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.