From irregular credit to entity failure

Credit & Financial Management Review, Third Quarter 2002 by Wasserman, Samuel

The advent of intangibles commerce

In the latter part of the 1980's, trade between firms began to show significant difference between tangible trade and intangible trade. Sale-leaseback transactions and the increased occurrence of goodwill on balance sheets required new accounting rules.11 When internet and software commerce exploded in the early 1990's, accounting, corporate structure, revenue and expense recognition, and credit granting were subjected to historic distortion. By the early 1990's, trade in intangibles began to rival trade in goods. New types of entities were built to take advantage of the evolving commercial model.

Enron is an example of many things, but it is at its best an example of a firm unable to withstand any change. When oil and energy prices moved too much, too suddenly during 1999 and 2000, Enron was unable to manage the price and leverage risks. Yet Enron was in trouble long before its vanishing act in December 2001. Enron went from being a decent energy utilities firm to being a poorly executed intangibles trading firm, with all of the debt leverage and intangible assets typical of this type of operation. Like AOL Time Warner, Enron was specialized in intangible commerce.

The mega merger mania of the 1990's responded to new commercial realities with innovative corporate structures designed to take advantage of license and royalty revenues, product sales, and sometimes from the sales of derivative instruments. Enron was all of this-a multi-purpose firm that expanded far beyond its origins as an energy service provider to become a risk swapping, intracompany enigma doing significant amounts of affiliated intercompany commerce. Today, questions are being asked about certain advertising revenue transactions within AOL Time Warner. Ad revenues are again an instance of intangible commerce. As long as this type of company exists, there will be irregular transactions within its network of affiliates.

Collections, reverse leverage, and the viability of firms

When credit is artificially inflated through money and discount rates, the credit granting process is corrupted. Prices quickly stagnate because of the higher amount of circulating currency, and firms must increase volume in order to make up for the lack of pricing power on new purchase orders. The combination of price stagnation plus volume pressure tends to make customer default risk analysis almost irrelevant. As these conditions worsen, firms tend to seek a higher volume of transactions on more complex terms that include volume discounts, rebates, and non-cash payments in the form of points, equity, or volume and price allowances.

It can be said about receivables and sales that a seller cannot collect on a sale made on credit terms until title and sometimes possession have passed to the customer. Contracts serve this purpose, and sales exist only if there is a contract.12 Even if the customer is distressed and collection is not assured, the sale is made and some degree of financial recovery is possible. Without a contractual agreement, however, nothing is convertible from the contract into currency. Thus, non-monetary assets must be converted into contracts before there can occur a conversion from monetary assets, such as receivables, into currency. Whether the collection is par for invoice-to-realized value (the collected amount), or highly distressed recoveries of less than 10% of invoice value, the contract has a range of value. That range and today's securitization and secondary market encourage poorly conceived sales and contracts. An excess of poorly conceived sales contracts, sales that collect slowly or below par invoice value, are directly connected to poorly structured businesses and the credit inflation that spawns them. When central banks, governments, and major commercial banks work together to intervene in business cycles-to prevent recessions-there occurs an increase in circulating money. This excess credit must be converted from circulating money into consumer goods and contracts-especially debt contracts. Stock is a debt contract-an amount owed by a firm to its shareholders. When excess credit is channeled into stock, as occurred after the Asian Crisis of 1998, then firms owe much more to shareholders, and savings in stock depends more than ever upon the viability of the firm. In the mid-1990s, dotcoms absorbed much capital while savings in stock-much of it issued by dotcom firms-increased significantly. The increase in savings was suddenly contingent upon the success and survival of many issuers. If they failed, then the savings foundation could be damaged. This is a very risky thing, given the historical precedent of the aftermath to The Great Crash.,