The Number: How the Drive for Quarterly Earnings Corrupted Wall Street and Corporate America - Hardcover

Berenson, Alex

Hardcover

ISBN 10: 0375508805 ISBN 13: 9780375508806

Publisher: Random House, 2003

Synopsis

In this commanding big-picture analysis of what went wrong in corporate America, Alex Berenson, a top financial investigative reporter for The New York Times, examines the common thread connecting Enron, Worldcom, Halliburton, Computer Associates, Tyco, and other recent corporate scandals: the cult of the number.

Every three months, 14,000 publicly traded companies report sales and profits to their shareholders. Nothing is more important in these quarterly announcements than earnings per share, the lodestar that investors—and these days, that’s most of us—use to judge the health of corporate America. earnings per share is the number for which all other numbers are sacrificed. It is the distilled truth of a company’s health.

Too bad it’s often a lie.

The Number provides a comprehensive overview of how Wall Street and corporate America lost their way during the great bull market that began in 1982. With fresh insight, wit, and a broad historical perspective, Berenson puts the accounting fraud of the past three years in context, describing how decades of lax standards and shady practices contributed to our current economic troubles.

As the bull market turned into a bubble, Wall Street became utterly focused on “the number,” companies’ quarterly earnings. Along the way, the market lost track of what companies are really supposed to do—build profitable businesses with sustainable futures. With their pay soaring, and increasingly tied to their companies’ shares, executives were more than happy to give Wall Street the predictable earnings reports it wanted, what-ever the reality of their businesses. Accountants, analysts, money managers, and individual investors played along, while the Securities and Exchange Commission found itself overwhelmed and underequipped to cope with the earnings game.

The Number offers a unified vision of how today’s accounting scandals reflect a broader system failure. As long as investors remain too focused on the number, companies will find ways to manipulate it. Alex Berenson gives anyone who has ever invested in—or worked for—a public company the tools necessary to see beyond the cult of the number, understand accounting and its limits, and recognize patterns that can lead to fraud. After two decades of stock market hype, The Number offers a welcome dose of truth about the way Wall Street and corporate America really work.

About this title

About the Author

Alex Berenson graduated from Yale University in 1994, with degrees in history and economics. After working at The Denver Post and TheStreet.com, he joined The New York Times in 1999 as a business reporter specializing in financial investigative reporting. He has three times been named one of the top thirty business reporters under the age of thirty. He lives in New York City.

From the Back Cover

Advance praise for TheNumber

“This will surely be the most important financial book of the year. Every CEO, CFO, CPA, broker, money manager, and congressperson in America will want to read it—that’s a given. But plain old investors will, too. ‘So that’s what happened to my 401(k),’ they will say.” —Andrew Tobias, author of The Only Investment Guide You’ll Ever Need

“The Number is number one. A first-class account of how the 1990s got that way.” —James Grant, editor, Grant’s Interest Rate Observer

Reviews

(Starred Review) In the wake of Enron's spectacular implosion, the scandals surrounding the collapse of Tyco's stock price and revelations that WorldCom inflated its earnings by $9 billion, many wonder how independent auditors could have overlooked such huge discrepancies in financial records. Others ask how the SEC failed to spot corporate fraud and errors of the accounting firms on such a scale when reviewing the annual reports. New York Times reporter Berenson provides eye-opening answers to these and other equally disturbing questions in this hard-hitting and well-documented study. Against a background of the decline in independent investment research and the shift in client base for investment houses from individual investors to corporations, he charts the ascent of earnings per share-"the number"-to measure companies' health. As stock options became a major element in executive compensation and the consulting role of audit firms increased while the SEC neglected to pursue fraud on any major scale, Berenson argues, corporate executives' motives to manipulate "the number" met with a perfect opportunity to defraud unsuspecting investors, and many couldn't resist. His coruscating portrait of the boldness and reach of corporate fraud over the past five years is a clarion cry for reform. But his discussion of the SEC's shortcomings-due to lack of staff and budget in 2001, it could audit only 2,280 of the 14,000 annual reports received and has investigated a mere fraction of all allegations of fraud in corporations-shows the agency, created to protect investors from exactly what's happened, in the direst state of emergency.
Copyright 2003 Reed Business Information, Inc.

Excerpt. © Reprinted by permission. All rights reserved.

Chapter 1

BOOM AND BUST

It had been a very long week for J. P. Morgan Jr.

Morgan--the world's leading financier, the personification of Wall Street--had endured days of testimony before the Senate Banking and Currency Committee about his firm's misbehavior during the 1920s boom and the crash that followed. Under pointed questioning by Ferdinand Pecora, a hard-charging New York prosecutor who was the committee's chief counsel, Morgan admitted that he and many of his partners had not paid any taxes in 1931 and 1932, with the Depression at its worst. He acknowledged that earlier, at the height of the bubble, his firm had offered government officials the chance to buy shares in a hot new company at a below-market price. With 25 percent of all Americans unemployed, with banks failing and farmers starving, these revelations did not elicit great warmth. A generation later, The New York Times would call the inquiry "remarkable for its unfriendliness even in that year of bankers' general unpopularity." [1]

That year was 1933. And on the first day of its sixth month--Friday, June 1--at 10 A.M., in a Senate hearing room crowded with reporters and photographers, Morgan and his aides waited for another difficult day to begin.

Then the midget showed up.

The reason Lya Graf came to the Senate that day has been lost to history. Her employer, the Ringling Brothers and Barnum & Bailey Circus, was in town, but Graf had no obvious reason to make her way to the Capitol. Perhaps Ringling was looking for some easy publicity; a Ringling press agent named Charles Leef had accompanied her. Perhaps she just wanted to see Morgan in the flesh. If so, both circus and midget got their wishes. Ray Tucker, a reporter for the Scripps-Howard news service, saw Graf in the crowd outside the hearing room and pulled her in. "I'm going to introduce you to J. P. Morgan," Tucker said. And he did. Photographers swarmed and reporters rushed to capture every word of the not-very-interesting conversation between Morgan and Graf (Morgan: "I have a grandson bigger than you." Graf: "But I'm older.") Then Leef, the press agent, picked up Graf and popped her onto Morgan's lap.

In pictures of the incident, Morgan looks stunned and Graf amused, her arms spread wide [2]. Richard Whitney, the president of the New York Stock Exchange and a Morgan flunky, quickly sent Graf off, and Morgan recovered his composure.

But he could not recover his reputation. In a moment he was transformed from a powerful plutocrat to a confused old man. It is impossible to imagine Morgan's father, the original J.P., who had been America's central banker before America had a central bank, being caught in a similar indignity. Morgan Sr. ended market panics, steadied the economy, and saved Wall Street from itself; he did not truck with midgets, or senators. Morgan Jr. could not stop the crash of 1929 or end the Depression. He had tried and failed. For that Morgan might have been forgiven--the economic crisis was too big for any private citizen to fix--but he and his well-paid factotums had failed in a second, inexcusable way. They had failed to understand how serious the Depression had become and how much America now distrusted financiers and big business. And so Morgan and the rest of Wall Street's Old Guard had become nearly irrelevant to the bitter national debate over how to save capitalism from itself. Commentators wrote later that the incident had "humanized" Morgan, as if a man who treasured power and discretion, whose firm did not advertise or even put its name on its front door, wanted to be humanized. As if humanization was not the ultimate embarrassment.

A midget sat on J. P. Morgan's lap. It would be two generations before Wall Street and corporate America again ran so far amok during a boom or were so badly humiliated in the bust that followed.

A few years before that Friday morning, the nation's attitude toward Wall Street had been very different. In Once in Golconda, John Brooks summed up the peak of the frenzy as well as anyone ever has, in words eerily familiar today:

Let us try, as best we can, to look at Wall Street as it was in August 1929, to catch its essentials....Newcomers have arrived in great numbers. They are men and women who are sacrificing their own vacations, or else have simply chucked their jobs, to spend their days sitting, or more likely standing, in the brokerage customers' rooms watching the quotation board report the glorious news....

Many of those now crowding Wall Street have burned their bridges. They have thrown over their jobs on reaching some predetermined goal, a paper net worth of $50,000 or $100,000 or $200,000; they have bought expensive houses and mink coats for themselves or their wives, and look forward to lives of leisure and affluence....

All through the days, and long into the evenings, the talk, talk, talk goes on. There are tales of fortunes just made and of fortunes about to be made--above all, talk of fortunes.... There is talk about John J. Raskob's article in that month's Ladies' Home Journal entitled "Everybody Ought to Be Rich...."

On the seventeenth the Ile de France and the Berengaria depart on transatlantic trips, the former eastward and the latter westward, each fully equipped for speculation with floating brokerage offices; when the Berengaria arrives in New York six days later, passengers tell of how every day the office on the promenade deck has been so mobbed that quotations had to be passed by word of mouth to passengers who couldn't get near enough....

The madness had been a decade in the making. From a low of 63.90 in 1921, in the deep recession that followed the Great War, the Dow Jones industrial average had climbed steadily higher. By 1925 the Dow had more than doubled. After a pause in 1926, it leaped ahead again, finally reaching 381.17 on September 3, 1929. In eight years the Dow rose sixfold, by far the greatest gain in the history of the index up to that point.

In the generations since, economists and financial historians have exhaustively parsed the boom. Most have agreed broadly on its causes, from easy margin requirements that encouraged speculation to technological advances that spurred economic growth and brought electricity and cars to millions of Americans.* [*Essentially, an investor who buys on margin is borrowing part of the purchase price from his broker. If the stock rises, the investor's gains are multiplied, but if it falls even a little, the investor can face a "margin call" and be forced to put up more cash as collateral. If he can't, the broker can sell the stock--without the investor's consent--and use the proceeds to repay the loan. As a result, heavy margin borrowing can worsen market crashes, because it can result in forced selling at times when stocks are already falling.] But there was at least one more factor in the decade-long rally, one less widely discussed. When the bull market began, stocks were cheap.

In the early 1920s, prudent investors usually stayed away from stocks, buying bonds instead. Many investors viewed the New York Stock Exchange and its weaker cousin, the Curb Exchange, as little more than casinos. And they were right to be cynical. Trading on inside information was common, and stock manipulation widespread; stock prices would swing wildly on rumors of "bear raids" and "short squeezes."*[ *Short-sellers borrow stock and sell it, hoping to buy it back later for a lower price and profit from the decline. A short squeeze occurs when many shorts are simultaneously forced to return the stock they have borrowed, or "cover" their short positions. If there are not enough shares outstanding for the shorts to close out their positions, they can be forced into a ruinous bidding war for the few shares of stock that are available. In a full-blown squeeze, a stock's price can rise 50 or 100 points in a day.] "All the bubble blowers of other days, the moonshine promoters, green goods, and shell game men, financial pan-handlers and wildcat exploiters, and skin-game fakers...are now engaged in the stock selling game," a Pennsylvania congressman thundered in 1919. [3]

Nor could investors expect much protection from the authorities. State regulation was minimal; despite the congressional bluster, federal laws against stock manipulation hardly existed. The New York Stock Exchange, popularly known as the Big Board, functioned more or less as a private club, following its rules sporadically--usually when their enforcement would benefit its members. Even the press, that beacon of democracy and fair play, could not be trusted. Financial reporters from The Wall Street Journal and The New York Times were later discovered to have taken hundreds of thousands of dollars in bribes in return for pumping stocks in print. [4]

"Nearly all of those who traded in stocks frankly called themselves speculators," Benjamin Graham, the first and greatest stock analyst, wrote of the era in his memoirs. "They did not draw too fine a distinction between their financial operations and racetrack or other betting." [5] In fact, Graham recalled drolly, before the 1920s brokerage firms routinely handled bets on the outcome of presidential elections for their clients, but "this genial practice was outlawed some years later when the stock exchange went all out for respectability."

A dearth of reliable financial information about companies contributed to the market's anything-goes nature. A few years before, Morgan Sr. had bemoaned the day when "all business will have to be done with glass pockets." [6] He need not have worried. The attitude of bankers and executives was that investors should cash their dividend checks and keep their questions to themselves. (In 1899, Henry Havermeyer, the president of the American Sugar Refining Company, was asked if he thought that corporations had the right to "offer stock to the people--to the whole community--and th...

Edition details

• Publisher: Random House
• Publication date: 2003
• Language: English
• ISBN 10: 0375508805
• ISBN 13: 9780375508806
• Binding: Hardcover
• Edition number: 1
• Number of pages: 304