Fooling Some of the People All of the Time

July 11 2014

Corporate fraud, questionable accounting practices and plain deception are nothing new on Wall Street. Hedge fund manager David Einhorn of Greenlight Capital even wrote a book about it. Aptly called ‘Fooling Some of the People All of the Time’, the book narrates a story about a private equity investment firm named Allied Capital, which Einhorn shorted in 2002. In 2008, after six long y

Fooling Some of the People All of the Time

Corporate fraud, questionable accounting practices and plain deception are nothing new on Wall Street. Hedge fund manager David Einhorn of Greenlight Capital even wrote a book about it. Aptly called ‘Fooling Some of the People All of the Time’, the book narrates a story about a private equity investment firm named Allied Capital, which Einhorn shorted in 2002. In 2008, after six long years and many insults and attempted cover-ups, Allied finally failed. Not the Securities and Exchange Commission, but a recession eventually led to the demise of another corporate accounting scandal. This week it was not Allied Capital, but Spanish Gowex and Banco Espirito Santo that went belly up in the markets. Gold prices, as a result, surged and are nearing a four month high.

Corporate Frauds Are Cyclical, Too

Somehow, corporate frauds always coincide with stock market booms. David Einhorn needed to wait more than six years for his short to play out. His thesis was correct along the way, but only when credit got tight and when exuberance turned into despair, Allied collapse.

Legendary value investor Warren Buffet perhaps said it best: “Only when the tide goes out do you discover who's been swimming naked.” And sometimes it takes time for the moon’s gravitational forces to adjust the water level. Some are able to swim naked longer than we initially imagine. In times of recession, however, everybody pays closer attention, whereas during boom times the money flows easily, critical remarks are quickly swept under the rug.

Gowex: Too Good To Be True

Last week, Spanish internet company Gowex became front page news all around the world. Gowex was a, supposedly, fast growing Spanish start-up that offers free, public Wi-Fi hotspots. Its main revenues were from advertising and contracts with cities to provide free Wi-Fi.

“Gooooood morning NYC!!!!!”, tweeted Gowex CEO Garcia, after signing a contract with New York City to install and service Wi-Fi hotspots. Garcia told NYC was paying 7.5 million euro’s to Gowex, while he told another analyst the contract was worth only 2 million euro’s. Eventually NYC came out and revealed the contract’s real worth was just $245,000. Garcia overstated the contract by 30 times. It was one of many cover-ups that eventually proved fatal. Gowex stock fell from €20 per share to €8 before the regulator suspended further trading.

Last March, Spanish Prime Minister Mariano Rajoy gave Gowex CEO Jenaro Garcia an award for its entrepreneurial achievements. That very same Garcia will now testify as a suspect in front of a Spanish court in three days. There is a thin line between being the hero and the villain, especially when you’re not terribly concerned about ethics.

Banco Espirito Santo: What Happened in Portugal?

Stock markets suffered losses and Portuguese bond yields surged this week, because a parent company of Portugal’s largest bank missed a bond payment. Apparently, Banco Espirito Santo tried the same trick as Allied Capital: funding debt issuance in one entity with another and overvaluing asset values. Mr Ponzi himself would probably approve.

Espirito Santo International (ESI) is a parent company of the Portuguese bank, Banco Espirito Santo. This week, it defaulted on some short-term debt warrants, sparking a panic and a big sell-off.

Investors have good reason to doubt ESI’s accounting practices. For some inexplicable reason, Espirito Santo International (ESI) — the parent —is carrying Banco Espirito Santo at a substantial higher value than its current market value. Not only that, accountants from KPMG discovered accounting irregularities in the financial statements of Espirito Santo in May. Their audit concluded that Espirito Santo International was in a “serious financial situation.”

A banker that previously worked with BES, argued that the bank has a two or three billion euro’s shortfall and might have to be recapitalized by the Portuguese government. BES hasn’t received a bail out before.

The panic that erupted this week due to Espirito Santo’s woes shows the euro crisis can re-erupt very suddenly and also how fragile the euro zone is financially, despite allegations to the contrary by bureaucrats in Brussels.

No Corporate Fraud with Gold

We are bound to see more fraud and corporate malpractices this and next year. Corporate fraud thrives on cheap credit. When one of the longest stock market booms in history comes to its end, excesses will surface. Or to repeat Warren Buffet, when the tide goes out, we’ll quickly see who has been swimming naked. As soon as the punch bowl is removed, fraud often times becomes undeniable and investors get weary.

Gold is one of the few assets that does not incur any counterparty risk. It is free of fraud by crooked managers. Gold doesn’t have any financial statements or hidden balance sheet items. It doesn’t consist of multiple corporate entities with unclear consolidation practices. It doesn’t even have a board of directors. It is the ultimate asset to own in times of exuberance, way before corporate excesses unwind violently. Yes, gold is the ultimate remedy for stock market hangovers.

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