Enron has dominated the news this week, but absent political scandal is unlikely to do so for much longer. There are too many other candidates to succeed it.
To recapitulate, Enron’s downfall was caused by (i) fraudulent accounting, for which both Enron top management and the Andersen partner responsible may serve jail sentences, (ii) management insider deals of a type usually seen only in the murkier corners of Eastern Europe, (iii) misguided and loss-making fixed asset investments, and (iv) trying to do big-volume derivatives trading with a BBB credit rating, which meant counterparties panicked when there were questions raised. The last reason was the immediate trigger of downfall, but not the most important reason for it.
All four of these problems have been common in U.S. companies in the last few years, and some at least of the malfeasances must inevitably end in bankruptcies.
It is not of course necessary for a company to resemble Enron to go bankrupt. Kmart, for example, went under because of over-extension in its traditional business and misreading of trends in the retail sector — both entirely traditional reasons for getting into trouble. However, just as the late 1990s was a unique era in American finance, so the bankruptcies that will result from its unraveling will have a great deal in common.
To take the reasons for Enron’s downfall in reverse order, there are a number of companies that are attempting to conduct a large scale energy derivatives business on the back of a BBB credit rating, barely investment grade. The most prominent of these are Dynergy Inc., intimately involved of course with Enron’s downfall, and The Williams Companies Inc. Undertaking a high volume derivatives business on the back of a shaky credit rating is very dangerous, because of the possibility that a credit squeeze could put you rapidly out of business, as happened to Enron. In practice, however, Dynergy and Williams have stuck more closely to the energy sector in their trading business than Enron, and therefore their business is likely to be attractive to a major Wall Street house (with a top quality credit rating) if financial difficulties occur. The proviso, of course, is that the Wall Street houses themselves are not in the middle of a deep recession when the crisis occurs; in that case, bankruptcy would be likely. Nevertheless, in spite of the size of these companies’ derivatives businesses, it seems unlikely that, given adequate credit and position controls, there will be more than an isolated problem, or possibly a series of forced takeovers in this sector.
Loss-making fixed asset investments, on the other hand, are central to what has gone wrong since 1999. The level of capital investment in the United States reached unprecedented high levels in the late 1990s and availability of almost zero cost funds for investment was more or less infinite in the last years of that decade. More than $100 billion was invested in private equity funds in 2000 alone, more than double the next best previous year; it seems safe to assume that the great bulk of that investment will be lost.
In terms of sectors, surely the most over-invested sector, apart from the dot-coms themselves, must have been telecoms, in which huge amounts of “broadband” capacity was installed, without any evidence that demand existed for it. It seems most unlikely, in calm judgment, that the average U.S. householder, on top of his $23.95 per month AOL subscription, his $50 per month cable TV subscription, and his $30 plus per month cell phone subscription, will want to subscribe another $30-$40 per month simply to obtain a faster connection to services he’s already receiving.
The same applies to the third generation cell phone investments of the major European telecom companies. They have bid billions of dollars each for licenses for a service which will cost further billions to construct and for which, in a recession, there is unlikely to be demand substantial enough to service the debts taken on.
If the demand is not there for these products, the capital investments made in them will have to be written off, and that in itself will cause unexpected bankruptcies, possibly of one of the major European telecoms companies, most of which are now thoroughly over-leveraged and subject to erosion in revenues on their primary businesses.
The problem of self-dealing by management reached extraordinary extremes in Enron’s case, in the creation of separate asset- and debt-holding companies from which Enron officers derived substantial hidden profits.
Nevertheless, the problem occurred in innumerable U.S. companies, particularly in the high tech sector, through the explosion in the 1990s of management stock options. While in moderation stock options are a sensible element in top management compensation, provided they represent no more than a fraction of 1 percent of a company’s capitalization, during the 1990’s the size of management stock option schemes exploded, almost wholly without outside control.
Compensation consultants were hired by management, whose job was to discover the largest grant of stock options that could possibly be justified by reference to other companies in the market, public or private. These consultants’ studies were then presented to stockholders at annual meetings as justification for enormous increases in management’s “incentive compensation,” where they raised the fear that this “key talent” might otherwise migrate elsewhere without this compensation. Of course, each new excessive stock option scheme could in turn be used by compensation consultants to justify still more excessive stock option schemes in other companies, which could then, a couple of years later, be used to justify still further increases in the original scheme.
Given a stock exchange bull market that lasted a decade, and was pumped up by loose monetary policy and every financial and psychological warfare resource of Wall Street, the sky was the limit. I have quoted several times the case of Cisco, in which the value presented to management through option exercise in 2000 was four times the company’s net income (and in which in 2001 the value thus presented to management was again greater than 2000’s net income, even though in 2001 the company reported a loss.) Cisco was however not alone; in almost the entire high tech sector (other than in companies like JDS Uniphase and Nortel that were subject to Canadian, not U.S. regulation) option grants exploded during the 1990s, and shareholder value was correspondingly diluted.
Theoretically, the grant of excessive stock options to management during a phase of stock market euphoria need not cause bankruptcy. When the stock market, and the company’s stock price returns to earth the options outstanding will expire valueless and shareholders can re-establish control by restricting further option grants.
In practice, of course, life doesn’t work like this. Management that expected to become billionaires, or at least centi-millionaires, through their stock options will not abandon this dream simply because conditions change. Instead, they will resort to increasingly desperate accounting tricks to pump up earnings, will issue impossibly rosy forecasts to keep up the company’s stock price, and may well attempt, like Enron’s management, to find alternative ways of looting the company if all else fails. If checked by stockholders or auditors, they will not relapse quietly into being salarymen, they will simply leave the company, possibly trying to engineer a takeover or leveraged buyout, and in any case ensuring that their “golden handshake” is as munificent as possible.
In some cases, their departure will be unmourned, more sober management will be brought in and the company, with its resources diminished will carry on successfully, if more modestly. In many cases, however, things will go wrong. Management will “swing for the fences” since the gain is largely its own while the risk falls on existing stockholders. In a downturn, most of these attempts will be strikeouts, not home runs. In other cases, management will remove so much cash from the company, and increase its debt so far, that bankruptcy is inevitable. In still others, attention will be diverted from the engineering and technological skills that have created the company towards financial dealing, generally with fatal results. Finally, and most damagingly, there will be cases in which the revelation of management’s accounting tricks, or attempts at extortion will cause an Enron-style crisis of confidence.
Over the nest several years, it can be very confidently predicted that huge grants of stock options will go RIGHT out of style as a management incentive tool.
Finally, accounting games have become almost universal during the ’90s. The most widespread, of course, is the failure to record properly the transfer of wealth from stockholders to management through stock options. This was blessed by the Financial Accounting Standards Board in 1994, after an intensive lobbying campaign, and has since been used to decimate traditional ideas about proper reporting of earnings and creation of stockholder value. “Pro forma earnings” too, were created as a concept during the 1990s so that inconvenient costs and losses could be ignored, as could generally accepted accounting principles, and investors made to focus only on the results that management wanted them to focus on. The SEC Thursday fined Donald Trump for this misdemeanor in 1999; it is to be hoped that they will be harsh indeed on the practice going forward.
Other accounting games were created during the period, too numerous to mention, many of which indeed have doubtless yet to be uncovered as companies run into trouble and are forced to “restate” past years earnings. In the case of such a universally admired company as General Electric Co., for example, apart from the unrecognized costs of the stock option scheme, the company’s 2000 results omitted to make any provision for staff pensions, and treated private equity profits and losses separately, putting profits through the income statement while hiding losses “below the line.” I calculated the effect of this as being to cause GE’s true net income to have been less than half that proudly announced to stockholders. In a down year, these games will not be available; it will be very interesting to deconstruct GE’s 2001 financial statements, due out shortly. But then, GE’s former Chairman “Neutron” Jack Welch, the darling of the media, has already retired, and will doubtless avoid blame for holes that appear after his departure.
There is a central theme to all these problems of the 1990s, which are now returning to haunt the 2000s, and will make this such a miserable decade. It is that during the period, it was felt no longer necessary for management to manage its stockholders’ assets as if they were in trust for their true owners, to report accurately and diligently on the results of their company’s operations, and to pay a steady and hopefully increasing dividend to stockholders, representing a substantial portion of the earnings on their money. Information, whether in annual reports, in management presentations, or in Wall Street research reports, could no longer be relied upon.
Perhaps the last hurrah of the period was the October attempt by former Treasury Secretary Robert Rubin, as chairman of Citigroup, with a large exposure to Enron, to get the Treasury Department to lean on the rating agencies and make them ignore the increasing evidence that Enron’s debt rating should be downgraded. After all investors, who rely above all on the rating agencies’ integrity to assure them of their money’s safety, don’t really matter — in Rubin’s eyes, and in that of ’90s Wall Street and much of ’90s management, they are only “little people” whose money is Wall Street’s and management’s to play with.
But then this was, after all, the era of the president who required us to suspend judgment on the meaning of “is.”
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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.