Enron-AIG-Berkshire: Regulating earnings management

Holman Jenkins2.jpgDon’t miss Wall Street Journal ($) columnist Holman Jenkins’ Business World piece today. In analyzing the Lord of Regulation’s assault on American International Group, Inc. and its long history of being rewarded by the market for its adroit management of earnings, Mr. Jenkins makes an interesting point about the importance of trust — or, as he dubs it, the “predictability premium” — in AIG’s business, something that was touched on in this earlier post:

That Mr. Greenberg did his accounting as he thought best was no secret to anybody, even before recent revelations. Money Magazine called AIG a “faith stock,” lumping it with other giant, complex money machines such as GE and Citigroup. This newspaper dubbed it one of the economy’s great “black boxes.” Indeed, the whole reason to own AIG in the 1990s was to reap the predictability premium built into its stock price thanks to Mr. Greenberg’s ability to generate uncannily rising earnings from a complex of more than 100 businesses, including not just insurance, but aircraft leasing, commodity trading and much else.
In some ways, this model was already falling out of step with the business mainstream by the 1980s, long before Enron made “transparency” the central virtue of the new corporate value system. But exceptions were granted to AIG and a few others (like GE). Their opacity might have earned them skepticism in the marketplace, but instead they were awarded higher share prices. AIG sold for about 26 times its earnings, compared to 10 or 15 for most insurers.
Let’s dwell on this for a moment: When the market was the arbiter, it unambiguously rewarded Mr. Greenberg and AIG’s shareholders for applying the techniques of earnings management. The market understood that behind the screen lay all the volatility and mishaps that insurance is heir to, but it applauded Mr. Greenberg for using his wiles to create a security (AIG’s stock) that transmuted that volatility into unnaturally smooth reported earnings.
One big albatross for [former AIG chairman and CEO, Maurice “Hank” Greenberg] will be the Enron overhang. By far, the largest factor in AIG’s stock decline is the evaporation of its predictability premium, not the accounting scandal. But that won’t stop trial lawyers, prosecutors or the media from assuming that the distance between AIG’s peak and its ultimate low reflects the damage Mr. Greenberg personally did to investors.

And in closing, Mr. Jenkins notes that it may still be a tad early to be making a play for AIG stock, which is down almost 30% in value from the beginning of the year:

[AIG’s board of directors] no interest in defending any of this, since board members have learned that their personal fates are best served by running up a white flag. Eliot Spitzer, New York’s attorney general, let it be known this week that their compliance had met with his approval.
There’s also a question of whether, in a market where skepticism rather than trust is the rule, it’s possible or sensible to maintain an organization as complex as AIG. Hold onto your seats for the battle over Starr International, a peculiar entity set up years ago and holding much of the incentive wealth of the company’s top executives. We can’t think of a quicker way to destroy the morale of AIG’s remaining leadership, and thus perhaps the company.

Houston-based Fortune 500 companies

Fortune-500.gifFortune magazine’s annual list of the 500 largest U.S. publicly-owned companies has just been published, and the following 21 Houston-area companies made the list. The asterisk next to Anadarko’s name notes that the company is based in The Woodlands, which is 30 miles north of downtown Houston:
Fortune-500 list.gif

ChevronTexaco wins bidding for Unocal

unocal.gifSan Ramone, California-based ChevronTexaco Corp. won the bidding yesterday for its California-based rival Unocal Corp. yesterday in a cash-and-stock package valued at $16.8 billion. The deal is the largest oil-sector deal since 2001 when the acquirer was created under Chevron’s merger with Texaco.
ChevronTexaco is paying a premium price for Unocal as U.S. oil companies face heightened competition for scarce oil-and-gas reserves, many of which are locked up in regions where the companies are not welcome. The theory behind the deal is that it turns the merged company into the second-largest holder of oil-and-gas reserves in Southeast Asia behind Petrochina Co. and also strengthens ChevronTexaco’s presence in the Caspian Sea region.
However, today’s high oil prices can turn such deals upside down in a hurry. Although the price allows companies such as ChevronTexaco to have the strong balance sheet necessary for such acquisitions, should oil prices retreat from current levels in the next two to three years, the risk of write-downs in goodwill is high. ChevronTexaco hedged that risk somewhat by financing the deal mostly with its own stock — ChevronTexaco will pay $4.4 billion in cash and the balance in stock, and will assume $1.6 billion in Unocal debt.
Moreover, the deal reflects the increasing price that oil companies will pay for reserves. ChevronTexaco was able to replace only about 20% of the oil and gas that it produced in 2004, even though it generated in excess of $13 billion in profits and ended the year with over $9 billion in cash. The merged company will have daily production of over 3 million barrels of oil equivalents and increases ChevronTexaco’s reserves by about 15%.
The deal values Unocal at $62.07 a share, which is a 3.6% discount based on Unocal’s closing price of $64.35 on Friday. Widespread market anticipation that Unocal would be acquired has increased its share price nearly 50% since the beginning of the year. News of the deal actually sent both Unocal and ChevronTexaco stock down yesterday on the New York Stock Exchange, Unocal to $59.60 and ChevronTexaco to $56.98.

The Lord of Regulation moves the market

SpitzerGov.jpgIn an effort to calm the harried investors in his latest target, American International Group Inc., New York AG (“Aspiring Governor”) the reigning Lord of Regulation Eliot Spitzer announced yesterday that his office expects to reach a civil settlement with AIG even as he rachets up the criminal investigation into several private entities closely tied to AIG’s business. Here are the previous posts on the developing AIG and Berkshire Hathaway debacle.
After being hammered for over a month, the price of AIG shares responded to the Lord’s announcement yesterday by increasing to $2.35, to $53.30 on the New York Stock Exchange. Even with yesterday’s spike, however, AIG shares are down 26% since the beginning of the Enronesque investigation into AIG’s finances. The seemingly bottomless drop in AIG’s share price is driven by the fact that no major financial company has survived criminal charges in the history of U.S. financial markets.
Meanwhile, seemingly just to make things more interesting, several senior AIG executives were fleeing the boards of C.V. Starr & Co. and Starr International Co,, two closely-owned AIG-associated entities, the former of which controls 12% of AIG’s stock. Former AIG chairman and CEO Maurice R. “Hank” Greenberg is the CEO of Starr International, which uses its stake in AIG to provide deferred-compensation to AIG executives. Inasmuch as the Lord of Regulation does not approve of Mr. Greenberg’s tentacles affecting AIG, the AIG board is scrambling to disassociate itself from the closely-owned entities and reassert control over AIG’s executive compensation program.
Given the Lord’s disapproval of AIG’s arrangement with Starr International, that the structure of the arrangement may actually benefit AIG shareholders does not appear to be a particularly important consideration at this time to the AIG board.

The Enron law of unintended consequences

Ken Lay.jpgRemember that motion that former Enron chairman and CEO Ken Lay filed last fall in which he requested a separate trial from his Enron co-defendants Jeff Skilling and Richard Causey?
You know, the one in which U.S. District Judge Sim Lake delivered a body blow to the Lay defense team when he granted Mr. Lay a separate trial on the bank fraud counts that are specific toward him, but ruled that he would also have to stand trial with Messrs. Skilling and Causey in regard to the securities fraud and related criminal counts that are common to all three of the former Enron executives.
Well, the effect of that ruling is reverberating through Houston’s Federal Courthouse today. The Chronicle’s Mary Flood is reporting that the Enron Task Force has filed a motion in which it requests that Judge Lake schedule the trial of Mr. Lay’s bank fraud charges in May or June of this year before the trial of the larger case against Messrs. Lay, Skilling, and Causey that is currently scheduled to begin on January 17, 2006. Apparently, in support of its motion, the Task Force is relying upon Mr. Lay’s prior pleadings and public statements to the effect he wanted a speedy trial of all criminal charges against him.
Of course, Mr. Lay made those statements in the context of seeking a separate trial altogether from Messrs. Skilling and Lay, and quickly waived his speedy trial right when Judge Lake ruled that he would be tried with Messrs. Skilling and Causey on the common charges relating to all three. Thus, the Task Force is taking Mr. Lay’s request for a speedy trial out of context in using those statements to support its request for a quick trial on the bank fraud charges. Mr. Lay has suggested that the separate bank fraud trial commence within 60 days after the conclusion of the multi-defendant trial.
Judge Lake probably will not want to risk the prejudicial publicity of having Mr. Lay tried on the smaller bank fraud case before the larger multi-party case, so my sense is that he will deny the Task Force’s request for an earlier trial of the bank fraud charges against him. But the results of Mr. Lay’s seemingly innocuous motion seeking a separate trial in this case will prompt defense attorneys to think twice (and maybe three times) before filing such a motion in future multi-defendant cases.

Is it possible to dissolve a governmental agency?

Harris County sports authority.jpgThis Chronicle article reports on the brewing controversy over whether the Harris County-Houston Sports Authority — the quasi-governmental agency created to coordinate the construction of Houston’s Minute Maid Park, Reliant Stadium and Toyota Center — should be dissolved because its purpose has been achieved and it has nothing left to do.
Seems as if a few local legislators are questioning whether the $3 million annual overhead for the Sports Authority is really worth it when it appears that all the Authority is doing is writing checks on bonds issued to build the stadiums. Supporters of the Sports Authority are concerned that dissolving the Authority would impair the debt rating on the bonds. After spending a total of $1.036 billion to build all three stadiums, the Authority voted to sell another $37 million in bonds last summer to induce the investment rating agencies not to downgrade the bonds from investment grade to junk. The additional bond revenue was needed to make up for lagging hotel and car rental tax revenues that are dedicated to pay the bond debt.
The sports authority has about a $3 million operating budget, about half of which is dedicated to contractual obligations and professional fees that either the city or county would have to pay even if the authority were dissolved. However, the bonds are amortized over 30 years, so saving $1.5 million a year over that period is not chump change.
Curiously, the Sports Authority is attempting to justify its existence by proposing the construction of yet another sports venue.

City of Houston Housing Department slammed in audit

houston logo.jpgComing on the heels of this earlier story regarding HUD’s decision to freeze over $48 million of federal funds allocated to the City of Houston until the City corrects serious problems in the City’s Housing and Community Development Department, this Chronicle article reports on a Jefferson Wells audit report that essentially concludes that the Authority has been run as the personal fiefdom of some of its directors for over a decade.
The report identifies serious deficiencies in every area of the department, including a dysfunctional management culture and ineffective systems for verifying such basic things as whether contractors were doing their jobs and ensuring repayment of loans. Probably only the department’s system for setting up directors’ travel arrangements worked without a hitch.
The findings in the report are no surprise to anyone who has attempted to deal with the City of Houston Housing Department in an honest and businesslike manner. Tip to Mayor White: Clean house.

Batter up! Stros 2005 Review: Stros 2005 Preview

MLB_Houston_Astros.jpgWith Spring Training concluded and Opening Day on Tuesday approaching, it’s time for my preview of the Stros and the upcoming Major League season.
My first year of blogging coincided with last year’s magical Stros season in which the club came within a game of its first World Series. Just to see how it would go, I decided to blog a post on each Stros game and, as it turned out, I’m glad I did. I’m not going to blog each game this season, but the Stros will continue to be a common blog topic throughout the season, and I will continue to analyze the club’s performance periodically using sabermetric-based statistics.
Last season was truly one for the ages. After falling to a season-worst 56-60 record on August 14th, the Stros won 36 out of their next 46 games, a run that included 12 and seven game winning streaks. During the last two weeks of the season, the Stros pulled out the NL Wildcard Playoff spot in a tight race with the Giants and Cubs by winning nine out of their last 10 games and their final seven straight. Then, after beating the Braves in the Divisional Series, the Stros lost to the Cards in the seventh game of a memorable National League Championship Series, coming within an eyelash of the Stros’ first World Series appearance. Regardless of that ending, the Stros’ closing kick was one of the greatest finishes in Major League Baseball history.
MinuteMaid Park2.jpgComing into the 2005 season and as noted in this earlier post, it has been fashionable for baseball experts to predict that this will be the season that the Stros will finally fall from the lofty perch that they have occupied among the top teams in the National League Central Division over the past decade. The experts at Baseball Prospectus have been particularly pessimistic about the Stros.
Baseball Prospectus’ theory is that the Stros have lost two of their best hitters from last season’s club (Beltran and Kent) and will not have their best hitter (Berkman) for the first month of the season. Meanwhile, the club continues to accomodate the aging Bidg, who is blocking the development of promising rookie Chris Burke at second base. Also, the club is forced for contract reasons to continue playing the declining Bags at first base rather than placing Berkman there, which is his natural position. Throw in the Stros’ continued inexplicable reliance on the consistently unproductive Ausmus at catcher, plus doubts about whether Andy Pettitte can rebound from elbow surgery, and skepticism that the Rocket can repeat last season’s incredible performance at the age of 43, and you have a decent argument that the Stros are cruising toward a big downturn. Baseball Prospectus’ Joe Sheehan — one of the most insightful baseball writers around today — is so down on the Stros that he projects the Stros to finish 77-85, or 14 games worse than their record last season and above only the woeful Pirates in the NL Central standings.
Could it really get that bad so quickly?
Bidg2.jpgWell, yes it could, but my sense is that such a dramatic downfall is unlikely. Although the Stros are coming to the end of the Bidg-Bags era, the club has an interesting mix of veteran players and youthful prospects that can still contend for a playoff spot.
In evaluating the Stros on this blog last season, I introduced two handy statistics that baseball sabermetrician Lee Sinins developed for evaluating hitters and pitchers. “Runs created against average” (RCAA) is the hitters’ statistic. RCAA measures the two most important things from a hitter’s perspective in winning baseball games ?- that is, creating runs and avoiding making outs. Thus, RCAA computes the number of outs that a particular player uses in creating runs for his team. RCAA then compares that number to the amount of runs that an average player in the league would create while using an equivalent number of outs. Inasmuch as the hypothetical average player’s RCAA is always zero, a player can have either a positive RCAA — which indicates he is an above average hitter (i.e., Barry Bonds, who had a +152 RCAA last season) — or a negative RCAA, which means he is performing below average (i.e., Ausmus, who had a -26 RCAA).
Clemens2.jpg“Runs saved againt average” (RSAA) is the parallel statistic for pitchers. RSAA measures the number of runs that a pitcher saves for his team relative to the number of runs that an average pitcher in the league would give up while obtaining an equivalent number of outs for his team (as with RCAA, RSAA is park-adjusted). As with RCAA, a hypothetical average pitcher in the league always has an RSAA of exactly zero. Thus, a pitcher can have either a positive RSAA, which indicates he is an above average pitcher (i.e., Randy Johnson had a +50 RSAA last season) or a negative RSAA, which means he is performing below average (i.e., Tim Redding had a -15 RSAA last season).
Clearly, the biggest problem for this Stros club is going to be hitting, which was also the biggest problem of last season’s club. The excitement of the Stros’ extraordinary play during the final quarter of last season tends to make people forget that the Stros meandered around 10th among the 16 National League teams in RCAA for the first three quarters of the season. Even after their hitting picked up during their closing drive, the Stros still ended up just seventh in RCAA among the National League teams. Given that the Stros’ collective +50 RCAA included substantial contributions from the now departed Beltran (28) and Kent (12), it is certainly reasonable to question whether the Stros’ hitting this season will be sufficient to sustain a playoff caliber performance.
Berkman2.jpgPart of the reason that I think the Stros will be good enough to contend for a playoff spot this season is that I expect big improvement from three players who did not contribute much hitting-wise last season — Jason Lane, Morgan Ensberg, and Adam Everett. Last season, Lane in limited play had only a +3 RCAA, while Ensberg (-12) and Everett (-11) actually reduced the Stros’ team RCAA by 23 runs. With Lane finally getting a long overdue full-time spot in the lineup, with Ensberg returning to his 2003 form (+20 RCAA), and Everett improving to become an average Major League hitter (0), I expect those three to contribute at least +40 to the Stros’ team RCAA this season, which would make up for the loss of Beltran and Kent.
Although Berkman’s 69 RCAA from last season (5th in the National League) will almost assuredly go down a bit this season coming off his injury, I do not expect a big drop off from any of the Stros’ other primary players this season. Moreover, given a chance to play, Burke is a good bet to be at least as productive as Bidg (8 RCAA) or Kent (12) at second base. Consequently, given all of the above, my sense is that that this Stros team could develop into being at least as productive hitting-wise as last season’s club.
JeffBagwell_P39.jpgWhich leads me to make a comment about Kent. Many pundits have criticized the Stros for not picking up their $7 million option on Kent for this season, but I don’t agree. Kent is on the downside of his career and has declined in production for the past three seasons, a problem that the Stros are already dealing with in regard to aging stars Bidg and Bags. For most of last season, Kent was barely above average hitting-wise, and only a late flurry over the club’s last two weeks allowed him to achieve a reasonably decent +12 RCAA for the season. Moreover, Kent was clearly below average fielding-wise last season as his declining speed resulted in a frustrating lack of range in the field. Throw in the increasing injury risk with Kent and either Burke (my preference) or Bidg is likely to be just as productive as Kent this season and certainly far cheaper.
However, where I think Baseball Prospectus is going wrong on the Stros this season is by not recognizing a markedly improved pitching staff. That’s not to suggest that the Stros’ pitchers were all that bad last season — in fact, the staff ended the season with a +45 runs RSAA, which was 4th among the 16 National League pitching staffs. Nevertheless, even though Clemens, Lidge and Oswalt were among the best pitchers in the National League, the rest of the Stros’ staff struggled, including an aggregate -41 RSAA from the quartet of Carlos Hernandez, Brandon Duckworth and the now departed Pete Munro and Redding. Those four generally ineffective pitchers were manning at least one of the starting pitching spots throughout all of last season.
Brad-Lidge2.jpgThis season, the Stros’ pitching staff appears to be substantially stronger. Brandon Backe, Chad Qualls, and Dan Wheeler all stepped up big time during the playoff run last season and appear to be primed to become solid Major League pitchers this season. Pettitte’s recovery from surgery has been smooth and he appears ready to take his spot with Clemens, Oswalt and Backe as solid starters. Finally, one of the pleasant surprises of Spring Training has been the dominating performance of Ezequiel Astacio, one of the Stros’ fine young pitching prospects who appears ready to take over the fifth spot in the pitching rotation. The Stros optioned Astacio to triple A affiliate Round Rock to begin the season to allow him to make a couple of starts before the Major League club’s schedule requires a fifth starter, but there is little doubt that he will be back with the Stros soon. Accordingly, barring injury, this Stros’ staff could improve by 10-15 runs in total RSAA over last season’s staff, which would likely place this group in the top three staffs in the National League.
Astacio’s performance in Spring Training prompts an observation about minor league players becoming Major Leaguers. Generally, it is more common for pitchers to be able to make the jump successfully from Double A ball than hitters. Astacio and the Stros Spring Training camp’s other young stars — CF Willie Taveras and LF Luke Scott — all played Double A ball last season. All three performed well during Spring Training and have made the Major League club, although Astacio is having a cup of coffee at Round Rock to begin the season.
Roy O3.jpgNonetheless, I would prefer that the Stros have Taveras start the season at Triple A so that he can continue to develop his plate patience and power before taking on Major League pitching (.402 OBP/.386 SLG, but only 38 walks in 409 AB’s at AA last season). The Stros probably need Scott’s left-handed stick on the Major League roster at least until Berkman returns, so keeping him on the Opening Day roster is a more reasonable move, but we should all remember that — despite Scott’s unconcious hitting performance during Spring Training — he was playing high A ball at this time last year. Thus, do not be surprised when both Scott and Taveras struggle against Major League pitching.
Another reason for my optimism is the Stros’ competition within the division. Although the Cardinals still appear to be the class of the division, the Cards pitching staff’s performance last season has a collective “career year” written all over it. Assuming that the Cards’ pitching returns to a more typical level this season, look for the Cardinals to lose at least 10-15 wins off of their 105 win season of last year. Mr. Sheehan of Baseball Prospectus predicts that the Cards will have 16 fewer wins this season (89).
The other probable contenders in the division also have problems. Although the Cubs have the best pitching in the division, both Prior and Wood are having arm problems and the staff still has no clear closer. Moreover, the Cubs hitting has declined with the losses of Alou and, to a lesser extent, Sosa, so run production is a concern there, too. Unless Prior and Wood can pitch for most of the season, my sense is that the Cubs will struggle to win 80 games this season (they won 89 last season).
Garner.jpgSimilarly, although the Reds‘ hitters can flat out tear the cover off the ball, the club’s pitching staff still creates an adventure for the club almost every time a member steps on the mound. My sense is that the Reds will improve on their 76 wins from last season, but their pitching will limit that improvement to about 5-10 wins and not the 15 win improvement that the Reds will need to contend for a playoff spot.
Thus, even with the loss of Beltran and Kent, the Stros still appear to me to be an above .500 team. The offense is probably going to slide a bit with Berkman out for the first month of the season. But the starting pitching looks very good, Lidge is currently the best closer in the National League, and the middle relievers look improved over last season’s dubious group. If Lane hits as expected, Ensberg rebounds, Bags (+17 RCAA) and Bidg (+8 RCAA) maintain as well as they performed last season, and the young players develop well, then my sense is that the Stros are an 85 to 88 win team with an outside chance to take it over 90 wins if the injury bug does not bite.
90 wins would put the Stros right in the middle of the playoff race in the NL Central, just as they have been for the past decade. Admittedly, I view the Stros somewhat through rose-colored glasses (except for Ausmus), but my sense is that the club’s run of competing for a playoff spot is not quite done. And with a couple of key acquisitions a couple of years from now when Bags and Bidg retire, there appears to be no reason why the Stros cannot build around their Berkman-Oswalt-Lidge core and continue their playoff-contending status for years to come.

Pictures of a great man

johnpaulii.jpgAs Pope John Paul II nears death, Newsweek provides this online review of its issues over the past 27 years that have featured a picture of the Pope on the cover.
George Weigel’s Witness to Hope is probably the best biography on Pope John Paul II. Mr. Weigal’s op-ed from ten years ago — The Mobile Pope — explains how the Pope modernized the papacy and in The Holy Father in the Holy Land from five years ago, Mr. Wiegel describes the Pope’s historic visit to Jerusalem and the Middle East.
Pope John Paul II leaves a legacy of grace, strength and forgiveness that is a beacon of light in an increasingly dark world. His is a life worthy of reflection, so take a few moments to review the momentous contributions of this remarkable man.
Update: Mr. Wiegel provides this interesting personal remembrance upon the Pope’s death on Saturday afternoon.

Oil prices hit record highs

traders150-pa.jpgOil prices climbed to record highs Friday on mounting concern about limited supplies.
Crude futures for May delivery on the New York Mercantile Exchange settled up $1.87 at $57.27 a barrel. That price is a new record closing price, beating the old record of $56.72 a barrel of a couple of weeks ago. Adjusted for inflation, Friday’s closing price close is the highest since Oct. 11, 1990 when Nymex crude closed at $40.42, which is equal to $58.18 in today’s dollars. Nymex crude would still need to reach $90 a barrel to beat the inflation-adjusted high price that was established in 1980.
This Forbes graph provides an instructive overview of oil prices over the past 150 years. The last 30 years of oil price fluctuations has been quite a ride.