WASHINGTON, April 5 (UPI) -- For sheer chutzpah, Intel chief executive officer Craig Barrett's Wednesday piece in the Wall Street Journal, explaining why he opposed expensing stock options, took some beating. The following day, it was revealed that Barrett himself doubled his allocation of stock options in 2003, presumably on the principle of "Get it while you can."
The exposure draft by the Financial Accounting Standards Board, recommending that stock options be expensed on the income statement, although remaining agnostic on the method, produced an even greater howl of outrage from the tech sector and its tame politicians than had been expected. Most ominously, House Minority Leader Nancy Pelosi (D.-Ca.), who presumably has many tech sector constituents and donors, and House Speaker Dennis Hastert (R.-IL.) who cannot possibly have the same excuse (at least in the case of the constituents) vowed to introduce legislation preventing the FASB from doing its job.
When politicians, particularly those with the intellectual qualifications of former wrestling coach Hastert, start setting accounting rules, the U.S. financial system is in trouble!
Make no mistake about it: the current method of accounting for stock options may not legally be fraudulent, but economically it is fraud. It pays employees and management something of immense value, that directly reduces shareholders' wealth, and then declares to shareholders that no value has been given. It is thus similar to embezzlement, which (because the embezzler knows he's got the embezzled money whereas the victim doesn't know he's lost it) also produces "higher productivity, higher returns on equity, higher returns on assets" (Barrett's words) -- until the embezzlement is discovered and the victim realizes something has been stolen. Technically, discovering embezzlement, by lowering the total of perceived wealth, through the "multiplier effect" reduces gross domestic product. It is on this level, and only on this level, that the current mis-accounting for stock options costs can be justified.
Barrett goes on to claim that if options costs are expensed "no wise investor or professional analyst will pay much attention to the expense figure." In that case, his argument that expensing would reduce productivity, return on equity and the joys of motherhood makes no sense -- how can a figure to which nobody pays attention have any effect at all?
Thomson FirstCall, the earnings estimates reporting service, has announced that it will strip out options costs when calculating quarterly earnings, so that those companies that have switched to options expensing are not penalized compared with their competitors. This is not really a defensible position even while only some companies expense options, because the volumes of options granted varies so enormously even within sectors, so that some companies, such as E-Bay and Cisco, would in most years lose their earnings altogether if options were expensed properly. However, Thomson FirstCall uses primarily the sell side analysts to calculate its estimates; there is no question that the sell side -- brokers attempting to peddle stock -- benefits enormously from having earnings numbers artificially inflated, particularly in the tech sector where earnings are so scarce.
The reality is that institutional investors will take very close note indeed of earnings after stock options costs, because it's their stakes in the investee companies that are being diluted by excessive stock options grants. Of course, sophisticated investors have been able to make their own calculations of options expense from the data given in company notes, but they have been hindered from doing so by the tendency of unsophisticated investors, Wall Street permabulls and the media not to undertake such complex calculations, and consequently to price stocks off the false disclosed earnings figure.
Theoretically, if you know more than the market about the real earnings that a greedy management has left for shareholders, you can make money from this. In practice, if you get an entire decade in which first a crazed bull market and then a determined liquidity-fueled reprise thereof cause optimists to outnumber the rational by a substantial multiple, if you calculate share prices based on true earnings you will, for that decade, get your clock cleaned. At the end of the decade, you may be proved right, but you will no longer have a job.
Martha Stewart lied about an insider trade on which she made $50,000, and which may not even have been a crime. She will soon be sentenced, presumably to several years in jail. Jamie Olis, a mid-level tax executive in Dynegy -- at least two levels below the boss -- was sentenced to 24 years and 4 months in jail for a tax scheme that did not benefit Olis by a penny directly, may have propped up Dynegy's stock price for about a year, but was no more than dubious accounting, disguising a $300 million loan as cash flow.
The theory behind the Olis sentence was that, for a period of about a year, he had artificially inflated Dynegy's share price, thereby creating a false market. So where are the 24 year jail sentences for tech company CEOs, who have, not for one year but for a decade or more, created a false market in their stock by reporting economically false earnings?
There is of course a deep unhealthiness to all this. Excessive grants of stock options, whose cost is unreported to shareholders, encourage executives to pursue short-term profit maximization strategies that in several cases have led to criminal activity. The profits available from this kind of rip-off become obscene, in the billions rather than the millions of dollars, so that as I discussed a few weeks ago top executives are now roughly 10 times as overpaid relative to the workforce as they were at the peak of the 1929 boom.
Conversely, lengthy jail sentences for activities that may well appear legitimate, or at least no more than "gray area" greatly increase the risks of ordinary business activity, so that ordinary upper middle class economic and lifestyle security is endangered, and the line between Martha Stewart and the Mafia becomes hopelessly blurred.
In a system where the potential rewards are immense, the potential risks are horrendous, and the line separating the two is hopelessly blurred, economic signals no longer function properly. As an investor, severe indications that economic signals are no longer functioning properly are a sign to sell. And keep selling.
The United States, in the randomness of its rewards, the arbitrariness of its punishments and the inequality of its society, is turning into a banana republic.
(The Bear's Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that, in the long '90s boom, the proportion of "sell" recommendations put out by Wall Street houses declined from 9 percent of all research reports to 1 percent and has only modestly rebounded since. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)
Martin Hutchinson is the author of "Great Conservatives" (Academica press, April 2004) -- details can be found on the Web site greatconservatives.com.
