What it is
Finance is the management of money.  Finance relates to all
economic activities carried out within our society.  When we buy
goods for cash or credit, take a bank loan to finance the
purchase of a car, or use our savings to buy government bonds, we
become participants in the world of finance.  At the individual
level, the activities I have just described are called Personal
Finance; the economic activities of all levels of government are
referred to as Public Finance; and lastly, when the economic
activities are carried out by firms organized for the purpose of
earning profits, we call it Business Finance.  My article will
focus on Business Finance.  Bear in mind, however, that all three
activities are interrelated, none of them can be considered in
isolation.

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When a corporation needs capital, it has the choice of
borrowing the money or issuing shares.  The trading aspects of
existing shares is the subject of my discussion.  The particulars
related to a new issue (such as who handles it, how is each share
priced, etc.) will not be considered here.

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Short selling

An investor can make money through short selling if he
determines that the price of a stock is likely to decrease in the
future.  The following example illustrates how it works.

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The concept of the stock market as we know it today goes
back many centuries.  Simple stock markets started in medieval
Italy.  Modern versions started first in Amsterdam in the 17th
century and then in London in the 18th century.

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On any given day, over $1 trillion crosses the wire
connecting the world’s major banks.  The human mind cannot even
absorb such a figure, let alone accept the possibility that a
major problem could affect the banking system.  And yet, the 2008
financial earthquake has forced us to look down at the abyss.
The pieces of the broken banking system are still being picked
out; it will take a long time to piece it back together, writes
its history, and learn our lessons.  Books have been written on
this financial calamity, even though this is an incomplete story.
But with the passage of time, we will we know most of the details
(both the honest mistakes and the sordid aspects).  And then it
will be the turn of the historians to write a comprehensive
history.

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Between the period of July to December 2008, the roof caved
in on the global financial system.  Should we have anticipated
such a calamity?  By “we,” I do not mean you and me.  We are but
mere mortals.  The reference is to the experts who get paid fat
salaries to protect us from such misfortune.  What happened?  Who
was at fault?  I will present you with an overview; brief and
general as it will be, use it to come to your own conclusion.
Keep a box of tissues close by, you will need it!  If you want to
know more, and find the subject absolutely fascinating, there are
many books out there on this sad saga.

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Leveraging

Big investment banks on Wall Street such as Lehman Brothers,
Merrill Lynch, and Morgan Stanley were until recently the most
prestigious financial corporations on Wall Street.  They made
huge investment bets with borrowed money, opened branches all
over the world, paid enormous salaries to their executives, and
in the process helped transform the financial landscape.

For so many years, it looked so rosy.  Nothing could go
wrong in this Shangri-La.  But these fortresses were built on
sand.  They were built on leveraging.  And, sooner or later, the
whole thing was destined to come tumbling down.

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Those that went down

“Changes that usually take place over years are happening in
weeks and days,” said Craig Wright, chief economist at the Royal
Bank of Canada.

In the spring of 2008, the news of the near collapse and
forced takeover of Bear Stearns took me totally by surprise.  I
read the article relating to its demise twice; I wanted to
properly understand how such an institution could fail.  Little
did I know that this was the beginning of a serious crisis.  By
the time it was over (assuming it is), I was reminded of the
biblical expression:  “How have the mighty fallen!”

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For more than a century, the free market has been the engine
of the economic prosperity we are enjoying in the developed
countries.  In turn, the free market is the child of laissez
faire.

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The most important profession after medicine and law is
accounting.  I am not expressing this opinion because it’s my
profession, but rather because when auditors fail to properly
perform their duties, we all pay a heavy price.  Let me give you
an example going back to the great depression.

Towards the end of the 1920s, the stock market was on a joy
ride.  The thinking was that there has never been a better time
to invest.  Financial statements of many corporations brought
tears of joy to one’s eyes.  They were not printed on pink paper,
but, oh, everything was so rosy.  In time it was realized that
they should have been printed on red paper, for there was so much
red ink behind the stated figures.

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Audit failures

The record of auditors over the last three decades does not
suggest a snarling dog standing guard over the interest of
shareholders and third parties.  There have been too many audit
failures.  This could mean that a bank can fail shortly after
receiving an unqualified opinion from its auditors.  One need
look no further than the hundred of Savings and Loans that
bankrupted even though they were repeatedly given clean bills of
health by prominent accounting firms.

Speaking of prestigious accounting firms, one of them,
Arthur Andersen, is no longer with us.  That’s how enormous that
particular audit failure was.  It sank with a ship called Enron!

If you’re interested in the topic, go on a search engine and
enter audit failures, you’re sure to get numerous examples.

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