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March 2002

Why excuses hamper explanations





The US is in recession, or, at best, slowly coming out of it. As with all recessions, some things remain constant. First, company executives, bankers and investors generally don't want to admit there is a problem. They'll convince themselves that there's a new dynamic in the market that this time will make recession impossible, avoidable or at least short-lived. They'll hold off sacking people. They'll blame it on another sector of the market - in this case, they say, it started with the bursting of the tech bubble in April 2000 - and swear it won't affect them. And they'll refuse to take action to protect their companies, such as shoring up balance sheets, because they look back with nostalgia to the time when their stock prices were higher - two weeks ago, two months ago, six months ago...
Enron is simply a spectacular symptom of an economic and financial system in decline for nearly two years. Yet even now, few want to believe it. They want the 1990s back. They know it's unrealistic, they know the tech boom is unlikely to repeat itself, but they still remember the drug of the boom times.
The shock on the faces of the CNBC analysts reporting on the unexpected drop in consumer confidence data announced at the end of February is a case in point. The index dropped for the first time since November, yet an hour before the announcement CNBC commentators were proclaiming that they - and therefore we - should be feeling bullish on America.
These were the same commentators telling us to celebrate when stock markets finished ahead at the end of the first week of January because this meant they would be ahead at the end of 2002. No doubt many of the sponsors of CNBC would have been delighted to see its viewers pile back into the stock markets. Unfortunately, markets were in the red again by the end of the first month.
Worrying signs have been surfacing for three years now. Back in late 1999 Rite Aid went bankrupt in part because of accountancy issues. Xerox soon followed suit. The tech bubble proved to be just that - a bubble - but it and the attendant growth in the economy had lasted so long that other, non-tech, companies had jumped on the growth-stock bandwagon.
Commercial banks, desperate to shake off the shoddy performance of the 1980s and early 1990s, entered into headline-grabbing in-market mergers where cost-cutting provided most of the benefits for shareholders. Then they got cocky: they started predicting huge growth in underlying businesses as well, despite having no evidence to back it up. By 1999 the more acquisitive banks, such as Bank of America, First Union and Bank One, had failed to meet their unobtainable targets, took hits, and watched as the share price dropped.
Enron was just another company desperate to share in the success of the 1990s. And, following the advice so often given in bull markets, it leveraged its balance sheet, as many others did. Of course it leveraged its off-balance sheet as well, as quite a few others also did. It just happened to do it on a larger scale, way beyond its means, and somehow forgot to make this clear. But debt was irrelevant as long as stock prices stayed up. And the longer they stayed up, the more debt companies took on.
Leveraging up was, says Goldman Sachs's chief economist, Bill Dudley, "a rational response by companies to a less cyclical economy, characterized by us as the Brave New Business Cycle. But now that the expansion has ended, the dark side of that cycle is in evidence: credit availability has declined as banks have tightened their lending standards to businesses and credit spreads have widened."
During the long bull run, characterized by Dudley as March 1991 to March 2001, net non-financial corporate equity issuance was mostly negative as companies used cashflow and issued debt to buy back stock. That pushed up returns on equity, and since the market value of equities rose faster than the level of debt, the debt-equity ratio was pushed down.
But the proportion of debt to net worth increased, from below 50% in 1995 to nearly 60% in 2001, and with inflation so low, the real burden of debt is going down more slowly.
And let's not forget that the net worth figure for debt from the Federal Reserve does not include most of the off-balance-sheet vehicles used by companies in the 1990s.
All this is now unwinding, as is to be expected in a recession. Enron, aided by executives that members of the US Congress are happy to brand as crooks, just happens to be the largest casualty thus far. The worry is that Enron is now the excuse for all ills - not the economy, which most commentators feel, hope and pray is already turning around. And that raises the prospect of us looking in the wrong places for answers.
Some corporations are coming to their own conclusions. For example, global energy company AES has a new financing and business strategy, and it flies in the face of all that the US financial market has tried to instil in corporations for the past 10 years. On February 19 AES president and chief executive officer Dennis Bakke announced that his firm was seeking to restructure its balance sheet in such a way that it would not need to tap the capital markets for the foreseeable future. Instead it would rely on internally generated cashflows to fund operations.
The company will deleverage by selling assets at home and abroad. It will curtail planned capital spending in a number of construction projects already under way.
It's hardly the largest issuer of debt, raising just under $1.5 billion in the US in the past 18 months, as well as $300 million via its Brazilian subsidy, but this triple-B issuer taps the markets enough to warrant having a shelf registration programme. But not this year. It has chosen to reduce its dependence on uncertain financial markets and adopt what Bakke calls a more conservative business model.
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