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It is the year 2000. A fat sedentary guy eats steak and bacon three meals per day. His cholesterol is high. A doctor prescribes a statin. Now he is a fat sedentary steak-eating guy with a low cholesterol lab result. Is he as healthy as a thin active guy who eats mostly vegetables?

Fast forward to 2008. We have discovered that statins have some side effects and that fat sedentary steak-eating guys with low cholesterol scores drop dead at about the same rate as fat sedentary steak-eating guys with high cholesterol scores.

What’s the equivalent situation in the corporate world? The true health of a company is measured by its long-run stock price. That is tough to manipulate and reflects what investors are willing to pay for the enterprise, taking into account all risks, all news, and any deferred expenses. At Enron, following the advice of the best minds of McKinsey, employees were compensated for book profit, as certified by Arthur Andersen, and EBITDA (earnings before income tax, debt, and amortization). The result was a company with tremendous reported profits, strong EBITDA, and an ultimate market value of less than zero. Conspiracy of Fools chronicles one of the discussions about EBITDA among Enron senior managers. One guy pointed out to Rebecca Mark, a Harvard Business School graduate star of the company, that EBITDA was meaningless because one could improve EBITDA simply by borrowing money at 10 percent and investing it in T-Bills at 5 percent and that was essentially what Mark was doing. She was borrowing money at X% to purchase businesses that would return no more than (X-4)% in a best-case scenario. This fattened her paycheck, but led the company towards bankruptcy. Another McKinsey idea was to set up a bonus as a percentage of profits; the employees went to the Clinton administration’s SEC and got permission to account for 20 years of future profits in the year that a gas contract was signed. This resulted in a 20X pay increase for employees in that division, but resulted in the company having no profits to report in future years, even if they continued to make cash profits on those gas contracts. The prospect of going to Wall Street and saying “we’ve already recorded all of our profit for the next 20 years” was so grim that the senior executives resorted to accounting fraud instead.

Enron worked out very badly for investors and average employees, but it was a great place to be a senior manager, some of whom are now among the wealthiest Americans (e.g., Lou Pi walked away with $250 million and become the second largest landowner in Colorado).

Have public company Boards learned any lesson from Enron? A March 31, 2008 article [sadly not online] about Stan O’Neal, the former CEO of Merrill Lynch, suggests not.

The Board at Merrill Lynch Enronized their company by promising to pay Stan O’Neal roughly $50 million per year if he made some numbers look good. One of the numbers that they wanted to see improved was Return on Equity. O’Neal managed to improve it by using the company’s cash to buy back stock. By reducing the amount of equity in the firm, whatever profit they managed to earn in a given year would be a larger percentage of the remaining equity. Unfortunately, for a company that faces risk, reducing the cash supply inevitably means courting disaster.

The Board also decided to give bonuses to executives based on where Merrill ranked in the business of creating mortgage-backed securities. O’Neal and colleagues managed to grab the number-one spot by 2005, near the tail-end of the real estate bubble. Merrill would buy up garbage mortgages from retail banks, mortgages that by 2005 hardly anyone else wanted. These were loans on houses that had never been independently appraised to homeowners who had never proved that they had any source of income. Merrill’s goal was to package up this junk and sell it to fools in the institutional investment community. This worked great for a while and Merrill pocketed a lot of fees. By 2006, however, the supply of fools to buy up baskets of junk mortgages was dwindling. Merrill could have simply stopped buying the mortgages, but that would have resulted in a loss of fees and a reduction in executive salaries. O’Neal, who had been the Chief Financial Officer of Merrill, and his subordinates decided to continue buying the junk mortgages and wrapping them up into CDOs but, because nobody out there was dumb enough to buy the CDOs, keep the CDOs for themselves and account for them at the value that they wished they could have sold them for. Merrill ended up with $32 billion in nearly worthless debt. O’Neal retired with the savings from his $50 million per year salary plus a lot of bonuses and retirement extras.

Oftentimes the debacle on Wall Street is painted as too complex even for the executives involved to understand. Merrill’s near collapse was easy to understand, though. They bought mortgages that nobody else wanted and repackaged them into securities that they couldn’t sell. They had a couple of huge warning flags. AIG stopped insuring these securities against default in 2005; when one of the world’s largest insurance companies says that these things are too risky for it to insure at any price, you’d think that anyone holding $32 billion of such items would take notice. The fact that the securities couldn’t be sold and were clogging up their balance sheet should also have been a warning sign for any executive with a pulse. The likely fact is that these were warning signs of doom for Merrill’s shareholders, not for executive bonuses, which were computed regardless of the risk that Merrill was taking or the collapse in overall firm value.

So… if you’re on a Board and you decide to compensate a manager with anything other than cash or a long-term stock option, make sure that you’re not granting compensation based on a number that the manager can easily manipulate. Keep in mind that managers are often a lot more clever in doing things that will benefit themselves than things that will benefit the company.

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Guy goes out in his twin-engine Beechcraft Baron. He returns home in bad weather, with clouds reported by witnesses as low as 500′ above ground level (AGL). He loses control of the airplane in a typical stall/spin accident, crashes into the ground, and kills himself. The NTSB did not mention any mechanical problems with the airplane or the engines and did not list engine failure as a possibility. The NTSB said only that the probable cause was “the pilot’s failure to maintain control of the airplane while maneuvering resulting in an inadvertent stall/spin.”

Teledyne Continental (TCM) was the manufacturer of the Baron’s engines way back in the 1970s or whenever this plane was produced (the NTSB doesn’t say). An engineer might say “it is impressive that those engines spun flawlessly for thirty years, not quitting until this pilot flew them right into the ground.” A jury saw this accident differently, ordering TCM to pay $4 million to the survivors of the pilot. The total market for these kinds of engines in new airplanes is about 2500 per year, of which Teledyne makes roughly half. So this judgment represents a cost of about $4,000 per engine sold every year to airplane manufacturers. The Federal Reserve Bank can cut interest rates to 0% and you’d still have to ask yourself how it could possibly be rational to invest in a U.S.-based company making aircraft or aircraft components. Subprime mortgages look great when you factor in this kind of litigation risk.

Full story on Aero-News.net; also check the NTSB report.

Related story: Airplane carburetor company sued out of business.

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Eric Falkenstein has posted a useful guide to climbing the corporate ladder; if you’re not interested in politics, simply ignore the references to Barack Obama and concentrate on such phrases as “this is the key subtlety to the empty suit strategy, you need some camouflage”.

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Todays’ NYT includes “Maybe Money Does Buy Happiness After All.” To moderate the dollars uber alles message, the article says “some of the things that make people happiest — short commutes, time spent with friends — have little to do with higher incomes.” In a United States that gets more crowded every year (“ask an American Indian what happens when you don’t control immigration” will become more poignant when we cross the 400 million and 500 million resident lines), houses that are close to jobs are going to become ever more expensive. If you work in Manhattan, have a wife and kids, and want a commute shorter than 45 minutes, you’ll need $3 million for a 3BR apartment. Things aren’t much better in California and the other coastal areas where most Americans live.

What about “time with friends”? Imagine that you work in Los Angeles and, because you can afford only $350,000 for a house, have a four-hour daily round-trip commute to an exurban subdivision. How much time will you have available to be with friends? Contrast that to a multimillionaire who lives and works in Santa Monica and can ride a bicycle 15 minutes to work.

“Time with friends” becomes even more of a luxury in a country where people disperse geographically after high school, after college, and after graduate or professional school. Peoples’ closest friends tend to be those made during the ages of 15-30. With domestic airfares getting closer to $1000 round-trip and hotel rooms in big cities between $300 and $400 per night, how often will a middle class American be able to see friends from college?

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All wisdom comes from watching television. Tonight a viewer on a political panel show called in and posed the following question to the assembled pundits: “All three current presidential candidates are senators. All three claim to have tremendous leadership skills and ideas for improving the lives of all Americans. If they have such great ideas and leadership abilities, why haven’t any of them been able to lead their colleagues in the Senate to accomplish anything significant?”

He raises a good point. Obama, Clinton, and McCain are among the 150 or so most powerful Americans. They can literally rewrite all of the laws in this country. Yet it would be tough to find anyone who can say that they have enjoyed greater opportunities or a better life because of something that one of these three has done.

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Today’s New York Times carries a story about the U.S. government financing home construction for Palestinians: “New Home-Buying Plan May Bolster Abbas”. You would think that we have demonstrated conclusively, by our own sagging economy, the dangers of investing almost exclusively in housing as opposed to factories and industry. Now the Palestinians, who have the world’s highest birthrate and a level of education and productivity that is not competitive with Asia, are going to have an even larger imbalance between housing and jobs.

The article does not address the question of why this is being funded by U.S. taxpayers. Wealthy Arab nations are buying up assets all over the U.S. because they can’t figure out what to do with the hundreds of billions of dollars that we’ve been sending them. These same folks often express solidarity with the Palestinians. If folks in the Emirates can afford to buy investment banks in the U.S., airports and container shipping ports throughout the world, and personal Boeing 747s (some of which cost about as much as this program), how come they won’t give their Palestinian brothers a mortgage?

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Today’s Wall Street Journal carries an article on the softening of the yacht market. This is consistent with some friends’ experience in the jet market. A group of pilots at Hanscom Field are trying to buy a Cessna Citation Mustang business jet without waiting the full three years it takes to get one from Cessna. The asking prices seem to have come down at least $100,000 (out of approximately $3 million) over the last two months.

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My lust for the smell of burning kerosene has driven me to spend a lot of time in the suburbs of Cincinnati. All of the stores and restaurants in Cincinnati seem to be staffed by high school students. This probably doesn’t seem unusual to the average American, but it struck me because I couldn’t remember ever seeing a Cambridge Public School student working an after-school or weekend job. Stores and restaurants in Cambridge seem to employ adults, often recent immigrants.

I can’t figure out what would account for the huge observed difference. It can’t be that Cambridge High School students are spending all of their time studying because they consistently score very poorly on achievement tests. Nor do I think that it is a question of household income because the Cambridge High School serves a lot of teenagers whose parents are on welfare, living in city-owned housing, etc. (after the chucking of an honors program, the higher-income parents moved their children to private schools or moved the entire family to Brookline or Newton).

If I go to a supermarket in Cambridge on a weekend, why don’t I see a Cambridge High School kid working the checkout?

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The newspapers are full of stories about politicians frantically searching for a way to prevent foreclosures and dramatic declines in the price of houses across the United States. The thinking seems to be that high house prices are good for the economy. Maybe they are good for the banks and Wall Street firms who lent money on the theory that a crummy 100-year-old wooden house was worth $1 million. It is tough to see how high house prices are good for the economy as a whole and for job growth.

Suppose that I want to employ a woman who supports a family of four in California, Boston, or New York City. I have to pay her enough that she can afford to buy or rent a three-bedroom place to live. If that three-bedroom place costs $1 or $2 million, I will have to pay her quite a lot of money simply so that she can survive. I might find that a worker in Guadalajara, Bangalore, or Shanghai could do the job for less than half the salary and yet live quite comfortably. The next time that I get a big tax break from the Federales, therefore, I invest it in a new office somewhere that has a reasonable cost of housing and therefore a reasonable cost of labor.

We spent most of our investment capital over the last ten years building huge and luxurious houses. Americans were by far the best-housed people in the world before, but now many of us are truly living like kings. Does this help our international competitiveness? Does an employer care that we can go home to a 6,000 square foot McMansion and watch a 60″ TV in our media room? I don’t see why the employer would care. In fact, an employer would probably prefer that his workers be housed in sufficiently squalid conditions that employees were encouraged to linger in the office. Certainly the employer doesn’t want to have to pay a worker extra just so that he or she can afford to pay rent or mortgage in an artificially inflated housing market.

Reporters and pundits are saying that government intervention in the housing market is inevitable. As we hand out tax dollars to ensure that $1 million houses are still priced at $1 million, let’s not forget to hand out some more tax dollars to employers as an incentive for them to keep hiring Americans who need to pay a $70,000 per year mortgage.

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Congress has decided to leave no house price speculator behind: “Homebuilders get breaks from Congress.”

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