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Dissecting the crunch – Bethany McLean on the lessons of Enron

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In “Don’t Get Fooled Again“, I look at the rise and fall of Enron, whose management sought to inflate the company’s share price by hiding bad debts amid a fiendishly complex internal accounting structure.

Bethany McLean, the journalist credited with being the first to raise serious questions about the company, has just written a fascinating piece highlighting parallels between the Enron scandal and the current financial crisis triggered by the “credit crunch”:

After Enron’s implosion, everyone talked about how important it was to be able to understand how a company makes money. Now raise your hand if you understand how a modern financial services firm makes money. No hands? The truth is, there is no way to understand. These companies are as opaque as Enron. Just as Enron had off balance-sheet vehicles – SIVs – that allowed it to book earnings and hide debt, Citigroup and other financial institutions had structured investment vehicles that did the same. Indeed, Citigroup had to take almost $50bn of SIVs back on to its balance sheet after they ran into trouble. It would be nice if the accounting rule-makers would grasp this basic tenet: if they want to hide it, we want to know about it.

Of course, SIVs are only a small manifestation of the deeper problem, which is the evolution of financial engineering into a dark art. Enron now seems like the canary in the coal mine. After its bankruptcy, Steve Cooper, who was in charge of restructuring it, told the Wall Street Journal his task might leave him “in a wheelchair and drooling” due to the complexity of its financial structures and the “unbelievable amount of debt accumulated around the company”. Doesn’t that sound like our entire financial system?

Just as Enron packaged bad investments into a private equity fund run by its chief financial officer, Wall Street packaged mortgages given to people who couldn’t afford the payments into sleek new instruments called RMBS and CDOs. But Enron’s machinations couldn’t make the losses go away, and Wall Street’s shiny acronyms can’t turn a defaulted mortgage into good money…

…Most of the believers in the free market only believe in it when it is going their way. When it doesn’t, it’s someone else’s fault. Enron’s former leaders often cited their free-market beliefs. Its demise, they said, was due to a short-sellers’ conspiracy.

Indeed, when all was booming, Wall Streeters said they deserved their pay because the market said they were worth it. But now things are falling apart, they say the market doesn’t work, and we need to stop short-selling, and taxpayers need to pony up. If there is a tiny bit of good in all this, it’s that Wall Street, although it was complicit in the Enron mess, managed to walk away relatively unscathed. This time, Wall Street has brought itself down.

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Written by Richard Wilson

October 4, 2008 at 1:40 pm

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