CHAPTER 9
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
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
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:
[Traditional
bankers were] 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
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
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
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,
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
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
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
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
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
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
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
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
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
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.
Typical
of Enron’s misadventures was the work of ECT Securities, launched in 1996 as
Enron’s in-house investment bank. ECT contributed to Enron’s catalogue of
bad deals by investing in a $650 million project to redevelop a steel mill in
ECT
Securities registered with the SEC as a securities dealer to “conduct business
as an investment-banking firm,” structuring M&A deals, underwriting debt
and equity offerings, and even doing financial advisory work.
Revenues peaked at $30.4 million in 1998 and then dropped to $8.3 million
in 2000. ECT’s twenty traders in
Besides
bad deals in the
Chairman
Lay and dealmaker Mark rushed to
In
August 1996, the government of
The
power plant, that had enough capacity to power two million
Enron’s
appetite for high-risk adventures included Mariner Energy, Inc., a 1996
investment in deepwater drilling. Mariner
apparently had been profitable, but then as it was shuffled among Enron
entities, it gained a reputation as another “tool for earnings management.”[29]
In
1997, Enron added to its catalogue of bad deals with a $400 million loss in a
British natural gas transaction, and a $100 million loss involving a fuel
additive.[30]
An investor lawsuit claimed that 75 power plants and pipeline projects under
Mark’s management had failed to report expenditures.
According to Enron’s chief accountant, Jeff Skilling would
not allow reporting these costs because “corporate did not have room
to take a write-off, as doing so would bring Enron’s earnings below
expectations.”[31]
A
bad deal in
In
2002, the slowly grinding legal process was identifying “Enron Alleged
Corruption Abroad” with comments such as this: “Claims of corruption in
Enron power or water projects have arisen over the years in many countries.”
[33]
The article describes Federal prosecutors’ investigation of Enron’s alleged
violation of the Foreign Corrupt Practices Act by bribing foreign government
officials to win contracts. Along with the alleged bribes, Enron was favored in
these foreign projects with more than $4 billion in U.S taxpayer loans and
guarantees. “Among the lenders were the Overseas Private Investment Corp.,
Export-Import Bank, and the U.S. Maritime Administration. Enron got $3 billion
more from other sources, including the World Bank, European Investment Bank, and
Demonstrating
that their affinity for bad deals was not limited to foreign adventures, Enron
not only traded in fibre-optics but also invested $1.2 billion in a network just
before others in the industry realized how overbuilt the networks were, and the
whole market tanked.
Enron
executives further enhanced their reputation with Braveheart. This deal with
Blockbuster, the largest peddler of videos in the
At
analyst meetings in early 2001, Lay and Skilling predicted a $126 stock price,
and they described the benefit to their broadband services from Braveheart.
Blockbuster treated it as a pilot program and were amazed that Enron was
anticipating revenues and profits in their financial results.
A few months later, in March of 2001, Braveheart was on the rocks and
Enron’s end was near. The end must
have been nearer than Enron was letting anyone know, for they were faking a
$57.9 million profit at the very time that the deal, the source of the alleged
profit, was going belly-up.
The
Wild Ride of Enron: 1996-2001
The
following quick review covers the six-year period during which, despite
the shrinkage of Enron’s operating profit margin from 5.1% to 1.3%, its total
market value increased from $12 billion to $70 billion! This disappearing
operating margin happened despite Enron’s best efforts to cook the books.
One can hardly comprehend how all of the agencies responsible for
protecting the shareholders and employees missed this dramatic profit erosion,
for it was there for all to see.
1996:
Operating margin was disappearing, but nobody was paying attention
Enron
was valued by the stock market at $12 billion with a P/E ratio below the market
average; Enron sales were about $13.3 billion; the operating profit margin
dropped from 5.1% to 3.8% in the year; and reported long-term debt increased
from $2.8 billion to $3.3 billion.[37]
Jeffrey
Skilling became President and Chief Operating Officer, continuing as president
of Enron Capital and Trade Resources. Rebecca Mark, CEO of Enron Operations
Corp., made a power project deal in
1997:
Big disappointment at Enron: The price of the stock was down
Despite
the determination of management, Enron’s stock price went down for a time
while the whole market was going up. Sales
were up to over $20 billion, but the market value and the P/E multiple had
improved little. For anyone who
bothered to look, however, trouble signs were clear: The profit margin during
the year fell from 3.8% to 2.6%, while the reported debt went up from $3.3 to
$5.8 billion.
Besides
shrinking profit margins and rising debt, Enron was faced every year with the
problem of what to do with the latest losses on bad deals. In November, 1997,
Enron’s top executives found new ways to manage earnings.
Lay, Skilling, and CFO Fastow attended “a meeting that would help put
the energy-trading giant on a fateful and ultimately dangerous course.”[38] A
new partnership called LJM2 was put together in a hurry because if Enron had
reported their real numbers, their stock price would have dropped.
Enron got the money for LJM2 from their friendly bankers, J. P. Morgan,
Citigroup, and Merrill Lynch; that is, the money came from both the institutions
and from personal investments from the partners. The borrowed money, according to The
Economist, was reported by Enron as
fictitious profits:
The
Enron virus spreads still through Wall Street beyond J.P. Morgan, Chase, and
Citigroup, whose roles as lenders and advisers to the firm have come under
scrutiny. Nearly 100 executives at
Merrill Lynch invested a combined $16 million in LJM2 an Enron off-balance-sheet
partnership….Within seven days of the money coming in from the banks and the
banking executives, Enron shifted a series of assets off its books in sales to
LJM2. Those assets included a 75%
interest in a Polish power plant and a 90% interest in an natural gas system in
the
SPEs
(Special Purpose Entities) were not invented by Enron.
Financial devices frequently have an honest beginning that are later
turned into ways to fool the shareholders. In
theory, an SPE matches companies that have more opportunities than money
together with companies or individuals that have more money than opportunities.
SPEs are covered by FASB Regulation 140 that specifies how to move assets
off the balance sheet by giving up control.
That
same year, Enron launched yet another new enterprise to bundle wholesale energy
delivery and risk-management services, Enron Energy Services (EES), signing up
contracts for $209 billion over two years.[40]
1998:
Another tough year at Enron
Enron
executives must have been disappointed in 1998 when, again, the stock price and
P/E ratio improved only slightly. Enron’s P/E multiple was up to 24.8, which
is good compared to the market’s sixty-year average of 15, but it was below
market average in 1998 and compared poorly to GE’s 30.3.
GE, however, was gaining market value on performance, whereas Enron was
trying to do it with smoke and mirrors. GE’s
15.3 % profit margin in 1995 improved to 16.8% in 1998, while Enron’s 5.2%
eroded in 1998 to 2.2%! GE slashed
their long-term debt while Enron’s continued to climb up to a reported $7.4
billion, despite Enron’s sleight-of-hand in moving debt off the books.
Enron’s executives wanted GE’s multiple without GE’s performance; in time,
Wall Street gave them that and more.
The
use of outside partnerships built momentum in 1998: Chewco was presented to the
Board, managed and partly owned by CFO Fastow.
These vehicles were usually located in either the
Despite
the rising debt, Enron continued to ignore other fundamental protocols of cash
management. Although they were
trying to be a high-growth, go-go company, they continued to pay out a large
percentage of the alleged earnings in dividends.
Back in the 1980s, when Enron had been a gas company, they paid out
dividends with yields of 5-6%, typical for utilities.
In the late 1990s, their high-growth time, they paid hundreds of millions
of dollars in dividends with cash they did not have; consequently, they further
escalated the debt.
1999:
Enron finally on a roll
Now
things started clicking for Enron. However
they managed to do it, and Wall Street did not care, Enron produced steady
earnings improvement and were rewarded with a P/E multiple of 31.8 and a stock
price up 55%, doubling Enron’s market value to $32 billion!
GE’s multiple, however, was still higher at 35.9.
During
the year, Enron’s Board waived Enron’s Code of Ethics in January and again
in June in order to expedite the addition of outside partnerships managed by
Enron executives.[41] Enron’s
deal making included an electricity-producing barge to be anchored off the coast
of
2000:
Enron in the promised land
In
2000, Lay, Skilling, and Fastow had accomplished what, with the right government
structure and oversight, should have been impossible.
Incredibly, Enron’s stock was up 87%, and their market value had doubled
again to $68 billion! Equally
incredible, the reported debt had grown to over $10 billion, and the profit
margin had almost disappeared at 1.3%—but, hey, who’s looking!
Enron was on a roll with an average P/E for the year of 50, which, for
the first time, beat GE’s 40.1. Enron’s
peak multiple for the year was an astronomical 70!
Enron’s sales were now over $100 billion. Fortune
magazine reported it
as
Rebecca
Mark was out. Poor results at Azurix and other sour deals gave Skilling the
opportunity to push her out.[43]
Mark took consolation from her generous severance contract and gross
proceeds of over $82 million from sale of Enron stock.[44]
By
the end of 2000, the difficulty of manufacturing earnings was stretching the
creativity of the accountants and the auditors. The accountants were struggling
to keep another SPE called Raptors afloat.
The problem was $500 million of Raptors’s losses that, unless a place
were found to hide them, would have to be subtracted from Enron’s profits, an
event that would have dropped the stock price like a rock and destroyed the
investment-grade rating that the trading depended upon. Raptors was financed
indirectly with Enron’s stock, and any drop in that value would have started
an unraveling process like a margin call in a dropping market—the lower the
price, the more money has to be found. Under pressure, the accountants became
even more creative, and just before the end of the first quarter, they managed
to refinance Raptors and hide the losses “by phony transactions that were
still vulnerable to further decline in Enron's stock.”
2001:
Enron continued to present fabricated profits while the company was dying
In
the strange world of ultra-capitalism, companies do not build a product and then
try to make a profit; instead, they calculate what earnings Wall Street wants in
order to support continued enthusiasm for the stock, and then they give it to
them. In 2001, a few months before
the company imploded, Enron reported a cosmetically attractive 20% plus
improvement in profit, with 47 cents a share for the first quarter, followed by
45 cents a share in the second, compared to 40 cents and 34 cents in the same
quarters a year earlier. Enron’s
reported debt was up to $13 billion—plus many unreported additional billions,
were the stock price to have dropped. Despite
this debt load, Enron paid the regular dividend.
Most shareholders had no way of knowing that the dividend was the last
value they would receive from Enron.
In
early 2001, Lay, Skilling, and Fastow had to have known that the accountants
were running out of tricks. As late
as this, Enron management might have bitten the bullet and made a major
restructuring effort, including a massive write-off to get all of the junk off
their books. To face such a move
takes courage and considerable expertise to execute.
Enron’s stock would have dropped, trading would have slowed, but the
stock market is very forgiving of onetime corrections, considering them a bump
in the road while anticipating good following-year results partly due to the
extent of the write-offs. This would have been the only action possible to
rescue some value for the general shareholders. Management did not choose that
approach, however. Lay retreated, and a few months later, Skilling quit.
A
few outsiders did take a hard look at Enron.
Short-seller Jim Chanos took the look in early 2001.
He had spotted the debt of $3.5 billion back in 1996 that had since
ballooned to a reported $13.1 billion, as well as a lot more contingent debt
taken off the books. By inspecting
the partnerships, Chanos found that Enron was using the high stock price as
credit support, according to which either a drop in the stock price or loss of
the investment-grade rating would result in billions of dollars of debt crashing
down on Enron’s balance sheet, exactly what eventually did happen.
After the bankruptcy, the off-balance-sheet debt was identified as $18.1
billion plus another $20 billion in other obligations and derivative trades.
Chanos was shocked to find that Enron was not even covering their cost of
capital, reporting less than a 7% return, despite the aggressive efforts to pump
up profits and pull down capital. The Enron bubble had been kept aloft for years
by Wall Street, but, as has to happen in time, it was punctured by a
short-seller motivated to make money from a stock price decline.
At
the time that Chanos was ready to attack, the whole stock market was in decline,
gas prices were down, and the dot.com bubble had burst.
The radio and TV analysts whipped up complicated explanations for the
drop in the market as a whole, but the real cause was the typical speculative
cycle: Assets had been bid up to artificial levels by greed, and now they were
driven down by fear. Enron would
have unraveled anyway with the stock market decline, but attack by short-sellers
such as Chanos accelerated and magnified the process.
Besides
the short-sellers, others in 2001 suspected that things at Enron were bad.
Sharon Watkins, V.P. Corporate Development, was the whistle-blower who wrote her
now famous letter to Lay describing her nervousness that the company would
implode from accounting scandals. Peddlers
of credit protection were also onto Enron at that same time.
The title of a Forbes article
described them:
“Someone
Knew, the Enron Belly Flop Stunned Almost Everyone, but a Select Group of Wall
Street Pros Had an Early Warning System You Cannot Access.”[45]
It is an obscure electronic-trading market where banks and other big
players buy and sell credit-protection contracts as an insurance policy against
loans that might go bad. On August 15, the day after Enron Chief Jeffery
Skilling abruptly resigned, Enron’s stock barely budged, closing just above
the $40 mark. But on the same day,
the price of an Enron credit contract jumped 18%. By October 25, as the troubles
sparked headlines, Enron stock had dropped more than 50%, while the credit
contract had soared in price to $900,000 per $10 million annually.
Even at the much higher price it was a great deal.
Citigroup used the credit protection approach to insure $1.4 billion in
loans to Enron.[46]
According
to the crazy logic of ultra-capitalism, Citigroup was pumping excessive
liquidity into Enron to speculate and engage in high-risk ventures at the same
time that Citigroup could afford to pay for insurance on these loans.
Why care about the quality of loans? Take out credit protection and
relax!
Citigroup
and the other big lenders are major targets for the contingency lawyers in the
Enron scandal. These lawyers know
how to find the deep pockets, and they will inspect the corruptions of
ultra-capitalism in great detail in numerous dispositions.
Citigroup will be sued for their involvement in the questionable
partnerships, sued for participation in the amazing number of bad deals around
the world, just as Citigroup’s Solomon Smith Barney operation was sued in 2002
for having misled unsophisticated investors. I find it bizarre that capitalism
cannot be reformed by the democratic process, but rather has to be reformed, or
at least punished, by short-sellers and contingency lawyers.
Citigroup and the other bankers will settle out-of-court, take their slap
on the wrist, and play again another day.
The
collapse of Enron, directly and indirectly, financially and emotionally,
devastated millions of people in various places around the world. The Enron
employees were the ones most dramatically damaged because they lost hundreds of
millions of dollars through the loss of their jobs, the value in their 401(k)
accounts, and their pension money that was also tied to the value of Enron
stock.
The
few cashed out for hundreds of millions of dollars benefiting from their stock
options, while the employees were locked in and could not sell. Lay, for
example, made one of many sales on
Besides
the Enron employees, however, other millions were negatively affected by Enron.
For example, the
All
over
The
incestuous relationship between the government and special interests was further
exposed in Enron. Ken Lay allegedly gave $326 million of soft money to the
George W. Bush campaign. Later, when Bush had become President and “Lay
complained to Bush that the head of the Federal Energy Regulatory Commission
wasn’t quite with the program, the man was replaced by a more docile
successor.”[50]
These examples of the corruption of both democracy and capitalism
included both Republicans and Democrats.
“Liberal”
Democrats like Robert Kuttner, quoted above, used Enron to attack “free
markets, laissez-faire, and market fundamentalism.” Such attacks focus
on what is profoundly wrong not with free markets but with the superficiality of
the debate in American politics. Enron
is an excellent example of the corruptions of free markets because of bad
government policies but is rarely presented that way for the education of
citizens. Instead, citizens are conditioned to believe that capitalism is an
immoral monster badly needing more government control.
Enron
was a tragedy for the many affected by the greed and incompetence of a few
executives, and the greed and ineptitude of far too many elected
representatives. The tragedy will be double if it goes into the memory bank as
an indictment of the free market system instead of an opportunity for citizens
to learn about the corruptions of democracy and capitalism so that they
may reform the system.
A
Reform Agenda
Perhaps
a few Enrons will stimulate the study process, an examination leading to the
reformation of ultra-capitalism. If
Enron is a case study in what is wrong structurally and philosophically with the
present political-economic system in the
The
answer to all of these questions and the subsequent action to be taken by the
voting public will determine whether the
Bright
financial engineers could design a comprehensive, integrated fiscal, monetary,
and regulatory policy to serve the general welfare.
If an improved design were presented to American citizens, and compared
to the present structure of privileged law, the pressure for reform would be
overwhelming. The action for reform
will have to come from a renewed democratic process, for the post-Enron
“reforms” coming out of
I propose the following agenda for democratic
examination and action. These structural corrections, I believe, address the
root problems with nearly fail-safe solutions, that is, they will discipline the
system, whether it be managed by people of integrity or greedy people.
I begin with Adam Smith’s concept of economic freedom that can
eliminate material scarcity if money is kept neutral, and speculators are under
control. I
draw part of my agenda from Karl Marx who argued that social progress depends on
movement to a superior economic system. Marx described a system as superior that
would motivate each individual to maximum development, maximize surplus as the
sum of this development, and distribute wealth broadly, a necessary outcome to
sustain both individual motivation and the economic growth dynamic.
One would think that by
now these attributes of a superior system would be upheld as a
priori tenets of economic faith; instead, they are ignored by policy makers.
These principles and practices have been validated through improvement in
the lives of millions, but they continue to be ignored because the requisite
structure has never been put in place for the system to function at full
potential. Few debate the benefits
of economic freedom, but many are confused about which disciplines are necessary
for free markets to lead the world to full economic and social potential.
Reform
#1: Democratization of capitalism through
large dividends to low-and middle-income wage earners
A
rededication by companies to paying large dividends to shareholders, encouraged
by more favorable tax laws, would be the fastest and most effective way to move
away from the corruptions of ultra-capitalism towards the worldwide benefits of
democratic capitalism. Dividends return the surplus to the economy, thereby
stimulating economic growth. A sound
annual income from dividends encourages the spread of employee ownership plans
and thereby improves productivity. Ownership
plans with large dividend income on a global level would add more spendable
income to workers in emerging markets and make free trade a universal benefit.
The reform needed is a departure from exclusive focus on e.p.s., the
short-term and greedy capitalism, to the capitalism that balances appreciation,
income, and long-term security.
Enron,
the dot-com-bubble, and the drop in the whole market in 2001, demonstrated, as
it did in the similar Wall Street catastrophe of 1929, the deficiencies of a
market that has little security or income. Large
regular dividends and stock appreciation, over a period of five years or more,
provides more security and strikes the correct balance in capitalism.
Dividends have become an unfortunate victim of ultra-capitalism because the Wall Street emphasis on e.p.s. and stock price encouraged companies to reduce the portion of surplus paid out in dividends. Surplus should go into greater growth and dividends, but in ultra-capitalism it goes, instead, into stock buybacks and non-strategic acquisitions. This trend is an example of special privileges successfully lobbied by Wall Street because tax laws favor capital gains from stock and even favor stock buybacks. The pattern became so pervasive that many forgot the long-term importance of dividends in capitalism, but a study challenged the myths: “The return on stocks over the past two centuries has averaged 7% a year, a large part of it—close to 5%—came from dividends.”