Chapter Content
Okay, so, this is about something I've been thinking about a lot, this whole idea of kind of, you know, borrowing the earth from our children instead of inheriting it from our ancestors. It's a quote that's been attributed to a bunch of different people, but the core idea is what matters.
And it all started, really, thinking about this conversation I had with this former chief engineer of a water company way back when. This was after the water industry in England got privatized, right? So, these state-owned boards became these companies listed on the stock exchange. Anyway, he was now a CEO, and he was explaining how basically, most of the people in his company, they were either stopping stuff from going wrong, or, you know, fixing it when it did. And he said, and this is the kicker, he said if you fired most of 'em, the water would still flow, probably for ages. All you really needed, he said, was a billing department! Revenues, like the water, would just keep coming and profits would skyrocket.
Now, obviously, there's no real scientific way to know how many people you *should* have working there, right? But he felt that the old nationalized industry, they just had too many people. Under public ownership, the main thing was to avoid being blamed for anything, so they avoided making tough decisions, especially about staff. I mean, in the water business, so much *can* go wrong, but everyone needs water, so the demand is always there.
But now, with privatization, prices were capped, so any cost-cutting went straight to the shareholders and the executive bonuses. So, this CEO, he figured that his company, and others, would keep cutting costs and reducing staff. And then, he predicted, something bad would happen, and there'd be this overreaction. Interestingly, he was right! Although it wasn't the water company, it was actually on the railways where a train wreck killed four people because of neglected tracks. And then everything went crazy, with speed restrictions and the rail tracks basically getting nationalized again. He's retired now, by the way, but his old water company? Yeah, they're constantly getting slammed for leaks and sewage discharges. Go figure.
And you know, these soft budget constraints? It's not just a socialist thing, right? I mean, we all saw it with the bank bailouts after the financial crisis.
It made me realize that what he was describing with the water company, it was an extreme case, but it happens to some degree in practically every business. Like, what's the *right* amount to spend on customer service, or getting new customers, or keeping things maintained, or preventing problems, or fixing them when they happen? How do you keep the business going in the long term? There are no easy answers, it's all about judgment and experience. So it's always tempting for new management to cut a little bit here, a little bit there, and just add the savings to the earnings. I've started calling it "leaky pipe and overflowing sewage syndrome."
I remember, shortly after talking to that water guy, I stayed in this once-fancy hotel, and it was just...off. The carpets were a bit frayed, the paint was scuffed, the minibar was a rip-off. So I did a quick search online and boom! The hotel group had been bought by some private equity firm known for buying businesses, boosting earnings fast, and then selling them again. And it turns out that most of those water companies that went public, they aren't listed anymore. They're owned by private equity firms. And this "leaky pipe" thing? It's everywhere.
This reminds me of the Enron story. There was this play about it, and it was a pretty big hit. It starts with this champagne party thrown by Jeff Skilling, the guy behind Enron's rise and fall. They were celebrating getting permission from the SEC to use "mark-to-market" accounting.
See, businesses report their earnings every year, especially if they're on the stock exchange. Back in the day, when farming was the main thing, it made sense. You planted in the spring, harvested in the fall, and the cycle repeated. Some years were good, some were bad, but the year was based on the sun's orbit.
Banking is different. Banks borrow cheap and lend more expensive. Borrow at 3, lend at 6, golf course at 3! They can borrow cheap because people think they'll get paid back, and they lend more expensive because there's a chance people won't pay *them* back, so they charge extra interest. Banks make money until they don't. It's a cyclical business. That's why lots of people, even "manager of the century" Jack Welch, wanted to get into finance. Borrow at 3, lend at 6. Apparently Welch also liked golf.
But the business cycle is longer and more up and down than the seasons. And banking isn't the only thing where annual accounting is misleading. Lots of businesses have contracts that last for years. So you have to figure out how to spread the costs and revenues over those years.
In the past, accounting was pretty cautious. You only counted revenues and costs when they actually happened, so the profit from a contract spread out over the contract's life. But with mark-to-market accounting, you could count all the profit you expected to make from the deal the moment the contract was signed. Skilling was all about it! He said businesses should be able to declare profits when they *created* the thing that would make the profits. Otherwise, they were just clipping coupons, enjoying the work of greater people from the past. He really overestimated his abilities.
Then there was Andrew Fastow, an accountant Skilling hired. He became Enron's CFO. He was the one who created these "special purpose entities," which are basically fake companies that don't have to have their accounts connected to the main company. So they could do fake transactions that made it look like Enron was making more money than it actually was.
Enron's impressive earnings and stock price ended with the biggest corporate bankruptcy in US history, Skilling and Fastow going to prison, and Arthur Andersen, Enron's auditors, going out of business. But, you know, other companies were using those same accounting tricks to make it look like their earnings were going up smoothly, which is what the financial markets wanted to see. After Enron collapsed, everyone realized that companies like General Electric and Fannie Mae had been doing the same thing. And mark-to-market accounting was a big reason why the banks looked so profitable before the 2008 financial crisis.