Enron, Derivatives, Sorry Excuses for Human Beings

by Tom on May 6, 2006

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.

{ 80 comments }

1

david 05.06.06 at 6:52 pm

Partnoy has a fascinating recent article on derivatives and proxy voting — turns out that you can vote multiple times on each share, and its not at all clear that votes like the Hewlett Packard/Compaq merger aren’t totally corrupted by institutions who can’t keep track of who has the right to vote a share.

2

Ted 05.06.06 at 7:32 pm

I’ve wondered for a while what, if anything, keeps bond rating agencies honest. It seems to me that, since so much money often rests on maintaining a certain rating, it would be manifestly worth it for some unscrupulous institutions to slip a few hundred thousand to the right analyst. But I never hear about it, even from the Enrons of the world.

3

y81 05.06.06 at 7:45 pm

Obviously, neither the bloggers nor the commentators here have the basic knowledge to write anything edifying about the regulation of financial markets, so this would be a silly place for me, who know a little bit about derivatives, to say anything. What is striking is the hypocrisy and utter lack of self-awareness that would lead someone from the academic left to criticize Wall Street for not seeing through Enron, when you people spent most of the 20th century rhapsodizing about Stalin, Mao, Ho Chi Minh, Castro and a half dozen other mass murderers. Really, you disgust me.

4

Tom 05.06.06 at 7:52 pm

Ted, I don’t think Partnoy means to allege that there are quid pro quos of that particular kind; his point is rather that there’s an arms-race of talent which the agencies are bound to lose, and that their monopoly allows them not to care too much about the fact of their losing it.

Dealers clearly exploit the lags between ratings and spreads to construct CDO portfolios, for instance.

5

Cheryl Morgan 05.06.06 at 8:06 pm

I certainly sounds like a book I’d find interesting. I particularly want to see his comments on regulation because in my experience the regulation of the physical side of the energy industry is often woefully inadequate compared to the regulation of financial markets. But here are a couple of comments based on your review.

– Firstly, the business of derivatives trading is all about the transfer of risk. While in theory it is possible for this to happen in a sane and responsible way, with those best capable of managing the risk taking it on, it is probably inevitable that a lot of risk ends up being owned by people who don’t understand it, or who are greedily hoping they won’t luck out.

– Second, not wanting to even try to understand the rocket science is dangerous. When a manager tells a programmer he doesn’t want to hear about technical details all he gets is buggy software; when a manager tells a commodity trader he doesn’t want to hear about technical details he can end up with a financial disaster. Sadly pointy-haired bosses are not limited to the software industry.

6

Cheryl Morgan 05.06.06 at 8:18 pm

You are dead right about the arms race – the regulators are always struggling to keep up. They generally can’t pay as much, and they are hamstrung by politicians. But then the alternative is often a system where the regulators get appointed by politicians whose campaign funds were provided to a large extent by giant regulated monopoly utilities.

7

roger 05.06.06 at 8:42 pm

Y81 is so totally right about the collaboration of CT in the show trials in the thirties – I remember that testimony by Henry that put away Zinoviev — but I do think we can forgive you all a teensy bit, if you support the liberation of Iraq. There’s a manly bit of killing for ya, and so moral, too!

As for the Smartest Guys in the Room — two bits of it stuck in my craw. One was the non-critical, not to say ridiculous, view of Gray Davis as some anti-corporate populist gunned down by the energy companies. Please, the guy was a corporate shill from the get go! The filmmakers did seem to go out of their way to tiptoe around the massive Democratic party collusion with Enron in the 90s. If the Clintonistas had wanted to regulate what was, essentially, an unregulated bank, they could have done so.

And the other was the use of Ken Rice’s girlfriend, Amanda Martin, to make commentary about Skilling. I couldn’t help but think her prominence had something to do with Rice’s lack of prominence — after all, he is the biggest head on the prosecutor’s wall, so far. And, according to Robert Bryce’s account in Pipe Dreams, Martin and Rice’s affair became a pretty disruptive matter in the company.

8

burritoboy 05.06.06 at 9:04 pm

I think one problematic way you analyze this topic, Tom, is that focusing on the personalities involved in Enron obscures the real issues.

First, Enron’s corporate culture was only a very slightly extreme version of the corporate culture advocated – and is still advocated – both by most other firms and by the “firm as nexus of contracts” economists. Much of Enron’s culture was an imitation of GE’s Welch era, and was also imitative of many other financial institutions. This was hardly some super-strange perversion by Enron’s management.

“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.”

There seems to be a severe disconnect in your statement. You’re inserting a vision of normative good into a system (late stage capitalism) which has, both theoretically and ideologically, rejected any such linking. The only thing the capital markets are envisioned to be interested in is if Enron would keep to its contracts and the law, not the morality or character of the firm (which I would argue was psychotic, but not much different from the vast majority of other American firms). I would argue that the envisioned role of capital markets is ludicrous, but it’s no more or less ludicrous than the rest of the ideology of neoclassical economics.

9

John Holbo 05.06.06 at 9:10 pm

Y81 in ’08! Ending our long national nightmare of Stalinism with Presidential Pardons like party favors for the Smartest Guys in the Room! (Ha! Take that, you big hippies!)

10

Adam Kotsko 05.06.06 at 9:24 pm

I demand that this thread be utterly halted until all participants have repented of their complicity with the atrocities committed in the name of international communism in the twentieth century! Then and only then will we have the moral standing to talk about regulating financial markets!

11

Maurice Meilleur 05.06.06 at 9:47 pm

I am so sorry about Stalin. Umm . . . my bad.

12

Maurice Meilleur 05.06.06 at 9:49 pm

Maybe someone should touch y81 in a way that causes involuntary sexual arousal.

13

Belle Waring 05.06.06 at 10:02 pm

you guys, that whole thing where I was so into Dzerzhinskii? it was sort of a girlish crush, and he was in all these Revolutionary Teen Beat mags. looking back it’s way worse than when I was into westlife. so, again, sorry. the cheka–so not cool. I mean, way cooler than the NKVD, obvs–they were such posers!!! LOL!!

14

Dan Simon 05.06.06 at 10:11 pm

I said my piece about Enron quite some time ago (here and here), and I’m sticking by it. The executive summary:

1) Nobody–and I mean nobody–invested in Enron after doing a careful analysis of its business and concluding that it was a solid long-term investment. On the contrary, Enron was never anything but a Ponzi scheme, pure and simple. Now, these are and should be illegal, and I’m glad to see the operators caught and punished. But on the other hand, everyone who bought in was either buying a bag of magic beans in the vague hope that it might lead to the giant’s gold, or else placing their faith in the “greater fool” theory. I have no sympathy for the latter, and while the former are indeed pathetic, it’s pretty hard not to see their loss as inevitable, given their readiness to make utterly ignorant, reckless investments.

2) Enron was hardly the only–or even the most egregious–dot-com-era financial scam. In those days, even stalwart blue-chips like Xerox and Lucent were feloniously overstating earnings to pump their stocks. Enron’s sins were (a) to actually go bankrupt, rather than, say, merely losing ninety percent of its value in a matter of months, after its deceptive accounting practices were exposed, and (b) to fail too late–after the public’s reaction to the collapse of the stock bubble had progressed from the “denial” phase (“it will surely recover”) to the “anger” phase (“those responsible must be punished!”). Had Enron simply gone bust a copule of years earlier, along with dozens of other multibillion-dollar dot-com-era flameouts, Ken Lay et al. would probably be respected venture capitalists today.

15

imag 05.06.06 at 10:13 pm

Yeah, I’m pretty much blameless – except for Ceausceau, which was my fault. Sorry bout that.

16

Walt 05.06.06 at 10:24 pm

The real purpose of banning posters is not for the same of your pride, but the sake of your readers. I enjoy Crooked Timber a great deal. But I would enjoy it a great deal more if I never had to listen to the moronic ramblings of y81 ever again. (But the replies were very funny, especially Maurice’s.)

Burritoboy: Wall Street basically never cared about any of the things you talk about, so I don’t see how that’s particularly a feature of “late-stage capitalism”. In fact, Enron is arguably evidence that Wall Street really does care about things other than money. Investors were taken in by Enron not just because they thought they would make a lot of money, but because they thought Enron was cool.

17

djw 05.06.06 at 11:10 pm

But I would enjoy it a great deal more if I never had to listen to the moronic ramblings of y81 ever again. (But the replies were very funny, especially Maurice’s.)

I agree in general, but in this case the replies made it all worthwhile.

18

Andrew Edwards 05.07.06 at 1:10 am

I’d like to also apologize, on behalf of lefties everywhere, for Napoleon. In our blind support for the democratic revolution in France, we inadvertently allowed a brutal dictator to come to power. Sorry about that. I’ll never look at my great-great-great-great-great grandfather the same way.

Same goes for Caesar – our eagerness to support his subsidization of corn for the Roman people caused us to overlook his undermining of the Republic. Again, our bad.

On the actual topic at hand, Cheryl has it right – derivatives are really really useful and can be used perfectly legitimately as tools to manage risk. The problem isn’t so much the derviatives market itself as the way that derivatives are sometimes accounted for under GAPP. SOX helped some of that, more probably could be done.

19

Andrew Edwards 05.07.06 at 1:11 am

Right – replace “GAPP” with “GAAP”. There we go.

20

a 05.07.06 at 1:13 am

Let’s not forget the asymettry works in both directions. Investement banks can get burnt by investors, who may e.g. claim that they are trading exclusively with the bank on an illiquid stock but instead are trading with five banks simultaneously, or e.g. buying calls or puts based on insider information.

“Dealers clearly exploit lhe lags between ratings and spreads to construct CDO portfolios, for instance.” Certainly. The arbitrage of the ratings is one of the main reasons for CDOs. If an investor claims ignorance of this fact, then they are either very very naive or very very insincere. I’d say more fund managers and insurers are willing accomplices – they buy the CDOs because they are legally obligated to hold paper better than a certain level, but they want to get the better rate that the CDO promises. The only ones who can claim a certain innocence are the Mom & Pop investors – but they are perhaps investing in a fund which has earned better returns than the benchmark and not worrying how that might be achieved.

21

Bob B 05.07.06 at 2:59 am

There is a British connection – this recent news item has been overlooked:

“Documents disclosed by prosecutors in the Enron fraud trial have shed new light on the conduct of the former Conservative minister Lord Wakeham, who was a director of the energy company when it collapsed in one of America’s biggest ever accounting scandals.

“Handwritten minutes of a boardroom meeting show that Lord Wakeham brushed aside the warnings of a whistleblower as ill-informed just two months before Enron abruptly plunged into bankruptcy. . . “
http://www.guardian.co.uk/enron/story/0,,1754433,00.html

22

abb1 05.07.06 at 4:52 am

Occasional rhapsodizing is not enough, Y81! Like renegade Kautsky, they betrayed the Proletariat, bastards, they dared to criticise Stalin, Mao, Ho Chi Minh and Castro!

I’m telling you: that was not criticism, it was the trick of a lackey of the bourgeoisie, whom the capitalists have hired to slander the workers’ revolution!

23

Ajax 05.07.06 at 8:42 am

Y81 — As you are someone with knowledge of financial markets, I would be interested to hear your response to the following: It seemed to me that Enron’s collapse was essentially due to its role as market-maker and banker (eg, in many of the new e-markets it established in energy and telecoms, where it took trading positions itself, and where it lent money, in order to initiate the market). Because they lend out again most of the money deposited with them, banks need to create and sustain confidence from their stakeholders (customers, financiers, regulators). Without such confidence, banks would be unable to meet all their simultaneous commitments.

It seems to me that this is what really did for Enron — they lost the confidence of their stakeholders (partly due to the dot-com crash, and partly due to their own malfeasance), and everyone called in their stakes at the same time (or refused to continue to participate in Enron’s e-markets, which amounted to the same thing). A regulatory question that then arises (still unposed, let alone answered, AFAIK) is to what extent the creators of online markets should be subject to similar regulations to those governing traditional financial institutions.

24

Tim Worstall 05.07.06 at 8:56 am

I always get a little confused when people start talking about Enron. From memory (an all too fallible thing these days) they went bust didn’t they? Not as a result of any regulatory or bureaucratic action, but because the markets finally noted their balance sheet practices and refused to roll over debt. That’s right isn’t it?
As I say, I may have misrecalled the events but if that is what happened, isn’t this a vindication of Cowperthwaite’s point? That while markets do indeed get things wrong they also correct those errors faster than other methods?

25

Adam Kotsko 05.07.06 at 9:27 am

Tim,

If not for public reporting requirements (i.e., government regulation), the error may never have been caught. Different regulations may have allowed the error to be caught before it became a catastrophic problem.

26

Andrew Edwards 05.07.06 at 9:32 am

That while markets do indeed get things wrong they also correct those errors faster than other methods?

Provided you’re willing to accept the enormous cost to Enron employees and shareholders, yes.

Morally, the best outcome would probably be to let the market nail them and then have the state compensate the vicitims, rather than building bureaucracy around prevention. But you’d have to worry about the incentives there – if the government hands out checks to shareholders whose companies go bust, shareholders suddenly have an incentive to encourage very high-risk behaviour from executives.

So if we’re not willing to see the localized destruction to shareholders and employees caused by these sorts of events, we sort of need to do our best to enforce and prevent, rather than compensate.

Now, none of that is to say that we can’t use market mechanisms to improve our enforcement and prevention strategies. Dollar rewards for whistleblowers, predicition markets for accounting fraud, and stricter liability rules for advisers to fruadulent firms are all things to discuss.

27

Uncle Kvetch 05.07.06 at 10:27 am

Maybe someone should touch y81 in a way that causes involuntary sexual arousal.

Absolutely brilliant. Snark on, Comrade!

28

roger 05.07.06 at 10:36 am

To say that the markets got things “right” with Enron is like saying that a disease will find its natural course, killing those bodies that aren’t fit. This is true. It is also true that the inventions of medicine actually save those bodies. Similarly, a properly constructred regulatory environment would prevent the kind of carte blanche given to Enron by Wendy Gramm’s Commodity Futures Trading Commission, and tacitly condoned by the Clinton White House. This could have saved a perfectly good pipe company. It wasn’t until Jeff Skilling ascended to the position of CEO that Enron’s management made the fatal decision to become an accounting anomoly, but because that governmental regulatory gap in futures trading on the energy market was there, some company was eventually going to be attracted to it. That is how gaps operate, as strange attractors.
In a sense, there is no such thing as non-regulation – the fraudulent will eventually destroy itself in the market place. The question is about the degree of harm spread. Enron not only harmed itself and its employees, but – until it was stopped – harmed consumers and spread a vicious model through the energy markets that was adopted by other companies.

29

Ray 05.07.06 at 12:11 pm

Morally, the best outcome would probably be to let the market nail them and then have the state compensate the vicitims, rather than building bureaucracy around prevention. But you’d have to worry about the incentives there – if the government hands out checks to shareholders whose companies go bust, shareholders suddenly have an incentive to encourage very high-risk behaviour from executives.

This is the Savings and Loan crisis of the 1980s in a nutshell.

30

Bernard Yomtov 05.07.06 at 3:18 pm

Morally, the best outcome would probably be to let the market nail them and then have the state compensate the vicitims, rather than building bureaucracy around prevention. But you’d have to worry about the incentives there – if the government hands out checks to shareholders whose companies go bust, shareholders suddenly have an incentive to encourage very high-risk behaviour from executives.

I’m having difficulty understanding who is to be nailed (aside from criminal executives) and who compensated in your scheme, and specifically on what basis shareholders are to be assigned to one group or the other, or neither.

My own feeling is that whatever protections are put in place there will always be frauds. That’s not to say there shouldn’t be protections. I think one very desirable thing would be holding boards more strictly accountable, and acting as if they really are responsible to shareholders, not management. The Enron board bears a very large share of the blame, and will face not much in the way of penalties, as far as I know.

31

abb1 05.07.06 at 4:13 pm

Every piece of journalism related to these things you read, there’s always this mantra, this common wisdom about the boards, how they need to be more responsible and accountable.

OK, once upon a time someone got the brilliant idea that if only people acted absolutely unselfishly doing their best for the common good, then all the problems in the world would’ve been quickly resolved. And it’s true, they would’ve been resolved; it’s a great idea, only it doesn’t work. We all understand that.

So, if we all understand what motivates normal people, then why would anyone still believe that the boards would act responsibly – just like that, just because we would like them to?

This corporate phase of capitalism is different from the Adam Smith’s phase; in this phase businesses (except real small ones) have no owner, there is no entrepreneur in the picture. There are managers who risk nothing and have no commitment, there are speculators who control nothing and have no commitment, and there are boards of directors who risk nothing, control nothing and have no commitment. What do you expect?

32

Ajax 05.07.06 at 4:38 pm

Abb1: “OK, once upon a time someone got the brilliant idea that if only people acted absolutely unselfishly doing their best for the common good, then all the problems in the world would’ve been quickly resolved. And it’s true, they would’ve been resolved”

On the contrary, it’s not true: it doesn’t even work in theory. What is this “common good” of which you speak? It is absurd to imagine shared interests, preferences, values, or desires across the millions of stakeholders in multiple countries (employees, managers, customers, shareholders, regulators, upstream and downstream business partners, competitors) of the modern corporation. Even in the Garden of Eden, when there were just two stakeholders, we saw a conflict of preferences requiring external regulatory action for resolution!

33

Dan Simon 05.07.06 at 4:43 pm

Provided you’re willing to accept the enormous cost to Enron employees and shareholders, yes.

This is what started the problem in the first place–a frighteningly large number of people somehow getting the bizarre idea into their heads that by investing money in Enron stock, one doesn’t implicitly “accept the enormous cost” if it turns out the company is not viable.

Yes, it’s true that Enron executives lied about a lot of things, and should be punished. But they didn’t lie about the main thing, which was that they weren’t about to explain to anyone on the outside, in clean, simple terms, just how they made their money, and that anybody who invested money with them would just have to have faith in them and in their ability to keep raking in the bucks. Why on earth, then, did so many people happily pour their life savings into this pig-in-a-poke?

The answer is that somewhere between the invention of index investing and the bursting of the dot-com bubble, it became conventional wisdom that putting your money into an arbitrary company’s stocks is/should be the equivalent of putting it into T-bills or FDIC-insured CDs, only with much better returns. This conventional wisdom is completely, absurdly wrong, and Enron was only one notorious counterexample.

In short, Enron is a symptom of a problem to be fixed, but the problem is not with corporate governance or government regulation–it’s with investor attitudes. To fix the problem, we may actually need more Enrons, not fewer, because no government regulation can keep naive investors from pouring their money into dubious businesses. Only lots of Enron-like flameouts can do that.

34

Bruce Baugh 05.07.06 at 5:25 pm

Dan: At the level of the end user, there’s an expectation that a lot of worthwhile stuff will simply be too technical to follow. As a patient, lots of folks expect, they will not get the details of GTPase interactions in synthetic lipids, they just trust that when the medicine is supposed to provide them relief, it will. Financial interactions of the sort Enron got into aren’t any more readily comprehensible to a lot of lay people, and it doesn’t seem reasonable (to me, at least) to expect people to invest only in what they can master themselves.

The problem comes when all the authorities that one should be able to turn on are also sucking. It wasn’t just Enron’s failure, but of a whole lot of other individuals and groups who let the end users down.

35

Oskar Shapley 05.07.06 at 5:39 pm

Shorter y81:

I know more than you about “derivatives”, but I ain’t telling you, you Stalin-lovers!

36

Bernard Yomtov 05.07.06 at 5:41 pm

So, if we all understand what motivates normal people, then why would anyone still believe that the boards would act responsibly – just like that, just because we would like them to?

It’s not a question of “because we would like them to.” It’s a question of being paid to represent someone’s interests. We don’t expect a lawyer to represent a client’s interest out of good-heartedness. We expect it because the lawyer has undertaken to do so as a professional matter. And a lawyer who wilfully or negligently disregards this responsibility is subject to various penalties. Board membership should operate similarly, allowing for the differences in the nature of the responsibilities and judgments called for.

37

Jake McGuire 05.07.06 at 6:04 pm

Financial interactions of the sort Enron got into aren’t any more readily comprehensible to a lot of lay people, and it doesn’t seem reasonable (to me, at least) to expect people to invest only in what they can master themselves.

We don’t expect people to go out and prescribe themselves medicines, or at least we don’t require that all medicines be safe enough to take without the guidance of a doctor. This is presumably why there are financial advisors, mutual funds, and the concept of the “qualified investor”.

Maybe we need the equivalent of the “this product is not intended to treat or cure any disease” that you see on various remedies in the drug store; but it’s not clear that those warnings accomplish much and that their financial equivalent (“This stock really could lose value! We mean it!”) would do any better.

38

Barry 05.07.06 at 6:43 pm

The distinction isn’t that stockholders take risks when then buy stocks; I don’t see anybody denying that. After all, we’ve seen massive losses taken on US stocks at the turn of the century.

With Enron, the second most important thing is that the upper management and board carried out a lot of fraud. The most important thing is that the punishments meted out, and to be meted out, will not have deterrent value to the next set of executives who can each get tens of millions of US$ from such frauds.

39

Dan Simon 05.08.06 at 12:07 am

We don’t expect people to go out and prescribe themselves medicines, or at least we don’t require that all medicines be safe enough to take without the guidance of a doctor. This is presumably why there are financial advisors, mutual funds, and the concept of the “qualified investor”.

Precisely. And in the case of Enron, many eminently qualified investors–pension fund managers, for instance–bought the snake oil as gullibly as any kitchen table stock-picker. In many cases, they did so because they simply couldn’t afford not to–the people whose money they managed were demanding of them the kind of unsustainable returns that less scrupulous money managers were routinely (if temporarily) earning. Thus did the misguided conventional wisdom undermine everyone’s security.

The distinction isn’t that stockholders take risks when then buy stocks; I don’t see anybody denying that. After all, we’ve seen massive losses taken on US stocks at the turn of the century.

Really? Here’s an experiment: start asking people–,today, not six years ago–whether they agree that “in the long term, stocks always outperform bonds, and are therefore a better choice for the ordinary investor”. I’d bet that most people will (still) unthinkingly answer, “yes”, without considering that (1) there is no natural law dictating that stocks will always earn a premium over bonds, (2) the “long term” may in any event end up exceeding the investment horizon of any particular investor, and (3) nobody knows how to invest in “stocks”, as opposed to particular collections of stocks, any one of which might end up underperforming compared to “stocks” as a whole.

With Enron, the second most important thing is that the upper management and board carried out a lot of fraud. The most important thing is that the punishments meted out, and to be meted out, will not have deterrent value to the next set of executives who can each get tens of millions of US$ from such frauds.

Here’s a quick question: what fraction of investors’ losses were lost to–or even as a result of–Enron executives’ fraud?

By my reckoning, not much. Virtually all of the money that was poured into Enron would have disappeared even had Enron’s accounting been impeccably scrupulous. As I pointed out, the vast majority of Enron’s investors had absolutely no idea how Enron made its money, and therefore would have been highly unlikely to be discouraged in their recklessness had the extremely dubious nature of some of Enron’s activities (and let’s not forget–although some of it was clearly crooked, most of it was simply foolishly speculative) been exposed.

It’s comforting to imagine that the widows and orphans who lost a fortune investing in Enron were simply victims of a big con. The uglier truth is that every one of them had enough information to recognize Enron as a huge Ponzi scheme, and most failed to do so because the mania of the moment, combined with simple greed and widespread financial ignorance, blinded them to the obvious.

40

abb1 05.08.06 at 2:06 am

Bernard Yomtov, I don’t know, for some reason I’m extremely sceptical about extrapolating the concept of “paying someone to do work” to “paying someone to act as the owner of your company”.

Even if we accept your analogy (even though represnting someone in court is a much better defined task), a more appropriate analogy would be a class-action situation on behalf of millions of clients. I’m not a lawyer, but something tells me that in this situation there are typically plenty of side deals made to benefit the law-firm at the expense of the clients (or most of the clients), no?

And that’s exactly what you’re going to have with boards of directors, no matter what you do. I just don’t see how they can be made accountable and responsible.

In any case, this is not necessarily a good analogy, because a lawsuit is one-shot deal with the simple goal of extracting maximum amount of dough; owning a business is nothing like that.

41

bi 05.08.06 at 4:09 am

Dan Simon: so you’re saying, the best way to stop fraud is to encourage more fraud? And considering that pyramid schemes have been around for a whole century at least?

Oh, and I apologize for Pol Pot.

42

Alex 05.08.06 at 4:33 am

The problem with Enron was that the fraud *was* the accounting – the reason why they could get away with running a really dire business for so long was that they were cooking the books to give the impression of profit.

That they were also stealing company funds was a byproduct of the bigger fraud. They were able to steal the money because they were already rigging the accounts on an epic scale. In fact, most of the directly fraudulent stuff, as opposed to the merely greedy, was skimmed off the super-weird off-balance sheet strangelet entities created to hide the losses.

Pretty much all the “new wave” things they got into, Enron Energy Services, Enron Broadband and such, were a complete fiasco. EES was based on a retail energy-efficiency/facilities management model for which they neither had the facilities managers, heating engineers, customer service staff or cash management. Enron Broadband was based on a total lack of basic technical knowledge about telecoms/internetworking. They wanted to dynamically allocate bandwidth between customers like trading natural gas futures.

Even if Customer X is only using 30% of their T-1, you can’t give the other 70% to Customer Y who’s congested unless they’re sharing the same wire – unless you dig up the road and move the actual physical copper. That ought to be obvious, but they didn’t get it, and nobody on Wall Street seems to have given a fuck.

43

Ajax 05.08.06 at 6:57 am

Alex: “Even if Customer X is only using 30% of their T-1, you can’t give the other 70% to Customer Y who’s congested unless they’re sharing the same wire”

This is not as stupid as you make it sound, since large telecoms users (by bandwidth and by value) tend to be geographically concentrated. At one time, NYNEX (now Verizon) supposedly received 11% of its multi-billion dollar revenues from just one short street in New York City, namely Wall Street. Likewise, COLT (City of London Telecoms) concentrated on the square mile which is London’s financial district.

44

Barry 05.08.06 at 8:20 am

Adding on, I’d like to point out that many of the obvious ante-Enron market correctors, such as banks and other brokers, have proven themselves to be eager participants in Enron’s numerous frauds. Something that’s obvious – large companies have the ability to offer concentrated incentives. If a participant feel that they can participate, dump the risk onto smaller, less sophisticated parties, then they should. The alleged loss of reputation probably doesn’t matter – how many individual investors know who Enrons’ banks and brokers were?

45

zephyr 05.08.06 at 9:17 am

Enron’s auditor, Arthur Andersen, also had a part to play in one of Australia’s most spectacular corporate crashes – that of insurance giant HIH. The dears didn’t notice that $6 billion was missing.

46

Andrew Edwards 05.08.06 at 9:50 am

there is no natural law dictating that stocks will always earn a premium over bonds

Well, there sort of is. Since stocks also carry higher risk, if they don’t outperform bonds over the long run then they’ll be less attractive to investors, and their prices will fall, pushing them back into ‘long-run outperform bonds’ territory.

For it to be possible for secured debt to outperform equity over the long run you’d need to model investors (including large institutions like Goldman Sachs or large pension plans, and various hedge funds) as risk-preferring, which doesn’t seem right.

That said there are debt-like instruments that may well outperform common equity over the long run – high yield unsecured debt or preferreds. But the average investor doesn’t play that game.

None of which is anywhere near the point of this thread, but it does say that if you’re 35 and investing over a 30-year time frame, equity seems to me like a far better deal than secured debt.

47

Andrew Edwards 05.08.06 at 9:55 am

how many individual investors know who Enrons’ banks and brokers were?

Wrong question. How many Fortune 1000 CFOs know who Enron’s banks and brokers were?

48

Bernard Yomtov 05.08.06 at 10:13 am

abb1,

I wasn’t suggesting that the analogy between lawyers and board members was complete. I just want to point out that using agents to represent our interests is not uncommon – lawyers being one example – and that there exist mechanisms that help to assure that these agents will act properly.

Your point about representing huge numbers of shareholders is valid, but their interests are reasonably aligned. The problem at present, as I see it, is that the incentives generally are for the board to act in the interests of management, or not to act much at all. Changing that isn’t a perfect solution, but it is desirable.

49

belle le triste 05.08.06 at 10:27 am

serious question from very ignorant poster (= me):
is there much free-marketeer/libertarian discussion of the problem of the commodification of information?

i can pretty much understand why the adam smith model of the market is said to produce better/swifter information than other systems: it’s because the EMPTOR is the JUDGE (rather than eg the govt); the commodity is judged by how it works IN THEIR HANDS (or bellies or homes), and the question of the goodness of the information isn’t open to doubt

but doesn’t the commodification of information hugely prioritise “buying into information which makes you yourself feel good” over “buying into information which is objectively good for you (and others) by being true”? ie when it comes to the stock market, instead of being able to make the judgement yourself, the bulk of punters are inetiably going to to be hiring people to make the judgements for them — analysist or columnists or whoever (whose judgement is skewed by the market towards hivethink)– and the collective effect of this is thus to tend towards a market in “feel-good information” (as opposed to ACTUALLY good information) = a BUBBLE

and of course the effects of a bubble bursting = social catastrophes far beyond your own doorstep? (ie yes the corrective comes eventually, but it will tend to be delayed and delayed until it’s a cataclysm: it’s not day-on-day correctable, the way it is if i go into a local shop and they sell me milk that’s gone off)

(i’ve no doubt this is all something-or-other 101 — that’s why i’m asking really: what is the free-market or liberatrian counter to the argt that the widespread commodification of information-about-the-market tends to produce mostly BAD information?)

50

abb1 05.08.06 at 10:31 am

Well, exactly, I completely agree about the incentives. All I’m saying is that I don’t see an obvious way to create the right incentives in this case.

51

Sebastian Holsclaw 05.08.06 at 11:52 am

“The problem at present, as I see it, is that the incentives generally are for the board to act in the interests of management, or not to act much at all. Changing that isn’t a perfect solution, but it is desirable.”

This is right on. Someone needs to come up with an intelligent way to realign (align?) directors with the stockholder interests they are to represent. The problem of CEO compensation is a symptom of the current lack of alignment of incentives.

52

burritoboy 05.08.06 at 12:33 pm

“This corporate phase of capitalism is different from the Adam Smith’s phase; in this phase businesses (except real small ones) have no owner, there is no entrepreneur in the picture. There are managers who risk nothing and have no commitment, there are speculators who control nothing and have no commitment, and there are boards of directors who risk nothing, control nothing and have no commitment. What do you expect?”

Precisely, the balance of power (and the way that power is understood and concieved of) is systemically wrong. That has essentially nothing to do with any particular firm, but is a systemic flaw. Mark Roe’s “Strong Managers, Weak Owners” is THE book to read on this.

“This is right on. Someone needs to come up with an intelligent way to realign (align?) directors with the stockholder interests they are to represent. The problem of CEO compensation is a symptom of the current lack of alignment of incentives.”

Nonsense. Concieving the problem as “incentives” (which to the reptilian American business mind = “bag full of cash which I use to run to Brazil with”) is actually part of the problem (i.e. Michael Jensen’s “brilliance” on this led us up shit’s creek without a paddle).

53

Barry 05.08.06 at 1:38 pm

Me: “how many individual investors know who Enrons’ banks and brokers were?

Andrew Edwar: “Wrong question. How many Fortune 1000 CFOs know who Enron’s banks and brokers were?”

Incomplete question – the real question is: “How many Fortune 1000 CFOs, shall we say, really liked the attitude (if you know what I mean) of Enron’s bankers and brokers?”

54

Bernard Yomtov 05.08.06 at 1:44 pm

There are managers who risk nothing and have no commitment, there are speculators who control nothing and have no commitment, and there are boards of directors who risk nothing, control nothing and have no commitment. What do you expect?”

This is bizarre. Managers on the whole do better if the firm is successful, as do the “speculators,” by which I assume you mean shareholders. The same applies to board members.

What do I expect? I expect a generally prosperous society with a fair degree of economic growth. Recognizing the obvious problems, isn’t that what we observe in countries that have “late-stage capitalist” systems in varying degree?

55

burritoboy 05.08.06 at 1:56 pm

“Managers on the whole do better if the firm is successful”

Well, yes, but only if their version of successful is the same as other stakeholders’ versions of successful.

It generally is not the same. Managers have two types of incentives – reputational and monetary. If managers are expected to work for a new firm every two to five years (which is the custome now), besides large sums of quick money within the very near horizon, their incentives will be largely reputational.

But, it’s reputational of the kinds of reputations that are easily recognizable by other firms (not necessarily within your current firm primarily). These are things like: very large profitability improvements (which often are done at the cost of long-term profitability or even long-term firm survival), mergers, acquisitions, big headline contract, headline grabbing reorganizations and so on. These actions may have either no relationship with the overall long-term success of the firm, or may even have massive negative impacts.

56

Bernard Yomtov 05.08.06 at 2:24 pm

You have no problem convincing me that managers and directors do not always act in the best interests of shareholders (the “speculators” you so despise except when they are being victimized). I think I made that clear, especially with regard to directors, earlier.

These problems can and ought to be addressed and improving governance is certainly a topic of considerable discussion. Of course there will never be a perfect solution outside of the imaginings of simple-minded ideologues like those who talk about the “reptilian American business mind,” and seem to think that incentives do not influence behavior.

57

abb1 05.08.06 at 2:52 pm

Your typical shareholder (Bill Gates is, of course, a different kind) is reduced to being a speculator simply because he/she has no control over the business, no input whatsoever either as individual or member of a group; that’s fact, there’s nothing here to despise or admire.

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burritoboy 05.08.06 at 6:33 pm

“seem to think that incentives do not influence behavior”

again, the trouble is with the word “incentives” – which is inherently part of the “firm as a nexus of contracts” theory – i.e., the people who spent the most time babbling about incentives had no idea what they were talking about. As typical with neoclassical economists, as soon as they got to the first solution which was both ideologically pleasing to them and very simple to grasp, they fell hard for it (essentially, their solution being very large grants of options to the most senior executives).

“Incentives” is too limiting a concept and too primitive a hammer to employ, which is why the concept has grossly failed in this instance of practice.

59

Bernard Yomtov 05.08.06 at 9:46 pm

burritoboy,

Your arguments are unclear to me.

60

Andrew Edwards 05.08.06 at 11:08 pm

Incomplete question – the real question is: “How many Fortune 1000 CFOs, shall we say, really liked the attitude (if you know what I mean) of Enron’s bankers and brokers?

Sounds about right. Hopefully few.

61

Alex 05.09.06 at 3:59 am

This is not as stupid as you make it sound, since large telecoms users (by bandwidth and by value) tend to be geographically concentrated…

Unfortunately, Enron lacked sufficient clue to work that out and were talking about distributing video-on-demand over their broadband network. Now, one of the key markers of looming stupidity in tech is getting involved in video-on-demand: it sucks, it always has sucked, and it’s very likely it will suck forever. But more importantly for our purposes, it’s a direct-to-consumer application. Cable TV with internet fairydust scattered on it.

So no, they really were that stupid.

Unable to grasp that in the end it’s about wires in the ground, Enron decided not to wait around for namby things like designing new switches and laying access network fibre or copper, and leapt full-good into the Great Backbone Network Building Binge of the 90s, thus neatly converting a billion bucks into dark fibre unused to this day.

62

bi 05.09.06 at 4:29 am

burritoboy, Bernard Yomtov: I’ll try to put it in plainer terms. Let’s think about, say, preventing theft. Should we provide “incentives” to people who don’t steal, in the hope that these “incentives” will cause burglars and thieves to turn over a new leaf?

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abb1 05.09.06 at 5:26 am

Managers on the whole do better if the firm is successful, as do the “speculators,” by which I assume you mean shareholders. The same applies to board members.

Look, go check your typical mom&pop business. What counts as ‘success’ there? Maturity, stable cash flow, soundness, no debt.

What counts as success in the corporate world? It’s exactly the opposite, it’s the potential for speculation, stock price volatility. They get or re-price their stock options when the stock is low and sell them when it’s high, boom and bust, boom and bust. And they love it: this stock is about to take off – buy, buy! it’s overvalued now – everybody sell, sell! But buy it again when their stock hits the bottom! And once company stabilizes and becomes mature, no one wants it anymore – that’s a failure to them.

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H.A. Page 05.09.06 at 6:48 am

With a boat named Amnesia, it’s Enron Spinron sailing away as the penultimate postmodern trial of our times. Enron tilted it all… but if Skilling had stayed married to Sue, maybe none of this would have happened…
Cheers, MotherPie… on culture.

65

Peter 05.09.06 at 9:31 am

It’s comforting to imagine that the widows and orphans who lost a fortune investing in Enron were simply victims of a big con. The uglier truth is that every one of them had enough information to recognize Enron as a huge Ponzi scheme, and most failed to do so because the mania of the moment, combined with simple greed and widespread financial ignorance, blinded them to the obvious.

Enron engaged in widespread accounting fraud, with the willing connivance of Arthur Anderson. There is no way that anyone outside of those 2 corporations would have been capable of detecting that fraud. Sarbanes-Oxley (SOX) might be an over-reaction to this fraud, but then GAAP was the result of earlier, equivalent, frauds in the 1970s.

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Bernard Yomtov 05.09.06 at 9:48 am

Let’s think about, say, preventing theft. Should we provide “incentives” to people who don’t steal, in the hope that these “incentives” will cause burglars and thieves to turn over a new leaf?

Stop being stupid.

Read my earlier comments. It is clear that my use of the term “incentives” includes penalties for misconduct or negligence.

So my answer is that we do in fact provide incentives not to steal, those incentives being jail terms for thieves.

What counts as success in the corporate world? It’s exactly the opposite, it’s the potential for speculation, stock price volatility. They get or re-price their stock options when the stock is low and sell them when it’s high, boom and bust, boom and bust. And they love it: this stock is about to take off – buy, buy! it’s overvalued now – everybody sell, sell! But buy it again when their stock hits the bottom! And once company stabilizes and becomes mature, no one wants it anymore – that’s a failure to them.

This juvenile rant does not merit a response.

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abb1 05.09.06 at 10:16 am

It’s a relatively common view, though. John Ralston Saul writes a lot about these things.

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Bernard Yomtov 05.09.06 at 10:38 am

It’s a relatively common view, though.

So what?

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abb1 05.09.06 at 11:00 am

No, nothing; fair enough.

70

belle le triste 05.09.06 at 12:06 pm

was my request (#49) too dumb? :(

there are implicit dabs towards what i am asking about on this thread, but no clue where i should go to follow it up properly

71

abb1 05.09.06 at 12:42 pm

Those who matter have good information about the markets, and most of the suckers who try to speculate will burn, there’s nothing new here. The house always wins.

72

burritoboy 05.09.06 at 2:22 pm

Belle,

Ezra Zuckerman-Sivan’s studies on security analysis (check his website on the MIT Sloan school website) list many appropriate articles in his bibliographies.

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burritoboy 05.09.06 at 2:28 pm

“Enron engaged in widespread accounting fraud, with the willing connivance of Arthur Anderson. There is no way that anyone outside of those 2 corporations would have been capable of detecting that fraud.”

However, while that’s true, it doesn’t really describe the entire situation. Investors (both institutional and individual) never knew what precisely Enron’s business model was and how Enron made money (or didn’t). Enron was always extremely resistant to having anyone investigate their business. Enron released extremely limited data.

These things should have made investors more cautious (or at least worried that owning Enron equity was not where they wanted to be in Enron’s capital structure). Instead, it seems to have made Enron more attractive to investors, not less.

74

Andrew Edwards 05.10.06 at 12:14 am

This juvenile rant does not merit a response.

It was perhaps unfortunately phrased, but not on its face absurd, especially if you regard it as a critique of agency problems:

Many executives are paid primarily through stock options. Option value increases with volatility. Ergo by ratcheting up leverage and taking high-volatility risks, those managers increase the value of their compensation. This is a danger for equityholders if it’s out of line with the firm’s historical performance and the increased volatility catches investors by surprise. It’s a danger for debtholders if they’ve been surprised by it. It’s a danger for line employees in that it may fail.

As a note, this isn’t intrinsically a bad thing – risk-taking is at the heart of capitalism, and in an environment of proper disclosure, where the firm is clear to shareholders about what it’s doing, investors as indivuduals can diversify away most of the risk if they see fit. We should encourage smart risk-takers and we should discourage firms that shrug and simply accept that “it’s a mature industry” and they can’t push the envelope any further.

I dunno whether that’s what abb1 meant or not, but “juvenille rant” seemed a bit much.

75

abb1 05.10.06 at 12:47 am

Stock volatility and risk-taking are not the same thing. That’s why the most important qualification for a CEO is not being able to take risks, but to be able to bullshit Wallstreet analysts; CEO is a salesman not a stuntman. Which brings us right back to Enron.

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bi 05.10.06 at 3:17 am

Bernard Yomtov:

Stop being stupid.

Hey, look who’s talking. If that’s what you meant by the word “incentive”, you definitely weren’t clear about it, and in any case “incentive” is commonly used to refer only to positive motivations, not negative ones — so indeed in many people’s minds “incentives” does mean “bag full of cash which I use to run to Brazil with”.

Of course, both positive and negative motivations can influence behaviour. But besides providing rewards and punishments for good and bad behaviour, one also needs to be able to detect bad behaviour when it occurs, to ensure that those who should be punished will be punished.

77

SamChevre 05.10.06 at 10:04 am

Belle,

You ask if the commodification of information doesn’t lead to a market/bubble in feel-good information, and if that’s been studied by libertarians. I don’t know of any studies from a political perspective, but the economic perspective is that feel-good information is not reality-based, and so is unlikely to persist. It may be widely held and used temporarily (and those temporary delusions can cause a great deal of harm), but it will eventually be disproven by experience.

It’s kind of like those high-schoolers who surround themselves with flatterers (thus living in a bubble of feel-good information). Eventually, they encounter reality.

See my next post for an example in the business world.

78

SamChevre 05.10.06 at 10:21 am

Tom,

I think you have two statements that explain one another, but you aren’t making the connection clearly.
Derivatives transactions are given indefensibly different treatment from a regulatory and accounting perspective from trades in the assets that underly them.
I’m not sure I’d agree with the “indefensibly”—this is true in GAAP, IASB, and insurance statutory accounting, so there might be a reason—but it’s true. It is a subset of a larger issue; that is, the relationship between accounting and reality is fairly arbitrary. This arbitraryness enters in everywhere, and it causes the second issue.
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.
The second sentence is key, and is basically what I stated above: the relationship between accounting and reality (economics) is arbitrary. Everywhere, risk management strategies are aimed significantly at accounting performance (they generally focus on economic risk some, but in my experience accounting risk is much more of a focus.) That makes sense, given that the relationship of accounting to reality is arbitrary, but perceptions are driven by accounting. You can end up with a vicious cycle quite easily—people perceive a business to be in trouble, due solely to accounting (the underlying economics haven’t changed), so they stop buying from it/lending to it, and then the business is in trouble. That is a reasonable risk to avoid, and the arbitraryness of the accounting code makes it generally avoidable.
However, the relationship between accounting and reality is not entirely arbitrary; long-term, a business needs to make money to stay in business. Thus, there is a significant amount of effort expended, by funders of businesses, to determine whether reality and accounting are roughly in sync.

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burritoboy 05.10.06 at 11:31 am

“feel-good information is not reality-based, and so is unlikely to persist. It may be widely held and used temporarily (and those temporary delusions can cause a great deal of harm), but it will eventually be disproven by experience”

Not entirely true. There are several studies that show that bad information does in fact persist (not eternally, but for quite meaningful periods). Plus, people with bad information and people with good information were initially argued with neoclassical economics to eventually all converge on the good information, but there are several more studies that show that’s not the case either (again, for meaningful periods).

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SamChevre 05.10.06 at 12:00 pm

Burritoboy,

Yes. Definitely. Bad information can (and does) persist for significant periods–up to several years. (e.g., the late 1990’s stock bubble, of which I had painful firsthand experience). It just doesn’t persist forever.

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