Enron: Poster Boy for Ultra-Capitalism
The rich and powerful too often bend the acts of government to their selfish purposes, many of our rich men have not been content with equal protection and equal benefits, but have besought us to make them richer by acts of Congress. Andrew Jackson, 1830[1]
Enron moved on many fronts in a wild ride of undisciplined capitalism to its record bankruptcy in 2001. Besides the original gas business formed in 1985 with the merger of several companies, Enron became the biggest trader in energy contracts, and it expanded into other commodities, including natural gas, paper, metals, crude oil, petroleum products, plastics, and strange areas like advertising, weather, and credit. This was the “asset lite” business that CEO Ken Lay hired Jeffrey Skilling to manage. At the same time, Lay entrusted Rebecca Mark with selling, building, and managing major projects around the world, including gas, water, steel, and power, a large percentage of which turned out to be big losers. After 1996, annual losses on many projects caused already thin profit margins almost to disappear. Chief Financial Officer Andrew Fastow was challenged to find ways to hide the losses, protect the high stock price and investment-grade rating, and keep the borrowed money flowing in. Enron’s true financial condition became apparent in 2001, the same year that both the stock market and oil prices were going down, and the company imploded.
The internal reason for Enron’s failure thus was Lay’s incompetence, for he committed Enron management to an oversized task beyond their capacity to manage. The external reason for Enron’s failure was that government-regulated banks kept pumping billions of dollars of good money into bad loans and bad deals at Enron. Ultimately, Enron is a case study in how economic freedom can function well only when the government provides the proper fiscal, monetary, and regulatory disciplines.
Criticism can begin with a management that bet the shareholders’ and employees’ money on ventures of which the size of the risks and the size of the bets kept rising. At the very least, management was incompetent in balancing risk and reward, so they slipped into illegality, trying to hide the losses. The Board of Directors failed the shareholders by ignoring the decline in profit margins, the ballooning debt, and the erosion of business disciplines and corporate ethics. The Audit Committee of the Board failed in their more specific responsibility to assure integrity in the numbers and in the process. The outside auditors failed in their more comprehensive responsibilities to assure integrity in the numbers and procedures. Wall Street analysts failed to advise investors of deteriorating circumstances; instead, they continued to recommend Enron as a desirable investment until a few weeks before bankruptcy was declared. The bond-rating agencies failed to alert lenders or investors of the increasing risk and finally downgraded their investment-grade rating a few days before bankruptcy. Banks that lent billions of dollars to Enron failed to determine the quality of loans, used the artificial stock price as collateral for real money, and kept funding the game until it imploded. The institutional investors failed in their fiduciary responsibility to judge Enron as a bad investment. The lawyers failed in their public trust by structuring the partnership scams that allowed Enron to move debt off the balance sheet to add fictitious profits to earnings. The financial press failed to find the truth and inform the public.
A nation supports economic growth by controlling currency and credit for the benefit of the general welfare with money that is neutral, nonvolatile, and patient. This mission can be accomplished through free banking, national banking, or a combination of private and public banking. Free banking is monitored by market disciplines, and it worked well in Scotland at the time of Adam Smith when bad loans were punished locally, quickly, and visibly. Governments, however, do not trust private bankers with the opportunity to concentrate wealth for personal benefit, so they establish national banking through which the government has direct control of currency and credit. Private bankers, however, do not trust government to print and spend money at will, debase the currency, and cause inflation. The bankers exercise power over governments because they can withhold lending needed for war or defense. National banking was terminated by President Andrew Jackson in the 1830s (see chapter 7), after which private banking failed to prevent recurring capital crises. The American banking system was then made part public and part private in 1913 with the establishment of the Federal Reserve Board. By the end of the twentieth century, this compromise resulted in a banking system that was the worst of both worlds. On the one hand, the bankers enjoyed growing privileges to concentrate wealth in record amounts; on the other hand, the government assumed the obligation to bail out the bankers after the inevitable crises.
Financial crises are inevitable when two economic principles are violated: the neutrality of money and market disciplines. The neutral, nonvolatile, patient capital specified by Adam Smith as prerequisite to the proper functioning of economic freedom, has not been provided by the government’s fiscal, monetary, and regulatory policies since the founding of the Republic. Easy credit, speculation, and lack of sensitivity to the quality of loans, however, became dramatically worse during the last quarter of the twentieth century when the banking system was deregulated, market disciplines were suspended, excessive volatility and liquidity were introduced by government mistakes, and electronic banking mushroomed in size, speed, and variety (see chapter 7). When money is dominant, not neutral, the market cannot find equilibrium, repetitive crises occur, and then, when the government violates the second economic principle by bailing out the private interests, greater disequilibrium and more crises are caused.
Economic disasters are caused by greedy people, and there will always be greedy people. In the republican spirit of the American Founders, we need to structure the system with the checks and balances that prevent greedy people from exploiting the economy and hurting the people. Every economic disaster thus far in American history has resulted from a structural failure of government to protect the people. The structure is one that must control currency and credit for the general welfare instead of allowing easy credit for the speculators and risk takers to do their damage. Freedom is functional only with discipline. Economic freedom depends on a structure in which money is a simple medium of exchange, not a marauding monster that dominates commerce.
The highly visible bankruptcy of Enron is an opportunity to examine the specific government policies that allowed ultra-capitalism to come to dominate our economy and cause its reversal. Enron also has a political dimension that should assure continued examination until the 2004 presidential election. Many in Congress, both Republicans and Democrats, posturing before the TV cameras, were the same politicians who had responded to corporate and Wall Street lobbying to pass the laws favoring ultra-capitalism during the quarter century that led up to the problem in the first place.
Citizens can learn about ultra-capitalism and how to apply democratic pressure to purge it from society by understanding the fundamental errors of those who support ultra-capitalism, and the collectivists who try to micromanage the economy. In the argument between the so-called “market fundamentalists” and the so-called “liberals,” neither the terms nor the argument can survive careful examination, so unless citizens insure that the quality of the debate improves, ultra-capitalism will continue to dominate.
Let me tell you a story of greedy people managing assets with limited intrinsic value up to extraordinarily high artificial levels. The greedy people included the officers of the company, wealthy private investors, partners of the banks, and government officials. The company was run by people whose total concentration was the price of the stock. Every one of the participants benefited by the stock price going up and from the opportunity to leverage their investments with extremely easy credit. In time, short-sellers drove the share price down. Most of the wealthy got out with big gains while most of the ordinary investors were devastated. This is not only the story of Enron in 2001 but also the story of the South Sea Bubble in Great Britain in the 1720s.[2] Fiscal and monetary policies have been in the hands of the wrong people for a long time!
The Wall Street-Washington Roundtrip
Enron is a case study in how unregulated easy credit allowed this misadventure in corrupted capitalism to happen. Enron is also a case study in how “structured financing” has allowed both lenders and borrowers to move debt off of the balance sheet and hide it from the scrutiny of shareholders. Financial expert Martin Mayer regretted the loss of traditional bankers who were more fiscally reliable:
trained to ask boring questions about how the investment of the money they lent would pay back the loan, and to follow up at regular intervals. An expanding business had to return repeatedly to its bank to finance its growth. The conditions of the loan forbade the entrepreneur from cashing in his stock while the bank stayed on the hook.[3]
Mayer went on to compare this basic banking to the age of ultra-capitalism ushered in by Congress:
The guiding principle of the New Deal legislation was that sunshine is the best disinfectant, and that is still true. Chanting the mantra that big boys can take care of themselves, Congress in the 1980s and 1990s made it possible for consenting adults to do financially awful things behind closed doors.[4]
In the latter part of the twentieth century, the Chairman of the Fed and the Secretary of the Treasury contributed to the domination of the economy by ultra-capitalism. They believed that there could never be either too much deregulation or too much liquidity. Consequently, they supported the abrogation of market disciplines necessary to prevent bad loans, and they supported the lobbying by Wall Street that diverted the government from oversight of hedge funds like Enron. These actions, in combination, caused repetitive economic problems, but instead of being red flags that attracted attention to the errors, they were used in support of additional abrogation of market disciplines in an effort to prevent systemic failure. Gradually the government’s function changed from being a regulator of ultra-capitalism to being its protector.
In 2002, Paul Volcker was picked to head the damage-control committee at Enron’s disgraced auditors, Arthur Andersen. The selection of Volcker was ironic because the root cause of the Enron scandal was not bad auditors, although they had added to the problem, but rather bad banking practices that were encouraged by Volcker’s own having bailed out Continental Illinois in 1984, on the “too big to fail” principle (see chapter 7). The argument for bailouts is that the whole system is threatened, but the threat is not used as a reason to raise the bank reserves proportionate to the risk, and, to stop the bailouts, subsidies, and insurance. Until the system allows market disciplines to punish banks for bad loans, and until the leverage is taken out of speculation, Enrons will continue to happen.
The failure and bailout in 1998 of the unregulated hedge fund, Long Term Capital Management, was another unheeded warning of the damage to come from another unregulated hedge fund, Enron. The chairman of the Fed, despite persistent, demonstrable evidence that the banks were not fulfilling their responsibility, made this extraordinary statement: Greenspan advised Congress that hedge funds do not need regulation because they get their money from banks, and banks are regulated.[5]
Ultra-capitalism scored another impressive victory in 1999 when the Glass-Steagall Act was repealed. This law, signed by FDR in 1933, was passed to separate basic banking, especially the lending of money, from investment banking, especially the making of deals. It was passed because of evidence that mixing the two types of financial activities caused a conflict of interest and contributed to economic damage. This conflict was demonstrated again at Enron when beneficiaries of the repeal of Glass-Steagall, such as Citigroup, made multi-billion dollar loans at the same time they were obtaining the investment banking contracts for many of Enron’s worldwide deals. Citigroup made bad loans to fund Enron’s bad business in order to manage the bad deals that eventually brought Enron down.
Citigroup is special because they had been put together in anticipation of the repeal of Glass-Steagall. In 2001, CEO Weil’s compensation was $26.7 million, excluding options. In approving this compensation, the Board commented, “Management had performed exceedingly well under these unusually difficult circumstances.” Citigroup was reportedly “one of the biggest lenders to Enron Corp., and the bank has been forced to write down much of its exposure to the collapsed Houston energy company.”[6] In other words, Citigroup was forced to reduce profits based on anticipated losses on the loans made to Enron. The Economist reviewed this history as follows:
J.P. Morgan and Citigroup, two financial conglomerates exist in their current form and provide the range of financial services they did to Enron, only because of the abolition of the Glass-Steagall Act. This imposed statutory barriers between commercial banking, investment banking, and insurance, and was introduced in 1933 following public protests about conflicts of interest on Wall Street in the aftermath of the 1929 stock market crash. Rivals on Wall Street now whisper that conflicts of interest at these two banks may have played a role in Enron’s collapse.[7]
Taken together, these details add up to a massive pattern of bad governance by leaders in government and banking. And yet American citizens so little grasp the implications that whispers in financial journalism never rise to the level of uproar of reformation. Only when voters, their elected representatives, and honorable people in government realize that the problem at Enron was not merely greedy executives but also the entire ultra-capitalist banking, investment, and governance system of the United States , will there be essential, structural change. In ultra-capitalism these monster financial services companies, courtesy of the U.S. government, mix money-lending, deal-making, and touting the stock of the same company. William Greider explored this triple play in the following words:
J.P. Morgan and Citigroup provided billions to Enron while also stage-managing its huge investment deals around the world. The larger and more dangerous conflict of interest lies in the convergence of government-insured commercial banks and investment banks, because this marriage has the potential not only to burn investors, but to shake the financial system and entire economy.[8]
Greider went on to describe how these major houses of Wall Street play the game of doing deals and making loans to companies “while their stock analysts are out front whipping up enthusiasm for the same companies’ stock.”[9]
Citigroup was neither alone in funding Enron nor in finding ways on their own balance sheets to get around bank regulations, some of which backfired on them:
They didn’t want to do it, but they had no choice: J.P.Morgan, Citigroup, Bank of America and other banks shelled out unsecured loans of $3 billion to the doomed Enron Corp. in October, weeks before the firm collapsed into Chapter 11 amid accusations of fraud, self-dealing, and a cover-up.[10]
Just as Enron was moving debt off its balance sheet by shady deals, these loans were not shown on the banks’ balance sheets: “Instead, the ill-advised promises were listed in the footnotes.”[11] These contingent loans were to be activated if Enron, and others, lost their financing from other sources. Something that was not supposed to have happened did happen. Apparently the capital division of corporations such as GE and Ford could sense troubled loans while the banks were ignoring it. The banks were forced to fulfill their promise to lend money to companies in the process of going broke.
Hundreds of billions of dollars of these bank obligations exist but cannot be seen by examining their balance sheets. Citigroup is distinguished by leading the list of these “off-balance-sheet commitments with a staggering total of $171.8 billion which is 15.7% of all of Citigroup’s loans outstanding.”[12]
The practice of bundling or securitizing loans to sell them to a third party was also an innovation of ultra-capitalism that began in the late 1980s in order to get more leverage than the balance sheet would normally allow. By 2001, use of this financial innovation in the U.S. had grown to over $1.3 trillion dollars per year! In earlier, simpler times, the quality of a company’s balance sheet could be judged by such standard measurements as the relationship of debt to equity. If the debt percentage was too high, indicating an over-leveraged company, then new money would be harder to obtain and at higher cost. Special Purpose Entities (SPE) and securitization of debts make this examination irrelevant because the reported figures do not give any sense of this relationship between debt and equity.
The problem of securitization of assets was compounded not only by hiding the extent to which a company was over-leveraged but also to the extent that Wall Street and companies like Enron were successful in lobbying against better disclosure of these practices. Shareholders need transparency in order to ascertain an increase in risk. If one cannot examine debt and equity the old-fashioned way, at least one could check the footnotes of the financial reports to find out what the additional debt was and what implied guarantees had been given to get this debt off the balance sheet. In Enron’s case, such a requirement would have exposed that the required 3% outside capital and the securitized assets were explicitly guaranteed and might as well have been pure debt. Some government officials did try to achieve better control in this matter:
In late 1997, the Federal Reserve, the Office of the Comptroller of the Currency, the Office of Thrift Supervision, and the Federal Deposit Insurance Corp. proposed strengthening rules that required banks to set aside additional capital against possible losses on risky securitization deals. Such reserves, in addition to limiting a bank’s freedom to make more loans, would have signaled investors that a lender was assuming greater risks.[13]
Because of political resistance, however, FASB’s best effort was a watered-down version of higher reserves. By that time, at least five banks had failed from problems of improper accounting for securitization.[14] The FDIC paid out several billion dollars of taxpayers’ money for these failures, but nowhere in the decade-long struggle was the ordinary taxpayer well represented. The lobby power of Wall Street and of corporations like Enron was too powerful, and in this case, the best efforts of government officials did not have enough democratic support. The reformers who claim to represent the peoples’ interests did not feature this subject on their agenda.
Capitalism depends on a flow of nonvolatile, patient money to fund greater growth. One of the vital aspects of capitalism is the responsibility of the bankers to determine that the money they lend serves the economy well, rather than going to speculators who will waste it. Bailed-out, subsidized, insured bankers, who are motivated by stock price and options, did a disgraceful job in the last quarter of the twentieth century, thereby contributing to the dominance of the economy by ultra-capitalism. I have described the evidence of this dominance in chapter 7 in terms of the over-funding of South American countries in the 1980s, Mexico and South East Asian countries in the 1990s, LTCM in the late 1990s, and then Enron. In each case, the bankers failed in their judgment on the quality of loans because they were not clear about how much money was being borrowed from other sources, what the money was to be used for, and what was the overall relationship between short-term money, “hot money,” and long-term patient capital. The record indicates that they did not care.
For centuries, the empirical evidence has been convincing that excessive liquidity flows to speculation and high-risk projects. Demonstrably, the more volatile and impatient capital is, the greater are the opportunities to make more money on money. In the United States , the empirical evidence is that bank regulation does not provide the discipline requisite to direct money away from speculation into economic growth. Rather, the money is used for speculation and causes economic swings that slow economic growth and hurt people. The repeal of Glass-Steagall also illustrates the government’s disinterest in both constraining easy credit and monitoring the growth of these financial empires. The new threat of “globalization” comes not from large companies that compete on product quality and price but, rather, from the huge financial services companies that have already caused great havoc in the world’s economies and are nevertheless being allowed to acquire more companies and grow even larger. Both internationally and domestically, the fundamental error is the
same: The use of free-market principles to spread ultra-capitalism, is upheld while the market disciplines and government control structure that the free market depends upon, are increasingly compromised.
Stock options are ultra-capitalism’s coupling device between Wall Street and corporate executives because stock options motivate the corporate executive to short-term goals and deals. Senator Joseph Lieberman (D., Connecticut) was out in front getting great TV exposure on the Enron investigation as the chairman of Governmental Affairs Committee, but between 1991 and 1994, it was Lieberman who had been out in front leading the charge when Congress prevented FASB from issuing new standards on stock options that would have provided a needed discipline by incurring a charge against earnings. According to a New York Times editorial:
In 1994, 88 members of the Senate voted for a “sense of the Senate” resolution in which they informed the FASB that its proposed standard would have grave economic consequences for entrepreneurial ventures. At one point in the debate, Senator Lieberman introduced a bill that would have effectively destroyed the FASB’s authority to set the standards for financial reporting.[15]
In the 1997-1998 session, Congress reviewed FASB’s efforts to get control of derivatives. Hearings were held on the collapse of LTCM, but Congress backed away from “controlling currency and credit for the general welfare” and instead added to its record of encouraging ultra-capitalism. The New York Times editorial commented further:
Congress paved the way for the current crisis. Congressional involvement in financial standard setting has been pure politics, fueled by a system of campaign financing that distorts the pursuit of the nation’s legislative agenda. If members of Congress are sincere about identifying and correcting weaknesses in the standards used for financial reporting, then they should investigate the old-fashioned way: follow the money. They are likely to find a trail that leads to the nearest mirror.[16]
Enron has been described as a hedge fund sitting on top of a gas line. It was a specially privileged hedge fund, however, for its 28 lobbyists in Washington , a multi-million budget for other lobbyists, and millions in campaign contributions to hundreds of politicians, allowed it to beat back efforts by the Commodities Futures Trading Commission to gain oversight of its trading activities. The hedge-fund oversight, proposed in 1998 after the failure of LTCM, would have been similar to bank oversight by the FED, and broker oversight by the SEC. The oversight proposal was defeated by Fed Chairman Alan Greenspan, Secretary of Treasury Robert Rubin, other government officials, and the lobbying efforts of Enron.
New legislation, instead, further freed Enron from government oversight and was passed in 2000 by the Senate Banking Committee, chaired by Senator Phil Gramm (R., Texas). Senator Gramm had received substantial political contributions from Enron, and he was the husband of Dr. Wendy Gramm, formerly head of the Commodities Futures Trading Commission, a Director of Enron, and a member of its Audit Committee.[17] As chair of the CFTC in 1992, Dr. Gramm “exempted energy swap derivatives from public scrutiny,”[18] another benefit for Enron. The special privileges nonetheless continued to flow from Congress when the Commodities Futures Act of 2000 was passed with additional opportunities for hedge funds to speculate with borrowed money.
The answer to the Enron blame-game question then is this: the United States government itself! After the fall of Enron, ten different Congressional committees were organized to determine blame and compete for TV exposure. There were so many candidates in the blame game that it will be easy for Congress to avoid blaming themselves and the bankers. Few recognize the Washington-Wall Street nexus as fundamentally responsible for the Enron failure. We Americans deplore “cronyism” in the commerce of other cultures, while at home we allow ultra-capitalists to dump huge amounts of money in various ways into the pockets of politicians, in return for which politicians dutifully pass laws and enact policies that result in more and more privileges for the few. Such is the mutual, interactive corruption of both capitalism and democracy.
Are not the citizens in a democratic republic responsible for their government? If democracy and capitalism are both being corrupted, is not the reform of both the responsibility of the citizens? “Of course!” anyone will answer, but that obvious answer is not enough to move the system out of its gridlock between the few who benefit from the special privileges; the political right that favors them; and the political left who, for lack of understanding, do not propose reforms that go to the root of the problems. This corruption of capitalism and democracy has gone on so long, and has now gained such power, that reform cannot come from within government itself. Reform and restructure can come, now, only from a collaboration of intellectuals, civic groups, universities, the media, and a new breed of politicians. Reform might more readily come from the institutional investors who are in charge of investing the collective wealth of America ’s working men and women, but the financial representatives of wage earners have not yet evidenced an understanding of their own democratic power and fiduciary obligation for reform. None of these groups has far to go in search of an appropriate reform agenda, for it is ready-made in a synthesis of the works of Adam Smith, Karl Marx, and John Stuart Mill that I detail in this book under the name of “democratic capitalism.”
Enron: How Greedy People Hurt Employees and Shareholders Because of a Faulty Government Structures
Ken Lay was an Economics professor before he became Deputy Undersecretary of Energy in the Interior Department. In both jobs, he was an evangelist for free markets and deregulation. Lay joined Humble Oil in Houston and became CEO of Houston Natural Gas in 1984. Later known as Enron, the original business was pumping natural gas through thousands of miles of pipelines across the United States . Natural gas became popular because it both filled the rising demand for energy and was an environmentally clean alternative to petroleum products.
Houston Natural Gas had come under attack by a famous takeover player, Irwin Jacobs, so Lay’s first job was to keep the company away from Jacobs. Lay did this by acquiring Florida Gas, Transwestern Pipeline, and then he negotiated a merger with Nebraska-based Internorth. Although Internorth was the larger company, Lay became the CEO of the consolidated company within the year. Lay then got rid of Jacobs by paying “greenmail,” that is, a premium over the market price of the stock. The money came from borrowing $230 million from the pension fund, and junk bonds organized by the famous Drexel Burnham junk-bond king—and later, convicted felon—Michael Milken.[19]
With the help of a New-York-based consulting firm, Lay changed the name of the newly consolidated company to “Enteron,” in 1986, but this had to be changed to “Enron” when someone belatedly discovered that “Enteron” means “alimentary canal” or “digestive tract.”[20]
Enron’s first hedge fund was Enron Oil, located outside of New York City , and it was a disaster. After adding big profits to Enron’s bottom line for a couple of years, Enron Oil was found to be cooking the books, went broke, and the top executive went to jail. Despite these early warnings about the self-destructive tendencies of ultra-capitalism, Lay pushed on and committed the same crimes that had caused the collapse of Enron Oil. In 2001, Enron became the largest bankruptcy in U.S. history, but, as ultra-capitalism had reached critical mass for self-destruction, Enron held its new record only a few months until World/Com fell apart.
As Enron’s $90 stock went into free fall down to 26 cents, Enron became a national scandal and a major media event because a few insiders took out hundreds of millions of dollars and left their employees and shareholders with virtually nothing. Many shareholders were also wage earners whose money had been invested in Enron through institutional investors.
Enron was symptomatic of a capitalism that subordinated everything, including integrity, to the price of the company’s stock; a banking system that provided too much money for too many bad investments; and a government whose monetary, fiscal, and regulatory policies encouraged this short-term and greedy capitalism. Enron was a house of cards precariously balanced on a high-multiple stock price and an investment-grade rating. As losses developed in various misadventures, Enron had either to find ways to hide them or report weaker earnings and watch the house of cards collapse. Once companies have sold their soul to Wall Street, they must either deliver the earnings that Wall Street wants or be penalized by a drop in their stock market value by hundreds of millions, sometimes billions, of dollars. Enron played the game by fabricating e.p.s. (earnings per share) of 87 cents in 1997, then $1.01 in 1998, $1.18 in 1999, and $1.47 in 2000. In 2001, when the company was falling apart, they still managed to fabricate earnings for the first two quarters that annualized to a fictitious $1.87.
Free of government oversight, Jeffrey Skilling launched the world’s largest energy trading activity by building up Enron North America, the trading company within the Enron company. Skilling, a Baker Scholar graduate of Harvard Business School and, later, a consultant with McKinsey, became president of his new company in 1997, and CEO in 2001. Skilling’s career path mirrors the importance and apparent success of the trading operations, while also mirroring the growth of debt, erosion of profit margin, proliferation of bad deals, and increasing practice of fabricating profits.
Under Skilling’s direction, the trading business in Enron North America grew from $20 billion in 1999, to an astounding $80 billion one year later, trading growth that catapulted Enron into the top ten of U.S. companies in terms of revenues. Those who questioned Enron’s high-flying trading growth were described by Skilling as “assholes” who didn’t “get it.” [21] Chairman Lay talked about matching buyers and sellers in long-term energy contracts through innovation, flexibility, and Lay’s word “optionality.” Record trading activity was supported by a weak balance sheet but one, nevertheless, that had the crucial investment-grade rating from Standard & Poor’s and Moody’s.
Enron had a “laser focus,” as Skilling called it, on e.p.s. growth. Along with an investment-grade rating, Enron’s growth was based on a rising stock price that was used as collateral regularly to move debt off the balance sheet, and this enabled Enron to borrow more and more money from eager bankers. Although Enron’s business had become 80% trading, its officials convinced a willing Wall Street that Enron deserved its price-earnings multiple that peaked in 2000 at 70, compared to a 17 P/E multiple for a top-quality trading company such as Goldman Sachs. Enron officials pointed to the reports of steady earnings improvement to demonstrate that they did not have the volatility associated with trading. Most Wall Street analysts ignored the evidence that the steady record was fabricated.
In the Alice-in-Wonderland world of ultra-capitalism, a high stock price and a high P/E ratio serve to do more than satisfy individual greed. They can be important tools in managing increased earnings. High P/E companies can acquire lower P/E companies and by that act alone improve profits; many are on acquisition binges for that reason. This is one of the many structural imperfections of the system. The bankers generally do not care whether they are getting collateral based on a 15 multiple stock price or a 70 multiple, although a prudent regulatory system would require significantly higher reserves for the obviously higher risk.
Enron had special ploys to fake profits. Along with the partnerships used as ways to manufacture profits, Skilling built a culture in which traders would change the assumptions and thereby seem to generate new profits. This was usually done at the end of a quarter when Enron was preparing to release their financial results and had to find the profits to meet Wall Street e.p.s. expectations. At that crucial time, traders were expected to “crank the dials,” an expression used by a trader who said that his trading portfolio had been taken away from him because he did not manipulate the market values sufficiently to fake more profits. [22] Traders reportedly “cranked the dials” as follows:
Reported profits were based on long-term trades that would not actually generate cash for many years. The value of those trades was largely based on the traders’ own speculation in an environment where the traders’ bosses were rewarded for higher reported profits. The trading desk used mark-to-market accounting. In a system where there was no established public market to set prices, a trader had to decide on a price curve.[23]
Under this pressure for profits, the traders learned how to “blend and extend,” that is, to package and add years to the life of a deal and then take the profit increment into the report of current earnings (see Warren Buffet’s attack on derivatives in chapter 7). When Enron went bankrupt, the trading-book value had fallen from $12 billion to $7 billion. According to a deposition by Enron’s new president, that value had shrunk even more dramatically to $1.3 billion by January 2002.[24] How much of the enormous shrinkage was due to the earlier cooking of the books to produce needed profits is not clear; certainly the effects of the distress-sale environment substantially added to the shrinkage.
Deals, deals, deals—most of them bad!
Adam Smith conditioned the success of free markets on control of the “prodigals and projectors,” as he called them. Enron’s Lay, Skilling, Mark, and Fastow were prodigals and projectors, and worse, they were not good at it. They deflected capital in the wrong direction, and then they messed up so many deals they had to resort to illegality to hide the damage.
Under this pressure for profits, the traders learned how to “blend and extend,” that is, to package and add years to the life of a deal and then take the profit increment into the report of current earnings (see Warren Buffet’s attack on derivatives in chapter 7). When Enron went bankrupt, the trading-book value had fallen from $12 billion to $7 billion. According to a deposition by Enron’s new president, that value had shrunk even more dramatically to $1.3 billion by January 2002.[24] How much of the enormous shrinkage was due to the earlier cooking of the books to produce needed profits is not clear; certainly the effects of the distress-sale environment substantially added to the shrinkage.
Deals, deals, deals—most of them bad!
Adam Smith conditioned the success of free markets on control of the “prodigals and projectors,” as he called them. Enron’s Lay, Skilling, Mark, and Fastow were prodigals and projectors, and worse, they were not good at it. They deflected capital in the wrong direction, and then they messed up so many deals they had to resort to illegality to hide the damage.
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