Arnold Kling  

Enron

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'Jane Galt" writes


If Mr Delong emails me, I will be quite happy to put him in touch with reputable and knowlegeable people, not paid to do so, who believe that Skilling and Lay, at the very least, may be innocent.

She is responding to an assertion by Brad DeLong.

I am not an expert on Enron. I saw the movie "The Smartest Boys in the Room," which is a documentary that tries as hard as it can to make the Enron executives look bad.

My sense is that Enron's off-balance sheet transactions involved using their stock as collateral. If the stock fell in price, they had to put up more collateral. Thus, it was as if they were writing put options on the stock. When you do that, you earn income as long as your stock stays high, but once it starts to fall you get killed.

If I am correct about the underlying source of financial instability, then my guess is that very few people understood what the risks were. I would bet that most stock analysts, and the Enron executives themselves, thought that Enron had figured out a new, clever way to earn income, when what they were really doing was picking up nickels in front of a steamroller (which is how a good friend of mine describes the economics of writing out-of-the-money options).

In the movie, Enron's use of market-value accounting was presented as an ominous, conspiratorial act. In fact, market-value accounting is the most informative way to present information on financial assets and liabilities whose market values change daily.

Unless the prosecution has a better case than the movie scriptwriters depict, if I were on the jury they could never get a conviction.


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CATEGORIES: Business Economics



TRACKBACKS (3 to date)
TrackBack URL: http://econlog.econlib.org/mt/mt-tb.cgi/569
The author at triticale - the wheat / rye guy in a related article titled Guilt Is Proven writes:
    I didn't pay much attention to Ms McCardle's first post on the Enron verdict. I read her blog for the discussion of non-emmiseration. After seeing the Econblog post on the topic I went back and read it along with her... [Tracked on September 26, 2006 7:37 PM]
COMMENTS (11 to date)
Mark writes:

Arnold, I believe that the term is "mark to market" accounting. And while there are legitimate purposes for mark-to-market to be used in some circumstances, Mclean and Elkind make a very good case--which I have never seen refuted by any reputable analysis--that it was grossly misused by Enron to inflate their earnings.

Jane Galt writes:

Mark, while Skilling and Lay may well have been guilty, I believe that the "Smartest Guys in the Room" theory has been substantially undercut by the government's case, in which one of the primary accusations is that Skilling et al hid $1 billion in profits in 2000 and 2001. No criticism of SGITR; they didn't have subpoena power. But I don't think it is now reasonable to believe that Enron was understating its earnings; only that it was smoothing them. Which is not necessarily better, but it is different. Of course, it's been a long time since I read SGTR, so maybe I misremember.

dWj writes:

I think there was some creation of fraudulent market prices to which to mark some assets. My impression is that Fastow was guilty as hell, Skilling perhaps of willful neglect, and Lay was mostly as much a victim as other shareholders, though he probably could have been more hands-on in his management. This is mostly formulated, though, from the book Smartest Guys in the Room, so it may be superseded by the people with subpoena power.

Mark writes:

Jane, the accusation in the indictment was that Skilling & co. tried to hide profits from one specific activity of Enron--their profits from the California energy crisis--not an attempt to hide profits of the corporation as a whole. McLean and Elkind do not deny that there were, for a time, individual units of Enron that showed paper profits. What they show is that the profits of the corporation as a whole were inflated. And the trial focused on this issue of inflation of profits repeatedly.

Les Livingstone writes:

Arnold:

I respect your expertise in economics. But the only true statement in your piece on Enron is:
"I am not an expert on Enron."

Your comment "My sense is that Enron's off-balance sheet transactions involved using their stock as collateral. If the stock fell in price, they had to put up more collateral. Thus, it was as if they were writing put options on the stock." is only a small part of the picture. More important is that these deals were made through hidden straw entities and not disclosed.

Your next comment that: "In the movie, Enron's use of market-value accounting was presented as an ominous, conspiratorial act. In fact, market-value accounting is the most informative way to present information on financial assets and liabilities whose market values change daily." is a common error. Corporate long-term assets such as Property, Plant & Equipment are held for use in the business, by ongoing companies and not for immediate resale, except for bankrupt or liquidating companies. They have value-in-use rather than value-in-exchange. Therefore valuing them at daily market prices is irrelevant and misleading.

Conclusion: stick to your knitting - where your expertise is valuable.

Jane Galt writes:

Mark, they weren't paper profits. They were receivables, which the prosecutors went after them for taking too large reserves against. IF the reserves were indeed much too large, then that $1 billion was cash in the bank . . . not "paper profit".

With that information in hand, to argue, as M&E do, that there was a huge hole in the balance sheet, you now have to argue that the losses dwarfed $1 billion. I find that highly, highly improbable.

Again, I am not arguing that Enron was sound . . . only that M&E's theory as to why it wasn't sound can't be correct. Enron did not collapse because its schemes to cover up losses.

RogerM writes:

Should the Feds even be involved in cases like Enron? The stockholders should have the board of directors to look out for their interests. In the Enron case, it seems that the board didn't see any problems that were too serious. Besides, investors have a responsibility to be diversified, in which case an Enron failure won't hurt them much financially. If investors and board's of directors are stupid, should that be a crime?

AJ writes:

I have studied this issue and I think your summary of the off balance sheet puts is excellent and very descriptive of one of the major problems.

Mark to market accounting was the other major problem, because they marked things to hypothesized (read manipulated) values when there was no market comparison. When there is a liquid (or even semi liquid market) your mark to market comment applies.

Stan Liebowitz--in his Rethinking the Network economy--quotes a January 3, 2000 Wall Street Journal piece by Thomas Petzinger:

Our 500-year-old system of accounting has grave limitations in this world.. But for now, according to the CS First Boston atoms-to-bits report, "there is a substantial and growing chasm between our accounting system and economic reality"…[I]n an economy awash in capital, the endgame, not the score at the end of each quarter, is all that counts…"Earnings are a decision variable, not a requirement," says Prof. [Brian] Arthur, the economist. "If everyone thinks you're doing fine without earnings, why have them?"
http://wwwpub.utdallas.edu/~liebowit/book/chapter1.html#_Toc536554

That gives a flavor of the environment Enron was operating in. It shortly thereafter exploded in Enron's face, as well as in a lot of others who believed in 'The New Economy'.

Whether that's a criminal matter is more a matter of philosophy than anything else.

Lord writes:

It was not mark to market that was the problem but reporting the profits while hiding the losses in shell companies. They did not lose all their money in one year, but hide their losses until they went broke.

Bloodstomper writes:

It's amazing how y'all avoid the truth. Be that as it may, here's one scumbag who, after pleading for leniency, isn't innocent:

Enron fraud mastermind gets 6 years after plea for leniency

THE mastermind behind the financial schemes that brought down Enron has been jailed for six years - four years less than he had agreed to in a plea bargain.

A judge in Houston felt that Andrew Fastow, the former chief financial officer who co-operated with prosecutors, deserved leniency.

The judge said Fastow, who agreed to serve a maximum ten-year term when he pleaded guilty in 2004, and his family had already suffered enough. His wife has already served a year in jail for her role in the scandal.

Fastow's lawyers had asked for a lighter sentence, citing his guilty plea and his help in the successful prosecution of Enron founder Kenneth Lay and chief executive Jeffrey Skilling.

But Rod Jordan, chairman of the Severed Enron Employee Coalition, said the reduced sentence was "a slap in the face".

Enron collapsed in 2001 following years of accounting tricks, wiping out thousands of jobs and billions in shares and pension plans.

--Scotsman

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