View Full Version : The Enron truth, very long but worth reading

01-21-2002, 11:46 PM
I have gotten sick and tired of every columnist and politician trying to make hay out of Enron when most have NO CLUE what happened in it. Ask them what happened and they tell you two things. 1. Some execs got rich selling stock as it fell. 2. Auditors shredded evidence. End of story. Do these fools even understand what exactly happened? Well for those that have wondered and want to truly learn lessons for the future, then I will go about it here. It takes awhile to explain and there are probably points that I missed because quite frankly, I don't read much about. This comes from my business/accounting experience and reading a few people's reports that I do trust. Don't trust what a columnist writes, they just want to call everyone greedy and blame someone. None of them blame the true final culprit and that is the MARKET! The market decided Enron's stock is worthless and they are the ones that "absconded" off with most of people's retirement funds, not executives. So here goes:

1. Off-Balance Sheet financing

Sounds sinister, but its not. In fact its legal and quite a few companies do it. Here is how it works. Say you are a company and want a loan. If you are like most companies your two most valuable assets are your inventory and your accounts receivable. Plant and equipment is tailored to your business so its not worth as much, but current inventory is generally easily salable (at a discount) and of course A/R is cash. So what you do is line up a loan against these two iteams. In the case of receivables what you do is create another company, the sinister off-balance sheet devil. This second company exists solely to handle this loan or line of credit, nothing more. The reason for it is that this is your collateral. Should you default on the loan, your creditor immediately takes possesion of this company and in that way collects because all A/R payments that are pledged are supposed to be paid through this second company. As long as the loan is in good standing, you get the proceeds. Second it goes bad, the creditor gets it and hopefully for him recovers what you owe him. Simple enough. Enron did this on a massive scale. Reason why has nothing to do with why most companies borrow money. The reason Enron took these loans is so they could be a market. Being a market in this case is fairly simple. Enron would have a customer call and say I need 1,000 watts of energy (simplistic example) in El Paso. Enron has a source willing to sell 1,000 watts of energy to deliver in Dallas. Enron makes a deal to get energy from Dallas to El Paso on its lines or it pays someone for the right to use its lines. Thing is Enron has to pay for the energy and the line use up front and the customer won't pay until the energy gets to them. This time of float is what requires the loans. Enron needs to borrow lots of money for this float simply because this is the nature of its business and no company keeps the kind of cash on hand that they would have needed to cover the float themselves. So these myriad of off-balance sheet loans were just a business need of any market maker. NYSE and NASDAQ are in a similar boat, except their rules are you have to settle the funds at the same time for both sides. They don't have float, but are insured for it by bank loans that they generally don't have to tap. Enron did have to tap theirs on a regular basis. So what happened? Well Enron was following accounting principles because these types of companies they set up are not supposed to be included in your financial statements. Why? Because they don't really control them. GAAP dictates that the true control of these companies wasn't in Enron's hands even though it involved their assets. Enron couldn't make any decisions for these companies, that was in the hands of others. What did become a bit messy is that Andrew Fastow, their former CFO was lazy and just made himself the chief of a lot of these "companies" because its a perfectly legal activity, it just doesn't look so clean. They could have hired independent people to "run" them (not much has to be done to run them), but that costs money and is an extra layer of work. So far so good, everything is completely normal and there are thousands of these around with even the most reliable companies using them because interest rates are very low when you secure a steady stream of A/R and only borrow say 50% of the value of it.

2. Credit agencies

These are some real culprits here, yet no one blames them. They are in the dark about all this because everything is legally done and Enron doesn't feel its that necessary to tell the world that they have these very short term and secured loans out there that are being regularly used, yet really aren't a major risk. After all Enron is dealing with tons of customers. They didn't have exposure risk to any particular customer, just they were functioning as a market which required very short term borrowing. Well the ratings agencies saw it differently. To them a loan is a loan, hell a line of credit is like a fully utilized loan. They freaked when they reviewed all the loans Enron had and downgraded their credit ratings quickly. This causes a big problem. When you are a market maker, you almost have to have perfect credit. Reason why is others could do what you do, just not as extensively or efficietly as you. If you have less than perfect credit you might not get loans (Enron lost some of its credit outright) or you have to pay higher fees for your loans which crimp your market maker margin so much that someone else could do your job cheaper. So what starts happening is Enron loses its competitiveness. Worse yet they made business plans with a high rating and that means they reserved capacity for transporting whatever they sold in their markets that is now idle because someone else can do it cheaper or they have to charge a price high enough that their customers don't buy the product. Losing business just makes things worse and worse. People stop coming to Enron first and for the customers they do still get they are getting squeezed worse on the float because they want to deal only in upfront cash, not loan guarantees or anything less than cash in the bank. The company then quickly sees almost all its businesses evaporate and there isn't a thing they can do about it. They have almost no business in their market and of course the stock is tanking. So when you look on it, the people Enron really needed to inform better were the credit rating agencies, not really Wall St.

3. The investigation

This is the biggest crock of them all. Money is lost and everyone looks for a way to blame and maybe get it back. Well damn someone had to be responsible. Notice no one every raised a finger at the credit agencies? They have very stiff numbers and rules and they rarely relax them even if there is clear supporting evidence that the loans aren't truly overextending a company. If Enron was taking its loans and spending it stupidly that would be one thing, but there was no evidence of that. Sure some execs made money in the market, but thats market money, not Enron money. Politicians and the media seem to forget the market is the market. That is people deciding what businesses are worth and in no way implies what money a company is or isn't making. Enron was making plenty of money up to the point of implosion. I saw a columnist say "well their margins were going down, that should have been a sign". Listen you idiot, their margins could have been going down for a hundred reasons, the main reason was that they were doing what all companies do, they were sacrificing margin to build new markets and gain future market share. Its beyond me how someone who is supposedly such an expert will now crucify what is a pretty standard business practice for almost all growth companies. And these are the people the media and politicans listen to!

4. The shredding

Granted this whole incident looked really bad. We all will want to know what went on here. No doubt in my mind what happened. You have to remember audit firms aren't like regular companies, they are limited partnership. This particular partner probably saved himself a ton of money. You see he lost his job and its earnings, but what must have been in that paperwork was so damning it probably saved him a lot more money. If the firm had a judgement against it of a large amount, the partners would have had to pony up the money, this guy included. What I would guess was in the shredded papers was evidence that Arthur Andersen reviewed or even discussed the whole off-balance sheet numbers. I really don't think much came out of the whole auditor/consultant deal, I just think they saw what the credit agencies saw. Auditors would talk about it and say "well it looks terrible, but you know that is how GAAP tells you to do it." Someone does an analysis and sees how bad their ratios are and presents it, but in the end they sign off on it because its technically correct. All this paperwork could have been a bonanza for a lawsuit and the partner knows it. He chooses to attempt to save his ass and that of his fellow partners and takes one for the team so to speak. AA people might still testify with damning evidence in the future, but nothing can be as damning as paperwork that said that the company had a huge loan exposure, no matter what its true reason. My mother said her boss in the past faced a similar situation and was smarter about it. What he did was gave the papers to his attorney before a court order for them came. Then they are under client-attorney priviledge and unobtainable! This partner with a clear head should have done that, but hey he faced a lot of pressure and didn't think it all through.

5. The aftermath

Undoubtedly these politicians will see to it that laws are passed, unnecessarily I might add. What are they going to do, make it illegal for a stock to go down? Tell credit agencies how to grade companies? Tell people they can't have off-balance sheet companies for simple loan purposes like this? Worst of all, tell auditors they can't ever consult for a company? Government needs to stay out of business here. I don't want to hear another politico telling us "well government has to have compassion for the people that lost their money". Sure its bad, but for every person that lost their retirement at Enron there must be 500 that got rich on such retirement plans at other companies before! Maybe you should make those people give some of their wealth back to the unlucky at Enron??? If anything else, I want all those reading this to agree with me that government has no business in this at all. Its a market occurence, not something that legislation could ever do anything about. All it will do is screw things up in the future. Investing will always have risks, but we run bigger risks with government in control of anything related to these issues. Imagine the dangers if government, not the industry or the market dictated accounting rules. That would be corruption and special interest city! Every time high tech was having bad quarters, they would just go ask their senators to pass a ruling or approve a friendly regulator that would make a ruling to improve their numbers. What a frickin mess that would be, yet I hear a lot of people on TV clamoring for government oversight of accounting. Unbelieveable, I hope they all look past that because that would be the real tragedy of this whole incident. I feel something for those that lost their savings, but nothing illegal happened here and to have 8 committees reviewing everything and have talking heads everywhere trying to get their piece out of it does no good whatsoever.

I leave with this last thought. People act like Enron was a no good for nothing. How about the profits they did make for people in the stock during its rise? How about the value of the innovation they brought, the idea of markets for more than just stocks? How about the efficiencies they brought to many ancilliary companies? Enron may not have had a happy ending, but people are looking far past its contribution to the economy while it was going. It was truly a one-of-a-kind company and it brought to light many ideas that people and other companies will benefit from for a very long time.

01-22-2002, 08:59 AM
You get a really tidy tell into how most people think when you hear news anchors and politicians saying how Enron should have warned employees, so that way "everybody" could have gotten out before the stock went down.

Gotten out by selling to whom, Martians?

If the Enron employees had decided to sell (which they never would have, believe me, I worked at Intel, and these people's religion is to double up on dips), then the scandal would have been "Greedy Enron Texas Oil Employees use insider trading to dump stock on unwary public" - or something.

On a different note, one day I was in a commodity office where they provided customers with chairs and screens. A new customer was fretting over one of his first charts. One moment he wanted to go long - wait - now it looks like it's going to go down! A lightbulb finally lit up above his head, and he asked the broker, hey, how about if I buy one and sell one at the same time!?

Human optimism is interesting to see how he could picture the ticket he had sold making a profit when the market went down, and he could picture the buy ticket showing a profit when the market went up, but he conveniently overlooked how the other ticket would lose exactly the same amount. This story really happened, by the way, and it pretty well explains why women all over the country (and 90% of all women are disappointed in their own husbands) would vote for Bill Clinton to take care of their children for them.

Oh, by the way Wild Bill, no laws will be passed, at least not any laws that matter. It will be like the airline security bill, where all this and that is called for to make politicians look good on TV, but hardly any of it ever will or even could realistically be implemented. It's like campaign finance reform, totally unconstitutional, Supreme Court has called it DOA. This is not about changing laws - they could care less about some accountant somewhere or protecting "the little guy" - it's about throwing the kitchen sink at George W in time for mid-term elections.

And if anything sticks, the only real law that will change is your taxes will go up. But so far as government screwing up business, remember it was actually poilitical "free market" arrogance on the Republican side that screwed up the stock market with decimalization and Rule Whatchamacallit (numbers - 314? 421? - the letter "A") in Nasdaq stocks.


P.S. I predicted some serious ruin of energy counterparties in the fall of 1999, and many times since - as I had long predicted all companies who touch half-baked new electronic marketplaces, as they are currently being structured, would get burned - after reading this article in Forbes:


(name: eLROY password: eLROY, the article is entitled "Web Powerhouse" and talks about Altra Energy)

Most "cutting-edge" electronic marketplaces are designed by the buy-one-sell-one-at-the-same-time crowd in one form or another. They miss the entire point of a marketplace, not order matching once supply and demand are already fixed, but non-redundant information/capacity/inventory/consumption coordination. But that's just the point: You can't "design" marketplaces, and nobody understands them.

01-22-2002, 12:36 PM
Hi wildbill,

I enjoyed reading your ENE commentary.

Sadly, I agree that this will not be the position that bubblevision, or the politicos will put forth.

Since ENE spread so many $$$ around to each party, we'll most likely see a lot of smoke and mirrors, and little else. I do hope eLROY is incorrect, but if there is a way to get more money to Washington, he may be right.

Here's a line from the Daily Reckoning that might fit:

"Investors don't get what they expect, but what they deserve"...B. Bonner

Steve B

01-22-2002, 02:34 PM
Good post. I still think having a 60% Enron allocation in the 401k plan was criminal though. Granted, many of the employees would have ruined themselves anyways buying Enron stock outside of their 401k, but you shouldn't help them along that path.

01-22-2002, 02:39 PM
Employees of Enron had to have known that by investing whatever portion of their salaries into a 401k that buys their own companies' stock, they were taking a risk. In gamblers terms, they may have been increasing their expectation, but by investing in an area so heavily (they were employees as well as share-holders) they are also increasing their variance. No commentators ever mention that the reward for getting "free" money (the matching funds in 401k's) the people were accepting a higher risk.

The value did not dissapear as it would have in a natural disaster or something; for every person that lost a dollar in their plan, someone else (who sold a little earlier) made a dollar.

Did not the employees of Enron have the ability to hedge their risk by buying put options in Enron? Where no such options traded?

01-22-2002, 03:17 PM
Interesting, but...

...if having those credit lines was so fundamentally important to this company's business model, and if those lines could be pulled up so quickly and easily (for what I think you claim are inappropriate reasons) then this is exactly the sort of information that should be made available (in screaming boldface, no less) to investors, isn't it?

01-22-2002, 04:38 PM
Well they might have done just that, however that is the way of the business world today isn't it? Since when do you hear a CEO or CFO say "well we had a great quarter, but you know if everyone stops buying our stuff our credit will be shot and our business model sucks." I don't think Enron had any reason to think this would have happened because quite frankly bankers sell this model all the time and its never happened before. In the future it obviously will be watched and people will take note of it, however that doesn't make it right. All credit is not equal and I think the credit agencies went out of their way to shut this company down. This is the nature of "bond guys". They always act like the 100 year storm is a once every 3 month thing. After all it would take something like every natural gas company in the country to say "I ain't paying another bill" for Enron to have truly been at risk. The end result of all this is that every one of us will be paying for it in a less efficient energy marketplace. Enron set up a nice market like EBay where just about everyone came to do business. Now energy companies have to go back to the terrible inefficient old ways of calling everyone up and buying insanely inefficient long-term contracts just in case there isn't a market functioning when they precisely need it. Look what CA did, they are paying 300% more (on average) than they need to for their electricity because they felt like the market wasn't efficient enough to insure they could keep enough supply going. Sure someone (energy companies) are benefitting, but that middleman is someone getting fat at the expense of the whole world because CA companies are truly global players and what affects them affects economies worldwide.

01-22-2002, 05:01 PM
can only comment on one aspect of this, shredding:

most plaintiffs' attorneys prefer proof of the intentional destruction of evidence to the actual "smoking gun." I assume the partner at AA conducted some sort of cost benefit analysis before cranking up the shredder, but it is probably as stupid a move as there is. The plaintiff probably is entitled to have a jury draw the most adverse possible inference as to what was containded in the documents as a minimum remedy for their intentional destruction. plus, it probably guarantees a punitive damage award. if the subpoena was issued, he could do time.

Finally, you can't create a privilege by giving a document to an atty. If it was prepared at the request of the atty, to communicate with the atty, it is probably privileged. if it is a regular business record, it is not privileged (as atty-client) and possession of the document as no bearing on the question.


01-22-2002, 05:22 PM
I'm a little disappointed that you would call long-term contracts inefficient, and so quickly assume that new electronic marketplaces are better than old ones, and that people will always, by some magic, know in advance what the demand for natural gas will be at some moment in the future.

The reason EBay works is because nobody bases a production decision on it. It simply reallocates out-of-production products - for which the supply is already fixed - to whomever has the greatest utility for them. But you cannot run a production-based marketplace without time-axis visibility and non-redundant coordination - usually created by middlemen and friction.

It is no coincidence that the Nasdaq marketplace became, like EBay, a junk warehouse. You can either A) trust me on this, B) continue to be wrong, or C) delve into some of the many hundreds of essays I have written in an attempt to save people from such foolish thinking.

Can you imagine, Jay Walker consciously built a marketplace for unsellable airline seats? What kind of an efficient world does that forebode? Or, I remember when one of these online semiconductor auction marketplaces advertised like over 6 million items listed. Meaning, 6 million pieces of garbage that were manufactured at a cost greater than the price where they were offered, and still couldn't sell.

People don't know the meaning of "liquidity" - it's a dance, not an abundant junkheap - and some are even still suckers for this failed-every-time theory of "critical mass." The last thing you want is unsatisfied limit orders, and the only reason many-to-many physical exhanges for unplanned counterparties such as the CME emerged spontaneously throughout history is because of geographic and economic friction, and basically in order to bleed off malcoordination.


01-22-2002, 09:48 PM
On the A-C privilege:

"My mother said her boss in the past faced a similar situation and was smarter about it. What he did was gave the papers to his attorney before a court order for them came. Then they are under client-attorney priviledge and unobtainable!"

Doesn't work that way. The privilege protects attorney-client communications, not other documents the client wants to hide. (One way of enlarging the scope of the privilege, however, is to involve the attorneys at the outset. Still, if the information is communicated to an outsider the privilege is blown, and courts have been known to see through the scam, as the tobacco companies learned).

The document destruction is incredibly damning as it gives rise to additional criminal and contempt liability and can create a presumption in favor of what the other side would otherwise have to prove. It's even more alarming given the recent stories from insiders claiming that it was going on after proceedings had begun, even after court orders had been entered prohibiting it. It's the sort of thing that happens when people are either very unsophisticated or worried about something worse than mere financial ruin.

01-23-2002, 12:00 AM
If Enron was actually providing a valuable service - making the market more efficient and therefore their counterparties richer - then why couldn't they get a single silver dime for their trading operation?

It's amazing, a cancer that was probably eating away at everything around it finally dies, and somebody is saying it will be missed?

Facts are, electronic marketplaces are surrounded by Darwinian business death.

Good riddance.


P.S. If someone still buys the line that Enron was doing something useful, I'm sure you could get all the stock you want for under $5.00. What a bargain! Name for me the company whose profits have risen thanks to new supply-chain management technology? Odd coincidence is, most of these big companies like Cisco were very profitable only a few years back! Did some meteorite fall out of the sky and hit them, did some disease rise up from the bottom of the ocean? No, a bad economy is nothing more than the sum of a zillion individual bad decisions made by a zillion different individual actors. The badness originates within the companies, not externally. Every company that has lost money in the last year could have made money if they had made the correct inventory and capacity decisions in time. To blame it on a "bad economy" is simply to say their predictions were wrong. They all blew it!

01-23-2002, 12:55 AM
Not getting any cash up front from UBS doesn't necessarily mean the trading operation is worthless. Presumably, UBS can come up with an up front cash only equivalent to its winning bid (no cash up front, paying 33% of pretax profit to Enron and its creditors).

01-23-2002, 01:02 AM
They actually got a pretty good amount of money for their trading business because the trading business had nothing to do with the business that brought them under. I greatly disagree with your assertions because many companies are in dire need of a market right now. They are calling businesses everywhere asking if they can get ready access to the things Enron made a market in. At some point this marketplace will be created again, it just probably will be a consortium of businesses and that will never work as well. And Enron's market was exactly like EBay's. It was a ready source for additional capacity. Enron never put up a market to serve as the primary source for its buyers and sellers, its where you put out and bought excess capacity when it was needed. If your users were using a lot of energy, you could go to Enron's spot market and buy exactly what you needed. If you had a web presentation to make once a quarter you bought the bandwith capacity for just the time you needed it instead of having to pay for a constant connection which mostly went unused (those that had these sold their extra capacity to Enron).

Then again the only thing that made the trading business good to be purchased is that you would get the "talent" that was in it. The trading business has no inherent value in itself, its simply the knowledge and experience of its people. The people could have easily jumped ship and many did. Reason why enough stayed to make it a "product" to sell is there aren't exactly a boatload of jobs for energy market sellers or buyers.

The contracts are inefficient because CA bought them under duress when everyone knew they were overpaying. They did it only because their energy policy mavens and governor are absolute idiots. All the money and supposed expertise they had and its clear to someone with even little energy market experience that these guys were fools and letting everyone push them around. Their response? We're gonna sue everyone that screwed us while we walked around with our butts in the air!!! CA to this day has no clue how to supply its residents with energy and those contracts are just a sorry legacy of it. Best part of all this is Enron isn't around for Gray Davis to sue anymore, who is he gonna blame now???

01-23-2002, 01:11 AM
Well I will be the first to admit I don't know the specifics of A-C privilege, only what I was told. I do know however without a doubt that is exactly what was going through the partner's mind. There is no other reason for him to do it. Problem is that there are two standards here. There is the accounting standards and then there are the jury standards. Accounting standards might have said no misdeeds were done, but a jury might ignore that standard and drive AA into bankruptcy with one judgement. I am fairly convinced that the partner saved a lot of money because even with the worst possible assumption, its still not the same as something that documents that AA figured out the level of these loans and discussed the matter and then decided not to force a disclosure. The attorneys would say "AA knew something could come about and didn't and after that an $90 stock went down the tubes to zero"...take them for everything they are worth! Instead it will be "AA should have known about it and might have prevented this from happening"...big big difference.

01-23-2002, 05:05 AM
I see two factors that make it likey that the AA partner ordered the shredding in a panic, and created a bigger problem. First, did he successfully destroy the damning material? I am no expert on the destruction of information, but I do know I would never feel secure that it was done correctly without obtaining expert advice. There are mirror files saved on hard drives, back up, unaccounted for copies, underlings' cya files at home, etc. Unless he had an advance plan to destroy key documents, it is my guess the "goods" are still out there.

Second, he has probably now totally ruined any chance for a successful defense of the malpractice, fraud, misrepresentation cases that are heading AA's way. I understand your point (and it is a good one) that a jury might not ultimately care about whether AA met the professional standard of care for accountants, but that ship set sail when he destroyed the documents. Instead of that being the debate point, plaintiffs' counsel can now create their own memos and blow them up (even put them on AA letterhead) and cross examine the partner saying:

"Didn't you write that you told Enron to misstate its earnings ?." "It was your idea to lie to the public?" "You intentionally did not follow GAAP?" "You instructed the Enron accounting team to change the numbers?" The protest that these questions are absurd is no longer valid. Indeed, a judge could instruct a jury that this is what the destroyed documents said.

Also, even if there was an adverse verdict soley because the jury ignored the standard of care for accountants, AA has probably lost the protection of having a judge correct the jury error. Finally, they may have lost the right to discharge civil liability verdicts in bankruptcy because of the intentional destruction of the documents.

At the same time, none of this should be news to a high level professional at a company with a document retention policy.


01-23-2002, 05:52 AM
It's a shame good economists fall for these kind of traps.

Suppose I am making $50,000.00 a year, and I am happy. Then, one day I learn that my neighbor makes $60,000.00 a year, and suddenly I am unhappy. Am I now making -$10,000.00 a year, am I taking a loss?? (That's what Democrats hope their constituents believe!)

If California, in July 2000, buys 290 megawatts of electricity for July 2002 delivery for $3.40, it is useful for them

1) to have 290 megawatts of electricity in July 2002 for $3.50, and

2) to know in July 2000 that they will have enough electricity in 2002, and how much they will pay for it.

To say that because 2 years later, third party Jose buys 1 megawatt of electricity from fourth party Juan for $2.50 does not mean that Califronia suddenly took a $290.00 loss! More likely, if both California AND Juan had shown up out of the blue demanding a total of 291 megawatts on the spot in July 2002, prices would have been $11.00! Moreover, CA would have scaled back to 190 megawatts just to get those prices!

So, when you say "Look what CA did, they are paying 300% more (on average) than they need to," that is utterly stupid and meaningless, it REALLY is. What do you mean "Than they need to?" Are producers supposed to somehow know exactly how much California will need, and then produce too much so that it will be a buyers' market? Are CA state employees supposed to be clairvoyant and know producers will squander resources producing too much electricity when other things are needed?

This sort of thinking is utterly perilous, as we have seen, and is what drives novice traders nuts in the commodity markets (as well as people who lay down the winner in poker - if only they could have known what their opponent really held!). Sure, "everybody" knew CA was paying too much, and they "could have" paid less in some parallel, superior universe, but not in this one. In reality, prices are cheapest when demand for alternaitve goods is transmitted from producers to consumers as far in advance as possible.

And this idea that producers would have all this glut just sitting in limit orderrs in the spot market, for people to pick and choose from or not, is economically disastrous as I said!

Counting on "linearity" in demand like Cisco did is sure death! The availability of contracts from producers with unknown counterparties at the time of delivery is proof of malcoordination. Moreover, with low friction to reallocate capacity, producers will respond to spot price signals redundantly and, with a time lag until their decisions become reflected in the price, it will start to oscillate in a series of gluts and shortages (as we have seen), you dolts!

Finally, I think Paul made an error in another thread when he seemed to imply that a guaranteed $1.00 is worth more than a 50/50 chance of .50 or $1.50, not because of declining wealth-utility curves, but because of asymmetric utility or something. The reason a 50/50 chance of 50 cents or $1.50 is worth only, say, 95 cents, is because information is useful in time to be able to do something with it.

Suppose you don't know whether you will make zero or two million dollars next year. And suppose you want to live in a million-dollar home. If you don't buy it becasue you don't know, and you make two million you will have wasted a year living in a hovel needlessly. If you buy the million-dollar home even though you don't know, and you end up making zero, you've got problems. It would be MUCH more useful to make a million and know you will in advance.

Finally, the main problem with low-friction electronic marketplaces is that they cause consumers not to deliver orders to middlemen at a price which reflects how much they would be willing to pay for how much - which middlemen can then reflect to producers - but rather consumers reflect to middlemen how much they think they can get away with paying. With both producers and consumers tranmsmitting not their own conditions to middlemen, but merely reflecting back to middlemen a historic, lagging, or redundant idea of what exists at the other end, nobody gets any useful coordination information.

If, instead, producers and consumers are forced to reveal their entire supply and demand curves to middlemen in advance, so that middlemen can pick them off and eat the entire overlap or "economic surplus," consumers will buy all they can carry every time and plan activities around this "cheap" price, producers will sell all they have every time, and in a very short period of time both ends will evolve to produce exexctly the amount where the middleman makes zero. The middleman will only make a dime if they are malcoordinated. Of course, to someone who overlooks the information-tranmission role of the middleman - like the idiot commodities customer who overlooked the offsetting profits and losses of his offsetting contracts - the middleman will appear to be a worthless parasite, as in the eyes of Hitler. I discuss this somewhat in this thread:



The entire gosh-darn economy is built on limit orders that get picked off, by which I mean reliable, advance information held by a party about what he can expect another party to have or want or need or do. Just because the second party can now figure out a way to make money because he knows what to expect of the first party - and the first party cannot now adjust the terms once he finds out how much the second party is making - does not mean the first party took a loss!

Moreover, if the first party sets a price and quantity which do not reflect his own needs, but rather reflect the killing he thinks the second party is making, but the second party takes this to reflect the first party's needs, and then reflects them back to him as the first party is doing, they both end up making nonsense decisions, and sending nonsense signals back up and down the chain!


P.S. I have an old parable I wrote that illustrates these problems a little more simply and, if I can dig it up off a blown harddrive, or find a copy somewhere else, maybe I'll post it!

01-23-2002, 06:12 AM
Okay, I haven't dug up the parable yet, but there is a point in it I really think is important to make.

In the parable, there is a middleman on horseback or something, traveling between the cities of the old Northeast - like Philadelphia - supplying people with coffee, I think.

Anyway, the point is, he chooses which city to ride to based on what he knows about the competing demand for wholesale coffee from taverns at various crossroads. Suppose one day he shows up and, even though you could make a profit in your tavern paying up to $5.00 a pound for coffee, you offer him only $3.00 a pound because you suspect that he has enough "extra" that he is willing to sell that low.

Next thing, he is riding off to the docks, and paying only $2.00 a pound to re-stock up on coffee, having gotten burned last time. Then the ship sails back to South America, and the coffee growers plant less coffee and lay off field laborers. Then the middleman comes back in a few months with only half as much coffee, because he is a greedy bastard, and hates getting burned by sly tavern owners.

And you know what? He doesn't even ride to your town, he rides to the next town, and sells all his coffee to a guy he has learned from experience is willing to pay $4.00. So now all your $3.00 coffee is gone and, you know what? Now you've got jack, you're not selling coffee at amy price, and so people are going elsewhere to buy their biscuits.

Because, so far as the field laborers in South America could tell, people in your town don't like coffee that much!

Of course, you don't have this problem on Ebay, because nobody is making anything, nobody is responding to a series of price events along the time axis.

The other 10 billion economists in this world - meaning everybody apart from me - really should get a clue.


01-23-2002, 06:26 AM
How can CA lose money buying electricity? After all, they can always sue the energy companies, and tax their profits, to recoup any money.

Moreover, when the energy companies all shutter and leave CA becasue of this, Gray Davis pays no price for it personally, in fact he twists it to his advantage somehow in the political arena.

So to say the guy making the decision - Gray Davis - is an idiot, when he has set up a win-win situation for himself, and he knows from experience that the CA voter will swallow anything, is pretty half-baked of you.

Or, if you're simply saying that the voter is an idiot, well tell it to the wind. Everybody is an idiot when he arrogantly tries to foresee the consequences of his decisons in an open system which extends beyond his own doorstep. And the voter is in reality no dumber than the average idiot who envisions an "Ebay for energy."

It's just a product of removing people from any remote feedback from the consequences of their decisions. It is this very removal which enables some random third party to speculate, on the Internet, that an unspoken-for glut of energy on the spot market - or anything Enron did - was useful. For the people whom Enron did have some direct impact on, it was all useless, there simply must not have been that positive sum all around.

Of course, any time the fish busts and leaves the table, there's going to be a moment of sad reflection.


01-23-2002, 06:48 AM
Why do people go to such great lengths to run and hide from this simple fact?

Why do they go broke over and over?

Why do they keep insisting it works, why do they choose to believe there is some Garden of Eden where there is both excess supply and demand, avaiable from a bottomless pit on short notice, and as many people as go broke thinking this?

In reality, there is nothing in this world except for what we choose for there to be and not to be by advance planning, and what information is directed to what individuals to make what plans under what cost of being wrong is the only criteria by which any marketplace mechanism can be judged.

If there would be one thing I could do before I die, it would be to eradicate this fantasy from otherwise smart people's heads!

Pure order-matching facilities are collectively neagtive utility, even if they may create a set of incentives which presents isolated utility to individuals in a negative-sum game, as well as the general illusion of utility! Once opposite haves and needs exist in nature, matching them off somehow is inescapable, you simply can't go wrong.

Of course it would be useful to every individual to never give up any information or lock into anything, and only pick off from the rest of the world like some fruit tree. But if you fulfill that fantasy for every individual, the world falls apart.

There is simply nothing that can be produced "on the spot," the laws of physics prohibit it (except maybe sunlight or something). And any market which encourages this, and reflects to anyone that something can be sold on the spot, and to consumers who then reflect back to producers that they want to buy on the spot, is DOOMED. It promotes a Darwinian system of survival by malcoordination, which inevitably collapses under its own weight.

It's like a maybe a year ago, some semiconductor company reported order texture was shifting from "leads" to "turns" - and yet they expected a stabilzation in business conditions!? But nothing can enable "spot" business, new technology only creates the illusion you can, since idiots assumed primitive friction was the only thing holding us back from raditiating the entire planet, like one giant atom bomb/free lunch.

So while people are chasing the illusion of spotness, the coordination information which causes things to exist gets lost in the shuffle.

Am I getting through here?


01-23-2002, 06:55 AM

01-23-2002, 07:05 AM

01-23-2002, 07:21 AM
I worked at a company where there was an employee stock purchase plan where we could allocate some of our salary to buying stock and we would get it at a 15% discount. we were also given options as part of bonus etc.

There was a rule that we were not allowed to short our company or by puts against it. An obvious conflict of interests would arrise if employees were short their own company. See why?

Well I also know a guy who worked at amazon who faced this same problem. He had a lot of stock options that hadn't vested but wanted to hedge against a decline in stock price. So be bought puts of correlated stocks. Like eBay and Buy.Com. He ended up making more money on the puts he had in 2000 than his stock options were ever worth. seem like a pretty clever way to hedge against a whole market decline.


01-23-2002, 08:02 AM
For people who are unfamiliar with economics, an instructive thing to understand is how Bill Clinton releasing oil from the Strategic Petroleum Reserve actually caused the price of oil to rise! And it caused the consumers of oil to get hurt. Why?

Because a momentary price dip (not "linear" in Cisco terms, and not a "trend" in my terms) to consumers of energy, creates the impression - Darwinistically - that more oil is available than actually is. Somewhere, some farm that is slightly more machinery intensive, and slightly less labor intensive, will get the last loan from the local Farmers' Bank while, for his more labor-intensive neighbor, the fraction of a cent less per bushel that he gets in the apple futures market will be the straw that broke the camel's back.

Meanwhile, some oil-rig contractor somewhere will forego raising money in the bond market to build rigs because, according to immediate prices - and he is no speculator - his wells would be marginal. So, a month after the oil from the SPR hits the market, demand will be greater, and supply will be less, than what it otherwise would have been had the SPR not been tapped.

So there is a short-term positive - in that we get to butn a little more oil than we otherwise woudl have - but tehre is also a longer-term negative - to the extent the false price signal about invisible supply-and-demand consitions threw the enitre system-wide coordination out of wack and set it oscillating.

In a world ever everyone evolves together to dance in the dark, some dumb politician throwing shocks into the system - or masking shocks that reflect true conditions - only makes things harder.

And if Enron was designed to be a clearinghouse for such missteps, well, it's no surprise their greatest designs yielded nothing more than smoke and mirrors. Who knows what silly illusion the executives got suckered by.


01-23-2002, 12:56 PM
*** Suppose I am making $50,000.00 a year, and I am happy. Then, one day I learn that my neighbor makes $60,000.00 a year, and suddenly I am unhappy. Am I now making -$10,000.00 a year, am I taking a loss?? (That's what Democrats hope their constituents believe!) ***


*** Finally, I think Paul made an error in another thread when he seemed to imply that a guaranteed $1.00 is worth more than a 50/50 chance of .50 or $1.50, not because of declining wealth-utility curves, but because of asymmetric utility or something. The reason a 50/50 chance of 50 cents or $1.50 is worth only, say, 95 cents, is because information is useful in time to be able to do something with it. ***

Miss. I recall someone else writing that. A partial summary of something I did write is that guaranteed outcomes can be leveraged more than chance outcomes. This has nothing to do with utility. It has to do with the fact that a prudent bookie is not going to let you bet bigger than he knows he can collect.

01-23-2002, 01:42 PM
here is the link-


01-24-2002, 01:19 AM
Ok, fair enough. Problem is that no one proved Enron was losing money on this spot market until the credit ratings dropped. They made plenty of money, albeit on a faulty premise. There is a reason to be a market maker here problem is that there might not be a way to do it without being a consortium of companies. Spot market or not, there is a value here Leroy and it was proved by the number and depth of the players that came to this market. Maybe the people in it were fools, but the fools all proved there was a heavily liquid and watched marketplace and the managers made mistakes in their decisions that had nothing to do with the market itself. Its a good lesson for all managers to re-evaluate your basic assumptions because that is where this fell apart. And its even more important to show what opportunistic idiots are out there trying to make hay on anything they can reach for, especially when they get to operate under the cloak of something few truly understand.

01-24-2002, 01:25 AM
What I love best about the news idiots these days is that they are interviewing people saying that Enron was shredding documents! Horror of all horrors, how dare a company that's "secrets" (value them whatever you want) are now going to be carelessly laid bare for all the world to see in court case after court case and heaven forbid someone would actually want proprietary information kept secret! Its just funny how anti-business so many people can become when a bandwagon starts rolling. All these Enron employees marching now seem to forgot about the career they did have or the fact that it wasn't everyone that was a big enough fool to put all their eggs in one basket, its just that Enron is down and lets kick it now because we have nothing to lose. We don't have work so they are a bunch of frickin bums. As the intelligence and clear-thinking level of this country go further and further south....

01-24-2002, 01:40 AM
Go down to the "march" with Jesse and ask someone these questions, in Tom Green fashion! This would be classic TV...

Tom Green: Sir I take it you were an Enron employee.

Joe Blow: Yeah I gave those bastards 7 years of my life!

TG: And now you are out to protest?

JB: They need to know we are fed up with greedy executives stealing our money!

TG: Wow you are taking this kind of hard don't you think? They did give you a nice career for 7 years? Did your paychecks ever bounce or something to make you this upset?

JB: No, but they took almost all my retirement savings!

TG: Wow, they took it? How is that when most people have some of their retirement savings in some sort of mutual fund. So obviously you never heard of investment diversification?

JB: Whats your problem idiot, they wouldn't let us sell our stock!

TG: So when you had say 40% of your retirement funds in stock you didn't bother you to ask them "you know guys, our stock that has been doubling in value every year and it needs to be sold?" I guess you just prefer to ride the profit wave?

JB: Dipshit, don't you listen???

TG: And so now you are unemployed, why are you marching here on a weekday when you could be out looking for a job?

JB: F*** you! My voice needs to be heard, besides there aren't any jobs in Houston right now.

TG: So your seven year career with one of the largest companies in the US, a growth company with a cutting edge business doesn't qualify you for another job?

JB: What is your point?

TG: Well did you learn anything during your 7 years or did you just surf the net and eat donuts while picking up your check?

JB: You are asking for it you a***ole!

TG: Yes, as a matter of fact, I am asking you why a 7 year career means you can't find work while kids are coming out of college and finding work?

JB: Kids out of college don't make what I do. I have a family to support.

TG: Well thats a shame sir, but you know if you are admitting to me that you didn't really learn much in your 7 years with Enron to the point you can't do better than a college kid with no experience on top of you admitting you never had a clue that half your retirement savings shouldn't be in your own stock...frankly whatever that kid is making out of college he deserves it because it seems to me he deserves to be paid more than you.

Unfortunately the interview ends as TG gets jumped by JB. In the end, JB ends up in jail for 2 years for assault and battery, but since he couldn't find a job no big loss right????

01-24-2002, 06:45 AM
It's a little bit funny in a way, I don't know what Enron actually did each day to make "plenty of money," what businesses they were in. I made a half-baked effort to get the types of data you seem to have, but all I came up with was Jesse Jackson! Only I think of an argument I had with my brother back when Refco blew out Neiderhoffer during the '97 Needle.

I said, "What an idiot that Niederhoffer!"

My brother retorted "But he was right!"

I said "What do you mean he was right, he lost everything!?"

My brother responded "Well, he was right to want to be long where he was long. The market turned around and rebounded completely only a moment after they sold him out!"

To which I responded the market is not really a matter of measuring the value of things, but more of predicting who is going to get washed out next, and how and when. The texture of price movments in stocks and commodities is cratered with economic disasters like the surface of the Moon. And the rest of the time the buy and sell orders are motivated by fear, and in an effort to avoid economic disaster. Your profits are created by timing someone else's mechanized death.

It's like, the disaster is such a rare occurence in frequency terms, but it has such a disproportionate impact on long-run Darwinian survival, that it becomes the primary factor in pricing for most participants you are likely to run into. It has nothing to do with economics, the market is more like a giant machine run amok, and you just have to learn to dance with it.

Can you imagine, many brokers paid something like 140 S&P points, for expiring at-the-money index puts (850's?), for what was at that point their own account, and precisely because with the customer out of margin it had become their own account!? The only ones who survived were the ones who paid too much/sold out first, or who refused to touch it in the first place.

In the weeks after the '98 Washout, a fly on the wall in any major margin/credit department could have timed the market perfectly. Atomistically redundant or synchronized risk-management decisions are by their very nature self-defeating.

So whatever the blowout point, that machine will sniff it out and rampage through it like a truck hitting a kite, and we live in a world of people whose best bet is to run and hide from the get-go. As such, the question is not "What is fair value?" but rather "Given that participants are predictably irrational robots, what cascade has the potential to become self-perpetuating?"

Thanks, Wild Bill, for the great thread!


01-26-2002, 11:39 PM
Of course, some of your best friends can't play in Nevada anymore.

01-29-2002, 06:17 PM
I was thinking about this statement I made, where everyone prices as if everyone else is on the verge of avalanching in a big blowout.

Really, if everyone is pinned already, the risk doesn't exist.

But hybrid or coordinated evolution is so difficult. Everyone is likely to have the same habit.

And the equilibrium identical habit is to price in disaster.