How the TSX can Rise from Wall Street’s Ashes

The Ninjas Strike Back
My first encounter with a 21st century Ninja came in the spring of 2006. I was on my way to a rendez-vous at a sandwich place in a dodgy part of Brooklyn. Emblazoned across a storefront were the words: “No job. No credit. No problem. We give mortgages to everyone.”  As I later learned, not only was this practice legal, but it was an institutionalized multi-billion dollar asset class, referred to by Wall Street bankers as NINJA loans [No-Income-No Jobs or Assets]. More than three-quarters of these subprime loans originated between 2003 and 2007 and had an exploding teaser rate feature: after two or three years, the low-introductory interest rate would spike.

Two years later, these co-conspirator Ninjas unleashed a flurry of blows on the solar plexus of predatory financiers. Rather than a shobo (a small ring used for hand-to-hand combat), the Ninjas’ weapon of choice was much more potent: jingle mail. With the popping of the housing bubble, thousands of people faced with exploding interest rates on a mortgage that was now worth more than their home did the only logical thing. They packed up, moved out, and sent an envelope with the keys to the bank.

The jingle mail unlocked the black box of risk management on which the reputations of the Wizards of Wall Street were staked. The financial markets reacted savagely to this betrayal of trust. Storied investment houses Lehman Brothers and Bear Stearns were buried alive without eulogies. AIG and Citibank became wards of the state. Within 15 months more than US $50 trillion (roughly equivalent to the annual world domestic product) in stocks, real estate, commodities and operational earnings had vapourized. 

Down the Path of Laissez-Faire
In 2004, my roommates and I threw a party at our condominium to celebrate our beautiful view which, par for the course in Toronto, was slowly being eclipsed by a rising condo. John was about to start a new job in New York, working with special purpose vehicles. “So you are getting into the car business…” Pepe said. “No,” John replied. “Wall Street.”

A recent accord for more sophisticated ways of calculating risk had been reached in Europe (Basel II), and the upshot was a whole slew of new financial products, including Ninja mortgages, could now be bundled and sold as rock-solid AAA investments. Wall Street had a new toy, and the parents were on a long vacation.  A multi-trillion dollar market for derivatives blossomed overnight, completely off the record of public registries, violating the general principles of property law, as economist Hernando de Soto points out. Rating agencies happily collected their fees and awarded AAA grades to complex products few people completely understood. Investment banks, with the help of big insurance houses like AIG, figured out a way to make $1.60 worth of reserves stretch to $100 bundle of credit. The “banksters,” as Ralph Nader, the de facto “unarmed Sherriff of Wall Street,” described them, made out like bandits. At their peak this decade, the financial sector, essentially a utility, took home 41 per cent of total domestic profits.

Too Many Zeros
Aside from the trillions of dollars (almost one quadrillion at the height) of unregulated bets made with derivatives, the other large number that foretold the credit crunch sits atop a Chinese restaurant in New York. That’s where the famous US National Debt Clock is located.  Driving by this fall, I noticed it had the same problem many of our gas pumps had when gas broke through the $1/litre barrier: too many digits, too few squares. In this case, the number that broke the camel’s back was $10,000,000,000,000, thanks to Washington’s first Wall Street bailout instalment of $700 billion. Where there used to be a $ sign, there was now a “1.”

At a Congressional testimony in October, the former Oracle of Wall Street, Alan Greenspan, delivered a eulogy for the age of excess debt: “Those of us who have looked to the self-interest of lending institutions to protect shareholders’ equity, myself included, are in a state of shocked disbelief.”

Paul Volker remarked: “Simply stated, the bright new financial system – for all its talented participants, for all its rich rewards – has failed the test of the market place.”

The verdicts of the two Former Federal Reserve Chairmen underlined the dangers of Alice-in-Wonderland approaches to risk management and greed gone wild.

Hungarian Wisdom on Replacing Debt
Six months later, I am sitting across the dinner table from George Soros, billionaire financial sage, at the Swiss mountain resort of Davos. Forgetting he was Hungarian, I ordered him a vegetarian meal. He promptly exchanged it for a beef dish.

For Soros, this threshold of debt and the careening financial markets signified the end of an era. No longer could the world depend on the debt-fuelled US consumer to power the global economy, he said. That engine is finished. “You need a new motor. And we have a big problem. Our dirty energy dependence from politically bad sources is hurting us in many ways,” he explained. “There are two ways out: pushing forward with alternative energy sources, and reducing energy consumption. This will require a large investment and investors who choose prudently will be rewarded handsomely.”

The Reality of Risk
Unsustainable situations crash and burn. Disconnecting from reality is not a cure. Debt eventually saps credit and confidence dry. Risks cannot be cast aside through vapourware math. Risks are real and they must be managed, not “managed.”
Many aspects of our society are “managed.” Managed Accounts are mostly automated accounts tailored to the “mass affluent” rather than the individual. Managed democracy is a term for a democratic government with increased autocracy, such as Russia and Singapore. In software, managed code means code that hides so much complexity behind it that you don’t need to worry about it. “Managed” is now a synonym for perverted, subverted, ignored, externalized and generalized.
The distortion of the word “managed” is all around us. Instead of accepting and dealing with reality, it seems to have become a catch-all for rejecting and running away from the essence of that which faces us.
In reality, managing risk should be all about seeking out and confronting the demons we’d prefer didn’t exist, taking care to steer clear as far as possible, but being ready to deal with them when the time comes.

The Looming Class of New Risks
Considering their alumni have been architects of the light-touch regulation that allowed Wall Street to dig itself into so deep a hole during the past decade, Goldman Sachs seems an unlikely prophet on whom to rely to tell us how to prepare for the new class of risks on the horizon. That is, until you consider that Goldman Sachs is an investment bank that emerged relatively unscathed from the subprime meltdown and has repeatedly proven its survival skills since 1869. According, then, to Anthony Ling, Global Chief Investment Officer at Goldman Sachs, economic returns in the resource sector are driven by access to new legacy (read: big and long-lasting) assets, which are increasingly difficult to find, and tend to be located in politically risky, technically complex, and ecologically sensitive areas.

Ling asserts that Goldman Sachs has found a strong correlation between companies who proactively manage social and environmental risks and those who are able to profitably win access to, and produce, new legacy assets. Sounds good, but as they say on Wall Street, “Bullshit talks, and money walks.” In June 2007, Ling and his team took up the challenge and formulated a new investment product, GS SUSTAIN, which identifies companies that are best positioned to sustain a competitive advantage, using analysis of return on capital, industry positioning and environmental, social and governance (ESG) performance. Since its launch on June 22, 2007, the GS SUSTAIN Focus List has outperformed the MSCI World index by 19.1% on an equally-weighted basis (as of June 2, 2009).

So here we have an example of one of the world’s most respected investment houses integrating environment and social factors, and outperforming as a result. But, it’s a lot harder than it should be. Goldman Sachs analyst Marc Fox laments the sporadic nature of environmental and social reporting. Instead of just pulling data from balance sheets, he and his team have to track down, cleanse, and double-check the ESG data to get it in shape to plug into the GS SUSTAIN framework. For instance, some data points (such as royalty payments by country) that would add value for his clients, by providing insight to a company’s relationship with its host government, are not broadly available (See sidebar for Goldman Sachs 'wish list' of 10 core KPIs).

Carbon Risk
In the fall of 2007, at the media christening of the new company created by Rio Tinto’s leveraged buyout of Alcan Inc by Rio Tinto, Rio Tinto Alcan CEO Dick Evans surprised a certain corporate lawyer friend of mine. The gist of his comment was that absolute carbon caps, which now seem inevitable, could force Rio Tinto Alcan to “offshore” billions of dollars of investments it was planning to make in Canada. “If you look at absolute reductions as a solution, […] you will drive the growth of aluminum production offshore,” Evans said. At the time, Alcan’s mandatory disclosure was silent regarding climate change regulatory risk.

But it’s not just Alcan. In a recent Goldman Sachs report, Change is coming: A framework for climate change – a defining issue of the 21st century, the firm states, “the penalties required to incentivize the emissions reductions necessary to stabilize concentrations of greenhouse gases […] are far higher than recent market prices on existing exchanges.”

At the high end, Goldman Sachs notes that “a carbon price of US$150/tonne applied to the total value of global carbon emissions represents more than five times the aggregate earnings of publicly listed corporations across the globe and approximately 15% of global GDP.” In terms of cash flow, Goldman’s analysis of 800 global companies with a market cap over US$3 billion finds that a value of US$60/t placed on all direct carbon emissions would result in roughly 20% of the cash flow of carbon intensive industries (oil & gas, airlines, other transport, chemicals, mining, steel & aluminum, power utilities and non-power utilities) moving from carbon inefficient to towards carbon-efficient companies.

Reclaiming the Land
Carbon has a way of hijacking the looming off-balance sheet risk discussion, but there are other potentially material extra-financial risks lurking in the shadows. For instance, it is little known that the oil sands companies, tearing up Northern Alberta and virtually ladling it with toxic lakes, are required by provincial law to restore decommissioned land “to a state equivalent to the capability that existed before disturbance.” Simon Dyer from the Pembina Institute has calculated that the industry has set aside funds to clean up the mess, amounting to less than $13,000 a hectare. He notes that in forestry, “you could barely plant trees after you’d harvested a cut block, for that amount, let alone deal with the issues of tailings ponds and moving all that material.”

Because the Government of Alberta has certified as reclaimed only one-square-kilometre of land after 41 years of oil sands development, it is hard to put a number on how much it will cost to clean up the vast swathes of disturbed land. The Oil Sands Developers Group points out, “The oil sands industry faces unique reclamation challenges for which there are no analogues.” As one reference, between 2002 and 2006, Syncrude’s reported reclamation costs averaged more than three times the $13,000/ha that has been put side, coming in at nearly $47,000 per hectare.

While it is definitely on the extreme end of the reclamation cost spectrum, the clean-up of 31 hectares of Sydney Tar Ponds in Nova Scotia is budgeted to come in at $400 million, or $12.9 million/ha. As the Oil Sands Developers Group notes, “Existing legislation effectively secures corporate assets if reclamation is not completed.”
 
Toxic Risk
In February 2003, Fortune Magazine put a French fry on the cover with the caption: “Is Fat the Next Tobacco?” The article raised the spectre of tobacco-style litigation against purveyors of fatty foods. It turned out to be mostly hype. After all, when you drink a McDonald’s milkshake, who’s going to believe someone who claims they didn’t know it was high in caloric content?

The real question is “what is the next asbestos?” A RAND Institute for Civil Justice study released in 2005 found that over 730,000 people had filed asbestos-related claims, costing businesses and insurers more than $70 billion.

The next asbestos is most likely to be the magnitude and extent of a company’s toxic footprint. The Investor Environmental Health Network (IEHN), representing $41 billion in investor assets, cites an evolving documentation of the multi-billion dollar drag that toxic chemicals place on our economy via health impacts, including increased asthma rates, environmentally related cancers, and learning disabilities.

In December 2004, as a prelude to the liability companies may face in coming years, DuPont was assessed the largest civil administrative penalty ($10.25 million) the EPA has ever obtained under any federal environmental statute for alleged violations to toxic substances laws relating to the chemical PFOA, most notoriously used in Teflon® products. In March 2005, a Wood County, West Virginia judge approved a large settlement ($107.6 million to $235 million, depending on the outcome of a study of the chemical, C8) to a lawsuit, which alleged that DuPont poisoned tens of thousands of people’s drinking water.

The IEHN Fiduciary Guide to Chemicals report cautions that an array of new legal requirements, especially in Europe, combined with government and corporate environmentally preferable purchasing programs, signals that chemical risk issues will need to be addressed, particularly by companies in the electronics, health care, personal care products, home cleaning products, automotive products, food processing,  retailing, “big box” retailing, building supplies, home and office furnishing, and, of course, the chemical sector.

A recent University of Arkansas study found that, although companies are required to disclose EPA proceedings under which they could face more than $100,000 sanction, 72 percent of the 309 companies involved in such proceedings did not follow that rule between 1996 and 2005.

So, investors are starting to take matters into their own hands. They have filed over 60 shareholder resolutions on toxic chemicals since 2006. Institutional Shareholder Services, a proxy advisory outfit with 1,500 corporate and institutional clients, recently adopted a policy on toxics and now recommends a “FOR” vote on shareholder resolutions requesting disclosure of policies related to toxic chemicals. However, in the absence of systematically enforced disclosure, investors have little knowledge of the extent of toxic surprises contained in their portfolios.

Facing the New Class of Risks
Many patterns of human behaviour can be traced back to Greek mythology. Paradoxically, Apollo, recognized as a god of light and the sun, truth and prophecy, provides an early example for the particularly human way that makes us generally reluctant to deliver (or hear) bad news. In Apollo’s case, he turned a white crow black for being the bearer of bad news: that the mother of his child had married someone else.

There are still many natural reasons to steer clear of more than boilerplate risk disclosure, the more so for complex and/or emerging non-traditional matters that almost nobody else is yet disclosing. When you throw in competitiveness concerns and liability considerations, it’s easy to fall prey to the circuitous logic that “if it was material, we’d be disclosing it, and since we’re not disclosing it, it must not be material.” And that’s how systemic failure happens.

The foundations of this new class of risks are framed by a human population approaching 7 billion in a world of finite resources, and grounded in matters of unrest in human and natural communities. No one is suggesting that companies should be responsible for comprehensively managing these complex risks. At a minimum, however, to the extent that it could be material, companies have a duty to err on the side of disclosure regarding their revenue relationship with host countries, potential carbon costs, chemical risks, and reclamation liabilities.

In the current regulatory vacuum the duty to publicly disclose extra-financial indicators is being shirked. The Ontario Securities Commission has noticed this, too. In March 2008, the OSC issued a Staff Notice, raising the red flag, that disclosure relating to known and contingent environmental liabilities in the continuous disclosure documents of many reporting companies does not fully satisfy applicable disclosure requirements.

That’s why many of Canada’s largest pension funds, including the Canadian Pension Plan Investment Board, continuously support shareholder resolutions calling for more disclosure on environmental and social risks not available through standardized channels. That’s why investors with over $50 trillion of assets under management have banded together under the Carbon Disclosure Project to pressure companies to be more forthcoming about their carbon liabilities. It also helps explain the activity among regulators from China to the US, aimed at shining more light on emerging extra-financial indicators.

In January 2008, China’s influential State-Owned Assets Supervision and Administration Commission (SASAC) released a directive encouraging state-owned enterprises to report on social and environmental profiles. Separately, the US Congress and the International Accounting Standards Board are considering requiring companies that raise capital in their respective jurisdictions to publish what they pay to governments in all countries of operation. 

At the Toronto Stock Exchange, we have an opportunity to lead the way, and define Canada as the place to invest for investors who don’t like surprises. With the burgeoning oil sands, heavy financial exposure to resource intensive sectors, and the exchange’s status as a launch-pad for the majority of the world’s mining companies, the upsides of transparency for accountability and investor safety could scarcely be higher.

In April, Ontario MPP Laurel Broten put forward a resolution that the “OSC seek to develop and adopt an enhanced standardized reporting framework for both quantitative and qualitative social and environmental information to ensure corporate disclosures are understandable, comparable and outcome-focused.” It passed through the legislature unopposed, with a deadline to report back by January 2010.

With portfolio wounds still being licked from the recent subprime blow-up and people’s retirement dreams being pushed ahead by a decade, the adage that ‘investors get the returns they deserve’ seems harsh. Now is the time for investors to take charge of this initiative and clearly articulate a 21st century disclosure framework that includes material extra-financial indicators that underpin the megatrends of our time. Fool me once, shame on you; fool me twice, shame on me.

Goldman Sachs 'wish list' of 10 core KPIs that would benefit global investors in assessing ESG performance across companies

(1) Social
- payroll ($)
- lost time injuries (LTI rate)
- training (hrs and $)
- social investment in communities of operation ($)
(2) Environmental efficiency
- greenhouse gas emissions (tonnes CO2e)
- energy consumption (joules)
- % energy consumption from renewable sources (solar, wind, hydro, etc)
- water consumption (litres)
- waste produced (tonnes)
- % sales derived from products/services that assist clients in carbon abatement/adjustment