Accounts fiction that landed us in it

Anthony Hilton
23 Jan 2009

Lord Turner, the chairman of the Financial Services Authority, delivered a paper this week that everyone ought to read. Using the platform of the inaugural Economist City lecture, in a little under 45 minutes he put together the most coherent and concise explanation yet of how the financial system got into its current mess.

It is no criticism to say that his analysis of the causes was rather more convincing than his advocacy of solutions, the latter being quite obviously still a work in progress.

But his demonstration that the regulators at least now understand how we got here provides some hope that the policy response, when it eventually arrives, will be aimed at the right targets.

And one of those targets, many outside the accountancy profession will be delighted to learn, could be fair-value accounting. He did not say it was a target, but he did say it was to blame for adding fuel to the market frenzy and driving it to ever greater excess - which is not normally why one has accounting standards.

"In conditions of irrational exuberance, as in the credit markets running up to 2007, mark-to-market accounting will swell declared profit in an unsustainable way, but in a way which, reflected in bonuses, may reinforce management's and traders' determination to do more of the clever stuff," he said.

In other words - my words, not Lord Turner's - the fictitious profits created by mark-to-market accounting delivered such absurdly large bonuses to those working in the credit markets, that they went off on a feeding frenzy of innovation in which they lost all sense of responsibility and created products that had no economic rationale other than to make them even more money.

Stelios may be airing right view

Low-cost airline easyJet is so firmly identified in the public mind with founder Stelios Haji-Ioannou it seems counter-intuitive that he should be in dispute with the company's management about its future direction.

It similarly runs against the grain that Stelios the swashbuckling serial entrepreneur is the one asking to throttle things back in the light of the global downturn, and it is the management hired hands who see the opportunity to grow through the recession.

But there is an explanation. Stelios and some of his family are by far the largest shareholders in the company, though he long since gave up its day-to-day management. He says he has no problems taking risks, but he only ever takes risks he can afford to lose. In this case he fears the risks to the company and its share price if the business stalls outweigh the benefits that might come from going for growth.

He has a point because, even when the business expanded in the good times, the benefits didn't really come through to shareholders. In the eight years or so since the company went public, the fleet has expanded from 16 planes to 170, but the shares have barely moved. They were up for a bit , they were down for a bit but now they are virtually back where they started. Aircraft do not come cheap. Vast amounts of capital have been deployed. Much management effort has been expended, but it has not translated into returns to shareholders.

Stelios' broader point is that easyJet is a grown-up company, and needs to start behaving like one. It carries more passengers - 45 million - than British Airways. While a small, young company can weave in and out of financial turbulence, it is naive to expect the same of a business of its size. And while it is reasonable to assume the situation will be eased as weaker rivals are grounded, there is as yet little sign of that happening. XL was the last big airline failure. Meanwhile, Alitalia has again been bailed out.

The problem for the board though is that marking time is not an option- or appears not to be - because it long since signed a deal with Airbus to purchase 109 new aircraft over the coming years. That is not all expansion because older planes will be retired, and some if possible sold, and obviously they don't all come at once - but it nevertheless amounts to a clear commitment to increase capacity. Stelios says capacity should be capped.

That would require the board to seek to renegotiate its deal with Airbus, and the manufacturer might be expected to resist any such suggestion - so it won't be easy for either. But with every day bringing clearer news about the extent of the slowdown, the board must surely bite the bullet soon, and Airbus must face the reality that it has nothing to gain by weakening a major customer.

This all has interesting implications for investors. The Stelios vision is for a business that goes for profit not growth, one that should give priority to dividends rather than expansion. This is anathema to a whole generation of fund managers who have been brought up on the mantra that businesses have to expand or die. But it may be that the Stelios vision is a much better way to run his kind of business, and probably many others, if these lean times are with us for some years.