Tuesday, October 07, 2008

Origins of the Crash

I've finished the very readable book by Roger Lowenstein, titled "Origins of the Crash". There are many books that talked about crashes, but this book focuses more on the dot.com bubble, collapse of Enron, accounting scandal at Andersen and the telecommunications bubble, with the author linking the excesses of past markets to the downfall of future bubble.

There are a few key take aways that I got from this book. Bubbles are caused by a series of factors:

1. Lack of corporate governance.

There are stories of dot.com companies where the CEO and chairman of the board of directors are the same person. Boards full of the CEO's 'independent' friends, some of whom are blatantly related in familial ties, some are the CEO's lawyers, accountants and so on. Audit committee do a perfunctory job of looking through results, and had absolute trust in the CEO.

Special purpose vehicles (SPV) are set up to transfer assets to these, so as to lighten the balance sheet to make it more attractive, less debt-ridden and thus able to borrow more.

2. Massive conflicts of interest

CEO is paid to direct the company. Board of directors are supposed to monitor the performance of the CEO. Audit committee in the board are supposed to monitor the results of the company, while external accounting firms are supposed to make sure the results released satisfied accounting standards.

All these broke down in the dot.com era when the CEO is the chairman of the board of directors. Audit committee and the renumeration committee are but cronies of the CEO, who are not only not independent but also had a massive stake in the company and/or subsidiaries. Some of them sitting in the board are also directors in the subsidiaries owned by the company. Accounting firms also act as consultants for the firm besides their accounting jobs, with some even switching over to become the CFO of the firm they used to work for.

3. Greed and emphasis on share price

Not only of the CEO with their massive pay scale and millions of options given to them, lifetime pensions and usage of company jet, serviced apartment, car with chauffeur etc, but investors are also at fault. Investors are so sure of being able to buy high and sell higher that all aspects of the business are thrown out. Only prices matter, even if the companies do not have earnings. In fact, earnings and fixed assets are seen as negative aspects anchoring the price because without them, the hopes and promises of the company becomes intangible - a value hanging in the air - and all who buy into it can hang onto their false hopes long enough to sell it to the next smitten investor.

(There's a very good side story of Jack Welch - famed CEO of GE, who got many perks after his retirement from GE. His lifetime perks included the use of a $15 million Manhattan apartment with complimentary wine, food, laundry services, newspapers and toiletries. He also have access to a corporate jet, floor level tickets to New York Knicks, courtside seats at the U.S Open, a box at Metropolitan Opera, a car and a driver. This is besides a $350,000 monthly pension, and a combined past earnings of more than $400 million while working at GE.)

Only when the share prices start to fall that the investors' dream become their nightmare.

4. Nobody guarding the guards

Gatekeepers are supposed to keep the gates, but who makes sure that the gatekeepers do their job? Apparently none.

Auditing firms became conflicted after the removal of rules that prevented them from doing underwriting business with their audit clients. Analysts in investment banks hyped companies that their firms did business with even if they felt that those companies did not deserve such praise. Directors turned a blind eye to many things management was doing. The government, with many ties to big business, failed in its regulatory role because times were good. There are also many stories of the whole lineup of politicians in the US being involved in the whole debacle.
Even the SEC chief was a lawyer who once fought against excessive clamping down on accountants.

Are we seeing more crashes in the future? I'll bet we will. But did you notice that many of the things that happened is happening now again? As the saying goes, there is no new thing in the market, history repeats itself again - in different forms.

(This site is a very good review of the book)


PanzerGrenadier said...

Hi La Papillion

The sad reality is that history repeats itself. This current market crash which was underpinned by greed and the power of leverage multiplied is but a different manifestation of the same story of economic boom and busts.

This type, it was caused by reckless lending to people who shouldn't be borrowing to buy over-valued properties in the first place.

No guesses on who loses though... The common people as the bailout will cost US taxpayers even as investors locally lose money in DBS High Notes 5 and Lehman Minibonds.

Just read a story about how AIG senior executives went to a expensive resort just a week after the bailout by US Treasury. They were spending $440,000 on a retreat while shareholders basically lost most of their stock value and even in Singapore we have a run on AIA!

la papillion said...

Hi PG,

I agree with you. History repeats itself in different forms. I also heard of the news of AIG top exec who went to a top notch resort partying - it speaks of corporate excesses and a lack of sympathy from the top.

The top man of companies used to earn 30-40 times that of the average worker in the same firm. Now, it's more like 500-600 times more, and we're not counting the pension, options, free perks that comes with the job. It's insane.

Unfortunately, pple do not mind the excess when the market is trending upwards. It's only when the price of their shares went down, that more scrutiny is paid. THAT is the sad part of the whole debacle.