Why is anyone still surprised at the magnitude of the disaster that has befallen our economy? An economic collapse that resulted from the faulty analysis performed by those organizations charged with bestowing ratings on the thousands of securitized and structured finance products.
That anyone is surprised is simply amazing, given the collective failures of auditing firms in the last 20 years, and the collapse of Arthur Andersen due to the Enron audit failure. While audits of financial statements and audits of securitized products are dissimilar in many tangible respects, the rationale behind their failures is remarkably similar.
Complex financial statements and complex securitizations share one common feature: no one really understands them. Financial statements continue to be obtuse rationalizations of highly complex organizations and disparate companies, cobbled together and “consolidated” to appear as if the reporting entity was one, giant, unified company, rather than a series of companies that may or may not have little in common. This “consolidated” financial report purports to “fairly represent” the financial results of the consolidated entities, while providing little in the way of unconsolidated and segregated information on the disparate companies that comprise the whole.
The audits are prepared by rotating bands of auditors who generally leave the “Big 4” after little more than 2-3 years in practice, having grown weary of the numbing nature of audits. These “experts” are charged with engaging senior management in lively discussions regarding the adequacy and materiality of their financial representations, while being tethered by the massive audit fees these engagements generate. Think there’s a slight conflict of interest here? Of course there is. Senior managers have a schizophrenic need to “preserve” the client relationship while ensuring the fairness of the financial statements, a tightrope that often fails.
Is the audit relationship any different from that of the ratings agencies and the securitized products? Not really, as they both walk that same conflicted path, generating millions of dollars in fees for their organizations. That no one has credibly challenged the assertion that these ratings agencies bestowed “A” ratings on products that they did not understand is not amazing, what is amazing is that these same agencies continue to bestow identical ratings on similarly structured products, even after this debacle.
That these agencies had little understanding of the complex nature of the structured finance products is understandable, given the lack of prior experience with these products. Regulators, though, failed to learn and absorb the lessons of Enron, and allowed essentially the same regulatory structure to permeate the world of structured finance. The lessons “learned” as a result of the dozens of magnificent audit failures were never understood, either in or out of the accounting profession.
These lessons involve the futility of self-regulation and the inherent conflicts that exist between client generation, responsibility to the investing public, and the sheer volume of work available and fees generated by these engagements. These conflicts may ultimately prevent any meaningful regulation of these industries. The caveat is the same for both investor groups, whether as a bank relying on a set of financial statements to bestow a loan, or an institutional investor deciding whether to purchase complex structured products: it behooves them to perform independent, critical analysis beyond that bestowed by these organizations. The value of either “stamp” has fallen precipitously over the last 20 years, and in fact may mean very little today.