nonsense!! see comments below -- Jim D. >December 26, 2001
>Enron's Success Story >By SUSAN LEE >The collapse of Enron was many things -- a gratifying slap in the face to corporate hubris and an exposure of the Alfred E. Neuman club of stock analysts, rating agencies and the SEC. It may even prove to be a fascinating look into criminal minds. But there is one thing, for sure, it wasn't -- a market failure. To the contrary, Enron's implosion was confirmation of the principles that govern competitive markets. >Enron's success and failure ran along the lines set down in any microeconomics text. The company discovered a new product -- mostly ways of trading energy in the derivatives market -- that allowed producers and users to lay off risk. This new product was wildly popular and, as the innovator, Enron made lovely above-market returns. But those abnormal returns attracted other firms into the business and Enron's advantage was gradually "competed away." Each new market entrant put the squeeze on Enron's margins. < JD: this Schumpeterian story, by the way, is not prominently displayed in micro books. Rather, the emphasis is on NC static equilibrium. >What happened next is still a matter of speculation, but there are several theories that seem reasonable. >Bad hedging. Although Enron started out as a plain vanilla energy company, it shed those hard assets that could have underpinned its financial business and morphed into a trading company and then, quickly, into a hedge fund.< JD: It's amazing how economists forget the difference between hedging and speculation. A true fund that hedges -- not speculative outfits like Enron or Long-Term Capital Management -- seeks to minimize risk by diversifying, locking in long-term prices (or interest rates) to avoid risks due to price (rate) fluctuations. But these so-called "hedge funds" were speculative and _highly leveraged_, as Lee notes below. The latter helps explain the high returns: it is very easy to show that the more leveraged a speculator is, the higher the return. >A trading company can make money no matter which direction the market goes by simply trading and taking its money from creating a market. If prices are falling, then suppliers rush into the market to get contracts that nail down prices; if prices are rising, then users rush in to get contracts. Traders can make money either way. Indeed, in this model, a volatile market is the best of all possible worlds. >But with its margins -- and cash -- getting squeezed, Enron started borrowing money and pretty soon it was running with remarkable leverage, thus becoming a giant hedge fund. When things started to go wrong, Enron's traders quite possibly were panicked into trying to hit a home run. That is, they started taking big bets on the direction of the market, perhaps taking aggressively long positions in energy. A successful hedge fund, however, depends on adequately hedging bets, especially leveraged ones. But as Enron started to lose money on its big bets, observers guess that the insufficiency of its hedges began to look lethal.< JD: This seems okay (given the misuse of the word "hedging"), but ignores the _fraudulent_ nature of Enron's enterprise. Marx pointed out that speculative booms involve a tremedous amount of fraud and that this cheating is typically revealed when the boom ends. >There are also more complicated theories that argue Enron was hiding its slowing growth in earnings with various accounting strategies.< JD: "strategies"? that's like calling the 1970 US invasion of Cambodia an "incursion." Enron spun off a lot of its debt to "parterships," to make its balance sheets look good. >Bad trading. Enron's main technique to pump up earnings probably revolved around a loose-as-a-goose process for the accounting of energy derivatives. Called mark-to-market, the technique involves evaluating contracts at "fair value" prices. >Since some of these contracts stretched out for 20 years, the futures market provides no firm prices. And, absent a liquid market with clear prices, "fair value" becomes a mug's game in which companies can vastly inflate value. >These overstated gains, of course, were also unrealized, noncash gains. In September 2000, Jonathan Weil, a reporter for the Journal, took a look at Enron's second quarter and found that absent noncash earnings, Enron would have had a loss. Mr. Weil later found that for the year as a whole, unrealized trading gains accounted for more than half of the company's originally reported pretax profits. Hardly a confidence-builder in the quality of Enron's earnings. >When their derivative strategies started to go sour, this theory runs, Enron removed the contracts from its financial statements and hid them in special entities created for just that purpose.< JD: here's the deliberate effort to save Enron's ass by cheating. >Bad Assets. Another theory locates Enron's earning problems in their hard assets. Enron had a bunch of huge and underperforming assets, like its broadband company, water company and power plants in India and Brazil. In order to hustle those assets and associated debts off its financial reports, the company created some limited partnerships to buy these dogs -- either with bank loans or money provided by Enron itself. These partnerships (allegedly) transferred enough control to third parties to get them off Enron's balance sheet. >Enron guaranteed these deals with "make good" provisions backed by Enron stock -- a promise that Enron would make good any losses in the value of the partnerships. When the value of the assets tanked, the make-good provisions kicked in, resulting, for example, in the enormous write-down in shareholder equity in November. >Depending on which theory one accepts, there are two bottom lines. >The first holds that the sagging earnings problem was fatal and that it is entirely possible Enron was in the process of liquidating itself. Jim Chanos of Kynikos Associates hypothesizes that Enron's cost of capital was higher than its returns on invested capital. A second argues that if Enron's managers had been content to accept the fact that in competitive markets their "first mover" advantage was going to be competed away, and had been willing to endure slower earnings growth, it would not be in bankruptcy today. >Enron's collapse also says something valuable about the energy trading markets: Competitive markets worked just as expected. As questions were raised about the quality of Enron's earnings -- and, just as important, not answered -- investors grew wary. Although the stock opened the year trading in the 80s, it started drifting down as investors bailed. The stock had already lost half its value and was trading below 40 before the company announced a big third-quarter loss and made its first disclosure of accounting "mistakes" in October. >At the same time, traders outside the company had begun to unwind positions and do business with other firms. At the end of September, Enron had 25% of the energy-trading market. Just two months later, its business had disappeared but that disappearance didn't cause the tiniest ripple in the market. The swift collapse of what once was a $77 billion dollar company failed to generate either a price spike or a supply interruption because the market was sufficiently liquid and deep to absorb it. >In short, no matter how one views the purposes or operations of a competitive market, the history of Enron proves that the market works pretty much as expected. And thus the story of Enron is, so far, a success story.< JD: So "market success" involves wild fluctuations, which is much more than the Schumpeterian story that Lee starts with. Instead of the story of the entrepreneur who gets temporary super-profits, which are then quietly competed away, this is a story akin to that of Marx: Enron's operations got the company further and further away from equilibrium -- as so often happens when fictitious capital rears its ugly head -- so that when equilibration happened, it was forcible, abrupt, and destructive. Second, as befits a contributor to the Wall Street JOURNAL, Lee ignores the external effects of Enron's fall -- on creditors, on workers (who were also pension-holders), and on auditors. The first rule of H*yek/Friedmaniac economics is to ignore or minimize the role of external effects. happy new year!
