THE REAL CAUSE OF ENRON’S COLLAPSE

            The first political scandal of the Bush Administration is at hand.   The bankrupt Enron Corporation and its C.E.O. Kenneth Lay were as close to George Bush Junior as anyone, as well as to politicians of both parties, conservative and libertarian think tanks and others.

            Now that the company has so spectacularly unraveled--and in such a way as a lot of “little people” have been hurt--these relationships will come under much more scrutiny.  An often circus-like atmosphere (you know it’s a circus when the Right Reverends Al Sharpton and Jesse Jackson are also involved) will be the fare for months to come.  Congressional committees, citizens groups and others will trip over each other in attempts to show that, by golly, they’re going to “get” somebody!

            And, some of them might succeed.  God knows that there are probably scores of candidates for a couple years’ vacation at Allenwood, Danbury, or one of the other minimum-security federal prisons.  Perhaps we’ll even see a couple people fairly close to the president offered up.

            In addition, we’ll hear lots of talk (but will see little meaningful action) relating to making companies give the public a more accurate picture of their finances.   We’ll probably see legislation aimed at “shoring up” American workers’ retirement plans; I’ll comment on those down the road as they come up. 

            Other fallout will certainly come from all of this mess.  Government will get bigger still to “protect us” from creative accountants and speculators.  We’ll probably see some kind of lousy, so-called “campaign finance reform” now have a much better chance of passing; the alternative for Republicans will be that if either the House or the president stop this reform now so obviously “needed,” they’ll be crucified in November. 

            In all of this, though, a few key truths will unfortunately be lost, or swept under the rug.  The biggest of these truths is that Enron’s very character and growth as a company, which took on frighteningly speculative attributes over the last few years, was made possible chiefly by the Federal Reserve and our fractional reserve banking system.  In fact, the nature of this system virtually required Enron to do much of what it did! 

            Enron’s big problem is that it was a few years late in building itself into the speculative trading vehicle that it eventually became.  Had it embarked on its multi-faceted activities of arbitrage, derivative creation and trading and the rest during the 1990's--and then sat back a while--its timing would have generally coincided with that of the broader economy and financial markets.  But while the latter peaked in early 2000 and have since been contracting, Enron apparently thought it could continue building what became a veritable skyscraper of cards with one risky scheme and one form of “investment” on top of another.

            The sobering thing is not that such a “corporate strategy” unraveled where Enron was concerned--and caused the biggest corporate bankruptcy in history--but that it has NOT yet unraveled in countless other corners of the economy.

            You see, we live and operate in what has been described as a fractional reserve monetary system.  It is this system that has created, in a broader sense, the ultimately unsustainable asset and credit bubbles over the years.  It is also a virtual requirement of this system that--in order to perpetuate its very existence--the many ways in which “money” is created must over time become more complex, numerous (and risky)--just to keep everything going.  (Refer back to my March, 2001 issue for my most recent version of my “Understanding the Game” essay that details how our funny money system works.)

ENRON, OTHERS TAKE “THE GAME” A FEW STEPS FURTHER

            As time has marched on and as total levels of debt have soared inexorably higher, it’s been necessary for the banking and financial communities to find ever-more-creative ways to create even more “wealth” on paper.  It is this “wealth” which has made it possible for America to plunge ever more deeply into debt, in order to keep the fractional reserve system chugging along.  As the stock market soared, new “money” was seemingly created in the form of larger market values for many companies’ shares; “money” even above and beyond that which was created by the banks.  Many companies during the 1990's used this “money” (artificially inflated share prices) to buy out hosts of other companies, creating even more paper wealth in the process.

            In addition, Wall Street, investment banks, hedge funds and others have invented ways to use the generally inflationary environment on Wall Street and in the credit markets to invent new fangled types of “securities” that would similarly multiply “wealth.”  A few of you are old enough to remember a time prior to the more recent credit expansion when things were fairly simple.  If you wanted to own a company, you bought stock.  If you wanted to loan money to a company, you purchased a bond or note.  If you didn’t want to do either, you put your money in the bank down the street, or under your mattress.  Anything beyond that was generally unheard of.

            The overall growth of our fractional reserve-based monetary system has taken us to quite a different “extreme.”  Bonds are now purchased, for example, by an investment house--and then that investment house breaks the bonds into pieces in various ways, and creates separate securities (derivative contracts) out of them.  In some cases, these have been layered, one on top of another, as means to create even more funny money on paper.  Other types of “trading” contracts have been created, which are (as best as I can describe it, folks) bets, on top of bets, on top of bets concerning everything from interest rate levels, to currency values, stocks and bonds, and even future energy prices.

            Where Enron is concerned, you will undoubtedly hear calls from many big government types that the company’s debacle demonstrates that deregulation of energy markets is no good, and that the government needs to step back in.  This is a sham argument--or an ignorant (and politically motivated one) at best.  Energy deregulation--if practiced as its better proponents have envisioned--has indeed resulted in many cases in greater competition, and in lower prices for consumers.

            Enron’s debacle was not due to the deregulation of the energy industry.  It really wasn’t even due that much to its accounting trickery, or its buying some extra time and favors by greasing the palms of politicians and regulators. 

            Pure and simple, Enron’s demise was an example of what happens when a company that shouldn’t have done it in the first place plays the excesses of a fractional reserve system to excess.  And lots of Wall Street concerns were happy to create this financial skyscraper of cards for the company, as they each undoubtedly reaped hefty fees as a reward.

            “The cast of characters involved in Enron's off-balance-sheet activities is much bigger than previously thought,” wrote Robert Hunter recently in a story at SmartMoney.com. “Limited partners included Chase Capital, G.E. Capital, J.P. Morgan Capital, Merrill Lynch, Dresdner Bank, AON, Credit Suisse First Boston, Morgan Stanley and First Union Investors, an all-star

list of Wall Street insiders.  Given the porous walls separating equity research from investment-banking operations, the suggestion that analysts at these firms knew nothing about the [Enron] partnerships before they blew up simply isn't credible...Enron's off-balance-sheet activities weren't the mystery they've been portrayed to be.”

            That’s quite right, folks--Enron was the big vehicle whereby these Wall Street firms pumped, and pumped, and pumped--but couldn’t dump.  They were finally dumped on due to the sheer magnitude and unsustainability of the financial pyramid that Enron became.  The important thing to understand, amidst all the hand-wringing, finger pointing and the rest in Washington is that this type of speculation--and subsequent debacle--is what a fractional reserve system creates.

ONE MORE THING

            In his item, Hunter went on to say that, “What's striking is how long Enron was able to get away with these transgressions without someone blowing the whistle.  People at Wall Street's biggest firms had intimate knowledge of these dealings, yet no one said a word.  Wall Street can keep a secret far better than anyone could have imagined.  How many other secrets is it keeping?”

            On that note, I want to put before you a thesis I’m working on. 

            A few years ago, Long Term Capital Management became a pariah in the financial community.  This hedge fund zigged when it should have zagged, and suddenly found itself insolvent when its bets evaporated. 

            This hedge fund had a reported $3.3 billion in assets; hardly the level of debacle that should have had bankers up in the middle of the night trying to figure out how to keep LTCM’s collapse from bringing the whole world down with it.   But that’s exactly what happened.  Led by Bill McDonough, President of the Federal Reserve Bank of New York, bankers and financiers had to scramble to find a way to keep LTCM’s vaporization from having disastrous ripple effects.

            There were two key reasons for this: First, LTCM was the owner/creator of over $1 TRILLION of derivative contracts.  Other players were involved here, too, whose balance sheets were hammered by those contracts’ going bust.  So, much was involved beyond the level of investors’ assets in LTCM, a hedge fund that could be called the Enron of its time.

            The bigger issue, though, was that the LTCM implosion came as a complete surprise to regulators, the Treasury Department and the Fed, necessitating McDonough’s 2 a.m. emergency meeting.

            Now let’s look at Enron.  Its market capitalization was some $60 billion at its peak, dwarfing the assets of LTCM.  Nobody has put their finger on the “notional” value of its derivative contracts, but I believe they are also many times greater than those of LTCM.  In spite of all this, though, Enron’s blow-up had virtually none of the deleterious effect on Wall Street as did LTCM.  Sure, several companies even rumored to have exposure to Enron’s woes saw their share prices beaten up to one degree or another.  But--so far--not even a burp where the structural integrity of the financial markets is concerned.  Why not?

            I contend that the answer is simple. Wall Street knew very well what it was doing with Enron every step of the way, in doing things that are an accepted part today of “wealth creation,” arbitrage and all the rest.  It also knew months ago that it might have gone too far.  During that time, I believe that several key players--including some current and former Treasury officials, and perhaps even some people close to the president--tried to arrange things so as to keep any major, affected parties solvent when the reality of Enron finally hit the hardest.

            I guess in one sense we might thank these big shots for not allowing Enron to bring the whole game to an end yet.  However, we must also consider just how stable a system is that has seen such a chain of events as I’ve described.  In the end, we are dealing with a monetary system that--based on simple mathematics--is ultimately doomed to at least a prolonged period of stagnation and deflation. 

            But don’t hold your breath waiting to hear our fractional reserve system even mentioned in any of the rings of Washington’s Enron circus.

Please reply to: chris@nationalinvestor.com

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