Enron and the Bubble

Grantsinvestor.com’s Andrew Kashdan explains why the Enron debacle cannot be understood outside the context of the Great Bubble…

One might not know it from the media feeding frenzy engulfing Enron, but this circus had its origins not in politics, although they certainly have helped it along, but in economics.

Even some of the more serious commentators have forgotten what kind of environment spawned the Enron calamity. One who didn’t was Paul Kasriel, economist at Northern Trust Co., who last month chided The Wall Street Journal for finding a way to blame Bill Clinton for this mess. A better target, says Kasriel, would be Fed Chairman Alan Greenspan and his rampant credit creation. Don’t misunderstand. This is not an attempt to absolve the supposedly oblivious Ken Lay, or the allegedly more devious Andrew Fastow. What we are trying to do is look at the bigger picture.

To make some sense of what has happened, it is first necessary to explain, albeit briefly, the nature of the business cycle. Many people, mimicking the maestro, will probably chalk it all up to "irrational exuberance," or perhaps in the words of John Maynard Keynes, "animal spirits." But this just begs the question…what is it that causes the irregular but recurring rise and fall of this exuberance? Paul Kasriel understands how the expansion of credit, spurred by the central bank’s creation of bank reserves, gives rise to the business cycle and to companies like Enron. Enron was not the first to be revealed as, shall we say, too optimistic, nor will it be the last.

Before Enron’s debt could be magically shifted off its balance sheet, Kasriel reminds us, someone had to have been doing a lot of borrowing. And indeed, there was an extraordinary rise in financial-sector borrowing relative to non-financial-sector borrowing during the 1990s. When demand for credit rises, the Fed prevents a rise in interest rates by pumping more money into the economy through the creation of more dollar reserves – that is, assuming it is not raising its federal funds target.

By the end of the 1990s, Kasriel points out, created credit as a proportion of savings was the highest in over 40 years. Whether or not one describes Enron as a "financial" company, which is debatable, its frenetic derivatives activity eventually led back to the financial sector. At some interest rate, it might be profitable to trade everything under the sun, as Enron wanted to do. At some Fed-engineered interest rate, Enron was certainly given the opportunity to try.

That said, we can’t overlook the fact that another culprit in this fiasco may well be all those credulous investors who poured money into Enron stock. During the bubble, when capital (i.e., credit) was plentiful, most investors weren’t too concerned about the details of Enron’s activities, or anything else for that matter. But as the investigation unfolds, it appears that a number of warning signs were ignored.

To pick just one example of something that should have raised red flags for every investor, Enron "marked-to-market" its energy trades, using its own assumptions to determine the value. The models included forecasts of energy prices for up to 10 years, and even assumptions on deregulation in different markets. Take a guess as to whether these assumptions were favorable to Enron. Certainly, Enron’s disclosures were far from comprehensive, but investors might have been more curious about the source of the company’s massive revenues.

To be sure, a few skeptical souls did question conventional wisdom, most notably Jim Chanos of Kynikos Associates. It was this "gain-on-sale" accounting that led to Chanos’s investigation of the company more than a year ago. Is Chanos smarter than the average investor? We don’t doubt it. After all, he read the same financial statements that were available to everyone else, but he came to different conclusions than most.

Another warning sign, says Gretchen Morgenson of The New York Times, came during the California power crisis, when energy costs were rising and profits should have rolled in. But Enron was earning only one-half of 1% on its sales. Morgenson further notes that investors could have seen a wide discrepancy between reported earnings and retained earnings – the profits that Enron made after all expenses and costs (like stock dividends) were paid – if they had been willing to look.

True, the cash-flow discrepancy was partially hidden by the extraordinary array of off-balance-sheet partnerships that are now coming to light. Nonetheless, as an accounting professor told the Financial Times, the ratio of operating cash flow to income declined in 1997, 1998 and 1999, before improving in 2000, due partly to a sharp rise in accounts payable. The ratio then declined again in the first two quarters of last year. Did anyone notice?

We might add that when a CEO uses a vulgarity to describe someone who asks about the balance sheet, as Jeffrey Skilling did during a conference call last April (as The New York Times has reported), that in itself should have been cause for alarm. (Unfortunately, this informative exchange is not available in the conference call archive on Enron’s Web site.)

Just this week, The Wall Street Journal related the tale of Monthly Income Preferred Shares, or MIPS, a type of security created by Goldman Sachs that could be considered as equity or debt, depending on a company’s needs. "Standard & Poor’s, in its rating of November 1993 of the first MIPS deal, cautioned that Enron’s financial maneuvers were ‘aggressive and not particularly supportive of credit quality,’" the Journal said. When the Treasury asked the SEC to stop the practice, "one of the pitches the Treasury made was, ‘Do you realize that companies have billions of dollars of debt that isn’t showing up as debt?’" So why did so many people not bother to follow up on their concerns over the next eight years? Enron’s skyrocketing stock price and its ambitious plans apparently worked like a tonic in soothing any skepticism, when they should have had exactly the opposite effect.

Incidentally, the fact that Wall Street analysts were bullish on the stock until the very end is really a non- issue. Even before the bursting of the bubble in 2000, no serious investor over the age of four took sell-side recommendations at face value (my apologies to any toddlers who know better). If investment banks want to pay their analysts exorbitant salaries to be cheerleaders, that’s their business. But that doesn’t mean that investors should listen.

At the risk of sounding heartless, it should also be understood that the outcry over the victims is yet another symptom of a misunderstood financial environment. We’ve heard that the government needs to "bail out the victims," or that "these workers need to be made whole." No one likes to see small investors lose money while top executives stash away millions. Yet such pleas overlook the fact that many held on to Enron shares when they didn’t have to, and many others have lost jobs at companies that have blown up (if less spectacularly and with fewer congressional hearings). At what share price would workers be "made whole"? Might it be at some number bandied about at the height of the frenzy, when investors were far too optimistic about Enron’s legitimate business prospects and the company itself was reporting illusory profits?

The issue of possibly illegal acts or liability to workers and shareholders – essentially whether Enron’s actions reached the level of fraud – will be settled in the courts. Rest assured, the lawyers will be quite busy for some time to come. But those issues should be kept separate from the issue of an overvalued company, of which Enron was only one of many in the Great Bubble.

Bridgewater Associates got it exactly right when it said, "Enron’s problems, and those of similarly aggressive public companies, are more symptomatic of post-bubble periods than they are unique."

The point is that financial manias bring with them a huge misallocation of capital. In other words, we see businesses that never should have expanded into certain areas, and many that should never have been born. The investors, and unfortunately the employees, will all pay the price. In hindsight, many of the rationalizations and assumptions will come to look ridiculous, as past bubbles illustrate.

In that sense, "irrational exuberance" is an apt description. But dumb ideas by themselves are not enough. They are far too plentiful. In the end, it’s all about the money. In the immortal words of Pogo: "We have met the enemy and he is us" – in this case, aided and abetted by the Fed.

Andrew Kashdan,

for The Daily Reckoning
February 06, 2002

Andrew Kashdan is an integral part of the team at Grantsinvestor.com. With offices at 30 Wall Street, the analysts and writers at Grantsinvestor.com serve as the Daily Reckoning’s eyes and ears in the heart of the U.S. financial industry

Stocks sink…but gold soars. Element number 79 on the periodic table rose $9 yesterday. It’s up $20 in the last 2 weeks.

Gold sales in Japan have risen 300%. And mining stocks are at a two-year high. Goldfields rose 13% yesterday. Harmony was up 5%. Gold mutual funds have been the best-performing sector for the past 14 months.

"The new bull market in gold stocks that has been underway for the past few months is not, however, being fuelled by us ‘bugs’," writes Gary North. "It’s not the gold sector funds or the mining sector funds…the gold sector funds don’t have any money, and the mining sector funds are skeptical of gold. It is my view that a few of the more savvy portfolio managers…are buying gold.

"Consider for a minute just how many mutual funds there are – ten thousand? – and how many trillions of dollars are invested in those funds. It is only logical that some of these thousands of fund managers understand the value of gold and are beginning to move a little money into gold stocks."

But why gold? Why now?

Because gold is what people turn to when they become suspicious of other assets. Enron, Global Crossing, Cisco, Amazon…America’s favorite stocks may get blown away…but gold stays put.

Eric is airborne this morning…so today’s Wall Street notes come from Addison, who is in New Hampshire, and at least in the same time zone as Manhattan…

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Addison Wiggin in Waterloo, New Hampshire…

– Not much doing on Wall Street yesterday. The Dow closed barely changed at 9685, despite another 23% loss for the beleaguered Tyco. The Nasdaq shed 17 points to 1838 on a heavy 2.1 billion share volume. Telecoms and Networkers were all suffering again.

– But the HUI…whoa. The gold bugs index stretched its gains to 46% in just over 2 months. The "barbarous relic" roared to within a whisker of the magic $300/oz mark, closing the day at a 2-year high. The index, which deliberately excludes the big bullion hedging concerns, is now up 148% in 13 months.

– JP Morgan Chase closed at its lowest price since the Long-Term Capital Management crisis of 1998. "I believe we handled everything with integrity, but we had too much exposure" was all JPM Chase CEO William Harrison could say to his staff about the company’s dealings with Enron. "Enron was merely the latest in a series of catastrophes," writes Sean Corrigan, the Daily Reckoning’s London correspondent, "for an entity many believe was the result of a hasty 1999 shotgun marriage intended to save the two great banking dynasties of Morgan and Rockefeller."

– Here at the Daily Reckoning we keep wondering: why are we hearing so much about Enron? What’s the problem? Fortunes were lost, reputations ruined; people didn’t get what they expected from Enron…but are they not getting what they deserve? Even senior management – who seem to have escaped with the loot – have not been spared.

– "Ken Lay et al will spend the rest of their lives in purgatory – burned by the courts," suggests your editor Bill Bonner, "poked by devilish lawyers, harassed by the hobgoblins of the press, facing time in the hoosegow as well as the poorhouse. What’s not to like?"

– No silver lining comes without a cloud. The Democrats have seized on Enron as a campaign issue. "The more people hear [Enron], the more corrosive it becomes," says a letter from James Carville to Democratic troublemakers. He urges the Democrats to use the Enron issue in the upcoming elections.

– But as Andrew Kashdan points out: "One might not know it from the media feeding frenzy engulfing Enron, but this circus had its origins not in politics…but in economics."

– "At some interest rate," Kashdan continues, "it might be profitable to trade everything under the sun, as Enron wanted to do. At some Fed-engineered interest rate, Enron was certainly given the opportunity to try." More below…

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Back in Gay Paree…

*** Layoffs rose 32% from December to January. And last year more companies went chapter 11 than in 1994, 1995, and 1996 combined.

*** No wonder business financing has been getting harder to get. Lenders are getting suspicious.

*** Let’s look at one very interesting case: General Motors is the strongest of the three U.S. automakers. 2001 was the second highest year on record for auto sales. And the Fed cut rates 11 times last year – making it much easier for businesses to finance their debt loads. Yet, Moody’s recently downgraded General Motor’s commercial paper from P-1 to P-2, making it impossible for GM to sell its debt to money market funds.

*** Result: GM has to pay more for financing at a time when its profits margins are being squeezed.

*** Why is GM hurting? Because U.S. manufacturers have been losing market share for years – thanks largely to the strong dollar. And because selling cars on-the-cheap does not give the company the profit margins it needs.

*** Why might GM be in even worse shape in a few months? Because zero financing and other temptations have done their work – moving auto sales that might have happened in the next few months to the last few.

*** "We expect a double-dip [a drop back into recession]," writes Sy Harding, "because of the way economic activity is being pulled from the future into the present to pull the country out of its mild recession."

*** Fifty years ago today, Elizabeth Alexandra Mary Windsor, 26 years old, took the throne of Great Britain, following the death of her father. Elizabeth II will go down in history, we believe, as one of the world’s great monarchs. As we celebrate her golden jubilee, we can’t help but reflect that in half a century, democratically- elected governments have done much mischief. Elizabeth, like gold, has done her job.