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Friday, November 10, 2006

What? Enron and Worldcom Weren't Enough?

All on the same day, November 10, 2006, the following three items appear in the Wall Street Journal:

  • news that standards for section 404 of Sarbanes-Oxley may be relaxed

  • news that the Public Company Accounting Oversight Board has yet to complete its audits of the four biggest accounting firms in the country

  • a full page ad from The National Association of Realtors aimed at getting home buyers back in the pool - the water's fine, don't worry, Greenspan said things are getting better.

To quote the character Old Lodge Skins in the movie Little Big Man, "the ponies are trying to tell us something."

In case a refresher is needed, section 404 of the legislation known as Sarbanes-Oxley (SOX) calls for publicly traded firms to include a report with their annual financial reports summarizing the state of the business process and systems used to produce the numbers in their financial reports and for officers to sign a statement which states they understand their responsibility for the accuracy of those systems and the resulting statements. It also requires the firm's auditors to include and sign a similar statement. See (#1) for a link to the exact language.

I've commented previously (see #2) that while SOX may have produced some unintended consequences and may have raised the cost of operating public companies, in a larger sense the requirements of SOX act as a form of relatively cheap macroeconomic mal-practice insurance. Insurance that protects the larger economy from the distorting effects and potential collapse of giant multi-national firms who accidentally or purposely exploit legal or financial loopholes to create fictitious profits.

Probably the key point from that prior commentary that still holds true is this:

On the flip side, how many public companies are going to come forward and announce cases where a new SOX-based process uncovered a major mistake in the company's accounting that averted a major correction in its public books? NONE. For the same reason banks never disclose when they've been hacked or suspect internal breaches of security affecting customer information -- doing so would spook customers or investors. Unless the new SOX-based audits turn up mistakes in books they've already closed and now HAVE to go back and correct, you'll never hear of a SOX success story."

If you need a reminder about the damage that can be done by huge companies with inadequate financial controls, look back to the bankruptcy of Enron ($63.4 billion in assets, $13 billion in debt according to their official books but another $25 billion in "off-balance-sheet" debt - see #3) and Worldcom ($107 billion in assets, $41 billion in debt -- see #4). Look at the jobs destroyed and retirement savings evaporated in those implosions.

If you need convincing that there are major portions of our economy still gambling on unsustainable bubbles and dependent upon suspect accounting and property valuations, just look at the full page ad from the National Association of Realtors, then look at recent statistics about mortgages in default. Per an October 23 story from Bloomberg (see #5), the 60-day delinquent rate on home mortgages reached 7.23 percent in July 2006 from 5.9 percent a year earlier. According to an article on CCNmoney.com (see #6), roughly 1.3 million ARM loans were issued in the past two years with interest rates below 2%. Now, roughly 21 percent of those mortgages involve properties whose outstanding principle exceeds the market value of the home. If both of these numbers are true and 7 percent of that 21 percent of loans are delinquent, that results in 19,110 homes getting dumped on an already glutted home market. This is just a few days of inventory at current sales rates but when dropped on the market at depressed prices, an extra 19,110 units can have a disproportionate effect on the larger market.

Think of Sarbanes-Oxley as a required annual inspection of the x-ray machine or CAT scan machine at your local hospital. Do you want to rely on the diagnosis of a machine that hasn't been calibrated since it left the factory? Would you really trust a clean bill of health from the machine? Why would you do the same for multi-billion dollar companies with pension obligations to you and your neighbors in an environment where we have recurring evidence their financial x-ray and CAT scan machinery cannot and should not be trusted?


#1) http://www.sarbanes-oxley.com/displaysection.php?level=2&pub_id=Sarbanes-Oxley&chap_id=PCAOB4&message_id=28

#2) http://watchingtheherd.blogspot.com/2006/05/is-sarbanes-oxley-really-problem.html

#3) http://foi.missouri.edu/usenergypolicies/enronexam.html

#4) http://money.cnn.com/2002/07/19/news/worldcom_bankruptcy/

#5) http://www.bloomberg.com/apps/news?pid=20601103&sid=adbsVAhN68TM&refer=us

#6) http://money.cnn.com/2006/10/09/real_estate/arms_nightmare/index.htm?postversion=2006100913