by Gary North
Enron 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.
(Dated 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.
A $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 viewers.
- Enron was located in Houston, not New York City.
- Enron funded Republicans.
- A Republican is now President.
- Enron funded Democrats.
- Viewers 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.
- Enron's Employees got hurt. (Enron's investors got hurt, too, but media liberals don't care about investors, unless the investors are common employees.)
- 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 America.
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.
THE 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 creditor banks.
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 disaster.
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.
WAS 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 possibility.
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 business.
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.
Enron 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 lemonade stand.
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.
And 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 the same.
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 laws.
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 wrong.
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 are over.
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.
February 5 , 2002
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