As we try to sort through the (ongoing?) financial meltdown, a little bit of history is always helpful. In that vein, the Economist has a review of a new book on an earlier financial crisis — Fraud and financial innovation: The match king:
A forthcoming book “The Match King” by Frank Partnoy, professor of law at the University of San Diego, will argue that the line of many of today’s most dazzling financial innovations can be traced directly back to Kreuger. So can America’s landmark Depression-era securities and accounting laws, which still shape the world of finance. So, too, can some of the most famous instances where those laws have been breached, such as the case of Enron, the collapsed American energy company.
Long before modern financiers created a market in asset-backed securities (the source of this year’s turmoil) Kreuger was a master of the art. Effectively, the securities he sold to investors provided loans for governments secured against assets that he himself controlled. The assets were held offshore, which today’s tax planners would welcome, and mostly off-balance sheet, the custom at Enron and many of the banks that have suffered this year.
The Economist explains how this was done, and why it fell apart:
After secretly acquiring factories around Europe during the years of post-war Depression in the early 1920s, from 1925 onwards Kreuger began offering a bargain to penniless governments that many found hard to refuse. Kreuger would, he said (usually with great secrecy), lend money to countries that provided him with a national monopoly on match production. His monopoly and skilled marketing would increase sales (Kreuger was a first-rate salesman, too: he is said to have propagated the myth that it is unlucky to light three cigarettes from the same match). Governments taxed matches, so the higher sales would raise tax revenues used to repay the loans. It was, boasted Kreuger, an almost foolproof business plan: the loans were secured against revenues that he controlled; the monopolies, meanwhile, ensured generous returns.
. . .
But despite the apparently flawless business model, match monopolies, it turned out, were not all that profitable. In order to offer spectacular returns, Kreuger paid dividends out of capital, not earnings. He was, in effect, operating a giant pyramid scheme, reliant on confidence to maintain a steady inflow of cash.
Key to pulling this off was a lack of transparency (or, as economists label it, asymmetric information):
Like other free-wheeling entrepreneurs, Kreuger did not disguise his contempt for accounting norms. In a rare interview in 1929, he told Isaac Marcosson of New York’s influential Saturday Evening Post that the key to his success was “silence, more silence, and even more silence”. (In a sycophantic letter to him found in Vadstena, Marcosson writes, “I regard it as a great privilege to be your Boswell.”) Secrecy, and his extensive network of paid informers around Europe, served him well; not only did it keep investors in the dark, but also enabled him to do deals with rival governments, such as republican France and fascist Italy, who loathed each other.
The point here should be clear – the more information out to the marketplace, the better. As I noted in our earlier paper, Reporting Intangibles, better disclosure is needed, especially of intangibles. History continues to teach us that lesson; we continue to ignore it.