Enron Corporation

Company Overview

Enron Corporation, the Houston energy-trading giant whose December 2001 bankruptcy was then the largest in American history, is the corporate failure Munger analyzed most precisely and most usefully. He never treated it as a surprise: the conditions that produced Enron — mark-to-market accounting for long-dated contracts, traders booking modeled profits and being paid bonuses on them, auditors dependent on the clients they audited — were conditions he had been publicly warning about for years, including in a fictional essay written before Enron fell that described the mechanism almost exactly.

Enron's role in Munger's thinking is therefore double. It is his principal worked example of incentive-caused bias operating at institutional scale, and it is the vindication of his central methodological claim: that certain financial disasters are derivable from first principles of psychology and accounting structure, without any need for inside information. The analysis appears in its definitive form in his April 4, 2002 op-ed "Optimism Has No Place in Accounting," written while the wreckage was still being litigated.

What Enron was matters to the diagnosis. In its final form it was not really an energy company; it was a trading operation with an energy-company ancestry, booking long-dated derivative contracts on gas, electricity, bandwidth, and weather, and reporting as current profit the estimated value of revenue that would not be collected for decades. That structure placed extraordinary pressure on the estimates — and the estimators had bonuses riding on them. The company's fall took its auditor down with it: Arthur Andersen, one of the five great accounting firms, convicted of obstruction and destroyed, tens of thousands of employees losing their livelihoods over the conduct of one engagement team. Munger watched both collapses as a single event with a single cause chain.

Munger's Diagnosis

The two causes. Munger opened his 2002 essay by refusing the simple version of the story:

"The fiasco at Enron had two causes: (1) perverted 'financial engineering' that portrayed failure as progress and (2) generally accepted accounting principles that practically invited delusion and fraud. The faults of those who misled now get much attention and create demands for greater criminal penalties. But the faults of generally accepted accounting principles are more important, because changing accounting rules, and the way they are adopted, has a greater potential for preventing Enron-type disasters."

— "Optimism Has No Place in Accounting," April 4, 2002

The ordering is the argument. Punishing the individuals satisfies the demand for justice but leaves the machinery that manufactured them untouched; Enron's executives were the output of a system, and the system — accounting rules that made misuse of numbers easy — would produce successors. His analogy was retail: every shopkeeper knows the shrink rate from theft depends on maintaining a system that makes theft hard. A rule-making system that makes misuse of numbers easy operates like a retailing system without cash registers, and troubles are sure to come no matter what the criminal penalties. Engineering, he noted, had responded to avoidable deaths in surgery by building anesthesia machines that cannot deliver zero oxygen; wise accounting rules must display similar shrewdness in preventing undesirable accounting.

The mark-to-model sewer. The specific mechanism, as Munger dissected it, was the "front-ending" of dubious and uncollected revenue into earnings. First, generally accepted accounting principles allowed mark-to-market valuations based on defective information about market prices and inadequate allowance for the risks of clearing trades. Later, hundreds of turgid pages of accounting rules were used to justify determining earnings on a mark-to-model basis — "in which 'model' prices were calculated by the very traders subject to audit while they were paid bonuses based on reported profits." At the 2002 Wesco annual meeting he gave the same analysis its colloquial form:

"If you're the least bit venal, you can do what Enron did. Even if you're not, your employees will still [get you in trouble with derivatives]... It [accounting for derivatives] is just disgusting. It is a sewer, and if I'm right, there will be hell to pay in due course. All of you will have to prepare to deal with a blow-up of derivative books. To me, it's always been obvious it [the accounting for derivatives] is ridiculous."

— Wesco Financial Annual Meeting, 2002

The prediction embedded there — hell to pay in due course, a blow-up of derivative books — was recorded six years before the 2008 crisis, in which derivative accounting at AIG and the investment banks detonated on precisely the lines he described: positions marked by interested parties, bonuses paid on the marks, and the bill arriving later.

The culture point. Munger resisted the all-villains reading of Enron as firmly as he resisted the no-villains reading. At the same 2002 meeting, discussing how organizations become balkanized, he said: "Look at what happened at Arthur Andersen and Enron. They weren't all bad people, but their cultures were dysfunctional. It's easy to create such a culture, in which you have good people but terrible results." That sentence is his whole institutional psychology compressed: outcomes are produced by cultures, cultures are produced by incentive structures, and good people in a dysfunctional structure will reliably produce terrible results — no conspiracy required.

The auditor trap. Andersen's fate illustrated the structural conflict Munger had long identified at the heart of public accounting: the auditor is paid by the client it audits, the engagement partner's career rides on keeping the client, and each year's acquiescence makes the next year's harder to refuse. Once an accounting firm has blessed a few statements containing a small phony share — the dollop-by-dollop logic of the Quant Tech parable, enacted here in nonfiction — it finds it, in Munger's phrase from the essay, unendurably embarrassing to stop. The trap is not a character flaw in auditors; it is a design flaw in the audit market, and it will keep producing Andersens until the design changes.

The gatekeeper indictment. As in the Quant Tech parable, Munger reserved his deepest criticism for the rule-makers rather than the rule-breakers. The accounting system was defective, he wrote, "because the desires of accounting firms and the wishes of their clients make it so"; huge vested interests love misleading accounting; and the SEC, even under a would-be reformer, is deterred by politicians serving those interests. His remedy was structural: move control of accounting rule-making much farther from the influence of accounting firms, corporations, and politicians — a new control body more independent than the Federal Reserve, with the SEC required to enforce its standards. Attempts to fix the problem with a new committee or more SEC power were, in his phrase, "equivalent to trying to influence an elephant with a peashooter."

The closing principle. The essay's title is its thesis:

"The way to get maximum safety from accounting rules is to force a pessimistic outlook. In the long term, huge public benefits are to be gained, with almost no public dangers, from pessimistic accounting, while optimistic accounting is a public menace."

— "Optimism Has No Place in Accounting," April 4, 2002

Business Analysis

What kind of business was Enron, stripped of the mythology? In Munger's reading, it was two businesses wearing one balance sheet. The first was a legitimate but unglamorous pipeline and energy-delivery operation with real assets and real cash flows. The second — the one that produced the reported growth — was a derivatives trading house masquerading as an industrial company. That second business had a fatal design property: unlike a retailer, whose revenue is cash collected this week, a trader in twenty-year gas contracts books today the present value of revenue that may never arrive. Every year of reported profit was therefore a stack of estimates, and the estimators were paid on the stack. The 2002 essay names the two-step precisely: first mark-to-market on defective price information and inadequate allowance for the risks of clearing trades; then, when markets were too thin to mark to, mark-to-model — hundreds of turgid pages of rules dignifying a system in which the traders calculated the prices at which their own positions were valued.

The analytical consequence for investors is the part of the case that outlives Enron itself. A business whose reported earnings are manufactured from internal models cannot be analyzed from the outside at all: the income statement stops being evidence about the business and becomes evidence only about the optimism of the modelers. This is why Munger treated accounting quality as prior to every other investment question — it is the instrument through which all other information arrives. Enron was a constituent of the major indices, audited by a great firm, covered by dozens of analysts, and celebrated in business-school case studies, and none of that apparatus could see the business, because all of it was looking at numbers the company had drawn itself. The engineering comparison in the essay is the standard he wanted applied: where a margin of safety can be built into a system — an anesthesia machine that cannot deliver zero oxygen — reliance on human restraint is a design error, not a moral one.

Lessons

Accounting quality determines whether management quality can be evaluated at all. Every judgment an investor makes about a business is made on reported numbers; if the numbers are manufactured by the people being judged, analysis is theater. Enron is Munger's standing proof that accounting integrity is not a back-office detail but the foundation of the entire investment process — and that when it fails, the failure is invisible precisely to those relying on the reports.

Mark-to-model with trader-set prices is an honor system for the dishonorable. The arrangement Enron used — traders calculating the prices at which their own positions were valued, with bonuses tied to the resulting profits — converts every employee's incentive-caused bias into reported earnings. Munger's rule: any accounting system in which the person being measured controls the measurement will eventually be gamed, and the gaming will be invisible until it is enormous.

Cultures, not conspiracies, produce catastrophes. "They weren't all bad people, but their cultures were dysfunctional" is the analytical alternative to the rotten-apple theory of corporate scandal. An investor evaluating institutional risk should therefore examine the structure — incentives, audit relationships, who reports to whom — rather than trying to assess the character of executives from a distance.

Predictions derived from structure outlast forecasts derived from timing. Munger never said when derivative accounting would blow up; he said the arrangement was a sewer and hell would be paid in due course. Six years later it was. The Quant Tech essay said the same thing in fiction the year before Enron confirmed it in fact. Deriving inevitability from incentive structure is slower than forecasting but, in his record, considerably more accurate.

Fools and knaves are a constant; systems are the variable. The essay's unsentimental premise — that fools and knaves will always be with us, particularly active where big money can be made — relocates the policy question. You cannot legislate away venality; you can only build systems in which venality finds no purchase. The anesthesia machine that cannot deliver zero oxygen is Munger's model for all rule design: assume human foible, engineer against it, and never rely on exhortation where a margin of safety can be built instead.

Mentioned In

• "Optimism Has No Place in Accounting" (op-ed, April 4, 2002)
• Wesco Financial Annual Meeting transcript, 2002 (the derivatives sewer; dysfunctional cultures)
• "The Great Financial Scandal of 2003" (essay, 2001 — the fictional pre-enactment; see the Quant Tech entry)