Bear Left!

The Fall of the House of Enron
Tim Francis-Wright

The case of Enron is such an exemplar of the pitfalls of both deregulated utilities and privatized social security that is seems like fiction. Its greed was rapacious and its collapse catastrophic. The invisible hands of the stock market tempted Enron's managers to do whatever it took to move the stock price upward. Deregulation let them invest where and when and how they wanted. And the stock market loved the company. For a while.

Enron grew from a owner of a Texas gas pipeline to a multinational giant that traded electric power in California. It was building a huge pipeline in Latin America, and planned new power plants in India and China. It spun off, then reabsorbed a conglomerate of water utilities. It even started a market in telecommunications bandwidth. Less than two years ago, its market capitalization was over $100 billion. Harvard Business School admired the company and its growth so much that it published a case study about the company in March 2001.* Now, however, that market capitalization is effectively nil.

It turned out that many of Enron's profits were illusory, and that the company had liabilities that did not appear on its books. In September, its auditors forced it to move some of the liabilities back on its balance sheet (eating through $1.2 billion of shareholders' equity in the process). But its prospects fell to bleak, then to grave, as more and more hidden liabilities, many due to dealings with the firm's former chief financial officer, came to light. Its bond rating plummeted, causing its lenders to call their debts. By the first business day in December, Enron had filed for bankruptcy.

The Commission to Strengthen Social Security plans to propose, later this month, that some social security contributions go into the stock market. Up to 4 percent of the 12.4 percent of wages contributed by employers and employees would be eligible for the private accounts. These would be great for the scions of Wall Street, but could be far from beneficial for anyone who depends on Social Security.

During the 1990s, proponents of privatized social security accounts could point to the long-term and short-term success of the stock market. The smart money was in equities. Magazines, newspapers, and television shows all trumpeted the clarion call to invest in the surefire companies of the new economy. Near the end of the decade, almost any stock with an angle on the Internet showed a huge increase in value. Software companies, commercial web sites, Internet service providers, and fiber optic producers all made their stockholders rich, at least on paper.

But the great Internet bull market is now so much hamburger. Many of the companies that Wall Street touted so loudly and consistently are battered or insolvent. Some lucky investors made money by selling early. Many venture capitalists and executives who sold shares as part of initial public offerings got rich. But numerous investors, many of whom believed that Enron was a solid, blue-chip investment, got soaked. In Enron's case, among the losing investors were thousands of rank-and-file employees who had all of their retirement savings in Enron stock. In a bizarre juxtaposition of responsibility and reward, senior executives received stock options and grants that they could sell quickly, but most ordinary employees could not sell the stock that Enron contributed to their pension accounts until they reached age 54.

Retirement accounts with stock holdings are certainly not bad things. But Social Security is a program that is designed as a safety net, not just for old age pensions, but for disability and survivorship pensions as well. The guaranteed income that Social Security does and should promise allows citizens to take informed risks with the rest of their money. Ironically, hidden in the last tax bill amongst the benefits for millionaires were beneficial provisions for tax credits for low-income taxpayers who contributed to IRAs. Unfortunately, most low-income taxpayers do not contribute, out of a combination of ignorance and penury. A federal government that cared about the long-term health of Social Security and had faith in the equity markets might well leave Social Security alone and encourage private money in IRAs.

Investment firms, eager for the fees that they would earn for managing any new accounts, would welcome millions of small Social Security accounts. But their love for those investors necessarily stops with their account numbers. On the other hand, the federal government is responsible to its citizens, or at least to the voters.

Deregulating public utilities can be beneficial to all involved, if the regulations are holding back innovations that are beneficial to all parties. One good example was the deregulation of the long-distance telephone market. The barriers to entry to new companies became quite low, as fiber optics and other technologies made carrying calls between cities cheap. Even in a competitive environment, companies could be and indeed were profitable.

But in many industries, deregulation could be bad for consumers and some of the companies involved. Most utility companies have clamored for regulation, hoping to shed expensive parts of the production cycle, but also hoping to make more money. Unfortunately, everyone involved in most instances of regulation expects to make more money. Consumers expect lower rates. The old utilities expect more profits. And the buyers of their old assets expect a good return on their investment, too. Unless a technological revolution (like fiber optics) happens, someone is the loser.

In benign failures of deregulation, like the partial deregulation of local phone service, the costs are intangible. No one makes the money that they expected, and consumers do not pay any more than they did before. But the side effects are annoying: a proliferation of area codes, mostly because a new phone company in a town or city generally gets a new exchange and about 8,000 phone numbers, whether it needs them or not.

In worse failures of deregulation, at least one of the parties grievously miscalculates. In California, the deregulated power market rewarded power plant owners who withheld electricity until the prices on the spot market were astronomical. If the electric utilities paid the going rates, they lost huge amounts of money, and consumers later paid the bill. If they did not pay up, then part of the state would lose power.

There are two big problems with deregulating a commodity like electricity. First, an unfettered market does not care if the supply of a commodity forces prices above the levels of some consumers. Second, if the market becomes too powerful, it is expensive and time-consuming for new suppliers to enter the market. These two problems are the reason that public utilities exist, whether privately or publicly owned. Some commodities are too important to allow the market to determine their price. Accordingly, if private companies will provide it, they give up their ability to charge what the market will bear in exchange for a fairly sure guarantee of a fair profit.

The federal government, with bipartisan support, has intervened with a vengeance in American commerce in the past few months. Shortly after the terrorist attacks on 11 September, the federal government provided loan guarantees and cash to several airlines, and began debating the best way to support an ailing insurance industry. The collapse of a Wall Street darling like Enron shows that even the companies involved in deregulation do not always act wisely. It also shows that what amounts to a sure thing on Wall Street on one day is a sucker's bet on the next.

*The details of this product on the HBS website now merely state "No such product, sorry." Who said irony was dead?