Did Kenneth Lay’s call of doom to Paul O’Neill contain a germ of truth? The Enron chairman claimed in an October telephone conversation with the US Treasury secretary that the collapse of Enron could lead to a systemic decline in the US financial system. It was easy to deride it at the time as the desperate ravings of a man scrambling to save the company he and fellow executives had crashed into the ground. For a while the Enron saga unfolded as an extraordinary but somehow remote and isolated event, rather like the collapse of Argentina. Financial markets took the biggest ever bankruptcy in America calmly. Neither credit nor equity markets sold off. But now, three months on, it seems Lay had a point.
Enron’s collapse has exposed serious shortcomings in pretty much all aspects of US corporate and financial life. At how many other corporations have executives colluded in cooking the books? If auditors have become accustomed to signing off questionable financial statements, if boards have generally failed to ask the right questions, how many more companies have got away with mis-stating their profits and misleading investors? And on what scale and for how long have they been doing it?
Has the dynamic performance of the US financial markets in recent years been based on nothing more than a huge con trick?
What is worrying is the extent to which every participant in the financial markets has been compromised. Boards have been packed with headline-grabbing names rather than those qualified to monitor complex business and financial decisions. Analysts from both the buy and sell side were unable or unwilling to delve deeper into Enron’s workings. Indeed any investor now trusting sell-side research deserves everything he gets.
And where were the regulators? Stymied, it appears, by trying to work within a decades-old structure based on endless rules rather than judgement – a system that had been outrun by market developments and outmanoeuvred by clever political lobbying. Meanwhile rating agencies are again trying to justify their actions, having missed yet another big crisis. Moody’s has decided to concentrate more on the broad effects of ratings triggers, and how a simple one- or two-notch downgrade might have a much more significant effect on a company or a sector. They’re chasing their own tails.
The banks are hopelessly and utterly compromised. Never mind the conflicts of tying lending to other business, where banks have made most money is not from underwriting fees but from devising the earnings-efficient and tax-efficient structures that got Enron into such trouble. Several of the largest banks in the world helped Enron construct off-balance-sheet vehicles, partly so that the banks’ own trading desks could do more business with the company. Banks ended up with far more risk than they realized, once trading exposure was added to conventional loan exposure. No-one paused to consider that if Enron was setting up the same kinds of vehicle with other firms it might be a much shakier credit than it first appeared.
The leading firms in risk management advisory and trading have slipped up spectacularly: something their customers should take into account next time those banks’ salesmen come calling to extol the virtues of that crucial knock-out option. Investors in bank securities should take note as well. The banks can shrug off their Enron losses because of their sheer size and earnings power but what if Enron and Global Crossing are just the start?
Every sector of the US financial world has been hit by Enron; to pretend that it is the fault of just a small group of executives in Houston, Texas, is to trivialize what has happened. Yes, there is a good chance that some of these executives committed crimes and will face jail sentences. But the problem is systemic.
It revolves around the quest for shareholder value. There’s nothing wrong with that per se, just as there is nothing wrong with off-balance-sheet vehicles, if used properly, or with properly structured and monitored executive compensations schemes. But shareholder value has become synonymous with increasing the stock price in the short term by whatever means or gimmick available, often to ensure that the executives’ options are well in the money. During the boom of the 1990s, delusion took hold. Investors came to believe that growth was perpetual, and that traditional methods of valuation were redundant.
The tech and dot-com boom was just the most obvious manifestation of that: stocks shot up based on promises and astronomical predictions for growth while companies did nothing but burn cash and lose money hand over fist.
Other sectors followed. Telecoms companies leveraged up, betting their futures on hugely expensive and untested technology, egged on by advisers and investors demanding that boring old utilities rebrand themselves as growth stocks. The result: unprecedented overcapacity and more bankruptcies – Global Crossing being the most worrying to date. Struggling NTL has bigger disclosed debts than Enron had when it went bankrupt.
The energy sector was convinced that massive expenditure on power-plant expansion was synonymous with growth. So any company announcing that it was investing in gas turbines, for example, would do so to a loud fanfare. When the California energy crisis hit, it looked even better. But energy is a cyclical business, dependent in part on the weather. And you can’t manage that. So when last year prices dropped as the summer stayed relatively cool and the winter mild across most of the country, growth prospects disappeared. Now such companies are cancelling or postponing projects all over the place, and scurrying to deleverage.
Traders have long known that what invariably kills them is loss of confidence. It’s not buying assets that fall in value but an inability to roll over funding when markets are seized with fear that a firm is in unquantified trouble that finishes them off. Economies and entire financial markets can suffer similar and profound loss of confidence – look at Japan. If the same fate is not now to overtake the US, all market participants will quickly need to rediscover some integrity and moral purpose.
