The economy is showing distinct signs of slowdown, which is unlikely to end in a “soft landing,” but instead in something much more exciting and noisy. When you are flying as high as the economy has flown in the past few years, and the engine of speculative fever is abruptly turned off by NASDAQ’s fall, you will not land softly, you will “auger in” from 30,000 feet. Should be fun to watch, if one didn’t have to participate in it.
When the crash has happened, and the U.S. people have begun to crawl out from the wreckage, the search will begin for scapegoats. Alan Greenspan will hopefully be one – he deserves it – and poor President-elect Bush will no doubt be another, for being around when the disaster happened. However, the most appropriate victims are the accountants, stock analysts and rating agencies, whose relaxation of standards and tolerance, even encouragement of falsehood have fueled the speculative boom.
Rating agencies, first, have not relaxed their standards as much as they have seen modern finance make them irrelevant. My colleague “Gekko” has poked fun at them for only now recognizing the drastic decline in creditworthiness of the California power system, but this problem extends more or less throughout the corporate sector. If management is paid primarily through short term speculative gains in the stock price, then they will leverage their company to carry out speculative takeovers or even LBOs, and will gamble on new products.
This increases both financial and operating risk in the company and means that post facto, debt which appeared to be of solid A or AA quality will be downgraded. This in turn removes the traditional distinction in default rates between investment quality and sub-investment quality debt — if AA long term paper can be downgraded to speculative quality after its issue, then its default is contingent solely on corporate management’s ability to guess right on products and avoid a large recession. Since these are the same factors governing survival of the shakiest BB or even B rated credit, the corporate AA rating is meaningless. Just as in the past, country AAA ratings were destroyed by the election of spendthrift governments (one thinks of Venezuela, AAA-rated until the early 80’s) so corporate debt ratings are now equally meaningless, and convey no security from default. The rating agency service no longer conveys meaningful information.
Accountants were hired by investors in the nineteenth century to provide them with operating information about their investments, and check that management wasn’t stealing them dry. Regrettably, this necessary function seems to have been lost sight of during the 1982-2000 bull market, as accountants have become a cozy oligopoly, driven by the huge consulting contracts they are able to negotiate with their audit customers. While the SEC has clamped down on accountants which do consulting for the same company as they audit, the accounting oligopoly does not compete with the same enthusiasm as, say the automobile business, and hence lenient accounting by one firm which leads to consulting for another may well be rewarded by an open or tacit quid pro quo in the other direction, the mechanism generally being the interlocking directorships and generous stock option schemes of client company senior management.
Four areas of accounting practice, in particular, have led financial statements to become opaque to investors, and to conceal risks and costs which will become only too apparent in a downturn, in the interests of propping up corporate management’s excessive stock options. While generally moderate in the case of the Old Economy, except in the case of companies which have undertaken an aggressive leveraged recapitalization or acquisition program, in the New Economy these distortions have achieved leviathan proportions.
The first is the cost of stock options themselves. In previous columns, I mentioned these in the context of Cisco, Microsoft and GE, and pointed out that in the first two cases, proper accounting of the 1999 cost to stockholders of employee stock option exercise wiped out Net Income entirely and left the company making a loss. The accounting profession, by first adopting a standard which required valuation of stock options at issuance by the Black-Scholes method and then retreating from Black-Scholes because of its imperfections, has not covered itself with glory in this matter. The height of corporate hypocrisy in this area is reached by Intel, among others, which uses Black-Scholes to value options it holds as part of its hedging activities, but refuses to do so in valuation of options the company itself has issued, stating that Black Scholes “was not developed for use in valuing employee stock options.”
I favor an options accounting method which deducts from Net Income the value of stock options exercised rather than those issued, and looks at the wealth transfer from stockholders to employees through issuing stock at below-market prices. This method does not require the use of doubtfully-valid valuation models, and provides a greater deduction from Net Income in times of rampant stock market boom, thus being automatically contra-cyclical.
A second accounting anomaly, particularly used in the high-technology and financial sectors in the last few years, is recording venture capital gains as operating income. Intel is a particular culprit here; at December, 1999 it had $7.12 billion in “strategic equity investments;” its 1999 gains on these investments, of $3.76 billion net of tax, were all recorded as operating income, forming 47 percent of Intel’s net income. Recording venture capital gains as operating income has two effects. First, it distorts ongoing operations, because Intel records additional income in good years which is not available to it in periods when the stock market is unfavorable — thus the downgrading last week in Intel’s profit forecasts. Second, while the value of a $3.76 billion investment gain is in reality $3.76 billion, it is multiplied by Intel’s typical P/E ratio of 30 to become 30 times $3.76 billion, or an additional $112.8 billion on the value of Intel stock. Naturally Intel management, holders of huge stock options and in Intel’s case, of stock itself, benefit by this sleight of hand.
Third, barter transactions are recorded at “market value,” as if cash had actually been received and paid. In the old days, when stocks were valued on the basis of actual Net Income, this had little significance, because only the occasional scam — one thinks of National Student Marketing in 1968-70 – was able to leverage barter transactions sufficiently to create a fictitious income statement. In the New Economy, however, where valuation is based to an extent on turnover, barter transactions are of far greater importance. Two Web sites, for example, can each undertake massive advertising programs on the other, creating no additional wealth and no additional cost, but both reporting massive increases in turnover, which is valued accordingly by the stock market. America Online has benefited from this, allegedly to a “non-material” extent; while close to 10 percent of Yahoo’s 1999 revenues resulted from barter transactions.
Finally, there is the question of whether acquisitions should be accounted for on a “purchase” or a “pooling” basis. In general, “purchase” accounting of an acquisition at a premium to the target’s book value requires a goodwill write-off which affects earnings for up to 40 years into the future. Hence companies prefer to account for acquisitions on a “pooling” basis, as if the acquisitions were simple poolings of interest between two equals; this therefore requires no goodwill write-off. Needless to say, the restrictions on pooling accounting, which were quite draconian in the late 1970’s after the previous round of recession-induced bankruptcies, have been steadily relaxed in practice during recent years, and today stock-based acquisitions, particularly those using stock valued at high tech-sector multiples, can produce a steady stream of earnings increases and hence stock price increases for the acquirer — at least as long as the boom lasts.
The final link in the chain of deception is of course the Wall Street stock analyst. These have never been particularly reliable — after all, they mostly work for companies which underwrite stock offerings and carry out analysis to flatter potential clients. Nevertheless, prior to 1990 it was customary for Wall Street analysts to look down on the analysts of, say, Nomura Securities in Japan, who would push their “share of the week” through their “sales-ladies” to Japanese housewives who traditionally controlled the family money (since husbands were too busy putting in a 14-hour day as “sararimen.”) However, as in other areas of the 1990’s bull market, Japanese financial technology invaded the United States. As reminded in the footnote to these columns, the percentage of bearish recommendations by Wall Street analysts declined from 9 percent to 1 percent over the 10 years to 1999, and price-earnings ratios, which used to be based on the solid foundation of actually reported previous year’s earnings, became calculated by analysts first on the basis of current year’s earnings and more recently on the basis of next year’s earnings, a figure treated as sacrosanct by analysts but in fact unknown and unknowable by either analysts or the company itself.
In respect of the quarter actually in progress, the “guidance” by companies to their analysts, inside information which was denied to the wider investing public, became so accurate that a higher and higher percentage of quarterly forecasts were met with just 1 or 2 cents per share to spare. One of the reasons for the increasing number of earnings “warnings” in the current quarter was the SEC’s change in October by which companies were no longer permitted to disclose insider information to stock analysts, for them to filter and disseminate to their clients. This change has increased the perceived uncertainty in the markets, and may perhaps end the pernicious habit of basing price-earnings ratios off next year’s earnings.
In summary, bond rating agencies, accountants and stock analysts have so lowered their standards during the current boom that it is no longer possible for an investor without a CFA qualification to discern the factors on which any bond or stock investment must be based. As described above, each individual lowering of standards may be felt to be arguably valid, and is in any case fairly arcane. Nevertheless, taken as a whole, the rating agency/accountant/analyst system is driving stockholders into investments based not simply on exaggeration but on outright falsehood.
Just as the stock market practices of the 1920’s were used in the following decade to condemn Wall Street, pass anti-business legislation and imprison prominent bankers and brokers, so too in the coming downturn can the Merchants of Falsehood expect a similar fate.
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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)
This article originally appeared on United Press International.