THE BEAR'S LAIR
Reality, where art thou?
By Martin Hutchinson
A new webzine, CFOZone, has highlighted a study showing that companies that
declare "pro-forma" earnings (dolled up by management to reflect the
most-favorable assumptions) suffer increased attention from short sellers,
about US$1.3 million worth initially after the pro-forma earnings declaration -
just north of 1% of trading volume. This is good news; it suggests that the
market is becoming hostile to attempts to fool it. The sooner we move to a
reality-based capitalism, the better - but it may take some considerable time.
Capitalist unreality takes numerous forms. Starting in the 1980s, it took the
form of excessive reliance on mathematical models that did not work, such as
the Black-Scholes options valuation model and the empire built on portfolio
insurance before 1987. This caused a record-breaking one-day market meltdown,
which itself was so far outside the predictions from the models as to render
them obviously wrong. Yet the market continued to use
them, preferring to wallow in computer-generated fantasy than to face up to
Also in the 1980s, the first auction-rate preferred stock was issued. These
were issues in which the interest rate was reset each week by an auction
process, with a maximum rate if the auction failed to produce bids. These
securities were treated for 24 years from their invention in 1984 as short-term
investments, and sold as such, in spite of the obvious flaw that in a tight
market there might be no bidders, making their price sink ad infinitum.
In the event, this flaw did not take effect until 2008, and the securities only
sank unexpectedly in price at that point. The money market funds that had
invested in them had a nasty surprise, discovering that they had been
participating for two decades in a market governed by unreality.
In the 1990s, we had the phenomenon of Long-term Capital Management (LCTM).
These people were thought by the market to be geniuses - the Nobel prizes of
two of its directors were frequently cited - and so they were allowed by the
market to leverage as much as they liked, in the belief that their arbitrage
trades "had" to come right. In the event, the relationships that LTCM relied
upon turned out to be short-term or spurious, and so LTCM became insolvent.
Following the failure of LTCM, the US Federal Reserve arranged a bailout by the
major New York banks and investment banks. Rather than taking this bailout as
evidence that there was something seriously wrong with both the US capitalist
system and Wall Street's risk management, investors continued to operate for
another decade as though the LTCM collapse had never happened. As we have since
discovered, that rescue led to practices that produced a much bigger crash a
Needless to say, the ultimate triumph of faith-and-hope-based-investing was the
dot.com bubble. Not only did valuations reach levels that could never be
justified, but initial public offerings were carried out for companies that
never should have existed. The central premise of Pets.com, that money could be
made by express shipping cat food around the United States, was so foolish that
a moment's reality therapy should have exposed it. In that market, no such
reality therapy was possible.
At the opposite end of the scale, there was a notable increase in questionable
and even fraudulent accounting. Enron and Global Crossing should have been put
out of business by any competent auditor long before they went bankrupt. Their
demise caused many to think that reality had once again dawned, but as we were
to discover its triumph was to be a transient one.
As we now know, reality did not after all dawn in 2002. Instead, bureaucracy
dawned (or blossomed) in the form of the Sarbanes-Oxley Act - legislation
designed to improve standards for the boards of US public companies - while the
Fed indulged in its unreality by fantasizing that the US economy was in danger
of deflation. That delusion in turn produced the over-stimulative monetary
policy that gave us another unreality known as the housing bubble.
There were several subsidiary fantasies going on at the same time as the
housing bubble, which made its demise much nastier. The investment banks
fantasized that a reputable financial institution could survive perfectly
happily with a 30-to-1 leverage ratio, pressurizing the weak-kneed regulators
of the George W Bush administration to eliminate their capital rules in 2004.
Homeowners without adequate credit fantasized that there was some benefit to
obtaining a home mortgage with no money down, at an interest rate double the
level of that paid by the homeowner next door. It really should be taught in
high schools: financing identical assets (or inferior assets with an extra
markup, in the case of McMansions) with a financing cost double that of the
general market is bound to end in disaster.
Investors in Germany, Japan and elsewhere fantasized that a Moody's or Standard
& Poor's AAA credit rating would magically improve the credit risk of a
blind pool of US home mortgages that were known to be in some way "subprime".
In such an environment, the concept of a "sophisticated" investor becomes
Regulators fantasized that banks "securitizing" their assets into separate
vehicles, while keeping the bottom tier of risk, were thereby improving their
capital ratios and rendering themselves sounder members of the global financial
community. The banks themselves fantasized that they could finance long-term
mortgage and other assets through issuing short-term commercial paper, without
any danger that the entire structure might collapse.
The perils of this structure had been demonstrated by the bankruptcy of Overend
& Gurney, which invested in a portfolio of long-term loans and equity
investments, financing it with short-term bank bills. But the Overend &
Gurney collapse happened in 1866 - did bankers learn anything at all over the
subsequent 140 years? Apparently not.
Finally, the credit default swap market was a triumph of unreality in all
directions. It involved fantasy that the appropriate contract payouts on a
bankruptcy could be calculated immediately through a Mickey Mouse auction
involving a thousandth of the CDS principal amount outstanding. It involved a
delusion by the dealers (and the somnolent bank and insurance company
regulators) that these highly lopsided contracts could be valued like interest
rate swaps, so that mismatches of trillions of dollars of principal amount
could be incurred while devoting only modest additional capital to the
And it involved a delusion by all participants in the market that creating a
gigantic gambling casino of this kind, with principal outstanding of 1.5 times
global gross domestic product, would in some way enable people to "manage"
credit risk, without creating bizarre upside-down incentives to push companies
and especially banks into bankruptcy.
Unlike most financial crashes, the collapse of 2008 did not inject reality into
the system, largely because of the global governmental response to it. The US
government injected $85 billion into AIG, thus protecting not only the innocent
holders of AIG insurance policies, but the entirely non-innocent and indeed
criminally culpable counterparties to AIG credit default swaps.
As has been widely noted, this injected a "too big to fail" protection into the
system (it had largely been there anyway since the 1984 Continental Illinois
bankruptcy). However, it also injected a "too unsound not to be subsidized"
protection through its bailout of AIG's credit default swap counterparties.
From now on, however foolish were a bank's bonus-driven creations of
economically catastrophic shell games, the system would be compelled to bail
them out. Indeed, the more foolish and catastrophic the new creation, the more
likely it would be to receive subsidy from unfortunate taxpayers.
It would have been much better to allow Goldman Sachs and the other major
counterparties to AIG credit default swaps to suffer the full losses, and then
send some random collection of CDS dealers and managers to jail for a couple of
decades or so, as was done after the Drexel Burnham and Enron collapses. If
criminally negligent civil engineering can result in jail sentences on the
collapse of a bridge or a building, so also should criminally negligent
financial engineering on the collapse of a bank.
As the bubble that has developed since March is showing, the bailout of the
world's financial system has stymied the normal bear-market correction
mechanism that restores reality to the markets. Further nonsense like the
declaration by the Federal Open Market Committee last Wednesday that "economic
conditions are likely to warrant exceptionally low levels of the federal funds
rate for an extended period" only encourages the unreality - if good quality
borrowers can borrow short-term at a cost well below the rate of inflation (let
alone the likely future rate of inflation), then fantasy continues to be
The Fed and the Bureau of Labor Statistics have managed for 14 years to avoid
reporting any inflationary effect from the perpetual loose money policy, but at
some stage the market itself may intervene and produce inflation that is too
rapid for the bureau to hide. That's probably the best hope; we cannot expect
help from policymakers, because voters are only dimly aware of the distortions
fantasy has brought and the costs to their own welfare it has imposed.
As an alternative, it's possible that the global commodity price boom will
eventually reach a level - perhaps $200 per barrel in the price of oil - at
which policymakers are forced by an enraged electorate to take action. Their
natural reaction would of course be to subsidize the retail price of gasoline,
but with a $1.5 trillion US budget deficit in the fiscal year that runs through
September 2010, that might prove to be a fiscal profligacy too far.
A third possibility is a crash in the bond markets, caused by a combination of
resurgent inflation and the deficits. No such correction is currently in sight,
but as we know they can arise very quickly.
A reality-based market seems almost like Nirvana. A market that punishes dodgy
accounting rather than rewarding it. A financial system that rewards savers
adequately. A capital market that selects only sound borrowers and rational
projects. A banking system that imposes no costs on taxpayers and treats even
its retail customers with respect and integrity.
It's a goal well worth striving for, and may well begin restoring US prosperity
when it arrives. But it will very likely require a horrendous period of
downturn and destruction before it can be attained, as the costs of fantasy
1. Pro forma financial statements provide data that reflect the world on an "as
if" basis, perhaps showing the balance sheet as if a debt issue under
consideration had already been issued.
Martin Hutchinson is the author of Great Conservatives (Academica
Press, 2005) - details can be found at www.greatconservatives.com.
(Republished with permission from PrudentBear.com.
Copyright 2005-2009 David W Tice & Associates.)