RateWatch #313 - Street Crime - as in Wall Street

July 20, 2002
By Dick Lepre
DickLepre@rpm-mtg.com

What's Happening

The technical picture, which had been a bit murky lately (at least to me) is clarifying. Listen closely (well read closely): the technicals as espoused by StoMaster are giving every indication that we are going to have a very substantial event. This is likely to consist of another big sell-off on equities and a spike upward in Treasury prices with a drop in rates, but this spike will be brief,
very brief. Somewhere between one day to one week.  The Dow may sell down right through 8000 and the 30-year Treasury price could gain 2 points.  You read it hear first.

Street Crime

As one scandal after another hits Wall Street it is difficult to keep perspective.  Let's try anyway.

The background for much of this is the fantastic gains that equity markets made in the '90's.  This is the perfect environment for "funny stuff."  That, coupled with a public more gullible than its historical average and perhaps more greedy than usual created an environment rich for fraud.  When stocks fall in price, these sins surface as the substance of lawsuits.

There are two decidedly different sets of these accounting scandals. One is the outright fraud.  Enron, WorldCom, Adelphia, and Global Crossing may be a lot to be happening at the same  time but such things are a) rare and b) inevitable. These are things that have always happened and will continue to happen.

While raising the penalties (sentences) for those caught might act as a deterrent I have to believe that a lot of folks are going to risk ten years at a minimum security prison if the reward is tens of millions of dollars.  Eglin Air Force Base (AKA Club Fed) is not exactly San Quentin.  Fraud will always occur. It will occur most often when times are good and the pickings are easy.  It was nice of President Bush to talk about harsh penalties for miscreants but let's face it, investor confidence is not built on the concept of "Don't worry, if you get ripped off the guilty will go to jail."  That might fly with street crimes but not if the street is Wall Street.

In fact, for those of you youngsters who do not recall it, the best one of these was called Equity Funding.  Equity Funding is a good starting place for understanding the present scandals because it served to use the weaknesses of auditors against then.  It also had, as its root, a common thread with many of the present-day scandals - the need to maintain an inflated stock price.  Rather than give a brief accounting of the Equity Funding story it would be best if you read this excellent
article: http://home.nycap.rr.com/dhancox/articles/equity.htm

My proposition is that while such frauds will always occur there is another thing happening that needs to be addressed.  That is "legal book cooking."  Some examples of legal book cooking are Merck and IBM.  What Merck and IBM do is, in all likelihood, legal and in keeping wit GAAP
but it is highly doubtful that this benefits shareholders - in the long run.

The problem here is really quite simple.  Everyone works for the shareholders.  If the executives are directing the accountants so as to maximize their short-term gains against the interest of shareholders then they should be replaced.  It matters not whether they are sent to jail or merely fired.  Corporate accounting should reveal the truest possible picture of shareholder value.  Ultimately, the only thing that determines the value of a stock (long-term) is its future cash flow.
Obfuscation, for short-term gain, of details that would enable an investor to determine that information is what led to the present mess.

There is a lot of blame to go around:  stockholders who were not really investors but just greedy people are the base of the problem. Add in Wall Streeters eager sell them stocks, which no reasonable analyst though had a chance of maintaining value, corporate executives, and auditors and the circus is complete.  Corporations would be better served if they all had real boards of directors.  A board of directors should have little overlap with management.  They should not be buddies.  The board serves the interest of shareholders and should tell management what to do.  They are like Congress.  Granted, Congressmen may look pretty silly at times but they certainly are good at challenging the nation's CEO, especially if they are from the other party.  Stockholders need to do a better job of getting control of the board from management.

In reality it is unreasonable to expect the average investor to be able to read a corporate quarterly report and determine the value of a stock. They need help from: the corporate board of directors, management and the auditors. They need help from Wall Street professionals and from mutual fund managers.  It is not impossible to produce a clear, understandable picture.  The master of this is Warren Buffet.  A corporation can actually issue a clear, meaningful report, see:
http://www.berkshirehathaway.com/1998ar/table98.html

Also, read the reports for 2001 at http://www.berkshirehathaway.com/2001ar/table01.html

Read both of these and you will see a rosy report behind a good year and an honest report about the effect of not taking a 9/11 event into account in the reinsurance business.

The truth is out there.  Unfortunately it does not get as much attention as the BS.

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