Arnold Kling  

Malcolm Gladwell on Enron

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This story rings true with me.


“There have been scandals in corporate history where people are really making stuff up, but this wasn’t a criminal enterprise of that kind,” [Yale law professor Jonathan] Macey says. “Enron was vanishingly close, in my view, to having complied with the accounting rules. They were going over the edge, just a little bit. And this kind of financial fraud—where people are simply stretching the truth—falls into the area that analysts and short-sellers are supposed to ferret out. The truth wasn’t hidden. But you’d have to look at their financial statements, and you would have to say to yourself, What’s that about? It’s almost as if they were saying, ‘We’re doing some really sleazy stuff in footnote 42, and if you want to know more about it ask us.’ And that’s the thing. Nobody did.”

Gladwell's thesis is that Enron was disclosing the information that someone would have needed to understand its precarious financial decision. However, not enough investors made the effort required to sift through the information.

I strongly recommend the article. However, I am not sure what to recommend to a professional investor, other than to make certain that you understand how a company makes its money. (For amateur investors, I simply recommend index funds. I am an amateur investor, and that is what I use.)

Over a decade ago, Warren Buffett sold a large holding in Freddie Mac when he decided that its new strategy of growing its mortgage portfolio made its business too complex for him to be able to understand how it was making its money). The portfolio growth meant that Freddie Mac was trying to make money by taking interest rate risk, and Buffett himself did not understand or have confidence in the mechanisms for doing so.

My guess is that he would not have found Enron appealing as an investment.


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CATEGORIES: Business Economics



TRACKBACKS (3 to date)
TrackBack URL: http://econlog.econlib.org/mt/mt-tb.cgi/622
The author at PointOfLaw Forum in a related article titled Malcolm Gladwell on Enron and Skilling writes:
    Must-read New Yorker piece on Skilling and Enron, demonstrating the fundamental flaws in the Skilling prosecution, even if Gladwell's framing device—the supposed difference between "mysteries" and "puzzles"—isn't, as Larry Ribstein points o... [Tracked on January 3, 2007 9:44 AM]
COMMENTS (10 to date)
Kevin Brancato writes:

In 2002, the CEO of TIAA-CREF stated that his analysts couldn't understand how Enron was making money, so they cut back investment in it where possible:


I am proud to report that our stock analysts covering the energy business could never understand how Enron could make enough money to cover its obligations--so our active portfolio held less than the benchmark level, resulting in relatively favorable results for our participants. We did unfortunately hold positions in our Index Funds since Enron once held a prominent position in the S&P 500.

KipEsquire writes:
"Enron was vanishingly close, in my view, to having complied with the accounting rules. They were going over the edge, just a little bit."
No, not really. Their use of mark-to-market valuation of hypothetical future contracts violated both the letter and the spirit of the revenue recognition principle. It may have been sanctioned by regulators and auditors, but it was preposterous -- and unethical -- to any unbiased observer with a remedial understanding of accounting principles.
"Enron was disclosing the information that someone would have needed to understand its precarious financial decision."
That's patently absurd. This was the company, you may recall, that called an analyst a profanity for daring to observe on a conference call that Enron couldn't even produce a simple balance sheet.
Matt writes:

The idea that the information was unavailable is not true. Enron may have obfuscated the reality, but they could change it. I doubt that it is possible in the U.S. for a large public company to produce totally false financial statements, as the case below demonstrates:

>>>In February of 2002, the US House of Representatives' Committee on Energy and Commerce asked Jim Chanos, one of the "cabal of short sellers," to give testimony regarding the demise of Enron. After all, Chanos' insights allowed his investors to know about, and ultimately profit from, Enron's problems over a year before Enron filed bankruptcy. In October of 2000, Chanos became aware of Enron's use of "gain-on-sale" accounting and believed that Enron was using this accounting method to materially overstate its earnings.

"Basically 'gain-on-sale' accounting allows a company to estimate the future profitability of a trade made today, and book a profit today based on the present value of those estimated future profits.

Our interest in Enron and the other energy trading companies was piqued because our experience with companies that have used this accounting method has been that management's temptation to be overly aggressive in making assumptions about the future was too great for them to ignore. In effect, 'earnings' could be created out of thin air if management was willing to 'push the envelope' by using highly favorable assumptions."

After analyzing Enron's cash flow and realizing that Enron was likely going backward while it was reporting "profits" to shareholders, Chanos began studying Enron's financial disclosures more closely.

"We were also troubled by Enron's cryptic disclosure regarding various 'related party transactions' described in its financial statements. We read the footnotes about these transactions over and over again but could not decipher what impact they had on Enron's overall financial condition. Another disturbing factor in our review of Enron's situation was what we perceived to be the large amount of insider selling of Enron stock by Enron's senior executives. Such selling in conjunction with our other financial concerns added to our conviction.

In the spring of 2001, we heard reports, confirmed by Enron, that a number of senior executives were departing from the company. Further, the insider selling of Enron stock continued unabated.

To us, however, the most important story was the abrupt resignation in August 2001 of Enron's CEO, Jeff Skilling, for 'personal reasons.' In our experience, there is no louder alarm bell in a controversial company than the unexplained, sudden departure of a chief executive officer no matter what 'official' reason is given."

John Thacker writes:

That argument leads into one I've heard made (not sure how far I credit it) that the assets would have worked out alright at the end, but that the shortsellers, convinced that there must be mispricing, pushed its stock price down and caused banks to stop lending it money, especially at favorable rates. In other words, I've heard the claim that it was a credit and liquidity crunch, essentially a bank run.

I don't think I believe that that's the whole story, even though the credit crunch certainly was there.

Shayne writes:

Enron (Schilling, Lay, et.al.) gets all the press. I'd be more interested in a bit of news about the (former) Arthur Anderson partnership, the related Justice Department actions against individual partners and the impacts on the accounting industry. When the Enron debacle became public, the Justice Department announced indictments against Enron's principals (Schilling, Lay, et.al.), but also indicted the entire Arthur Anderson partnership. It seems to me that is a far larger and more compelling story than that of Enron.

Shayne writes:

My apologies for the triple-post - my Internet connection was acting up (again.)

[Duplicates removed--Econlib. Ed.]

MQ writes:

It's rational to buy a stock even if you *know* the underlying company has no viable business model, so long as you believe others will believe the company is viable and bid up the stock price. Short-term stock purchases are not based on the fundamental value of the company, but on predictions about other peoples' beliefs about the company. A lot of people made a lot of money buying Enron.

In theory, short-selling could eliminate this, but since one can never predict exactly when the scam will collapse short-selling is very risky without a huge reserve to meet margin calls.

Ray G writes:

Gladwell is intelligent and an eloquent writer. But knowing his basic views on economics and individual rights, I wouldn't recommend him to my enemies.

Having said that, I used to work for Morgan Stanley, and the basics of what I would tell people is to shop for securities the way a prudent person would shop for just about anything else of value.

I really like Allen Edmonds shoes, but I'm not paying full price. So I'm constantly looking for deals (on a number of things).

This is really just what Buffet is known for, but it kind of brings it home for some people.

Then some people are just not wired to be comfortable investing. Those people need to shop around and find a good broker/advisor. Ask your lawyer, CPA, but not your doctor. Do not ask your doctor!

Personally, you can't go wrong with bonds, and if you have a good broker, he can find you good bonds. Some of the best deals on corporates get eaten up as soon as they're released, and you need a broker for that kind of info. "Junk" municipals are actually good, and "junk" for a munnie isn't anywhere near as "junkie" as junk anywhere else.

Morgan had a short term bond fund consisting of nothing but Treasury notes that was making around 4% at a time when the average money market was pulling less than 1%. Min of 10K, and you could move in and out like cash. But again, that's something you need a broker for.

JWR writes:

Macey's account rings fairly true to me as well.

A friend of mine works at a mid-size regional bank that lost very little money to Enron, because they had lent them very little. I asked him why, and he told me they couldn't understand Enron's balance sheet so they didn't lend them much money.

As for KipEsquire's comment: it's true that Enron execs. berated anyone who questioned their balance sheet as being a simpleton who couldn't understand things. If you were a competent analyst and were told that by a company, would you (a) crawl into a hole in embarrassment at being a simpleton and give the company you couldn't understand a glowing rating; or (b) downgrade the company?

The obvious answer is (b). Most of the analysts did (a).

Roman Lombardi writes:

That's patently absurd. This was the company, you may recall, that called an analyst a profanity for daring to observe on a conference call that Enron couldn't even produce a simple balance sheet. Posted January 2, 2007 09:46 AM

While the above statement is close, someone did figure it out; it was actually a well known short-seller named Richard Grubman who worked for Highfield Capital. In a Quarterly earnings conference call he asked CEO Jeff Skilling to produce an accurate balance sheet and cash-flow statement for the Quarter. When Skilling gave him the run around, Grubman said, "you're the only institution that can't produce a cash-flow statement with your Quarterly earnings."

Skilling replied, "We appriciate that"

Grubman said, "You appriciate that?"

Then Skilling said, "A@%hole"

The short sellers smelled blood and got it. This all happened close to a year before Enron imploded. I am sure Jack Grubman didn't lose any money on Enron.

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