With the announcement of the Oscar nominees, try watching Margin Call to combine movie watching and compliance. Margin Call received an Oscar nomination for best original screenplay.

The movie sets Kevin Spacey, Demi Moore, Jeremy Irons, Stanley Tucci, and Simon Baker as the key players at an investment firm during the earliest hours of the 2008 financial crisis.

Tucci is the head of risk management for the mortgage trading desk, but gets laid-off in the first few minutes of the film. On his way out, he hands an unfinished project to a low-level risk analyst to find the problem. He finds it and it’s big. The holdings on the mortgage desk could lead to the downfall of the firm. that leaves it up to the firm’s employees on whether to save the firm at the risk of fleecing millions of investors.

Unlike Inside Job, Margin Call does not paint the characters as evil, mustache-twirling, robber barons. They’re humans staring at the face of a monumental choice. One choice is to hold and likely bankrupt the company. The other is to sell the garbage and likely being painted as a bad guy. They’re up all night thinking about the problem and trying to find a way out. Dawn comes and they all need to make choices.

Being a lawyer, I like a good legal thriller. If you’re looking for a legal thriller to keep you up at night, try William Landay’s latest novel: Defending Jacob. Jacob is a fourteen year old boy whose classmate is found murdered. Jacob’s father is an assistant district attorney. You can guess from the title that Jacob gets accused of the crime.

Before I go on, I should point out a few of my biases. I’m friends with the author. Our sons went to daycare and preschool together for many years. So I see bits and pieces of him and his family in the story. (But not that I think Bill’s son will grow up to be accused of murder.) I think I see flashes of Bill, his family, and the community in the book. Maybe that distracted me from the characters or maybe it made me like them more. I’m not sure.

Not being a trial lawyer, I can’t vouch for authenticity of investigative procedures or the trial. Again, with a title like “Defending Jacob” you would expect there to be a trial. You end up with the expected clash between the clash of guilty and not guilty against the question of whether Jacob actually committed the crime.

That’s what kept me reading chapter after chapter. Who was Jacob? Could he have committed the crime? Did Jacob’s father really know who he was? Facts quickly start being revealed, twisting the story through reveals and lies. It pushes the father, son, and mother to the edge until…

Defending Jacob should be on the bookshelf of your local bookstore on January 31 and is also available through Amazon.

An acquaintance in the compliance field sent me a copy of Dov Seidman’s How and I let it sit around  for months. (My “To Read” stack has grown very tall.)  I assumed How was vanity book and would rattle on and on about Seidman’s company: LRN. I recently moved and my “To Read” stack was tumbled around in a plain cardboard box.  How resurfaced in the stack and I noticed the forward was by President Bill Clinton. That was enough to catch my eye.

Seidman spends the first half of the book talking about transparency, trust, reputation, and the new inter-connected world. He does a fine job with these topics, but I’ve seen them handled better elsewhere. The second half of the book, which focuses more on Seidman’s philosophy of business, is when the book becomes more valuable.

Seidman highlights an empirical study about reputation using eBay’s seller reputation information. Chrysanthos Dellarocas used eBay as an experiment. In a study selling the same product, in the same way, through eBay sellers with different levels in the site’s reputation scores, the researchers found a measurable difference in price. A seller with a high reputation on average would get a measurable price premium over a seller who did not.

As you might expect, the book is full of stories as examples. One that really caught my eye was the description of four factories as examples of four types of corporate culture. The factories are to be toured and the measuring stick is the use of hard hats. At the first factory, one of lawlessness and anarchy, the factory tour guide does not offer hard hats to the visitors and many workers are seen without hard hats. At the second factory, an example of blind obedience, all workers wear hard hats and the tour guide says everyone has to wear one or they get fired. The tour guide admits that he doesn’t know why he needs to wear it or why the boss also makes him wear blue pants.

The third factory is the next step up the corporate culture ladder as an example of informed acquiescence. Hard hats are there for everyone with big signs saying everyone must wear one. But when one member of the tour group asks to be excused from wearing one, the tour guide scampers off trying to find a higher-up to approve the lack of a hard hat.

At the top of the corporate culture is the fourth factory, an example of Seidman’s self-governance. The tour guide insists that everyone wears a hard hat and when that same member of the tour group asks to be excused the tour guide says no. “I take personal responsibility for what happens to you. I don’t want to offend you, and you can call my boss or the owner if you like, but I believe your safety and the safety of everyone are paramount. “

The how of culture is broken into five parts: how we know, how we behave, how we relate, how we recognize, and how we pursue.

One common theme in the book is an indictment of a rules-based culture. Rules-makers “chase human ingenuity, which races along generally complying with the rules while blithely creating new behaviors that exist outside of them.” The example that caught my eye was the clerk who insisted on wearing ties with cartoon characters. His bosses fought him and finally insisted that he obey the rules on permissible neckwear. The clerk acquiesced and showed up the next day with Tasmanian Devil suspenders.

Ultimately, a rules-based governance focuses on the things you can’t do, while a values-based governance focuses on what is desirable.

This ends up with Seidman’s Leadership Framework. I think that is better left for more to readers of the book.

If this sounds interesting to you, I ended up with a second copy of How. Rahter than have it sitting on my bookshelf, I want to share it with one of my readers. If you are interested, leave a comment on this blog post or send an email to compliancebuilding@gmail.com. I’ll pick a winner on February 1.

Michael Lewis packages his stories on the effects of the global financial crisis in Iceland, Greece, Ireland, Germany, and California into one book: Boomerang. If you had ready the stories when they were published in Vanity Fair, then you’ve ready the book. If you missed some (or all) of those stories then this book is great viewpoint on how five countries got themselves into trouble with excessive debt.

I had already read the first four articles when they appeared in Vanity Fair, but I had not yet gotten to the article on California. In fairness, Boomerang was a given to me as a gift so I did not come out of pocket to put it on my bookshelf. I enjoyed revisiting the four stories and the new California story.

They each seemed to work better in the collection than standing on their own. Since each story is relatively short, they lack the depth and understanding I’m used to getting in one of Michael Lewis’ books. Collectively, there is bit more depth as you can see how the five different countries got into trouble in different ways by becoming over-leveraged.

It’s a Michael Lewis book, so that means it’s easy to read and smart. He has a gift for taking complicated subjects and using individuals to highlight how his theories work in the real world.

My gripe is not with the book, but with Vanity Fair who sponsored Lewis in writing the five stories, each of which has appeared in the magazine. I purchased a subscription to Vanity Fair just because of these Lewis articles. I thought I was choosing to upgrade the freemium model.  I was willing to pay more for the superior experience of reading the article in the magazine instead of online. However, the publisher would put them on the website (for free) before the magazine ended up in my mailbox. One premium of getting access to the content first, was actually the opposite. I was getting the content later than if I had chosen not to pay for it. It’s not like the magazine is ad-free.

So why I would I renew my subscription?

So what caused the 2008 financial crisis? We know that the direct cause was the meltdown in the US housing market. I think we are still trying to put together the pieces and point the finger of blame. It was a big bubble and the explosive reaction when the bubble burst. It took many different forces to get the bubble so big.

In Reckless Endangerment, Gretchen Morgenson and Joshua Rosner take their turn looking at the outsized ambition, greed, and corruption that lead up to the crisis. They point the finger of blame directly at Fannie Mae and its executives.

The authors portray a company that ruthlessly leveraged the implicit government guarantee to create billions of dollars of shareholder wealth and millions of dollars in executive compensation. They beat the drumbeat of housing as the American Dream. Everyone should get a chance to own their own home. Fannie Mae used their version of the American Dream to bully Congress and their regulators to let them have a very thin capital reserve and to keep their finances very opaque. The authors pin the blame squarely on James Johnson, the CEO of Fannie Mae during the 1990s and his successor, Franklin Raines.

The rating agencies also get some of blame by the authors. I think the rating agencies have not received enough of the blame. Their shoddy rating of debt instruments let them get AAA ratings that they did not deserve. Only a handful of companies and a handful of countries get the top rating. But when it came to real estate backed securities, the rating agencies were handing them out like cotton candy at the state fair.

Institutional investors were looking for safe place for their money that could still earn a coupon. US treasury bonds were paying a very low interest rate. Pension funds and insurance companies determine their funding levels based on a projected rate or return. Many were limited to only invest in the highest quality asset either by regulation or internal policies. That meant they would only buy the top rated bonds.

Banks has to maintain their capital levels based on the quality of the loans/bonds/assets they held. With top-rated bonds, the banks had to retain very little capital. By holding AAA ratted bonds, the banks could retain less capital and put more to work.

The rating agencies were telling them that these mortgage-backed securities were top rated. (They were wrong.)

The vast majority of the book is spent sticking pins in Fannie Mae, their lobbying efforts, and their executives. I agree that Fannie Mae abused its position. I agree that Fannie Mae helped create an attitude that everyone should be a homeowner and everyone should be able to afford to buy a home. But their story comes to crashing halt in 2004 when Fannie Mae gets caught in large scale accounting fraud. Most of the manipulation can be tied directly to triggers for executive compensation.

In 2005 the first signs of bad mortgages were popping up and the buyers for the lower rated pieces of mortgage debt were not buying them. Without those buyers, the mortgage securitization would fail. Fannie Mae was leading the charge up until that point. But it didn’t stop there. That’s why have a problem pointing the finger at Fannie Mae. The mortgage/housing boom kept going.

The authors pull some of the dubious lenders into the book. Countrywide, Novastar, and Fremont all get ripped apart.

It’s not until the last chapter that they hit upon the issue that hyper-inflated the real estate bubble. The buyers for the lowest rated pieces of mortgage-backed securities were not buying as much. In part, this was because the increased quantity of junk they saw ending up in the pools. In part, it may be because they saw the bubble. Then the magic happened.

Wall Street firms packaged the lower rated pieces into new pools and sold those securities. These were the toxic assets. Somehow they convinced the rating agencies that some tranches of this pile of junk could still get the top ratings. Those high rated tranches were sold off to the institutional investors and the real nasty stuff was sold off to more speculative investors. This kept the mortgage securitization pipeline going for two more years.

Why keep going when you could see the bubble? It was their job. There were thousands of jobs tied to originating the mortgages, the warehouse lines that funded them, the organization of the pools and the selling of the final securities. It was not their job to assess the bubble and just stop working. There was no brakeman in the system. The regulators do not have the oversight, the power, or the willingness to stop an asset bubble. (Let’s see what happens with the price of gold.)

The brakes were slammed on when the Wall Street firms realized they were holding on to the lowest rated tranches of the securitizations and they couldn’t get rid of them. They stopped the production. They stopped it fast. In early 2007 warehouse lines were cut off and underwriting standards were suddenly raised to higher (more sensible?) levels.

With the pipeline cutoff, the hyper-inflated housing bubble reached the bursting point. Then mortgage-backed securities investors stopped getting their checks. They realized that their coupon-paying beauty queen was just a pig with lipstick.

I think All the Devils Are Here did a better job of putting all the pieces together and The Big Short did a better job explaining the mechanisms of the mortgage-backed securities industry. If you don’t like Fannie Mae or want to read a story of how corporate greed exploited American politics then Reckless Endangerment should be on your reading list.

You can’t really criticize Harry Markopolos. He was right. He had spotted something wrong with Bernie Madoff years before the biggest Ponzi scheme collapsed. Unlike many others, Markopolos contacted the Securities and Exchange Commission about his suspicions. They ignored him. Markopolos went to the press, but no meaningful article came of it.

When Madoff’s scheme collapsed and he  turned himself in, Markopolos became lauded by the press, testified in Congress about the failings of the SEC, and was even offered the job of Chairman of the SEC by an ill-informed Congressman. No One Would Listen is another step in the Markopolos victory lap.

He celebrates his brilliance in discovering the fraud and the incompetence of the SEC for not stopping it. He fills his attacks with similes:

“His returns were as reliable as the swallow returning to Capistrano.”

“As I continued examining the numbers, the problems with them began popping out as clearly as a red wagon in a field of snow.”

Markopolos lays out how he first ran into Madoff and the years he spent trying to figure out how Madoff was generating his returns. Eventually, he came to the conclusion that he couldn’t do it. Since Madoff ran a big trading organization, he could have been front-running orders to generate illicit profits. Effectively, he would be stealing from his brokerage customers and giving it to his money management operations.

The other likely possibility was that Madoff was making up his returns and using new funds coming in to redeem those leaving. Markopolos could not find any footprints of Madoff’s split-strike trading strategy. There didn’t seem to be enough options traded on the markets to support the amount Madoff had under management.

I think it’s important to see why Markopolos was focused on Madoff. The principals at his firm wanted him to reverse engineer Madoff strategy so they could offer a similar product to their clients. Markopolos could not figure out how Madoff was generating his steady returns. He first contacted the SEC as a way to get his boss off his back. If he could prove Madoff was a fraud, his boss would quit demanding that Markopolos duplicate the Madoff strategy.

Markopolos starts off  No One Would Listen by stating that he made five separate submissions to the Securities and Exchange Commission over a nine-year period. So far, I’ve only seen one, his December 22, 2005 letter. Frankly, I found the letter to be a rambling, half-coherent diatribe. It was penned by a competitor who couldn’t figure out the trading strategy of the legendary Bernie Madoff, the founder of NASDAQ.

As Chris MacDonald notes “Markopolos is a bit of a strange cat. He’s a likeable guy, and apparently a man of integrity, but also a bit paranoid-sounding.” (He had seen the new movie, Chasing Madoff, based on the book.)

Clearly the SEC was unable to stop Madoff. Was it their fault?  Yes. They relied on the well-established credentials of Madoff and dismissed the paranoid ramblings of an eccentric analyst. Markopolos’s barbs against the SEC are over-the-top and eventually got distracting. On top of that, I was often distracted by his misuse of “principle” instead of “principal” in the book. You would think that a financial analyst would know the difference.

Michael Lewis has written some great stuff on our most recent financial crisis: The Big Short, Iceland’s Meltdown, Greece and Corruption, and Popping the Irish Bubble. This was not his first rodeo. Lewis had a brief career in finance working as a London-based bond salesman for Solomon Brothers during the mid eighties. His finance career came to crashing halt in 1988 just after the big stock market crash of 1987. He tells his tales of finance and the excesses of Wall Street in Liar’s Poker.

Lewis covers the birth of the mortgage securitization market and trading of mortgages at Solomon Brothers. The firm dominated the market for a few years. They helped shepherd through the regulatory changes and convinced the bankers at S&Ls to buy and sell their mortgages. They essentially created greater liquidity in the American housing market. This would grow tremendously over the next twenty years, leading to the events Lewis later documents in The Big Short.

As a young, inexperienced, and mostly incompetent bond salesman, Lewis mostly screws his customers selling them bad products. But it was good for Solomon Brothers. It was good for his wallet. Wall Street greed is on full display.

It’s eerie reading this book, realizing that it was not 2008, but 1986. The book is not as good as The Big Short, but is still a very good book. I think it’s important to look back to make sure we don’t keep making the same mistakes.

The financial crisis of 2008 was not the first. In reading Lords of Finance you see some of the obvious parallels from the 1920s.

Liaquat Ahamed focuses his story on Montagu Norman of the Bank of England, Benjamin Strong of the New York Federal Reserve, Hjalmar Schact of the Reichsbank and Emile Moreau of the Banque de France.

One focus of the 1920 s financial crisis was the stock market crash. Rampant speculation caused a bubble, even though it was initially rooted in economic reality. This was the “new economy” era of automobiles and radios. The old railroad based economy was being surpassed by trucking. Stock prices were rising, but so were the profits of the companies listed on the stock exchange. But then stock prices began rising out of proportion to the rise in corporate earnings.

There was clearly a speculative bubble. Investors were clamoring to find the next Google General Motors. Amateur investors were pouring in and borrowing to make their investments. The Federal Reserve did nothing and then when it decided to act it found it was unable to find a way to curb the speculation. When the Fed pulled back on the ability of banks to lend for stock speculation, non-banks stepped in to provide capital.

There was a thought that “the Fed could pierce the bubble with a surgical incision that would bring it back to earth without harming the economy. It was a completely absurd idea. Monetary policy does not work like a scalpel but more like a sledgehammer.”

As far back as the beginning of the Federal Reserve system there was the question of whether the Fed should intervene in an asset bubble.

The 1920s financial crisis was caused more than just stock speculation, just as the 2008 crisis was caused by more than just residential real estate speculation. It was fueled by debt. The world economy was trying to recover from the economic effects of World War I. Germany began the 1920 owing $12 billion ($2.4 trillion in 2011 values) in reparations to France in Britain, France owed the US and Britain $7 billion ($1.4 trillion in 2011 values)  in war time debts and Britain owed the US $4 billion ($800 billion in 2011 values).

The book goes further back  and focuses on the gold standard as one of the core underlying economic problems that helped cause the Great Depression. Up until this point there was an “almost theological belief in gold as the foundation for money.” Gold was the international currency. Each country’s currency was pegged to the value of gold. The ability to convert paper money into gold instilled confidence in the currency.

By coincidence, the discovery of gold through the late nineteenth century kept pace with economic growth. Then came World War I. The largest economic powers in the world met in the battlefield. Pound Sterling and Franc versus the Mark. The United States and the Dollar came in eventually. After spending the first few years sitting on the sidelines and supplying the Allies, the United States had accumulated an enormous trough of reserves.

One of the problems with the gold standard is that it gives people the option to cash in that paper money for actual gold. That obviously creates some faith in the currency. But it has opposite effect in times of crisis. people will lose faith in the paper money and redeem it for gold. That drains the system of gold, causing a tightening of credit. To counter, the banking system will need to raise interest rates to encourage people to keep money in the bank instead of gold in their mattress. Raising interest rates during a financial crisis will make things worse. You want to be able to reduce interest rates to encourage the flow of capital.

The other contributing factor was the failure of banks. This was before the days of the FDIC and insured deposits. So if you thought your bank was going under, you pulled your money out. This lead to bank runs and banks hoarding cash instead of investing the cash in loans that would grow the economy.

In the end, each economy began its recovery after it suspended the gold standard.  Is some ways the gold standard is just about digging up gold and re-burying it. The huge treasure of US gold was sitting underground, literally underneath Wall Street. France’s gold reserves were underwater; its vaults sat beneath a subterranean aquifer.

As George Santayana wrote: “Those who cannot remember the past are condemned to repeat it.” Ben Bernanke was a scholar of the Great Depression. He saw what the four Lords of Finance did, leading them to the subtitle of the book: The Bankers who Broke the World. It’s worth your time to read the book.

Was it Fannie Mae? Was it the lack of regulatory oversight? Was it the rating agencies? Was it pure greed?

Yes, yes, yes and yes. Plus, there were lots of other factors.

Bethany McLean and Joe Nocera put together an insightful look at the many factors that created the housing bubble and amplified the destruction when it popped in All the Devils are Here: The Hidden History of the Financial Crisis. Pundits and purists have tried to pin the blame on a single element. It seems clear that many “devils” were at work. It’s not just institutions that failed in the crisis. The authors paint the pictures of key individuals who helped inadvertently build up the housing bubble or allowed for it cause mass destruction.

Certainly, Fannie Mae and Freddie Mac were part of the problem. It was their stranglehold on the securitization of conforming mortgages that lead Wall Street to look at non-conforming mortgages as a source of profits. Subprime mortgages, by definition, were outside the definition of “conforming” by Fannie Mae and Freddie Mac standards.

Wall Street’s thirst for product was an ample funding source for subprime lenders. They didn’t need the deposits of conventional banks for funding. They could just sell their loans to Wall Street for packaging into mortgage-backed securities. Wall Street would also provide the warehouse funding to help subprime lenders with capital to originate mortgage loans.

The federal government was pushing for increased home ownership. The Clinton administration announced its National Homeownership Strategy, with the goal of raising the number of homeowners by 8 million over the next 6 years. (Bush carried on a similar strategy.) The flaw is that to meet that goal, riskier borrowers would need be made homeowners.

JP Morgan developed Variance at Risk, an analytical method to analyze the risk in a bank’s portfolio. They understood that the mathematical models were merely an indicator risk. Although correct 95% of the time, they were also wrong 5% of the time. Other lenders adopted VaR, but failed to grasp its limitations.

AIG and its Financial Products division played a key role. They helped provide the back stop that helped the market accept the AAA rating of mortgage-backed securities. Eventually they also moved into credit default swaps. The authors paint a picture of AIG-FP as a collaborative workplace where employees could express their skepticism about deals. Then Hank Greenberg threw out the management and replaced them with Joe Cassano. He ran the shop in a more dictatorial manner and doled out information on a need-to-know basis.

Of course there were the rating agencies who gave the RMBS and CDOs undeserved AAA ratings. That was supposed to mean that the securities are just a little riskier than US Treasuries. It was Fitch that changed things. Moody’s and Standard & Poor’s had a business model based on subscribers. Fitch changed things by charging the issuers instead of the subscribers. That would eventually lead to the ratings shoppings that became part of the subprime bubble. Of the AAA rated subprime residential mortgage-backed securities from 2007, 91% were downgraded to junk status and 93% of those from 2006 were downgraded to junk status. That is a horrible track record.

I suppose that was a bit of a spoiler, but we all know that the financial markets came to a grinding halt in 2008, crushing big banks, speculative investors, small banks, and those just hoping for a small part of the American Dream.

There are a dozen other “devils” discussed in the book, but you should just read it yourself instead of reading my ramblings.

The worst part of the subprime crisis is that the bigger goal of increasing ownership was a failure. Between 1998 and 2006 only about 1.4 million first-time home buyers purchased their homes using subprime loans. That was only about 9% of all subprime lending. The remaining 91% of subprime lending was refinancings or second home purchases (or third or fourth …). “By the second quarter of 2010 the homeownership rate had fallen to 66.9% percent, right where it had been before the housing bubble.”

I found this book to be a great companion to The Big Short and In Fed We Trust. The Big Short does a great job of focusing on how the CMBS and CDO markets worked. In Fed We Trust focused on the events of 2008. All the Devils are Here focuses on the macro events that swarmed together into an apocalyptic mix of bad bad loans, bad underwriting, bad risk assessment, bad investing and bad goals.

I don’t often include fiction books in my book reviews on this site. But I was drawn to The Death Instinct because its historic fiction is centered around an event on Wall Street. So I thought the book would be interesting for a compliance professional.

A horse-drawn wagon passed through Wall Street’s lunchtime crowds on September 16, 1920. Inside the wagon was 100 pounds of dynamite and 500 pounds of cast-iron slugs to act as shrapnel. The wagon exploded in front the Morgan Bank and the US Treasury building, killed 38 people and seriously injured hundreds.

It was the most destructive terrorist attack on US soil until the Oklahoma City bombing. Jed Rubenfeld draws some analogies between the 1920 attack and the 9-11 attacks. Unlike those attacks, the 1918 attack went unsolved. There were some vague accusations of plots by Italian anarchists, but nobody was ever charged.

Rubenfeld puts together a sweeping storyline to find his explanation for the bombing. He inserts many subplots branching out from the main story line. He also includes several real-life characters, fictionalized for the book. This includes Marie Curie, Sigmund Freud, Senator Albert Bacon Fall, and former Treasury Secretary William G. McAdoo. The main protagonists are Dr. Stratham Younger, Colette Rousseau – a radium scientist, and James Littlemore a detective with the NYPD.

There is a lot going on and I thought the story might go spinning out of control at a few points, but Rubenfeld manages to keep it together.

My biggest quibble is with the title.  When the publisher offered me  copy I almost passed on it. The “Death Instinct” is one of Freud’s theories. He came to the conclusion that humans have not one but two primary instincts: the life-favoring instinct and the death instinct. In other words, humans strive for both tenderness and thrills. Personally, I found the whole Freud sub-plot to be a distraction to the story and the title merely reinforces an aspect that I did not like.

Otherwise, I enjoyed the main characters and the twisting storyline as it jumps from plot-to-plot and character-to-character. There is romance, financial intrigue, and police procedural elements all mixed in.