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You Can't Become Rich In Your Pocket Until You Become Rich In Your Mind | ||||
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What we have learned is that not only did the investment bankers lean on analysts to say nice things about existing investment banking clientsThe three justifications the Street adduced for its collective ban of the S word were, of course, not the real reasons. The real reason was the porous permeability of the Chinese Wall. This imaginary structure that supposedly extended across investment dealers offices was there to keep investment bankers and research analysts apart. Because of SEC rules, the Streets research reports have long included a fine-print note that the firm had recently performed investment banking services for the company covered in the report. That alerted clients to possible bias. What we have learned is that not only did the investment bankers lean on analysts to say nice things about existing investment banking clients, they demanded good recommendations for potential investment banking clients. Bankers griped that a lukewarm research report on a potential client would prevent that prospect from switching existing investment banking arrangements with enthusiastic research recommendations. Investment banking clients and investment banking prospects are like men and women: Everybody is one thing or the other. So all publicly traded corporations were either existing or potential investment banking clients for every Wall Street organization. What are investorschances of survival in this world in which predators multiply like rabbits and dangerous practices proliferate? And will the new independent research imposed on the Street by New York Attorney General Eliot Spitzer really change things? The seasoned survivor takes note when the balance of nature becomes regionally upset in favor of a potentially dangerous fast-propagating menaces, whether it is gypsy moth caterpillars or Lyme disease or Mad Deer Disease. What happened during the technology Triple Waterfall was that the self-corrective processes of the Street broke down. Shared Mistake became Law and Order. Everyonetop management, investment bankers, research directors, analysts, and sales managerspromoted the same story of endless growth in sales and profits for technology and telecom companies. The Street, like any other marketplace, only works well when theres disagreementand the more vigorous, the better. When everybody who matters on the Street is getting rich from being on the same side of the story, the natural balance that makes capitalism a good financial ecosystem is imperiled. Get out while your (financial) health is still sound. STOCK OPTIONS AND NASDAQS TRIPLE WATERFALL Have you ever seen a forest fire? It is terrible. Thousands of acres are destroyed, and many a time men and women and children have been cut off by a tornado of flame and burned alive. The person whose carelessness starts such a holocaust is worse than a fool he is a criminal and a disgrace to the good earth he treads. H. KEPHART In one sense, it is different this time: No past Triple Waterfall transferred so much wealth from retail investors to corporate insiders and Wall Street elites. The scale of the elites depredations during the Nasdaq mania is truly majestic. A few CEOs and CFOs accumulated spoils on a scale reminiscent of the Spanish Conquistadors. That makes this crash unique. Why the difference? Because in each previous crash, the only great fortunes accumulated that outlasted the catastrophe were those who sold out and those few (like Joe Kennedy in 1929) who sold short. Those who sold out simply protected the wealth they hadthey didnt grow it exponentially through the mechanisms of the bubble. This is the first mania in which the really big winners had seemingly unlimited access to an off-market enrichment device: stock options. In a way that few observers understood, these seemingly obscure and unremarkable instruments allowed insiders to leverage up their position without having to find or borrow more capital. Because of this multiplier effect, they could grow their wealth exponentially in time periods so brief that they would have seemed science fiction to the great barons of the past. It took timelots of itto make the billionaires of the pastthe Rockefellers, the Morgans, and even Warren Buffett. But through the leverage effect of stock options and the publics avidity for Initial Public Offerings in which entrepreneurs could sell a fraction of their company and mark up their holdings gigantically, billionairesand near billionaireswere created in time periods of four years and less. Moreover, most of these fabulously rich newcomers didnt get that way by building something of enduring value, as had such robber barons as John D. Rockefeller, Cornelius Vanderbilt, or J. P. Morgan. Gary Winnick made $735 million from Global Crossing in the three years before the company went bankrupt. Joseph Nacchio, the former CEO of Qwest, and Philip Anschutz, a co-founder, made a combined $1.8 billion in sales of stock before the price collapsed. Even political history was made during the mania. Maria Cantwell made so much money on a bubble dot com that she largely financed her own winning bid to become a U.S. senator in Washington State (what could be called Silicon Valley North), heavily outspending established Republican incumbent Slade Gorton. She sold her insider shares to pay for her campaign, thereby displaying superb market timing. The dot com was history before she attended her first Senate meeting, but then so was Gorton, and she was now Senator Cantwell. Had she lost, the Republicans would have kept control of the Senate even after Jim Jeffordss defection. That defunct dot com made a few people like Ms. Cantwell rich, changed American history, and made a lot of people a lot poorer. In past eras, entrepreneurs couldand didsell off shares of their companies when bubble mania inflated their values. But this time investors had no idea of the scale of fortunes quietly being accumulated by their heroes in Silicon Valley and Wall Street. How Big Is Big? ? The State of California disclosed that its residents reported $85 bil lion in taxable income from exercise of stock options in the year 2000 alone. To put that sum into perspective, its more than the total reported earnings of all technology companies; nor does it include the profits earned by the elites in the other 49 states. ? Fortune published a list of insiders who had made $66 billion from stock options, on big companies whose share prices collapsed by at least 75 percent. They explained that the reason they had limited it to those whose shares had fallen so faror had gone bankruptwas that these were clearly cases in which top management had failed stockholders dismally, yet cashed billions in personal gains. ? Larry Ellison, CEO of Oracle, cashed $706 million in option profits in 2001 alone, a grim year for investors in his company. ? In 2001, when Cisco Systems was announcing terrible sales and earnings, CEO John Chambers, who already cashed in more than $150 million in option profits, blamed the companys troubles on a 100 Year Storm. He was cleverly tying his results into a successful book and movie about a unique storm off New England that engulfed a boatload of brave fishermen. To this writers knowledge, not one prominent person in Wall Street or the media ridiculed Chambers for his explanation. None pointed out that he had cashed a fortune in stock options. None pointed out that his reduced reported profits came despite what some financial experts consider unethical cleansing of the earnings to disguise the cost of his option program. (Ciscos unreported option costs were 13,921 percent of the earnings reported to stockholders, according to a Lehman study.) None pointed out that the 100 Year Storm was the most modest economic downturn since World War II. As Fortune noted, these gigantic payouts were to men who failed on a gigantic scale. The stockholders lost heavilyin many cases their life savingsbut the men in control made fortunes that had in previous capitalist eras gone only to those who built great companies that were the foundations of Americas rise to international leadership. In this cycle, most of the biggest bonanzas went to those in charge of most of the biggest collapses. The system was perverse and anticapitalist in the extreme. It was as if the manager of a baseball team that was in first place by 10 games in July, and then had a record 37-game losing streak to finish in last place, had been rewarded with a $50 million bonus, plus a contract for a further five years at a guaranteed salary equal to all the money that his players would earn in that time. In essence, it was the equivalent of Las Vegas giving insiders the word on slot machines that were about to pay mega-jackpots. According to the National Center for Employee Ownership, 75 percent of all options outstanding in the year 2000 were to the top five corporate officers, 15 percent to the next 50, and just 10 percent for all the rest of the employees. Yet in 1993 when the Financial Accounting Standards Boardthe policy-setting board for the accounting profession announced that it would be issuing a rule requiring publicly traded companies to report the costs of stock options issued as a deduction from reported net income, Silicon Valley reacted with the horror of a vampire faced with a cross. The chip culture called in its political chips and got the Senate to issue a resolution barring the FASB from promulgating its rule. Leading the charge was Connecticut senator Joseph Lieberman, who would later run for vice president. As the senators agreed in their very brief discussion of the Lieberman bill, stock options were the way startup companies became great companies, and millions of Americans had stock options. True, but what might be needed by start-ups should hardly be the basic mode by which men running some of the highest-capitalized firms in America get to make vast fortunes for a few good years from vehicles whose costs are not reported in the companies earnings statements. Congress draws distinctions elsewhere between small business and bigger businesses with special tax provisions and with an entire government department devoted to the care and feeding of smaller companies. Why did Congress assume that what made sense for privately held start-up companies or even for publicly traded small companies should apply to Cisco, Sun, Microsoft, Dell, and Intel? Perhaps the senators should stop their fund raising from Wall Street and Silicon Valley and do some financial analysis. Here is a way to understand the impact of stock options on the stock market and the economy. Lets start with those $85 billion in stock option profits cashed by California taxpayers alone in the year 2000, the year the bear market got rolling. Given that it was Californians, its safe to assume that the overwhelming proportion of those profits came from tech and telecom stocks. . Their employers claimed the $85 billion as tax-deductible expenses, so the government recognized them as reductions in corporate profitability, even though the companies never showed that $85 billion in reduced profits in their earnings reports. 2. Technology and telecom stocks were trading at triple-digit multiples in 2000, but for this exercise, well assume that the companies that issued those stock options to Californians were trading at just twice the S&P, or roughly 60 times earnings. That back-of-the-envelope calculationwhich, though rough, is doubtless closer to reality than almost any of the tech companies earnings reports for the year shows that the implied stock market value of those phantom earnings was $5.1 trillion. But total losses by investors in all stocks since the market peak is on the order of $7 trillion. Therefore . . . 3. The insiders share of the profits of the tech and telecom compa nies expressed as market values of stock was on the order of all losses experienced by all stockholders in all stocks (because investors didnt lose $7 trillion in 2000 or even in 2000 and 2001that $7 trillion figure is as of July 2002. Furthermore, that doesnt include the stock option gains of the top people at companies such as Microsoft and Dell, because Bill Gates, Steve Ballmer, Michael Dell, and their close cronies arent California residents, so the total stock option profits are far higher). 4. In other words, the crme de la crme of the tech industry cashed profits which, if they had either been properly accounted for or stayed with their companies would have been sufficient to prevent Nasdaq from reaching such perilous heights that its subsequent descent damaged the entire global economy, let alone plunging to levels that devastated the wealth of ordinary stockholders. Most of those same people are accruing more stock options as you read this, set at the price of those companies shares today. If Nasdaq does recover, then theyll get another multibillion payday. But you wont. Stock Option Accounting It took a crash to get corporate America to focus on the problem of stock option accounting. Not that the battle was easy: Despite the prestigious intervention of Warren Buffett, Paul Volcker, and Alan Greenspan, the New Economy stars hung tough. They argued (through their political supporters) that the backers of option accounting wanted to ban the use of options. In fact, Volcker and some others have recommended abolition, but the actual proposals debated in Congress simply called for full and clear disclosure. When the elites find their backs against the wall, they can be formidable: Senator John McCain bitterly denounced his fellow senators for arranging that no vote would be held on his stock option accounting proposal. The fix is in, he said, comparing the Senate to a boxing ring when a bribe has been paid. Despite alleging serious misconduct, he was not reproved by the president of the Senate pro tem or censured. Arthur Levitt, the wise leader of the SEC in the Clinton era, recently published a noteworthy book detailing the problems of securities regulation in the 1990s. He makes it clear that his big regret was not standing by the Financial Accounting Standards Board when the Senate attacked it on the options issue. Professor Niall Ferguson, the eminent British historian, argues that this crash vindicates one component of Karl Marxs analysis: This was class conflict; but it was not the clash of greedy owners against workers, it was an intraclass war within Marxs despised bourgeoisie, between what Ferguson calls the CEOcracy and the suckers. The rapacity of the CEOs, which he ascribes primarily to the leverage effects of stock options, is beyond any level of greed seen previously in capitalism, and the losses of the suckersretail investors, particularly those who invested in equities in their 401(k)sin what has been a relatively modest recession, are on a scale previously seen only from the worst economic cataclysms. In previous compensation arrangements, the fortunes of the CEO and other top insiders were aligned, over reasonable time frames, with those of the stockholders. But this time, Ferguson believes, there was the creation, across much of the business community, of a cabal of consultants, directors, and senior officers who created overgenerous stock option plans by arguing that everybody does it. What happened here was that the CEOcracy could cash fabulous rewards in a huge, brief, stock market run-up, while the suckers who bid up the share prices, creating those option profits, were wiped outall within a matter of a relatively few months. Nothing like this perverse wealth allotment process had been seen in earlier cycles except in cases of fraud and insider trading. This time, apart from a few crooks, the process of reverse enrichment applied to much of corporate Americaand was justified as being of the essence of capitalism. Ferguson, an avowed Thatcherite, observes that those who should be most eager to change the rules on stock options are capitalists, because history shows that when revulsion against big business becomes widespread, investors and workers naturally seek to shift power away from the private sector to government. Wall Street was both actor and abettor in the large-scale fleecing of the American investing public by the abuse of stock options. It handled the trades when the insiders sold their millions of optioned shares. It handled the investment banking for the companies the insiders were milking. It created the dot-com mania with its eagerness to issue Initial Public Offerings of companies with no histories of profitabilityand in some cases no histories of sales revenues. According to investigations conducted by New York Attorney General Eliot Spitzer, some Wall Street firms used the dot-com IPOs as free money to give to investment banking clients. (During the idiocy era, newly offered shares of dot coms routinely leaped 50 to 100 percent in their first week after going public; investors who got stock in such hot offerings at the underwriting price were virtually guaranteed huge instant profits.) Wall Street is not a seething den of corruption. But it isnt a safe place for the unwary either. Investor survival means taking Wall Street seriously and not letting Wall Street take you seriously. |
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