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Foolish Boom Time Forecasts Give Cover to Fraud

By Realizingresonance @RealizResonance


When times have been good, and people are optimistic, it is easy to be fooled by the trend. The enthusiasm of the boom years is the optimum atmosphere for swindlers and fraudsters to take advantage of the abundant trust in the market. The ratio of risk over reward is reduced during times of growth and this changes the incentive structure for unscrupulous behavior by rewarding it more and punishing it less (Kindleberger 168). Capital is abundant during the economic rise, but when the best finance options become exhausted the continued demand for investment opportunities lead to greater appetite for risk and speculation. Promises of unrealistically high returns become an easy sell and the chances of getting caught holding the bag are reduced by the expansion of credit. The easy access to credit can have a direct effect on fraud by allowing for Ponzi finance schemes. Ponzi finance occurs when the payments on existing loans are financed by taking on additional debt (Kindleberger 13). As long as the debtor can bring in enough new money to service the current debt load then the scheme works, but if credit becomes unavailable for any reason the fraud is revealed by the inability to make payments. The positive correlation between credit and corruption is related to people’s propensity to be fooled by bad forecasts of the future, especially when the future is forecast to be just more of the same.

The Savings and Loan Crisis did not start out involving corruption, but attempts to save the industry with deregulation in the early 1980s opened the door for it. The problems began when the 3-6-3 business model of borrowing short term at 3%, lending long term at 6% and teeing off by 3 o’clock (Johnson “Savings & Loan Crisis” Lecture), which had worked for the thrifts for last 50 years was destroyed by the Federal Reserve’s decision to curb inflation at the end of the 1970s by raising interest rates (Kindleberger 172). To stop the bankruptcy of the S&L; industry the Reagan administration pushed for changes that were intended to introduce new earnings opportunities. In order to promote consolidation of the thrifts, accounting rules on amortization were changed to allow for the net worth of failing institutions to be brought out of the red through the esoteric value of “goodwill”. The value attributed to “goodwill” increased from $7.9 billion to $22 billion between June 1982 and December 1983 (“Chapter 4” 174). The disconnection of regulatory accounting standards (RAP) from generally accepted accounting standards (GAAP) encouraged greater risk taking, such as investments in “junk bonds”, by lowering capital margin requirements. It was thought that the expansion of investment opportunities into areas of greater potential reward would help grow the thrifts out of the red, but with no additional capitalization for the commensurate rise in risk (Stiglitz 37). Allowing future potential earnings to contribute to current net worth opens the door for manipulation because value becomes dependent on a forecast.

When the thrifts moved into the commercial loan business, their accountants were able to book origination fees for loans as current income when these fees were included in the future payments on the loan and not truly received. As long as the supply of credit was increasing and new construction deals could be initiated, the losses from the collapse of risky deals could be hidden from investors (“Chapter 4” 184). Tax treatment changes in 1981 instigated additional growth in the real estate market by turning these investments into tax shelters, and by the middle of the decade vacancy rates on commercial properties were as high as 30% in some cities. The supply of real estate investment dried up when new reforms put a curb on tax shelters. The bubble in commercial investment could not be sustained and the tax payers eventually had to cough up more than a $100 billion to bailout the S&Ls; (Stiglitz 38). The official government resolution at the end of the decade does not change the fact that the crisis in the early 1980s had been made more expensive with the underwriting of what essentially amounted to a Ponzi finance process that inflated real estate prices.

Before their accounting tricks became known to the market, the executives at Enron were able to pump up the company’s stock price using various unscrupulous tactics. Manipulation of the supply of electricity to the deregulated energy markets in California resulted in rolling blackouts for the State, but in giant bonuses for the Enron traders who forced price hikes and outages by artificially restricting supply (“Enron”). Besides the predatory exploitation of deregulated energy markets, Enron accounting treatment was designed to hide an immense Ponzi scheme by the creation of off-balance sheet deals with shell companies set up by Enron’s CFO Andy Fastow. Shell companies, with names like Raptor, were used to borrow large sums of money with Enron stock as collateral, keeping the debt out of view for Enron stock holders and the public (Stiglitz 245-246). Borrowed funds were then used in schemes to prop up the stock price by consistently beating Wall Street analyst’s earnings expectations (“Enron”). This allowed Enron’s executives to keep bringing in new money in order to keep their own personal compensation intact, which was significantly held in stock options.

Enron utilized the magic of mark to market accounting, which allowed them to book profits for the future delivery of oil and gas. They also booked early earnings from optimistically predicted future gains from risky new ventures, like the construction of the Dabhol II power plant in India, and a deal with Blockbuster to deliver video on demand. The shady accounting practices at Enron could not be kept hidden once the market turned along with the trajectory of the company’s stock. The use of stock options as a form of compensation affects incentives by placing the emphasis on short term capital gains through stock price appreciation rather than long term value creation (Stiglitz 126). The incentives for Enron’s decision makers were aligned in the wrong direction, resulting in fraud. The fraud was possible to such a degree because Enron fooled everyone, including their own employees and probably themselves, with rosy forecasts of the future under the cover of an economic boom.

Nobel Prize winning economist Joseph Stiglitz (134) points out how incentive structures matter, and how the conflicts of interest between the consulting and auditing arms of accounting firms can occur, in which the more lucrative consulting side reduces honesty by pushing for lax auditing. Conflicts of interest also contribute to the corruption of stock analysts and bond rating agencies, making their regulation essential for financial markets to be free of fraud (Kuttner). A Senate investigations has recently found that the bond rating agencies Standards & Poor’s and Moody’s caved into pressure from Goldman Sachs, and at least six other financial firms, and gave their very best AAA bond rating to the incredibly risky mortgage backed securities that brought the world financial system to the brink of utter devastation (Faux). The problem was, and still is, misaligned incentives. The ratings agencies are private, profit seeking companies and they earn their income from the financial firms who pay them to rate financial products. Large dominant financial firms can leverage their market power to influence the better judgment of seemingly independent bond rating agencies into lowering standards by threatening to remove business. Another factor was at play as well, the ratings agencies allowed themselves to be fooled by unrealistic forecasts about the risks they were taking, and so did the investors who depend on them. Unfortunately this also gives them cover.

Jared Roy Endicott

Foolish Boom Time Forecasts Give Cover to Fraud
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Works Cited

Enron: The Smartest Guys in the Room. Dir. Alex Gibney. Magnolia, 2005. Film.

Faux, Zeke. “Moody’s, S&P; Caved In to Ratings Pressure From Goldman, UBS Over Mortgages”. 13 Apr. 2011. Web. 18 Apr 2011.

Galbraith, John Kenneth. The Great Crash 1929. Boston: Mariner Books, Houghton Mifflin Company, 1997 (orig 1954). Print.

Kindleberger, Charles P., and Robert Aliber.Manias, Panics, and Crashes: A History of Financial Crises. Fifth Edition. Hoboken: John Wiley & Sons, Inc., 2005. Print.

Kuttner, Robert. “Seven Deadly Sins of Deregulation – and Three Necessary Reforms”. 17 Sep. 2008. Web. 16 May 2010.

Stiglitz, Joseph E..The Roaring Nineties: A History of the World’s Most Prosperous Decade. First Edition. New York: W. W. Norton & Company, 2003. Print.

“Chapter 4: The Savings and Loan Crisis and Its Relationship to Banking”. FDIC History of the 80s Volume 1: An Examination of the Banking Crises of the 1980s and Early 1990s. 5 Jun. 2000. Web. 5 May 2010.

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