by Maggie Mahar
“A society of organizations and people profiting from the boom will exhibit resistance to any interference with it,” the report concluded. “Every source of political power—business managements, the investors themselves, the public officials taking credit for the good times—will favor rules and policies that appear to protect, not threaten the goose laying the golden eggs.”
OPTIONS AND PROFITS
One of the rules that protected the golden goose laying the virtual profits was the rule Senator Carl Levin had fought to change in the early nineties—the accounting wrinkle that let corporations hide the cost of the stock options that they awarded to their top executives. According to the Levy Center report, this was the second major way that companies artificially inflated their earnings.14
During the final run-up, stock options became an ever more popular way of padding executive pay without counting the cost: By 2000, the value of options granted by the nation’s 2,000 largest corporations had climbed to $162 billion—up from $50 billion in 1997.15 The lion’s share of those options was still flowing straight to the very top of the corporate pyramid. “In 2000, the Bureau of Labor Statistics looked at who actually received options in 1999, and found that, nationwide, only 1.7 percent of non-executive private sector employees received any stock options—and only 4.6 percent of executives received them,” reported a member of Senator Levin’s staff. “In other words, in 1999—which was a banner year for stock options—98 percent of U.S. workers did not receive a single stock option as part of their pay.”16 Meanwhile, at the end of ’99, the CEOs running the 800 largest public companies in the United States were sitting on options worth $18 billion—up 46 percent from a year earlier. These were “fully vested” options—which means that the waiting period had expired. If the market began to falter, they could cash them in at any time. Which is exactly what they would do.17
As for the effect of those options on corporate profits, a 1999 Federal Reserve study of 138 large firms estimated that by failing to account for the value of options, those companies had boosted their earnings by 10.5 percent.18
But this was just one way that companies used options to burnish their balance sheets. Options programs also created a tax shelter that could make a company look far more profitable than it really was.19 As the use of options grew, the tax deduction turned into a windfall. At the end of the decade, when Jack Ciesielski, a CPA at R.G. Associates, totted up the tax benefit associated with options, he discovered that for some S&P 500 companies the amount of money saved in 1999 and 2000, thanks to the options deduction, was actually equal to or greater than the cash the business generated. The list included Sprint, PCS GP, Morgan Stanley, J.P. Morgan, Lehman Brothers, Motorola, Bank of New York, and Countrywide Credit. In other words, “These leading lights of tech and finance actually consumed cash through their operations instead of coining it,” observed Kathryn Welling, who published the list on [email protected]
Meanwhile, as executives exercised their options to buy stock, the number of shares outstanding mounted. In 1990, just two U.S. companies had more than a billion shares outstanding—Wal-Mart and AT&T. By 1995, GE, Coca-Cola, Exxon, Merck, and Ford had joined the group, bringing the total to seven. Then things got out of hand. Seven years later, 65 companies had joined what Steve Leuthold called “The Billion Share Club.” Near the top of the list: GE (9.9 billion), Cisco (7.3), Intel (6.7), Pfizer (6.3), Oracle (5.5), Microsoft (5.4), Citigroup (5.2), and AOL Time Warner (4.3). “Of course stock splits and stock based acquisitions explained part of this quantum leap,” Leuthold acknowledged, “but stock options have also been a major factor.”21
The potentially disastrous effect on earnings per share was obvious: when billions of new shares are issued, the earnings pie has to be sliced into smaller pieces. If earnings per share dropped too much, companies would never be able to meet Wall Street’s quarterly estimates no matter how diligently they padded their earnings reports. There was only one solution: companies had to begin buying back their own shares.
And this is exactly what they did. At the height of the bull market, companies began paying a premium for their own overvalued shares, squandering money that could have been used either for research and development or to distribute dividends to shareholders. Some even borrowed to finance the buybacks. And so, in what was supposedly the most prosperous decade in U.S. history, corporate debt mounted. But unless executives wanted to cut back on their own lavish options programs, buybacks were necessary, whatever the price.
The total cost was breathtaking. In 1999, the Federal Reserve Board estimated that their sample of 138 large firms spent some 40 percent of their earnings buying back their own shares.22
TAKING SHARES WITH ONE HAND, BUYING THEM BACK WITH THE OTHER
Dell Computer provided a case study in just how costly options programs could become. In 1998, Michael Dell took home 12,800,000 options—in addition to nearly $3.5 million in salary and bonuses. That year Dell himself received 21 percent of all the stock options granted by the company to its employees. A year earlier, Dell had announced that it was expanding its share buyback program—even though its shares were trading at almost 40 times projected 1997 profits. The next year, the company paid $1.5 billion to buy back 149 million shares.23
In theory, companies gave out stock options in order to ensure employee loyalty and retain top talent. But who was going to steal Michael Dell—Gateway? Other founder-entrepreneurs—CEOs like Microsoft’s Bill Gates or Amazon.com’s Jeff Bezos—did not take options, though they did give them to their employees. Moreover, while receiving options, Dell was also selling his Dell stock—some 8 million shares in 1998 alone. No one quarreled with Dell’s right to diversify: “It’s unwise to keep all your eggs in one basket, even if that basket is Dell Computer,” acknowledged Fortune’s Thomas Stewart in a story titled “Does Michael Dell Need Stock Options?” “But why is Michael Dell, wearing his founder’s hat, selling stock, while in his managerial garb he sucks up so many options?”24
In fact, 1998 was a good year for Michael Dell to begin giving serious thought to diversification. A year earlier, Dell’s shares had led the S&P 500, gaining 216 percent, and in ’98, Dell once again ran at the head of the pack, climbing 248 percent. But this would be the stock’s last golden year. From the end of ’98 through the spring of 2000, Dell’s shares would rise by only 58 percent—then plunge. By year-end, they had lost 70 percent of their value. In the summer of 2003, Dell still traded below its December ’98 high.
By September of ’98, Jim Chanos was shorting the stock. Worldwide computer sales continued to climb, but prices were falling. Chanos knew that the market was approaching saturation. Nevertheless, Dell’s shares were changing hands at 67 times the previous year’s net income and 49 times book value.
Meanwhile, in order to try to offset the cost of buying back its shares, Dell Computer decided to gamble on its own stock. In an effort to make buybacks less expensive, the company began buying call options that gave it the right to purchase Dell shares at a preset price for a defined period of time. If the stock continued to soar, that preset price would wind up being lower than the actual market price.
Dell’s foray into the options market did not stop there. To pay for the call options, the company began selling “put” options on its stock. The “puts” gave the buyer the right to sell the stock back to Dell at a preset price over a specific period of time. If the share price fell during that time, the investor who bought the put would win the bet, but if the shares continued to climb, the revenues the company raised by selling the puts would become pure profit. For a while, the strategy paid off. In one quarter, Dell made more by selling options than by peddling computers.
But once Dell’s share price began to plummet, the gamble backfired. In the fiscal year ending February 1, 2001, Dell paid an average of more than $43 a share for the roughly 68 million shares that it bought back that year. Meanwhile, Dell’s shares were trading on the open market at an average price of $
25. Dell’s problems did not end there: “The company eventually must buy 51 million more shares at around $45—again, well above Dell’s current price—through 2004,” Barron’s reported in 2002. Moreover, a built-in “trigger” provision requires that if Dell drops to $8, the box maker has to settle up on all the puts. Dell would have to spend $2.3 billion to cover this; it had $3.6 billion in cash at fiscal 2002’s end.25
Investors who bought Dell stock thought they were investing in a computer company, not a hedge fund. But unbeknownst to most shareholders, Dell had temporarily turned itself into a company that specialized in high finance—and high risk. Because Dell had gotten involved in the derivatives game, the shares it bought that year cost an extra $1.25 billion—a number that slightly exceeded Dell’s net income for the entire year. Under accounting rules, Dell was not required to show the cost in its financial statements.26
FINANCIAL “INNOVATIONS”
Dell was not the only company to sell puts on its own stock. Microsoft and Intel had adopted the same practice. “In the New Economy, everyone wanted to be in our business,” recalled Senator Jon Corzine, chairman and chief executive of Goldman Sachs until 1999.27 In other words, everyone wanted to be a financial engineer. And this worried Maureen Allyn, chief economist at Scudder, Stevens & Clark.
A tall brunette with a wide smile, Allyn watched this final phase of the bull market with a terrible sense of foreboding. “You had no idea what earnings really were,” she remembered a few years later. “The government gave you one set of figures; the New Economists had another. Until finally, in the summer of 2001, the Department of Commerce’s Bureau of Economic Analysis quietly announced that both the New Economists and the government’s national profits data had been wrong. After reexamining the data, and adjusting earnings for the cost of stock options and other hidden expenses, they realized that there had been NO profits growth since 1995.”28
Allyn, who had formed her idea of a reasonable price to pay for a stock back in 1974 when she bought Rite Aid for $3.50, had been an outspoken member of the bull market’s Greek Chorus. “But, it was worse than I thought,” she said in 2002. “Prior to the revision, the same government statisticians had reported profit growth of roughly 8% a year between the end of 1994 and 2000. Now, they said it was zero,” said Allyn, “and they were using the IRS data, which is the best data you can get.
“At that point, I felt like Gilda Radner when she said, ‘No matter how cynical I get, I can’t keep up.’ I was cynical—but I couldn’t keep up.”
Allyn had come to Scudder, a white-shoe money management firm with a Park Avenue address, in 1989, just in time to see Japan’s financial bubble in full bloom. “I came in, looked at it, and said ‘Run, don’t walk,’” she remembered. “People were surprised by how adamant I was.”
Nine years later, she was just as worried about the U.S. market—though she could not be quite as adamant. “Our chairman really got annoyed with me—my profit forecasts were so much lower than Wall Street’s,” Allyn recalled. “But,” she added cheerfully, “I always found you can get away with a lot if you say it with a smile.”
So, with a smile, she tried to warn her colleagues. Allyn was alarmed by the way the technological revolution was feeding—and being fed by—a revolution in the financial world. “The interaction between an incredible outpouring of financial innovation and a once-in-a-couple-of-generations technological revolution created a dangerous situation. Both of these are good things in themselves,” added Allyn, “but together they created an upward spiral. What you had was the interaction of two complementary events that do not reach equilibrium. Instead, they continually reinforce each other until conditions become maximally unstable.” In other words, the spiral could become a tornado.
Allyn ticked off a few of the examples of financial “innovation” that worried her. One was the way that companies like Dell were selling puts on their own stock: “Economists know that there is no more chance of getting a free lunch than there is of finding the fountain of youth. It doesn’t stop people from looking for both of them,” Allyn wrote in a memo to her colleagues. “Corporate treasurers of technology companies probably believe they did find a free lunch—they could sell puts on the shares of their own companies and pocket the premium. Since their stocks only went up, the puts always expired worthless. Free money! But we’re talking about derivatives,” Allyn warned. “These things can turn on you if the market changes!”
“Crossholding, American-Style” also made her list of dubious innovations: “Taking a page out of the Japanese play book American tech companies have become just about indistinguishable from keiretsu, the Japanese industrial groups that financed each other and held interlocking shares for strategic purposes,” Allyn remarked. Cisco was not the only company financing its customers. “There are lots of examples. Microsoft has a massive portfolio of investments in alliance partners and new technologies. Oracle is another great example. They have $500 million in an Oracle Venture Fund to invest in promising startups. One condition: They’ve got to buy Oracle software.”
But keiretsu did not top Allyn’s list of potentially dangerous innovations. That space she reserved for one of the greatest sources of financial ingenuity: hedge funds. Combining computerized models with high finance, hedge funds served as the perfect example of how the revolution in technology was reinforcing the financial revolution. “At some point in the middle of 1999,” Allyn recalled, “a few of them—the Soro$Drucken-miller Quantum Fund, in particular—began investing in technology. They couldn’t resist getting involved. And they got badly, badly burned.
“A hedge fund is a particularly ill-suited vehicle for technology investing,” she added. “The problem with hedge funds is that their investors wanted to see some distributions when the calendar turned over. Their friendly bankers knew their positions and lay in wait. As Soros noted, ‘Quantum is far too big and its activities too closely watched by the market to be able to operate successfully in this environment.’29 There was no way they could raise cash from these illiquid investments without having their heads handed to them.”
But it was not only hedge funds that invested in technology that mixed high tech with high finance. In the fall of ’98, Long Term Capital Management (LTCM) used high technology to create a new way to play financial markets—and in the process, it demonstrated just how volatile a combination high tech and high finance could be.
DRESS REHEARSAL FOR A BEAR MARKET: THE SUMMER OF ’98
For the market as a whole, it had been a sorry summer. This, after all, was the August when Ralph Acampora returned from an African safari only to realize, as he put it at the time, “I’m going to have to shoot my best friend—the bull.” Reluctantly, Acampora stepped up to Prudential’s global in-house PA system: “Ladies and gentlemen,” he announced, “I have something very important to say.” Then he uttered the dread words: “bear market.” Over the next two months, the Dow lost 1900 points.30
But that August, Acampora turned out to be far from Wall Street’s biggest worry. On the 19th, Russia defaulted on payments on its bonds—an event that would send a shiver of uncertainty around the globe.
In Greenwich, Connecticut, Long Term Capital Management thought it had little to worry about. Led by the famed bond arbitrageur John Meriwether, LTCM’s partnership included two Nobel Prize–winning economists. Under their guidance, an elite circle of traders played the options market, identifying tiny inefficiencies in the prices of the calls and puts that large institutions use to hedge against risk.
By 1998, LTCM had amassed $100 billion in assets. Only four years old, it had racked up annual returns of more than 40 percent, “with very little volatility…seemingly no risk at all,” Lowenstein reported in When Genius Failed, the story of LTCM’s rise and fall.31 The partnership’s investment strategy was founded on a firm faith in efficient-market theory, the theory, popular in academic circles, that said that at any given time, stock and bond market prices reflect all available information
. Like other efficient-market theorists, LTCM’s stars acknowledged that inevitably, tiny cracks appear in the system and a security is temporarily mispriced, but they contended that market forces quickly restore order.
LTCM’s arbitrageurs aimed to take advantage of those cracks, secure in the knowledge that a rational market would always correct its errors. This is how they made their money. Using mathematical models, they also had devised ways to offset the risks of one bet against another. It seemed a perfect system, at least on paper.
“But what LTCM failed to take into account is the role of psychology in markets, a factor that hung over all its misunderstandings of the nature of markets,” observed Leon Levy, who had recently closed his own highly respected hedge fund, Odyssey Partners. Even with the best technology, mathematical models just cannot predict the vagaries of human behavior.
When Russia defaulted on its bonds, it set off a domino effect. Floating anxiety prompted many hedge funds to want to raise capital, and a cascade of selling began. “With dozens of hedge funds trying to flee the markets, the selling pressure sent prices haywire around the world. Erratic prices served only to increase volatility,” Levy explained.
Suddenly, LTCM found itself in an irrational market. That August, the fund lost roughly 45 percent of its capital—an event that, “according to LTCM’s mathematical model, should happen no more than once in the history of Western civilization,” Levy reported in his memoir, The Mind of Wall Street.32
LTCM had been undone by what Nassim Nicholas Taleb would call “a black swan.”
CONFUSING PROBABILITY WITH CERTAINTY
Taleb, who was also an options trader, made his living by betting on unlikely events. Like a racetrack fan who gambles on long shots, he might place 1,000 wagers and lose 999 times. But he would only lose small amounts. And when he won that one time out of 1,000, the odds were so long that his return was huge. In the cases where he won, he was betting on the unthinkable—the option that no one thought could materialize (say, an option that depended on GE falling below $10).