Loose Ends


A Housing Crash Will Soon Hit America

If you go into what I call a bubble boom, every bubble bursts.

- Margaret Thatcher

by Christopher Ruddy

Successful investor Sir John Templeton warns of the looming Baby Boomer crisis that is about to devastate Europe and the United States in the next few years.  In the US alone, 77 million boomers are about to retire - and they will wreak havoc on Social Security, private pension systems and the health care system.  Economists know they will force a massive equity sell-off to pay for these benefits - a sell-off that will create a long-term market decline in the US.

Already Alan Greenspan has issued a serious warning.  He said, "Our country will face abrupt and painful choices unless Congress acts quickly to trim Social Security and Medicare benefits for the baby boom generation.  Government resources, even under the most optimistic economic assumptions of growth and productivity, will be inadequate to provide baby boomers with the level of benefits their parents got."

Simply put, Greenspan is warning us in his diplomatic, make-no-enemies way that America IS going broke.  Templeton knows it's true, and so does Warren Buffett, Paul Volcker and other leading financial giants.

Source: newsmax.com Feb 2005

Are Taxpayers About to Bailout the Hedge Funds?

by Dean Baker

The media seem to be saying that this is the financial markets' expectation now that Fannie Mae and Freddie Mac might loosen some of their lending restrictions.  Fannie and Freddie are implicitly backed up by the government.  The business press reported (see the Post for example) that the stock market jumped yesterday on reports that they would loosen restrictions and buy up subprime and jumbo loans that previously would have been excluded from their portfolios.

I would question whether even Fannie and Freddie (with our tax dollars) can support the housing bubble in the long-run, although a few trillion dollars can certainly slow the collapse.  It can also give the smart money enough time to unload their positions.

It would be nice to see a bit of analysis of the implications of the sort of intervention that Fannie and Freddie might undertake.  Given that we are having a huge debate on whether we can spend another $10 billion a year to provide health insurance to kids, the public would probably be interested in knowing how many trillions Fannie and Freddie might put at risk in an effort to sustain the housing bubble.

Source: prospect.org Beat the Press 7 August 2007

The Implications of Kelo

An Assault on Personal Liberty?

Susette Kelo's 1893 New London cottage with part of Pfizer's Global Research & Development Facility
looming in the background.  Source: cottagecoalition.org

by Paul Craig Roberts

Kelo does not mean the end of private property per se, but it does mean the end of anyone’s secure possession, be the owner an individual or a corporation.  To the extent that Americans still possess constitutional rights, Kelo could mean their end as well.  In 1981 General Motors used eminent domain against the Detroit ethnic suburb of Poletown.  To make space for a GM assembly plant, 1,400 homes, 140 businesses, and several churches were destroyed.  Today the exemplar of this practice is Wal-Mart.  What if Poletown had been a Chrysler plant that GM wanted to eliminate as a competitor?  Under the Kelo ruling, if GM could show that its cars are more successful and produce higher taxable profits than Chrysler’s, and the eminent domain authority is not in Chrysler’s pocket, GM could prevail.

Today, Toyota, for example, could seek to condemn Ford’s River Rouge plant, which is known to be largely obsolete, in order to obtain the site for its own economic use.  There appears to be nothing in Kelo to prevent this outcome.

Note some of the implications: According to economic theory, monopoly profits are higher than competitive profits.  Kelo becomes a way to get around anti-trust laws and increase concentration in the name of public benefit.  Libertarians might be tempted to welcome the demise of anti-trust, as they see it as government intrusion, but not if they consider Kelo’s public choice aspects.  Kelo opens up new channels of rent-seeking that enhance government power.

Consider, for example, Justice Souter’s New Hampshire property, which Kelo opponents gleefully note may be lost to the justice as a result of his vote.  A hotel wants the property and can produce higher revenues for the community.  But which hotel gets the property?  Hilton?  Hyatt?  That decision rests with the enlightened insight of the eminent domain authority.  As it is up to government to determine ownership, many considerations regardless of fact can determine the outcome.

Kelo could introduce new instability into share prices and financial markets as analysts factor into share prices the risks of firms being Keloed by competitors.  With Kelo, eminent domain could be used to condemn cigarette companies on the strength of the argument that the product produces more societal costs than are covered by tax revenues from tobacco products.  Producers of alcohol products could find themselves Keloed as could gun manufacturers.  Indeed, Kelo’s public benefit concept of eminent domain could be used to condemn privately owned firearms.  The Second Amendment would still be there.  We would have a right to firearms in the abstract just as we have a right to property in the abstract, but every specific right can be condemned.

Did the 5 justices who inflicted this calamity intend the implications of their ruling or are these implications the unintended consequences of a thoughtless decision?

While left and right engage in combat over Judge Roberts’ nomination to the Supreme Court and Roe versus Wade, more far-reaching issues go unattended.  Left and right think control over court appointments is a life and death matter, but no matter who is appointed, the trend is always more power concentrated in government and more erosion of constitutional protections and civil liberties.  Is abortion really more important than habeas corpus, the attorney-client privilege, and the prohibitions against crime without intent, ex post facto laws, and self-incrimination?

It is astonishing that no bar association, no political party, no politician, no organised interest group, and no columnist or reporter ever asks a court nominee’s position on the legal principles, achieved over 8 centuries of struggle, that make law a shield of the innocent instead of a weapon in the hands of government.

A country that so consistently neglects the basic foundations of liberty will not remain free.

Paul Craig Roberts has held a number of academic appointments and has contributed to numerous scholarly publications.  He served as Assistant Secretary of the Treasury in the Reagan administration.  His graduate economics education was at the University of Virginia, the University of California at Berkeley, and Oxford University.  He is coauthor of The Tyranny of Good Intentions.  He can be reached at: paulcraigroberts@yahoo.com

Source: counterpunch.org 5 August 2005

While I think Roberts goes much too far, I am disappointed in the Kelo ruling because it means one more instance of "might makes right".  If someone had owned a home for decades - far longer than the rules have been in force, it seems wrong that that home can be taken away and destroyed.  It underscores the lack of certainty in any area of endeavour.

A Critique of Jared Diamond

Date: Fri, 29 Jul 2005 16:46:06 -0400
From: Cody Hatch <cody.hatch@gmail.com>
Reply-To: cody@chaos.net.nz
To: Ruth Hatch <ruth@chaos.net.nz>

On 7/29/05, Ruth Hatch <ruth@chaos.net.nz> wrote:

> You may not feel reading this is worth the effort - it is a well-done praise, then blasting of Jared Diamond and a fairly-well-presented admonishment not to only look at the down side of human progress however, nothing new is presented.  See lrb.co.uk/v27/n10/dasg01_.html

Yes, interesting.  Read the whole thing.  I agree overall, assuming that his representation of Diamond is accurate - and from what I've heard elsewhere, he's probably being much too kind.  The point about wealth versus GDP being the correct way to measure how well a society is doing is rather debatable, but ultimately doesn't matter.  The important bit is to make sure you're fully "costing" human activities; wealth per capita may or may not be the "perfect" measure but it is good enough.

I'm also rather more optimistic than he is - he notes that wealth in the rich world plus China has increased using current measures, but expresses doubt that it would have been found to do so using better measurements.  For my part, I suspect we'd still find that major chunks of the world are still growing wealthier.  For example, I believe that the environment in the US is far better today than it was in past decades.

Either way, he's right that the tools to measure and debate past and future policies exist.

Cody Hatch cody@chaos.net.nz     chaos.net.nz
"A society that puts equality...ahead of freedom will end up with neither equality nor freedom." - Milton Friedman

The Reliability of Corporate Financial Statements

"New" Enron logos
Sources: richter.colorado.edu    nanosite.com    westermayer.de

Recent financial statements of several large well-known corporations - Enron, Global Crossing, WorldCom, Adelphia, Rite Aid and others – have required significant changes after being published.  Does this indicate that accounting rules are inadequate?  That rules were not being followed and auditors not doing their jobs?  Were the corporations badly governed?  Why have so many problems surfaced in the past few years and are they truly widespread?  How do problems today compare with those in the past?

There are many members of an audit chain that have duties to perform, including the board of directors, independent auditors, and state and federal regulators.  In times past, companies traditionally used historical cost models of accounting.  Although economic values would have been more useful than historical costs, those amounts were considered difficult to measure and verify, so only known figures were used.  Nonetheless, it has never been possible to completely eliminate manipulation of these (or any other) figures.

The Securities Exchange Act of 1934 stated that corporations with at least $10 million in assets and at least 500 shareholders must file quarterly returns with the Commission that followed generally accepted accounting principles and were audited by a registered public accounting firm.  The Act was passed in response to multitudinous complaints about dishonest and deceptive accounting practices.  It was seen as a big step forward.

Unfortunately, no rules can eliminate all opportunities for deceit: over the years, various scandals led to changes in the Act.  Finally, the Financial Accounting Standards Board was created in 1973 to control the practices used by accountants and auditors.  As a result, from that point the trend has been to report current values for assets rather than the sometimes irrelevant historical costs.  Current values are theoretically quoted market prices but that value is often determined from models for assets not actively traded.  Thus, inevitably, corporate balance sheets have become patchworks of historical values, current values and fair (estimated) values.  Do they still best reflect to potential investors how managers have been managing the company's resources?

The Financial Accounting Standards Board's move toward a non-market-based system of fair value accounting has caused many investors concern as it appears to make financial statements less, rather than more, useful.  In case after case, it appears that fair value accounting is not based on reliable market prices and has been abused by managers to create many of the recent misleading financial reports.

One of the main purposes of financial reports is to motivate managers to operate their companies in the interests of the shareholders.  Further, investors wish to determine the possible value of their investment in the future.  Managers consequently are pressured to misstate figures.  That's where auditors come in.  For a given reporting period, net income or loss is the difference between the beginning period values and ending period values; this means, in an ideal world, that economic values, rather than historical values, should be more relevant.  Rather than using historical values as in the past, market values are now used when available and estimated "fair values" are used when not.

Here's the rub: a fair value is a guess about how much an asset could be exchanged for (but has not been) or how much a liability might be settled for.  Financial statements based on estimates will have varying degrees of reliability.  But historically accurate numbers are not considered relevant in a rapidly-changing market.  What to do?

To solve this problem, investors often look to sources of information other than the company's financial statements.  Measuring the value of a company's tangible assets is difficult and subjective and the models used change over time.  Intangible assets - comprising the worth of a company over and above the net value of tangible assets - are even more difficult to value.  Managers who want to do well in a particular accounting period can (and do) raise the fair value of a few assets.  This results in a bigger net income for the company.  Managers can (and often do) work backward toward the numbers that they want and then provide a rationale that is difficult for an auditor to refute.  Later, managers can argue that "conditions changed" (as they inevitably will).

Audited statements at least can force a consistency from year-to-year, allowing periodic changes in wealth to be estimated with a degree of accuracy, and allowing trends to be identified.  (Are inventories getting larger or smaller?  Are sales growing or shrinking?  Are profit margins changing?)  In addition, variations of actual figures from those which were estimated can be discovered by an analysis of past statements (especially in the areas of write-offs and employee layoffs).  Thus, an idea of past statements' accuracy can often be determined.

Areas of concern in accounting are: "When, exactly, can a sale be said to be completed?" (some sales are recorded as completed which, in fact, take place much later or not at all) and "Is this transaction completely at arm's-length?" (some transactions are merely agreements between companies to exchange goods - often called "sham sales" - to make both look better).  Additionally, sometimes the sale or revaluation of a company asset is intermingled with the sale of its inventory.  Unless auditors can prove that one or more of these events have occurred, they have no option but to accept the transaction as valid.  Managers can also use alternative accrual procedures and the timing of transactions to alter the reporting of income and expenses.  However, these variations naturally smooth out over time.  Thus, the best protection for investors is the requirement that new statements must be consistent with earlier statements unless differences are noted and explained.  And so, analyzing multiple statements becomes important for investors.

Unfortunately, auditors are often under pressure from some managers to overlook or misrepresent a company’s poor performance.  If the auditor refuses, the client may go to another firm whose accountants are more compliant.

The bankruptcy of Enron in 2002 (and the ultimate destruction of their long-time auditor, Arthur Andersen), was a watershed event that generated substantial concern about the inadequacies of generally accepted practices and standards and culminated in the enactment of the Sarbanes-Oxley Act of 2002.  The Sarbanes-Oxley Act is the most sweeping regulation of accounting since the 1930s.

Enron avoided reporting losses on substantial investments through loopholes called "special-purpose entities" (SPE).  They compounded their use of this loophole with several violations.  For example, Enron controlled some SPEs but treated them as if they were independent entities.  It funded some with its own stock, taking notes receivable in return.  Several SPEs paid Enron fees for guaranteeing them bank loans - fees which should have been spread over the life of the loan, but were all recorded up front.  The SPEs sold back to Enron assets they supposedly had purchased, allowing Enron to report phony profits.  Finally, Enron transferred assets to subsidiaries, exchanged nonvoting stock in those subsidiaries to SPEs in exchange for money that the SPEs borrowed, and swapped rights to the cash flow from those assets for an obligation to pay the bank loan.  This allowed Enron to keep its assets, borrow funds from banks, record the transactions as sales and not record the debt.

Generally, Enron's failure resulted from violations, not loopholes.  (That, essentially, is why Arthur Andersen also failed.)  One change to fair practice rules does appear to be needed: fair values should not be included in financial statements unless they can clearly be shown to be based on trustworthy numbers determined by arm's-length transactions.

Most recent accounting problems, statement re-statements, and (often) subsequent bankruptcies also appear due to violations, not loopholes.  These include fictitious sales, booking sales up front that actually occurred over a long period, sending out unordered goods but recording this as a sale, making sales subject to unenforceable side agreements, misclassification of gains as revenue, extending amortizations beyond normal periods, understating bad debt, over-counting inventory, understating future employee benefits due, et cetera.  The underlying causes of such practices are often weak boards of directors.  Most violations involve fictitious or premature revenue, overstated or misappropriated assets and understated expenses - all of which should be detectable by an auditor.  While the officers of the companies involved are often fined, penalized, or even jailed, their auditors rarely have actions taken against individuals.  Consequently, it might help if individual auditors who knowingly violate the rules are routinely punished.

The Sarbanes-Oxley Act of 2002 now requires disclosure of all material off-balance sheet transactions that may affect the company's financial condition now or in the future.  But many think the Act does not go far enough.  It does not require corporations to expense stock options granted to executives - theoretically because options cannot be readily valued, though it is clear that they have an economic cost which the company will have to meet - which to be consistent should be charged against revenue in the same period that the revenue, presumably generated by that employee, is reported (and not when the options vest).  Further, more pressure should be brought to bear on those people (directors, auditors and regulators) who were meant to enforce the rules but didn't.

It is boards of directors who approve the granting of senior management compensation based on performance.  This gives senior management a very strong inventive to do whatever they can to make their balance sheets look good.  The new Act requires that all members of the board’s audit committee be independent directors.  This means they are not employees of the company nor of its auditors and have not been an employee of same for at least the preceding five years.

Law changes in the mid-90s made it more difficult for investors to sue public firms for accounting abuses.  Perhaps this is what encouraged accounting firms to balance their lowered risk of being sued by the higher audit fees they found they could charge for deliberately cursory audits.  Auditors’ salaries and bonuses depend on how much business they bring in.  Further, their liability costs may be covered by insurance.  They have considerable incentive to give in to the demands of their clients.  If they do not, if they are responsible for losing a client, they may lose some of their personal income or risk their next promotion.  Misstatements are likely to not be discovered.  If they are discovered, they may be blamed on accident or on a genuine misunderstanding.

The major audit firms also offer consulting services.  Auditors often feared losing substantial consulting fees from the clients they audited.  Thus, the Act has made it unlawful for a public accounting firm to provide virtually any consulting services to the companies it audits.

As to the regulatory bodies for auditors: they rarely take disciplinary action or publicly disclose the results of their investigations.  The bodies have not been effective, in part because the remedial measures they can take are limited to expelling the offender from their membership rolls.  State agencies are under-funded and understaffed and consequently have performed little better.  The new Act has established an independent oversight board that reports to the SEC.  This board has the power to impose fees on offending corporations.  It will set standards, regulate ethics, register accounting firms, and conduct investigations and disciplinary hearings.  It is hoped that this will prove successful, though it is generally accepted that it will prove costly to shareholders.

The future will determine the extent of the Act’s improvements in the current situation.

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