Detox: Curtain Ready to Fall on Conseco

The end is now in sight at Conseco (CNC Quote).

After a brutal struggle for survival, the Carmel, Ind., insurer and lender as much as gave up the ghost Friday, saying it would miss upcoming interest payments on its massive parent company debt and that it would enter talks with its lenders over restructuring the troubled enterprise.

This latest bombshell nearly ensures that Conseco stock, already down more than 90% this year amid doubts about its ability to service its debt load, will soon be worthless. A bankruptcy filing will at last end a lurid saga in which a onetime highflier was brought down by the missteps and misdeeds of overpaid bosses, including accounting chicanery, absurdly glossy projections and a taste for acquisitions and debt.

And though Conseco will enter Chapter 11 in the shadow of more celebrated fiascoes such as Enron and WorldCom, investors shouldn't lose sight of the lessons of the company's collapse. Conseco, after all, was among the first of the 1990s go-go companies to fall prey to the excesses and abuses that now fill the headlines.

"The tragedy is that the faults I identified at Conseco are so very consistent with what we see all around us today," says Abraham Briloff, an early critic of Conseco's bookkeeping and professor emeritus of accounting at Baruch College in New York. "I can't help but lament that we passed over it."

Damage

Conseco, which has over 14,000 employees, stands to default on over $4 billion of debt at its holding company. State insurance regulators will now scramble to gauge the health of Conseco's insurance subsidiaries to determine whether bailouts are necessary.

Conseco's creditors will also feel the damage. Among them are bank lenders J.P. Morgan Chase (JPM Quote) and Bank of America (BAC Quote). Lehman Brothers (LEH Quote) has been a lender to Conseco's lending arm, Conseco Finance, which the company implied was not entering the debt restructuring. None of three banks immediately returned calls seeking comment. Conseco didn't return a call, either.

Meanwhile, the reputation of Gary Wendt, the celebrated ex-GE (GE Quote) executive who joined Conseco two years ago with a pledge to revamp the company, now lies in tatters. Some of Wendt's boldest actions -- like making high-interest loans on used mobile homes to borrowers with bottom-of-the-barrel credit -- helped deepen Conseco's misery. And, according to Conseco employees, it was during Wendt's time that the company deployed a raft of unconventional loan practices to artificially reduce the amount of bad loans it reported.

A coming restructuring will also hand victory to the band of skeptics who had long expressed serious doubts about Conseco's performance. One of the critics, Salomon Smith Barney analyst Colin Devine, took a lot of flak for his negative stance from the company and its supporters, who included market big shots like onetime corporate raider Irwin Jacobs.

From his Web site and in a full-page ad in The Wall Street Journal, Jacobs last year poured scorn on Devine, all the time confessing a rapturous faith in Wendt. Jacobs, of course, was a big owner of Conseco stock.

"We stuck to the facts and the facts have spoken," says Devine. "The issues about Conseco we first raised back in early 1999 have been fully verified and we can see that in the stock price." (Salomon hasn't done recent investment banking for Conseco. Devine rates Conseco a sell.)

Tale of Two Bosses

Conseco's terrible tale divides into two chapters: the two-year Wendt era and, before that, the 20-year reign of Stephen Hilbert. Wendt took over as CEO in June 2000, soon after the departure of Hilbert, a brash ex-encyclopedia salesman who founded the company in 1979 with, according to company lore, a $10,000 loan from his father.

Hilbert took a good idea -- targeting the working class for life insurance products -- and built an industry giant. But he did this chiefly through acquisitions, a strategy that allowed for loose accounting and one that made it easier to disguise operating problems. By continuously buying other insurance companies and, of course, their policies, Conseco was able to show much lower expenses than if it had written the policies itself.

Steve Hilbert

Conseco stock soared in the $90s on the back of ecstatic applause from Wall Street analysts, bruising doubting short-sellers along the way. The meteoric stock rise allowed Hilbert to pocket huge amounts through the exercise of stock options. In 1997 alone, his total compensation came to $119 million, on par with what some Enron executives got paid.

Mirroring the loans that were made to WorldCom's ex-CEO Bernie Ebbers, Hilbert borrowed over $150 million to finance stock purchases, credit that was guaranteed by Conseco, and a good chunk of which still effectively sits on its balance sheet. Conseco's board of directors, populated with management's cronies, apparently did nothing to rein in Hilbert, despite growing criticisms of his style in the late '90s.

However, it was not outsiders, but Hilbert himself, who began Conseco's unraveling. In a heartstoppingly hubristic move in 1998, the CEO led Conseco to pay some $7 billion, or a stunning seven times book value, for Green Tree Financial, the nation's largest mobile home-loan maker, and a company that also carried the whiff of legerdemain.

Green Tree targeted borrowers with bad credit histories, charging high interest rates in an attempt to compensate for the risk that the loans would default. This business was wildly profitable for most of the '90s, because unemployment was low and borrower selection was mostly on target.

But the good times couldn't hold. Once part of Conseco, Green Tree's operations quickly became a burden because bad loans were ramping. But rather than take their lumps, Conseco executives allegedly moved to cover up the toxicity of Green Tree's loan book. According to testimony in one investor lawsuit, Hilbert and other senior executives allegedly traveled to Conseco's Tempe, Ariz., loan collection center to tweak computer records and artificially reduce delinquent loan totals. Conseco contested these allegations. Hilbert and his CFO, the memorably named Rollin Dick, finally left Conseco in April 2000 -- with hefty financial payoffs and liberal rights-of-use on the company's jets.

Divorce Court

In came Wendt, who at that point was a legend in American business. He was credited with building GE Capital into a financial services juggernaut and was seen as one the nation's toughest and most skillful deal-makers. Bowled over by this reputation, Conseco immediately gave Wendt a Hilbertesque $45 million check -- just for signing on.

Gary Wendt

At first, it looked like he might be worth at least some of that money. Within three months of coming on board, he secured a debt restructuring deal from Conseco's bank creditors in September 2000 that effectively enabled the company to avoid a bankruptcy filing.

Despite this brush with death, Wendt then declared that Conseco would be earning as much as $3.30 per share by 2004, even though the company ended up reporting a net loss of $3.69 in 2000. It was classic Wendt; when at GE, the executive was quoted as saying: "Net income isn't the only thing in business, but as Vince Lombardi said, I don't know what the second one is."

With Wendt telling the world that net income would start cascading back in, Conseco stock began to soar again, sucking in a horde of retail investors, who fought vociferously for the company on internet message boards. On May 3, 2001, Conseco stock, which had sunk as low $5 in the previous months, went above $20, its peak under Wendt. On that day, one Yahoo! board poster, going by the alias "cncmillionaire," told skeptics: "Don't forget to drink the koolade."

Pitcher With a Face

Those who did quaff on the Jim Jones Special Brew were soon rudely greeted by even sharper deterioration in credit quality at Green Tree, renamed Conseco Finance. And credit problems were in fact worse than public numbers stated, skeptics surmised.

Along those lines, TheStreet.com reported often on tactics Conseco was using to stem bad loan growth. One device was to take repossessed mobile homes and sell them to new borrowers, who financed the purchase with a Conseco loan.

While these loans had higher interest rates, they were made to a class of borrower that had even scuzzier credit than the first home owner. No surprise, then, when delinquencies leapt higher. In fact, loans made under Wendt went bad a lot faster than those made by Hilbert did over equivalent time periods.

And in some ways, Wendt's tenure was seedier. The earnings releases Conseco published under Wendt were deeply misleading, with all sorts of negative operating items removed from what management considered core earnings.

Kool-Aid

Even Wall Street analysts grew tired of the presentational trickiness and the gratingly folksy tone of Wendt's ceaseless notes to investors, which he called "Turnaround Memos." And in April 2001, Conseco bought exlService, a financial services outsourcing company in which Wendt and his wife and daughter had a large stake. The apparent incestuousness of the deal was bad enough, but the company never made it clear whether Wendt's wife and daughter dumped the Conseco shares they received in the deal.

Meanwhile, the state of the lending operations became dire, particularly in the $25 billion mobile home loan portfolio. Faced with rapidly rising past-due loan levels, Conseco Finance executives tried another approach towards troubled borrowers: They would allow many of them to skip payments and restructure their loan.

Loan collectors told TheStreet.com that managers were pressing them to do substantially larger amount of these. "Our managers were most concerned about reducing loans that were more than 60 to 90 days past due, so that they didn't get into numbers reported to Wall Street," a sickened ex-Conseco employee said at the time.

Conseco denied that these actions were being done to suppress bad-loan totals. But after that, credit quality went from bad to terrible. For example, a stunning 15% of loans have either been written off or are past due in a $440 million pool of Wendt loans sold to investors at the end of 2000. To see that sort of deterioration in just over 18 months is unprecedented, even in an economic slowdown (though the economy hasn't really been that weak).

The poor performance of Conseco Finance and the insurance operations meant cash flows were insufficient to pay off debt. Asset sales didn't go as planned. A second bank debt restructuring had to take place. That didn't stop Gary Wendt from taking an $8 million bonus payment in June, a sum he could presumably have elected to take in stock.

In recent days, even as Chapter 11 loomed larger than ever, there were still some message board posters touting the stock. There was always a desperate-sounding value manager to talk up the stock.

The Value Trap

That is one lesson for investors from Conseco: Beware the value trap. A stock may fall far from its high, a new CEO may join and initially project robust earnings growth once operations recover. The hasty investor will then use those earnings to arrive at a valuation and claim the stock is cheap, usually ignoring debt on the balance sheet.

"Just because a stock is down 70%, it doesn't mean that a company's enterprise value is down that much if it has a lot of debt," says Jim Chanos of the Kynikos Associates hedge fund, which had sold Conseco short in past years. Enterprise value refers to the market value of a company's stock plus its debt, and it gives a fuller picture of what the market thinks a company is worth. Even with its stock worth next to nothing, Conseco's debt, at face value, gives it an enterprise value of $4 billion, way too high for a company showing such staggering losses.

The remaining mystery about Conseco is why the authorities never took punitive action against Conseco for its accounting gimmickry through the years.

But it's partially consoling that the market ended up meting out some justice. It appears that some sort of prepackaged debt restructuring will be attempted, but any bankruptcy-type reorganizations are always hard to pull off at financial companies, where access to markets is absolutely critical to stay liquid. For all intents and purposes, Conseco is dead. And it is only fitting that its most loyal chronicler should also write this obituary.