NEW YORK — From humble origins as a natural gas distributor, Enron became a trading operation with the Midas touch. It made bets on oil, water, Internet traffic, even the weather. Wall Street’s brightest worked there. Its stock tripled in two years.
Virtually no one knew how it had made so much money.
Ten years ago Friday came the answer: It hadn’t.
Enron’s bankruptcy on Dec. 2, 2001, revealed a fraudulent illusion. Investors swore they would not be so profoundly deceived again. But it was only the beginning of a decade when so much in the economy was not as it seemed.
Can’t-lose Wall Street guys turned out to be cheats. Home values did not go up forever. Promising signs of recovery after the Great Recession turned out to be nothing, and hard times endure.
The theme was shredded faith — that and debt, the more the better.
“We have faith in the big score,” financial historian Charles Geisst says, trying to explain why Americans have, time and again, believed in what was too good to be true.
In the simple story of the past decade, a journey from corporate scandals to a housing bubble, then to a collapse and a frustratingly slow recovery, the villain is Wall Street and the victim Main Street. The reality is more complicated.
One reason people didn’t know how Enron made money was that it was an amalgam of 3,000 private deals that came to light in its collapse, partnerships with names like Raptor, Condor and Chewbacca.
Behind those obscure names, Enron shunted billions of dollars of debt off its books. Investors were safe as long as they didn’t ask too many questions. The company borrowed from Wall Street banks, mutual funds and insurers, pledging its hot stock as collateral.
The collapse wiped out $11 billion in stock value, nearly 10 percent in the 401(k) retirement accounts of Enron employees.
A month later, an outspoken, Harley-riding CEO with an uncanny ability to pull profits out of a seemingly dull New Hampshire manufacturer appeared on BusinessWeek’s list of top corporate managers. His name was Dennis Kozlowski. By the end of 2002, he was indicted for stealing $150 million from shareholders, and his company, Tyco International, was bankrupt.
Several other heroes of capitalism toppled after him. Bernard Ebbers drove WorldCom into bankruptcy after misleading investors in his high-flying company in an $11 billion accounting fraud. John Rigas, who turned a $300 purchase into a cable TV empire, was convicted of fraud after prosecutors said he ran Adelphia Communications like a “personal piggy bank,” including using $26 million of company money to buy timberland next to his home to preserve his view.
Martha Stewart, who built her cooking and decorating business on an image of homespun goodness, faced a grilling from regulators that suggested a life more tawdry than tidy: She had dumped shares of a drug company on what appeared to be an illegal tip from her Merrill Lynch broker. She was convicted of lying, though never accused of insider trading. The amount the one-time billionaire saved by selling early was $51,000.
It was a time of plummeting stocks, trashed retirement accounts, lost jobs and lost trust. One headline from 2002: “Scandals Shred Investors’ Faith.”
Regulators cracked down, offering hope. Congress created a board to police the accounting industry. It also passed the Sarbanes-Oxley Act, requiring executives to sign off on financial statements so they could be criminally liable for posting phony numbers.
Investors were thought more vigilant, too. But they got sloppy again, and almost immediately.
Around the time of Enron’s collapse, press reports detailed how Italy, years earlier, had struck complicated “currency swap” deals with banks so it could borrow money without having to recognize the debt on its books. Later, Greece was shown to have camouflaged its debt in a similar way.
In 2002, no one seemed to care. By the end of the year, Italy was paying about 4 percent a year in interest on its national bonds, roughly what the U.S. was offering and a sign that few investors were worried.
THE HOUSING BUBBLE
In 2003, as jurors heard how Kozlowski got Tyco to pitch in $1 million for his wife’s birthday party, featuring an ice sculpture of Michelangelo’s David that urinated vodka, the seeds of a new crisis were being planted.
American consumers had run up debt to record levels by the end of 2003, and more of them than ever were filing for bankruptcy. Yet the stocks of companies extending mortgages to the riskiest borrowers, so-called subprimes, were rising fast.
Subprime was a euphemism for people who had too little income, too much debt, a bad record of paying lenders back — or all three. As home prices rose, worry that they would not meet their mortgage payments was replaced with faith that, even if they couldn’t, they could always sell the home for more than they borrowed and return the money.
Lenders eventually grew so cocky that they seemed willing to give money to virtually anyone who wanted a home. They also offered mortgages on top of mortgages — so-called home equity loans that allowed people to tap their magically rising values to raise cash for flat-screen TVs or Caribbean vacations. Or to pay their credit card bills.
“If your home keeps appreciating, why not use the equity,” Robert Cole, CEO of mortgage lender New Century, said at the time.
If the lenders were duping Americans, they made easy targets.
Long before the housing boom, Americans were borrowing more, saving less and increasingly convinced they would not suffer the consequences. In the 1980s, Americans saved more than 6 percent of what they earned each year in income. Their debts totaled 70 percent of take-home pay. By 2007, they were saving nearly nothing, and debt had exploded to 140 percent of income.
“People were using their homes like automated teller machines,” says David Rosenberg, chief economist at Gluskin Sheff & Associates and a big critic of lending during the boom. “At some point, people have to own up to their mistakes.”
Stoking all this borrowing was the Federal Reserve, which had slashed benchmark interest rates to 46-year lows after the 2000-2001 tech-stock bust, pushing the cost of loans lower. Fannie Mae and Freddie Mac, the government-sponsored companies that buy mortgages from lenders, played a role by targeting ever-riskier loans.
The biggest, most sophisticated Wall Street firms fooled themselves, too.
Banks bought subprime lenders whole. Elegant mathematical formulas from their “risk management” departments told them their gambles were fine. Standard & Poor’s and other credit rating agencies provided reassurance by slapping their highest ratings on bundles of risky mortgages.
Wall Street was gripped by what chronicler Roger Lowenstein called a “mad, Strangelovian” logic. Not content to bundle thousands of subprime mortgages into mortgage securities, banks bundled the bundles into something called collateralized debt obligations, or CDOs. Next, they created bundles of bundles of bundles, called CDO-squared.
They created something known as synthetic CDOs that didn’t even contain mortgages but merely referenced them, exchanging cash between two parties taking opposing bets that a mortgage lender unconnected to them would get its money back.
Adding to the confusion, it wasn’t clear which financial firms held many of the original mortgages on which everyone was betting. They had been bought and sold so many times among investors that no one could follow the paper trail.
By 2006, the men who had wounded a nation’s faith in capitalism were finally getting justice. Enron’s former president, Jeffrey Skilling, began serving 24 years in prison. Kenneth Lay, the chairman, died before he could be sentenced. Rigas, the cable titan, got 15 years, Ebbers and Kozlowski 25 each.
But we were about to discover that the lies we tell ourselves can be more damaging.
In 2007, subprime lenders went bust, one after another. Then all the mounting debt, made possible by years of half-truths and self-deceptions, turned the fall of a single industry into a worldwide financial crisis.
In March 2008, investors fearing bad mortgage bets at Bear Stearns pulled money out of the bank, leaving it to collapse into the arms of a rival.
Unable to untangle the web of mortgage risk, they began to wonder who was next. They focused on Lehman Brothers, and as that bank teetered, it became clear that the danger of complexity wasn’t the only lesson from Enron that had been ignored.
Lehman had hidden debt just like Enron.
Using a financing technique called Repo 105, the bank had borrowed money in a series of deals structured to make it seem as though it had been “selling” assets to raise money. Lenders demanded money back, triggering a run on the bank and leaving ordinary investors scrambling to understand just how much the company had borrowed.
Lehman’s bankruptcy in September 2008 froze credit worldwide and helped turn the U.S. recession into the worst since the Great Depression. Stocks eventually fell to 12-year lows, retirement accounts were devastated, and many Americans’ biggest asset, their home, plummeted in value.
By the end of 2008, Bernard Madoff was arrested for lying to investors in a $60 billion Ponzi scheme over two decades. A few months later, President Barack Obama started talking up the strengths of the economy, but that soon proved a bit of a mirage, too.
More than a year later, the White House announced its “Recovery Summer,” a series of public projects to goose economic growth. But a year and half later, the unemployment rate is stuck at 9 percent and economic growth uninspiring.
A sad footnote: After an overhaul of Wall Street rules last year, broker MF Global turned to the same Lehman-like Repo 105 deals to fuel its bet on indebted European governments. The heavy borrowing helped send the firm run by ex-New Jersey Gov. Jon Corzine into bankruptcy, throwing 1,000 people out of work and creating chaos in markets as brokerage customers scrambled to get their money back.
A month after the firm’s collapse, regulators still can’t find $1.2 billion of customer funds.
Now Europe is paying for years of using government debt to fund early retirements and long vacations that its citizens really couldn’t afford. Streets are choked with protesters, governments are toppling and interest rates rising, some to crippling highs.
Rosenberg, the prescient housing critic, sees trouble for America, too.
Frightened investors are buying Treasury bonds, which is making it cheaper than ever for Washington to borrow despite its trillion-dollar-plus deficits. The danger is that low rates could lull Americans into believing that, even if they themselves can’t borrow recklessly, it’s OK for their government to.
“A government debt bubble is already creating misery in Europe,” Rosenberg says. “If we don’t watch out, we’ll face the same problem.”
Stocks have barely moved in the decade of lost faith. On the Friday before the Enron bankruptcy, the S&P 500 closed at 1,139. Last Friday it closed 19 points above that. The incomes of many middle-class Americans haven’t kept up with inflation. Home prices are still falling.
Pretending we were wealthier has made us poorer.