[A-List] Enron "profits" and the dismal science

[Sabri Oncu <soncu@xxxxxxxxxxx>]

FEBRUARY 25, 2002

COVER STORY - Business Week
By Marcia Vickers in New York and Mike McNamee in Washington,
with Peter Coy, David Henry, Emily Thornton, and Mara Der
Hovanesian in New York, and bureau reports

The Betrayed Investor

Americans bought into the idea that stocks could only make them
richer. Then the market bubble burst -- and then came Enron


It's 2 a.m., and Jim Tucci is staring wide-eyed at the
ceiling--another sleepless night. Instead of counting sheep, he's
anxiously tallying up how much he has lost in the stock market.
Half of his $400,000 nest egg, he figures, has evaporated in just
two years. Forget the retirement property on the Gulf Coast.
Forget the long-planned trip to Italy with his wife. Tucci, a
60-year-old sales manager at a voice-recording company in Boston,
admits he blew a wad on speculative tech stocks during the
Internet bubble. But a year ago, he dove for safety in blue-chip
stocks like IBM (IBM ), Merrill Lynch (MER ), General Motors
(GM ), and Delta Air Lines (DAL ). Now, 40% of that is gone.
Tucci feels suckered. "I'm paralyzed. I can't sell because I'd
take such a big loss. I'm sure as heck not going to buy anything.
And even if I were, who would I listen to for advice? No one
seems to even give off a whiff of honesty about any of this
stuff. These days, I just pray a lot."

Some 100 million investors--about half of all adult
Americans--can relate to that. They're the new Investor Class
that has emerged over the past decade. Predominantly
middle-class, suburban baby boomers, they bought into the idea
that stocks could only make them richer. They exulted during the
long bull market of the 1990s. But they've lost $5 trillion, or
30%, of their stock wealth since the spring of 2000, when the
dot-com implosion launched the second-worst bear market since
World War II. It wasn't Monopoly money: It was earmarked for
retirement, for college tuition, for medical bills.

The Investor Class boomed in the 1990s as more and more people
plunged into the market. At the start of the decade, they had
$712 billion in 401(k) and similar plans, 45% of it in stocks. By
the end of 2000, that had ballooned to $2.5 trillion, with 72% in
equities. Their holdings of stock mutual funds mushroomed, too.
Over the decade, the amount invested in them increased
sixteenfold, to $4 trillion. By the late '90s, the bull market
had spawned the cult of equities. Not only did more people begin
pouring cash into stocks, but their holdings increased
exponentially as the indexes, especially the tech-laden Nasdaq,
kept hitting new highs. CNBC and others covered the stock market
like Monday Night Football. Investors of all stripes and sizes
bought into the stock culture. Owning stocks--whether those of
conservative Procter & Gamble or racier Yahoo!--was being in tune
with the zeitgeist, simply a part of living in the '90s. "We were
just riding the market, and we all felt like we were brilliant
because our stocks were going up," says James J. Houlihan Jr., an
accountant from Fort Wayne, Ind.

The market's steep rise in the late '90s had a dramatic effect on
business, too. Companies merged and acquired furiously. Investors
clamored for initial public offerings. "Ventures were able to
raise money much earlier in their life cycle, far before any
anticipated profitability. In a different era, some of those
would have died before getting funding," says David M. Blitzer,
chief investment strategist at Standard & Poor's. Millions of new
jobs were created, and economic growth and productivity soared.
It was boom time. Then it went bust.

Today, the Investor Class is angry and disillusioned because it
feels betrayed. On the heels of Enron Corp.'s Dec. 2 bankruptcy
filing--America's biggest ever--they are questioning the very
integrity of the financial system. And they won't be ignored.
They are a powerful group. Most--76 million, or a third of the
adult population--are baby boomers who grew up in the era of
protests and social activism. Then, they settled into comfortable
middle-class prosperity. Once roused, they could again become a
force of nature. And they vote.

Suddenly the deck seems stacked against them, at a time when they
expected to reap the fruits of their prime earning years.
Instead, they're getting poorer by the day, while corporate
insiders seem to make out like bandits: taking out millions in
personal loans on cushy terms, rewarding themselves with rich
options, bonus packages, and feather-bedded pensions. According
to a Feb. 11 BusinessWeek/Ipsos-Reid poll, 81% of investors don't
have much confidence in those running Big Business. And 68% have
little or no faith that the stock market treats average investors
fairly. The result: The new Investor Class is losing its appetite
for risk and is parking its cash in unglamorous, low-yielding
money-market funds and bank savings accounts. Far fewer are
opening brokerage accounts. And last year, investors slapped a
record 341 class actions on brokers--lawsuits that could cost the
brokers as much as $14 billion to settle--charging them with
everything from issuing misleading prospectuses to taking
kickbacks for IPO allocations. Individual complaints for bad
advice soared as well.

How all this shakes out is vital to the health of the U.S.
economy. If the crisis galvanizes companies and government into
cleaning things up, investors will regain the confidence they
need to put money to work in productive investments. The stock
market will rebound, and companies will get the funding they need
to grow. But if the malaise lingers, the bear market will drag on
and the economy could suffer as capital for entrepreneurial
ventures and research and development dries up. For sure, the
fear that many big companies may be cooking their books makes for
a much riskier market. Some experts paint fairly extreme
scenarios: "It could lead to a rise in the cost of capital [and]
lead to serious concerns about foreigners wanting to invest in
America," Senator Jon S. Corzine (D-N.J.), a former Goldman,
Sachs & Co. co-chairman, recently told the Senate Budget
Committee.

With investor angst rising, Washington has swung into action.
Never before have the politicos faced the wrath of so many
disaffected investors. In a highly partisan atmosphere,
Republicans and Democrats are both moving to shape post-Enron,
confidence-building reforms. Even conservatives who extol the
virtues of deregulation, individual choice, and private accounts
for Social Security and medical care know they cannot promise the
magic of democratized investing, while the impression grows that
the game is rigged against the little guy. No fewer than 12
congressional committees are probing the Enron scandal and
rushing to hammer out reforms designed to do everything from
reining in Wall Street analysts to imposing tougher accounting
rules on companies and shoring up safeguards on America's
retirement savings.

Rarely has Capitol Hill reacted so fast to a burgeoning market
crisis. But it will take more than dozens of rapidly crafted
proposals and public posturing to restore confidence. Suddenly,
no one knows who to trust. In the BusinessWeek/Ipsos-Reid poll,
54% of investors said they are concerned about the honesty and
reliability of the investment information they receive. "It's a
strange time. People wonder if the wool is constantly being
pulled over their eyes. It makes for a very vulnerable market,"
says Robert J. Shiller, economics professor at Yale University
and the author of the 2000 best-seller Irrational Exuberance.

Indeed, the Enron scandal and the swift bankruptcy of upstart
telecom Global Crossing Ltd. have cast a long shadow of suspicion
about possible accounting improprieties at company after company.
The stock prices of energy outfit Calpine (CPN ), conglomerate
Tyco International (TYC ), and megabank J.P. Morgan Chase (JPM )
have been battered because of questions about accounting
practices. Even such blue chips as General Electric Co. (GE ) and
IBM are under the microscope. Americans who came to see their
free-market economy as largely immune to the cronyism that
plagues many foreign countries were shocked to see how Enron's
cozy ties with its own accounting firm inoculated it from
scrutiny. "Enron has been elevated to a symbol," says Woody
Dorsey of Market Semiotics, an institutional forecasting service.
"There's a whole new level of uncertainty about profits, about
the integrity of the accounting profession and of Wall Street."

The usual investor watchdogs--the board, auditors, and
regulators--all seem to have been asleep or deeply conflicted
about their roles. Even professional investors are consumed with
fox-minding-the-henhouse worries. In a Feb. 5 study by Wall
Street Reporter magazine, 43% of 322 professionals polled said
that they are "extremely concerned" about the potential for
widespread financial-reporting fraud, and 61% said regulators
could do a better job.

Of course, the heavy hitters in Washington, on Wall Street, and
in corporate boardrooms contend that investors are overreacting.
Says Treasury Secretary Paul H. O'Neill: "While we may need to do
some repair work, I don't believe that our system is broken. We
have the lowest capital costs of any place in the world, because
we've demonstrated that investors' money is safer here." These
Establishment figures argue that the economy seems to be picking
up steam and that company earnings will soon start to look
better. Despite the flaws, they say, the U.S. still has the most
rigorous, reliable accounting system, and most companies follow
the rules. "The market has already responded to the potential of
overstated profits in the same way it responds to an unexpected
negative event: ready, fire, aim," says Jeffrey M. Applegate,
chief investment strategist at Lehman Brothers Inc.

Even so, some analysts believe the market as a whole remains
overvalued. The market's price-earnings ratio is high by
historical standards--despite today's low inflation and interest
rates. The S&P 500 stocks now trade, on average, around 21 times
estimated 2002 earnings--down from around 25 near the March,
2000, peak but still way above the historical average of about
15.

Worse yet, the e's in the p-e ratios could be substantially
overstated. The worry is that thousands of companies have
consistently, and legally, overstated earnings for the past few
years. Robert Barbera, chief economist at Hoenig & Co., figures
most of the 26% operating earnings growth reported by S&P 500
companies from 1997 through 2000 was the result of accounting
shenanigans. "I don't believe that the earnings growth in the
late 1990s was there," he says. That's because tactics such as
inflating earnings by excluding the cost of employee stock
options from expenses and relying on massive restructuring
charges came into vogue. Even established companies started using
accounting voodoo, like turning the rising value of their
pension-plan assets into higher earnings and using so-called pro
forma numbers.

But post-Enron, the accounting games are coming to a shuddering
halt. For years to come, investors may question the figures they
accepted in the past. Financial reporting is sure to become more
conservative. So even when the market settles down, reported
earnings aren't likely to boom again and rekindle the force of
the last bull market. "It is not that we can't get back to where
we were. We were never there to begin with," adds Barbera.

That's especially worrisome because when a crisis like Enron
occurs during a bear market, stocks typically take about 12
months to recover, according to a study by Crandall, Pierce &
Co., a Libertyville (Ill.) investment research firm. And recovery
times from earlier stock bubbles are sobering. It wasn't until
1958 that the market regained its inflation-adjusted 1929
pre-crash level, according to Yale's Shiller. For two decades
after 1929, the average real return for the stock market,
including dividends, was 0.4% a year, vs. the 25% investors
became used to in the late 1990s. Most economists doubt that
history will repeat itself so cruelly. After all, the U.S.
economy is in much better shape now, and the stock market--though
it may be a riskier place than many new investors imagined--has a
more level playing field than it had in the post-Depression era.

Still, that's cold comfort for ordinary investors, who read daily
about corporate chieftains profiting from insider sales while
their own portfolios shrivel. Says Charles Prestwood, a
63-year-old retired Enron employee who lost practically all of
his $1.3 million savings, invested in the company's stock:
"Something stinks herethere are people at Enron who made millions
selling the stock while we, the rank and file, got burned." Such
practices weren't confined to Enron. According to SEC filings,
Global Crossing Chairman Gary Winnick sold $734 million in shares
before the profitless company collapsed.

Arrogant execs are not the only targets of investors' ire. Morgan
Stanley Dean Witter analyst Mary Meeker, the onetime "Queen of
the Net," pulled down a $15 million pay package in 1999--the eve
of the dot-bomb. There's no telling how much money analysts such
as Meeker cost investors with their interminable buy
recommendations on Internet stocks that eventually went bust.

Indeed, many Wall Street analysts seem to need their own analysts
these days--those of the Freudian persuasion. Eleven out of 16
analysts who follow Enron had buys or strong buys on it as late
as Nov. 8, despite a series of red flags ranging from a $1.2
billion reduction in shareholder equity to an SEC probe. Part of
the problem is that few truly analyze companies these days. Says
Paul Patterson, a utility analyst at ABN Amro Inc. in New York:
"Analysts don't want to be on the wrong side of a stock that's
going up."

What's worse, since they often get paid according to how much
investment banking business they can drum up for their firms,
analysts play a dual role that is often deadly for investors. At
the height of the bull market, Salomon Smith Barney telecom
analyst Jack Grubman had buy recommendations on practically all
the companies he covered. During that time, Salomon was loading
up on investment banking fees from telecom companies, racking up
almost $1 billion since 1997--more than any other Wall Street
firm. Now, nine of the companies Grubman cheered during the
telecom craze are trading for less than $1 a share. At least four
are in bankruptcy.

No surprise, then, that shareholders are clamoring for more
accountability. Most want to see some of the high-profile execs
and accountants who've misled them join the ranks of the chain
gang. In our poll, 89% of investors say they strongly favor the
criminal prosecution of corporate officials who are implicated in
serious financial fraud.

In an effort to placate an angry public, the New York Stock
Exchange and the National Association of Securities Dealers
issued a proposal to the Securities & Exchange Commission on Feb.
7 that would limit compensation that analysts can receive from
investment-banking activity. Other rules would restrict analysts'
trading of stocks they cover, ban them from reporting to their
firm's investment bankers, and prohibit them from promising
favorable ratings to companies they cover.

Enron's collapse has also rocked the agenda of Washington's
conservatives. For a decade, GOP strategists predicted that the
steady rise of the Investor Class would create a powerful
political force in their favor as shareholders saw that wealth
came from capital gains, not wages. The result would be an
inexorable tilt toward GOP-enshrined policies, such as
across-the-board cuts in marginal tax rates, deregulation, and
budgetary restraint. Ultimately, the proselytizers insisted, the
embrace of the small-investing ethic would create a receptive
climate for conservatives' choice agenda. Empowered by the
success of their self-directed 401(k) plans, they hoped, stock
owners would vote for policies that put individuals, not
government, in charge of retirement and health care.

Many voters still support choice, but the crown jewel of the
agenda--replacing part of Social Security with individual
accounts invested in stocks and bonds--stalled when federal
budget surpluses ended. But officials like Lawrence B. Lindsey,
President Bush's chief economic adviser, think that the bear
market hasn't shaken the agenda. "The theme of all of the
President's policies is to give people more control of their
lives--be it their tax money, retirement savings, or Medicare
decisions," Lindsey says. "There's a recognition that we're in
this for the long term."

Even so, investors' response to Enron--and the fear of more
Enrons--has taught conservatives a sobering lesson. The clamor
for accountability in the financial system means more rules and
regulations in a sector they have spent decades trying to
deregulate.

With "we told you so" Democrats also in full cry, there's a
predictable result: a regulatory stampede not seen since the
savings and loan crisis of the 1980s. Democrats were first out of
the blocks, calling for limits on the amount of company stock in
401(k) plans and moves to ease shareholder suits against
corporate officers, directors, and auditors. But GOP lawmakers
are starting to fill the House and Senate hopper with proposals.
On Feb. 13, the Republican leadership of the House Financial
Services Committee introduced a sweeping set of reforms. They
include the creation of a Public Regulatory Organization to
investigate auditing failures and discipline errant CPAs, a ban
on accountants consulting for audit clients, and increased
funding for the SEC's enforcement and corporation-finance
divisions.

Despite bipartisan tears for Enron's victims, the parties are
taking different approaches. Democrats see Enron as justification
for a strong assertion of government power to outlaw conflicts of
interest and even restore the ban on companies operating in both
the banking and securities industries. "We cannot legislate
against greed, but we can and should do what is possible to
prevent greed from prevailing," says Senate Judiciary Committee
Chairman Patrick Leahy (D-Vt.).

But in the GOP, proponents of investor empowerment are more
likely to prevail. Treasury Secretary O'Neill--charged by
President Bush with proposing reforms in corporate
governance--and SEC Chairman Harvey L. Pitt don't think that
Washington rulemakers can anticipate "all the combinations and
permutations of every business activity in the world," as O'Neill
puts it. Instead, they would cater to the Investor Class with
more transparency.

On Feb. 13, the SEC took a large step in that direction by
announcing plans to impose far stiffer disclosure rules on
companies. Companies must produce quarterly reports within 30
days, rather than 45, and their annual reports in 60 days, rather
than 90. Significant trading in company stock by officers and
directors must be revealed immediately. Any important changes in
business must be reported within days, including waivers from
corporate ethics rules or off-balance- sheet financing.
Write-offs large enough to affect a company's earnings must also
be reported quickly. And the SEC wants laws to bar serious
corporate wrongdoers from serving in key posts again. "We believe
that we should not give officers and directors who betray their
trust a second bite of the apple," says Pitt.

O'Neill wants to hold both corporate CEOs and auditors
responsible for ensuring that investors are fully informed. CEOs
would have to sign off on a checklist of corporate health
indicators--the 5 to 10 key factors affecting a company's future.
Top company officials would be personally liable if the list were
incomplete or misleading. Similarly, the Treasury chief is likely
to propose that auditors give their client companies performance
ratings for the quality and completeness of their financial
controls. That would replace today's boilerplate audit
opinions--a test that few companies ever flunk.

Washington, is of course, responding to an angry Investor Class.
That's not half bad. But investors shouldn't let down their guard
too soon. After all, what got us to this sorry state was a
willing suspension of disbelief about the laws of the market.
Real resources went to waste on dimwit dot-coms and overstocked
telecom gear. The irrational exuberance of the '90s was as
harmful as the irrational pessimism that could grow out of
investors' feelings of betrayal. The best outcome from the
present wave of angst would no doubt be a return to commonsense
investing. Investors should place their bets on rationality, not
the next skyrocketing stock.

By Marcia Vickers in New York and Mike McNamee in Washington,
with Peter Coy, David Henry, Emily Thornton, and Mara Der
Hovanesian in New York, and bureau reports