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January 2, 2007

Malcolm Gladwell on Enron

enronlogo30.gifMalcolm Gladwell, he of Tipping Point fame, has authored this must-read New Yorker article on the demise of Enron. Although Gladwell gets a couple of things wrong, his article provides a refreshingly candid and objective view of what happened to Enron and highlights several aspects of the company's demise that makes criminalization of the affair so troubling. Reading Gladwell's account along side this earlier post on the case against Jeff Skilling, is there really any meaningful doubt that an enormous injustice has occurred in regard to the conviction and sentencing of Skilling to 24 years in prison?

By the way, these observations are quite interesting regarding a lecture that Gladwell recently gave in Dallas.

Posted by Tom at January 2, 2007 12:07 PM |

Comments

Tom,




I’ve read your posts on Enron and Skilling over the past few months and agree with your sentiments, and thanks for pointing out Gladwell’s article – it’s very good.




A couple of additional thoughts:




Although I haven’t looked up the sources, I distinctly remember in the 1998-1999 time period some analysts calling Enron essentially a “hedge fund,” and that it should be viewed by investors as such. It was certainly therefore well known in the financial community Enron was a riskier investment than a standard industrial company (even without benefit of detailed decomposing its financial statements), but of course a standard physical-asset company wouldn’t have had the growth rates and returns that Enron generated (investing 101 -- risk/reward trade-off). Certainly Skilling understood Enron was essentially a hedge fund (partially underpinned by some tangible assets). It was telling that from the beginning of the downward spiral, he quite rightly termed it a “run on the bank” phenomenon.




In that sense, I think the best parallel to Enron’s fate is the (in)famous Long Term Capital Management (LTCM) hedge fund, which had its own set of rocket scientists, along with Nobel prize winners. It initially generated excellent returns for its highly astute investors. But then, in the summer of 1998, a whole bunch of variables that were assumed to be uncorrelated turned out to be correlated, and they all moved in the wrong direction in a big way. Shockingly, LCTM went belly-up with very little warning.




Of course, LTCM executives didn’t go to jail for this business failure (although reputations, including those of Nobel prize winners were certainly tarnished). The key difference – LTCM was not a publicly traded company. This was the root of the Enron/Skilling problem – publicly traded hedge funds have a significant gotcha regarding information disclosure – when things start to go bad, you’re damned if you do, and damned if you don’t . . .




I see no reason to believe Skilling wasn’t completely aligned with the interests of all other Enron shareholders. As such, I’m sure Skilling recognized he was sliding into a no-win situation a year or two before his resignation. But when you run a fund or a bank, if you portray undue or premature pessimism, you risk creating a death spiral. And everything is shades of gray anyways, depending on huge number of variables you have no control over (if markets had gone in a different direction in 2000, we wouldn’t be having this conversation . . .).




I believe any thinking person could see themselves caught in exactly this same type of trap as Skilling. And when there exists such a trap wherein a series of legal activities lead to a no-win fiduciary responsibility/legal trap, it suggests to me the legal rules of the game are flawed . . .

Posted by: Steve Author Profile Page at January 3, 2007 12:31 PM

Steve, I think your observation about Enron being a public company is insightful -- there is no question that the public nature of the investors mitigated heavily toward the government taking action against Enron's principals, regardless of whether there was any basis beyond a reasonable doubt in doing so.

On your hedge fund analogy, I see where you are coming from, but my sense is that Enron's position as a market-maker gave it a considerable advantage and a considerably-reduced risk level in comparison to the typical hedge fund that would engage in a similar trading operation.

As for your speculation that Skilling anticipated the run on the bank, I don't think his actions over his final two years indicate that he had any such notion. My sense is that the combination of his frustation over dealing with Enron's international asset portfolio -- which Skilling had always opposed building -- and family problems were what drove Skilling to resign as CEO. Unfortunately, the company had not done a good job in preparing for succession in management, and Mr. Lay was ill-prepared to undertake the CEO role again after being largely out of the day-to-day operations for the previous five years.

Posted by: Tom K. Author Profile Page at January 3, 2007 4:00 PM

Tom,

Regarding the “hedge fund” analogy, to be even more precise, the underlying business model that presents particular information disclosure issues (especially for a public company) is one in which there is a very strong positive feedback loop between market sentiment and the long-term financial returns of the company. Any sort of model that is based on increasing returns of scale of customer or participant base is prone to this. This includes creating new marketplaces, where ultimately the biggest market network will win, but it also is the basis of many IT business models, where there is only room for one (or a few) winning standards or electronic marketplaces. Not every business model is that way – for many industrial models it pays to not to try to stimulate too much positive sentiment because that will attract competitors that will build new capacity and ultimately crash the market for everyone. For these more classic business models it may pay for executives to sandbag a bit – a very different situation than Skilling and other Enron executives would have faced given Enron’s increasing-returns-to-scale model.

By the way, I would argue that being a market maker increased the risk to Enron, not decreased it. If you think of a market maker as an intermediary in a mature market (such as the NYSE), then yes, being a market maker is less risky than being a market participant because you win no matter which way the market moves. But Enron was a market MAKER – meaning they were actually creating new markets for the transfer of risk by securitizing things like weather, bandwidth. When you are this kind of maker of markets, you have more risk than other market participants – they can move in and out at will, but you can’t, and if they all leave at once, you’re left holding the bag.

As an aside, it should be noted that securitizing new areas is a doing a service for all of us by making the entire economy more efficient, but seems to be a public service particularly prone to getting crossways with the government. For example, Mike Milken was demonized for inventing the securitization of high risk (“junk”) debt – that is standard now in today’s economy and just about everyone would agree it serves a highly valuable service. Likewise, just about every securitization area that Enron pioneered is now becoming standard, operated by traditional financial players.

With regard to what Skilling (or Lay) was thinking before the downward spiral became obvious to all, I have no direct knowledge, and the factors you cite were undoubtedly things that weighed on Skilling. However, I have got to believe that senior-most Enron executives understood the risks if multiple things kept going against them (the directions of the cash flows alone would have gotten their attention). But what could have been done differently? – a year earlier proclaim the sky is falling??? Then, in all likelihood, we would have just had the run on the bank and collapse a year earlier . . .

Posted by: Steve Author Profile Page at January 3, 2007 10:21 PM

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