is the story of the month. I think it will remain in the public’s
eye for months to come. The media can’t leave it alone. Neither
can the Democrats in Congress. There is something irresistible about
this story. It has greed, lies, scandal, heartbreak, and revenge.
It is a prime-time soap opera.
Compared to Enron, last week’s bankruptcy
of Global Crossing hardly gets any exposure, despite the fact
that it was the fourth-largest bankruptcy in U.S. history. It was
selling for $60 a share in March, 2000.
The market — the nearly omniscient market, which no one can
beat, not even Warren Buffett (say academic economists who are not
investors) — was caught up in a mania for four years. The obvious
insanity of the high-tech boom was accepted by just about everyone
as rational. It was in fact irrational, and those investors who
participated in the mania lost a lot of money. But, we are assured
by those who failed to warn us then, that the S&P 500 is different.
No mania here! Enron is not representative. Global Crossing is not
representative. “Buy and hold!”
When the biggest and fourth-biggest bankruptcies hit in one month,
the public ought to wonder: “How did the experts not see this coming?
Why were there no warnings?” In this issue and the one to follow,
I discuss some possible answers.
How did it happen? Enron supposedly had checks in place. It had
accountants. It had bankers looking over its shoulder. It even had
an ethics manual. You could have bought it last week on eBay.
July, 2000, 64 pages, paperback). Perfect condition, like new.
Sections include: Principles of Human Rights; Securities Trades
by Company Personnel; Business Ethics; Confidential Information
and Trade Secrets; Governmental Affairs and Political Contributions;
Consulting Fees, Commissions and Other Payments; Conflicts of
Interest, Investments and Outside Business Interests of Officers
and Employees, etc.
It sold for $355. That would have bought over 700 shares of Enron.
Enron’s internal checks failed. Then its checks bounced. How? After
all, these were experts. Can it happen again?
Count on it.
$70 BILLION SOAP OPERA
There are reasons for the media’s fascination with Enron. Here are
a few of them:
TV journalists don’t understand economics. They understand scandals.
- Ditto for
- Enron was
located in Houston, not New York City.
- Enron funded
- A Republican
is now President.
- Enron funded
don’t know any politicians’ names except Bush I, II; Cheney, Clinton
I, II; and Kennedy III. Clinton I is missing. Clinton II wasn’t
officially in politics before last year — no Enron money
(maybe). Kennedy III has been invisible for years.
- Vice President
Cheney is stonewalling on who attended the White House’s energy
policy advisory meetings. This is Watergate-type stonewalling,
not Monica-type stonewalling. The media are interested in dirty
money, not unlit cigars. This looks like media pay dirt.
Employees got hurt. (Enron’s investors got hurt, too, but media
liberals don’t care about investors, unless the investors are
- It is the
biggest corporate bankruptcy in history.
- Media pundits
really are angry. On Sunday’s “60 Minutes,” Andy Rooney excoriated
Enron and the hundreds of politicians who took Enron’s money.
He was not humorous. He was really outraged.
- Ken Lay
really is a rich, arrogant man who took $300 million for services
rendered for three years. He thought it was easy. He believed
his own press releases. He was a hypester. He was Mr. No-Can-Fail.
Then he got caught, tripped up by his own arrogance. Viewers always
like comeuppance for rich guys. Envy is still alive and well in
Is Enron’s bankruptcy being hyped by the media as much as the New
Economy’s hypesters hyped Enron’s stock? Yes. It’s action-reaction.
First the financial network journalists, then the prime-time network
journalists. First CNBC, then NBC. First the cheering, then the
booing. Before and after, viewers are informed about the “inside
story” by blown-dry talking heads who know almost nothing about
economics and are not themselves investors. Viewers believe CNBC.
Then, possibly much poorer, they believe NBC.
ECONOMIC ISSUE: DERIVATIVES
Enron deserves all this attention. It just doesn’t deserve the slant
that the networks are putting on it. Enron deserves attention because
it is offers a warning — the second big one — of an underlying
threat to the world’s economy. The first warning was Long Term Capital
Management’s bankruptcy in 1998. This is a repeat, but on a much
larger scale in terms of its immediate impact.
The international currency markets got a shock when Long Term Capital
Management went down in 1998. That was a $4.6 billion loss, with
banks lending an extra $3.5 billion, and with somebody — this
was never clear — assuming $1 trillion in leveraged futures
obligations, also known as derivatives. (You read that right: one
trillion bucks of bets on debt.) Supposedly, these contracts were
liquidated slowly. The story dropped off the media’s radar screen
not long after Greenspan pulled off his weekend bailout by the 16
When I first heard about Enron’s troubles I thought: “derivatives.”
Only derivatives could sink a $70 billion company that fast. I was
correct. The leverage got them. Sloppy accounting only delated the
Keep in mind that smart, rich, influential men do not deliberately
destroy the source of their wealth and influence. They get trapped
in a nightmare of their own creation. Enron’s failure was not deliberate.
It was the result of a series of interconnected events.
The men in charge were trapped by their own arrogance. They built
a mountain of debt and then could not control events. The story
of Enron is the story of incalculable debt that got away from those
experts who had agreed to it. This debt was accepted voluntarily
by the company’s senior managers, and it destroyed the equity of
the company, and maybe the equity of other companies before the
debt dominoes are through toppling.
Everyone — especially Alan Greenspan — hopes that the
toppling of Enron is one lone domino. Investors and central bankers
hope there will be no domino effect. But with the massive interrelated
debt structure of the modern economy, nobody knows. This is the
great uncertainty: the complexity of the web of debt.
ENRON’S FAILURE RANDOM?
The financial commentators are telling us that this was a one-time
event, that it is not a prelude of things to come, that its effects
on the economy will be minimal, that — as always — “the
market has already discounted the negative effects of all this.”
In short, this is as bad as it gets.
But what if this is as good as it gets? Nobody on TV mentions this
What about the supposed genius of the market in discounting all
the bad news? If the market is so smart, then why did it allow the
stock of this debt-laden nightmare reach $80 a share one year ago?
And if the market failed to warn the investors in time regarding
Enron, why should we trust it to warn us about the next Enron?
Here’s the reality: “the market” is no smarter than investors are,
and investors have come to believe that the economic system’s “gatekeepers”
— its accountants, bankers, and government regulators —
know what they are doing and can be trusted to keep such events
as Enron isolated from the rest of us. Enron is seen as an aberration,
a one-time event. Investors also believe that the Federal Reserve
System can intervene in time to keep future Enrons from doing any
more than ruining their own investors.
The theory of efficient markets leads to a conclusion: a stock’s
next price is random. You can’t forecast it accurately in advance.
The stock’s price’s trend is random. You can’t forecast it accurately
in advance. This is the “que será, será” theory of
forecasting: what will be, will be. This means that we can expect
anything in pricing. Anything can happen.
Then why shouldn’t bad things take place as often as good things?
Why aren’t there other Enron’s ahead in our lives? The economists
have great faith that all future Enrons will be offset by future
Microsofts. The good and bad will balance out, except that there
will be 3% growth per year, forever.
The only warning that the market gives is a falling share price.
But random-walk theory teaches that there is no trend lines that
matter, that what has happened so far tells us nothing about what
will happen next. So, the “warning” that the market gives is no
warning at all. So, do nothing. Don’t change your portfolio. You
can’t beat the market. “The great market has spoken. Pay no attention
to the little man behind the curtain.”
The economists assume that we can’t know anything about future prices.
This means that what happened to Enron stock is random. This necessarily
means that, in the grand scheme of themes — the great random
economic universe — what happened to Enron was random.
Enron’s demise was not random. This is my main point. Enron’s failure
was not only not random, it was subsidized by the present system.
The system increased the likelihood that it would happen. The system
led to a greater than random probability that such an event would
happen. And if it did this once, then the tendency of the system
is to do it again.
This is our problem. It isn’t going to go away.
In detailed testimony to a Senate committee on January 24, Frank
Partnoy, a law professor and former Wall Street derivatives specialist,
offered an introduction — in English — to this complex,
terrifyingly complex market.
If you want to know what we are facing, read this. What Enron did
was not exceptional. On the contrary, it is becoming normal in big
Partnoy reported that Enron still owes tens of billions of dollars
worth of debt in forfeited derivatives contracts. Chapter 11 bankruptcy
proceedings have only delayed non-collection by the investors who
were on the right side of the derivatives trades, but with the wrong
company on the other side.
Nobody in the prime time media is talking about this. It’s too complex
for sound bytes. The economic ripple effects have only just begun
to be felt.
has been compared to Long-Term Capital Management, the Greenwich,
Connecticut, hedge fund that lost $4.6 billion on more than $1
trillion of derivatives and was rescued in September 1998 in a
private bailout engineered by the New York Federal Reserve. For
the past several weeks, I have conducted my own investigation
into Enron, and I believe the comparison is inapt. Yes, there
are similarities in both firms’ use and abuse of financial derivatives.
But the scope of Enron’s problems and their effects on its investors
and employees are far more sweeping.
According to Enron’s most recent annual report, the firm made
more money trading derivatives in the year 2000 alone than Long-Term
Capital Management made in its entire history. Long-Term Capital
Management generated losses of a few billion dollars; by contrast,
Enron not only wiped out $70 billion of shareholder value, but
also defaulted on tens of billions of dollars of debts. Long-Term
Capital Management employed only 200 people worldwide, many of
whom simply started a new hedge fund after the bailout, while
Enron employed 20,000 people, more than 4,000 of whom have been
fired, and many more of whom lost their life savings as Enron’s
stock plummeted last fall.
In short, Enron makes Long-Term Capital Management look like a
At any given time, he says, there are $13 to $14 billion in market
(notational) vale derivatives traded on the major capital markets.
These are government-regulated markets, so we know the totals. But
the outstanding totals of all derivatives at the end of 2000 was
at least $95 trillion. Therefore, 90% of these markets are OTC —
over the counter. Sounds like your local drug store, doesn’t it?
Well it is a kind of drug: the debt drug.
Enron had made deals with 3,000 off-balance sheet entities. Talk
about a labyrinth! It was too complicated for Enron’s “masters of
the universe” to handle. Partnoy told Congress:
Specifically, Enron used derivatives and special purpose vehicles
to manipulate its financial statements in three ways. First, it
hid speculator losses it suffered on technology stocks. Second,
it hid huge debts incurred to finance unprofitable new businesses,
including retail energy services for new customers. Third, it
inflated the value of other troubled businesses, including its
new ventures in fiber-optic bandwidth. . . .
The critical piece of this puzzle, the element that made it all
work, was a derivatives transaction — called a “price swap
derivative” — between Enron and Raptor. In this price swap,
Enron committed to give stock to Raptor if Raptor’s assets declined
in value. The more Raptor’s assets declined, the more of its own
stock Enron was required to post. Because Enron had committed
to maintain Raptor’s value at $1.2 billion, if Enron’s stock declined
in value, Enron would need to give Raptor even more stock. This
derivatives transaction carried the risk of diluting the ownership
of Enron’s shareholders if either Enron’s stock or the technology
stocks Raptor held declined in price. . . .
In all, Enron had derivative instruments on 54.8 million shares
of Enron common stock at an average price of $67.92 per share,
or $3.7 billion in all. In other words, at the start of these
deals, Enron’s obligation amounted to seven percent of all of
its outstanding shares. As Enron’s share price declined, that
obligation increased and Enron’s shareholders were substantially
diluted. And here is the key point: even as Raptor’s assets and
Enron’s shares declined in value, Enron did not reflect those
declines in its quarterly financial statements.
so on. Now, for the real problem:
All of this complicated analysis will seem absurd to the average
investor. If the assets and liabilities are Enron’s in economic
terms, shouldn’t they be reported that way in accounting terms?
The answer, of course, is yes. Unfortunately, current rules allow
companies to employ derivatives and special purpose entities to
make accounting standards diverge from economic reality. Enron
used financial engineering as a kind of plastic surgery, to make
itself look better than it really was. Many other companies do
Partnoy warned, “Enron is not the only example of such abuse; accounting
subterfuge using derivatives is widespread.” The accounting firms
and banks are allowing this to go on. He calls them “gatekeepers.”
Moreover, a thorough inquiry into these dealings also should include
the major financial market “gatekeepers” involved with Enron:
accounting firms, banks, law firms, and credit rating agencies.
Employees of these firms are likely to have knowledge of these
transactions. Moreover, these firms have a responsibility to come
forward with information relevant to these transactions. They
benefit directly and indirectly from the existence of U.S. securities
regulation, which in many instances both forces companies to use
the services of gatekeepers and protects gatekeepers from liability.
I have a friend who runs a small closed-end Canadian fund. He has
been warning me for years regarding the decline in standards in
the accounting profession. He says that what passes for honest accounting
today would have resulted in jail sentences 40 years ago.
I guess it’s a form of “grade inflation” to match monetary inflation
. . . and ethical deflation. But it’s worse than grade inflation.
In college, students don’t pay professors big money to raise their
grades. Enron paid fortunes to buy . . . what?
It has been reported widely that Enron paid $52 million in 2000
to its audit firm, Arthur Andersen, the majority of which was
for non-audit related consulting services, yet Arthur Andersen
failed to spot many of Enron’s losses. It also seems likely that
at least one of the other “Big 5″ accounting firms was involved
at least one of Enron’s special purpose entities.
Enron also paid several hundred million dollars in fees to investment
and commercial banks for work on various financial aspects of
its business, including fees for derivatives transactions, and
yet none of those firms pointed out to investors any of the derivatives
problems at Enron. Instead, as late as October 2001 sixteen of
seventeen the securities analysts covering Enron rated it a “strong
buy” or “buy.” Enron paid substantial fees to its outside law
firm, which previously had employed Enron’s general counsel, yet
that firm failed to correct or disclose the problems related to
derivatives and special purpose entities. Other law firms also
may have been involved in these transactions; if so, they should
be questioned, too.
Finally, and perhaps most importantly, the three major credit
rating agencies — Moody’s, Standard & Poor’s, and Fitch/IBCA
— received substantial, but as yet undisclosed, fees from
Enron. Yet just weeks prior to Enron’s bankruptcy filing —
after most of the negative news was out and Enron’s stock was
trading at just $3 per share — all three agencies still gave
investment grade ratings to Enron’s debt. The credit rating agencies
in particular have benefited greatly from a web of legal rules
that essentially require securities issuers to obtain ratings
from them (and them only), and at the same time protect those
agencies from outside competition and liability under the securities
So, once again, we learn that monopolistic favoritism by the government
can be abused.
One theory offered for the fall in the stock market earlier this
week was investors’ fears regarding the possibility that the government
may tighten accounting standards. Now, that’s some theory. The market
falls because investors are afraid of honest accounting! In short,
once somebody buys a stock whose price has been inflated by fraud,
he wants society to maintain the same level of fraud.
Enron was run by smart men. They indebted the company by using what
are now standard techniques: derivatives. These techniques are so
complex, so highly leveraged, that the “gatekeepers” spotted nothing
This debt complexity is worldwide and is growing. Derivatives are
everywhere: over $100 trillion worth, at least. No one know how
much money is at risk.
The “masters of the universe” who use these techniques seem to have
no idea just how vulnerable their companies are. They don’t see
disaster coming. When it comes, they lie. This makes the disaster
worse. Before the collapse takes place, their investors and employees
believe their rhetoric. And then, at the very end, just before bankruptcy,
they strip the company of its remaining money and retire.
The legal system subsidizes these morally corrupt hot-shots who
use other people’s money to play leverage games, and then strip
the firm of its remaining assets when they lose the bets.
This is now big business as usual. Enron is the tip of the iceberg.
This is going to happen again because the existing legal system
offers tens of millions of dollars to executives who have lost the
bet. First, they indulge in the fantasy that their in-house trading/forecasting
systems can beat everyone else’s in-house trading/forecasting systems.
They believe that their traders are smarter than all those other
traders. Then, when they lose, they take the remaining money and
retire. They consider this moral. They consider this fair payment
for a failed strategy.
Nobody inside a company ever blows the whistle in advance. If someone
does, he faces a lawsuit from the company. The one Enron officer
who did blow the whistle is now dead — a suicide, they say.
Nobody outside the company blows the whistle because key whistle-blowers
is being paid to keep investors happy: by brokerage firms, business
magazines, or whoever is paying his salary. They are paid not to
blow the whistle. This is why no one in a brokerage firm ever puts
a “sell” recommendation on a major stock.
It is almost as corrupt here as it is in Japan. If Congress ever
makes the accounting-banking gatekeepers responsible for what they
report, there will be a crisis in the stock and bond markets. To
tell the truth to investors at this late date would bring down many
high flyers. Many pensions funds would be hurt.
It looks as though the Democrats may make an issue of this. Enron
is too visible to shove under the rug in a Congressional election
year. There are political points to be gained by “helping the little
guy.” But I doubt that there will be fundamental change. The system
rewards incumbents too highly. When they retire into jobs as lobbyists,
they get rich.
The longer that Cheney stonewalls, the more the Senate will pretend
that it’s another Watergate. It’s much worse than Watergate. The
rot has spread too far. That’s why I don’t expect any fundamental
reform. But the Democrats will make as much noise as they can without
actually doing anything substantive. It will be like it is in Japan:
no growth, few winners, and a sense that the days of wine and roses
P.S. The Lays live in a $7.5 million penthouse, according to one
TV report. They will keep it. Texas law has a homestead provision:
no one can be evicted from his home in a bankruptcy. For anyone
contemplating bankruptcy, a move to Texas is smart business. Get
liquid, buy the most expensive home you can afford for cash, and
you will retain your wealth. It’s the law.