Financial Engineering: Cure For General Motors?

Three days ago, after tens of billions of American taxpayer dollars were used to bail out the auto industry under the supposition that a bankruptcy filing would lead to the catastrophic liquidations of General Motors and Chrsyler, the audit firm of Deloitte & Touche nevertheless expressed substantial doubt that GM would survive in its present form.

Deloitte & Touche, as well as other public accounting firms, call this a going concern opinion. But investors, lenders, suppliers, customers, and employees of GM might ruefully call it a kiss of death.

The primary cause of Deloitte’s pessimistic conclusion is the heart-stopping crash of automobile sales volume since the global economy collapsed in late 2008. GM has seen a 53% sales decline in the month of January 2009 alone, and an overall 40% decline since sales peaked in 2007. But what can companies like GM do to boost sales in such times of crisis?

Jaded business professionals might retort, with a bit of sarcasm in their voices, “How about selling better quality automobiles for more affordable prices?” Yes, that is always a good idea …

… but many companies, including GM, have often resorted to financial engineering strategies as well.

Gary Winnick: The King Of Financial Engineering

Shortly after the technology bubble of the late 1990s burst, for instance, the telecommunications firms Global Crossing and Qwest Communications engaged in a series of swap transactions that were designed to boost declining sales numbers. Though the transactions were not designed to significantly increase net earnings, they were required to maintain revenue levels and thus persuade investors that the firms had bright futures as high growth businesses.

Such high growth businesses, of course, usually trade at high price/earnings multiples; thus, these swap transactions helped senior executives maintain personal levels of compensation that were determined by their firms’ stock market valuations. Global Crossing and Qwest were publicly excoriated by a committee of United States Congressmen, who accused them of conjuring up “sham transactions” for the private benefit of their senior executives.

But Gary Winnick, the head of Global Crossing at the time, protested that these transactions were perfectly legal acts of financial engineering; he said that they were developed and booked in order to keep his firm competitive in the financial markets. Although he was raked over the coals during Congressional public hearings, he never spent a single day in jail.

Other Tales of Financial Engineering

Similar types of swap transactions have been developed and implemented throughout recent American corporate history. Many firms engage in sales and leaseback transactions, for instance, that appear to have no valid business purpose other than the financial engineering of balance sheet and income statement items. By the time that the original owner of an asset leases it back from its purchaser in such a transaction, there is usually no discernable impact whatsoever on the business operations or overall cash flows of either firm.

And Enron, for instance, used internal transfer prices between its own divisions to establish extremely high market rates for a series of commodity transactions that were traded on its own system; they then used these data points as benchmarks for revenue transactions with third parties. The revenue rate setting process itself was considered perfectly legitimate (and even quite clever) at the time; Enron quite possibly would have escaped any criticism about these practices if not for the collapse of the firm for other reasons.

And what of GM and its fellow automobile manufacturers? Well, the automobile industry has actually engaged in internal transactions of questionable economic value for decades. In 1996, for instance, the Ford Taurus only managed to hold onto its “Best Selling American Automobile” title because more than half of all its sales that year were made to rental car companies. Ford, not coincidentally, had been a partial owner of Hertz and Budget for many years, while GM was a partial owner of Avis and National for many years as well. In other words, the automobile rental agencies that purchased Ford and GM automobiles were often partially owned by the manufacturers themselves.

What’s An Auditor To Do?

So what is an auditor to do when confronted with an income statement of an organization that claims to produce the best selling automobile in the nation, but that sells 51% of its output to special entities? Or an energy company that marks-to-market its asset values on the basis of transactions that are placed on a private system that it directly owns and, in fact, thoroughly dominates? Or a firm that has removed significant amounts of debt from its books with a series of sales-and-leaseback transactions that have no underlying economic value whatsoever? What, exactly, is an auditor to do?

Unfortunately, even government regulators are not opposed to the use of financial engineering transactions that serve no discernable underlying business purpose. For instance, many regulators are still espousing the development of a gigantic government-owned “bad bank” to purchase problem assets from our wobbly private financial institutions, an idea that Paul Krugman derides as “the belief that fancy financial engineering can create value out of nothing.” And, in a sense, each tax incentive that has ever been passed by a governmental entity is designed to encourage businesses and individuals to engage in transactions that they would not have otherwise considered if not for the incentives themselves.

So what’s an auditor to do? Sadly, the conventional wisdom appears to encourage them to sign off on the financial engineering activities of their client organizations. And what is GM to do? If it continues following the same conventional wisdom, it may continue engaging in these very activities as well.

Unless, of course, our society finally realizes that the individuals and firms who followed the conventional wisdom are the ones who are responsible for creating our present economic crisis to begin with …

… and with that realization, in the blink of an eye, we might finally start down the path to a sustainable recovery.