From Irregular Credit to Entity Failure
by Richard D. Hastings
August 30, 2002
full text: financialsense.com
Corporate Governance, Accounting, and Necessary Causes
Insufficient discussion has taken place regarding the prevalence of poorly structured corporations in today’s uproar about corporate governance. Before continuing the assault on the individuals responsible for bad corporate leadership, more serious discussion needs to occur about the widespread acceptance of the badly structured corporations many of these persons led, and certainly some other companies we do not yet know who led them because their structural faults have yet to be discovered in a new public scandal. It was the degree of such acceptance--less during the 1980’s and then with no reservations during the 1990’s—that led to an unusual worsening of the size and risks of badly structured companies.
Poor corporate structure is an important, unexplored similarity between today’s crisis and the breakdown of the employment resource base during The Great Depression. This was particularly the case in late 1930 and in 1931 when the pace of business failures quickened, ruining the foundation of the employment base and triggering a massive contraction in aggregate demand. This article completely redirects the focus of analysis of this subject away from corporate governance as a reason for entity failure, and directs our attention to credit expansion and the role of non-viable corporate structures in cycles. The tendency of entity failure does play a role in whether a cyclical decline is brief or sustained. This again is the reverse of popular logic that typically says the inverse; that recessions cause firms to fail. This article vigorously rejects that line of thought as a fatal error of causative logic.
The argument is simple. It says that artificial credit expansion inevitably induces poorly structured firms to absorb (monetize) such credit, and that such firms eventually merge as the credit expansion continues (it usually does) and the outcome is entity failure and a decline in the employment base. Cycles result from this sequence. Today’s crisis takes place as we anxiously walk on the precipice of the future of the employment resource base.
This re-direction of emphasis is similar to the warnings issued in “Why Analysts Can’t Deliver”[ii] where it was strongly asserted in July 2001 that stock analysts were never the real problem; that accounting itself was the core of the developing crisis since stock analysts never had access to the information that mattered. Accountants did, and still do. It was not until Enron[iii], many months later, that accounting’s structural flaws became the subject of popular curiosity. Since Enron, accounting inefficiencies have exploded into a major crisis of historical dimensions without comparison in modern business history.[iv] We are today well into the most serious crisis in accounting since the mid-1400’s.[v]
In the same logic, the reasoning that points to the crisis of corporate governance as a necessary causative factor for entity failure distracts us from necessary causation. It is herein argued that the necessary cause regarding corporate structural collapse is found in the purpose of such entities. Poorly structured corporations are designed not to withstand cyclical events, but are designed exclusively and very efficiently to absorb irregular, artificially inflated monetary credit. Irregular credit—the primary necessary cause—occurs as a combination of i) poorly executed evaluations of credit grantor/customer risk in bank loan and securities capital markets, and ii) excess bank credit resulting from monetary interventions by central banks to increase the money supplies.
In this definition of entity failure, we may view poorly structured corporations as a partner in a wider system willing to move risk to entities unable to sustain such risk.
Good things happen when trade in contingent, risky, claims transfers risk towards those more willing and able to bear it and away from those less willing and able. At times, however, risk is traded to parties most willing but quite unable to bear it. This misallocation may reflect ignorance or dishonesty and fraud. When disorderly, illiquid markets prevail, the financial market system not only fails to allocate the unavoidable global risk efficiently, it creates additional, avoidable risk, through costly defaults and bankruptcies and unnecessary economic dislocation. (Buiter, Recession and Financial Crisis, April 2001)
Today, we witness many instances of misallocation, and this is critically relevant to the discussion of credit, credit granting, and liquidity. The discussion must focus, therefore, on the process of misallocation as an irregularity of credit. The popular focus upon human personality traits of corporate leaders must give way to a meaningful discussion about the breakdown in credit granting, how and why it has occurred today, and how this may support an eventual, sustained contraction in credit. Without this discussion, it will be nearly impossible to see that today’s financial crisis is typical and ordinary—regardless of its specific damages.
Not Very Long Ago and Not Very Far Away
There are numerous interesting similarities between 1929 and 2002. The most obvious are the stock market crises of 1929 and 2000-2002. And, like today, the autumn of 1929 found business conditions statistically satisfactory, making it all the more disconcerting the shock of The Great Crash. Today, there is a similar disconnect between evidently sound business conditions, satisfactory employment levels, and the stunning wealth destruction taking place in the equity markets. There has not recently occurred a one-day decline to the Dow Jones Industrial Average of more than 20%--such as what occurred on October 19,1987 when the DJIA declined by 22.6%, or the cumulative 30% collapse during The Great Crash of 1929. Instead, the equity markets in 2002 have lost more than $7 trillion in value since the NASDAQ Crash in April 2000. Not with a single crash, but with a dull relentlessness have stocks declined from their highest prices in early 2000, now surpassing the percentage losses of the legendary 1929 Crash.[ii]
Other similarities exist between then and today. These include:
◘ Central bank intervention to increase money supplies[iii]
◘ Changing relation of labor to productive output[iv]
◘ Consumer and wholesale price deflation
◘ Debt leverage
◘ Technological innovation
◘ Direct and indirect savings based upon stocks
◘ Wealth destruction from stock price declines
◘ Contraction of aggregate demand
One similarity is singularly interesting: the prevalence of poorly structured corporations, especially those performing significant amounts of intracompany trade (revenues from trade within a network of affiliated entities). In the late 1920’s, poor corporate structures occurred (notoriously) as holding companies. The structure of these entities was similar to the structure used in many leveraged buyouts of the 1980’s. At the top of the structure typically are holding companies. These typically issue debt securities to fund the merger and acquisition costs, and to receive upstream cash dividends from the subsidiary operating companies to pay for interest expense and debt principal retirement. Mega-mergers in the 1990’s had this feature, but broadened the purpose of the entity with significant leveraging of information technologies to deploy existing assets at carefully built customer profiles. The precision and power of mega-merger marketing and research efforts to build customer database profiles offset their brute exposure to induced change and external diseconomies—the outcome of firms so large and poorly planned that they are unable to escape the effects of their scale and impact.
AOL Time Warner's Example
AOL Time Warner is illustrative of a 1990’s mega-merger, conceived during the peak of the equities bubble in 2000, and legally effective on January 11, 2001—after business conditions had peaked and the recession had almost begun. AOL Time Warner was designed to leverage customer information, cross-sell related products to the same customers, and leverage the power of the means of delivery—something AOL Time Warner’s creators believe they controlled. It all sounds impressive, as we read from Part 1, Item I/Business, from AOL Time Warner’s Annual Report on Form 10-K for the fiscal year ended December 31, 2001:
The Company has undertaken a number of business initiatives to advance cross-divisional activities, including shared infrastructures and cross-promotions of the Company’s various businesses, and cross-divisional and cross-platform advertising and marketing opportunities for significant advertisers. The Company’s integrated Global Marketing Solutions Group develops individualized advertising programs through which major brands can reach customers over a combination of the Company’s print, television and Internet media. The Company expects to continue and expand such arrangements.
This naïve marketing plan helps to obscure a more challenging and brilliantly executed plan to sell stock, fund the merger and acquisition with bonds, and to build a corporate structure rich in transfers between affiliated entities—the essence of intracompany trade. In the Annual Report comments cited herein, the entire marketing device is based upon “initiatives to advance cross-divisional activities” and “cross-platform advertising.” These are the premises of intracompany commerce, when fair value is guess work and revenues for such trade is a poor substitute for normal trade with unaffiliated third-party entities. Intracompany trade, as I call it, is a major red flag. There is more.
These intercompany transactions are recorded by each segment at fair value as if the transactions were with third parties and, therefore, impact segment performance. While intercompany transactions are treated like third-party transactions to determine segment performance, the revenues (and corresponding expenses recognized by the segment that is counterparty to the transaction) are eliminated in consolidation and, therefore, do not themselves impact consolidated results. (AOL Time Warner, Form 10-Q, period ended March 31, 2002, page 32)
For the three months ended March 31, 2002, AOL Time Warner reported intracompany trade of $495 million. Although AOL says they eliminate intercompany segment revenues for reporting, this form of trade helped AOL report better consolidated EBITDA and gross profit margins in their fiscal year ended December 31, 2001. Regardless of any pronouncement by AOL Time Warner regarding its accounting, it is highly probable that the asset valuations of this firm are distorted by the fair value accounting used to recognize revenues in their intercompany segment transfers. If trade occurred with completely unaffiliated third parties, including ordinary bids and closes on price and terms, then we would have a better intuition of the market value of the firm’s assets after transaction occurred. The firm may disclose its revenue valuations for intercompany segment transfers, but the segments are given an asset value based upon internal estimates and not upon real market competition. It is not surprising that the firm recently reduced its goodwill valuation account by an historic $54 billion, and more asset write-downs are a certainty.
AOL Time Warner is today’s example of yesterday’s LBO, or yester-year’s “holding company.” If it is any consolation to AOL Time Warner executive officers, they can be certain that The Walt Disney Company media and entertainment conglomerate is in slightly less difficult condition. The Walt Disney Company conglomerate is yet just as much a business trying to manage itself instead of letting its many businesses focus on each precise customer market. Anyway you put it, this type of firm does a good job of issuing securities, absorbing monetary inflation, and doing business with itself. They often do a poor job of withstanding economic cycles and providing reliable information about their internal commerce. They are irregular in purpose, process, and outcome. They are unusually vulnerable to reverse leverage, an outcome of irregular credit that will be discussed in this article.
Irregular Credit and Psychology
Mega-mergers serve a purpose: to absorb irregular credit. Monetary inflation caused by central bank reductions to discount rates always result in artificially induced expansion of credit. Monetary inflation and artificial credit expansion tend to freeze consumer and producer prices, resulting in slower organic revenue growth and problems with organic profits. This is an important similarity to the early 1930’s when the employment base deteriorated in the aftermath of contracting aggregate demand and corporate failures. The response to the recession of 1920-1921 was to increase the money supplies, leading to the boom years of the 1920’s. One of the outcomes was a sharp increase in the number of poorly structured firms. In the 1920’s, holding companies were many and issued a huge amount of stock.
“Of the 573 active corporations with securities listed on The New York Stock Exchange in 1928, 92 were pure holding companies, 395 were holding and operating companies, and only 86 remained operating companies alone.” (Klein, Rainbow’s End, pg. 152).
With so many firms in the economy poorly structured and unable to withstand cyclical phenomena and discontinuous shocks, there was risk that labor would not find sufficient employment, thus weakening consumer liquidity and spending power. Although much is said today about consumer and market psychology, there are some brute facts to consider. These are:
1. Psychology matters when credit inflation occurs
2. Psychology seems dominant when credit inflation fails
3. Psychology does not matter when reverse leverage occurs
4. Reverse leverage requires numerical measures of liquidity—not sentiment or psychology
5. Debt contracts do not decline in value along with aggregate demand
6. Thus, liquidity is real in situations of reverse leverage, but illusory during credit and monetary inflation
Price deflation also contributes to financial losses, as firms become unable to pass along costs or obtain better prices on new purchase orders. As revenues stagnate because of monetary intervention, there is less strength to the outcome of central bank moves and the economy will eventually weaken despite lower interest rates.[ii] The longer and deeper the monetary intervention, the longer its reversal. It is interesting to observe that monetary intervention did occur in response to the severe recession of 1980-1981, while pent up demand after years of economic challenges in the 1970’s led to a normal expansion of demand and credit. The excess of this situation was never resolved by the recession of 1990, and the monetary intervention in 1992 was a doubling of the efforts of 1982—leading directly to an historic credit bubble in the 1990’s. The outcome was a record setting proliferation of international mega-mergers, and some of the most poorly built corporations ever conceived.
When the credit expansion is most aggressive, and mergers and acquisitions activity seems unusually robust, human psychology is finally engaged. At this point, rational levels of enthusiasm are exceeded and mass psychology is invoked. This was not what happened in early 2000, but it is precisely what happened in the early 1990’s when the money supplies expanded at a record pace.
The Advent of Intangibles Commerce
In the latter part of the 1980’s, trade between firms began to show significant difference between tangible trade and intangible trade. Sale-leaseback transactions and the increased occurrence of goodwill on balance sheets required new accounting rules. When internet and software commerce exploded in the early 1990’s, accounting, corporate structure, revenue and expense recognition, and credit granting were subjected to historic distortion. By the early 1990’s, trade in intangibles began to rival trade in goods. New types of entities were built to take advantage of the evolving commercial model.
Enron is an example of many things, but it is at its best an example of a firm unable to withstand any change. When oil and energy prices moved too much, too suddenly during 1999 and 2000, Enron was unable to manage the price and leverage risks. Yet Enron was in trouble long before its vanishing act in December 2001 as any conventional credit analysis will show.[ii] Enron went from being a decent energy utilities firm to being a poorly executed intangibles trading firm, with all of the debt leverage and intangible assets typical of this type of operation. Like AOL Time Warner, Enron was specialized in intangible commerce.
The mega merger mania of the 1990’s responded to new commercial realities with innovative corporate structures designed to take advantage of license and royalty revenues, product sales, and sometimes from the sales of derivative instruments. Enron was all of this—a multi-purpose firm that expanded far beyond its origins as an energy service provider to become a risk swapping, intracompany enigma doing significant amounts of affiliated intercompany commerce. Today, questions are being asked about certain advertising revenue transactions within AOL Time Warner. Ad revenues are again an instance of intangible commerce. As long as this type of company exists, there will be irregular transactions within its network of affiliates.
Collections, Reverse Leverage and The Viability of Firms
When credit is artificially inflated through money and discount rates, the credit granting process is corrupted. Prices quickly stagnate because of the higher amount of circulating currency, and firms must increase volume in order to make up for the lack of pricing power on new purchase orders. The combination of price stagnation plus volume pressure tends to make customer default risk analysis almost irrelevant. As these conditions worsen, firms tend to seek a higher volume of transactions on more complex terms that include volume discounts, rebates, and non-cash payments in the form of points, equity, or volume and price allowances.
It can be said about receivables and sales that a seller cannot collect on a sale made on credit terms until title and sometimes possession have passed to the customer. Contracts serve this purpose, and sales exist only if there is a contract. Even if the customer is distressed and collection is not assured, the sale is made and some degree of financial recovery is possible. Without a contractual agreement, however, nothing is convertible from the contract into currency. Thus, non-monetary assets must be converted into contracts before there can occur a conversion from monetary assets, such as receivables, into currency. Whether the collection is par for invoice-to-realized value (the collected amount), or highly distressed recoveries of less than 10% of invoice value, the contract has a range of value. That range and today’s securitization and secondary market encourage poorly conceived sales and contracts.
An excess of poorly conceived sales contracts, sales that collect slowly or below par invoice value, are directly connected to poorly structured businesses and the credit inflation that spawns them. When central banks, governments, and major commercial banks work together to intervene in business cycles—to prevent recessions—there occurs an increase in circulating money. This excess credit must be converted from circulating money into consumer goods and contracts—especially debt contracts. Stock is a debt contract—an amount owed by a firm to its shareholders. When excess credit is channeled into stock, as occurred after the Asian Crisis of 1998, then firms owe much more to shareholders, and savings in stock depends more than ever upon the viability of the firm. In the mid-1990s, dotcoms absorbed much capital while savings in stock—much of it issued by dotcom firms—increased significantly. The increase in savings was suddenly contingent upon the success and survival of many issuers. If they failed, then the savings foundation could be damaged. This is a very risky thing, given the historical precedent of the aftermath to The Great Crash.
When excess credit is funneled into unviable entities, the assets are usually of poor quality while the debt contracts remain firm in price until bankruptcy. When debt leverage reverses upon the firm under conditions of distress, it can cause a sudden collapse like what occurred at Enron during late 2001 or at Worldcom in July 2002. The collapse in the value of Enron common stock perfectly recognized Enron’s insolvency. Enron’s shares reached a high of $90.00 per share on August 23, 2000. On November 27, 20001, with the news out that a bankruptcy filing was being written, the shares traded down to $4.11 on volume of 69 million. The next day, Enron’s shares were completely dumped on volume of 345 million shares, ending the day at sixty-one cents per share. It was forgotten that a stock is an unprioritized debt contract, completely subordinated to most other claims, and usually worthless in the case of corporate failure.
With these kinds of dangers in place, it is easy to think that only psychology and irrational human nature could build savings in these risky objects. Yet the human attraction to numerical and special differences is significant, and sometimes reaches mass effects. If a yield spread seems numerically attractive, the simple numerical gain may render prudence and caution as unjustifiably neurotic and destructive. For this story, the truth is duller and more obvious: irregular credit builds stock prices just as much as it builds poor sales contracts and poorly structured corporations.
Contractual liabilities do not enjoy the constant adjustments of daily market trades in the way stock prices move. When revenues are based upon poorly conceived sales and credit, and cash flow shortfalls begin to occur, there is no simultaneous adjustment to debt contract prices. If business conditions deteriorate, the central banks may intervene by lowering the cost of borrowing (lowering the overnight rates and/or the discount rate). When this occurs too much over time, there are many firms left with a higher historical cost of capital. However, prices are often frozen because of the higher amount of credit in the system, and firms with high debt leverage are forced to reduce their purchase order contract prices in order to build a higher volume of cash flow. The outcome is usually lower quality of receivables and sales contracts.[ii] These are some of the foundation of reverse leverage.
Collections occur within a range of the debtor’s capacity to convert non-monetary assets into currency. This can only occur sufficiently if the debtor continues to exchange non-monetary assets into currency. If corporations are built from a series of mergers and acquisitions during a period of declining interest rates, there is risk that purchase order prices will weaken, and that growth rates may decline below the average borrowing rate of the firm—the dreaded reverse leverage. If contract quality is poor, and the corporate structure is poor (with high debt leverage), then the firm is exposed to the risks of entity failure due to reverse leverage and price deflation. To be sure, the Federal Reserve Bank has cut the discount rate aggressively since the recession of 1990-1991, with some slight increases during 1998-1999 that failed to reduce the money supply. Another reduction to the discount rate, down to 1.00%, would simply increase the risks of widespread reverse leverage rather than encouraging new rounds of business investment.
The Purpose of Poor Corporate Leaders
Gailbraith, in The Great Crash 1929, cited “the bad corporate structure” as second among five weaknesses that he believes led to The Great Crash. Gailbraith found it difficult to determine the few necessary causes of the Crash because there seemed to him so many causative factors to choose from. If enough large firms are not viable, then there is risk of higher unemployment and, following the logic of the preceding section on Irregular Credit and Psychology, then it is logical to conclude that poor structures lead to failures that lead to higher unemployment and later on, lower aggregate demand.
Irregular credit always requires irregular corporate structures and irregular lending systems. One requires the other. This irregularity is common among today’s crisis and that of 1929. The stock market decline that started in April 2000 is associated with a widespread awareness that corporate viability is not dependable—and that stocks are worthless if the firm fails (unless you are Wilbur Ross or Michael Price). The bankruptcies of Enron and Kmart, record-setting in their own way only six months ago, are today superceded by larger corporate failures at Global Crossing, Adelphia, and the largest U.S. bankruptcy ever at Worldcom in July 2002—a bankruptcy that includes a multi-billion dollar pathetic and hilariously simple accounting hoax. Amidst all of this is the recent indictment of former Rite Aid Corp. executive officers for allegedly concocting one of the biggest corporate frauds in U.S. history.
It is no wonder that so much attention goes to the subject of poor corporate governance instead of poor corporate structure and irregular credit. Ludwig von Mises talks of a “misdirecting of entrepreneurial activity” that occurs during periods of governmental intervention to prevent business cycles. Obviously, a down cycle can help kick out a ruling government anywhere, as it did to the former President George H.W. Bush in 1992. So, it is no wonder that the government, through it quasi-agency central bank, will intervene to make things appear satisfactory, thus preventing the important and necessary liquidation of non-viable firms, along with preventing faster collection of and write down of bad loans.
If the crisis were ruthlessly permitted to run its course, bringing about the destruction of enterprises which were unable to meet their obligations, then all entrepreneurs-not only banks but also other businessmen-would exhibit more caution in granting and using credit in the future. Instead, public opinion approves of giving assistance in the crisis. Then, no sooner is the worst over, than the banks are spurred on to a new expansion of circulation credit. (Mises, On the Manipulation of Money and Credit, pg 150)
Poorly structured entities, during the height of the panic in 1931, were unable to collect enough currency from operations to pay for their own contractual liabilities, thus ending their role in the circular flow of resources, products, households and businesses. However, reverse leverage that came from price deflation and cash flow insufficiencies—and the negative debt service and debt defaults that helped crack the banking sector in 1931—all played a role in the breakdown of the employment and consumption foundations. Households found fewer employment resources as more and more companies failed. Investors found their savings portfolios destabilized and damaged as stock investments into poorly structured entities declined to near-zero and, as was the case very often in the early 1930’s, many stock issuers simply disappeared and their equities were cancelled with zero recovery.
Under those trying circumstances, it was inevitable that aggregate demand contracted and consumption declined sharply from its previous levels. In today’s crisis, there is the risk that another round of interest rate cuts will be quickly monetized into stock purchases by financial institutions, and by purchases of installment credit-based commodities such as homes and automobiles. Regulators do ignore the facts that lowering the cost of capital deflates consumer and producer prices and that the credit expansion will trigger a more widespread deflation—making it tougher for firms to make sufficient cash flow form ordinary, organic operations going forward. Many firms dependent upon installment credit sales already pay for some of the financing cost since it is impossible to ask higher prices from consumers—another drain on profits. Credit inflation only worsens this trend, and reduces available cash flow for investment and debt repayment, thus weakening firms and the employment resource base.
This threat is worsened if consumers and institutions begin to re-assess their measurements of liquidity. Just as lower interest rates stimulate a certain round of purchases and some moderate degree of investment, there is an offsetting decline in the rate of savings, thus triggering more problems for consumers who are trying to balance life style, retirement planning, and liquidity over a lengthy period. This represents a threat to aggregate demand since the best way to save will ultimately come from less spending.
Firms that are poorly structured are typically poorly positioned to withstand this risk. Just as Enron was completely unable to withstand the effects of changing demand and price factors for energy, too many firms today are built expressly to absorb excess credit and will have significant difficulty if aggregate demand declines for a sustained period. Mega-mergers are a symptom of credit inflation. Their failure is part of the cure.
If credit expansion leads to poorly structured companies, and their failure is an expected outcome, then the type of corporate leader best suited to govern unviable firms will have the best aptitude for credit and capital markets. In this drama, the need to sell business plans to capital markets is equally played out by financial officers as well as chief executive officers, thus expanding the sense that nothing is wrong since it would seem not possible for a chief financial officer to be as deceitful as a corporate CEO. Instead, poorly structured firms sometimes need the most aggressive and clever persons in charge of financial matters in order to best sell unviable business plans. During periods of irregular credit, and where poorly structured corporation prevail, it takes equally irregular personnel to make the best of a bad situation.
© 2002 Richard D. Hastings |
