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CEDA: Integrity for sale

Maurice L Newman, Information Age

18/06/2003 16:42:24

The recent corporate scandals in the United States have shown that if the stakes are high enough, and where leadership is weak, integrity can be bought, said Maurice Newman in his inaugural speech as Patron of CEDA.

What I am about to describe Is a story of what can happen when first we practise to deceive. It is a story about the tangled web woven in the United States in the heady days or the late 1990s which began to unravel with the onset of he bear market in 2000. It is an unfinished story that may eventu-ally influence the balance of power in the world. It also offers a glimpse of the complex relationship that exists between the ethical underpinnings of a society and economic outcomes. While we can only speculate how It will end, we already know that the world Is a very different placeStarting with Enron, the whole sordid mess of spin, lies and malfeasance practised on an unprecedented scale, is coming to light. We have watched a parade of US executives defending the indefensible, or seeking to negotiate deals with the authorities to escape prosecution. And as the depth and breadth of US corporate and financial services scandals come to light and aggrieved investors gather to launch class actions, the accused are beginning to count the costs.

In December 2002 the ten biggest investment banks and the United States authorities agreed to a settlement of almost $US1.5 billion. The settlement resolves multiple investigations without the firms having to face prosecution and trial, however, individuals who committed acts of wrongdoing will be brought to justice. More importantly, much of the incriminating evidence uncovered by the investigations will be made public and can be used by investors who may seek retribution in the courts. Such legal suits could exceed $US5 billion.

Unfortunately for Americans the culprits are not all from the "sharp end" of town. Names like Citibank. CS First Boston, JP Morgan, Xerox, IBM, Cisco Systems, Computer Associates. Merrill Lynch, Salomon Smith Barney, General Electric and many other trusted names have had to acknowledge accounting and other practices that have been less than candid or downright scandalous.

Even casual observers of financial markets will remember the naive enthusiasts and assorted experts who extolled the virtues of the new economy. Australians were told we had missed out on the dotcom boom, we were an "old economy"; our currency was therefore weak and our stock market properly priced at lower multiples. So much for experts. Our economy is currently the strongest in the OECD, and our stock market In 2002, when currency adjusted, finished as the world's best performer.

These so-called experts, the evergreen optimistic economists and market analysts, have much more to answer for than simply exaggerating the virtues of the new economy. Not only did they add hot air to the market bubble, but their influence on public and private expectations has led to serious economic miscalculations, for which we are now paying.

All this notwithstanding, and despite Alan Greenspan's aggressive interest rate cuts and the hype of the other cheerleaders, around $US8 trillion was wiped off investor wealth ($US13 trillion globally). This is unusual because normally when the Fed starts to ease In earnest, the stock market rises by about 20 per cent within 18 months. The only exceptions to this rule are 1930 and now. Before the October 2002 rally, which now seems spent, the Dow Jones Industrial Average fell about 30 per cent from its 1999 highs.

Wall Street-has also for the first time in 60 years, fallen three years in a row. On the business front, profit margins continue to be at their lowest levels since the I930s, excess capacity abounds. business capital investment remains depressed, and companies still have no pricing power.

The United States Government's feverish attempts to stimulate activity - including consideration of dividend franking (many years after It was introduced in Australia) - may postpone a downturn, but debt alone cannot sustain economic growth.

To quote Morgan Stanley's Stephen Roach, one of Wall Street's most reliable economists:

"Perhaps the most troubling aspect of the ‘Washington fix' is the temptation to go back to the same recipe that got America in trouble in the first place … hyping the stock market and the bubble induced excesses it prompted in the real economy."

Governance issues

With the benefit of hindsight, it's easy to describe what has happened: the hype, manipulation, suspension of ethical and professional standards and compensation practices which rewarded bad behaviour. But identifying the cause and effect will not of itself recommend, let alone implement, a remedy.

The common denominator that links Enron and other financial scandals is the performance of gatekeepers: directors, auditors, journalists, economists, security analysts, regulators and others the market has trusted to filter, verify and assess complicated financial information. None of these watchdogs issued warnings until it was too late, if they did at all.

Sadly. we once believed gatekeepers and other watch-dogs would not compromise their principles and reputations for money. but the US experience has shown that if the stakes are high enough, and where leadership is weak, integrity can be bought.

Could something this widespread happen in Australia? We are not without our blemishes. HIH, Harris Scarf and One.Tel are examples of corporate failures in which lack of disclosure, lapses in good governance practices or fraud played a central part. Again, the gatekeepers did not perform their roles effectively and the regulators are being accused of not being aggressive enough.

As the shock waves from the collapses in the United States and our own HIH failure continue to radiate collaboration between the international securities commissions on disclosure, accounting standards and corporate governance will intensify.

Some political fallout in Australia is inevitable, even though our own governance standards are generally superior to those operating elsewhere. Despite attempts to draw odious comparisons between events here and those in the United States, it would be a grave mistake for Australia to surrender the benefits of its well-regulated, well-functioning markets for the more prescriptive US approach, all in the name of better governance. Its Imperfections granted, Australia's principles-based system, with its emphasis on codes of conduct for boards and management and peer-group pressure on good behaviour, has demonstrably produced superior outcomes to the US rules-based arrangements.

Those who push for heavy-handed legal solutions should be careful what they wish for. Whatever the crimes and misdemeanours of corporations, rules alone will not address them, nor will they stop corporate failure or stock market losses. No, the problem is cultural, and in the United States the blatant flouting of rules highlights the weakness of a system that is dependent on prescription.

The final bursting of a once-in-a-lifetime bubble has released far-reaching global forces. These have a long way to go before they are fully resolved. According to The Economist, while stock market falls since this bear market have been less severe than in 1928-30, they have, as a percentage of global GDP, destroyed more equity wealth.

It would be dangerous to think that the US bear market is finished. Throughout the decline sentiment has been much too bullish, and on any historical basis price earning multiples are still way too high. Profit growth that could render multiples even halfway acceptable is not on the cards. Much of the recent profit growth is a consequence of aggressive cost-cutting and job-shedding. The benefits tend to be one-off, yet "buy, buy, buy" is still Wall Street's mantra.

United States structural weaknesses

As the equity king tide recedes, structural weaknesses in the United States economy which in the avaricious days of the new economy boon, had been either covered up or conveniently ignored-are now being revealed. These will take time and careful management to repair.

In particular, the enormous accumulation of debt in the government (federal, state and municipal), household and business sectors. aggregating more than $US30 trillion, resonates loudly. For example, household debt is around 80 per cent of United States' GDP and state governments expect to accumulate deficits of well over $US100 billion this year. By law, state budgets have to be balanced. So in some states criminals are being released early to save costs. At the city level, New York is forecasting a $US6 billion deficit next year. with many others In a similar bind. As the different levels of government seek to bring their existing budgets under control, government layoffs are likely to add to the unemployment pool already created by the corporate sectorHowever, the United States Treasury doesn't have to balance its budget, and last Christmas Eve quietly asked Congress to raise the debt ceiling by $US450 billion, the second request for an increase in a year. On an accrual accounting basis, the United States budget deficit is approaching $US1 trillion, while on a cash basis the deficit could rise to $US300 billion - the highest ever. This doesn't even account for a war on Iraq The United States Is surely living on borrowed money and borrowed time.

The United States pension funds have been another victim of the bubble. In the boom years these were cynically raided to inflate corporate profit on the basis of contrived surpluses certified by actuaries.

In the United States, Britain and Europe, defined benefit plans are the rule for government and company funds. Now faced with a growing ratio of retirees to active employees, low interest rates and three consecutive down years for the stock market, funds are facing massive shortfalls, which in some cases exceed the employer's net worth.

US employers are legally obliged to make good any pension fund shortfall of more than l0 per cent. This is requiring many state government funds to spend 40 per cent more for employee pensions to bridge the gap. According to The Economist, the aggregate shortfall of funds for all firms in the S&P 500 is around $US300 billion for 2002. The total doubles when other post-employment benefits, such as health-care, are added. These are typically underfunded because unlike pensions, firms get no tax breaks for setting aside assets against future liabilities. Watson Wyatt assess pension underfunding in Britain at £100 billion for this year alone.

Looking to the future, Morgan Stanley says: "What people are missing is how high returns need to be just to stop the underfunding problem getting worse." Goldman Sachs calculates that if pension fund returns average 6 per cent per year in future, US firms may have to come up with $US80 billion to close the gap. At 4 percent a year, the figure rises to $US110 billion. We won't ask what the gap will be if the market is down for a fourth year, but on any likely scenario, pension liabilities will be a source of continuing pressure on government budgets and company profits.

The future

The empirical evidence is that all markets over time revert to trend. There are no exceptions, no ifs, buts or maybes. The greater the excess the bigger the correction. Nor do they return to trend and simply stabilise. They overshoot. it is the timing of the moves which is obscure.

Bubbles like the Dutch Tulip mania of the 1600s, the South Sea Bubble in the 1700s and the Japanese properly bubble of the 1980s, have all produced extraordinary examples of excess ending in steep adjustments and serious economic pain, accompanied by social hardship.

Why should the legacy of the 1990s stock market bubble - the largest bubble in modern times -be any different? While we will undoubtedly see good bear market rallies from time to time, it may be years before Wall Street finally reaches historically attractive valuations and returns for investors. Time alone will tell, but as Japan frequently reminds us, post-bubble economies remain vulnerable to setbacks for a lot longer than may have been believed, or indeed hoped for, at the onset.

For the time being, we Australians will have to await developments. Fortunately, 20 years of comprehensive economic reform, together with responsible monetary and fiscal policies have produced a robust, competitive, modern economy. Our financial markets are still held in high regard. thanks in part to investor confidence in our corporate governance and regulatory system.

While Australia is not without its weaknesses, so far we have avoided the extremes that have variously afflicted so much of the world. Our household savings may not be high enough, but defined benefits pension plans are not prevalent here and, unlike most major economies, the Australian Government has run budget surpluses for many years, resulting in low government debt. This means Australia is increasingly likely to be seen as a small but safe harbour, which should provide support for our currency and other asset classes such as shares.if the threatening global economic clouds do envelop us we will have many more policy options than most economies to moderate the painful adjustment process. Australia should fare better than most economies and certainly better than we did in the I 930s when our economy was one of the worst affected.

To conclude, what has emerged in the United States is more than investor losses and shattered reputations. It Is a massive shock to the underlying integrity and structure of the system. Clearly, a mercenary, self-indulgent culture does not provide sufficient glue to bold an organisation or a society together. When the money runs out people turn inward, become risk averse, and look for something they can believe in. Aspiration may give way to calls for security and protection, which in turn will be expressed in public policy and bigger, more intrusive government.

Good leaders are committed to defending the right values, even when it means taking a less popular or less profitable direction in the short run. Today, this view may seem naïve or idealistic. Perhaps it is, but societies that don't defend their codes of honour and lack passionate conviction about the principles of freedom and justice may be in danger of losing them. Integrity should not be for sale at any price. Our way of life depends on it.

Maurice L Newman is Chairman, Australian Stock Exchange Limited.