If The Greek Can Do It, So Can You!

April 2005 Dr. Hans Black

With apologies to our many Greek friends, we cannot help but draw parallels between the now well-documented revelations leading up to Greece’s entrance into the European Union in 2001 and the -accounting irregularities perpetrated by so many publicly-traded companies over the past ten years. Financial journalists — rightly so — are still obsessed with the dealings at WorldCom, Enron and currently HealthSouth. To what degree were earnings numbers inflated or other balance sheet problems hidden from view? While this is hardly a new story — it can be traced unfortunately to the excesses in the 1960s — the recent experiences of the late 1990s and early 2000s have been monumental. The accounting profession has had to deal not only with these difficulties but also with its regulatory response, namely the Sarbanes-Oxley Act.

In recent months fresh revelations about the extent to which Greek bureaucrats engineered their entry into the European Union have come to light. Writers like Jim Grant of Grant’s Interest Rate Observer have commented on how, in the pivotal years of 1998 and 1999, the Greek deficit was just below 2 percent of Greek GDP. In subsequent years, after the decision had already been made to let Greece into the European community, enormous revisions were published exposing the previous numbers as difficult to believe at best. The deficit to GDP ratio was suddenly revised to well over 3 percent, a fact that would have effectively blocked Greece’s entry into the European community had they been revealed at the time. Now, in early 2005, in the midst of a global love affair with the euro, Greece is being criticized more loudly than ever by its European allies for its staggering 2004 deficit-to-GDP ratio of well above 6 percent. So much for the European Union Stability and Growth Pact, which enshrines 3 percent as the target level for its member nations. Indeed, just as currency markets have been rushing to embrace the euro as a so-called safe haven, the Europeans are hurrying to redraft the Stability Pact itself. Nor is this a friendly gesture to make Greece feel less conspicuous: Italy, Germany and France are all in violation of the same 3-percent rule and are engaged in devising various accounting sleights-of-hand to crunch the numbers in such a way as to come up with acceptable ratios. Whether by counting or not counting certain capital expenditures — or indeed defense spending — certain nations and their ministers believe that they can somehow avoid criticism within the context of the earlier Stability Pact ratios. Imagine for a moment the United States arguing that they will not count certain defense expenditures in their deficits as they can be considered longer-term security benefits. The outcry would be enormous. But this is exactly what the Europeans are proposing. We should not be too shocked, however, as the game of dealing with numbers in a not entirely honorable way is age-old and universal.

Somewhat related to the revelations above, a new twist has appeared, one on which we have commented on so many occasions, namely derivatives. In mid March the Federal Reserve Board took the unprecedented step of publicly advising the United States’ largest bank to clean up its internal controls (presumably derivatives) before any new expansions or mergers could be contemplated. Remarkably, this has had very little press coverage, but with Washington increasingly focused on the mess in Freddie Mac and Fannie Mae, we must wonder if some of the larger banks are not far behind. Indeed, given the fact that there is somewhere in the vicinity of $150 trillion of cumulative derivative exposure in the global banking system — some have argued the number is actually twice as large — we are becoming more deeply worried than ever about exposure to banks or insurance companies. Many months before the Fed took its unusual step, the New York State Attorney General, Eliot Spitzer, had already created havoc within the insurance industry with allegations of price fixing last fall. The recent forced retirement of AIG’s chairman, Hank Greenberg, and the literally dozens of subpoenas flying around the corridors in Hamilton, Bermuda (which happens to be the world’s reinsurance capital), make us profoundly uneasy.

Although well cognizant that our decision to severely underweight banking and financial stocks from our portfolios has been controversial, we remain very comfortable with our decision-making process. In time, the under-performance of the past several months should surely lead to even greater under-performance for the sector as a whole. Until the storm has passed, we prefer to go fishing in calmer waters — the recent weakness in biotech is an excellent example — selecting companies with which we feel more comfortable and which have business plans we can at least understand.