Friday, February 29, 2008

Sprint Nextel’s $29.5 Billion Loss From A Risk Manager’s Perspective

Another mega-billon loss reported by major corporation[i].

Reuters reports that Sprint Nextel has posted a $29.7 billion in goodwill write-off that led to the reported $29.5 billion operating loss for 2007. After months of similar news, one sort of becomes inured to the magnitude of the losses. However, this loss is not due to investment in structured products, like the other recently reported losses, but appears to be a symptom of failure to exercise prudent risk management around Sprint’s merger with Nextel.

In looking at their February 28 press release of the 4th[ii] and their 3Q 2007 financial statement[iii], one can see Sprint Nextel admitting to improper management of their risks. From a risk management perspective, one can see the business risks, based on their financial statements: quarter 2007 financial statement

Improper understanding and accounting for the business risk of merger with Nextel
“As a result of our 2007 annual assessment, we recorded a non-cash goodwill impairment charge of $29.7 billion.” (source:

Risk Assessment: The $35 billion merger in December 2004 has resulted in a goodwill charge of $29.7 billion, or 84.8% reduction in the value of the Nextel purchase within three years. Given this, it appears that Sprint did not fully account for the business risks of the merger:

Product stagnation: lack of product innovation and product differentiation
Competition: allowing competitors to take “Push to Talk” market shares
Industry: paradigm shift in mobile technology
Strategic Planning: Not having strategic plans, which could have been announced with the 4Q 2007 financial results.

Losses from the above risk events: $29.7 billion, so far. Based on the recent statements from Sprint Nextel, the overall loss may be the initial merger value of $35 billion.

1. Questions to Sprint Nextel:
What was your medium- to long-term market risk assumptions going forward from 2005 behind the merger with Nextel, given that Sprint operates on a CDMA platform and Nextel on iDEN platform?
How have these assumptions changed?

2. Business risk from failure to integrate two cultures, operations, and IT systems on a timely basis
"Internally, we have rolled out a unified company culture focused on accountability and on providing a superior customer experience.”(source:

Risk Assessment:
It typically takes 18 to 36 months to integrate two large companies. I think a good example of how to merge and integrate two cultures, operations, and IT systems come from the $58 billion JP Morgan Chase merger with Bank One in July 2004. The merger of these two large financial institutions went relatively smoothly culminating with a stronger money market center.

Even the $41 billion merger of AT&T and Cingular in December 2004 has been completed with relative ease. Given that Sprint is still marketing phones and plans using Nextel logos, three years after the merger (see web shot), indicates that the “…unified company culture…” as stated by Dan Hesse, the Sprint Nextel CEO, is still far from being over.


The business risks of the delayed integration of the two firms:
Organizational: continued tension within the workplace as people from each culture try to gain control of the corporate identity.

Stakeholder Management: Stock prices are at a 5-year low and showing no signs of recovery

Brand: additional cost of having to support two separate brands, even on their website

Marketing: continued expenses of marketing “Nextel Direct”

Operational: IT system and support integration may not be complete.
According to the Washington Post report Sprint Nextel will maintain its iDEN platform to 2012[iv].

Competition: allowing competitors to take “Push to Talk” market shares

Reputational: Fitch Ratings cut its credit rating for Sprint Nextel to BB+ from BBB – by stating that they expect that 2008 financial metrics will be “significantly worse than expected.”[v].

Losses from the above risk events: On-going costs from separate marketing, operating, and support expenses and from increased cost of borrowing in the credit market.

Questions to Sprint Nextel:
How are you addressing the fact that AT&T and Verizon both offer “Push To Talk” features, a similar walkie-talkie service as Nextel, with their service?
Do you think that offering a $99 per month plan that is just slightly better than AT&T will help to stop the hemorrhaging?

Business risk from their inability to mitigate the deterioration of the customer base
“Sprint Nextel ended 2006 with a total of 53.1 million subscribers, compared to 47.6 million at the end of 2005…” (source:
“At the end of the [3Q 2007] period, Sprint Nextel was serving approximately 34.1 million customers on CDMA, 18.7 million on iDEN, and 1.2 million PowerSource users who access both network platforms.” (source:
“As previously reported, wireless subscribers declined 108,000 in the fourth quarter…At the end of the fourth quarter, Sprint Nextel served a little more than 35 million subscribers on the CDMA platform, 17.3 million on iDEN and 1.4 million PowerSource subscribers who access both platforms….In the fourth quarter, total post-paid subscribers declined 683,000 due to a loss of iDEN users.”

The business risks of their inability to mitigate the customer base deterioration:
Financial: Using Sprint Nextel’s revenue per post-paid of $58/month per customer to the 108,000 subscribers lost in 4Q 2007 alone, this equals to reduction of $75 million per annum< title="" href="" name="_ednref6">[vi]. Having to respond to criticism rather than providing strategic vision, is a clear indication of reputational damage.

Losses from the above risk events: Using Sprint Nextel’s revenue per post-paid of $58/month per customer to the 108,000 subscribers lost in 4Q 2007 alone, this equals to reduction of $75 million per annum. Given the revised revenue of $56/month per subscriber on 53.7 million subscribers, at the end of 2007, Sprint Nextel is projecting to earn $2/month less per subscriber in 2008, which equates to additional $1.3 billion in lost revenue.

Questions to Sprint Nextel:
Do you have other plans, besides starting a price war with AT&T?

What plans do you have to retain subscribers, especially those using the iDEN (Nextel) platform?

Will they move over to the CDMA-based push-to-talk platform?

What are you doing to inform your subscribers?

Lack of a strategic plan or a failure in implementing their strategic plan
“Given current deteriorating business conditions, which are more difficult than what I had expected to encounter, these changes will take time to produce improved operating performance, and our near-term subscriber and financial results will continue to be pressured.”

“Strategic assessments and changes may take longer to complete," Hesse said.”(source:

The business risks of missing strategic plan:
Financial: For each $1/month per subscriber reduction, Sprint Nextel will forego $644 million per year in lost revenue.

Stakeholder Management: Even with the wholesale replacement of CEO, CFO, Chief Sales Officer and Chief Marketing Officer[vii], shareholders may not wait long before demanding more heads.

Brand: intrinsic value of the Sprint Nextel brand is rapidly deteriorating

Competition: competitors will continue to take additional market shares

Strategic: Even as its base is deteriorating, Sprint Nextel is forging ahead with WiMax platform, which is draining cash that it could apply to securing its subscriber base. According to CNET October 2007 report, Wall Street analysts have voiced their concern about WiMax as a “dangerous diversion”[viii].

Losses from the above risk events: Potential revenue loss of $644 million per year, assuming no further loss in subscriber base. If WiMax platform fails to deliver, then expect a portion of the $4.3 billion in capital expenditures spent in 2007 to show up later as goodwill write-off.

Questions to Sprint Nextel: With a new CEO since December, two new board members since September 2007, and replacement of the CFO, Chief Sales Officer and Chief Marketing Officer in January, this is a great time to announce a brand new strategic vision. When will that occur?

As a risk manager, I do not speculate on whether Sprint Nextel will survive or not. What I am concerned about is whether the new CEO will take a page from John Thain of Merrill Lynch and install a new Chief Risk Office.

Have a great weekend everyone!

Ed Kim

DISCLOSURE: The author holds no long or short positions in Sprint Nextel Corp. at this time.









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Thursday, February 28, 2008

Brokerages fined over Improper Mutual Funds Sales & Transfer Practices

According to the recent Reuters’ news report[i], FINRA (Financial Industry Regulatory Authority), a regulatory agency that regulates more than 5,000 brokerage firms, “…units of Merrill Lynch & Co (MER.N) and UBS AG (UBSN.VX), have agreed to pay $2.4 million in fines and reimburse more than $20 million to customers to settle probes into improper mutual fund sales and transfers…”

Here is the breakdown of the regulatory issues and a quick review of the risk events and corrective actions required by the regulatory findings:

(click the picture to enlarge)

While the findings seems to be straightforward, there are additional questions left unanswered, such as:

How is that it has taken nearly four years after the fact to find the violations?

If Wells Fargo was able to find the violation, then why didn’t the other firms?

Do the other brokerages not have a risk management program?

When did Wells Fargo identify the violation? Just before FINRA came in?

What changes did the brokerage firms agree to make as a part of the FINRA finding?

By when will the brokerage firms reimburse the customers?

Is there a stated timeline and deadline?

How will they deal with customers who are deceased?

How will they deal with incorrect addresses for the customers?

How much will they spend to fully comply with the required corrective action?

What is the total cost (regulatory fine + cost of reimbursing customers) of the corrective action?

Of course there additional questions that any experienced risk manager will ask but the overriding question that a senior executive should ask is: Why did it take FINRA to identify the violations and not their internal audit or risk management groups?

I wonder if there are other brokerage firms whose risk management units are now kicking it into high gears and carefully reviewing their existing supervisory systems around improper mutual fund sales and transfers of classes B and C shares. Let me know your thoughts.

Ed Kim

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What Really Happened at SocGen?

The story[i] from SocGen is that Jerome Kerviel, a former middle-office worker who was promoted to his dream position of a trader on the equity derivative trading desk, was able to, from 2007 to 2008, bypass SocGen’s entire credit, market, and operational risk management systems unilaterally. From an operational risk management perspective, the ability of an employee to hide unauthorized trading on European equity market indexes for over a year by providing fake email trade confirms and manually bypassing built-in transaction monitoring systems through posting phony counter-trades seems so remote that I think the probability of SocGen’s story being true is lower than that of a person winning a lotto and simultaneously getting hit by a lighting, twice. But then again, who knows. Perhaps the SocGen story was based on the 1952 Daffy Duck cartoon, Fool Coverage[ii].

Let’s look at the breakdown in SocGen’s risk management, using their own press release on the “..exceptional fraud.”[iii]:

“…Societe General has put in place a large number of controls designed to monitor the risks involved: controls of operations and control of market risk linked to the changes in the prices of portfolios of financial instruments. The exceptional fraud which we have suffered consisted of avoiding these controls or making them inoperable; the trader inserted fictitious operations into portfolio B in order to give the impression that this portfolio genuinely offset portfolio A which he had purchased, when this was not the case. These fictitious operations, were registered in Societe Generale’s systems but did not actually correspond to any economic reality.”

My comment: I don’t know about the size or sophistication of the controls of operations that SocGen had in place but when a company boasts of “…a large number of controls…,” I tend to think of a number greater than ten. So, if SocGen had “…a large number of controls…” in place for operations, then based on my guesstimate, Jerome Kerviel had to fool at least 10 control points within operations alone and kept them fooled for a year. Additionally, Jerome had to enter false counter trades into SocGen’s systems, which adds more complexity to the equation.

Most I-banks the size of SocGen typically have multiple systems on different platforms ranging from desktop and web-based proprietary third party systems to server and mainframe systems. Typically, a basic trade would feed a (1) Trading Desk system (typically MS Excel or MS Access trade book), (2) Bloomberg or other proprietary trade blotter systems, (3) General Ledger system, (4) Trade Confirm/Affirm system, (5) Trade Limit Monitoring system, (6) Collateral Monitoring system, (7) Counterparty Limit Monitoring system, and (8) VaR calculation system, and (9) Trade Reporting system. So, if SocGen is to be believed, then Jerome had to bypass nine different systems each with different IT safeguards and controls, in addition to the email system.

Knowing that each of these systems performs and generates daily reconciliation reports that go to multiple departments within the bank, that would mean that Jerome Kerviel would had to be a super genius with Administrator access to all these system and had to be able to hack the web-based vendor system. I don’t know if anyone that talented exists in reality. If SocGen is to be believed, then Jerome Kerviel will have a bright future ahead of him with one of many spy agencies, who would just drool at having someone with such talent working for them.

Ed Kim

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Wednesday, February 27, 2008

Broken State Of Operational Risk Framework In Financial Institutions

It seems that many major financial institutions are still using a version of the original operational risk technique developed in the late 1990’s by Bankers Trust and JP Morgan, the pioneers in operational risk management. What is even more surprising is that the financial institution’s own auditors have so far accepted the continued use of the antiquated operational risk technique even after the roll out of Basel II Accord in June 2004, which provided the guideline for a more robust operational risk methodology.

Understandably, soon after the Enron, Pamalat, and Arthur Andersen problems erupted, financial institutions quickly instituted operational risks management frameworks to appease the regulators. However, with a rush to put something in place, strategic planning of operational risk management was glossed over in favor a quick tactical fix of throwing more people and money at the problem.

The resultant of this quick fix method is that most financial institutions currently use a motley patch of probabilistic and statistical models, adapted from their existing credit risk framework, mated to a static a-point-in-time, backward-looking management report for their operational risk management process.

While this patchwork approach seemed to have been sufficient to meet the initial regulatory requirements, continued use of this ineffective operational risk management process leaves the financial institutions widely exposed to further operational risk losses, as clearly shown by the recent events at Societe Generale (SocGen).

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