The Importance of Earning Interest ... i.e. Being Solvent

So Enron went belly-up a couple of years back and people were furious! I lost millions! This is all somebody else’s fault! Well, here’s a bit of throwaway introductory text from the early chapters of an accounting textbook I happened to be glancing at. I’ve highlighted a few choice words.

Intermediate Accounting 7th Canadian Edition (2005) Volume 1, Chapter I pp 5-6

Consider the much-publicized case of Enron. Enron was formed in 1985 through a merger, beginning life as a pipeline company. Its business changed over the years as energy wholesaling and trading overtook pipeline operations. Revenues grew exponentially to more than $100 billion (U.S.) and the company reported profits of just under $1 billion (U.S.) by 2000. Enron's shares were trading at over $80 (U.S.). All this came to an abrupt halt when the company declared bankruptcy in December 2001. Its shares were delisted by the New York Stock Exchange in January 2002. Since then, thousands of people have been affected by the fall of Enron, losing investments, jobs, and pensions.

Arthur Andersen, one of the top five public accounting firms in the world, was a direct casualty of the Enron bankruptcy, closing its offices later in 2002 after being convicted of obstructing justice in the ensuing government investigations. Credit rating agencies such as Moody's Investor Services and analysts came under scrutiny, the government wanting to know why the rating agencies had not been able to determine much earlier that Enron was overextended. Investment banks such as Citigroup and J.P. Morgan Chase were criticized for assisting Enron in setting up the very aggressive financing schemes that eventually led to its downfall.

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The Securities and Exchange Commission, although it collected the financial information from the company on a timely basis, failed to detect any problem. Finally, the investors and creditors invested their capital without really understanding what they were investing in. They did not really understand the significant risk that they were taking. Most of these stakeholders were overly keen on being involved with such a large, apparently successful company. They did not stop to ask whether Enron was just too good to be true. In hindsight, it was.

Anyone who is interested in investing his money, as opposed to giving it to someone else to steward as best he can, should be familiar with Ben Graham’s The Intelligent Investor. There is a case study in the book that would have induced anyone to take a hard look at selling his shares when they were at $80, long before the descent to Zero. Not because the shares were at $80, though this is a good point. Because the company expanded exponentially. Because it went through a phase of enormous growth coupled with extremely aggressive diversification, change of business focus, and undoubtedly acquisition. Such change can hardly be managed except by taking on extensive obligations -- usually debt disproportional to the growth’s ability to generate income. This alone should have been enough for serious warning. The fact that in 2000 earnings constitued less than 1% of total revenue could probably have been another clue.

Yes, the allure of cocktail party conversation makes people overly keen on being involved in large, apparently successful companies. It is much harder to be involved with miscellaneous unsexy actually successful companies. Definitely, shame on Citigroup, Chase, Moody’s, &c. But c’mon: anyone who was involved in the decision to own Enron securities within several years or more of the bankruptcy has only himself to blame.