Enron and current Credit fiasco

As the credit crises unfolds and more skeletons tumble out of closet I find it amusing that there is an element of surprise at this crises. It’s like something similar to this never happened. Remember the Enron? Anyone? The way Credit fiasco took place and the way it is unfolding is different on the surface but the underlying philosophy and the culprits are the same. Enron had all the ingredients necessary for a Hollywood melodrama with deadly climax and plethora of villains while current credit crises is rather boring in the appearance and no one is sure about the culprit. Yet, there are unmistakable common threads like short public memory, greedy Wall Street and self-deceiving society that believes in continuous growth in everything. These factors seems to be common in these two crises. Perhaps, in all the prior bubble and bursts in capitalistic society.

Way back in 1848, Karl Marx predicted that capitalism will have bubble and burst, that is, cyclical economy. Though, his measure to counter such bubble and bursts were worst than anything but his assertion was dead on the target. Greed is good and it can be satiated only by consuming more. All though, we can say that Adam Smith’s greed is more Socialist in nature but the current format of Greed i.e. American greed is draconian. Both of these crises in essence are hallmark of American style capitalism. Consumers has to consume more, producers has to produce more, year after year, till the eternity. Profits has to go up every year, a company has to show growth ever quarter. Thinking rationally it's not that hard to see that such an unlimited growth is not possible considering the resources are finite. Agreed, tremendous increase in productivity was achieved but that was due to sustained efforts in the fields of science and technology over the period of last century. But Shit doesn't happen in one quarter and yet, corporations are expected to show growth every freaking quarter!

It is obviously going to strain corporations. They do everything humanly possible to put rosy balance sheets in front of Wall Street. This brings me to certain snippets about Enron. Please try to understand that I have no intention of defending Enron or its cronies. But in spite of all the hoopla surrounding Enron, I didn’t read about ‘short term memory loss’ public syndrome often. In 90’s Enron was one of the biggest companies in the world. They were the star of Fortune 500 list and specialized in Energy sector. But there was something fishy. They weren't earning much of money and they forged some really shady deals to cover their losses. Their Futures contracts were based on too optimistic scenarios and in all possibility their cash flow problems were heading for major disaster. Reports started trickling out about these shady deals and false accounting and before you know this multi-billion dollar company went bust. With Thousands of employees loosing their pension and provident funds and hundreds of thousands of stockholders saw their equity getting wiped out, it was quite obvious that the public reaction was so strong that politicians as well as prosecutors were in need to put someone’s head on the table. Enron’s Chairman and CEO were charged and found guilty. Mr. Kenneth Lay, Chairman died of heart-attack before being sentenced and Mr. Skilling, CEO was sentenced to twenty-five years in jail. Mr. Lay and Mr. Skilling were certainly guilty of being excessively greedy and perhaps, they deserve such a stern jail term but I think they were not the only villains of this tragedy. The ‘other’ culprit is still at large and will continue to cause trouble in foreseeable future.
Off many missteps that Enron is blamed for, was innovative accounting tactics। Now, all most all of the companies do certain form of innovative accounting to hide the trash on the balance sheet or to project the trophies (i.e. profits) more prominently. Enron resorted to an accounting technique called market-to-market accounting. The logic behind this accounting goes like this -: suppose a company A signs a deal with other company B that company A will provide certain product over the period of time for certain amount of money. But the exchange of money, in this case, doesn’t happen for years. So what accountants does is to try to project how much profit will be made every year from the deal, had the money is to be exchanged. Enron accountants were aggressive in showing these phantom profits to such an extent that in the year 2000, instead of showing net loss, Enron showed $745 millions of profit. But to Enron’s credit, they stated everything on their balance sheet. The footnotes (an integral part of balance sheet) contained the source of the profit and with careful eye, financial analyst and accountants could see through this tactic. Another indicator that financial world didn’t see or refuse to see was the amount of taxes Enron paid. For Revenue Services you pay taxes only if you earn money. All the cash flow that was to come in future makes no sense to I.R.S. and Enron wasn't paying much taxes

As I said prior, all this information was published by Enron. It’s just that publishing full accounts would take hundreds of thousands of pages. In their effort (which again is a common practice) they bubbled up the reports but in this process they had to smoothen or massage the data and that’s where the trouble started. Most of the common analyst missed this part was either or it was too detailed to understand but when some analyst took a hard look they figured this game out and published negative reports about the Enron. And, rest is the history.

After facing business as well as financial problems what Enron could have done was to admit their shortcomings in public. Their shares would have dropped drastically and Wall Street’s fury would have lead to departure of few high flying executive. But in the long term the business would have been taken care of and balance sheet would have been strong for real. This would have saved pension of thousands of employees as well as billions of dollars worth of equity would have been saved. Of course, this was for long term. What about the quarterly earning? That’s where the problem lies with American style capitalistic model. No matter how poorly the business is running, a company has to show profits quarterly and if that’s not the case then share prices goes down and CEO’s are flagged as if they are criminals. So, CEO’s in turn either cook the books and the deals as in Enron or end up taking unrealistic risk as in host of investment banks in current credit crises.

The sub-prime mortgage crises (i।e. credit market crises) was based on greed and unnecessary risk too. Mortgage firms started giving out loans to people with bad credit which in turn created housing bubble. The risk was high but it was conveniently blanketed with innovative financial engineering. Products were created out of these loans (i.e. securities) and sliced off according to consumer demand. High ratings were given to such risky securities so that they will be sold at high prices. Lending agencies are to blame, investment banks are to be blamed, ratings agencies are to blamed and at the end general public are to blamed because all though, everyone was aware about the bubble consumers kept buying pricy houses that were beyond their means. And, this pack of cards came down quickly when borrowers (i.e. home owners)started defaulting. Lenders couldn’t continue their cash flow to the investment banks who in turn couldn’t sale the existing Securities based on sub-prime mortgages. The investors who had the mortgage backed securities are still trying to figure how much in hot water they are. This lead to confidence crises in the credit market and that is leading American economy right into a recession. This is a very simplistic explanation of Credit Market fiasco. The securities structure and the cash flows are so complex that investment banks are still trying to figure out the mess they created. Fed is taking weird steps in its attempt to stop the capital market’s downturn and job market is bracing itself for long winter.

But in spite of all this, come back after few years and we will be heading towards another downturn। Actors will b new and methods will be more novel and yet the result will be the same

Agreed that US economy doesn’t command as much as clout as it used to be. But unfortunately this translates into more grave situation for the world economy. Other countries (specially, India and China) are following US capital markets step by step and they are about to start their own economic upheaval of insatiable greed, unrealistic risks and very short growth horizons.