Why Did The Crisis Happen? One Does Not Need To Look Too Far Back

In this age of manifestations of human greed, a financial crisis partly attributable to bank managers´ quest for short term profits: one wonders the origins of such behavior and the old adage of “history repeats itself.” One does not need to look too far back in history to understand that all financial disasters have the same set of usual suspects: an overzealous CEO who is fixated on conquering the world, compensation based on incentive pay that relies on short term profits that mitigate manipulations, shareholders and other government officials who fail to recognize “red flags” and act as primary cheerleaders for the company up until its demise.

Consider Nortel, for example – a company  which, in my opinion, experienced the most spectacular rise and fall of any public corporation. Although overshadowed [in the press?] by peers such as Enron and Worldcom, Nortel´s story outshines the others because, apart from its disastrous failure, its rise from a small regional player to become the global name in telecommunications was a path like no other. If a picture is worth a thousand words, then the image below of the stock price of Nortel says it all.

        Figure 1: Quarterly Market Value of Equity of Nortel, 1993-2002
 
The rise of Nortel comes straight from a story-book fairytale. From a small regional player, Nortel became a giant corporation at its peak.  In July 2000, at the height of its success with a market capitalization in excess of $350 billion Canadian dollars, the company accounted for more than 37 percent of the Toronto Stock Exchange Composite Index value and ranked among the largest firms in the world.
    
As a diversified company focused primarily on telecommunications, Nortel seemed invincible.  Commentators were pleased with its “strength across the board in its product markets” and its focus on the fastest growing wireless and broadband communication segments.  Its particular expertise –enabled the company to post very impressive revenue gains in product segments where it was a relative newcomer and Nortel seemed poised to exploit new Internet technologies, particularly [?] with an wave of international deregulation expected in this sphere.  Using an aggressive acquisition strategy, Nortel grew quickly and well beyond North America.  As a result, analysts praised what they perceived to be “solid, sustainable growth” from large R & D expenditures fueling the ‘perpetual surpassing‘ of earnings expectations. The below graph illustrates Nortel’s  earnings surprises in comparison  to all the other players in the technology [or should it be telecommunications industry?] industry (an aggregation of 18 other firms, including Ericsson, Cisco, etc). It is evident that Nortel consistently beat analyst expectations by a few cents, hence, continuing a perception of “invincibility.”  

Figure 2: Nortel Earnings w.r.t. Consensus Analyst Forecasts

 

Nortel’s share price more than tripled in four years. By mid-2000, it reached a peak of more than $200 Canadian dollars per share. Starting from a strategy of being in every high-growth area in telecommunications, and benefiting from tailwinds due to regulatory and market conditions, Nortel tripled its sales and multiplied its pro forma operating profits several fold within five years. Consequently, the media proclaimed CEO John Roth a man of boldness and vision with a Midas touch.  This mania also spread to the analyst community as the market grew increasingly reliant on technology sector proliferation in the late 1990s.  Nortel greatly increased its institutional investor ownership as more analysts hailed its performance.  Meanwhile, analysts began to grow lazy with their assessments.  They justified high priced acquisitions such as the $US 3 billion purchase of Qtera (a firm with no sales), failed to critically scrutinize accounting changes that had revenue impacts, and cheerleaded questionable spin offs.  All the while, government regulators draped the company with the Canadian flag as a symbol of national economic vitality.  Everyone wanted to believe in the Nortel supernova.  

Well, does all this sound familiar at this point? How about investment strategies by major banks that were based on underlying fundamentals that no one understood? How about the big investment banks in the US falling one after the other like domino chips? It is only in cold blood one can realize that overzealous CEOs, hungry at pushing the boundaries of their game and industry, that went on buying sprees, enriching themselves a hundred-fold in the meantime. And yes, most of these US banks lost 80-100% of their market values in the ensuing crash, just like Nortel.
    
Nortel’s fall from grace came swiftly and on many fronts.  Beneath the unsustainable rate of growth and earnings lied massive accounting financial irregularities where results had been seriously manipulated for some time.  Not only could analyst targets no longer be achieved, but good will had to be reinforced.  For years, a cloud would hang over accounting results reported by Nortel, including the perennial belief that the company had “cookie jar reserves” for the purpose of normalizing results.  Ultimately, Nortel announced several restatements, including the largest one in Canadian history. 

The accounting problems led commentators to retroactively question previously unassailable acquisitions.  Trading in Nortel stock was suspended as the trading price went into a free fall.  Before it was over, more than two thirds of Nortel’s workforce would be discharged.  Several waves of high-level corporate executives resigned, including John Roth, and former CFO Frank Dunn was appointed to the helm.  Investors complained that even in its downward spiral, these executives received bonuses and issued excessively optimistic projections.  But soon enough, there would not be much left to the company other than lawsuits alleging issuance of misleading financial statements and blatant insider trading.  Nortel’s fall had been as steep as its rise. From a share price of more than $200 CDN to $0.67 CDN at its nadir, Nortel left more than 60,000 employees unemployed.  Nortel still continues on today, but with a legacy of continuing investigations, rapid executive turnover, and empty optimism.
    
During this time, Nortel followed a compensation strategy heavily based on option compensation. Fixed salary awarded every year amounted to a bit less than, or around, $1 million a year, while short term bonuses reached $1.3 million in 1998, $4.2 million in 1999, and $5.6 million in 2000.  It must be pointed out that, according to Nortel’s 2000 and 2001 proxy statements, the most heavily weighted driver for bonus compensation was revenue, followed by operating earnings per share (i.e., non-GAAP earnings).  Thus, on a straight cash basis, there was strong inducement for Nortel’s CEO to engage in an unbridled growth strategy, mostly through acquisitions. In contrast, in a year where the Nortel CEO received a bonus of $5.6 million, the CEO of Lucent did not receive any bonus payment, and the CEO of Motorola received a meager bonus of $1.25 million. The graph below shows the compensation of the Nortel CEO  compared to the industry median; and as one can clearly see, the $308 million earned by Roth in 1999 by far surpasses those of other executives. However – and naturally – after the scandals and the tanking of share price, the value of these options dropped dramatically.

Figure 3: Value of Total Options Held by CEO
 

    The steep rise and the dramatic fall after the year 2000 can be understood in terms of equity “overvaluation.”  Overvaluation occurs when there is a large deviation between share price and underlying value, where there is a near impossibility in delivering to expectations.  The conception is that once overvaluation occurs, it sets in motion unmanageable organizational processes. Specifically, market delusion prompts value destroying managerial behaviour.

    Why is this story of Nortel still relevant today? Well, because history repeats itself. What happened to Nortel is a copy/paste version of Lehman brothers, Citigroup, and the rest of the banks that caused this crisis: Greedy CEOs set to conquer the world, compensation heavily reliant on incentive pay such as bonuses and share payouts that induced short term thinking, risky Las-Vegas style investments that were more like bets unto the unknown, shareholders and government regulators who were buoyed by the cash bonanza that no one bothered to check fundamentals. It is the same all over again – a new mask and a different setting, but the essence is identical. Human nature is fallible and greed is the cardinal sin of modern corporations.

What is the solution? The solution is simple – as Jack Welch would say, “hire good managers.” Such a simplistic view does trivialize the suffering that has resulted from the largest wealth destruction in modern history, but, sometimes the simplest remedies are the best.

Garen Markarian is Professor of Accounting, IE Business School

[This research paper has been reproduced with permission of the authors, professors of IE Business School, Spain http://www.ie.edu/]