Avarice and markets

Citation

Hensler, D. (2002), "Avarice and markets", Measuring Business Excellence, Vol. 6 No. 1. https://doi.org/10.1108/mbe.2002.26706aaa.001

Avarice and markets

Avarice and markets

As the Enron/Andersen story unfolds it appears to be revealing a level of avarice, and arrogance to go with it, that many may think is new. While this case surely is unusual, it is not new in the annals of human enterprise. Many times corporate activities of this ilk involve well-intentioned deeds designed to enhance stockholder wealth. The quest for successive quarterly improvements provides further pressure in this endeavor.

As a result, sometimes these deeds involve risk shifting from stockholders to other stakeholders of the firm. A classic case in the finance classroom is the simple example of going to the bank for a loan in order to do a project. Table I below shows just such a one-project firm that represents to the bank that it will do Project A and needs $60 to do the project. To simplify this one-period economy, let's limit the outcomes to two, Bust and Boom.

The bank looks at the possible outcomes for Project A and grants a loan of $60 at 10 percent interest due in one year when the project outcome occurs. Project B is what the company really has in mind but the company withholds that information from the bank. Project B has the same expected outcome as Project A, but it is riskier. What is the problem?

The problem is that the expected outcome for the bank and the stockholders are different comparing Project A to Project B and the effect is to shift wealth from the bank to the stockholders. If Project A is actually done, like the firm told the bank, the expected outcome for the bank is $66, the loan plus 10 percent interest. In that case, the expected outcome for the stockholders is $34. However, if the company does Project B, the expected outcome for the bank is $58 ($50 with a probability of 50 percent or $66 with a probability of 50 percent). With Project B, the stockholders have an expected outcome of $42. This represents a wealth transfer of $8 from the bank to the stockholders. Of course, if the bank had known that the company would shift to Project B, it would not have made the loan under the terms that it did.

If this sounds farfetched, in the 1990s Marriott Corporation started to do something very similar in outcome when it started to split the company into two parts with the intent of straddling one of the new companies with almost all the debt and the other new company with nearly no debt. Financial markets responded quickly and there was an enormous increase in stock value and a commensurate decrease in debt (bonds) value. Of course, the debtholders screamed bloody murder and Marriott had to back off its plans.

How does this relate to Enron? Enron apparently engaged in huge amounts of off-balance sheet financing, largely with debt. With the assistance of financial market analysts through benign neglect, this was not caught and Enron's stock price soared. What was built was a house of cards (better stated, a house of avarice), for the purpose of embellishing successive quarterly net incomes (that accounting phantom), and shifting risk away from stockholders, somewhat fictitiously it turns out. To wit, as Enron's stock price was falling, executives were selling off, all the while locking out employees from selling Enron shares in their retirement plan. In the end, debtholders, outside stockholders, and employee stockholders were left holding an empty bag.

What drove the construction of this house of cards? Simply put, it appears that it was avarice; and avarice carries with it its own punishment. This is because markets seem to always catch up to avarice and markets are the great discipliners. Not only is the stock market punishing Enron, and unfortunately stockholders who relied on the Enron board and Enron executives to make decisions in their interest, but other markets will also punish. Enron's auditor, Arthur Andersen, is suffering at the hands of the market for accounting expertise and audit. Some believe that Andersen will succumb as a company. Financial markets will impose punishment beyond these companies to other companies in the form of increased vigilance and questions of the audit industry.

Last but not least, the market for executive talent will impose its punishment. That market will extract pieces of hide from the executives who set up the house of avarice. As Eugene Fama argues, there will be full ex post settling up for these folks.

As I tell my students all the time, "greed will always get the greedy". There is a lesson in this, but it is not an old lesson. One can hide what one does, but if it is greed that one is hiding that greed will grow until it can no longer be hidden.

Doug Hensler