A year and a half later, investigators are still trying to sort out what went wrong and who is to blame. (On Tuesday, JP Morgan became the third bank involved with Enron to be investigated for allegedly helping the energy trader hide its losses.)
Frank Partnoy’s new book, “Infectious Greed: How Deceit and Risk Corrupted the Financial Markets”(Times Books), explores the rise and fall of Enron as part of a larger, scary trend. In the book, Partnoy, who has worked as a corporate attorney and securities trader and wrote the 1997 best seller “FIASCO: Blood in the Water on Wall Street,” looks at the world of derivatives trading and the financial tricks (many of them legal) Enron used to hide its losses. The book warns that the factors that led to Enron’s collapse still exist today.
Despite new efforts to tighten regulations and increase oversight of accounting practices, Partnoy says another Enron–or many more–could happen. And, of course, some already have (WorldCom, which he includes in a final chapter, broke the bankruptcy record last year with its $103 billion filing). NEWSWEEK’s Jennifer Barrett spoke with Partnoy about how investors can spot potential problems in a company and what regulators can do to fix them before its too late. Excerpts:
NEWSWEEK: Why did you write this book?
Frank Partnoy: The idea came when I started looking at Enron. I really thought that in late 2001 that most people were getting the story wrong. I wanted to retell that story and then connect the dots to show how we got to that point. At the time, Enron was the largest corporate bankruptcy. But since then, there’s been WorldCom and Global Crossing, so I added a chapter on that.
Congress passed the Sarbanes-Oxley Act in response to Enron and other corporate collapses. But you say the act’s reforms are largely cosmetic and you don’t think Congress will do much more. Why?
I think people in Congress didn’t have a road map for what to do, and the finance lobby was very powerful in opposing reforms related to derivatives. Sarbanes-Oxley created this new accounting board [whose new chairman, New York Federal Reserve Bank president William McDonough, was announced Tuesday]. It might improve disclosure related to this kind of risk, or might not–the jury is still out. But at least there is an independent board out there.
But extending the penalties for financial fraud was largely symbolic or politically driven. You could have made the penalty for financial fraud death and it wouldn’t have influenced people’s behavior because the probability of being prosecuted for that is basically zero.
Why is that? How hard would it be to follow the paper trail–assuming it hasn’t been shredded?
Actually, obstruction of justice cases are much easier to bring than complex financial fraud cases. But if you prosecute for complex financial fraud and only get them on obstruction of justice, which has happened, then you send the message that you can go ahead and commit financial fraud–just don’t shred the documents this time. That’s the wrong message. The only way to get people’s attention is by actually sending some to jail for financial fraud. That hasn’t happened yet, and if it doesn’t soon, we’ll have another cycle of this [financial fraud].
You compare the markets to Swiss cheese, with the holes–or unregulated areas–getting bigger each year. Can we reverse the process?
We could if we wanted to do it. It’s an imbalance between lobbying forces and the public. We used to think that security analysts and credit-ratings agencies and independent accounting firms did–and then we found out that they didn’t. There are fewer and fewer people left to look out for investors. You have to rely on yourself because the people you thought you could trust, you can’t.
Investors have been told to stay away from derivatives because they are risky and complex. But you say many people often expose themselves indirectly–and inadvertently–to derivatives since many of the companies they invest in engage in derivatives without making it apparent on the books.
Investors who think they are not exposed to derivatives are kidding themselves. There’s no way to avoid these instruments now. Every aspect of the financial market is infused with derivatives. Even the most basic forms, like stock options, are everywhere.
What can investors look for in a company’s annual report that might alert them to off-the-book deals or other potential risks?
Part of the problem is that the disclosures are so bad that investors who look at the basics might not know they have exposure to these risks. Most of the disclosures you get are in the footnotes of the annual reports and most people don’t look at the footnotes. You should. And if you can’t understand what’s written in the footnotes then, as Warren Buffett says, the company doesn’t want you to understand. And you probably shouldn’t invest in that company.
If more investors paid more attention, that would encourage legislators to enact more reform and, hopefully, it would encourage companies to disclose more of what they are doing. The markets are complicated but not that complicated. You don’t have to know everything about someone’s dealings to know something is fishy.
Buffett has called derivatives “financial weapons of mass destruction.” Would you agree?
They do carry these huge hidden risks. Warren Buffett doesn’t want anything to do with them. He knows his way around these markets, and he is a very savvy investor. I can’t say I blame him, but I wish he would stay. Without someone who investors trust involved in derivatives, it is hard to convince investors to trust them. I want to tell him, you can’t get away from these markets anymore and please don’t; but let’s try and reform them from within and make them better and prevent another Enron.
As you point out, derivatives are not a bad thing in themselves. The concern is that the industry is largely unregulated and the risks aren’t disclosed to investors, right?
These are wonderful instruments. They can be used to reduce risks and have made certain institutions much safer. Derivatives are nothing new. They have been around forever and can be used for good or for ill. What I am pointing to is the increase in complexity in how they are used and the movement over the last decade to use them to avoid the law. And there isn’t much disclosure about where they are and what the risks are. The real concern I have is that because these are largely unregulated, people don’t understand the risks they are taking on. They have become hidden from view.
How hopeful are you that this will change?
I’m not incredibly hopeful. I tend to be an optimist, but there is so much negative information out there and there is the force of history. Probably, you and I will be having this conversation again one day about something else that happened that was unforeseen. There are massive scandals and then periods of retrenchment. But often what happens in the periods of retrenchment is that people gain wisdom. You have a period that is good for investors–even if you don’t have 30 percent returns.
