As we have since learned, at the peak of the mortgage bubble, “no doc” and even “liar loans” were offered in remarkable supply. Thanks to unprecedented confidence in the stability of American home prices, borrower scrutiny was deemed to be superfluous, if not outright unnecessary. At the top, the operating protocol for many in the mortgage industry seemed to be simply a civilian version of the military's controversial “don’t ask, don’t tell” policy, which was repealed a year ago.
As a socionomist who tracks social mood and how changes in confidence affect our decision-making, it is hard not to see striking underlying behavioral parallels from the mortgage bubble in this week’s news regarding “accounting improprieties, disclosure failures and misrepresentations” associated with Hewlett-Packard’s
(NYSE:HPQ) acquisition of Autonomy.
The inverse correlation of confidence and scrutiny strikes again.
While it will take time for the forensic accountants and the regulators to complete their analysis of the Autonomy merger, I strongly doubt that this will be the last acquisition-related scandal we see. Many of the same risk management failures evident at the peak of the housing crisis appear to have been in ample supply in corporate mergers and acquisitions ("M&A") over the past decade.
For many corporate leaders, oversized complexity-laden acquisitions were required merit badges. And much like the participants in the housing bubble saw home price appreciation out as far as the eye could see, for corporate executives, boards of directors, equity analysts, and investors, the same was true for global growth.
Opportunity, particularly in Asia, was unlimited. Even more, time was of the essence.
But if confidence and urgency weren’t enough to bring buyers to the table, there was accounting help (not to mention peak-of-the-market deal-eager investment bankers) too. Until 2001, when a business was purchased at a premium, the acquiring company was forced to amortize the premium paid (goodwill) over time. In 2001, the Financial Accounting Standards Board (FASB) eliminated that requirement.
Rather than amortizing goodwill, companies instead would be required to justify the purchase premium through forecasts provided to its accountants annually. So long as the conditions assumed at the time of an acquisition were sustained or bettered, acquisitions -- even at high premiums -- were costless.
Rather than flowing through earnings as an expense, goodwill and other acquisition-related intangibles were capitalized as assets on the balance sheet.
For business leaders, so long as the economy remained strong, the changes in accounting made business purchases far more attractive than organic growth. Not surprisingly then, 2002-2007 brought with it record M&A and more than $1.0 trillion in capitalized goodwill. Over the past several years, as global growth has slowed, however, companies have been forced to write down the value of their goodwill. Up until very recently, however, analysts, investors, and even boards of directors have shrugged off these impairments because they are “non-cash.” In fact, earlier this summer, when HP wrote off more than half of its acquisition cost of EDS -- an $8 billion charge -- one analyst even offered, “This is just an accounting thing.”
Whether criminal fraud ultimately is concluded, what last week’s Autonomy news has revealed is both lax due diligence and heroic management forecasting on the part of Hewlett Packard. Even more, the financial media, the analyst community, and investors have now awakened to the fact that goodwill impairment tests are forward-looking. They are now focused on acquisition-related goodwill as a concern and are beginning to challenge corporate leaders’ forecast assumptions and to ponder what write-downs mean for future earnings and corporate cash flow.
Given the past decade's boom in global M&A, there will be plenty to look at. If events unfold as the recent housing crisis suggests, corporations will need to be much more forthcoming with their acquisition-related assumptions, and should goodwill write-downs snowball -- as auditors, audit committees, and investors take a much harder look at the balance sheet values of intangible assets -- the FASB won’t be far behind with stricter rules for mergers and acquisitions much like the group was with securitization accounting principles in 2009.
And if things really deteriorate, you can bet that Congress will weigh in with something akin to “Son of Sarbanes Oxley” too.
If at the peak, corporate M&A was shrugged off by the bottom, under stadium lighting and with more refs on the field, no stone will be left unturned. That is what falling confidence does; and corporate leaders and boards of directors would be wise to prepare for what is ahead.
Like the subprime mortgage crisis, the Autonomy situation won’t be contained. When confidence turns, the worst simply hit first. We saw that in loan quality five years ago, and we are seeing it now with corporate intangible assets.
Peter Atwater's groundbreaking book "Moods and Markets" is now available for pre-order on Amazon and Barnes & Noble.
“Peter Atwater brilliantly provides a framework for understanding both the socioeconomic hubris that led to the great credit bubble of the past decade and the dark social-psychological hangover that has resulted from its collapse. In so doing, he offers an invaluable guide to what promises to be a very difficult and turbulent period ahead as we experience what he calls the ‘me, here, and now’ behavioral tendencies of the post-crash world.” —Sherle R. Schwenninger, Director, Economic Growth Program, New America Foundation
No positions in stocks mentioned.
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