|Man Without Qualities|
Thursday, January 24, 2002
When Texas cowboys ruled television and the movies, a common plot concerned stampedes triggered by the scent of water wafting over the thirsty herd. O, the pained voice of the hapless director charged to evoke the shift of a bovine multitude from dehydrated indifference to self-destructive hysteria: “Is this the kind of ‘character development’ they expect of me?” Today, such a passage to bovine panic could be modeled on reaction of the media and business and political commentators to the Enron debacle.
Could it be – O heresy of heresies! – that Enron did not fail because of fraud? Could it be that the worst its accountants, attorneys and related professionals – and perhaps even its officers and directors – are guilty of is lack of imagination or maybe mere negligence? It’s very hard to say from most of the media coverage. But, unfortunately for the orthodox, the most likely outcome is that exactly this heresy is the truth.
Let me go further and hypothesize an entirely different scenario for Enron’s failure, which I will defend below:
1.Enron’s stock price soared because it had a fashionable business plan, not because it had earnings. So the alleged earnings-boosting schemes are mostly irrelevant to explaining why the stock soared. Simply put, for a long time the stock market did not care about profit where companies in Enron’s categories, e-commerce and broadband, were concerned.
2. Enron’s financial statements were not opaque enough to fool any serious financial analyst who cared about what they might conceal. True, the financial statements were not easy to read – even for professionals. But many professionals were perfectly well aware that the notes in Enron’s financials were red flags as possible earnings holes – if you were the odd person who cared about earnings for e-commerce and broadband companies. There were always Enron skeptics, those skeptics were not silenced, and their views were known and ignored by the same analysts now claiming Enron and Arthur Andersen fooled them. “[T]]he company was a master of obfuscation in its financial statements… But a determined investor looking closely at its financial statements would have found that even in the California power crisis, when energy costs were in the stratosphere and profits should have rolled in, Enron was earning only one-half of 1 percent on its sales.” How 287 Turned Into 7: Lessons in Fuzzy Math, By Gretchen Morgenson, NYT January 20, 2002. (emphasis supplied).
3. When the stock market fell out of love with e-commerce and broadband, Enron’s stock price fell. Also, the people concerned with both debt and equities on Wall Street began to again care about whether even e-commerce and broadband companies had earnings. So they started looking at those financial notes. Enron’s credit rating was supported by its high stock price and by the lack of interest in its earnings, even by creditors. So when the stock price fell and the relevance of earnings rose, Enron’s credit was impaired.
4. Unlike other e-commerce and broadband companies, Enron needed a high credit rating to continue much of its businesses – especially trading and derivatives investing. So, while, say, e-Toys, could just waste away until its equity proceeds were consumed, Enron did not have that luxury. It’s fall had to be more spectacular.
5. Therefore, failure and bankruptcy.
Not a pretty picture, and plenty of villains. But notice that the villains aren’t the same as the ones in the “fraud” scenario. In my scenario, the villains are the stock analysts, journalists, hedge fund managers, bankers and investors who drove the stock price up and ignored the need for earnings to support a top corporate credit rating – the same people who drove up the stock price for, and provided credit to, all those OTHER e-commerce and broadband companies.
What about all those “special purpose companies,” “offshore partnership” transactions and other devices? I continue my heresy; here I stand, I can say no other! The bulk of Wall Street’s financial analysts following Enron either knew about the “special purpose companies,” “offshore partnership” transactions and any other devices or knew that they could find out but didn’t care to do so. For example, a not-often-cited paragraph in the so-called “whistleblower” letter of Sharren Watkins puts it this way: “The related party footnote tries to explain these transactions. Don't you think that several interested companies, be they stock analysts, journalists, hedge fund managers, etc., [have] their smartest people … poring over that footnote disclosure right now? I can just hear the discussions – ‘it looks like they booked a $500 million gain from this related party company and I think, from all the undecipherable half-page on Enron's contingent contributions to this related party entity, I think the related party entity is capitalized with Enron stock.’" So this “whistle blower” letter says that a smart analyst could see what had been done. The media choose to focuses on the rest of this paragraph, in which Ms. Watkins rails that such an analyst would have rejected the disclosure because it was “too fraudulent”. But if it was disclosed, it wasn’t fraudulent. So no analysts would reject such disclosure.
That Enron's financials were complicated was as well-known to the market as was the fact that the public was being assured by some of the most sophisticated analysts on Wall Street that they did, in fact, understand Enron - even if the public did not. As FORTUNE magazine put it in March, 2001: "How exactly does Enron make its money?... [T]he numbers that Enron does present are often extremely complicated. Even quantitatively minded Wall Streeters who scrutinize the company for a living think so. 'If you figure it out, let me know,' laughs credit analyst Todd Shipman at S&P. 'Do you have a year?' asks Ralph Pellecchia, Fitch's credit analyst, in response to the same question." Is Enron Overpriced? By Bethany McLean, FORTUNE, March 5, 2001. It is particularly worth noting that Messrs. Pellecchia and Shipman were not stock analysts - they were credit analysts at those very credit rating agencies whose grant of a high credit rating was essential to Enron's continuing its business. Such analysts are empowered and required to ask questions and demand answers entirely unrestricted by any limitations placed on the Enron financial statements by Arthur Andersen or Enron. Their responses to the FORTUNE questions do not indicate any anxiety at their level of understanding of Enron's financial statements. For example, there is no hint that these credit agency representatives were prepared to lower Enron's credit rating unless those "incomprehensible" financial statement notes were cleared up. Why not? Most likely because those notes were, in fact, comprehended after considerable effort. The teaser to the FORTUNE article sums it up nicely: "It's in a bunch of complex businesses. Its financial statements are nearly impenetrable. So why is Enron trading at such a huge multiple?" Fair questions, which Wall Street professionals, especially credit analysts are trained and paid well to understand and answer - and almost always do. Those credit agency professionals aren't and weren't stupid or lazy - not the great majority of them, anyway. Further, these agencies are experts at understanding "off-balance-sheet" transactions. And they certainly weren't on the take from Enron or in any Enron-induced conspiracy. Rather, it is much more likely that they obtained as much information as they thought useful and sufficient, that they DID understand the "off-balance-sheet" transactions disclosure in the Enron financial statements - and didn't regard those transactions as dangerous, improper or improperly reported. And those professionals probably did all that in good faith. All of which strongly suggests that Enron's disclosure wasn't all that bad.
Nor is it likely that Arthur Andersen conspired maliciously against Enron’s investors. It is far more likely that Arthur Andersen viewed these “special purpose companies,” “offshore partnership” transactions and other devices as aggressive, but within the rules. In fact, while many observers have adopted a high dudgeon “obvious fraud” view of these transactions, buried in some of the better reporting is a much more nuanced approach. “Enron used plenty of other special-purpose entities, and it appears that some of them were just as misleading as the one Andersen now cites. They apparently conformed to accounting rules, but they did not "present fairly," as the auditor's letter says, Enron's real financial situation.” The Distorted Numbers at Enron, By Floyd Norris, NYT December 14, 2001 (emphasis supplied). So which is it? Were these transactions “obviously fraudulent” or did they conform to applicable accounting rules? Clearly an accounting firm has a separate obligation to determine whether financial statement “fairly present” the financial status of the company. But such a determination is an art, not a science. It is much more likely that Arthur Andersen decided in good faith that the financial statements did provide enough disclosure, certainly enough disclosure for the uses of financial professionals. But as discussed above, most of those professionals just didn’t care. Later, Arthur Andersen changed its mind and required the earnings to be restated. Unfortunately, by that time the markets had started to care about earnings again.
Understanding any scandal generally benefits from a review of the incentives the scandal creates for those who are speaking about it. Those who speak often, early or emphatically, normally have a definite interest or agenda, often concealed in what they say. Neither having nor concealing such an interest or agenda needs be wrong. But knowing the incentives helps isolate probable interests and agendas, and those often limit or skew the information being conveyed.
Enron’s huge failure is absolute and undeniable. But few of the causes of Enron’s failure are absolute or undeniable. Rather, the causes involve human discretion – first on the parts of Enron’s officers and professionals, and now on the part of those passing judgment on Enron’s operatives with the benefit of much hindsight. And that’s the rub when it comes to incentives. Enron’s huge failure creates powerful incentives for those judging Enron now – incentives at least as powerful as the incentives imposed on the officers and professionals who sought to keep Enron going when the questionable deals were done. Specifically, there is a very strong incentive for most financial analysts, accountants, financial reporters, regulators and especially politicians, to construe Enron’s transactions in the harshest light, and a very strong dis-incentive for such people to directly defend a loser like Enron. All of these players benefit much more from either directly condemning Enron or attempting to distinguish Enron from other enterprises.
On the political front, Democrats are excited and Republicans are scared. "The dynamic over Enron cannot be that Democrats are against Enron and for reform, and we're defending Enron and against reform," said one strategist who is close to the White House but who would not allow his name to be used.“ In Shift, Bush Assails Enron Over Handling of Collapse By David E. Sanger with David Barboza, NY Times January 23, 2002.
In practice, no particular fact seems to support the full weight of any particular serious accusation against Enron’s professionals. Criticisms resemble a dash across a partially frozen lake, with the argument leaping from chunk to chunk, never pausing long on any particular fragment. Some of the arguments are discussed specifically below.
It is worth beginning with the powerful, all-purpose smear that has been getting much use recently: “It smells bad. Whatever the particulars turn out to be, it just smells bad.”
But does Enron really have the smell one expects in a good financial scandal? Consider:
Enron’s board of directors was of very high quality, and relatively independent of management.
This board was reportedly kept informed of the practices now found to be so “obviously” improper on the part of Enron’s critics.
Members of the board seem to have benefited little from the alleged chicanery they approved (at least in comparison with the risk they were creating for themselves), and in some cases lost quite a lot when the stock collapsed. In addition, their careers and reputations have now been permanently marred, at least.
Enron used Arthur Andersen as its auditor, the firm considered to be the best and most independent of the large national accounting firms. Arthur Andersen approved the now-notorious “special purpose companies” and “offshore partnership” transactions whose revelation led directly to Enron’s demise, and certified Enron’s financial statements. Further, not a single employee of Arthur Andersen or Enron ever went to any regulator with a tale of fraud prior to the bankruptcy. Is that what one expects where fraud is pervasive and obvious as Enron’s critics claim?
Arthur Andersen’s procedures were themselves subject to review by another “Big Five” accounting firm, which did not find those procedures lacking.
Enron’s attorneys were Vincent & Elkins, one of the best law firms in the country. Vincent & Elkins apparently provided “true sale” opinion letters which were necessary to allow the accounting treatment Enron and Arthur Andersen gave “special purpose companies” and “offshore partnership” transactions to go through.
Enron’s principle lenders were noted for their sophistication: Citibank and JP Morgan. Each bank now claims hundreds of millions of dollars in exposure to Enron – although they may have made money on Enron even allowing for this exposure. Each also claims it did not know about Enron’s irregularities and did not foresee the coming collapse, even though their credit agreements with Enron entitled them to inspection and audit rights far in excess of those of ordinary investors, including stockholders. It is also worth keeping in mind that both of these banks (as well as every large investment bank) fully understand the nature and risks of “off balance sheet” transactions and structure because they have extensive departments that create “off balance sheet” products which employ all of the devices Enron’s questionable investments employed.
To survive accounting scrutiny and warrant “true sale’ opinions, each questionable Enron transaction would normally have been supported by a formal appraisal of the value of the property transferred to the “special purpose company” and “offshore partnership.” If these appraisals were created in good faith by seasoned professionals using standard appraisal measure (all of which is normally required), it is difficult to see how the transactions could possibly be as “obviously” improper as Enron’s critics now claim.
Does any of this “smell” the way a scandal should smell?
To conclude that Enron’s fraud had the scope its critics now allege, complicity of Arthur Andersen and a conspiratorial intent on the part of Enron’s own officers is only the beginning. One must then assume that each member of the board of directors was willing to risk his or her personal fortune, career, reputation and honor – all for compensation reportedly of less than half a million dollars per year. Then one must contend with the bizarre fact that not one single member of that board of directors at any time resigned in protest or under suspicious circumstances – and no former member of that board has come forward to date. Are we to assume that ALL of the board members saw what was so “obviously” fraudulent and then without exception elected to keep quiet? Was this a board of directors of an American public company or the Soviet Politburo under Stalin?
For the “fraud” hypothesis to be correct, hundreds – if not thousands – of employees and professionals at many levels of society had to be in the conspiracy and had to keep quiet for years, notwithstanding the constant threat of exposure to the Securities and Exchange Commission, Citibank and JP Morgan – the latter two of which had extensive contractual rights to audit and investigate Enron.
Then there were reviews and investigations by the credit rating agencies – which were certainly not restricted by what Arthur Andersen put into the financial statements. These are the same agencies that rate derivatives and off balance seet structure every single day. We are asked to believe they were fooled by incomprehensible financial notes.
We are then further asked to assume that Citibank and JP Morgan (and the investment banks employing the financial analysts who were supposedly “misled” by Enron’s “opaque" financial statements), banks which maintain large staffs creating “off balance sheet” products these banks sell on a regular basis didn’t know how to analyze them or realize the risks they created.
Once we’ve digested that, we must move on to believe that the appraisers used to certify the questionable transactions were somehow compromised to the point of risking their reputations - even criminal sanctions - alonmg with all the other professionals involved.
And let us not forget that we are asked to accept that all the ultra-sophisticated people involved in the above were reduced to fools and/or charlatans even though a distinct but vocal minority of analysts and other Enron critics – including one highly visible analyst resident right there in Houston – regularly complained that Enron was a house of cards.
In an unintentionally hilarious article, Investors Lured to Enron Deals by Inside DataBy Kurt Eichenwald, NYT January 25, 2002, the New York Times now seeks to add to the growing vastness of the conspiracy some of the largest investment banks in the country. Essentially accusing Merrill, Lynch and other banks of fraud and violation of insider trading laws, the Times portenteously proclaims : "The disclosures created conflicts for Wall Street firms, as well. For example, the investment banking arm of Merrill Lynch & Company, which underwrote the LJM2 offering, was aware of the off-balance-sheet figures for Enron; indeed, Merrill's name is on the cover page of the offering containing the data." So the Times thinks that Merrill "was aware of the off-balance-sheet figures for Enron," thought the figures were fraudulent and underwrote the offering ANYWAY? It is also worth noting that this article is discussing a private placement to very wealthy and influential investors - exactly the kind of investors who would have the power to really damage Merrill if the kind of thing the Times is alleging were true. So we are asked to believe that Merrill is financially irrational and self destructive, as well as perhaps criminals. None of it very likely. While the Times seems not to get the point, Merrill's treatment of the "off-balance-sheet figures" is just more evidence that the Enron "off-balance sheet figures" were NOT viewed as improper at all by most people who reviewed or dealt with them. Those people may have been wrong. But it is very unlikely they were all malicious and conspiratorial.
In a subsequent article about the LJM2 partnership, the Times appears to come unglued from its accusations of fraud and insider trading. Addressing that partnership, the Times admits in its confused excitement: “But did the [LJM2] arrangement … actually violate the nation's securities laws and regulations? That is far more difficult to answer, legal scholars say.” A Fog Over Enron, and the Legal Landscape By Diana B. Henriques with Kurt Eichenwald, NYT January 27, 2002. In fact, the January 27 article breathlessly trolls for negative, condemnatory comment from the gathering of legal scholars it covers. But, curiously, not a single one of the persons quoted in that article actually says that anything Enron did - regardless of whether it touched LJM2 - was clearly illegal. This appears to be a surprise to the Times reporters. The article finally settles for assertions that Congress will surely act to fix the problem through legislation. So it comes to this: Times coverage of LJM2 began with accusations of fraud and insider trading and progresses to assertions that Congress must act to stop "improper" acts which nobody seems to be able or willing to say were clearly illegal. Perhaps a microcosm of the entire Enron fiasco? One can almost hear the Times reporters "moo."
At some point, one just has to say “ENOUGH!” “NO!” “I will not believe that thousands of people had fraudulent intent and maintained a years long conspiracy virtually doomed to fail!” It has been correctly said that "A foolish consistency is the hobgoblin of little minds." To which one might add that the ready imputation of conspiracy and maliciousness is the most foolish consistency of all. It is certainly a delicious irony that the same herd mentality that created the idiotic run up in the fortunes of profitless e-commerce and broadband companies, including Enron, in defiance of all finance wisdom should now swing so savagely against those it formerly, irrationally, blessed. But it's a shame that the real villains are not caught. Indeed, they are now impersonating victims.
“To understand the strange world of Enron accounting, think of a carnival fun house.” The Distorted Numbers at Enron, By Floyd Norris, NYT December 14, 2001.
Yes. Think of a carnival fun house. But the fun didn’t really start until AFTER the bankruptcy!
Sunday, January 20, 2002
The third volume of Robert Skidelsky's biography of John Maynard Keynes, "Fighting for Freedom: 1937-1946" has just appeared and has been reviewed by Sylvia Nasar in the Book Review of today's New York Times. I have not read the book, and do not comment on it here. But the publication and review of this book seems to be an opportune time to discuss Keynes and what seems to be something of a revival in his reputation.
I continue to believe that Keynes has enjoyed (at least among academics and certain others) a reputation far inflated from what he deserves, even as that reputation has waxed and waned. Judging from Ms. Nasar's well-written review, this book appears to be more of the same. Keynes is overrated for one sufficiently overpowering reason: To be great, an economist must address the central concerns of economics, which are how to (i) increase the chance that the correct actors (that is, most efficient or wealth producing) in the economy will receive the power to deploy the economy's real resources, and (ii) create incentives for those actors to make the efficient decision once they have such power. Keynes did not concern himself very much with either of these two central concerns of economics - and his policy recommendations suffer greatly, especially in their generalizability, because of it.
Any economist who fails to grasp and advance these basics must remain a niche intellect, and that is what Keynes really is - a good niche intellect concerned with a certain set of rather specialized problems in finance (notwithstanding the pretensions of the title "General Theory ... "). Keynes should therefore be compared more to Miller, Modigliani, Black, Schoales and people like that. But even in that area of finance I'm not sure Keynes' insights are the most important. (If you work in the finance industry, have you ever used Keynes in your work? How about Black-Schoales?) In part this may be because Keynes had to deal with extreme and rather weird questions and conditions: depression, two wars and the wars' aftermaths. So, while he arguably did a good job cultivating his rather narrow strip of turf, the broader claims made for him seem, shall we say, imperialistic.
Ms. Nasar's review acknowledges his failure - although the review (and, apparently, the book) fails to understand how small Keynes becomes inside of economics because of it. And, oddly, the review and book describe these central concerns of economics (that is, getting resources to their best user and then getting those users to employ the resources in the most efficient fashion) as "social policy"! Here is the full passage from the review with the most important part highlighted in bold:
"[T]he far more likely cause of Britain's failure to keep pace with the war's losers, Germany and Japan, in the decades following World War II -- [was] ...Britain's disastrous postwar experiment with socialism. [Skidelsky] does note, however, that Keynes had curiously little to say about the infamous Beveridge ''cradle to grave'' social security plan, which inaugurated that experiment. Keynes focused exclusively on the plan's affordability, ignoring its potential for wreaking havoc with incentives and efficiency. ''The battle lines on social policy were being drawn up which have raged ever since,'' Skidelsky writes. ''Keynes's incuriosity about this battle is itself curious. The truth seems to be that he was not interested in social policy as such, and never attended to it.''
Note that Skidelsky writes about Keynes' "incuriosity" not as something limited in its scope to the Beveridge fiasco - it was a general "incuriosity" about the basics of economics.
Compare Keynes in this sense with Milton Friedman - who has made huge contributions to finance theory while never losing sight of the biggest picture! Friedman is many times the economist Keynes was. And that doesn't even begin to take into account Friedman's role in fostering and/or creating the whole "Chicago School" of economics.
Much more than (at least pre-Thatcher) British culture, American culture has historically placed greater importance on getting resources to their best user and then giving that user major incentives to employ them efficiently, normally by making the user rich. But the "best user" of a resource is often not a gentleman or a lady - and Keynes didn't like that, and he didn't think it was "British". I think what Skidelsky calls Keynes' curious incuriosity about "social policy" (that is, the central issues of economics) correlates with two of Keynes' more distinctive traits: (1) aversion to Americans (he called them "complete boobies" - although in his defense he was apparently referring to the economic bozos Roosevelt had brought to Washington) and (2) his British "patriotism".
In short, Keynes as a niche player concerned mostly with finance who avoided the central issues of economics that others have labored so brilliantly to address.
Turning from reputation to application, it is instructive to look at a recent application of Keynes' policies: Japan. That country, with neo-Keynesians like Larry Summers cheering them on, has run up a huge national debt to finance mostly counterproductive government public works over the last ten years or so. These efforts were justified as attempts at "pump priming" the Japanese economy. But government is almost NEVER the most efficient user of resources, and government operates under a set of rules that almost NEVER incentivizes it to be efficient. It rather makes sense, then, that this Japanese "pump priming" has resulted in the needless paving of river bottoms, construction of ugly, counterproductive concrete "beach stabilizers" which now mar much of the Japanese coastline accelerating the oceanfront erosion which they were supposed to reduce, construction of thousands of miles of roads where none were needed, and the building of wildly expensive bridges linking some of these roads to fishing villages. Of course, in a depression or war, the counterproductiveness of allowing the government to direct so much of a nation's investment might escape notice or be of lesser significance - at least for a while.
But now? In Japan?
There is a famous story of someone telling Keynes: "But, Mr. Keynes, in the long run your policies cannot possibly work!" To which Keynes wittily replied: "In the long run we'll all be dead!"
Well, now it IS the long run, Keynes IS dead, and the Japanese are stuck with the consequences of his policies.