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Taking a Shortcut Through the Numbers

“The two most dangerous words in Wall Street vocabulary are ‘financial
engineering,’ ” said Wilbur Ross, the turnaround specialist. Warren Buffett
refers to derivatives as “financial weapons of mass destruction.”
It wasn’t always so. Originally, the term “financial engineering” evoked
images of Wall Street math wizards taming the vagaries of risk by conjuring
up esoteric financial instruments, in the process creating liquidity and
enabling markets to function well. From 1987 through 1996, the average
worldwide growth rate in the face value of the major forms of derivatives was
40 percent a year, according to CFO magazine. Paul Kasriel, director of economic
research at Northern Trust, says profits from the financial sector now
account for 31 percent of total U.S. corporate earnings— up from 20 percent
in 1990 and 8 percent back in 1950. Profits from this country’s financial
engineers now far exceed those generated by mechanical engineers.

As the wizardry spread, however, nasty surprises occurred— even
before the subprime mortgage disaster that shook the financial world
beginning in 2007 and 2008. Barings Bank, once the oldest merchant
bank in London, collapsed in 1995 because of $1.4 billion in losses by one
rogue trader, Nick Leeson. ING, a Dutch rival, bought Baring for one
British pound. Long Term Capital Management, a hedge fund founded
by legendary bond trader John Meriwether and whose partners included
Nobel Prize winners in economics, dazzled with 40 percent–plus annualized
returns in its first few years before losing $4.6 billion in the course of
a few months in 1998. (While LTCM claimed the market had become
irrational, it’s worth remembering John Maynard Keynes’s observation
that “the market can stay irrational longer than you can stay solvent.”)
In general, it only takes a few bad bets in the trading business to lose billions,
as happened in 2006 when the Amaranth hedge fund lost almost
$6 billion and was liquidated because it, essentially, lost some highly leveraged
bets on the weather.

The wizardry spread from Wall Street into the rest of corporate America,
where companies increasingly used financial and accounting techniques
to enable broad corporate initiatives, such as restructuring,
increasing financing available to customers, funding new ventures, and
hedging operational risk.

Problems have shown up in the non–Wall Street crowd, too. Companies
get sucked into the idea that they’ll indulge in some creative accounting,
but only briefly, until the business clears some hurdle and earns its
way out of the current difficulties. But the one or two quarters of aggressive
accounting can become three or four, then become a way of life—
until disaster strikes. That disaster can sometimes mean regulatory
censure and fines. In extreme cases, à la Enron Corporation, the aggressive
accounting can turn into fraud and jail terms. But even if the accounting
stays just this side of the line, once investors learn about it they can
still punish a company severely.

Every once in a while, you even see a company that manages to come
out the other side after a period of creative accounting. AOL’s profits for
years came from financial chicanery. The company blanketed the world
with free introductory CDs to get people to sign up for its service but
didn’t absorb the costs as expenses right away. AOL capitalized the
expenses, spreading them out over several years. The theory was that AOL
was attracting customers who would be with it for years, so it was fair to
defer much of the expense of acquiring those customers. The problem
was that the average person who signed up because of AOL’s free discs
didn’t stay with the company for even a year. The SEC investigated, eventually
fining AOL $300 million and issuing a stinging rebuke in 2005, but
by that point AOL had become a legitimate business.

But there have been enough failures associated with financial engineering
that it’s worth distinguishing, in Warren Buffett’s words, acceptably
aggressive accounting from attempts at alchemy. In the end, as
Buffett once wrote his shareholders, alchemy fails. Financial alchemists
may become rich, but gullible investors rather than business achievements
will usually be the source of their wealth. We’re interested in spotting
the alchemists and helping both executives and investors head off
inherently flawed financial engineering strategies before they wreak
havoc.

We’ll begin with a story that, had it been studied by subprime mortgage
lenders, would have warned of how mortgage lending can become so
addictive that financial institutions can stop paying much attention to
whether borrowers will ever pay off their loans.

To continue reading, download Chapter 2 of “Billion Dollar Lessons.”