By Kennedy Maize
At a pleasant Christmas dinner with friends last week, a smart diner posed a question: when should the government or the market have known that the U.S. (and the world’s, as it turns out) financial system was in life-threatening peril?
After pausing to scratch my head, I proffered an idea: it all began with Enron. Just a thought, a top-of-the-head proposition fueled by a glass of good wine, but worth contemplation.
My notion was not obvious, even to me, and I thought about it before I tossed it up for conversation. After further consideration, it’s an interesting proposition. I’m not sure of its explanatory efficacy, but I offer it for your consideration. It’s about market psychology.
Before Enron, many of us thought we understood financial markets, including trading in derivatives. It was all about the fundamentals: risk versus reward. Welcome to Vegas (where the bookies always have better market information than the punters). Package the risks and sell them to hedgers. Let the market sort out the winners and losers.
That approach to markets seemed to work well until 2001, when Enron’s market plays went south in a major way, just about the time terrorists struck New York and Washington. I described it at the time, borrowing from one of my favorite authors, Baltimore’s Edgar Allen Poe, as the “Fall of the House of Enron.” The analogy between Poe’s House of Usher and Enron was chilling. The houses fell beyond the comprehension of the observers of the day.
It turns out that Enron was engaged in multiple, complex derivative-based trades, meshed with deals for physical assets, so convoluted that even the geniuses at the Houston-based energy company couldn’t parse or value them. Enron, once a straight-forward gas pipeline company, became an energy and bandwidth trading conglomerate – much of it existing in the virtual world – too strange to comprehend.
The Enron folks were masters of the financial universe; they told us so repeatedly. The company had a greater percentage of employees with advanced degrees than any other major firm in the U.S. PhD’s and MBA’s abounded. Clerks had honors degrees in economics. Lawyers carried CEO Ken Lay’s briefcase. Lay had a doctorate in economics, as well as a pious self-image as a devout, practicing Christian. What a company!
The argument I posited last week over roast goose and gravy was that Enron opened our minds – the simplistic minds of some regulators, some investors, some reporters – to the notion that perhaps our financial institutions weren’t as transparent and straightforward as we believed. Maybe they were so complex that neither we, nor the Enron folks playing the markets, could really understand them. Maybe there was a need for real regulation?
After Enron crashed, investor faith in markets began to erode. Good thing, too. When the housing bubble burst in 2007 and 2008 and investigators started probing the derivatives game (as well as the role of short-selling in conventional markets), the resulting picture was frightening. Who knew that Wall Street brokers (and some significant streets in Washington) were packaging lousy mortgages (the term of art is “sub-prime”) with sound investments, slicing and dicing them (“securitizing” is the buzzword, which those who lived through electricity restructuring understand), and selling them to investors with no immediate interest in whether the debtors performed?
Sound mortgages and bad loans went into the same financial meat grinder, producing a sausage of debt-based derivatives that tasted just fine but were tainted with bad ingredients. No financial regulator – the equivalent of the now-discredited Food and Drug Administration – was able or willing to take the toxic products off the shelf. The market invented its own regulatory mechanism – credit default swaps – that quickly turned into another way to gamble on the markets.
Following my riff on how Enron started it all, I came across a fine column by Joseph Stiglitz, a Nobel laureate in economics and former Clinton administration advisor, writing in the January 2009 edition of Vanity Fair. Stiglitz noted that in the aftermath of the Enron and WorldCom failures, Congress passed the Sarbanes-Oxley Act, designed to pour more light into the convoluted financial transactions that led the telecom and energy companies to financial ashes.
Congress, Stiglitz observed, ducked a “fundamental, underlying problem” in the markets: stock options. Sarbanes-Oxley, as a result of heavy lobbying from the financial folk, didn’t regulate the use of options to price companies and reward executives. Options, Stiglitz argued, are a lousy way to value a company’s performance. They create perverse incentives for bad accounting: the need to pump up the companies’ performance overcomes the necessity to provide accurate information about the actual results of the firms. That means lies distorting the ability of investors and regulators (if such exist) to suss out the real profits and losses of the high-flying firms.
In the words of the late, great songwriter E.Y. “Yip” Harberg, “Say it’s only a paper moon, sailing over a cardboard sea. But it wouldn’t be make-believe if you believed in me.” In short, the market depended on belief, or a suspension of disbelief, on the part of investors that these investments could never go sour. That belief held for many years. Along came Enron.
Enron’s collapse made belief in financial markets far tougher. As the sub-prime mortgages surfaced and defaults accumulated in 2007, the market kicked into cascading disbelief and cynicism. Credit cramped up across the board. The result of Sarbanes-Oxley in the real world was less transparency and more financial constipation, the exact opposite of the law’s intentions.
Enron’s destruction in 2001 didn’t trigger the financial collapse of 2007-2008. But Enron lifted a veil on the malignant machinations of the market-makers that came to light last year, creating a climate of distrust of all markets and all market dynamics. We will see how this plays out in the next four years of the Obama administration.
I’d love to hear from readers with their thoughts on this very crucial and difficult subject.