Janet Tavakoli: How to Uncover Fraud and Unleash Your Portfolio

There’s a new (little) big short ripe for plucking. And finance expert Janet Tavakoli, one of the most vociferous critics of the financial world, reveals just where it lies in her new book.

In an interview with ThinkAdvisor, Tavakoli discusses this potential investing opportunity and identifies another new big short, too.

Tavakoli, who has logged more than 30 years working in complex finance, is well known for calling out industry and government cover-ups and bold-faced names that she brands liars, phonies and crooks — plus, charging the fourth estate with negligence in reporting.

Founder-president of Structured Finance, a risk consulting firm in Chicago, Tavakoli is all about finding problems in advance and identifying opportunities therein. In “Risk: Your Global Guide” (Lyons McNamara), she writes about both reducing unintended portfolio risk and seeking rewards for taking calculated risks.

Indeed, with her meticulous due diligence and wary eye, Tavakoli has discovered big risks most others have missed. That has enabled her to predict the thrift-industry blowup, the demise of Enron and that excessive leverage and structured products’ misratings would lead to the worldwide financial crisis, which was precipitated by hidden “malicious mischief” that in fact “could be seen in the course of competent work,” she contends.

Last spring, in her book, “Decisions: Life and Death on Wall Street” (Lyons McNamara, April 2015) and in an interview with ThinkAdvisor that May, Tavakoli discussed weak balance sheets at Deutsche Bank. Some readers of the book sold the stock; some shorted it, she says. In June 2015, Deutsche Bank posted a record loss.

It’s not surprising that one of Tavakoli’s favorite quotations is a line from David Mamet‘s film “The Spanish Prisoner”:  “Always do business as if the person you’re doing business with is trying to screw you because most likely they are – and if they’re not, you can be pleasantly surprised.”

In “Risk” and in our most recent interview, Tavakoli pinpoints more than 10 red flags for fraud. By scrubbing fraud from your portfolio, “you’ll outperform almost everyone,” she writes. You must anticipate fraud as a part of doing business and look for it by doing a fraud analysis when evaluating any company, bank, corporation, hedge fund, pension fund manager or creditor, she says.

Formerly a chemical engineer, before founding her company she held senior posts in investment banking, trading and structuring and marketing structured products at firms such as Merrill Lynch, Goldman Sachs, PaineWebber, Bear Stearns, Bank One and Westdeutsche Landesbank.

ThinkAdvisor recently caught up with Tavakoli, who has also just released an edition of “Twenty Years of Inside Life in Wall Street,” by William Worthington Fowler, published in 1880, which she has annotated. In our interview, the outspoken risk consultant discussed fraud, the Fed’s “blind eye” and what financial advisors must do to protect themselves, as well as the unique investment opportunities often inherent in market distortions — such as the current ones. Here are highlights:

THINKADVISOR: Why is it critical for financial advisors to perform a fraud analysis on whatever they’d like to invest in — or when doing any deal?

JANET TAVAKOLI: You need to protect yourself. The Fed and the [Securities and Exchange Commission] aren’t doing their jobs, and the banks are financing a bunch of bad guys. You’re cruising for a bruising if you don’t take fraud into account and do a fraud analysis. Fraud is the most important thing to evaluate. When there’s fraud, there’s permanent value destruction in investments. Should you conduct a fraud analysis only when you suspect someone of fraud?

No. But look at situations with a jaundiced eye. Do a fraud analysis thorough enough to uncover fraud if it exists — unless it’s extremely clever fraud. If you don’t look for fraud, you won’t find it. The problem is that fraud starts seeping into everything.

Why do a fraud analysis when you’re diversifying a portfolio?

It will help minimize the times you inadvertently diversify into fraud.

What are the red flags for fraud?

Bad character. Character is paramount [to investigate]. It must include looking into personal life, like drug use and [involvement in] prostitution, and background checks on fund managers.

What’s another big red flag?

Poor transparency. We have negative real [interest] rates, and yet financial institutions have goals to earn double-digit returns. How do you pull off that magic trick? If you aren’t fudging around the edges, you can’t. There has to be something else going on. If you’re getting subsidized, then it’s not your genius that’s giving you a double-digit return. You can’t spin straw into gold.

Other red flags?

Profits that appear out of thin air. Lots of borrowing or hidden leverage. Poor risk controls. Questions that aren’t answered coherently or if the manager patronizes you. Principals who are cult figures that dodge scrutiny. Banks gauging consumers in terms of credit cards or other loans in order to earn higher returns, so that as one bubble bursts, another is put in to take its place.

How, specifically, do you do a fraud analysis?

Start with the underlying securities. If you find fraud in them, you have to do a greater sampling because your burden of due diligence becomes greater.

Where do you start when performing a fraud analysis on a bank?

Look at the bank balance sheet and large loan exposures – oil sectors, sovereign debt. Look at the exposure to European banks and European debt – even if they [insist], “This is as good as Triple A because it’s part of the European Union.” They come up with narratives to distract people from the underlying value of the debt and say, “Oh, don’t worry about it!” In housing, during the financial crisis, it was: “Don’t worry! It’s collateralized!” Or “Don’t worry. It’s Merrill Lynch!”

So should advisors be skeptical, in general, of what banks say on analyst calls?

Absolutely. Instead of facts, often you get force of personality trying to tell you what the “facts” are – in the face of contradictory evidence. You have to keep brushing aside the veil and makeup that are put on problems. Bank analysts say they’re taking great safeguards in securitizations and that the ratings agencies are being more careful. You’ve got to be kidding me!

You write: “It’s fair game to profit from market distortions born of fraud”— unless you “actively participate in the rigging.” What if you do uncover fraud and want to use it to short the market?

Fraud is a good short. You’d look for things that are growing fast, where people say that even though it’s growing fast, there isn’t much risk here. But it’s hard to make money by shorting the market.

You write that there’s a shorting opportunity in auto loan fraud, where losses are climbing. This is an example of shorting par-valued fixed income securities that are being securitized — and, you say, they have the same issues as CDOs in the financial crisis.

Yes, subprime auto loans are good candidates for a big short. Another is federal student loans.

What’s going on with auto loans?