“I’m so bored. I hate my life.” - Britney Spears

Das Langweilige ist interessant geworden, weil das Interessante angefangen hat langweilig zu werden. – Thomas Mann

"Never for money/always for love" - The Talking Heads

Thursday, September 26, 2002


The flame is on under CFO magazine's 99 CFO of the year --- everybody's favorite, Andrew Fastow! Yes, Enron's man with the plan -- the plan to loot the company's resources for his own benefit -- is edging close to the bonfire of the Vanities currently being lit in a court in Houston. This WP article is clearly a prosecutor's ploy,
but it does include one interesting detail for the Enron-maniac: the focus on Braveheart, the deal whereby Enron sold its potential profits to a Canadian bank in order to realize a sum in its books for 2001, coming up with a 100 million dollar profit. This deal is so incredible that it certainly needs to be examined -- and the heads of the execs at the Canadian company that made it need to be examined twice as hard. Only Enron would make a deal selling its potential profit to a third party, in order to mark down an immediate profit. In '99, CFO caught the great man himself explaining his tricks:

"When Andrew S. Fastow, the 37-year-old CFO of Enron Corp., boasts that "our story is one of a kind," he's not kidding. In just 14 years, Enron has grown from a heavily regulated domestic natural-gas pipeline business to a fully integrated global energy company with thriving activities in natural gas, electricity, infrastructure development, marketing and trading, energy financing, and risk management. And much of that growth has been fueled by unique financing techniques pioneered by Fastow.

"When I came here in 1990, Enron was a company with a $3.5 billion market capitalization," says Fastow. "Today, we're around $35 billion, and that's without issuing a whole lot of equity. We've increased shareholder value, grown the balance sheet, maintained a stable outlook from the rating agencies, and achieved a low cost of capital."

In fact, when energy stock analysts look for paradigm companies to vaunt, they point resolutely in the direction of Houston-based Enron, with $31 billion in revenues last year. And when they seek to explain how Enron has remade itself so completely, they point to "remarkably innovative financing." Says Ted A. Izatt, senior vice president at Lehman Brothers Inc. in New York: "Thanks to Andy Fastow, Enron has been able to develop all these different businesses, which require huge amounts of capital, without diluting the stock price or deteriorating its credit quality-- both of which actually have gone up. He has invented a groundbreaking strategy."

As Raymond Chandler might say, that's cute as a pair of tarantula pyjamas. Inventing those groundbreaking strategies for hiding huge amounts of capital -- hey, a round of applause right here!

If the prosecutors have any sense, they have sharpened their knives for the head of Enron's Broadband division, Ken Rice. The royal road to the conviction of Jeff Skilling might well lie through Mr. Rice, an amiable lout, by all accounts, who made off with 76 million dollars in cashed out stock options. A man who never, at any time, understood fiber optic cable, which is what his division was supposedly about. Luckily, he was only involved in it as its president - most of his billable time, at least according to Robert Bryce's book on Enron, he spent racing motorcycles.

Although you might think the piggy bank is broken, the new CEO of Chapter 11 Enron is still poking around for loot. Maybe it is something about the name, or maybe it is something about Houston business culture, but according to the Houston Chronicle,

"Stephen Cooper wants to hire 15 more managers from Zolfo Cooper, in a move that could earn him a rich reward. In a request filed with the bankruptcy court Tuesday, Enron asked to pay the restructuring firm founded by Stephen Cooper $864,000 a year per manager, the same rate as 15 Zolfo directors already with Enron." Cooper has apparently decided that his firm should staff Enron's skeletal crew, where they rub shoulders with highly compensated lawyers and such. And that, incidentally, he will receive money both from the company which he is running, Enron, and the firm he was running, Zolfo. Sweet, a deal like that. I mean, how do you squeeze more juice out of a dead carcass? See, Enron is pioneering entrepeneurial bankruptcy -- are we happy now?

This brings us round to yesterday's post. If you will remember, fair reader, we were discussing John Cassidy's New Yorker article, The Greed Cycle. One thing especially impressed LI about that article: the place of Michael Jensen in it. Jensen, Cassidy claims, was the academic godfather of the amazing inflation in top executive compensation packages. Jensen is currently hatching an academic paper to explain the collapse of Enron that blames it on -- get this -- the Wall Street bubble mentality. Why -- the universal solvent of explanations, now, that bubble. Once upon a time, the conservative view was that there are no bubbles -- this was, after all, the orthodoxy of efficient markets theory. Time moves on, however, and as it has become apparent that something has to be to blame for the crash -- and as it becomes apparent that the clash laid bare the irrationality of radical free market doctrine -- there's been a noticeable shift in that plank of the doctrine. Suddenly, there are bubbles -- and they are all the fault of Clinton! How convenient.

According to Cassidy, Jensen's idea is that Enron had to do what it did to maintain its stock prices because of pressure from Wall Street jockeys. It is the familiar story of trying to meet higher and higher expectations, and at some point going to the shadow side in order to do so.

Well, that is, to put not too fine a word upon it, bull shit.

Enron had to maintain its stock at a high level because much of its dealing depended on the stock being at that price. That guaranteed credit. Why was the need for credit so pressing? Because cash flow was so radically out of synch with claimed earnings. This occured because Enron made a systematic attempt, under Jeff Skilling, to institute mark to market accounting, a financial instrument by which it could aggregate future earnings as present earnings. Why did it do this? Well, among other things, such an accounting system could justify huge bonuses for execs. These bonuses were not postponed until the real profit was realized -- since in the vast majority of the deals Enron pursued, profit either never appeared, or was eaten up by costs. In fact, in the vast majority of those deals, including those being made by the thousands at Enron's famous energy trader's desk, Enron was losing money. So it was not Wall Street expectations that caused Enron to engage in the massive distortion of its financial position, but the need to justify grossly inflated compensations -- which of course brings the ball home into Jensen's court, doesn't it?

Jensen, who is working for something called Monitor, has posted a version of his version on the site. Here's the first three grafs -- and a word to the wise: notice that the "problem", as Jensen carefully designs it, is "fixed" by a courageous CEO. Jensen is the type of guy any CEO would be proud to have in his court -- a natural born syncophant:

Once, companies gave whispers and informal advisories to favoured analysts of what to expect in coming earnings announcements. Then the conversations became more elaborate, engendering a kind of twisted logic. No longer were analysts only trying to understand a company so as to predict what it might earn. The analysts' forecasts themselves became the centre of discussions. The forecasts no longer represented a financial by-product of the company's strategy but came to drive that strategy.

Yet as the case of Enron suggests, when companies scramble too hard to meet unrealistic forecasts by analysts they often take highly risky value-destroying bets. The process - euphemistically referred to as "earnings guidance" - is a high-stakes game, with management seeking to hit the targets set by analysts and being punished severely if they miss.

But a few courageous chief executive officers have wisely decided to put an end to the game by saying "no". Managing Wall Street's expectations may be a decades-old game but Barry Diller of USA Networks and Jim Kilts, Gillette's CEO, have decided to end it."

Jensen is a typical Chicago economist. He uses mathematical models to achieve results that he wants -- such as the model that shows why executives, as agents of the shareholders, must be compensated in such a way that their "interests are aligned with the company." Unlike, say, secretaries and technicians, I guess. When this model, in the real world, produces bad results -- when it is tested, that is, and found wanting, because of an insufficient attention to other, structural variables -- he reaches immediately for psychological terms. In other words: cue the mind when the going gets tough. That's always a good strategy to detract from your pisspoor mathematical models. Thus, his suggestion that Enron executives, hitting their targets, are driven by "egotism:" "High share prices stoked already amply endowed managerial egos.." Psychology intrudes when, embarrassingly, rational self-interest is really the parameter at stake. If compensation is set up to award performance without any index for performance -- if, that is, compensation is set up in the absense of those constraints that come with a competitive job market -- then guess what? performance will be skewed to justify compensation. This happens over and over again -- merger and acquisition is substituted for entrepeneurship, accounting shenanigans for true cost cutting, and pensions are looted in place of products being innovated. You would have to be a fool -- or an economist -- not to see that something in the system must be causing this systematic effect.

Discussion of corporate performance and its relation to compensation is on a truly childish level in the business press. Take General Electric. LI has seen, compulsively repeated, justifications of Welch's swollen compensation package by reference to how vastly GE grew under his leadership. No attention is paid, in this analysis, to the growth of other, similarly structured companies during the same period, or the patterns of organizational adjustment common to all of them. In other words, no argument is made that Welch added some unique value that, in the boom that began in 1982, distinguished his operations in some special way. As an instance of Welch's genius, measured by capitalization, take GE Credit, which contributed significantly to GE's profit in the last ten years. Was this some unique contribution of Welch's? By no means. Disintermediating from orthodox financial institutions -- ie banks -- is a common pattern in American industry. If I truly wanted to bore my readers, I would allude to Alfred Steinherr's exhaustive treatment of this in Derivatives: the Wild Beast of Finance. GM, Ford and Sears have all done it, and it wasn't due to the genius of CEOs. It was due to the opportunity presented, accidentally, by the confluence of two events: pools of capital that came into these companies from various sources (like pensions) that could more profitably be used as a financing instrument, and the peculiarities of the American financial structure due to regulations deriving from the Glass-Steagall act. Does anybody really want me to go into this? No. But the fact is, a pattern is found in various similarly capitalized companies that strongly implies no one CEO was the innovator in this area. So when the market soared, in the long boom from 82-2000, guess what? Those companies started overflowing with apparent money, as they "managed" financial assets. Of course, the flow depended, to a large extent, on two things: the equity bubble, and the enlargement of financial services, like loans to customers. Well, the equities bubble collapses, and the loans begin to bite back as interest rates lowered, customers defaulted, and returns in other areas of company activity slowed. Welch hopped off before the full bust hit, but his final days, riding the Honeywell fiasco, might well tell us what his CEO-ship would look like now if he had stayed on.

So, Welch is paid genius bonuses for non-genius work. Competent, even excellent some years, but not great -- and certainly not something to give him compensation equivalent to one of the founding capitalist fathers, like Carnegie. Yet I have never seen an article in the financial press make this simple comparative point. The point needs to be made because the question should be: could GE have acquired its financial position cheaper -- ie, with a cheaper leadership? This is, of course, taboo for the CEO apologist, and the multitudes that labor to create the uber-management myth.

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