Fixing the Enron Economy

The sudden collapse of what had been assumed by most to be an apparently robust global economy bears parallels to that of Enron (a company that was the fifth largest in the US by value at its peak) which had invented the 'asset-lite' energy trading model, and was declaring record profits before its collapse in 2001. Average pay for each of its top 200 executives had gone from a generous $1m in 1998 to a stunning $7m by 2000, just before the business was revealed to be a massive fraud.

When Enron unravelled, the $13bn of debt declared on its balance sheet was revealed to actually amount to $38bn, hidden in offshore and off-balance sheet 'special-purpose vehicles' established with the connivance of Wall Street bankers (very like the off-balance sheet mortgage SIVs that have blown up the US banking sector). The stock price collapsed from $90 to pennies, but not before insiders had dumped most of their holdings. Although a handful of directors got jail time, the hundreds of energy traders and financial wizards (who shamelessly engineered 38 major black-outs in the recently deregulated Californian electricity market to boost profits), were scattered across hedge funds and investment banks, carrying with them a contagious virus of aggressive amorality that have defined financial markets in recent years. Wall Street has always been happy to sell the latest brand of snake-oil to gullible investors, but the scale and utter cynicism of activity in the securitized mortgage market is truly unprecedented.

Enron, like the mortgage crisis, was a conjunction of reckless political deregulation, investor delusion, management corruption and stunningly short-sighted greed by all concerned. If there was one clear lesson from the Enron debacle, it was to be suspicious of financial complexity. And yet the illusory prosperity of the last few years has been based on a financial pyramid scheme of such complexity that the senior directors of the very banks building it didn't comprehend the instruments involved, let alone the solvency risks entailed. Per-capita real economic growth in the US has averaged 1.4%, 1.7% and 1.9% over the past 25, 50 and 100 years. Let's call it 2% at best. The corporate sector in aggregate can't grow sustainably faster (or corporate profits would end up bigger than the economy); trend share prices and earnings can't grow sustainably much faster either.

So what on earth were we thinking this last decade? Investors delude themselves into believing that their domain, be it dot com stocks or beach-front condos or commodity hedge funds, can somehow beat this constraint and grow to the sky; that 2% rule should have acted as a reality check on anybody recommending stocks since 1998.

For a long-term investor, assuming stable P/E averages, stock returns will revert to a 2% real rate over time. Real growth in EPS for the S&P 500 has been 3.2, 2.0 and 1.5 % over the past 25, 50 and 100 years respectively. Note how real economic growth has been trending lower in the past 25 years than preceding periods, but real EPS growth has been trending higher. What does that tell you about the quality and sustainability of those earnings?

As I've analysed in previous posts, a decade ago the markets were on a normalized earnings multiple higher than that in 1929. The negative compound returns since then reflect a brutal reversion to the historical mean after many years of self-serving distortion and delusion. The adjustment process to economic reality in equities and corporate bonds is now well advanced, but that in government bonds is about to begin.

Comments

[Did U Think...:]

Good post. The terms "Ponzi Scheme" and "Organized Crime" seem to fit the current situation. When will Americans and the rest of the world say "enough!" to these fiat currency, fictional reserve pirates?

Jail time. We need to put them in jail before they start WW3 with their little financial games. Assuming it is not already too late to avert WW3, that is.

2008 Dec 05 09:15 AM

[rogersails:]

As a Californian, I've been seething at the parallels between our "electricity crisis" driven by Enron and their Ilk, and the current "Banking Crisis". With their foot on out throats, the "energy companies" demanded huge sums of money or else. Yes, the or else happened 38 times. The irony is these companies were so bizarrely corrupt that they imploded even AFTER raping California to the tune of billions.
Now the financial industry is demanding trillions in money and guarantees (which will turn into real money our kids will pay)... or else. Screw em. We can right size our financial industry down to half its current size. I lived without power for a while. I can go to a different ATM. My city has 13 banks per square mile - and most of us don't even do our banking at physical banks anymore !!!! Big banking has been a growing burden on our economy as surely as big government. If we don't right size it now, we never will.

2008 Dec 05 11:39 AM

[website:]

I what Just To Point this out ( Posted by Sean Maher)
{ Enron, like the mortgage crisis, was a conjunction of reckless political deregulation, investor delusion, management corruption and stunningly short-sighted greed by all concerned }

Jan 01 03:56 PM