How to avoid Enron

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By: Margin of Safety Equity Research.How to avoid Enron

Will You be able to Avoid the Next Enron?


In an era of “too big to fail” and trillion dollar bailouts, the Enron debacle seems to have faded into a distant memory and, along with it the lessons that, if they had been applied, may have even prevented the credit catastrophe triggered just seven years later. The Enron bankruptcy, at $63 billion in assets, was the largest on record at the time, however it pales in comparison to the 2008 Lehman bankruptcy valued at nearly 10 times that if Enron’s. The similarities in the causes behind these colossal failures are to close not to ascribe a good deal of the blame to the one entity that “oversaw” both of them – the Securities Exchange Commission. Yet, there were other players, co-conspirators if you will – that played key roles in two of the most notorious financial calamities of our time. Who are these players, and are the conditions still present that might allow them to wreak havoc on the financial system again?


The S.E.C and the Regulatory Environment


Both the Enron collapse and the credit crisis occurred in a regulatory vacuum which allowed companies to act with impunity in their incessant quest for profits at any cost. In both instances, much of the initial finger pointing was directed at the S.E.C. for its apparent neglect of oversight responsibilities.  But, by all accounts, the agency was, and still remains, woefully underfunded relative to its enforcement responsibilities.  Although its budget as doubled since 2001, many continue to question its capacity to conduct timely investigations or to apply the teeth necessary to substantially change the narrative.


The Enron scandal gave us Sarbanes-Oxley which did serve to enhance transparency and criminalize financial manipulation, and the credit crisis gave us the Dodd-Frank Financial Reform legislation, which seems to do everything except directly address the problems at the root of the credit crisis. FASB standards were strengthened to curtail the use of questionable accounting practices. And more accountability was imposed upon corporate boards in their role as management watchdogs.


Credit Rating Agencies


In the aftermath of financial calamities, when the usual suspects are rounded up, the credit rating agencies are usually among them.  The credit rating agencies have long been struggling to remain relevant, however, their actions, or inactions, in the cases of Enron and the credit derivatives, could very well lead to their complete obsolescence. Granted, Enron’s accounting shenanigans fooled everybody, enough so that all three of the major credit rating agencies rated Enron’s bonds as investment grade just before its bankruptcy filing.  They were fooled once again by the investment houses that somehow sold them on the notion that neatly packaged credit derivatives were investment grade worthy of their highest ratings. Fool me once, shame on you; fool me twice shame on me. For shame credit agencies, for shame.


The Investment Banks


Closer to the heart of the matter, we find the investment banks – the bastions of free market capitalism that make their money off of other people’s money.  There are those who believe that, if the Enron Scandal hadn’t come along to deflect the regulator’s attention, a lot of investment bankers would have been jailed for their manipulation of stock values that led to the dot com bubble. Back then, investment banks hungry for a piece of the burgeoning dot com pie would bring just about any company with a .com following its name to the market. And with an assist from their firm’s research analysts, they would promote the stock to frenzied investors knowing that the company didn’t have a leg to stand on.


During the Enron scandal, investment banks, such as Merrill Lynch aided and abetted the company’s deceptive practices, and then, under pressure from Enron which paid Merrill millions for its services,  it fired one of its analysts for a producing a negative analysis of the company. Some have made the case that the investment banks engaged in similar practices when they packaged toxic mortgages to create derivative products that no one understood while they had full knowledge of their toxicity. Goldman Sachs paid record fines when it was determined that it had been shorting the same securities that it been encouraging its customers to buy.


Lessons Learned?


To this day many wonder how it is possible that one of the world’s largest energy companies and one of the most established investment houses (Lehman Brothers) could just evaporate overnight. Yet, one was precursor to the next. If the lessons of Enron were not learned in time to prevent a much bigger crisis, how do we know they’re not being ignored to this day? The main lesson investors can take from this is to only invest in what you know and understand, stick to the fundamental investment tools and diversify among non-correlating asset classes. And remember, no one cares about your money more than you do.

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