Jim Chanos is a well-known investor and investment advisor who specializes in shorting stocks — one of his most famous shorting targets was Enron back in 2001.
Making money by selling stocks short is most often accomplished through the process of borrowing stock, selling it, and then covering the loan of the stock at maturity by purchasing the stock in the market later at a lower price. The process is often criticized by the short seller’s target because it generates profits from misfortune (i.e., when the target company’s stock price goes down) and is counter-intuitive to the usual way folks make money on investments — that is, holding stocks long-term as they appreciate in value. Nevertheless, the practice provides a valuable market purpose in hedging risk and, thus, is a component of any well-structured securities market.
In this Wall Street Journal ($) op-ed, short-seller Chanos provides the following ten lessons (without Chanos’ explanation for each rule that is provided in the article) on the Enron saga:
1. The Enron scandal shows a need for a standards-based accounting system, rather than a rules-based one.
2. Mark-to-Market accounting was not the problem at Enron, Mark-to-Model was.
3. Off-balance-sheet deals and entities are “off” the balance sheet for a reason.
4. Wall Street analysts don’t “do” complex.
5. The rating agency system breaks down when most needed. Rely on it at your own peril.
6. Beware of, and question, unexpected executive resignations.
7. Whistleblowers aren’t whistleblowers if they blow their whistles inside the company walls (note: Chanos is referring to this).
8. Special investigations by corporate boards are almost always a waste of time/money, and often prove highly misleading.
9. Character cannot be compartmentalized.
10: Friends do not let (possibly guilty) friends take the stand in criminal trials.
Read the entire op-ed. Probably because Chanos did not actually read Lay and Skilling’s testimony about Enron’s short sellers, his comments regarding the extent to which the Lay-Skilling defense strategy relied upon short sellers in explaining Enron’s demise reflects the generally overblown nature of the media’s reporting of that testimony. Nevertheless, Chano’s rules are helpful reminders of the myth that underlies much of American securities regulation and prosecutions such as the one against Lay and Skilling. As noted several times previously on this blog, investing heavily in a company such as Enron without a corresponding hedge is akin to playing the slots in Las Vegas. You can win big, but you can also lose big. The difference is that we don’t generally create morality plays to assuage folks who gamble away their money in Las Vegas, and we don’t prosecute the casino owners, either.
Chanos is understandably eager to pat himself on the back, but – in my view – he got the right answer the wrong way, as Enron’s collapse was attributable to Enron’s inability to continue borrowing money after the nature of Fastow’s OBEs came to light… and not the issues that Chanos focused on. Enron didn’t collapse because they were ‘marking to model’, nor because they shifted their money-losing operations into larger more profitable divisions, nor because they shifted liabilities and losses off the Enron balance sheet.
Had Fastow set the OBEs up properly*, with true third party independence from Enron, and had Fastow not treated them as his supplemental pay package, then there’s a good chance that Enron would have kept going… perhaps to collapse another day, perhaps not.
* assuming of course that Fastow could have done so.
Steve, I agree with you regarding the reason for Enron’s demise, particularly the part about the crisis in the commercial paper market after the revelations about Fastow’s shenanigans with the SPE’s coupled with the company’s relatively low credit rating. Nonetheless, I have to admit that I chuckled at Chanos reasons 3, 4, 5 and 7. Pretty much right on target.