Thursday, October 28, 2010

Diagnosing the Problem

The last post brought up the Sarbanes-Oxley financial reform. The reform created tight new accounting standards and included stiff penalties for accounting malfeasance.

This reform followed the collapse of Enron and Worldcom. Both companies were rife with accounting scandals.

The fact that we saw big accounting reform after these troubles indicates that our leaders had diagnosed the troubles at Enron and Worldcom as accounting problems.

In my opinion, the troubles at Enron and Worldcom resulted from their business models. Enron was a company that used a complex models of dirivatives to control risk. With risk seemingly controlled, they took a hugely leveraged position to dominate the energy market.

Bernie Ebber's Worldcom was built upon a complex system of debt financing. The company tooked massively leveraged positions in the market and simply hoped that it could grow fast enough to become solvent.

IMHO: Both the Enron and Worldcom business models were flawed and doomed to big time failure. From my point of view, it appears that the accounting problems at the two companies appeared because their business models were falling apart.

If my opinion is right (and we all know that I am right) then the accounting scandals were a symptom of a bad business model. In which case, Sarbanes-Oxley confused a symptom for the underlying disease and was the wrong remedy.

By misdiagnosing the disease, Sarbanes-Oxley did not provide economic stability as its authors hoped. All it did was put a stranglehold on the productive portions of our economy that now had to comply with onerous regulations.

During the financial collapse of 2008, we had really good well audited data telling us that the complex business models built on complex derivatives and highly-leveraged debt financing was a house of cards.

Back to the current crisis: Our current president diagnoses the economic problem as resulting from the existence of Republicans. We've engaged in two years of new regulations and spending designed with the purpose of rewarding friends and punishing enemies.

If the root of our financial problems is the existence of Republicans, then the economy should be improving. If, however, it is the fault of these complex derivative based business models (hedge funds) and debt financing, then we are in store for ugly times ahead. One can't solve the problem of debt financing by borrowing and spending more.

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