance of all precepts of risk analysis, if by risk analysis we understand a process that uses the systematic analysis of available information in identifying hazards. Using obscure equations to detach the element of risk on bundles of sub-prime mortgages so that they can be repackaged as products with an excellent credit rating, after all, is effectively reversing that process taking a known product with a probabilistically high risk quotient and then obscuring that which is known about it.

CDOs using subprime packages, after all, have the effect of making it impossible to determine the probability and frequency of mortgage default by mortgagee and the possessing bank alike, making it impossible to determine the severity of the likely consequences of that risk and thereby neutralising the two main determinants of which risk itself is a function. In an inversion of the separation of risk and uncertainty introduced by Frank Knight's (1921) pioneering work on risk analysis, "Risk, Uncertainty and Profit", CDOs internalise uncertainty as something highly profitable a process which could only work (with the benefit of hindsight) under special, "irrationally exuberant' market conditions such as those underwritten by the housing and consumer bubble of the mid-1990s onwards.

Quis custodiet ipsos custodes?

"There are ominous long-term implications in the accountants' slide to marginalization. Balance sheets loaded with toxic assets that are "marked-to-whatever" will suffer for credibility under the noses of skeptical investors, who know full well that the pile of manure is still fermenting somewhere (Peterson, 2008)."

Concealed by the market-fundamentalist beliefs discussed above there is another interesting and powerful socio-political theme of really-existing globalization. This is the effective development over the last three decades of a supra-politics of hyper-accountancy, the massive increase in growth and concentration of power in the accountancy sector and the extension of the involvement of the big four accountancy firms (PricewaterhouseCoopers, Deloitte Touche Tohmatsu, Ernst & Young and KPMG) in every area of nation-state activity, as well as those of international and multi-national quasi-governmental institutions. The concentration of power in the big four firms of the accountancy sector has given those firms shadow-state powers in vital areas of the business of the nation-state, by becoming at the same time national and international advisors on privatisation of state functions, prime engines for the carrying-out of that privatisation and then auditors of the effectiveness of that privatisation in the UK and the USA. In addition, there has been a substantial "revolving door" for important political and governmental actors between employment and executive/non-executive positions within the big accountancy firms and employment in public office or government-contracted consultancies.

Historically, the series of mergers that increased the power of the big accountancy firms in the last two decades of the twentieth century came accompanied by two further phenomena that at once increased conflicts of interest whilst at the same time pushing the firms to ignore them, in the search for audit clients and profits. These two phenomena were, firstly, that audit clients became increasingly sophisticated purchasers of accountancy services and thus shopped around more for the best deal; and secondly, because of the flexibility in the interpretation of accounting standards, audit clients increasingly looked for accounting firms that would give interpretations as close as possible to those desired by the board, so-called "opinion shopping", so that the financial statements of the firm resembled as closely as possible the picture of the firm that the board wished to present.

Both of these two factors increased pressures to lower prices and diminish profit margins and thus increased the tendency towards mergers, to take advantage of the economies of scale that such mergers might bring. At the same time, the increasingly unhealthy nature of the auditor/client relationship was further exacerbated by the increase in numbers of accountants leaving their previous employer and taking up posts in the firms that they had previously been auditing (for instance the relationship between Arthur Andersen and Enron). One other logical consequence of the shrinkage in profit margins for auditing was the diversification of the big accountancy firms into (particularly) management consultancy, in order to pursue non-audit profitability.

Whilst this may have been logical, it of course represented an even starker conflict of interest; providing management services to a firm for which one also had responsibility for auditing was a direct conflict and yet the practice grew and was subjected to very little effective regulation. As a direct result of the increasing influence of the big firms over accountancy institutions, as well as increases in direct political influence in the US and UK governments, initiatives to regulate auditor/client relationships by bodies such as the Auditing Practices Board in the UK and the Securities and Exchange Commission in the USA were stillborn, whilst the big accountancy firms continued to insist that if no direct evidence of conflict of interest could be produced, then none existed.

Auditors of course became involved in the trade in derivatives through the auditing service which they provided to financial services and banking institutions, only here the problems and conflicts of interest were worse. Firms were being paid to audit banks/financial services firms to whom they were also contracted, in order to "properly audit" capital, cash flow and assets of the bank/firm, to asses the "fair value" for existing and new derivative products, a value which was arrived at by using selected information from and modelled by methods provided by the firm itself effectively a perfect storm of interest conflicts. As discussed above, however, derivatives have increasingly been constructed to detach them from the inherent risk of the original product and the auditors had little knowledge of the market into which they were sold (where markets actually existed), so as to make the concept of fair value increasingly imaginary yet it became an increasingly important factor in marketing these surreal products.

In general terms auditing services provided by firms of accountants have been consistently promoted as a technology for the management of risk, whereas the reality of the ways in which auditing has developed in the last three decades of the twentieth century mean that auditing is in increasing danger of becoming that thing of which it purports to be the cure, i.e. a creator rather than a manager of risk. As Ernst & Young themselves put it:

". . . mathematically modelled fair values based on management predictions are not fair values as that term is generally understood, and their use raises many questions about the reliability and understandability of the information (Ernst & Young, 2005)"

By 2008, however, during the first financial crisis to occur under a predominantly fair value regime, opinions seemed to have changed. PricewaterhouseCoopers for instance still believes that: "Fair value measurement does not create volatility in the financial statements, any more than a pipeline creates what flows through it. It captures and reports current market values".

According to PWC the financial statement by the auditor is an objective and neutral analysis of the current state of affairs; there has been no pressure on the auditor to comply with board requirements, there is no close and mutually beneficial relationship between auditor and client, and the information provided by the firm (or the model used) is as fair and objective as can be managed.

Despite the massive problems that financial derivatives have already caused and (as related above) the sheer volume of those still being traded, the big four accountancy firms continue to defend fair value calculations as being the best way to assess the value of such derivatives. Irrespective of "financial statement volatility, reporting the impact of risks and the judgements required to develop and implement fair value measures" and "the impact of fair value on regulatory measures of the capital adequacy of financial institutions" (PricewaterhouseCoopers, 2008, p. 9), "fair value yields a relevant measure for most financial instruments". The big accountancy firms quite rightly point out that there were few complaints from financial services firms and investment banks concerning fair value when the markets were forging ahead; the complaints (akin to those about short selling) have all occurred since the roll-out of the sub-prime initiated financial crisis which, given what is now known about the way that CDOs have been put together, is not really relevant to a consideration of whether the ways by which fair value is calculated can ever be sufficient for such surreal financial instruments.

Markets through the looking-glass

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http://www.lboro.ac.uk/departments/gy/research/res_gawc.html

Jon Cloke is a research associate with the Globalization and World Cities Network and also Project Officer for an alternative energy network, EnergyCentral, devoted to the promotion of alternative energy links between and within Europe and Central (more...)
 

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