by Bill Bonner
03/07/2002
Source"The worst part of the bear market in stocks is still before us, and it will essentially involve the wholesale destruction of the pseudo-financial wealth that the bubble economy has created in the past years."-- Dr. Kurt Richebacher
What have I done, I asked myself.
"You promised to tell readers what company would be the 'next Enron," explained a colleague.
"What was I thinking?"
I was thinking wildly. If it is a surplus of credit and not a shortage of character that produces Enron situation, wouldn't it be easy to spot the next one? Wouldn't it be a matter of checking to see where the credit went and who got most of it?
But this turns out to be no easy matter. For as Martin Weiss tell us, there are hundreds, or even thousands of candidates. It is like trying to figure out who is the dumbest member of Congress... there are simply too many good choices.
Government sponsored enterprises such as Fannie Mae and Freddie Mac, for example, added trillions to their 'assets' over the last few years. They borrowed at artificially low rates in order to buy residential mortgages. Had not the credit markets, real estate market, and appraisers been so generous, they would not have been able to grow so much and homeowners would not have been able to borrow so heavily against their homes.
GSEs are not literally 'backed' by the federal government, but who believes they would ever be allowed to fail? They will cost investors a lot of money when the credit cycle shifts against them. But at least their liabilities are in plain view... and they are sure to be bailed out somehow.
A company with liabilities out of plain view is, for example, the derivatives king J.P. Morgan. In recent years, J.P. Morgan has managed to get its name in the paper often. The context is almost always the same - a large company or sovereign nation goes bankrupt and there, prominent among the list of major creditors is J.P. Morgan. The company seems to have a nose for sniffing out bad credit risks combined with an irresistible urge to lend them money.
So, we would not be terribly surprised to discover that J.P. Morgan eventually costs investors a lot of money. Not that we know anything you don't know, dear reader. But if the company wanted to blow itself up, J.P. Morgan has had access to plenty of HAZ MATS, as they call them on the highways - not the least of which are its derivative trades.
According to the Bank of International Settlements, exchange-traded derivatives grew by 31% since Long Term Capital Management blew itself up. The 'over the counter' derivatives market, meanwhile, approaches $100 trillion dollars.
Martin Mayer says that derivatives are a way of shifting risk to the dumbest guy in the room. J.P. Morgan, of course, has some of the sharpest traders on Wall Street. But then, so did LTCM.
An analyst, caught by the ear and brought before a committee of politicians to explain why he had recommended Enron, made an arresting argument. His inquisitors had forbidden him from using inside information, he explained. That would have been against the law. But the information available to the public - that is, the pronunciamenti from the PR departments and CEOs - all said Enron was doing just fine. Who was he to argue with them?
Alas, being an analyst is hard work again. For a few years, it was a celebrity sinecure - with nothing more backbreaking than appearances on CNBC and lunches with media hacks. But now, they're being asked to actually do analysis!
And almost no matter where they look, they are likely to find candidates for the 'next Enron' competition.
"This is almost a culture of corruption," said Senator Byron Dorgan. Dorgan heads the group of poseurs and mountebanks that pretends to explore the Enron case. It will come as no shock to Daily Reckoning readers - he was speaking not of Congress itself, but of Enron's management. But the same might have been said of a great many companies. Investors wanted great numbers, and management found ways to give them what they wanted.
"Companies use every trick to pump earnings and fool investors," said an article in Business Week from May of 2001. "The latest abuse: Pro forma reporting."
"By so called pro forma reckoning," writes Dr. Kurt Richebacher, "the companies in the S&P 500 stocks index earned $45.31 per share in 2001, giving the market a price-to-earnings ratio of 24.7, according to Thomson Financial/First Call. But by using generally accepted accounting principles, earnings were just $28.31 per share in the 12 months through September, equating to a P/E ratio just under 40."
"The particular attraction of this profit formula [pro forma] is that it literally allows a company to omit any expenses it [wants]... and to report any profit it wants," Richebacher concludes.
Companies have typically wished to report earnings of 'a penny more' than investors expected. How did they do so, quarter after quarter, year after year? It was not a feature of careful business management, we believe, but of numbers so vigorously massaged that their bones were broken.
GE, IBM, Quest... and hundreds of other companies... throughout the entire private sector the numbers were twisted into appealing new shapes and sizes. But if massaging the numbers was such a hit in the private sector, mightn't it have caught on in the public sector too? after all, the same politicians who criticize Skilling and Fastnow for not revealing the full extent of Enron's liabilities would never dream of producing a GAAP-based report on the federal budget or its pension schemes.
We have discussed, from time to time, the way in which the masseuses at the Department of Labor do their jobs, too. They do not hesitate to deliver a blacksmith's blow to the productivity numbers - when the occasion seems to call for it. Nor do they mind taking off their shoes and walking all over the GDP figures... or the CPI. What is left is a body of digits so pliable they can bend them into almost any shape they want.
So completely are the CPI numbers squeezed, extruded, and pawed over, says Dr. Richebacher, that "in the end, the calculation of CPI becomes so sophisticated that they can pick any number they like, and they like low numbers." Widely reported in the media and celebrated in the stock market is the 'fact' that GDP grew in the 4th quarter at a 1.4% rate. Yet, explains Richebacher, "had it not been for the government spending and the hedonic deflator [by which Labor Dept. statisticians adjust actual dollars for 'quality enhancements'], US real GDP growth would have been down in the 4th quarter at an annual rate of more than $50 billion, or more than 2% - far worse than expected."
But in the New Economy of the late '90s and early '00s investors got the numbers they asked for.
Working on the numbers - earnings, debt, liabilities, productivity, GDP, inflation - the magic fingers on public and private payrolls made them look far more fetching than they really were. P/E's, lower than they really were, were justified by productivity figures that were higher than they should have been, because the CPI numbers were reported lower than they actually were.
The entire picture looked better than it really was. And it resulted in an immense amount of wishful credit going where it should not have gone. To Enron... and elsewhere.
More to come...Bill Bonner