I’ve just had a chance to see ‘Enron: The Smartest Guys in The Room’, (previously reviewed on CT by Ted here), having also just finished reading Frank Partnoy’s ‘Infectious Greed’, a fascinating history of large-scale larceny in the financial markets over the last quarter-century in which, unsurprisingly, Enron figures fairly prominently.
‘The Smartest Guys in the Room’ gives some explanation of how Enron’s central scams worked, but it mainly tells a modern-day horror story about the doings of the the repellently amoral, dishonest people at the top of the company: CEO Jeff Skilling comes over as an especially nasty piece of work, and it seems clear that he did his best to build a corporate culture in which his own arrogance and brutality would be writ large; Andy Fastow, the CFO whose creative accounting kept the shell-game going long enough to take tens of millions of dollars out of the company for himself, is pretty clearly a psychopath; and Chairman Ken Lay, who of course to this day denies any wrongdoing, seems to alternate between buffoonery, cynicism and utter delusion.
Enron’s ethos, despite the company’s smug choice of ‘Ask Why’ as its strapline, seems dominantly to have been one of gung-ho groupthink. Sherron Watkins famously emailed Ken Lay to tell him Fastow’s schemes were likely to cause Enron to ‘implode in a wave of accounting scandals’, but the atmosphere of the firm largely reflected the leaders’ gargantuan public boosterism. Many employees stuffed all their retirement savings into Enron stock, naturally, since they were continually told that they were working at the world’s greatest company. The film makes a brutal constrast between the likes of Skilling, who resigned as CEO shortly before everything went bad, successfully cashing out tens of millions of dollars worth of options shortly afterwards, and the ordinary people who were left with nothing.
I wouldn’t claim to be an especially astute judge of character, but at the risk of appearing utterly naive it is both breathtaking and disgusting that Wall Street was so willing to be taken in by guys whose morals were so obviously non-existent. And let’s not even go into the nauseating tributes the film shows being paid to the Enron high-command by Bush pere et fils…
‘The Smartest Guys in the Room’ scarcely leaves you overbrimming with faith in human nature, but it’s pacy and compelling. Some of the contributions are inevitably somewhat self-serving, and finance geeks will demand more details about the innards of Enron’s deals, but I’d suggest that if you’d like to know roughly what the firm actually did and why it did it but you don’t want to have to qualify as an accountant beforehand, this film is a damn good place to start.
‘Infectious Greed’ is a broader history of the use and abuse of derivatives since the 80’s, so Enron is only one part of the story that Partnoy wants to tell. None the less, many of the general themes of the book crystallise in the Enron chapter. Partnoy emphasises the point that, in the US at least, derivatives transactions are given indefensibly different treatment from a regulatory and accounting perspective from trades in the assets that underly them. Throughout the period, this has meant that market participants who are not permitted to strike particular deals in bonds or equities get around the economic point of the regulations by entering into derivatives trades with those same assets as underlyers instead. Partnoy argues that this state of affairs makes no sense, since transactions whose economics are similar should be regulated, and accounted for, similarly.
In the case of Enron, the ease with which derivatives trades can, perfectly legally, be hidden off balance-sheet was exploited in the notorious Raptor, LJM and LJM2 special purpose entities, which were used to hide the firm’s losses and inflate the values of its assets, thereby pumping the stock price. Partnoy gives chapter and verse in his testimony to the US Senate here. Indeed, Enron’s executives were explicit about their priorities in their Risk Management Manual, from which Partnoy gleans the following Alice-in-Wonderland nugget:
Reported earnings follow the rules and principles of accounting. The results do not always create measures consistent with underlying economics. However, corporate management’s performance is generally measured by accounting income, not underlying economics. Risk management strategies are therefore directed at accounting rather than economic performance.
Partnoy excoriates those whom he calls the ‘gatekeepers’ whose responsibility it should have been to make sure that Enron’s published accounts were true and fair. The lawyers, accountants, bankers and credit rating agencies could each have put a stop to the firm’s deceptions, but none did. The accounting firm Arthur Anderson was eventually, of course, shredded when the scandal broke, but Partnoy believes that the structure of incentives that apply to the gatekeeping institutions are too badly distorted to enable the market to function properly: investment bankers have been able to lean on their analysts; accountants have been greedy for consultancy fees; and S&P, Moodys and Fitch have an effective legal monopoly but no liability for the reliability of their ratings. Partnoy emphasises the last point especially, arguing that because companies are legally required to use one of the main agencies to rate their debt, the latter have little reputational incentive to make sure they get things right. He is particularly keen that the rules covering the assets which institutions are permitted to hold should be rewritten to use market values like bond spreads relative to Treasuries rather than the flawed and compromised ratings produced by the agencies.
‘Infectious Greed’ also makes a fascinating point about the way in which the banks which had exposure to Enron’s debt were able to shrug off the company’s collapse without creasing their expensive suits. By buying protection in the credit default swap market, such banks were able, in Partnoy’s metaphor, to pass the hot potato on to investors who were in general less well-placed to assess the company’s propensity to default on its debt. He writes:
An insurance company – especially one outside the United States – couldn’t do much more than look at a borrower’s public financial statement. Nor would it have an incentive to monitor the borrower, because each credit default swap represented only a small portion of the borrower’s overall debt. Moreover, an insurance company that bought credit risk from a bank might pass it on to another, and so on. Because there were no disclosure requirements for credit default swaps, it was impossible to know who held the risk associated with a particular company’s loans. But it required a fantastic leap of faith to assume that the holder of the hot potato was in the best position to keep tabs on the borrower.
The asymmetries of information and indeed of sophistication between buyers and sellers of derivatives products are a recurrent theme in the book. The Panglossian assumption that the parties to derivatives transactions are pretty much on a level is belied by the cases of Proctor & Gamble, Orange County and Gibson Greetings that Partnoy describes in depressing, forensic detail.
‘Infectious Greed’ is a terrific, thought-provoking read for those of us with an interest in financial markets but who remain largely ignorant of the rocket science. I’d be fascinated to hear what other CT readers, rocket scientists or otherwise, thought of it.