Corporate America

So Mr. Skilling got sentenced this week. Strange that this should happen the week that the Dow hits a record high. That remanded me of this piece which I wrote 4.5 years ago about Enron and Wall Street.

Enron and Beyond - What Went Wrong?

Something went wrong with Enron. An underlying question should be: was this an isolated case or an indication that something is wrong with our economic system?

One reality is that we live in a very capitalistic system. Our economic resources and means of production are entrusted to corporations. For the most part, this has worked well. The most basic answer as to what went wrong at Enron is that the folks who ran the company forgot whom they were working for. The shareholders own corporations and management should be working to allocated the resources of the company to maximize something. That something - dividends perhaps - should benefit shareholders. The problem, I think, is that corporate management has lost sight of what it was supposed to be maximizing.

I see four problems:

1) not enough attention is paid to the bottom line. The definition of "the bottom line" used to be clear - the bottom line was dividends. Everything else was just a light.

2) an unhealthy alliance has come into existence between Wall Street and corporate America.

3) shareholding is highly diluted. This may be the result of conglomeration, mutual funds or some more general notion of sharing the risk. The result is that few companies have individual stockholders with "clout".

4) corporate officers compensation is too often tied to having a great year.

1) The Bottom Line

When I was a kid (no, this was not before The Great Depression, people used to talk about dividends. The values of stocks were measured by the quaint notion that they were somehow related to the dividends check that you got each quarter. Folks help equities in order to get their share of the (post-tax) profits.

Several things started to undermine dividends as the method of ultimate evaluation. As Greenspan pointed out part of the problem was that share repurchases became more popular in the 1980's. Presumably, this was preferred because it lowered shareholders tax liability. An unintended consequence was that dividends, now obscured, fell from a typical 6% to something more like 1%.

With dividend disappearing it became natural for Wall Street to concentrate on earnings as "the" preferred method of evaluation. The rub is that while dividends have an exact value "earnings" are subject to interpretation.

In a simple world pretax profit would equal cash receipts less out of pocket cash costs. In the complex, real world of corporate American a significant part of pretax profit results from the change in the value of balance sheet items. Balance sheet items should reflect the future flow of income but there are two problems here: 1) for even a noble soul, future income can be difficult to forecast and 2) for the scoundrel the obfuscation of future income affords limitless opportunity to juice the balance sheet.

Measuring the present value of an asset based on its future income can be a problem. Related to the mortgage business is the valuation of mortgage-backed securities. Their value must be based on the anticipation of future income and that income can get truncated when rates fall and refinancing occurs. Thus, the problem with evaluation the present value of assets is that it is based on an ability to predict the future.

In Enron's case it was not merely a case of mis-evaluating future cash flow. They hid losses and debt in "partnerships". The movie "Enron: the Smartest Guys in the Room" points to the problem Enron had as "marking to market" its assets. The producers/writers missed the point. "Marking to market" is a perfectly legitimate accounting method. It means evaluating your assets at their present market value, not what you paid for them. Enron was nor marking to market. It was marking to some contrived dream view of value. It was doing this for the exclusive purpose of deluding Wall Street about its balance sheet.

2) Wall Street

Wall Street has had an unnaturally high upward bias on estimating earnings. Note the following fact: if one looked at the three- to five- year earnings forecasts growth of all of the S&P 500 companies as compiled from the projections of securities analysts from 1985 to 2001 (Thompson Financial's I/B/E/S estimates) they averaged 12% a year. Actual growth was more like 7%. If these guys were Las Vegas odds-makers their employers would be out of business.

One may infer that firms that sell securities have a bias toward analysts with "rose-colored glasses". In fact, it is not merely Wall Street but also the media that has an upward bias. When you listen to TV or the radio upward movement in equities prices is good news. Downward movement is bad news. To be sure, there is positive socioeconomic value in increased equity values but analysts should be objective. Period.

It may be too idealistic but it would also make economic sense if investors starting putting a premium on the accuracy of analysts' forecasts.

3) Shareholder Dilution

Recently (remember this is a piece form 4.6 years ago) there has been a lot of attention paid to the HP/Compaq merger. Take note of the clout that Walter Hewlett had. He owned enough stock that he could create a stir This is rare in corporate America today. As a practical matter, business are no longer controlled by the owners but by the CEO. The CEO chooses the Board of Directors who tend to support his business strategy and, generally, formulates accounting practices and chooses an outside audit firm that will go along with those practices.

This has served us well but there has been too little objective analysis by Wall Street of the practices of CEO's and their auditing firms. The same folks who are providing the analysis are in the business of selling the securities of the firms they are analyzing. In fact, what may exist is a vicious cycle. CEO, CFO and analysts sit down. CEO and CFO do their pitch. Analysts like it and sell it to the public. The CEO/CFO have to figure out how to deliver what was promised and come up with some "creative" accounting practice to make up the difference.

Part of shareholder dilution is related to the fact that there are more people in the market than ever before. Stocks used to be held as investments. Now they are traded furiously and speculatively. A consequence is volatility. There are more nuts in the market and their bad investment decisions cause volatility.

4) The Pack-it-into-one-big-year-effect

In its simplest form the notion here is that it is not beneficial to allow CEO/CFO's to benefit by getting large bonuses as a result of front-loading the future value of contracts with the purpose of creating one great-looking year and a large bonus.

The solutions are clear: we need objective audits and we need objective securities analysis by Wall Streeters who are not working for the same firms that are pitching the securities. This objective auditing and analysis must point out the cases where corporations may be fudging future cash flows for the benefit of a few officers.

The purpose of corporations must be reconfirmed. They exist to serve a public good by controlling the nation's assets and to produce a real profit (dividend) for the folks whom they really work for - the shareholders.

More recently we have had scandals regarding backdating of options. Corporate America must understand that they work for the shareholders. What must be reaffirmed is that the Board if Directors works for the shareholders and the CEO works for the Board of Directors. The shareholders must assure that the Board is looking out for them.

The HP story in a sense appears more comic than anything else. But I have an HP computer at home. I have not really seen anyone discuss this to any extent but it is most discomforting to know that the company which made my computer felt that planting software in peoples' computers to find out who is talking about the company does not exactly induce me to ever buy another HP computer. In my opinion, that was really dumb of them.

 

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Dick Lepre

Mortgage Payments After a Disaster

Fifteen year ago today I woke up on a weekend morning and, after starting the coffee machine, opened the thick curtains in our living room. The effect was strange. The light was not the same color as it was any other day. I looked our my living room window and saw that there was a lot of smoke in the sky at a distance. I thought that there was probably an industrial fire in the eastern part of San Francisco. That was not the case. The hills in Oakland were on fire and, by the end of the day, 3,000 homes were gone. I recall a TV news crew late that evening showing a long lens shot of the Oakland Hills with what seems like several hundred plumes of fire. These were places where the entire home was gone and the gas supply line was on fire. Very stark.

California (as well as Hawaii) is subject to earthquakes. Florida and the Gulf Coast have hurricanes. The middle of the country has tornadoes. Catastrophic loss of one's home is no a far fetched thing and it helps if folks understand what to do regarding their mortgage after a catastrophe.

If your home is severely damaged by fire, flood,landslide, earthquake or whatever you must not ignore your mortgage payments. If your home is damaged to the point where it cannot be occupied you must, of course, first contact your insurance carrier and file a claim. You need to get back on track to have your home repaired/rebuilt but understand that you still have an obligation to your mortgage holder. If you need "forbearance", that is, a few months break from payments you must discuss this possibility with them. Make your mortgage payments on time until you have a forbearance agreement in writing. If that does not come, you must continue to make your mortgage payments or you will rack up mortgage lates which will have a severe price at a later date. Do not believe for a second that sometime a few years from know you can say, "Sorry about those two mortgage lates - but my house burned down". People may understand, but that understanding will not be reflected on your credit report and a mortgage lender will, in all likelihood, report those as lates in the future.

If your house is totally destroyed it will be either rebuilt with funds provided by the insurance carrier in which case (to make things a bit simple) you keep your old mortgage just as if nothing happened but you must continue to make your mortgage payments. The fact that the house burned down does not affect the mortgage. If the house is a total loss and you are not going to rebuild, the insurance company will pay off the mortgage holder because they are named as the "loss payee" in your policy. You still must make the mortgage payments until it is paid off. Do not underestimate the damage to your credit that will occur as a result of mortgage "lates". If a "Notice of Default" is filed thing are worse. It is extremely difficult to undo the damage caused by a NOD. Mortgage lenders regard mortgage lates, NOD's and foreclosures as much more serious transgressions than credit card lates.

To take this to an extreme, even death does not take a holiday from mortgage holders. If a relative dies the impact on their credit may not matter but a foreclosure could still take place if the mortgage is not paid on time. If you are the executor of a decedent's estate or the beneficiary-to-be make sure that the mortgage is paid in a timely manner. In California, a non-judicial foreclosure can take as few as 111 days from start to finish.

This picture can be complicated by tenancies-in-common and other factors but the point is this: do not expect sympathy, defend your interests and make sure the darn mortgage is paid.

Dick Lepre
www.loanmine.com

What the Fed Is Up To

This past week Treasuries saw some serious selling after the FOMC minutes indicated that there was a substantial risk that inflation may not recede as expected and noted they must ensure it slows. The statement has about as much original content as notification that the sun rises in the East. Has the Fed ever said, "Inflation? No problem, don’t sweat it. We got it covered." In fact the Fed is merely putting the word out that unless inflation is contained to its satisfaction it may not lower rates as the market participants wanted/expected.

The underlying fact it that it is amazing that the Fed can exert so much power as it does not by changing rates but by taking an attitude to changing rates. Years ago the Fed "ran the economy" by adjusting money supply. That, intuitively, seemed real. Lower the money supply and less stuff get bought and inflation slows. But the Fed no longer has any meaningful control of the money supply. I have written about this before. Much of the money supply is outside the control of the Fed's reach over the banking system and the massive amount of credit availability through credit cards and HELOC’s creates buying power.

The Fed's ability to control the economy by regulating one interest rate on something that does not get used anyway (banks do not really borrow from the Fed window; they borrow from other banks) is impressive, The Fed, in effect, controls prime and interest rates up to 2 years. It is only the perception of the containment of inflation that keeps longer term rates in check.

Part of the reason why the Fed is so effective is that it is outside the control of politics or politicians. The forces which control what people say or do to get elected or reelected do not induce people to make wise fiscal choices. In fact, politicians have little to do with the ups and downs of the economy. They merely use them to take credit or ascribed blame to their opponents.

The market's present reaction to the Fed is yet another example of how players try to induce the Fed. Clearly it was the case that the amount of buying in the latest week-to-week bull cycle was based on a belief that the Fed would ease sooner rather than later. The FOMC simply said, "No, thank you. We are still concerned about inflation and, guess what, we control interest rates not you."

I do not believe that the Fed's words should to any great measure be construed as a warning that inflation is about to break out. The Fed is 1) being cautious and 2) serving warning that business must not allow CPI to move up if they want lower rates.

The pieces are in place for inflation containment: 1) lower energy prices 2) very high corporate profits allowing companies to absorb wholesale price increases and wage increase without passing the cost to CPI (the consumer) 3) flat housing prices will translate into less construction and lower costs for building materials and all that stuff that Home Depot sells.

Strangely, we see little concern about higher wages caused by a tightening labor market. To some extent this merely reflects the nature of the media. By classic standards we have such a low unemployment rate that we should be seeing wage inflation but just as in the 1990's wage increases remain modest. Contained wages are likely the result of 1) globalization and 2) weakened labor unions. The notions of nominal wage, real wage and employee compensation have been blurred by workers getting higher compensation in the form of the increased cost of medical benefits.