January 28, 2002
From the desk of Jane Galt:Enron debacle
Here is an excellent, excellent post describing the Enron debacle in clear, no-nonsense terms. I have only two things to add:
1) For those who didn't go to business school, the term leverage is apparently confusing. So before you read it, just to let you know, it basically means how much debt you carry. It's called leverage because the debt works like a lever: it gives you the ability to move bigger objects with the same amount of force; or in the case of a company, to buy more stuff with the same starting assets.
2) The author points out that Enron failed because it was highly concentrated in the most rapidly deteriorating sectors of the economy. True. But I think it's important to ask why it was so concentrated there.
My opinion: because Enron's original business -- trading energy -- was extremely successful. It produced very high margins and rapid stock growth. However, it followed the classic competitive model of new markets: the high profits attracted new entrants, who competed Enron's profits away. Energy trading was a brilliant idea. Unfortunately, no company can guarantee a steady stream of brilliant ideas. Left with declining profit margins in their core business, Enron execs couldn't just face that they were in a maturing market -- they sought other markets with higher returns to keep the stock price and their paychecks rising. Well, the riskier an investment is, the higher the return.
Take two investments, one that returns 5% and one that returns 8%. You want the one with the higher return, right? But suppose the 5% is guaranteed, while you only have a 50% chance of getting that 8% -- there's a 50% chance that the company will go out of business and leave you nothing but a pretty piece of paper with some numbers printed on it. Well, probability weighting the returns gives you an expected value of only 4% on the riskier return. So you'll always choose the 5% guarantee unless the investment currently paying you 8% offers more interest -- at least 10%, so that the probability-weighted return evens out. Actually, you'll demand even more, because people are risk averse: they don't like not knowing whether they'll have $10 or pocket lint at the end of the year.
So in order to get the higher returns, Enron pushed into riskier markets. Knowing what that higher risk would do to the stock price, they concealed it from the stockholders through a variety of shoddy financial tricks. To be fair, they only did this because they were just as caught up in the magic of the bright millenial future as were those of us who bought stock in Pets.Com, and they thought that the returns would make it pay off. But that's no excuse, because when it became clear that this whole house of cards was about to come tumbling down, they sold out and left the investors holding the bag.
Posted by Jane Galt at January 28, 2002 1:14 PM | TrackBack | Technorati inbound links"); ?>