Wednesday, March 08, 2006

3/8/06: Enron trial misses point: Corp America responds to distorted incentives of speculative financial system; Sarbox counterproductive 1806 words

Revised 3/9/06 1:27 pm

3/8/06 Reuters "Enron's Fastow says Lay lied about company problems" link "Ken Lay, a former chief executive of Enron Corp., repeatedly lied to investors about the company, portraying it as financially sound even as it spiraled toward bankruptcy in 2001, the company's former finance chief, Andrew Fastow, testified on Wednesday."

I'm leading with the Enron trial story today, but there's no need to read the new stories on the trial, they're basically old re-runs that still completely miss the critical point.

The corporate scandals of 2001-2002 during the crash of the TMT equity bubble led to the passage of Sarbanes-Oxley (Sarbox). The Wrong Solution to corporate governance problems such as those exposed at Enron is to saddle productive corporate America with all sorts of very burdensome busywork bureaucratic rules and regulations, a la Sarbox.

That is extremely counter-productive, especially for innovative and/or small companies which help drive the U.S. economy. E.g. I recall an accounting firm study that said the biotech industry, one of the key industries for the future of the U.S. economy, lost more than $6 billion in 2004, I believe, and about $1 billion of that was due to the costs of Sarbox compliance. (I will give the old link if I can track it down.)

Besides being economically counter-productive, Sarbox is also very unfair and not in the American tradition of presumed innocence and fair dealing. Corporate America, which all but an infinitesimally small part of (on which the mass media focused) is honest, productive and well-meaning, was put in the perpetual Sarbox penalty box.

It is simply NOT fair and honest to punish very hard-working entrepreneurs, executives and managers with this onerous regulatory burden when they have never done anything wrong, and never will.

Sarbox has just been the Wrong Solution to the Wrong Problem all along. Unfortunately, nothing has really changed to address the Real Problem since the corporate scandals of 2001-02. Yes, Sarbox was passed, but it was simply a knee-jerk political response--just what you would expect--most definitely barking up the wrong tree.

The Real Problem running through all the corporate scandals of 2001-02, which the mass media NEVER got right despite the huge coverage, was, and still is, that corporate America, through the direct link via CEO stock options to actions to maximize short-term shareholder value, for many years now has been explicitly governed to slavishly respond to the grossly distorted market price signals and profit incentives created by global speculative financial markets. (See my 3/6 review of Jim Cramer's "Real Money" on how the hedge-fund dominated equity market currently really works.)

This very close corporate governance-global capital markets link might be fine if the latter were operating properly. But they are not, they are clearly very overly speculative, hence they are misallocating real activity and real resources in the real economy via the distorted financial signals that the corporate CEOs are responding to.

My key point is that the TMT equity bubble of the late 1990s essentially Caused the corporate governance scandals, not the other way around. If the banks, venture capitalists and Greenspan had taken away the bubble, which they were not incentivized to do (the financial system has no real anchor), then that would have had the effect of also removing the distorted market incentives that led to the corporate scandals.

I would guess that most of the corporate executives who went astray during the TMT equity bubble, especially those at more mainline firms, did so because they saw their peers becoming so extraordinarily wealthy so quickly and easily, especially those in newly formed IPO's that didn't have profits or even viable business plans. Remove that source of greed and jealously, and corporate America probably would have acted its normal self.

In Enron's case, it was no surprise, in fact it was almost inevitable, that bubble's perverted market incentives (which culminated in and was best exemplified by the merger of "new, new thing" AOL and real thing Time Warner) is what people like Skilling, Fastow, Lay, et al would respond to, in the way that they did.

So did all the investment bankers and venture capitalists complicit in issuing hundreds of essentially fraudulent, if legal, IPOs, during that period, which also was almost inevitable under the circumstances. NASDAQ lost 78% and the equity markets $8 trillion in market cap, March 2000 top to October 2002 bottom, one of the two largest crashes in history, and most IPO's lost far more than the market averages.

I apologize to those, especially fair, honest people in the financial industry, who may take exception with such a strong characterization, I fully realize that most probably believe the "irrational exuberance" explanation of that bubble. Since this is not the time nor place to rehash that discussion, I hope they will continue to read on.

A Real Solution to the Real Problem that caused the corporate scandals, and this is where most readers might start to disagree with me, if they haven't done so already, must address the core issue of the increasingly pressing need to start to rein in the worst excesses of the global speculative financial system.

In this credit cycle, these excesses may be even more out of control than during the TMT equity bubble. But up until now, they remain far more hidden from the media and public view in the credit and derivative markets (hence the credit excesses may have a chance to build up to dangerous levels before recognized by investors in public markets that may be affected, similar to an undetected gas leak that results in an unexpected explosion).

A Secondary Solution, the one that interests honest investors like Buffett, is to focus on excessive CEO compensation in relationship to subpar performance, and perhaps to lessening the overly strong short-term link to equity markets' obsessive focus on quarterly earnings reports and "guidance."

I should make it clear, especially to new readers of this blog, that I am not an uncritical cheerleader for Corporate America, which has its hands full dealing with an intense global competitive environment.

E.g. elsewhere on my blog, I have been very critical of excessive executive compensation, as has Warren Buffett, the world's second wealthiest man and most successful investor, most recently in his "Chairman's Letter" in the just released "2005 Berkshire Hathway Annual Report." link (Also see the 2004 book "Pay Without Performance: The Unfulfilled Promise of Executive Compensation" by two respected academics published by Harvard University Press link.)

I have been particularly critical of excessively compensated CEO's asking working Americans, whose average real weekly earnings have declined 17% since 1972 (see "2006 Economic Report of the President," Table B-47, pg 338, link) to "give back" hard-earned gains in binding legal contracts, often under the threat of outsourcing or bankruptcy.

Intense corporate competitive pressures notwithstanding, I simply don't think that's a fair and honest way to deal with things, and again not in the American tradition of fair dealing.

I also think it has greatly damaged the credibility of Corporate America with ordinary Americans, which came back to haunt Corporate America with the passage of Sarbox, and could do so again with even more onerous laws and regulations in the future. "Enlightened capitalists" should take heed and learn that lesson before it's too late.

Imho, the Real Scandal of the corporate scandals is that the major global financial institutions got off with essentially light slaps on the wrists (in terms of fines compared with their enormous profits), and have been free to go on their merry way (with some regulations that they have said they don't like), creating even larger credit excesses than during the TMT equity bubble.

For the past five years, global speculative financial markets, with the help of their good friends at the central banks, have deliberately created a global real estate-led consumer boom, hence that is what corporate America is currently responding to, again directly through the incentive link of CEO stock options. (E.g. see my 2/27 article, "The New, Old Thing: Silicon Valley, Hollywood, Madison Ave," link.)

At some point, who knows when, it is likely that those new excess credit chickens will come home to roost, just as they did previously with the Enrons of the corporate world. Hopefully, whenever the next crisis hits, it will be handled better than the crash of the TMT equity bubble and the corporate scandals.

Those credit excess problems in the last cycle were financially "papered over," so to speak, in the new cycle by a massive expansion of credit into the global real estate markets, and also by a government-mass media shift in focus away from the corporate "bad guys" at domestic places like Enron, to terrorist "bad guys" at very foreign places like Iraq and now Iran.

But that has just resulted in more credit excesses to ultimately be resolved, without other obvious, at least not to me, areas of potential credit expansion on a large enough scale to take up for any slack in global real estate, along with a lot of very costly, thorny geopolitical issues contributing to mounting government debt and declining U.S. leadership in world public opinion polls.

The deliberate opacity of the credit and derivative markets (which is being addressed behind the scenes in places such as the Counterparty Risk Management Policy Group) makes the current credit excesses potentially dangerous, especially given the unfathomable size of the markets (derivatives are $300-400 trillion in notional value).

The big speculators in these markets ultimately expect to get bailed out, yet once again, should their overly leveraged trades ever blow up in their faces, e.g. as they have been going all the way back to the Latin American debt crises of the 1980s, through the S&L crsis, the Mexican bond crisis, Asian financial crisis, Russian default crisis, Brazil and Argentive crises, and ultimately the TMT equity crash, in the last case through Greenspan's negative real interest rates for three years igniting a global real estate boom and Japan's zero rates funding speculative global "carry trades." Yes, it'a long list, and these bailouts have been a bipartisan political policy.

This combination of enormous gains on opaque private trades with the public providing implicit insurance against economically-destabilizing losses (the "too big to be allowed to fail syndrome," a la the LTCM precedent in October 1998) is blatantly NOT fair and honest and creates immense "moral hazard" which greatly distorts global capital flows into speculative activity and away from real productive uses.

Frankly, I doubt that the Real Problem will be adequately addressed before the next crisis happens. The global speculative financial vested interests are too powerful; whatver alternatives that exist are far too weak and unorganized; and it is just human nature for most people not to face up to the most difficult issues until a crisis forces them to do so.