When greed is fact and control
is fiction
Enron's spectacular collapse was not an isolated
financial disaster, says Frank Partnoy. It was
symptomatic of a new culture of concealment in
business and a reckless disregard of risk
Friday February 14, 2003
The Guardian
The 1990s were a decade of persistently rising markets - 10
years of economic expansion, with investors pouring record
amounts into stocks and pocketing double-digit returns year
after year. The recent stock price boom was the longest-lived
bull market since the second world war. Some stocks or sectors
suffered periodically, but almost anybody who remained invested
throughout the decade made money.
During this time, stocks became a part of daily conversation and
investors viewed the rapid change and creative destruction
among companies as investment opportunities, not reasons for
worry.
The decade was peppered with financial debacles, but these
faded quickly from memory even as they increased in size and
complexity. The billion dollar-plus scandals included Robert
Citron of Orange County, Nick Leeson of Barings and John
Meriwether of Long-Term Capital Management, but the markets
merely hiccoughed and then started going up again.
When Enron collapsed in late 2001, it shattered some investors'
beliefs and took a few other stocks down with it. Then Global
Crossing and WorldCom declared bankruptcy, and dozens of
corporate scandals materialised as the leading stock indices
lost a quarter of their value.
Most investors were perplexed. The conventional wisdom was
that markets would remain under control, that the few bad
apples would be punished and that the financial system overall
was not under any serious threat.
The conventional wisdom is wrong. Any appearance of control in
today's financial markets is only an illusion. Markets have come
to the brink of collapse several times in the past decade, with
the failures of Enron and Long-Term Capital Management being
prominent examples. Today, the risk of system-wide collapse is
greater than ever. The truth is that the markets have been - and
are - spinning out of control.
The relatively simple markets that financial economists had
praised during the 1980s as efficient and self-correcting had
radically changed by 2002. The closing bell of the New York
stock exchange was barely relevant as securities traded 24
hours a day around the world. Financial derivatives were as
prevalent as stocks and bonds, and nearly as many assets and
liabilities were off-balance sheet as on.
Companies' reported earnings were a fiction and financial reports
chock-full of disclosures that would shock the average investor if
they ever even glanced at them - not that anybody ever did.
If investors believe in the fiction of control and ignore the facts,
the markets can continue to rise. But if investors question their
faith, the downturn will be long and hard.
As investment guru James Grant recently put it: "People are not
intrinsically greedy. They are only cyclically greedy."
There have been three major changes in financial markets in the
past 15 years. First, financial instruments became increasingly
complex and were used to manipulate earnings and avoid
regulation. Second, control and ownership of companies moved
apart as even sophisticated investors could not monitor senior
managers and even diligent senior managers could not monitor
increasingly aggressive employees. Third, markets were
deregulated.
These changes spread through financial markets like a virus.
Before 1990, markets were dominated by the trading of relatively
simple assets: mostly stocks and bonds. The sinaqua non of
the 1980s was the junk bond , a simple fixed-income instrument
no riskier than stock. The merger mania of the 1980s, driven by
leveraged buyouts in which an acquirer borrowed heavily to buy
a target's stock, involved straightforward transactions in stocks
and bonds. Individual investors shied away even from stocks,
and most people kept their savings in the bank or in certificates
of deposit, which paid more than 10% annual returns during
most of the decade. From 1968 to 1990, individuals sold more
stock than they bought and money flowed out of the market.
Birth of derivatives
Derivatives - the now notorious financial instruments whose value
is derived from other assets - were virtually unknown. The two
basic types of derivatives, options and futures, were traded on
regulated exchanges and enabled parties to reduce or refocus
their risks in ways that improved the overall efficiency of the
economy. Customised, over-the-counter derivatives markets,
often used for less laudable purposes, were less than 1% of
their present size, and most complex financial instruments still
had not been invented. In Barbarians at the Gate, the classic
book about 1980s finance, derivatives are not even listed in the
index.
Some companies used basic forms of derivatives in the 1980s,
including "plain-vanilla" interest rate swaps. But the forms of
structured financing and gizmos that later would bring hundreds
of companies to their knees simply did not exist. Even stock
options, the primary source of executive compensation in the
1990s, were relatively uncommon.
The legal environment in this period was harsh. The go-go 1980s
led prosecutors to clamp down hard on securities fraud, indicting
dozens of financial market participants.
The financial market watchdogs made investors feel secure -
almost smug - about financial fraud.
Even highly paid investment
bankers were technologically primitive, without email or internet.
They used calculators instead of computer spreadsheets and
statistical software. Few had formal finance training, and almost
nobody had a maths or finance PhD. Individuals were
technologically primitive, too. Investors placed orders to buy and
sell stock by letter or phone, not with the click of a mouse.
People learned how their stocks were performing at most once a
day, from the newspaper, not in real time on TV. Financial
analysis was available through the mail at a price, not on the
internet for free.
In sum, the 1980s were a relatively primitive period on Wall
Street. Life was uncomplicated if aggressive. The financial
markets became increasingly competitive and profit margins
dwindled.
The crash of October 1987 didn't help. After the Dow Jones
tumbled more than 7% in a day, investors became skittish and
investment bankers' business faltered. The last years of the
decade were likely to be lean, and the future looked grim. It was
not a good time to be working on Wall Street. But all of this was
about to change.
Cash conversion
By 2002, most people knew the basic story of Enron: how three
radically different characters - the professorial founder Kenneth
Lay, the free market consultant Jeffrey Skilling and the brash
financial whizz Andrew Fastow - converted a small natural gas
producer into the seventh largest company in the United States,
on the way generating fabulous wealth for shareholders,
employees - and particularly insiders, who cashed out more
than $1.2bn.
Most people also knew about Enron's spectacular fall into
bankruptcy, the thousands of lay-offs, the imploded retirement
plans, the controversy surrounding political contributions and
even the details of executives' personal lives. But the basic story
was unsatisfying, because by focusing on just a few
transactions and people it failed to place Enron in perspective.
Simply put, 15 years ago Enron could not have happened. It was
made possible by the spread of financial innovation, loss of
control and deregulation in financial markets. Enron's managers
- with the assistance of accountants at Arthur Andersen and
several Wall Street banks - used complex financial instruments
and engineering to manipulate earnings and avoid regulation.
Enron's shareholders lost control of the firm's managers, who in
turn lost control of employees, particularly financial officers and
traders. Enron oper ated in newly deregulated energy and
derivatives markets, where participants were constrained only by
the morals of the marketplace.
Enron's officers combined the risky strategies of Wall Street
bankers with the deceitful practices of corporate CEOs in ways
investors previously had not imagined. Even after more than a
year of intense media scrutiny, congressional hearings and
other government investigations, most of the firm's dealings
remained unpenetrated.
A special committee appointed to decipher Enron's collapse
spent several months reviewing documents and interviewing key
parties, but its 200-page report covered just a few of Enron's
thousands of partnerships and was filled with caveats about its
own incompleteness. Congress held dozens of hearings but
barely scratched the surface. Incredibly, after Enron's
bankruptcy, its own officials were unable to grasp enough detail
to issue an annual report; even with the help of a new team of
accountants from PricewaterhouseCoopers, they simply could
not add up the assets and liabilities.
A close analysis of the dealings at Enron leads to three key
conclusions, each counter to the prevailing wisdom about the
company.
First, Enron was in reality a derivatives trading firm not an
energy firm, and it took on much more risk than anyone
realised. By the end, Enron was even more volatile than a highly
leveraged Wall Street investment bank, although few investors
were aware of it.
Second, the core business of derivatives trading was actually
highly profitable - so profitable, in fact, that Enron almost
certainly would have survived if key parties had understood the
details of its business. Instead, in late 2001, Enron was hoist
with its own petard, collapsing not because it wasn't making
money but because institutional investors and credit-rating
agencies abandoned the company when they learned that
Enron's executives had been using derivatives to hide the risky
nature of their business.
Third, Enron was arguably following the letter of the law in nearly
all of its dealings, including deals involving off-balance sheet
partnerships and infamous special purpose entities. These
deals, which blatantly benefited a few Enron employees at the
expense of shareholders, nevertheless were disclosed in its
financial statements, and although these disclosures were
garbled and opaque, anyone reading them carefully would have
understood the basics of Enron's self-dealing - or, at a minimum,
been warned to ask more questions before buying the stock.
Illegal or alegal?
To the extent that Enron, its accountants and bankers were
aggressive in transactions designed to inflate profits or hide
losses, they weren't alone. Dozens of other companies were
doing the same kind of deals - some with Enron - and all had
strong arguments that their deals were legal, even if they
violated common sense.
Relative to many of its peers, Enron was a profitable, well run
and law-abiding firm. That does not mean it was a model of
corporate behaviour - it obviously was not. But it does explain
how Enron could have happened.
Although the media seized on
its collapse as the business scandal of the decade, the truth
was that Enron was no worse than Bankers Trust, Orange
County, Cendant, Long-Term Capital Management, CS First
Boston, Merrill Lynch and many others to follow, including
Global Crossing and WorldCom, which collapsed soon after
Enron.
Enron's dealings were not illegal, they were alegal, and Enron
was a big story - not in itself but as a symbol of how 15 years of
changes in law and culture had converted reprehensible actions
into behaviour that was outside the law and therefore seemed
perfectly appropriate, given the circumstances.
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