Identifying Enterprise Risk In Financial Markets

Market Assurance – Early Warning System (MAEWS) A s s u r i n g M a r k e t I n t e g r i t y & T r u s t w o r t h i n e s s t h r o u g h D e t e r r e n c e o f Q u e s t i o n a b l e & F r a u d u l e n t F i n a n c i a l R e p o r t i n g Ly l e B r e c h t C a p i t a l M a r k e t s R e s e a r c h 1

Vision Statement It is technically feasible to build a system that automatically assesses the probabilistic risk of a public enterprise (including banks, any financial industry firm or any enterprise that is regulated and that must produce periodic statements of financial condition) overstating its economic results System would work even if the firm was deliberately releasing false financial statements overstating earnings System would serve as a screening tool for SEC and other regulatory agencies (Federal & State) and enforcement personnel to focus on specific firm’s riskiness

(c) Lyle Brecht 30-Sept-04, 2009

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Goal and Objectives Goal is for regulators to discover enterprises that are misleading investors or in a risky financial situation BEFORE such companies go bankrupt or their shares loose significant value when the truth becomes known to the wider market

Objectives include: annual 98% reduction in surprise bankruptcies; annual 90% reduction in accounting fraud; US public markets viewed by global investors as the most honest and fair market in which to invest capital

(c) Lyle Brecht 30-Sept-04, 2009

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Today’s Situation ENRON, WorldCom, Global Crossing, Computer Associates, Adelphia Communications, Tyco, Quest, etc. financial reporting problems were largely unanticipated by regulators Problems that caused collapse of CDO market in 2008 were brewing for many years beforehand After-the-fact enforcement is expensive and lengthy process. Collapse of Wall Street CDO market required taxpayers to provide reserves of $17,500 billion Lyle Brecht 30-Sept-04, 2009

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Big Picture Need to flag public companies and regulated enterprises not providing an accurate reporting of the firm’s economic condition Need to identify specific individuals affiliated with public companies engaging in self-enrichment to the detriment of shareholders and the taxpayers The market expects the regulator to proactively identify problems with financial markets before the situation becomes catastrophic (c) Lyle Brecht 30-Sept-04, 2009

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Available Options to Restore Confidence Additional regulations – without a much increased enforcement budget will not be effective Additional money for enforcement of existing regulations – alone will not be effective: largely afterthe-fact and means to evade continually more sophisticated Efficiently identify potential problem firms – implement a market assurance early warning system (c) Lyle Brecht 30-Sept-04, 2009

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Analogues Similar to systems already employed in the credit card industry to identify credit card fraud Similar to systems already employed in the banking industry used to approve loans based on credit risk Similar to systems already employed in the U.S. Intelligence Community (IC) to identify potential “individuals of interest” who may have ties to terrorism (c) Lyle Brecht 30-Sept-04, 2009

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System Development Costs Proof-of-Concept ~ $800,000 (7mo) Technical Specifications & Prototype ~ $3M (9mo) Pilot Test ~ $22M (14mo) System Build and Rollout ~ $105M (over time, based on performance metrics and type of firms analyzed) (c) Lyle Brecht 30-Sept-04, 2009

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Sources of Funding Regulators fund development of this facility within existing budget, or Regulators enter into a long term, performancebased contract with 3rd party to provide system services This long-term contract is used to secure private debt funding from the capital markets (c) Lyle Brecht 30-Sept-04, 2009

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Sources of Funding if Regulatory Agency Funds Not Used Proof-of-Concept – Angels Technical Specifications – Foundations, Vendors Pilot Test – Pension Funds; Venture Investors; Industry Consortium System Build and Rollout – Sell 10-15 yr. bonds; Industry Consortium (c) Lyle Brecht 30-Sept-04, 2009

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Organizational Structure for Market Assurance Early Warning System Development System is developed as a financial markets assurance Utility Available for a fixed annual subscription fee to regulators Utility services also available by subscription to institutional investors: pension funds, mutual funds, banks. Utility is organized as a Non-Governmental Organization (NGO). Utility is run as a not-for-profit entity Chartered by regulatory agency of the federal government (c) Lyle Brecht 30-Sept-04, 2009

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Rationale for Structure Myth of rational markets – broad base of usage acts as deterrent, before-the-fact Wide usage enables AI system to learn and evolve as fast as companies develop new ways to beat the system Broad coverage can identify systemic risk that is not being managed (e.g. CDO derivatives market) Additional fees can be re-directed to continually improve system’s capabilities (c) Lyle Brecht 30-Sept-04, 2009, 2009

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Next Steps Letter of Intent from regulator’s commissioners Use this letter to obtain proof-of-concept funding Interested regulatory agerncies will establish internal team to discuss system requirements Concurrently, develop project plan and staffing recommendations for utility development As part of development process implement NGO structure (c) Lyle Brecht 30-Sept-04, 2009

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Lyle Brecht 410.963.8680 [email protected]

Business development executive and consultant Raised a total of approximately one billion dollars for projects. Producer for two AI systems Degree in business from Harvard Business School and a graduate degree in Applied Ecology (Systems Theory) from the University of Minnesota.

(c) Lyle Brecht 30-Sept-04

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