Smartest guys in the room? Are you kidding?

Peter Cresswell's picture
Submitted by Peter Cresswell on Wed, 2006-03-01 22:30

I saw a new film the other night at The Academy. A very simple film in which there are good guys and there are bad guys, and the film makes very sure we know which is which. But it seems to me that the film makes the same mistake as the people it criticises -- rather than showing all the facts, it invites us to take somebody else's judgement for our own, which was in part the reason for the catastrophic failure the film portrays.

The film was The Smartest Guys in the Room, portraying the collapse of what was then America's seventh-largest company. The bad guys were not 'baddies' in the usual Saturday matinee fashion of wishing harm on everyone. They were baddies because they had failed to perform a simple human task: they had failed to think about what theywere doing.

I bet they 'brainstormed.' I bet they thought they were 'thinking outside the square.' They sure as hell thought they were 'ahead of the curve,' because they kept telling each other they were. Seemed to me that here was a bunch of people playing at what they thought big shot executives should be like, with all the cliches that go with that. Only problem was, they had no clue what they were doing.

A basic question for every businessman and every investor to keep in the forefront of their mind at all times is this : how are we making money? If they can't answer that, then they shouldn't be in business. Enron's executrives couldn't answer that simple question, and nor, it turned out, could its investors.

Everyone figured that everyone else knew. Turned out no-one did. How are we making money? Somehow! But they weren't, and they didn't even know it. Turned out all of Enron's senior management and all of its backers and investors were complete second-handers who preferred to have others do their thinking for them, and who had all joined the stampede downhill in the hopes that someone else knew what they were doing. They didn't. One simple question asked by a Fortune magazine journalist brought down the whole house of cards: how does Enron actually make money? They didn't know. And they weren't.

The CEOs were not in control at Enron, the traders were, and all the traders were interested in was their own small piece of the action. Without any executive with an overview, Enron was like an engine revving itself to destruction. The billions of borrowings on the back of a huge trading cash flow and a ballooning share price fed the illusion of success, and allowed even more borrowing and an even higher share price. Short-term successes were reified into belief in the success of Enrons's long-term strategy -- except that there was no long-term strategy, just the casting around for the 'next big idea' -- the 'New Economy's' 'new new thing' -- so that like a bunch of dumb old bastards they could hand out backslaps all round and feel like they were all 'ahead of the curve.'

But these people were not dumb by any means. They were clearly highly intelligent, highly ambitious human beings. How had they been so blind? Why had they failed to think? Answer: they had blinded themselves, and they had done it by their bad fundamental ideas. Enron was a house built, not on sand, but on bad philosophy. And as with all bad philosophy that tries to deny or to fake reality, they soon enough found that reality is the ultimate avenger.

These people were complete and utter pragmatists. As philosopher Leonard Peikoff explains, the philosophy of pragmatism can be summed up as the "principle of not being principled":

In the whirling Heraclitean flux which is the pragmatist's universe, there are no absolutes. There are no fact, no fixed laws of logic, no certainty no objectivity. There are no facts, only provisional 'hypotheses' which for the moment facilitate human action. There are no fixed laws of logic, only mutable 'conventions' without any basis in reality...

The leitmotif of the pragmatist is short-term thinking, a range-of-the-moment obesssion with the here-and-now that blinds the pragmatist to the longer-term reality. What works now is what concerns the pragmatist, and a fig for the long-term consequences. As Lord Keynes put it on behalf of pragmatists everywhere, "in the long run we're all dead anyway." In the modern world, this is called 'being pragmatic.' Being 'practical.' In the real world it's called making yourself a dumb-arse, and setting yourself up for failure.

At Enron they were nothing if not 'practical' -- they were obsessed with the short-term, and at the real expense of the long-term. Obsession with today's share price; with today's 'strategy'; with screwing California's electricity consumers today, despite the long-term consequences for California and themselves; with whatever seemed to work today, whatever its consequnces for tomorrow . Here at Enron was range-of-the-moment thinking taken to its logical conclusion: selling off the future in favour of the present, just like a farmer chewing up his seed corn and then finding he has nothing to plant next year.

But the future does not stay hostage forever to the present. When the sun does eventually rise tomorrow on the hangover of today, it may be seen that the Emperor is naked. So it was with Enron. The collapse happened quickly, so quickly that many are still trying to work out what went on. Alex Epstein has perhaps the clearest diagnosis:

...to Skilling and other Enron executives, there was no clear distinction between what they felt should succeed, and what the facts indicated would succeed--between reality as they wished it to be and reality as it is. Time and again, Enron executives placed their wishes above the facts. And as they experienced failure after failure, they deluded themselves into believing that any losses would somehow be overcome with massive profits in the future. This mentality led them to eagerly accept CFO Andy Fastow's absurd claims that their losses could be magically taken off the books using Special Purpose Entities; after all, they felt, Enron should have a high stock price. Smaller lies led to bigger lies, until Enron became the biggest corporate failure and fraud in American history. Observe that Enron's problem was not that it was "too concerned" about profit, but that it believed money does not have to be made: it can be had simply by following one's whims. The solution to prevent future Enrons, then, is not to teach (or force) CEOs to curb their profit-seeking; the desire to produce and trade valuable products is the essence of business--and of successful life.

Instead, we must teach businessmen the profound virtues money-making requires. Above all, we must teach them that one cannot profit by evading facts.

Too true. All too true. A lesson all too many in business need to learn.

Now, one final point about the film: There are a number of myths about Enron (some of them debunked here), some of which make it into the film. One significant myth that still gets retold is that the California energy market was deregulated. It wasn't. For chapter and verse on that particular myth, I cannot recommend too highly George Reisman's 'California Screaming, Under Government Blows', and Scott Sutton's 'California Power Trips.'

LINKS: The Unlearned Lesson of Enron - 4 Years Later - Alex Epstein (ARI)
Myths about Enron - William Anderson (
Mises Institute)
California Screaming, under Government Blows - George Reisman (
Mises Institute)
California Power Trips - Scott Sutton (
The Free Radical)

TAGS: Films, History-Modern, Philosophy, Economics, Objectivism


Group consolidation rules

Merlin Jetton's picture

You're welcome, Tim. The following qualify my earlier post.
1. FASB raised the 3% rule to 10% in 2002.
2. Whether or not consolidation is required is not strictly on the basis of ownership. There is also the question of control, which can be quite complicated.
3. There are good reasons for SPEs. I believe the most common historical use of them was for sale-and-leaseback deals. They are virtually required for legal reasons in some situations such as when the asset is in a foreign country.
4. Many of Enron's SPEs were very complicated, which makes applying rules difficult. For example, see the graphic here. http://www.trinity.edu/rjensen//theory/00overview/speOverview.htm#Introduction
No, I had nothing to do with the Merlin limited partnership in the graphic. Smiling

Group consolidation rules

Tim S's picture

But to claim that making the attempt to understand why is "appallingly stupid" is uncalled for.

Quite. It is also wrong to try to conclude that "Objectivists make crap capitalists" from a post that dealt with the reasons and ethics underlying Enron's actions, and said nothing about how shareholders might have reacted to those actions.

Merlin, thank you for that post. I knew the group consolidation rules for corporations but I didn't know about the differential treatment for partnerships. You can see how easy it is to hide losses and take debt off-balance sheet under those rules.

Your trader friend

Tom Matassa's picture

Your trader friend apparently doesn't care why Enron collapsed. Fair enough. But to claim that making the attempt to understand why is "appallingly stupid" is uncalled for.

I'm a bit troubled...

atlascott's picture

...by Andrew's admiration and kind words regarding Enron.  I saw the movie and followed the news as Enron collapsed.

It is not ok to lie, cheat, and steal, and that is PRECISELY what Enron did and its executives did in order to amass the fortunes that they did.  Being in business does not give an individual carte blanche to do anything possible to make a profit.  I agree that they created a 'market' for energy.  I agree that they learned the rules of [really stupid] California energy legislation, and used that knowledge to their advantage.  But they also PURPOSELY screwed with the supply--not a market based supply and demand situation--they literally called in favors at power palnts and had them take plants off line. 

That is not selling a good or service at its fair market price, it is tampering with a market and screwing the consumer, and then lying about why the prices were so high.

Enron went out and hired the most sleazy accounting people they could find and made up bullshit assets.  They wrote nonsensical deals, and accounted for speculative future profits as current, banked profits.  And then wrote more and more speculative, ridiculous deals to keep the profits high and going higher.  That's fraud.

They knew the bubble was bursting--so they told their shareholders to buy-buy-buy, and then sold massive amounts of their own shares.  That's deceptive.

When the shit fit the fan, suddenly all of the guys running the company had no idea what was going on?  Is that why one of the executives blew his brains out--because everything was hunky-dory?  There is an obligation and a responsibility that goes along with a CEO title--any executive title.  How can you possibly run a company if you dont know whats going on in the company?

The bottom line is that folks can spin the Enron thing into an anti-government regulation diatribe--but that's not the real story.  The real story is that nihilism has effectively destroyed any semblance of morality in business and politics.  These guys did wrong.  Some got away, some are getting punished.  It doesnt really matter, because they were able to do it in the first place.  And in a world with a value system based upon the tenet of 'cash, by any means necessary' the next Enron, hell, the next 50 Enrons, are out there, waiting to be discovered--or not.  Because story after story, the public becomes immune to the injustice, just as we have become inured to the foul conduct of American politicians.  We expect the bullshit behavior, and so we allow it.  Change becomes an impossibility, as the theives themselves become the legitimate, powerful, and wealthiest members of society.  And the cry of "Justice" becomes the mewling of a tiny minority who still understand the importance if ideas.

Objectivists make crap capitalists

Capitalist's picture

Not all of us lost money on ENE. I find it interesting that many Obectivists eschew technical analysis, as was discussed on another thread. My trader friend finds the philosophic posturing in the above post 'appallingly stupid'. As he says:

This stock was in a longterm uptrend, had been for over a decade. EVERYONE made money on it. The only ones who KEPT the money they made were those who sold. So, who sold? Trend-followers who sold when the downtrend began. Those running stop losses, stopped out after ENE dropped x% from its $90 high. Who was left holding? Those with no plan, no exit strategy. The "Buy and Hold" brigade. Some of these will have held over the course of the entire downtrend while ENE went from $90 to nothing. This was no sudden catastrophic crash. It was a simple, clear downtrend than ran for over a year. There was plenty of warning and plenty of time to get out with some profits intact.

Take a look at this
http://www.thestreet.com/pf/co...
"Enron's stock gave many signals that it was under "distribution" by large shareholders. You may not have read about it in the paper, but Enron's chart told astute observers that big institutions were quietly unloading millions upon millions of shares."

http://www.turtletrader.com/en...
"There was only one key piece of data needed to judge Enron as an investment: the share price"
"Why would anyone hold onto a stock that goes from $90 to 50¢? Even if Enron was the biggest scam ever must we not also take to task the mindless investors who held on down to 50¢ a share? Are they not guilty of something more than simply being lazy?"

Another good take by Gary North, the author of Mises on Money :-
http://www.lewrockwell.com/nor...
"Fund managers should have known something was wrong, just by looking at the chart of Enron's price history."
"The financial press would not believe what the market was telling them. Enron's officials said that what the market was saying had to be wrong, but it was right."

...Use of the simplest trend-following TA would have got you out of this stock at a good price well before you gave too much of your profit back to the market. Similarly, use of the simplest, crudest stoploss strategy would have saved you. (Just a small point, but this wasn't a sudden "event" - it was an uptrend that ended and became a downtrend, that's all. Happens all the time. As I said above, there was plenty of warning and plenty of time to get out.)

Accounting fraud

Merlin Jetton's picture

I saw the movie soon after release and read the book even earlier, so they are far from fresh in my memory.  As I recall, the movie said little about the accounting shenanigans that were going on at Enron. (It would not make great cinema.) The book only partly covered the accounting shenanigans. Crazy accounting rules and Enron's auditors are partly to blame, as enablers. Of course, Enron stretched accounting rules to the maximum in order to report favorable accounting results, more earnings and less debt, to shareholders, creditors, and the investment community.

The movie said nothing about Jeff Skilling's initiatives in "market value" accounting. The book covered it some , but was skimpy on the details. Basically, he tried to book future profits on long-term capital investments long before they are realized under ordinary accounting rules. "Market value" accounting is appropriate in some businesses, like investment banking and trading firms, when the market value of assets is readily ascertained and assets are liquid. However, it is inappropriate for long term investments in plant and equipment, a large part of Enron's business.  The market value of such assets are not readily ascertained, nor are they liquid.

The crazy accounting rules are those for the different accounting treatment of partnerships versus corporations. If corporation P (for "parent") owns 50% or more of corporation S (for "subsidiary"), then P's share of S's accounting results -- revenues, expenses, etc. -- must be combined with P's own. If corporation P owns at least 20% but less than 50% of corporation S, then P's share of S's accounting results must be reflected on an "equity basis" -- the investment in S is initially recorded at cost and thereafter adjusted to recognize P's share of the earnings or losses of S. However, corporation P and its principals can have up to near 97% interest in a partnership and ignore the partnership in P's accounting. All that's required is that 3% of the partnership be owned by an independent, unrelated, party. All those special purpose entities (SPE's) that Enron (Fastow, in particular) set up to shield losses and debt from Enron's books were partnerships.

It's happening around the world

Andrew Bates's picture

I read the book (don't have it with me now so don't expect names) but haven't seen the movie. I agree with your analysis that the leadership suffered from wishful thinking and short-sightedness. There were some good people at Enron but the culture forced the vast majority of them out long before the sh!t hit the fan and they got out with huge payouts due to the perverse incentives created by the company's remuneration scheme (which capitalised projected future profits for deal makers).

Australia is also suffering from too much environmental protection legislation, which in turn prevents development of power generation plants. It's happening all around the world - hydro destroys forests, farms and upstream townships; petrol, gas (supplies dwindling) and coal pollute and increase greenhouse gases; wind creates visual and aural pollution; nuclear is a terrorist target that creates harmful long term pollution; the environmentalists want man disempowered! That's one smart thing the Enron guys did - they saw that coming and took a long position in energy supplies before the tech boom took off and casued massive increases in electricity demand.

WRT to California, Enron played the system intelligently, maximising their profits through the strategies they took to the regulated pseudo-market, exploiting all it's flase aspects. PC makes the point that doing this was short-sighted (they bankrupted the state-owned local utilities who couldn't put retail prices up) but the people of California should not have expected the players in their pseudo-market to play nice. As the Enron people said at the time, the Greenie Californian hippies got what was coming to them.

In a way, they were ahead of the curve - by owning the major gas transmission lines they could see supply and demand imbalances as they were developing and engage in near-arbitrage profiteering. By developing the software trading platform, they became the counterparty to all transactions and were able to set the margins people traded at. In some ways, it's not that management didn't know how they were making money, it's that they didn't want the financial community to know. They started off doing power supply (high barriers to entry, low risk, low capital cost) and became a power trading company (speculation, volatility, conter-party risk, high capital cost) and then bought into their own BS.

Finally, another smart thing they did was the initial North Sea gas development - the former army commander who lead the generation deals was a highly competent visionary man who deserved his riches. As did the men who took their payouts and cheaply purchased a seemingly unimportant refining (?) plant on the Gulf of Mexico coast, turning a tens of millions purchase into a billion dollar listed company. 

Ayn Rand gets two smearing mentions in the book - one by way of mention of The Fountainhead being a mercenary trader's favourite book, the other being the likening of the attractive woman responsible for the Dahbohl Disaster to an Ayn Rand character - probably Dagny Taggart. Objectivists should emphasis the kudos-drive, short-sighted, wishful thinking of the former was in vast contrast with the character traits of Dagny Taggart.

One last thing - The Smartest Guys In The Room was written by a former IB analyst, now Fortuen journalist Beth McLean and a Washington Post (IIRC) journalist by the name of Elkind. It seems the latter journalist sponged off McLean's detailed research. You could spot two different writing styles in the book - the thorough explanation style being used when discussing the history and the nature of the problems, the sneering style being used when at times tenuous connections were being made to the Bush Administration. I am not a Bush-fan seeking to whitewash him and his mates but the book would have been better had it not had the latter.

Thanks PC

Tim S's picture

I didn't know there was a movie made of this. I've been looking forward to reading the book, but now I guess I'll have to see the movie as well.

The problems in the California market are similar to those New Zealand is facing - local council restrictions on land use, restrictions on peak prices, higher costs of coal-fired generation due to Kyoto and government ownership of most of the generation capacity in the country.

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