Breakingviews

The Federal Reserve will celebrate its centennial in 2013. Though independence for the U.S. lender of last resort and its peers elsewhere has historically come and gone, in recent decades it has become an article of faith. But these days, faith in central banking is far from rock solid.

Independence for the management of monetary affairs is supposed to allow prudent policymaking that is insulated from short-term political pressures. That should provide, for instance, the freedom to quash voter-pleasing bubbles. The problem is that Western central banks are looking more like volatile players than stable referees. To start, the sheer size of their balance sheets has expanded dramatically. Since 2007, the eve of the financial crisis, British and Swiss central bank assets have surged roughly five-fold, while the U.S. and European equivalent holdings have both approximately tripled. In the UK and the euro zone, central bank balance sheets have already swollen to around 30 percent of GDP.

And central banks are taking the sort of risks that normally merit political scrutiny. Ben Bernanke, the Fed chairman, portrays unprecedented post-crisis activities like quantitative easing – large-scale bond-buying programs undertaken by the Fed, the Bank of England, the European Central Bank and others – as technical variations of traditional monetary policy. But critics see QE as straying into the government’s fiscal realm, distorting financial markets, fueling future inflation, or all of the above.

Central banks also have responsibilities which are undeniably political. The Fed is America’s most powerful bank regulator, the lender of last resort and, especially now, a major influence on interest rates and financial asset prices. The Bank of England, which gained monetary policy independence only in 1997, is about to take on a bigger watchdog role. Even in Japan, where the central bank has maintained a near-zero interest rate policy for well over a decade and is supposed to operate in harmony with government policy, newly elected Prime Minister Shinzo Abe wants more influence.

Up to now, central banks have been able to defend their autonomy, which anyway isn’t complete. But anti-Fed political rhetoric and demands for greater accountability resonate with some American voters and many economists struggle to defend institutions which failed to predict or prevent the worst financial crisis in decades. Another big error or an unpopular move – perhaps a return to more typical interest rates – could mean the beginning of the Fed’s second century is marked by an assault on central bank independence.

Sprint is taking on some starry-eyed activists. The U.S. mobile operator being acquired by Japan’s Softbank is offering $2.1 billion for the 48 percent of Clearwire it doesn’t already own. At $2.90 a share, the 5 percent premium to the closing price on Wednesday won’t satisfy uppity investors who want Clearwire to seek other options for its storehouse of wireless spectrum. Sprint’s control limits their power, but the activists could yet elicit a sweetener.

Between them, Mount Kellett Capital Management and Crest Financial own just over 14 percent of Clearwire. They sounded the alarm last month about the company possibly selling on the cheap to Sprint. Mount Kellett says AT&T bought somewhat comparable spectrum for about 38 cents per MHz-POP, a common industry measure of the number of people covered by the bandwidth. By their reckoning, Sprint should be paying at least four times as much for Clearwire. Though they would appear to have little clout given Sprint’s 52 percent stake in Clearwire, the minority owners aren’t being entirely quixotic. Sprint still needs more than half of other shareholders to sign off. And while Softbank may not yet be in control of Sprint, the Japanese company seems eager to embark on its U.S. ambitions. Clearwire’s spectrum is an integral component.

Sprint nevertheless retains the upper hand. Clearwire’s operating loss for the first nine months of the year exceeded $1 billion. While heavily indebted, Clearwire also desperately needs to roll out its next generation cellular network to keep up with rivals. That means its financial position is grim and getting worse. And with Sprint ultimately in control, there seems little chance of auctioning Clearwire’s spectrum - as the activists have urged - or selling equity to raise cash.

That means the only real option is to sell the company. For many reasons, Sprint is Clearwire’s natural partner. With a bid on the table that’s nearly three times where the stock was trading this summer, Clearwire’s non-Sprint owners can’t easily dismiss it. They can fight, but won’t get anything close to quadruple what has been put forward. They are, however, just enough of a nuisance that it’ll probably cost Sprint a little more to seal the deal.

Read more at Reuters Breakingviews.

The difference between “and” and “or” could undo the Federal Reserve. At its meeting Dec. 12 the Federal Open Market Committee replaced its estimated duration for low interest rates with thresholds for the unemployment rate and inflation. If reality makes the two measures diverge, the new approach could prove rocky for markets.

Last time around, the Fed suggested it would keep short-term rates near zero until at least mid-2015. Now, it’s replacing that with the idea that its loose monetary policy probably won’t change while unemployment is above 6.5 percent, inflation a year or two out is forecast to be below 2.5 percent, and long-term inflation expectations are under control. That’s “and” rather than “or.” In theory, that means crossing any one of these thresholds - vague as the last one is - could have the Fed rethinking its policy.

But it’s easy to read this as saying the Fed won’t tighten policy unless all these indicators are the wrong side of the thresholds. That could breed confusion if, say, unemployment continues declining only slowly, as it has for the last two years or so, while inflation quickly gathers steam. Plus as the relevant economic indicators approach the Fed’s thresholds, market responses could be odd. A drop in the unemployment rate that brought it within range of the threshold ought to be good economic news, but investors might fear a withdrawal of easy money by the U.S. central bank and react badly instead.

Then there’s the Fed’s ramping-up of quantitative easing, or bond-buying. Chairman Ben Bernanke made clear that he is worried about the possible negative economic impact of the so-called fiscal cliff, the tax increases and cost cuts that could come on Jan. 1 if Congress can’t agree otherwise. While he knows the Fed alone can’t offset that, it’s also surely a factor in flooding markets with yet more cheap money. If those fiscal shifts do happen, the United States will suddenly need to borrow less. The Congressional Budget Office reckons the deficit would fall to under $400 billion in the year to September 2014. But the Fed would be trying to buy $540 billion of Treasury securities every year.

That conflict between monetary and fiscal policy is another potential source of confusion. Add the new focus on specific economic indicators and Bernanke could easily find he has set the stage for volatility, rather than the Fed’s desired stability, in financial markets.

Read more at Reuters Breakingviews.

HSBC’s $1.9 billion fine for money-laundering is a record for a bank, but its one-off nature means that it’s largely symbolic for an institution with a market cap of 118 billion pounds. The outcome could have been worse. Some U.S. regulators wanted to indict the UK lender, according to a New York Times report, but they backed down on fears that a heavy-handed approach could destroy HSBC’s U.S. arm and destabilise the wider banking system.

Prosecutors at the U.S. Justice Department were considering three options for HSBC and in the end chose the least punitive, according to the report. Of the two tougher calls, a money-laundering indictment would have spelt the end of the bank’s U.S. business, forcing it to withdraw its banking charter; a lesser criminal indictment would have left HSBC facing restrictions on the scope of its operations as a minimum. Both could have triggered a negative impact on the economy that authorities were keen to avoid.

Of course, the wide-ranging steps that HSBC has taken to overhaul its business in the wake of the alleged money-laundering may also have swayed prosecutors’ opinion. But the consideration given to the prospect of systemic risk shows how little has been done since the beginning of the financial crisis to force banks to plan for orderly resolution, in spite of pledges to the contrary.

True, a joint paper on how to deal with failing banks published on Dec. 10 was welcome evidence of joined-up thinking between the U.S. Federal Deposit Insurance Corporation (FDIC) and the Bank of England - but the details were scarcely fleshed out. Meanwhile, other contradictory moves by regulators do little to help: German, UK and U.S. watchdogs are angling for banks to set up separately capitalised subsidiaries, in order to keep cash from leeching abroad.

As it is, HSBC is one of the globally systemic banks that would be one of the easiest to break up: its overseas entities are separately capitalised to a greater degree than most peers’. Yet regulators chose to leave its U.S. business largely unchanged - even though they have another five years during which they can indict the bank if it fails to stick to its side of the bargain. In the meantime, the record-breaking fine is yet another sign that, four years after the collapse of Lehman Brothers, finance is far from fixed.

Read more at Reuters Breakingviews.

How could Hewlett-Packard find a $5 billion-plus hole in an $11.1 billion deal? The U.S. tech giant claims to have uncovered all kinds of accounting nasties at Autonomy, the British software outfit it bought last year. But HP won’t say quite how the allegations - strongly denied by Autonomy’s ex-boss Mike Lynch - could produce such a colossal writedown. Breakingviews tries a spot of reverse-engineering to see how it could be possible.

Given what it now believes about Autonomy’s profitability and growth, HP is effectively saying it would have paid a little more than half the sticker price for the Cambridge-based company. The writedown outstrips the deal’s $4.6 billion premium over Autonomy’s market value at announcement.

Autonomy doesn’t have much in the way of hard assets or outstanding invoices, so the charge can’t relate to a sudden revaluation of kit or the failure of existing customers to pay their bills. The last balance sheet shows just $43 million of plant and equipment, and “accounts receivable” - customer debts - of $330 million: 0.4 percent and 3 percent of the purchase price respectively. Even if, say, half of accounts receivable proved suspect, that would only make up 3 percent of the mega writedown.

So the charge must reflect a reassessment by HP of the future cash flows it will obtain from the business. HP now thinks these are worth a lot less than it thought: smaller and growing less quickly. HP has provided one or two hard data points. The most important is Chief Executive Meg Whitman’s assertion that Autonomy’s real operating profit margin was 28-30 percent, not the reported 40-45 percent.

The difference between these numbers has to be explained by some combination of exaggerated revenue and understated expenses. It sounds like HP is more concerned with the former: Whitman accused Autonomy of “stripping the revenue out of the future” by turning long-term deals into upfront licence payments, and also of being too eager to record sales made through resellers.

The booking of revenue is a minefield in the software industry - and one that differing accounting rules make even harder to navigate. Still, if the claimed distortion comes from revenue manipulation, the window-dressing would have to have been on an industrial scale. Here’s why.

With Whitman’s comment in mind, imagine a company that has $80 million of revenue, with $56 million of costs. That leaves $24 million of operating profit, for a 30 percent margin. Now suppose it can somehow record $20 million of future sales now, without recognising any of the extra costs. This year’ revenue will swell by a quarter to $100 million, while operating profit will nearly double to $44 million, lifting the operating margin to 44 percent.

Do the same revenue adjustment at Autonomy using Morgan Stanley’s pre-acquisition estimate of 2011 revenue and earnings and Breakingviews calculates that the “true” income statement would show revenue 19 percent lower than HP expected. This assumes operating margins drop from 42.7 percent to 30 percent. In that case, EBITDA would be $372 million, about 34 percent below the number Autonomy would otherwise have reported.

A revision of this magnitude would cut the bid value by $3.8 billion, since deals are valued as a multiple of EBITDA. And that assumes that enterprise value was still calculated at the same 20-times multiple that was actually paid by HP.

Of course, that still leaves another $1.2 billion of destroyed value to explain. But that could easily stem from applying a lower multiple too. Profitability is one factor in determining the EBITDA multiple a business can command.

HP goes further. It also complains about poorly disclosed - and loss-making - sales of hardware. Autonomy was supposed to be a high-margin software company, so it’s easy to see why such sales would jar. But it is hard to see how this could move gross margins more than a percentage point or two.

The hardware sales, HP reckons, helped inflate revenue and boost gross margins, because some costs were mislabelled as sales and marketing expenses - which come out further down the income statement. The most striking impact would be seen if these sales were rising fast, flattering Autonomy’s overall growth rate. Since growth is another factor in valuation multiples, that could also have affected the price HP thought it could justify paying for Autonomy. But it is hard to tell whether what HP alleges was happening: Autonomy did in fact say some sales involved hardware, or “appliance”, but did not break out the exact revenue contribution.

Finally, there are potential factors that others have pointed to. For example, companies can boost profit by inappropriately treating current expenses, which must be written off as they occur, as investments, which are amortised over several years. Some analysts accused Autonomy of doing just that with research spending. Also, Autonomy was acquisitive. Takeovers can, for example, flatter growth rates, if pre-acquisition sales are understated. Sceptics also questioned Autonomy’s acquisition accounting.

It is, then, technically possible that HP could demonstrate that bad accounting led to a hole of the size it identifies. Lynch rejects all charges of distortion. He says he did nothing other than follow international accounting rules. Until HP’s accusations are spelled out fully, and investigated properly, it will be impossible for outsiders to know what really happened.

China’s shaky accounting practices are a sound target for U.S. regulators. Or at least, they would have been ten years ago. The Securities and Exchange Commission’s action against China-based auditors, including affiliates of big accountants like KPMG and Deloitte who refuse to hand over files on U.S.-listed companies, comes too late. If the SEC pushes the point, it could bring a moral victory, but a financial mess.

The SEC’s position is fair, but futile. Auditors say they can’t give up Chinese documents for fear of accidentally passing on state secrets. The power to release audit work performed in China resides with the securities regulator. Besides, under China’s loose definitions, auditors don’t always know what is a secret and what isn’t. American and Chinese authorities have been in talks for at least five years on closer co-operation, but with little progress.

By escalating the issue to a 300-day court review, the SEC may just prove that compromise is elusive. The SEC is effectively asking Chinese auditors to flout local law, or China to cast off its preoccupation with state secrecy. Neither is plausible. Starting a fight as China prepares to hand over power to new leaders, who may wish to score easy political points by swatting away attacks on the country’s sovereignty, looks especially unwise.

It didn’t have to be this way. Back in 2000, when Chinese companies like Sohu and Sina first listed on U.S. exchanges, a tough stance on accountability might have worked. Instead, regulators foolishly turned a blind eye, despite the obvious contradictions in China’s state capitalist model. Now the cost of taking a stand is high. Were the SEC to refuse to accept accounts audited by Chinese firms, it might leave even established Chinese companies with no choice but to delist.

A mass delisting is no longer far-fetched. It might even be welcomed in China, where executives and bankers talk misguidedly about the merits of companies “returning home”. State banks and wealth funds might be happy to help scoop up distressed stakes in companies like Baidu and Sina. As for the SEC, it would be left with the moral upper hand, a market free of Chinese accounting risk – and thousands of angry U.S. investors.

Read more at Reuters Breakingviews.

The wealthy in America are creating their own personal stimulus. Special dividends are coming thick and fast. Oracle’s Larry Ellison and the Walton family of Wal-Mart Stores are among the noteworthy beneficiaries. Payouts have potentially saved recipients billions in taxes so far. Uncle Sam might have put that to work fixing infrastructure.

So far this quarter, U.S. companies have pledged more than $21 billion in one-off dividends – and that’s not including early payment of regular ones. Shareholders receiving them will be able to book the gains at the 15 percent tax rate currently in place rather than the worst-case 39.6 percent scheduled to go into effect next year if President Barack Obama and Congress don’t agree on an alternative rate.

Enterprises with big family shareholdings feature prominently in the special dividend ranks. Individual owners may be particularly attuned to the risk of higher taxes. Take Ellison. Oracle is paying three quarters’ worth of next year’s dividends this month. The boss could reap up to $50 million more after tax from the payouts, depending where tax rates actually end up. He would have no trouble spending it – he recently bought a Hawaiian island for 10 times that amount, according to reported estimates.

Walton family members, who hold a combined 51 percent stake of giant retailer Wal-Mart, could save as much as $166 million with the shift of a single quarterly payment from January to this month. Private equity firm KKR, which holds a 20 percent stake in HCA, could net $44 million in tax savings from the hospital operator’s one-time payout this month.

If this quarter’s special dividends alone were instead paid out next year with the highest feasible tax rates in force, the U.S. government’s coffers would be at least $5 billion heavier in a few months’ time. That’s already about one-tenth of what Obama wants earmarked for spending on much needed infrastructure upgrades across the United States.

Well spent, that seems of greater long-term national benefit than anything billionaire shareholders are likely to do with their cash. Of course, as long as they can afford it, companies are doing all shareholders a legitimate favor by paying cash out before a tax rise. And Washington can blame its own dysfunction for concern that tax rates might rise so sharply. But despite calls from corporate America for the government to right its finances, it seems some of the richest are still happy first to take care of their own pocketbooks.

Read more at Reuters Breakingviews.

Pharma has landed a double blow against the American government. The U.S. Court of Appeals in New York has ruled that a drug salesman was exercising his right to free speech by pitching a narcolepsy drug as effective against insomnia, chronic fatigue and other conditions the Food and Drug Administration had not approved. If the Supreme Court upholds this decision, companies will pay fewer multi-billion dollar fines and useless healthcare spending will increase.

Regulators argued that the pitch showed the salesman was illegally selling a misbranded drug. But the court said he had a free-speech right to give doctors truthful information so they could legally prescribe the medicine. The regulator violated that right, the judges ruled, by barring his off-label recommendations.

The decision applies only in three states, but the FDA is likely to appeal. That could put the case before the Supreme Court and make this victory for the pharmaceutical industry a national precedent. GlaxoSmithKline, for instance, shelled out $3 billion in July to settle three indictments, two of which were off-label marketing of antidepressants and other drugs. In the past four years Pfizer, Johnson & Johnson, Abbottand Eli Lilly have each paid, or are negotiating to pay, settlements over $1 billion.

It’s not just missing these regular injections of cash that will cause the government pain. It will also increase medical spending. That’s because pharma reps will be allowed to discuss studies of drugs that the FDA has not vetted. Unfortunately, some studies are shoddy and clinical trials cherry-picked by sales staff. This encourages doctors to prescribe extremely costly drugs, which can have little benefit, to patients.

In the GSK settlement, for example, the company allegedly participated in preparing, publishing and promoting a journal article that misleadingly asserted its drug Paxil was effective in treating depression in minors. Other studies showed the drug didn’t work in teens, with some demonstrating that antidepressants like Paxil may increase suicide risk.

The industry has engaged in such behavior because it is financially appealing. The ruling increases the temptation, which is likely to pile more costs onto Medicare and Medicaid, which spent $86 billion on branded pharmaceuticals in 2010. With Medicare already accounting for about 4 percent of GDP, that’s bad news for the nation’s financial health.

Read more at Reuters Breakingviews

Tom Ward, chief executive of troubled oil and gas explorer SandRidge Energy, has set the bar even lower for the oil patch. He is not the first energy boss to live large at shareholders’ expense. But his extravagance at the nearly $3 billion U.S. company would make even TV villain J.R. Ewing blush. Angry owners are right to want him out.

Elsewhere in the sector, Chesapeake Energy’s Aubrey McClendon, who co-founded his company with Ward, convinced his board to pay him a $77 million bonus even as the stock plunged in 2008. Nabors Industries’ Eugene Isenberg stepped down as chief executive this year after realizing $173 million in compensation since the end of 2005 despite his firm’s stock lagging badly. And two executives at pipeline firm Southern Union tried to bag $100 million in goodies when selling the company to a rival, including non-competition payments that continued after their deaths.

Investor rebellions at least partly curbed these abuses. Ward deserves a shellacking, too. A letter from a disgruntled shareholder, TPG-Axon Capital, outlines the rap sheet. The company’s annual general and administrative expenses have recently been equivalent to almost 8 percent of its market capitalization, against about 1 percent to 3 percent for peers. Only Chesapeake, an example to be avoided, comes close at 5 percent.

TPG-Axon has set out its explanation for the flood of outgoings: an extraordinary series of executive perks. Ward himself has drawn $150 million in payments from the company in the five years since SandRidge’s 2007 initial public offering, despite an 80 percent fall in the stock price. His chief financial officer has seen his pay quadruple since then to $6.8 million. Before Ward sold shares to the public, the company had a small, old jet aircraft and two propeller planes, according to TPG-Axon. Now it has four jet aircraft, two of which are expensive intercontinental models. The firm’s wells all lie within a few hundred miles of each other, but Ward is allowed unlimited personal use of the fleet.

Ward, along with McClendon, also dabbles in the ownership of the Oklahoma City Thunder basketball team – and his company buys courtside suites. He has set the bar low, and shareholder action is overdue. If Ward is knocked out, governance would be the winner.

Groupon’s melodrama is discounting dual-class share structures. Chief Executive Andrew Mason and Chairman Eric Lefkofsky appear locked in a dysfunctional battle over how to run the flailing company. The board is keeping Mason at the helm, but the fighting probably isn’t over. Super-voting shares like the ones both men own are meant to give founders flexibility. But Groupon is a reminder of just how dangerous the arrangement can be.

Any company would be in disarray with this kind of performance. Groupon shares are down about 80 percent since they debuted on the market a year ago. Rivals are struggling, too. Last month, for example, Amazon wrote down nearly its entire investment in LivingSocial. Groupon’s coupon revenue is falling sharply and the company is devoting more space in daily emails to offering goods directly. The strategy looks shaky: margins on good sales are about a third of coupons.

It’s not obvious leadership is so much the problem at Groupon as the business model. Even so, the chairman’s camp has raised the possibility of getting rid of Mason. Instead of helping steer the ship in a better direction, it could make it sink faster. Mason will now spend months addressing questions about his job security and whether the strategy will suddenly change.

There isn’t exactly great confidence in the other co-founder either. Lefkofsky has had several contentious business failures in the past, sold equity before the IPO and made statements about Groupon’s eventual profitability that the company had to publicly disavow. Ousting the chairman might be a more logical first step, but isn’t a realistic option.

Lefkofsky and his longtime ally Bradley Keywell have an iron grip on Groupon. With Mason, the trio has about 35 percent of the votes with just 1 percent of the economic interest. All told, they control the company. In theory, the super-voting stock pervasive among technology and media companies is supposed to enable visionaries to pursue their long-term visions without the short-term pressures often imposed by other investors. In practice, though, it can leave minority shareholders stuck with little recourse. Groupon owners are learning the lesson the hard way.