Bull!

by Maggie Mahar

  Teitelbaum did not mention how he knew that the market would average a return of 12 percent a year over the next 25 years.

  Fortune’s advice was about par for the course. In a 1993 story headlined “Asset Allocation and the Winner Is…Stocks, by Several Lengths,” Business Week quoted gurus such as PaineWebber’s Edward Kerschner—who recommended allocating 72 percent of an investment portfolio to stocks—and CS First Boston Corp.’s Jeffrey Applegate—who advocated committing 80 percent to equities.47

  At The Washington Post, James Glassman joined what was fast becoming a pundits’ jamboree, with a headline that said: “Playing Safe Will Make You Sorry.”48 Glassman, who would become more widely known later in the decade as the coauthor of a mildly lunatic book, Dow 36,000, spooned out a seductive argument: “One dollar invested in stocks at the start of 1926 became $800 by the end of 1993; a dollar in long-term corporate bonds rose to just $28. It’s true that in the short run, stocks are far more risky than bonds,” Glassman allowed, “but after 10 years or 20 years, there’s almost no difference in volatility…. Since practically everyone who putsmoney in a pension plan has a time horizon beyond 20 years, putting nearly all retirement dollars into equities makes eminently good sense.”

  It sounded so deliciously simple—invest in stocks for the long term and you’re home free. On closer examination, Glassman’s definition of “long term” seemed a bit slippery. Was he talking about the 66 years “from 1926 to 1993”? Or “10 or 20 years”—and if so, which? True, the stock market’s 66-year record looked impressive—but that is no guarantee of how the market would perform over the next 66 years.

  Moreover, for the individual investor, “average returns” over 66 or 36 or 26 years are of only academic interest. They do not reveal how any particular investor fared.49 In reality, few investors have either the emotional stamina or the deep pockets to ride out decades that include bear markets, sideways markets, recessions, and wars. The Rockefeller Family Trust might well persevere in the expectation that, over generations, returns will even out. The investor who expects to spend most of his savings during his lifetime cannot. Ultimately, “average returns” exist only in the abstract. The difference between that average and an individual investor’s experience in the real world marks the difference between the best-laid plans and reality. As Gary Wasserman put it, “Life intervenes.” A once-in-a-lifetime bear market, a divorce, a career change, a layoff, triplets, a business opportunity—these are only a few of the contingencies that can determine when an individual investor gets into the market—and when he gets out.

  As it turned out, investors who began establishing large positions in the late eighties or early nineties would be the lucky ones. Even if they took heavy losses at the end of the century, they got in while stocks were still relatively cheap. At the time, the conventional wisdom had it that timing no longer mattered. In fact, in the nineties, timing would be everything. At the end of the millennium, your results pivoted on how much you paid when you got in.50

  At the beginning of the decade, it was not too late to join the party. The curtain had not yet risen on Act III, the dizzying and ultimately disastrous last act of the Great Bull Market of 1982–99. At this point Jennifer Postlewaithe owned both Dell and Microsoft. “I felt that, in a very small way, I was part of the revolution in American technology,” she said. By now Shirley Sauerwein was managing a mid-six-figure portfolio. As for Gary Wasserman, he was betting his son’s college savings on blue-chip stock funds: “When he graduated from high school in 1995 we had $50,000 in his fund—about half of what he needed for four years. After paying the first year’s tuition, I decided to leave the rest in the market,” Wasserman recalled.

  The midpoint of the last decade of the 20th century would mark a turning point. Early in ’95, the Dow broke 4000—and the bull was just hitting his stride. To fully appreciate what happened in 1995 consider this: It had taken the Dow 76 years to reach 1000, a barrier that it breached, for the first time, in November of 1972. Another 14 years elapsed before the index crossed 2000 in January of 1987. Dow 3000 came four years later, in the spring of 1991. Four years after that, in February 1995, the index broke 4000. Of course, the jump from 1000 to 2000 represented a 100 percent gain, while the move from 3000 to 4000 meant a gain of “only” 33? percent. Nevertheless, the 1000-point advances represented important psychological signposts. And the bull was just warming up. Before the year was out, the beast would demolish yet another record, driving the Dow straight through 5000. This time it had taken just nine months.

  That might have been a warning, but few saw it as such. One of the peculiarities of the stock market—when compared to the market for virtually any other item—is that, rather than dampening demand, spiraling prices whet desire. In 1995, Shawn Cassidy, a divorced mother of two who had managed to accumulate nearly $200,000, began to envisage becoming part of that privileged circle of people whom she had always thought of as “rich”: “For the first time in my life, I imagined, I might wind up with enough money—plenty of money—more money than I need,” she said. “I might be one of those people who goes on vacation to Costa Rica.” She vowed to double her investments.51

  —8—

  BEHIND THE SCENES, IN WASHINGTON (1993–95)

  In the early nineties, two events paved the way for Enron—and they both took place in Washington. First, in 1993, corporate lobbyists buried a proposal that would have forced companies to reveal the cost of the stock options that they were issuing to their top executives. Then, in 1995, Congress passed legislation that protected corporations—and their accountants—against being sued if they misled investors with overly optimistic projections. After that, the whole system could be gamed.

  —Jim Chanos, 20021

  As Senator Carl Levin prepared to testify before the Senate’s Subcommittee on Securities on the morning of Thursday, October 21, 1993, he knew that he faced a lonely fight. Then again, the Michigan Democrat was accustomed to tough fights—he had trained in Detroit. A member of the Detroit city council from 1970 to 1978, Levin was known as a civil rights activist. After being elected to Congress in ’78, he built his reputation as a liberal on social issues, a conservative on fiscal issues. When it came to reducing the deficit, he was a hawk.

  On the Hill, Senator Levin was seen as a workhorse, not a show horse. Although he would serve in Congress for more than 25 years, it was not likely that he would ever make the cover of Time magazine. But, unlike many congressmen, the Harvard-educated lawyer possessed both the patience and the skills needed to analyze and absorb vast amounts of information, which meant that when he sank his teeth into an issue, he could be a tenacious opponent.

  Today, Levin had come to the Senate Committee on Banking, Housing, and Urban Affairs’ Subcommittee on Securities determined to defend the one group on Wall Street that has no lobby in Washington: the individual investor. The issue at hand: full disclosure of executive pay. Few shareholders realized that they were footing the bill for the multimillion-dollar stock options packages that corporations had begun to lavish on their top executives. But now, the Financial Accounting Standards Board (FASB) had proposed a new rule that would force companies to lay bare the cost of those options in a way that any investor could understand. FASB is an independent, private-sector board that is supposed to serve as a watchdog over corporate accounting, and Levin supported FASB’s right to set accounting rules. But some of the most powerful CEOs in corporate America had lined up to fight FASB’s reform. In Congress the battle lines had been drawn. On one side, Senator Levin was spearheading the effort to support FASB’s proposal. On the other side, Connecticut Senator Joseph Lieberman led the charge to quash the new rule. In the wings stood Arthur Levitt, the new chairman of the Securities and Exchange Commission: FASB desperately needed the SEC’s support, but Levitt had not yet shown his hand.

  In recent years, stock options packages had become an increasingly popular component of executive pay. These options gave insiders the opportunity
(literally the option) to buy their companies’ stocks at a fixed price—usually the current market price—over a fixed period of time. For example, if a company’s shares were trading at $10, a chief executive officer might be given the right to purchase 100,000 shares at $10 sometime over the next 10 years. Typically, he would be required to wait a few years before exercising his options, but in a bull market the delay would work to his advantage: he could expect the stock to be trading well above $10 by the time he exercised his right to buy the shares. By then, the stock might well have climbed to $30, and after making the purchase at $10, he could turn around and sell the shares at $30, pocketing the difference.

  Senator Levin’s research told him that at the nation’s largest corporations, stock options were becoming the preferred form of executive compensation. A year earlier, a Fortune magazine survey of 200 of the nation’s largest corporations revealed that in 1991, newly granted options accounted for roughly half of the $2.4 million that the average CEO earned.2

  Nevertheless, the cost of stock options remained hidden. Unlike cash bonuses, options did not have to be shown as an expense, and subtracted from corporate profits. After all, corporate lobbyists liked to explain, when a company gave an executive stock options, no cash changed hands. The options were free. Yet—and this was a contradiction no one seemed able to explain—corporations were allowed to deduct the “cost” of these options as an “expense” on their corporate income taxes.3 In other words, when the company reported to shareholders, it claimed that options cost nothing; but when the same company talked to the tax man, it subtracted the cost of those supposedly “free” options from its earnings. Levin knew that the IRS was getting the true story: options did carry a very real cost, and it came directly from shareholders’ pockets.

  Unlike many investors, Senator Levin understood that when insiders exercise their stock options, the new stock issued adds to the number of shares outstanding, undermining the value of the ordinary stockholders’ shares. Imagine, for example, that a company has 9 million shares outstanding: a shareholder who owns 1 million shares owns one-ninth of the company. Then consider what happens if the company decides to give each of its top five executives 200,000 options. When they exercise those options, the company will have to issue 1 million new shares, bringing the total shares outstanding to 10 million. The companies’ profits now have to be split among 10 million shares—and the shareholder who owns 1 million shares will find that his or her slice of the earnings pie has been cut from one-ninth to one-tenth.

  Meanwhile, as the bull market picked up speed, the value of those options was climbing. In 1991, the S&P 500 jumped 26.3 percent, and the next year Disney CEO Michael Eisner realized a stunning $197 million gain when he cashed in his options. That same year, Thomas F. Frist Jr., CEO and chairman of HCA (Hospital Corporation of America), hauled home $127 million, with the bulk of his compensation coming in the form of options. At Primerica, CEO Sandy Weill earned $67.6 million. Options accounted for 96 percent of the total. Meanwhile, Mirage Resorts’ casino king, Steve Wynn, cashed in 1 million stock options, raking in a profit of $23.3 million.

  Million-dollar windfalls had become the rule, not the exception. By 1993, Fortune’s survey of 200 of the nation’s largest corporations showed that average CEO compensation had jumped to $4.1 million, with options representing an ever-larger share of the total. In the even more elite group of Fortune 100 companies, 29 percent of CEO pay now came from options—up from 17 percent in 1987.4

  As CEO salaries mounted, so did public outrage. In the early nineties, many questioned whether CEOs deserved such largesse. In 1991, for example, chief executives’ pay at the country’s 350 largest corporations climbed by 3.9 percent—even while corporate profits at the companies surveyed slid by about 15 percent.5 National Medical Enterprises (NME) CEO Richard K. Eamer stood out on the 1991 list. Eamer earned the bulk of the $17 million that he took home that year by exercising stock options. A year later, he resigned in the wake of a scandal involving allegedly fraudulent activity at NME’s psychiatric hospitals. Meanwhile, shareholders who, unlike Eamer, had not cashed out watched NME’s share price plummet by 60 percent.6

  In ’92, U.S. Surgical’s Leon C. Hirsch followed Eamer’s example, turning a neat profit even while his company turned south. That year Hirsch netted $60.4 million by exercising options to buy his company’s stock for as little as $12.25 a share. He then bailed out, selling the shares at prices ranging from $65 to $120. Ordinary shareholders might well have envied Hirsch his good fortune: first, he was able to buy the shares well below market price, and then he managed to get out while U.S. Surgical was still riding high. By 1993, the company’s shares had tumbled to $30.7

  PERVERSE INCENTIVES

  Eamer and Hirsch were able to scoop up their profits before their companies tanked because, although there is normally a waiting period before an executive is allowed to exercise his option to buy stock at a fixed price, there is no waiting period before he sells. An insider can exercise his option to buy, and then dump the shares the next day at the current market price, reaping huge gains. As a result, once the window has opened, an insider sitting on a pile of options has a perverse incentive to do whatever might be necessary to goose his company’s share price over the short term—even if that means sending it to unsustainable heights. A well-timed press release announcing a new acquisition can do the trick—even if the acquisition turns out to be a lemon. The stock needs to stay aloft just long enough for him to cash in—and cash out.

  Those who defended the generous use of options argued that the grants served to align the interests of management and shareholders. In theory, it seemed a marvelous idea, but in practice, managers and outside shareholders often have very different goals. While the typical shareholder invests for the long haul, many executives use their options to score short-term gains.8

  Critics also noted that options encourage senior executives to take unreasonable risks while trying to boost their company’s stock. If the strategy boomerangs and the stock plunges, insiders face no real downside. At worst, their options expire worthless—but then again, they paid nothing for them in the first place. On the other hand, if the gamble works out, and the stock shoots up, their upside is open-ended. No wonder so many insiders preferred options to cash bonuses. As one Silicon Valley banker put it: “Nobody wants cash anymore—it’s too final.”9

  But now, FASB, the private-sector accounting board that served as a kind of Supreme Court for accountants, wanted to spoil the party. Under FASB’s proposal, companies would have to deduct the cost of options from profits before reporting earnings to shareholders—just as they subtracted the cost of any other form of employee compensation. FASB did not question whether the benefit of distributing large option packages to top executives justified the expense. That was not the accounting board’s job. It just wanted companies to make that cost clear.

  In the corridors of corporate power, FASB’s seemingly modest proposal triggered a violent and vitriolic response: “The first stage I went through was total rage,” Raychem CEO Robert Saldich confided to The Wall Street Journal.10

  Accordingly, a legion of lobbyists descended on Washington, intent upon killing reform. Not satisfied to rely on corporate lobbyists to plead their cause, many executives showed up in person. MCI Communications’ chief financial officer, Douglas Maine, worked the Senate. Citicorp’s chief executive, John Reed, paid a special visit to Arthur Levitt, the newly appointed chairman of the Securities and Exchange Commission, the body that was supposed to enforce accounting rules.11

  Rumor had it that the SEC had pledged to provide FASB with “political cover” in Congress. But in fact, Levitt—who had arrived in Washington only a few months earlier—had not yet decided whether it would be politic to support the proposed reforms. And the question of what was politic was important to the new SEC chairman.

  ARTHUR LEVITT

  Silver-haired and soft-spoken, Arthur Levitt was a diplomat who took consi
derable pride in his powers of persuasion. No ideologue, Levitt had friends on both sides of the aisle. He counted both Alan Greenspan, the Republican Fed chairman, and Alan Alda, the liberal Hollywood actor, as close friends. It was Ronald Reagan who first seriously considered Arthur Levitt Jr. for chairman of the Securities and Exchange Commission, and President Bill Clinton who finally gave him the nod. That he would wind up on the shortlists of two presidents—one a Republican, the second a Democrat, the first a dedicated deregulator, the second an equally zealous reformer—said a great deal about his ability to find common ground. Other SEC officials described their new chairman as “always interested in hearing both sides,” “always collegial,” and “always civil.”

  But that very civility was part of what would make the SEC’s Levitt a somewhat reluctant regulator: “Every time we create a regulation, somewhere deep inside of me, I feel diminished,” Levitt confided during his first months in office.12 As a rule, he greatly preferred self-regulation to government regulation. Rather than imposing edicts, Wall Street’s new top cop favored the more gentle art of moral suasion, hoping to prod, flatter, lead, and cajole both politicians and Wall Streeters into “doing the right thing.”