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Origins of the Crash: The Great Bubble and Its Undoing by Roger Lowenstein


Rating: (Mildly Recommended)


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Pedantic Primer

Readers who expect the same talent shown in When Genius Failed will come away disappointed after reading Roger Lowenstein’s new offering, Origins of the Crash. Lowenstein does a good job here as a chronicler, and presents an entertaining tour by a talented guide, but there’s not much insight and perspective. Here’s an excerpt from the beginning of Chapter 4, “Number Games.” pp. 55-61:

The standard for shareholder value was set by Jack Welch. He came from Salem, Massachusetts, a tough, hot-headed son of a Boston & Maine Railroad conductor who had, as Fortune mag­azine described it, a primal need to win. He laid off so many people that his own son was once beaten up by the son of a man he had fired. That was Neutron Jack. A chemical engineer who hadn’t been able to get into an Ivy League school, he started his career, in 1960, in plastics in Gen­eral Electric’s facility in Pittsfield, Massachusetts, and within a year he was so frustrated by the company’s bureaucracy he nearly quit. Two decades later he was CEO. General Electric, a sprawling conglomerate with assets in everything from locomotives to refrigerators, was a com­pany where, as Welch described it, tradition meant everything. To Welch, tradition meant nothing. If a business wasn’t first or second in its industry or didn’t have a good chance of getting there, Welch unloaded it. This knocked GE for a loop. In fact, it upset bureaucracies all over the country. In 1981, corporate America was in its dark days. Welch was a perfect antidote. With Welch in charge, no Japanese keiretsu would overtake General Electric. The thing about change, Welch declared, was that it never stopped. You kept inventing, kept redefining. It would be hard to think of a philosophy more attuned to the market—to share­holder value. By the ‘90s quite a few other CEOs wanted to be like Jack, too. Year after year, Fortune named him its most-admired CEO. The magazine ran glowing articles just for the purpose of letting Jack talk about how he did it. His annual reports, artful sermons on the beauty of a “boundaryless” company, on defeating bureaucracy wherever it lurked, on retaining the soul of a small company inside of a big conglomerate, inspired generations of managers.


Welch and his underlings collected plenty of stock options, and few executives made more of their incentives than GE’s did. In a ten-year stretch, Welch earned $400 million in salary, bonuses, and options—an extraordinary fortune for a hired hand. Most of it derived from the rise in GE’s stock. Over Welch’s entire two decades as CEO, adjusting for later splits, GE’s shares rose from $1.20 to roughly $50. How did Welch orchestrate such a phenomenal rise? First, he cashiered businesses he deemed unattractive, even the division that made GE’s famed toasters, and redeployed their capital into more profitable businesses, such as broadcasting and financial services. Second, he demanded relentless im­provement in the quality and productivity of the businesses that he did keep. His unceasing focus on profits helped to raise GE’s reported earn­ings eight times over.


But if GE’s earnings rose eight times, why did its stock rise forty_two times over the same span? Why were investors now willing to pay five times more for a dollar of GE’s earnings than they had been in the past? That was what analysts really meant by shareholder value—getting a higher value in the stock market. And nobody did that better than Welch.


The secret of GE’s perennially rising stock was not just the growth of its profits but the consistency of its growth. Through war, through re­cession, through market crashes, its bottom line kept growing. In fact, GE’s earnings from continuing operations rose a phenomenal one hun­dred quarters in a row. Investors gladly paid for that consistency. It saved them from sleepless nights, from having to analyze the company themselves. They could simply rely on Jack.


Welch liked to talk about “stretch,” meaning imposing seemingly impossible targets on managers and getting them to deliver. He also talked about making growth consistent—”with no surprises for in­vestors.” Of course, the businesses that GE managed had plenty of sur­prises. Every business does. Over the years, Kidder Peabody, GE’s brokerage unit, took a billion-dollar loss. GE Capital, its huge financial arm, suffered numerous hits to its portfolio. GE’s turbine business was ever riding up and down with the cycle of aircraft manufacturing. The list could go on and on.


But you wouldn’t know it from GE’s smoothly rising bottom line. GE was said to enter every quarter with a specific profit goal in mind— and to do “everything in its power” to make the number, regardless of whether its actual performance turned out to be better or worse. The idea that a company has discretion over its reported earnings might sound strange. Companies never announce earnings of “somewhere be­tween 50 cents and 60 cents a share”—they announce a single figure as though it had been chiseled in stone and was beyond the power of man­agement to influence.


But in fact, modern accounting is as much art as science, and one is allowed a great deal of discretion in deriving the earnings for any one quarter. To take a simple example, when should a company recognize revenue—when it ships a product to a store or when the product is sold? For that matter, when is it sold—when the customer orders or when he pays? And if the customer buys on credit, when should the retailer con­clude that the loan is bad—and if so, how much of the receivable should be written off? These and a hundred similar issues yield to judgment, not to an absolute answer.


This doesn’t mean that anything goes. The object of accounting re­mains to present a true economic picture of the underlying business and to permit useful comparisons of earnings from year to year and from company to company. Auditors may honestly differ, but if a product is stacking up in the warehouse, the numbers ought to reflect it. Other­wise, disclosure is worse than meaningless—it’s misleading.


Unfortunately, as corporate activities became more complex, the range over which auditors could invoke their discretion widened. Stephen Key, an accountant and later the chief financial officer at both ConAgra and Textron, recalls that when he entered accounting, in 1968, it was possible to read the entire rulebook in a day. At recent count, however, the rulebook had grown to 4,750 pages. “When you have 4,750 pages,” Key explained, “you start salami slicing. The rules become a cookbook.”


One way GE used the cookbook was to adjust the reserves that GE Capital maintained against problem loans, adding to the reserves in strong quarters so as to save income for a rainy day and reducing them in weak quarters, when the income was “needed.” GE Capital was so complex it was considered a black box to outsiders, even those who were financial experts. In any given quarter, depending on the assumptions it made about its multitudinous assets, loans, and derivative deals, GE Capital could report almost whatever earnings number it pleased.


Naturally, bad news could not be put off forever. But whenever GE suffered a major loss—say, from a restructuring—in one part of the em­pire, Welch inevitably found an unusual gain in another part. And these offsetting items always seemed to occur in the same quarter. For in­stance, in 1999, GE booked a huge paper profit from selling assets to its Internet baby, NBCi. Instead of reporting the extra profit, GE used the occasion to add to reserves, giving it a cushion to draw on in the future. The following year, GE Capital took a $200 million charge when one of its borrowers, Montgomery Ward, filed for bankruptcy. GE offset the loss by selling part of its stake in the broker PaineWebber. The size of these onetime items could be substantial.


None of these maneuvers was illegal, and any of them might have been adopted for the right reasons. But in the aggregate, they helped to depict a business that was inherently rife with the normal business fluc­tuations as preternaturally smooth. It suggested that when Welch’s ef­forts to win were insufficient, he ordered his managers to prettify the scoreboard, much to the betterment of his stock options.


Moreover, Welch, like other CEOs, used the pension plan to signifi­cantly inflate reported income. In an economic sense, pension plans are a black hole. By law, once money goes into a plan it can never be used for the benefit of stockholders. Nonetheless, the plans can be used to create an appearance that is favorable to the stock. When pensions earn a sur­plus, the parent company can book a credit to its earnings, the size of which is highly dependent on management’s assumptions. At GE, which relied on such adjustments to keep its earnings streak going, about 10 percent of the profit reported to Wall Street was actually money safely locked in the pension plan that neither Wall Street nor shareholders could ever touch.


Robert Friedman, a certified public accountant with the rating agency Standard & Poor’s, deconstructed GE’s earnings by stripping out gains from its pension plan, adding a tiny charge for stock options, and netting out the gains and losses from unusual items. The result was what Friedman termed core earnings. As you would expect, core earn­ings were a lot lower than reported earnings—over six years, anywhere from 1 percent to 20 percent lower. They also grew at a slower rate. Most interesting, perhaps, is that GE’s core earnings didn’t grow smoothly at all. One year they grew 39 percent. Another year they fell 4 percent; in another, 8 percent.’ This is not as desirable as a steadily ris­ing slope—it just happens to be how business in the real world works. People do not increase their consumption of every product and service by identical increments in each twelve-month interval.


Friedman didn’t publish his findings until after GE’s shares (as well as the market generally) had lost their luster, but the thrust of his argu­ment was well known before. In 1998, SEC chairman Levitt gave an impassioned speech at the Stern School of Business at New York Univer­sity, warning that the reporting of corporate earnings had become “a numbers game.” Levitt blamed the zeal of managers “to satisfy consen­sus earnings estimates and project a smooth earnings path.” What’s more, he said, “trickery is employed to obscure actual financial volatil­ity,” and not just by smaller companies. “It’s also happening in compa­nies whose products we know and admire.” As a government official, Levitt didn’t name names, but it’s a good bet that GE was on his list. In the private sector, though, GE was anything but scorned for managing earnings. Indeed, Welch was admired for it. Executives wanted that steadily rising slope and, given the structure of their option packages, they certainly wanted the stock price that went with it. The long boom, the yawning sense of a modern Babylon, of a world of easy profits with­out accountability, was eroding people’s standards. Though deception was at the core of creative accounting, the ethical distinctions of another generation were being whittled away.


Almost unnoticed, executives who played number games became less candid with their investors. Their moral basis was undermined. Execu­tives who consistently relied on accounting contrivances to sugarcoat their results came to respect the process less, and ultimately. they re­spected the shareholders less. At times, their contempt was plain. Al Dunlap, the cost-cutting executive at American Can, Scott Paper, and Sunbeam, glorified his supposed concern for shareholders in a best-selling book, Mean Business: “The most important person in any com­pany is the shareholder. I’m not talking here about Wall Street fat cats. Working people and retired men and women have entrusted us with their 40l(k)s and pension plans for their children’s college tuition and their own long-term security.” While his concern for pensioners, uni­versity students, and other investors seemed touching, at Sunbeam, an appliance maker, Dunlap coldly betrayed them. According to an SEC complaint, the “revenue growth” that Dunlap reported to investors was actually achieved by “stuffing the channel,” meaning that he was se­cretly offering huge discounts to get dead inventory out the door. He also established phony “cookie jar” reserves to inflate profits. Sunbeam tiled for bankruptcy in 2001, and the shareholders were wiped out.


More commonly, accounting artifice encouraged, if not outright fab­rications, a more casual relationship with the truth. Corporate disclo­sures—which, it bears repeating, are the heart of America’s system of governance—became tainted by a cynicism in which companies re­sorted to legalisms. They reported results in a way that was lawfully permissible as distinct from a way that would openly answer the ques­tion that Mayor Ed Koch used to ask of himself (“How’m I doin’?”).


IBM was asked by various news organizations about its practice of lumping onetime asset sales with administrative expenses, which had the effect of making it appear as though its costs, which Wall Street watched closely, were lower than they were. The computer giant replied that its accounting was “within the letter of accepted industry practice” and was “fully compliant with regulatory standards.” One wants to groan. What dedicated employee would defend a misleading entry by telling the owner that he was “fully compliant” with government standards? The more it played the game of touching up the numbers, the more IBM forgot what shareholders were—owners who deserved its complete candor. And it was hardly alone.

It may be that we are in a period of time still too close to the bubble to have insight and perspective. Lowenstein presents a readable and comprehensive story in Origins of the Crash, but readers looking for deeper insight will have to wait for another book.

Steve Hopkins, March 23, 2004


ã 2004 Hopkins and Company, LLC


The recommendation rating for this book appeared in the April 2004 issue of Executive Times

URL for this review: of the Crash.htm


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