Enron Trial in the News

Are any of you keeping track of the news on the trials of Enron executives Ken Lay and Jeffrey Skilling? Andrew Fastow, their CFO, was on the stand yesterday. There’s a terrific book about Enron by Kurt Eichenwald, in which the House Energy and Commerce Committee is mentioned (they had a piece of some Enron hearings). I’d like to spend a few minutes explaining what my take is on the actual Enron fraud, since many people (IMHO) don’t understand the differences between the fraud and simply losing money and then ruminate a little on data policy.

It seems obvious to me that Enron’s failure was because it made lousy investments (not because money was stolen in limited partnerships). Enron was able to raise far more capital than it was able to invest intelligently and they simply pissed billions of dollars away in lousy investments all over the world. From Eichenwald’s book, it sounds like ordinary procedures for investment due diligence were abandoned as the cash rolled in. If Ken Lay decided that he wanted to be in India for example, they blew billions on a hopeless project with virtually no due diligence on the project itself. Same over and over.

If you’re going to keep raising money, you can’t start losing money or the wheels fall off the wagon. You may not have to make a lot of money relative to the capital, but you have to show some profits or you get on the wrong radar screens.

After a while, Enron’s lousy investments started to take their toll. Investments were non-performing and completely under water and needed to be written off. But if they wrote off the assets and took the losses, all of a sudden they’d be in the red and the capital would stop pouring in. So rather than taking the writeoffs, they pretended to sell non-performing and hopeless assets to a series of limited partnerships. These limited partnerships were set up to look as though they were “independent” but they weren’t. Enron guaranteed debts of the limited partnerships and a variety of contingent liabilities were not shown on the books. If writeoffs had been recognized when the investments were known to have gone south, then losses would have been reported at least a few years earlier and Enron’s access to capital would have been cut off much earlier.

It’s important to recognize that it was the lousy investments, not the unreported debt in the limited partnerships that did Enron in. There was “only” a billion or two in the limited partnerships. If all the debt in the limited partnerships magically was made good, Enron would have stayed above water only a few weeks longer; Enron was toast anyway. The role of the LPs in the trials of Lay and Skilling is that the fraudulent limited partnerships disguised Enron’s non-performance and enabled it to raise billions more (to piss away) even after it was already under water. There was a failure of full, true and plain disclosure (obviously). Lay and Skilling are not charged with making lousy investments; they are charged with, among other things, withholding adverse information.

Eichenwald credits short-sellers with being the first people to seriously see that there was a problem at Enron. One day, a sharp trader (not a securities regulator) noticed that Enron’s profits were piffling compared to the capital employed. If you have razor-thin results from big capital, then you’ve got to wonder whether there have been decisions that tip the balance north or south. People can always think up justifications to delay writeoffs. But it got harder and harder as the problems piled up.

One of the NAS panellists observed to me privately with some satisfaction that even our writings show that “science works”. He mentioned, in my opinion, a little condescendingly that “science” would have got to the present situation with or without us, as others were already starting to do what we did. I’m not sure that I agree with the latter part, but I’ve never said that “science” doesn’t “work”. I think it works.

But let’s suppose that I said that the collapse of Enron proves that markets work – Enron was worthless and the markets eventually recognized that. Thus, proof positive that markets work. You’d say that the Enron collapse obviously doesn’t show that markets "work" — but what’s the exact flaw? Here’s my take. While the market for Enron shares worked “eventually”, that’s not good enough. We expect better performance on the way through. There’s money involved; we don’t accept being tricked on the way through and “eventually” working is not enough. Too many people can get burned. To make the market work “better” (although nothing is ever perfect and this is not what I’m arguing) is requiring full, true and plain disclosure. That’s the hook to get guys like Lay and Skilling; you can’t charge them with lousy investments.

I’ve never argued that businessmen are more honest than academics. In general, I would say the opposite, although I don’t think that the balance is as clear as academics would like to think. But I admit that I’m dealing with a rough crowd and that might bias my perception. But I’ve deal with tricky people in business too.

So yes, science works “eventually” in the sense that flaws in MBH98 and similar studies, if any, will be eventually discovered. But you want the process to work on the way through as well – "eventually" is surely not enough, as we see in the Enron example. If there are easy ways of making this particular “market” a little more efficient, why not use them? Right now the costs in time and effort of simple replication makes it prohibitive, unless someone is prepared, like me, to fight the Hockey Team over every single refusal and non-disclosure. but it’s a stupid system to place such obstacles in the way of simple replication. Archiving data and source code is not in itself a magic bullet, but it’s a simple thing to do in paleoclimate and there is no reason not to.

Sure, even paleoclimate science will work “eventually”, but it should work better on the way through as well.


16 Comments

  1. George
    Posted Mar 9, 2006 at 11:06 AM | Permalink

    Steve, it would have been really easy for “science” to continue forging ahead and never bother looking at MBH98 — after all, that’s “old” by now. I’ve been criticized for citing papers published prior to 2002, for goodness’ sake. The fact that you were an outsider meant that you (and Ross) viewed climate science with a fresh perspective. You saw a key paper/concept (Ross and Chris called it TRex) and applied a concept largely foreign to climate science: an audit. When you attempts to actually perform the audit were rebuffed, the fun began. And a fun ride it has been!
    This is exactly what Kuhn talked about in his famous 1962 book, “The Structure of Scientific Revolutions” — paradigm shifts are usually triggered by a scientist from the outside, young and naive or new to the field. You guys aren’t young and naive, but as newcomers to climate science you had an objectivity that was sorely lacking. All of science should be grateful that you exxerted such enormous effort to do what you did, because what really matters in science is honesty and truth.

  2. Steve McIntyre
    Posted Mar 9, 2006 at 11:20 AM | Permalink

    BTW, I’m sure that Ken Lay would have liked to tell the invetigators that he’d "moved on". He had retired from Enron and taken up new interests. Maybe he even had a deal for them to invest in. Last year a Canadian bank reserved nearly a billion dollars as an allowance against their role in financing one of the Enron limited partnerships. Yeah, they’d like to "move on" as well. You don’t always get to "move on". Sometimes you have to stand up.

    I was naive enough to think that there would be due diligence and due diligence packages, and that there would be full, true and plain disclosure. Silly me.

  3. jae
    Posted Mar 9, 2006 at 11:28 AM | Permalink

    Great post, Steve. The Enron analogy is perfect, since we could waste a tremendous amount of money if we aren’t sure about this AGW stuff. Maybe we already have.

  4. Posted Mar 9, 2006 at 12:31 PM | Permalink

    I think the senitment that “science works” is self-congradulatory bunk. If it wasn’t for the statistical skills from econometrics of Ross and the quasi-litigation skills of Steve in creating the chinks in the armour in what has always been suspected as a politically motivated cartel we would be nowhere near here. Its unfortunate that in the present day scientists need quasi-legal skills to get published, get noticed, and prosecute their real trade, which is falsifying theories. Sad, but what is, is.

  5. Gary
    Posted Mar 9, 2006 at 1:02 PM | Permalink

    Look at scientific misconduct (from incompetence through negligence to fraud) as noise mixed with signal (which is the true understanding of natural processes). Unless your methods decrease the noise, you won’t see the signal very well. The longer you take to improve your instumentation, the longer it will take to understand the meaning of the signal. Early on it may be easy to assume you’ve got satisfactory methods and instrumentation, but with time it may become clear that you don’t. Short term profits might tempt you to plunge on, but long term survival demands you get better at what you do.

    All this is obvious to those not deeply into the work, so it takes outsiders to stir things up a bit faster than would happen with the in-crowd.

    A somewhat-related question: has anybody attempted to analyze the relationship between temperature and tree-rings in the last 50-100 years at sites in close proximity to the temp stations? There must be many trees of suitable agee to be found near a lot of U.S. stations. Such a study would improve the instrumentation by showing the tightness of correlation, identifying species differences, and perhaps standardizing the measuring process.

  6. nanny_govt_sucks
    Posted Mar 9, 2006 at 3:05 PM | Permalink

    A lot of people want to point to the Enron scandal and say that we can’t trust free-society economics and we must push for some type of totalitarian government control so people don’t lose their nestegg when they invest. But the people who lost their nestegg were not diversified as virtually every broker will advise, and the government record with taxpayer funded investments is far far worse and makes Enron pale in comparison. The Department of agriculture, and education can’t audit their books, the Bureau of Indian Affairs cannot account for millions (perhaps billions) of dollars allegedly held in trust for the poorest of the poor, there were $12.1 billion in improper Medicare payments in 2001, and the Department Of Defense cannot account for 2.3 Trillion (t-t-TRILLION) dollars.

    I’m not worried about Enron.

  7. John Hekman
    Posted Mar 9, 2006 at 4:06 PM | Permalink

    Steve
    I also agree that Enron is a good analogy. From my perspective, I think that there is an additional parallel to mention. What I heard about Enron in its salad days of the Nineties was that they considered themselves to be superior to most everyone else in the area of making new markets and handling risk (no, not ironic that it was risk that did them in–just hubris). When I was doing a project having to do with the newsprint market–large contracts for sale of newsprint to the MSM–I found that Enron had created a market for trading these contracts. Fixed-price contracts and floating price contracts could be traded through swaps, following the lead of interest rate swaps. Enron was exposed to risk in this market.

    Again, when I was doing a project related to DRAMS, I found that they were considered so commoditized that Enron had created a market for swaps here too. So computer manufacturers could off-load risk by trading fixed-price contracts for floating ones and so forth.
    Enron execs crowed endlessly about their expertise in creating these new markets. They believed that they could handle the huge financial risks. They were wrong.

    The hubris is very similar to what you are fighting against.

  8. Paul Penrose
    Posted Mar 9, 2006 at 9:28 PM | Permalink

    Of course, the fact that the Auditing company and the Financial Consulting company were one in the same did not help. It was a big mistake to change the law that had previously required independent auditors.

  9. Posted Mar 10, 2006 at 6:15 AM | Permalink

    Re # 8
    Paul

    So what you are saying is that the problem was that the auditors (reviewers) were from the same consulting company (scientific community) as the consultants (collaborators)

  10. Paul Penrose
    Posted Mar 10, 2006 at 8:38 AM | Permalink

    Re: #9
    That was a major contributing factor behind the fall of Enron, yes. Apparently the consults put pressure on the auditors to overlook some red flags that had been uncovered, and they won out because the consulting contract brought in much more money. That was the reason for the original legislation.

  11. Steve McIntyre
    Posted Mar 10, 2006 at 8:55 AM | Permalink

    #10. My recollection is that, long after the destruction of Anderson as an accounting firm, there was some measure of exoneration in the final litigation.

    As an aside, the amount of money paid to consultants baffles me. How could a company year after year need millions of dollars of consulting? What is the value added by some kid fresh out of B-school?

  12. Mike Carney
    Posted Mar 10, 2006 at 9:33 AM | Permalink

    One of the NAS panellists observed to me privately with some satisfaction that even our writings show that “science works”. He mentioned, in my opinion, a little condescendingly that “science” would have got to the present situation with or without us, as others were already starting to do what we did.

    This sounds like both sour grapes and hubris of the worst kind. Steve deserves congratulations for his contribution to the science. A contribution done in spite of terrific resistence from the climate community and media. Would some else of done it? Maybe, but just because “someone” would have discovered it, don’t disparage Steve’s contribution. He is the one that did it.

    An assumption of invincibility is always dangerous and there are counter examples where science hasn’t worked. A good one is Paul Erhlich who is comfortably ensconced at Stanford despite his penchant for wild predictions that fail to materialize (e.g. he was willing to bet even money that England would not exist in the year 2000). To his credit he has actually made testable predictions. To his discredit he assiduously ignores his failures. Then there was his bet with Julian Simon that was very well defined, over a ten year period. Once again his theory went down in flames. He actually wrote an entire book on this bet exlaining why it doesn’t matter, why he did not really lose, and how he won a new bet he created that Julian never accepted. And yet “science” has rewarded him handsomely with respect and position. Julian, best as I am aware, was not so rewarded. Here the scientific community has failed miserably.

  13. Posted Mar 10, 2006 at 9:39 AM | Permalink

    Another excellent example is The inertia of scientific thought by Thomas Gold http://www.suppressedscience.net/inertiaofscientificthought.html

    Shortly after the discovery of pulsars I wished to present an interpretation of what pulsars were, at this first pulsar conference: namely that they were rotating neutron stars. The chief organiser of this conference said to me, “Tommy, if I allow for that crazy an interpretation, there is no limit to what I would have to allow”. I was not allowed five minutes floor time, although I in fact spoke from the floor. A few months later, this same organiser started a paper with the sentence, “It is now generally considered that pulsars are rotating neutron stars”.

  14. Steve Sadlov
    Posted Mar 10, 2006 at 10:58 AM | Permalink

    Sarbannes-Oxley has been a highly effective albeit possibly heavy handed way to force better tranparency and disclosure in the business world.

    Imagine if it were applied to:
    * Government
    * NGOs
    * Education establishments?

  15. JerryB
    Posted Mar 10, 2006 at 11:21 AM | Permalink

    During an interview, Jack Eddy happened to characterize early reactions to the idea of there being a “solar wind”:

    WEART: I see, so how did you get started on the Maunder Minimum? In your 1976 science paper, you mentioned Gene [Eugene] Parker.

    EDDY: Right, Gene Parker was an occasional visitor at the High Altitude Observatory in Boulder. He’s from the University of Chicago, as anyone who listens to this knows. I remember him coming there in the late 1950s and giving a colloquium on his wild idea that there was a solar wind, before that was accepted by anyone. I remember the unanimous reaction of the solar physicists to his idea: what a ridiculous notion that was — a wind blowing charged particles out of the Sun. It reinforces what I said earlier: that new ideas, if they are worth anything, will always be met by a knee-jerk rejection on the part of the disciplinary experts. It also tells something about Gene, who was never afraid of stepping into new things. Later, in the early 1970s, he called Maunder’s early papers to my attention: did I know about this thing in the past? (I did not.) Because he knew I had an interest in history. I don’t know just why he told me. He may have known that at that time I was cautiously and with some prejudice digging back into the history of sun weather relations, which is another story.

  16. ET SidViscous
    Posted Jul 1, 2006 at 1:02 AM | Permalink

    Since the search function in WordPress is as bad as the search funstion in most forums I couldn’t find the relevant discusion.

    But this link shows what’s can possibly happen to those that pursue research fraud.

    http://tinyurl.com/r7hmw

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