The Next Enron?

"Give him enough credit and even a dumbbell will find a way to blow himself up."

Bill Bonner

The newspapers and TV stations are turning the Enron story into a the sort of tale they can handle.

"Witnesses clash" heralds the NY TIMES account of Enron officials’ testimony before the Senate Commerce Committee.

"I never duped Ken Lay," Jeffrey Skilling told the pols. Soon, they will be looking for a ‘deep throat’ or a stained blue dress.

Here at the Daily Reckoning we will try a different approach. We take it for granted that even a Presbyterian or moron will find a way to lie, cheat and steal – if it pays well enough. And any fool will allow himself to be duped or hypnotized… if not for money, for love or glory.

While the rest of the press and the politicians look for a tragic character flaw or lamentable regulatory gap, here at the Daily Reckoning we continue to search for the comic absurdity. Not that it provides any better explanation or any more entertaining reflections… but we hope it helps us anticipate other Enron-like farces.

What’s more, it allows us to come to the end of our story without having to sort out who told what to whom when. For it was not a shortage of character strength that gave rise to the Enron debacle, we reckon, but a surplus of easy credit. Too much credit leads to financial

hicanery as surely as a fat wallet left on a car seat in a bad neighborhood leads to a smashed window.

In that light, we can anticipate a lot more glass on the nation’s streets. Because the amount of financial leverage in America has gone up – since ’29…since the bull market began in ’82… since the collapse of Long- Term Capital Management in 1998… and even throughout the recent recession that never happened.

In September 1998, the Fed panicked when LTCM faced extinction. The ‘systemic risk’ was so great, feared the central bankers, that they had to do something. They brought the bankers together to bail out Long-Term, and not coincidentally, loosened credit worldwide.

But LTCM was peanuts compared to what lay ahead. The hedge fund raised only about $2.5 billion – still, the most successful launch ever. By 1998 the fund was out of business… but John Meriwether and the other partners were back in the game in a matter of months. And, thanks to the easy credit, the number of new hedge funds ballooned. By 2001, the amount of money in the funds had grown to $500 billion… with $86 billion of new cash raised in 2001 alone.

In September 2001, the Fed again feared ‘systemic risk’ – after the WTC towers were destroyed by terrorists. Again, they loosened credit worldwide.

In fact, throughout the entire post-WWII period, central bankers have maintained a bias towards looser credit… putting so many extra dollars in circulation that the purchasing power of the greenback is down at least 75%. A glimpse at a single company shows how the culture of credit has expanded since the Great Depression.

In ’29, General Electric was a very healthy company, almost debt free. "At its peak," writes Jim Grant, "it covered fixed charges out of cash flow (that’s EBIT, not EBITDA, an invention of the 1980s) 109.6 times over. In 1932, at the bottom, it covered by 11.5 times. In 1929, GE generated a return on equity of 18.8%. In 2001, a thoroughly up-to-date GE produced an ROE of 26.3% while employing vastly more debt (it had, of course, long before entered the financial services line)."

How much debt? While the company had debt of only one half of one percent in ’29… by 2001 GE’s debt reached 60% of its capitalization.

The biggest increase in debt has occurred in the recent past. "To get a broad idea of the ravage imparted to corporate balance sheets during these years," writes Dr. Kurt Richebacher, "just compare the two following figures covering 1995-2000: U.S. business net fixed capital investment edged up $321 billion; indebtedness ballooned by $2,472 billion. For each dollar added to net new fixed investment, there were 7.7 dollars added to indebtedness."

The stunning difference between the two figures essentially reflects the fact that the debt orgy went overwhelmingly into unproductive use, mainly stock buybacks, mergers and acquisitions. Counterpart to the soaring gap between debt growth and net investment growth were bits of paper bearing the pretentious title of ‘goodwill.’

But the more debt U.S. corporations took on, the better investors seem to like them.

"It is said that millions of investors are angry and disillusioned about the financial community that has so grossly defrauded them," adds Dr. Richebacher. "Looking at sky-high P/E ratios, we have the impression that complacency and hope still grossly outweighs worry."

"At the 1929 top," Grant continues, "the capitalization of the U.S. equity markets amounted to just 81.4% of U.S. GDP. By the March 2000 peak, the reading was 183% of GDP."

While debt grew faster than an escapee from a fat farm… profits and earnings slimmed down.

But that part of this story… and the exciting climax – in which we reveal the biggest ‘next Enron’ of all – will have to wait until Thursday.

Until then, adios…

Bill Bonner

"I’m getting murdered," a friend said to me at dinner on Saturday night.

Guillaume imports lawn care products from America and sells them in France. The products are good, he says. But the dollar is so high he can’t sell them. This is a big part of the reason why U.S. corporations have just suffered their biggest drop in earnings since WWII… and why manufacturing output has fallen for more consecutive months than at any time since the Great Depression.

"I’m just waiting for the dollar to go down," Guillaume continued. "It has to go down sooner or later, doesn’t it? Or America will go out of business!"

It is remarkable how little the world has changed in the last two weeks. We are still on the edge of our seats… waiting for things that have not happened yet.

Stocks are still priced as though we were at the top of a bubble market. The dollar is still regarded as though it would last forever. And Americans still spend money as if they had some.

The world shuddered when the World Trade center towers came down. But according to the latest statistics, it soon returned to business more-or-less as usual. And recession? Forget it. It never happened. The airlines are full. Bars are crowded. Reservations are once-again advised for good restaurants.

A new bull market has begun on Wall Street. At least, everybody says so.

Right Eric?

*****

Eric Fry in New York…

– Stocks are soaring…everywhere! Across every time zone, the financial markets are smiling on the bulls. Japan’s Nikkei 225 Index led the Asian markets with a sparkling 6% rally – its biggest one-day gain in almost a year. Heading east, Russian stocks jumped 4.4%, bringing their considerable gains in 2002 to more than 25%.

– The stock-buying wave continued rolling east (somehow making its way past the Maginot Line), buoying share prices as it swept across the European bourses, before finally splashing up on the shores of lower Manhattan, home to the NYSE.

– Here in New York, where we put the "bull" in bullishness, the Dow gained 217 points to 10,586. The Nasdaq soared more than 3% to 1,859.

– This latest stock market rally in the States has all the classic signs of a short-squeeze: the move is abrupt, ferocious and led by stocks better known for their recent problems than for their considerable virtues.

– For example, the beleaguered banking giant, J.P. Morgan Chase, led the blue chips with a 10% gain. Similarly, Cisco and Tyco – two companies beset by accounting concerns – both surged about 10%. Even truly marginal companies like Providian Financial managed to tack on 12%.

– "When the market rallies violently, as it has the past several days, the stocks of troubled companies sometimes climb more than good companies," explains C.A. Green, Investment Director of The Oxford Club. "The reason, ironically, is short covering… When the market starts to really gather steam, short sellers often panic and buy to cover their positions. The higher prices then cause other short sellers to cover as well, adding fuel to the fire."

– Green is "keeping his powder dry" while awaiting for this rally to exhaust itself.

– "Last weekend," Green continues, "I spent over an hour on the phone with Jim Rogers, the former partner of legendary hedge fund manager George Soros. Jim believes, as I do, that many of the best opportunities in the month ahead will be on the short side. He said individual investors are going to have to learn to sell short if they want to make money in the volatile financial markets we’re experiencing."

– Not all investors, however, possess the mutant gene that predisposes a person to short-selling. For the vast majority of investors – the kind of folks who invest hoping stocks will go up, not down – the recent rally on Wall Street is welcome relief.

– For them, the "cause" of a rally is about as important as the color of a free Ferrari. Gains in the market are no less valuable for having been produced by short- covering. But it’s helpful to remember that short- covering rallies tend to be short and swift – often reversing their moves very quickly. And since stocks are still expensive, in fact more so than three days ago, and since corporate CFOs are no more (or less) honest than they were last week, the latest rally might be a gift worth accepting.

– One thing is for sure, the stock market’s rip-snorting advance over the last few days is reminiscent of the good old days of 2000, when the only thing needed for a stock market rally was an opening bell. Back in those Halcyon days, stocks seemed to soar every day, IPOs soared the highest of all and the Red Herring magazine was a must-read of the venture capital crowd.

– "The September 200 issue of Red Herring," writes the New York Times, "weighed in at 552 ad-stuffed pages – more than two pounds of hubris that would kill a small cat if it fell off a table."

– The issue paid tribute to "a style of business pioneered in Silicon Valley, but now practiced everywhere: sunny, optimistic and endlessly creative."

– Unfortunately, the ink had scarcely dried on the September 2000 issue before storm clouds gathered over the Internet economy’s sunny business-scape. The endlessly creative Silicon Valley business practices quickly become endlessly expensive, as one venture capital deal after another imploded in a heap of na?ve optimism.

– Fast-forward 18 months: The post-bubble Red Herring has undergone a little journalistic liposuction. "The March 2002 issue," according to the Times, "all 6.5 ounces of it, runs a scant 100 pages, and includes public service ads for the Girl Scouts and the United Way, along with six pages of the magazine advertising itself.

– "The spate of magazines living off the Internet boom have turned into a journalistic rust belt," The Times observes. "The fizzy vocabulary that had become part of the genre is now of little use in the telling of stories of Cisco’s inventory debacle, the evaporation of investment and the unwillingness of traditional businesses to hire dot-com veterans. There is really no enjoyable way to talk about a trip to the gallows, after all."

– Interestingly, despite the demise of the Internet economy, its spirit of sunny optimism and endless creativity lives on…in the pages of Wall Street research.

******

Back in Paris…

*** Has Warren Buffett been reading my old friend, Lynn Carpenter’s Fleet Street Letter reports?

*** It sure looks that way. Last year Lynn released her special report… "The Three Best Midcaps for 2001" right here in Daily Reckoning.

*** Did you buy these stocks? You should have. A value investor with her own proprietary system, Lynn’s been beating Warren Buffett to the goodies. Since we gave you a chance to peek into Lynn’s style for free with her special midcap report last year, Warren Buffett took stakes in all three companies she recommended.

*** He bought, then sold Jones New York. He still owns H&R Block (up 170% so far and still rising) and he just announced that he’s begun buying Outback Steakhouse. Outback’s up 37.6% in this past year, but now that the market knows Buffett’s in, it’s sure to keep on rising… just as Office Depot did. Office Depot is another stock that Lynn recommended before Warren Buffett got in that took off after the Buffett news came out. That’s why we call her our "Warren Buffette."

*** Lynn’s own proprietary TUFF value investing system has beaten the market and given investors double-digit returns for the past three years.

*** Normally, I use frequent flier miles to cadge a seat in business class. Coming back to France from Nicaragua, however, in a gesture of solidarity, I sat in economy with the rest of the family. Uggh. The seats on American Airlines seem to have been designed by a sadist. Or, perhaps it is a government plot? Before a new immigrant ever touches the ground, his shoulders are already hunched over and his spirit is already broken.