January 27, 2002
From the desk of Mindles H. Dreck:The Enron Rorschach Test
For most people, the fact that something is too complicated to understand is a problem. For editorialists in the New York Times (not to mention congresspeople) it's an advantage.
Enron's failure has become a Rorschach Blot for pundits, revealing to each each individual viewer the unmistakeable lines of their own agendas and pet peeves. It's a bit like seeing a Sphinx in Martian Rock Formations. Recent New York Times editorials are a good example. Bill Keller's "Enron for Dummies" pins the Enron failure on fancy derivatives trading; Edward Chancellor tars Enron as the "quintessential internet company", which should come as a surprise to all you netizens; and Maureen Dowd's "Planet Enron"...well who knows what she's saying, but she manages to name most of the key administration figures and make a lot of puns, which seems to be about her limit these days. It must be nice to live on "Planet Pundit", where facts and opinions are scarce, and bad poetry can fill an entire column:
On Friday, the once-serene orb imploded with the news of the sad death of a leading citizen, who shot himself in his Mercedes after telling friends he did not want to have to turn against his own.But Planet Enron is bigger than one company or one tragedy. It's a state of mind, a subculture, a platinum card aristocracy. Its gravitational pull has long proven irresistible.
With these empty lyrics ringing in our ears, let's consider the fundamental issues that caused Enron's performance to deteriorate, and then look at the nature of the accounting concerns:
Fundamentals:
Enron had physical utilities and energy assets, a large trading business, and a variety of private investments in new ventures. The trading and energy businesses benefited from a big runup in energy prices through the middle of 2001, and the new ventures benefited from the valuation bubble in telecommunications and internet investments through mid-2000. Over 2001, energy prices decreased and valuations of telecom/ broadband and other related investments plummeted. Telecom companies dropped like flies from dramatic overcapacity.
Enron was levered up and exposed to all of this. The value of its physical plant and investments was tanking, and its trading business was less profitable. By analysts' accounts, the trading operation was not a problem, and is, in fact, expected to continue to turn a profit for its purchaser UBS.
Accounting:
While the post-mortem is not over on accounting, it appears that Enron fell into a new variation on an old corporate accounting moral hazard. They moved their accounts and assets in ways that allowed management to use their discretion in valuing them.
In business school, you always do a few case studies on how management can do this. The classic example is usually a contract business that recognizes its revenue based on the "percentage of completion" method. If a business creates a contract over, say, three years, it has to decide how much of the contract revenue it has earned in any given year. If management front-loads its estimate, the company looks incredibly profitable, then deteriorates in later years. The lack of cash flow usually gives this ploy away.
Enron's tactics appear to be a variation on the the same idea. They moved failing assets into partnerships in which they had less than a 20% interest. The low level of ownership prevents the partnerships from being consolidated into the parent company. Usually their partnership interest came from contributing an asset at a value estimated by management. If the asset then decreased in value, Enron could still carry the partnership at cost. Disclosure on the books of the partnerships was poor, so analysts and other street watchdogs had trouble second-guessing the company's valuations of its interest. You can find one analyst/journalist who was skeptical here (July 2001) and here (October).
Enron's cash flow statements certainly looked odd over the last two years. They tended to run cash negative for the first three quarters and then have sudden large "other adjustments" in the fourth quarter of each year. Unfortunately, trading businesses always have odd cash flow statements (they deal in cash all day), so that isn't as good an indicator of inappropriate revenue recognition or asset valuation as it otherwise might be.
Another "innovative" scheme was to raise financing for these partnerships by pledging Enron Stock, or agreeing to pledge the stock if the value of the partnership assets fell. And fall they did, so Enron had to issue and put in stock to satisfy the lenders. Which is dilutive, and the stock fell again. Put in more stock...and so on.
These agreements were, apparently, not well disclosed by the company. The company is obliged to disclose "material" contingent obligations of this sort. Apparently, Enron and its auditors got together and convinced themselves they were immaterial (or the auditors didn't know).
Clearly both the company's valuation of its assets and its judgement of what constitutes "material" are highly suspect at this point.
To sum up, Enron found itself highly leveraged (because trading businesses require leverage to be profitable) and, in its traditional businesses, horribly overinvested in the most severely deteriorating segments of the economy. In order to try to keep the party going, they maximized their use of managerial discretion in valuation of assets and concealment of obligations. Plenty of analysts soured on the company because of its poor disclosure. If disclosure had been better (and it should), many more analysts would have bailed out.
There is no way to keep a corporation's books without asking management, at some point, to use its judgement to value certain contracts and assets. Full disclosure of those details, however, allows the street to second guess those valuations. The community of analysts that objected to Enron's limited disclosure policies certainly had it right. Wall Streeters should be embarassed there weren't more.
Enron wasn't an internet failure. It isn't emblematic of an era so much as emblematic of a moral hazard that has been with us since the industrial revolution. It didn't get burned by fancy derivatives (in fact, it seems to have done that better than most other things) and it's failure appears to have little to with the administration (as opposed to its attempts at influence peddling). If insiders sold stock acting on proprietary knowledge that the company was failing, there are existing laws to deal with it that can require treble damages and incarceration. Then come the civil suits.
But the punditocracy will make of it whatever they want, whether that's "the end of internet hype" or "fancy financial engineers get handed their heads" or "poppy and junior and the VP in his cave".
Here's a reporter who deals better with the complexity - he makes it the story
Posted by Mindles H. Dreck at January 27, 2002 9:59 PM | Technorati inbound links"); ?>