The unfolding global financial crisis has now served to expose not only excessive risk-taking, compensation and personal greed, but also massive fraud. One of the latest episodes involves the iconic IT services company Satyam where billions in cash went missing on its balance sheet.
The Caribbean has witnessed in quick succession, both situations – the collapse on CL Financial under the weight of a liquidity crisis and the collapse of the Allen Stanford group under charges of massive fraud. As one noted investor is said to have observed: “You can only see who is swimming naked when the tide goes out!” Jamaicans would have fresh in their memories the recent fraud of the pyramid schemes which left many Jamaican investors naked.
The CL Financial group (CLF) led by Lawrence Duprey was probably the largest conglomerate in the Caribbean with assets of over US$15 billion and with interests in Petrochemicals, Petroleum, Lumber, Land and Property Development, and Alcoholic Beverages, in addition to the core insurance and financial services businesses. CLF is a private company and operated with few if any of the governance structures which public listed companies are obliged to put in place. The Group is highly leveraged and used its financial services companies to fund its adventures in various non-financial businesses in the Caribbean, Florida and more recently the Middle East. The CLICO insurance company developed and sold the “Executive Flexible Premium Annuity’ (EFPAs) product which, disguised as an insurance product, offered the subscriber high interest rates. CLICO Investment Bank also offered its depositors interest rates which were not obtainable elsewhere in the local market.
As the stories on what went on in CLF over the last several years emerge, it is certain that recklessness and greed will be found in the rubble. Whether or not there was also fraud and other criminal activity remains to be seen.
Allen Stanford became the main financier of West Indies cricket in the last 15 years and his 20/20 tournament between England and the West Indies offered the highest prize money ever for a single game of cricket –US$20 million.
The complaint filed by the SEC in the United States against Allen Stanford is clear that there was massive fraud in the businesses run by him, to the tune of about US$8 billion. The complaint alleges that:
“…SIB [Stanford International Bank], acting through a network of SGC [Stanford Group Company] financial advisors, has sold approximately $8 billion of self-styled “certificates of deposits” by promising high return rates that exceed those available through true certificates of deposits offered by traditional banks.”
Lessons for Investors
There are several parallels in the stories of CL Financial and the Stanford Group and, indeed, investment banks in the US and Europe which have collapsed or have sought the protection of the state or regulatory bodies there.
Lesson #1 – “If it’s too good to be true, it is probably too good to be true”
In buoyant times as continued growth seems to be the norm and the stories of ‘success’ multiply, it is difficult for investors not to succumb to the notion that higher than normal returns are to be had somewhere. If returns in the USA are at a certain level, there is China and India, Brazil and Russia, where even higher returns can be had. And you look timid and foolish if you do not participate in the gold rush when so many of your friends tell you what astonishing gains they have made in a short period of time.
Some of these opportunities are indeed real and sensible, but the fact remains that where returns are higher, the risks are indeed always higher. Those risks might take the form of exchange rate or currency risk, excessive volatility in thinly-traded stock exchanges or weak governance structures of investee firms. The rising tide may conceal or mask these risks for a time, but the inevitability of the cycles will expose those risks and many investors who are not protected will be caught and will lose their shirts.
It takes real discipline, resistance to peer pressure and resolve to stick to an investment strategy where the level of risk is appropriate to one’s particular circumstances. Most investors succumb and when losses begin to roll through fall victim to the perverse psychology of hanging on and hoping that the situation will miraculously turn around and losses will be restored to gains. Some comfort themselves with the foolish thought that “It’s not a loss until I actually sell.”
Lesson #2 – “Know Where Your Money (Really) Is”
In recent years, financial institutions are required to ‘Know Your Customer’. The reverse is also absolutely necessary. Snake oil salesmen may dress in business suits and be armed with slick Powerpoint presentations and glossy brochures containing- as appeared to have occurred with the Stanford Group- fictional historical returns. Investors need to know who they are dealing with and where (exactly) their money is invested. The CLF and Stanford cases would suggest that a good rule for the conservative investor is to avoid private companies whose governance structures may be weak if they exist at all. There is a better chance that listed companies will be better governed, although the Satyam case (a listed company) should give the investor pause.
Lesson #3 – “Look out for the Black Swan”
A ‘Black Swan’ is an event which is a statistical outlier, highly improbable but all the same quite possible. (Black swans do exist.) These events are also quite dramatic in their effects. In other words, as improbable as certain outcomes may seem they can and do occur. Indeed events like the market crash of October 1987 are held to be ‘one in a thousand year events’, yet they have occurred several times in the last century, leading to the notion of ‘fat-tailed distributions’ meaning simply that these events are not as improbable as they might first appear.
If that is so, then investors need to be mindful and maintain a portfolio of assets that can absorb a ‘black swan event’. In practical terms that means holding some cash, a difficult sell when the market is roaring ahead because cash earns a zero or very low return. True, but remember the Black Swan.