February 2, 2006

WRTA

Brown Shoes Diary

Enron: The Untold Story

This past week the top two executives of the infamous Enron corporation have been brought to stand trial.  What crime are they charged with?  As best I can determine, these executives may have mis-led the markets about the financial soundness of their company.  Is that a criminal offense?  Apparently so.  Should it be a criminal offense?  Absolutely not.  Let's look at the economics of this.

First, for all their bellyaching and for all the play they've gotten on the national airwaves, the employees of Enron were not harmed by the reported fraud.  In fact, they were massively aided by it.  How is that possible?  Had the accountants done their job correctly and had executives not tried to flim-flam the marketplace, the employees would have been out of work two years earlier.  Thanks to Ken Lay (if he is guilty as charged), employees got two years worth of pay for doing nothing productive.

The other complaint from the employees was that all their retirement assets were in Enron stock.  I want to say to them, "Okay, you were idiots, why do you want to go public with that?"  Is it harsh to call these aggrieved workers idiots?  I don't think so.  Any sensible person who has a significant retirement portfolio makes sure his choice of assets reflect sound investment advice, which isn't expensive nor hard to come by.  Investing in the company one works for is usually an extremely foolish mistake and always a big gamble, because it leaves you very undiversified.  That is so because the wages a person earns (a person's human capital) and the value of his home is closely tied to the prospects of the company he works for and its local economy.  For example, an area in an economic downturn will have a lot of job losses and housing prices will go down.  So the smart thing to do with one's financial investments is to invest in companies outside of the local market.  If you don't, and instead invest in the company you work for, you're potentially headed for a very ugly trifecta: loss of job, loss of home value, and loss of financial wealth.  The prudent investor uses his financial choices to diversify his wealth away from his human capital and his real estate holdings.  Enron employees did exactly opposite.  Further, they did no research at all about their investment.  (They even admit to being clueless as to what was going on.)  When you buy a house, which is an asset a lot easier to understand than a stock, you contact a lawyer, you get title insurance, you hire a building inspector, you look at the neighborhood, you investigate the house's history, and you personally walk through it, probably several times.  Enron employees apparently didn't give their purchase of Enron stock any thought at all.  And I'm supposed to feel sorry for them?  I don't think so.

So the employees weren't hurt by the fraud at Enron and were very likely helped by it.  Maybe it was Enron's customers who were hurt by the fraud?  Hard to see how and none of them are complaining.  When you buy a good or service it matters not one whit to you about how it gets recorded on the seller's books.  We have to assume that those who dealt with Enron as customers got a fair deal or moved on to other suppliers.

So who was hurt by the alleged "cooking of the books"?  Answer: Shareholders.  Those who owned the company lost massive amounts of money due to the reported fraud of Enron's management.  Serves them right.  They hired the doofusses that created the house of cards, so they ought to, and did, bear the losses of this fraud.  That's justice in the world of capitalism--stockholders are the ultimate risk-bearers.  They reap success and they bear failure. That should be the end of the story.

The economic reality is this.  An advantage of a corporate form of ownership is the ability to raise a lot of capital through stock ownership. This advantage comes with a potential downside: the bigger the company gets, the more difficult it is for shareholders to monitor what management (their employees) is doing.  There are market mechanisms for dealing with this downside such as oversight by boards of directors, equity-based compensation of management, and discipline by institutional investors.  These mechanisms don't always work and that's a reality every stock owner ought to appreciate.  For us to now turn over the responsibility for corporate scrutiny from investors and the market to the government and prosecutors is to abandon capitalism for socialism.  That's always a bad trade.  We are all better off with the occasional Enron and WorldComm that pop up and are corrected in a self-regulating market than those massive nationwide economic failures so typical of Commieland. 

Contact John D McGinnis

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