Les Jones

Word of the Day > Word of the Day: EBITDA

EBITDA - Earnings Before Interest, Taxes, Depreciation and Amortization. Pronounced "ee bit dah." A non-GAAP means of accounting that helps make unprofitable businesses sound profitable, basically. It was popular in the dot-com era. More info at Investopedia.

And that WOTD is prelude to Phil Greenspun's post on Enron, in which he explains how bogus EBITDA is:

Conspiracy of Fools chronicles one of the discussions about EBITDA among Enron senior managers. One guy pointed out to Rebecca Mark, a Harvard Business School graduate star of the company, that EBITDA was meaningless because one could improve EBITDA simply by borrowing money at 10 percent and investing it in T-Bills at 5 percent and that was essentially what Mark was doing. She was borrowing money at X% to purchase businesses that would return no more than (X-4)% in a best-case scenario. This fattened her paycheck, but led the company towards bankruptcy.

And from a commenter at Phil's I found Malcom Gladwell's New Yorker piece, Open Secrets: Enron, intelligence, and the perils of too much information. He makes the case that Enron gave investors all the information they needed to see the problems with the company's business, information that an investigative reporter sifted through, prompting Enron's downfall.

I think Gladwell lets Enron off too easily, but it's probably true that many modern financial transactions are so large and complex that they're impenetrable. Warren Buffett said as much in a recent Fortune interview:

Your OFHEO example implies you're not too optimistic about regulation.

Finance has gotten so complex, with so much interdependency. I argued with Alan Greenspan some about this at [Washington Post chairman] Don Graham's dinner. He would say that you've spread risk throughout the world by all these instruments, and now you didn't have it all concentrated in your banks. But what you've done is you've interconnected the solvency of institutions to a degree that probably nobody anticipated. And it's very hard to evaluate. If Bear Stearns had not had a derivatives book, my guess is the Fed wouldn't have had to do what it did.

Do you find it striking that banks keep looking into their investments and not knowing what they have?

I read a few prospectuses for residential-mortgage-backed securities - mortgages, thousands of mortgages backing them, and then those all tranched into maybe 30 slices. You create a CDO by taking one of the lower tranches of that one and 50 others like it. Now if you're going to understand that CDO, you've got 50-times-300 pages to read, it's 15,000. If you take one of the lower tranches of the CDO and take 50 of those and create a CDO squared, you're now up to 750,000 pages to read to understand one security. I mean, it can't be done. When you start buying tranches of other instruments, nobody knows what the hell they're doing. It's ridiculous.

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