As with the explosion of household mortgage debt, the Fed had no trouble remaining oblivious to the soaring business debt which underpinned these financial engineering ploys, maneuvers, and outright scams. As the latter mushroomed throughout the corporate world, the stock averages rose mightily, and that was the main thing. After all, the purpose of stock market levitation was to induce households to spend because they felt richer, whether they actually were or not.
Not surprisingly, financial TV happily parroted the Wall Street shibboleth that massive corporate spending for buybacks and M&A on the floor of the New York Stock Exchange proved American business leaders were bullish on the future. What it actually proved, however, was that runaway financial engineering was generating unheard of levels of Wall Street profitability from speculative trading and transaction fees and finance. In 2007, for example, global M&A fees alone reached $50 billion, compared to an average of $20 billion per year during 2002–2004. And this was a tiny tip of the iceberg.
Not surprisingly, the Fed’s meeting minutes from 2007 do not evince even a hint of worry that the surging stock market averages were being “bought” by means of massive cash and equity extraction from the balance sheets of American business. Nor was there any recognition that the deluge of financial engineering transactions was reaching a truly freakish extreme.
For example, as recently as 2005, M&A deals in the United States had totaled about $1 trillion and at that point represented an all-time record. Yet during the second quarter of 2007, the annualized run rate of M&A deals hit nearly $3 trillion. At the same time, prices paid for new deals were soaring.
Takeover premiums thus reached an all-time high of 60 percent compared to a traditional norm of 25–30 percent, while purchase multiples literally flew off the charts. Compared to a traditional ratio of total enterprise value to EBITDA of five to six times, the average purchase multiple during the mid-2007 deal frenzy exceeded eleven times EBITDA.
During the same quarter, new LBOs clocked in at an $800 billion run rate, four times higher than a few years earlier. And in the third quarter of 2007, stock buybacks shot the moon, hitting a run rate of $1 trillion annualized. That compared to $300 billion per year as recently as 2004, which at the time was considered robust.
These trends in the aggregate volume of financial engineering transactions were truly an aberration. Yet they did not trouble the nation’s monetary central planners because all three variations were rationalized as representing the free will of the free market.
This proposition had been stoutly embraced by the supreme voice of monetary authority, Chairman Greenspan, and had become catechism in the Eccles Building. Indeed, over the years the maestro had continuously lent his imprimatur to this deal mania, praising it as evidence of a robust market for corporate control.
Buyouts, buybacks, and takeovers, Greenspan explained, all embodied the free market at work, recycling capital and other business resources to higher and better uses. In so doing, he claimed, this energetic market for corporate control endowed the US economy with unparalleled flexibility and capacity for self-renewal, a dynamism largely unavailable to its competitors elsewhere in the developed world.
As in so much else, Greenspan was right in theory but failed to recognize that free markets go haywire when inundated with unsound money and central bank manipulation of key financial prices, like interest rates and stock indices. Accordingly, the idealized financial market which Greenspan envisioned may have existed once upon a time, but had long since disappeared. Its demise was owing to the post-1971 rise of printing-press money and, especially, the Wall Street–coddling version of monetary central planning that, ironically, the maestro had himself fashioned during his long tenure as chairman of the Fed.
PROOF OF DEFORMATION:
GENERAL ELECTRIC’S AAA TOWER OF DEBT
The evidence that Greenspan’s idealized markets were actually vast financial deformations was in plain sight in the case of General Electric, whose CEO sat on the prestigious advisory board of the New York Fed in good crony capitalist fashion. Had CEO Jeff Immelt only been asked to describe GE’s financial engineering binge, it might have given pause even to the money printers.
For much of his nineteen years at the helm, Jack Welch had conned Wall Street into embracing the financially impossible; namely, that GE’s mammoth, highly cyclical, globe-spanning businesses could generate clocklike growth of “operating profit,” hitting the company’s guidance to the penny.
These monotonously (and comically) reliable gains came straight from the accounting cookie jar, but at least under Welch they were profits that GE had earned the old-fashioned way: out of fanatical cost discipline, product innovation, and aggressive marketing. The cookie jar didn’t invent profits, it just shuffled and smoothed them among the quarters, as needed.
But after Welch’s retirement, General Electric had gone all-in for financial engineering of a less innocent type. Between early 2000 and early 2008, its total debt doubled from $400 billion to $800 billion, and most of this had gone into stock buybacks, M&A deals, and purchase of both operating and financial assets at rates which were self-evidently unsustainable.
Its fevered borrowings were not hidden from either investors or the authorities, or the ratings agencies. According to its SEC filings, GE’s balance sheet grew by $100 billion just in fiscal 2007, or by 19 percent. And the smoking gun was plain to see. Only $4 billion of this sizzling growth had been funded by equity; $81 billion was attributable to new debt and the balance to sundry other fixed liabilities.
Something was rotten in Denmark when the nation’s top blue chip AAA-rated credit was expanding aggressively on 96 percent leverage, and resorting to balance sheet contortions to feed the stock market with a rising quotient of engineered EPS. Yet the Fed blithely persevered in its prosperity management gig, coaxing the stock averages higher through mid-2007 in an attempt to perk up GDP growth with more of its wealth-effect elixir.
THE “EARNINGS EX-ITEMS” SMOKE SCREEN
One of the reasons that the monetary politburo was unconcerned about the blatant buying of earnings through financial engineering is that it fully subscribed to the gussied-up version of EPS peddled by Wall Street. The latter was known as “operating earnings” or “earning ex-items,” and it was derived by removing from the GAAP (generally accepted accounting principles)-based financial statements filed with the SEC any and all items which could be characterized as “one-time” or “nonrecurring.”
These adjustments included asset write-downs, goodwill write-offs, and most especially “restructuring” charges to cover the cost of head-count reductions, including severance payments. Needless to say, in an environment in which labor was expensive and debt was cheap, successive waves of corporate downsizings could be undertaken without the inconvenience of a pox on earnings due to severance costs; these charges were “one time” and to be ignored by investors.
Likewise, there was no problem with the high failure rate of M&A deals. In due course, dumb investments could be written off and the resulting losses wouldn’t “count” in earnings ex-items.
In short, Wall Street’s institutionalized fiddle of GAAP earnings made PE multiples appear far lower than they actually were, and thereby helped perpetuate the myth that the market was “cheap” during the second Greenspan stock market bubble. Thus, as the S&P 500 index reached its nosebleed peaks around 1,500 in mid-2007, Wall Street urged investors not to worry because the PE multiple was within its historic range.
In fact, the 500 S&P companies recorded net income ex-items of $730 billion in 2007 relative to an average market cap during the year of $13 trillion. The implied PE multiple of 18X was not over the top, but then it wasn’t on the level, either. The S&P 500 actually reported GAAP net income that year of only $587 billion, a figure that was 20 percent lower owing to the exclusion of $144 billion of charges and expenses that were deemed “nonrecurring.” The actual PE multiple on GAAP net income was 22X, however, and that was expensive by
any historic standard, and especially at the very top of the business cycle.
During 2008 came the real proof of the pudding. Corporations took a staggering $304 billion in write-downs for assets which were drastically overvalued and business operations which were hopelessly unprofitable. Accordingly, reported GAAP net income for the S&P 500 plunged to just $132 billion, meaning that during the course of the year the average market cap of $10 trillion represented 77X net income.
To be sure, after the financial crisis cooled off the span narrowed considerably between GAAP legal earnings and the Wall Street “ex-items” rendition of profits, and not surprisingly in light of how much was thrown into the kitchen sink in the fourth quarter of 2008. Even after this alleged house cleaning, however, more than $100 billion of charges and expenses were excluded from Wall Street’s reckoning of the presumptively “clean” S&P earnings reported for both 2009 and 2010.
So, if the four years are taken as a whole, the scam is readily evident. During this period, Wall Street claimed that the S&P 500 posted cumulative net income of $2.42 trillion. In fact, CEOs and CFOs required to sign the Sarbanes-Oxley statements didn’t see it that way. They reported net income of $1.87 trillion. The difference was accounted for by an astounding $550 billion in corporate losses that the nation’s accounting profession insisted were real, and that had been reported because the nation’s securities cops would have sent out the paddy wagons had they not been.
During the four-year round trip from peak-to-bust-to-recovery, the S&P 500 had thus traded at an average market cap of $10.6 trillion, representing nearly twenty-three times the average GAAP earnings reported during that period. Not only was that not “cheap” by any reasonable standard, but it was also indicative of the delusions and deformations that the Fed’s bubble finance had injected into the stock market.
In fact, every dollar of the $550 billion of charges during 2007–2010 that Wall Street chose not to count represented destruction of shareholder value. When companies chronically overpaid for M&A deals, and then four years later wrote off the goodwill, that was an “ex-item” in the Wall Street version of earnings, but still cold corporate cash that had gone down the drain. The same was true with equipment and machinery write-off when plants were shut down or leases written off when stores were closed. Most certainly, there was destruction of value when tens of billions were paid out for severance, health care, and pensions during the waves of head-count reductions.
To be sure, some of these charges represented economically efficient actions under any circumstances; that is, when the Schumpeterian mechanism of creative destruction was at work. The giant disconnect, however, is that these actions and the resulting charges to GAAP income statements were not in the least “one time.” Instead, they were part of the recurring cost of doing business in the hot-house economy of interest rate repression, central bank puts, rampant financial speculation, and mercantilist global trade that arose from the events of August 1971.
The economic cost of business mistakes, restructurings, and balance sheet house cleaning can be readily averaged and smoothed, an appropriate accounting treatment because these costs are real and recurring. Accordingly, the four-year average experience for the 2007–2010 market cycle is illuminating.
The Wall Street “ex-item” number for S&P 500 net income during that period overstated honest accounting profits by an astonishing 30 percent. Stated differently, the time-weighted PE multiple on an ex-items basis was already at an exuberant 17.6X. In truth, however, the market was actually valuing true GAAP earnings at nearly 23X.
This was a truly absurd capitalization rate for the earnings of a basket of giant companies domiciled in a domestic economy where economic growth was grinding to a halt. It was also a wildly excessive valuation for earnings that had been inflated by $5 trillion of business debt growth owing to buybacks, buyouts, and takeovers.
CHAPTER 23
THE RANT THAT SHOOK
THE ECCLES BUILDING
How the Fed Got Cramer’d
AFTER CLIMBING STEADILY FOR FOUR AND A HALF YEARS, THE stock market weakened during August 2007 under the growing weight of the housing and mortgage debacle. Yet in response to what was an exceedingly mild initial sell-off, the Fed folded faster than a lawn chair in a desperate attempt to prop up the stock averages. The “Bernanke Put” was thus born with a bang.
The frenetic rate cutting cycle which ensued in the fall of 2007 was a virtual reenactment of the Fed’s easing panics of 2001, 1998, and 1987. As in those episodes, the stock market had again become drastically overvalued relative to the economic and profit fundamentals. But rather than permit a long overdue market correction, the monetary central planners began once more to use all the firepower at their disposal to block it.
The degree to which the Bernanke Fed had been taken hostage by Wall Street was evident in its response to Jim Cramer’s famous rant on CNBC on August 3, 2007, when he denounced the Fed as a den of fools: “They are nuts. They know nothing … the Fed is asleep…. My people have been in the game for 25 years … these firms are going out of business … open the darn [discount] window.”
In going postal, Cramer was not simply performing as a CNBC commentator, but functioning as the public avatar for legions of petulant day traders who had taken control of the stock market during the long years Greenspan coddled Wall Street. What the Fed utterly failed to realize was that these now-dominant Cramerites had nothing to do with free markets or price discovery among traded equities.
AUGUST 2007: WHEN THE FED CAPITULATED TO FINANCIAL HOODLUMS
The idea of price discovery in the stock market was now an ideological illusion. The market had been taken over by white-collar financial hoodlums who needed a trading fix every day. Through Cramer’s megaphone, these punters and speculators were asserting an entitlement to any and all government policy actions which might be needed to keep the casino running at full tilt.
If that had not been clear before August 2007, the truth emerged on live TV. The nation’s central bank was in thrall to a hissy fit by day traders. In a post the next day, the astute fund manager Barry Ritholtz summarized the new reality perfectly: “I have two words for Jim: Moral Hazard. Contrary to everything we learned under Easy Alan Greenspan, it is not the Fed’s role to backstop speculators and guarantee a one way market.”
Yet that is exactly what it did. Within days of the rant which shook the Eccles Building, the Fed slashed its discount rate, abruptly ending its tepid campaign to normalize the money markets. By early November the funds rate had been reduced by 75 basis points, and by the end of January it was down another 150 basis points. As of early May 2008 a timorous central bank had redelivered the money market to the Wall Street Cramerites. Although the US economy was saturated with speculative excess, the Fed was once again shoveling out 2 percent money to put a floor under the stock market.
This stock-propping campaign was not only futile, but also an exercise in monetary cowardice; it only intensified Wall Street’s petulant bailout demands when the real crisis hit a few months later. Indeed, on the day of Cramer’s rant in early August 2007, the S&P 500 closed at 1,433. The broad market index thus stood only 7 percent below the all-time record high of 1,553, which had been reached just ten days earlier in late July.
Ten days of modest slippage from the tippy-top of the charts was hardly evidence of Wall Street distress. Even after it drifted slightly lower during the next two weeks, closing at 1,406 on August 15, the stock market was still comfortably above the trading levels which prevailed as recently as January 2007.
Still, the Fed threw in the towel the next day with a dramatic 50 basis point cut in the discount rate. Although no demonstration was really needed, the nation’s central bank had now confirmed, and abjectly so, that it was ready and willing to be bullied by Cramerite day traders and hedge fund speculators. The latter had suffered a “disappointing” four weeks at the casino; they wanted their juice and wanted it now.
Needless to say, the
stock market cheered the Fed’s capitulation, with the Dow rising by 300 points at the open on August 17. The chief economist for Standard & Poor’s harbored no doubt that the Fed’s action was a decisive signal to Wall Street to resume the party: “It’s not just a symbolic action. The Fed is telling banks that the discount window is open. Take what you need.”
The banks did exactly that and so the party resumed for another few months. By the second week of October the market was up 10 percent, enabling the S&P 500 to reach its historic peak of 1,565, a level which has not been approached since then.
Pouring on the monetary juice and signaling to speculators that it once again had their backs, the Fed thus wasted its resources and authority for a silly and fleeting prize: it was able to pin the stock market index to the top rung of its historic charts for the grand duration of about six weeks in the fall of 2007. There was no more to it, and no possible excuse for its panic rate cutting.
HOW THE FED GOT CRAMER’D
The Fed’s abject surrender to the Cramerite tantrums in the fall of 2007 was rooted in ten years of Wall Street coddling. Mesmerized by its new “wealth effects” doctrine, the Fed viewed the stock market like the famous Las Vegas ad: it didn’t want to know what went on there, and was therefore oblivious to the deeply rooted deformations which had become institutionalized in the financial markets. The sections below are but a selective history of how the nation’s central bank finally reached the ignominy of being Cramer’d by financial TV’s number one clown.
The monetary central planners only cared that the broad stock averages kept rising so that the people, feeling wealthier, would borrow and spend more. It falsely assumed that what was going on inside the basket of 8,000 publicly traded stocks was just the comings and goings of the free market—and that this was a matter of tertiary concern, if any at all, to a mighty central bank in the business of managing prosperity and guiding the daily to-and-fro of a $14 trillion economy.
The Great Deformation Page 65
