Enron's Success Story

[Michael Perelman <michael@xxxxxxxxxxxxxxxxx>]

                 December 26, 2001

Commentary

Enron's Success Story

By SUSAN LEE

The collapse of Enron was many things -- a gratifying slap in the

face to corporate hubris and an exposure of the Alfred E. Neuman
club of stock analysts, rating agencies and the SEC. It may even
prove to be a fascinating look into criminal minds. But there is
one
thing, for sure, it wasn't -- a market failure. To the contrary,
Enron's implosion was confirmation of the principles that govern
competitive markets.

Enron's success and failure ran along the lines set down in any
microeconomics text. The company discovered a new product --
mostly ways of trading energy in the derivatives market -- that
allowed producers and users to lay off risk. This new product was

wildly popular and, as the innovator, Enron made lovely
above-market returns. But those abnormal returns attracted other
firms into the business and Enron's advantage was gradually
"competed away." Each new market entrant put the squeeze on
Enron's margins.

What happened next is still a matter of speculation, but there
are
several theories that seem reasonable.

    Bad hedging. Although Enron started out as a plain vanilla
    energy company, it shed those hard assets that could have
    underpinned its financial business and morphed into a
    trading company and then, quickly, into a hedge fund.

                A trading company can make money no
                matter which direction the market goes by
simply trading and taking its money from creating a market. If
prices are falling, then suppliers rush into the market to get
contracts that nail down prices; if prices are rising, then users
rush
in to get contracts. Traders can make money either way. Indeed,
in this model, a volatile market is the best of all possible
worlds.

But with its margins -- and cash -- getting squeezed, Enron
started
borrowing money and pretty soon it was running with remarkable
leverage, thus becoming a giant hedge fund. When things started
to go wrong, Enron's traders quite possibly were panicked into
trying to hit a home run. That is, they started taking big bets
on
the direction of the market, perhaps taking aggressively long
positions in energy. A successful hedge fund, however, depends
on adequately hedging bets, especially leveraged ones. But as
Enron started to lose money on its big bets, observers guess that

the insufficiency of its hedges began to look lethal.

There are also more complicated theories that argue Enron was
hiding its slowing growth in earnings with various accounting
strategies.

    Bad trading. Enron's main technique to pump up earnings
    probably revolved around a loose-as-a-goose process for the
    accounting of energy derivatives. Called mark-to-market, the
    technique involves evaluating contracts at "fair value"
prices.
    Since some of these contracts stretched out for 20 years, the

    futures market provides no firm prices. And, absent a liquid
    market with clear prices, "fair value" becomes a mug's game
    in which companies can vastly inflate value.

These overstated gains, of course, were also unrealized, noncash
gains. In September 2000, Jonathan Weil, a reporter for the
Journal, took a look at Enron's second quarter and found that
absent noncash earnings, Enron would have had a loss. Mr. Weil
later found that for the year as a whole, unrealized trading
gains
accounted for more than half of the company's originally reported

pretax profits. Hardly a confidence-builder in the quality of
Enron's earnings.

When their derivative strategies started to go sour, this theory
runs, Enron removed the contracts from its financial statements
and hid them in special entities created for just that purpose.

    Bad Assets. Another theory locates Enron's earning
    problems in their hard assets. Enron had a bunch of huge
    and underperforming assets, like its broadband company,
    water company and power plants in India and Brazil. In
    order to hustle those assets and associated debts off its
    financial reports, the company created some limited
    partnerships to buy these dogs -- either with bank loans or
    money provided by Enron itself. These partnerships
    (allegedly) transferred enough control to third parties to
get
    them off Enron's balance sheet.

Enron guaranteed these deals with "make good" provisions backed
by Enron stock -- a promise that Enron would make good any
losses in the value of the partnerships. When the value of the
assets tanked, the make-good provisions kicked in, resulting, for

example, in the enormous write-down in shareholder equity in
November.

Depending on which theory one accepts, there are two bottom
lines.

The first holds that the sagging earnings problem was fatal and
that it is entirely possible Enron was in the process of
liquidating
itself. Jim Chanos of Kynikos Associates hypothesizes that
Enron's cost of capital was higher than its returns on invested
capital. A second argues that if Enron's managers had been
content to accept the fact that in competitive markets their
"first
mover" advantage was going to be competed away, and had been
willing to endure slower earnings growth, it would not be in
bankruptcy today.

Enron's collapse also says something valuable about the energy
trading markets: Competitive markets worked just as expected. As
questions were raised about the quality of Enron's earnings --
and,
just as important, not answered -- investors grew wary. Although
the stock opened the year trading in the 80s, it started drifting

down as investors bailed. The stock had already lost half its
value
and was trading below 40 before the company announced a big
third-quarter loss and made its first disclosure of accounting
"mistakes" in October.

At the same time, traders outside the company had begun to
unwind positions and do business with other firms. At the end of
September, Enron had 25% of the energy-trading market. Just
two months later, its business had disappeared but that
disappearance didn't cause the tiniest ripple in the market. The
swift collapse of what once was a $77 billion dollar company
failed to generate either a price spike or a supply interruption
because the market was sufficiently liquid and deep to absorb it.

In short, no matter how one views the purposes or operations of a

competitive market, the history of Enron proves that the market
works pretty much as expected. And thus the story of Enron is, so

far, a success story.



Ms. Lee is a member of the Journal's editorial board.



--

Michael Perelman
Economics Department
California State University
Chico, CA 95929

Tel. 530-898-5321
E-Mail michael@xxxxxxxxxxxxxxxxx