Post-Enron Fixes Solved Nothing, As Mortgage-Related Mess Shows

Six years after Enron, we're right back where we started.

In 2001, politicians saw Enron's collapse as an unprecedented market failure needing an unprecedented remedy: the Sarbanes-Oxley corporate "reform" act.

Yet, as the mortgage crisis shows, no law can protect investors and the economy from catastrophic misjudgment—and Sarbanes-Oxley may have made things worse.

Enron failed because it overvalued its assets while undervaluing its liabilities. It was easy for Enron to do this because many of its assets were difficult to value. They were worth what Enron said they were—until the market decided otherwise.

By booking future profit immediately, Enron worsened its predicament. A mistake or a lie compounded over 20 years is far greater than one that covers only one year.

What's more, the company didn't disclose clearly enough, in hindsight, that it was funding precarious investment partnerships with its own stock—which it might have to replace with cash if the stock price fell.

Sound familiar? Until last spring, mortgage-backed securities were worth what their "securitizers" said they were worth, and it's obvious they disregarded, at minimum, some key risks to shareholders and mortgage-securities investors.

Ratings agencies awarded the securities top grades. Sellers and buyers of such securities booked all future profits immediately. Just as with Enron, while some state regulators fretted and fumbled over growing risks a couple of years back, it was the market that finally turned off the spigot.

Unfortunately, it's unlikely that the similarities will stop there. The nation may be in for another long period of recrimination and revenge that won't do much for small investors.

Mumbling Accountants

The highest-profile Enron cases—the trials of co-chiefs Jeff Skilling and the now-deceased Ken Lay—showed that in court any complex accounting is suspect. For anyone involved in the last two years' worth of mortgage underwriting or sales, this is bad news.

"They were accountants," said Skilling-Lay juror Freddy Delgado of witnesses. "They mumbled, and I didn't know anything about what they talked about."

Further, prosecutors pressed companies and people to cooperate who might otherwise have cleared up what Skilling and Lay knew about the firm's questionable accounting. Banks like CIBC and Merrill Lynch, which participated in Enron's financing, reached deals with the government that kept employees from testifying for the defense.

Whether one thinks Skilling and Lay were guilty, it's undeniable that these constraints hurt their chances.

To wit: Before his firm agreed to cooperate, one CIBC worker "emphatically denied the allegation that (Enron CFO Andy) Fastow had ever made a guarantee" of profit on certain side deals, a vital part of the criminal charges, according to Skilling's appeal. After CIBC secured its deal, the worker refused to testify.

This technique, too, is bad news for mortgage and banking executives who may find themselves under indictment. Practices considered normal, if creative, business at mortgage and i-banks at the height of the subprime bubble may seem like criminal conspiracy in hindsight to unindicted witnesses eager to escape their own charges.

When Juries Prejudge

From an honest businessman's perspective, the most worrisome thing about the Enron case was the jurors' unconcealed prejudice.

One juror wrote on a pretrial questionnaire: "I think (Skilling and Lay) probably knew they were breaking the law." Another wrote that the "collapse was due to greed and mismanagement." A third said "pure greed" motivated all CEOs and that "some get caught and some don't."

If anything, prejudices will run even higher in the mortgage trials: Whether a juror lost substantial equity in a home due to falling prices or lost his home altogether, it's likely he'll be looking for someone to blame.

Enron's remedy, SarbOx, makes things scarier still. It requires that top executives of publicly traded companies and their outside auditors carefully analyze and report on their "internal controls" to ensure that a new Enron doesn't happen on their watch.

Another requirement calls on CEOs and CFOs to attest to their financial disclosures' veracity. The potential criminal penalty for "willfully" signing off on statements that are less than "fairly representative," notes UCLA law professor Stephen Bainbridge, is a 20-year prison sentence.

The most recent round of spectacular business misjudgments raises the question of what happens, in the SarbOx era, when a CEO misses a warning sign in his company that later becomes painfully obvious.

Were banks' huge and unexpected mortgage losses the result of poor internal controls? Didn't the CEOs realize that their opaque models for structuring and valuing these securities were disastrously vulnerable to error? Or did the losses result from spectacular misjudgments—unavoidable in a free-market economy?

How a jury sees it in the hands of an ambitious prosecutor—both the feds and states are already investigating more than a dozen banks—may mean the difference between a ruined career or a prison sentence.

Similarly, while banks may have skirted or ignored regulations and law during the mortgage bubble, no company can clearly disclose every potential obligation and risk in every conceivable market condition. A juror who doesn't understand this context may have a hard time fairly determining what's fraud.

The worst thing about criminalizing what should often be civil regulatory matters is that it creates a false sense of security for investors.

Disclosure—even if it's slow and imperfect—is still the best protection, far better than prosecution, which comes only after investors lose money.

But perfect knowledge and disclosure of risk, and perfectly rational responses to available disclosure, aren't attainable.

Curb Our Enthusiasm

One partial solution in an imperfect world is for the government to put checks on a normally beneficial force: natural optimism. For retirement savings, the feds should revive a failed Enron-era proposal banning companies from letting employees invest more than 10% in their companies' stock.

Congress should also prohibit the owner of any independent 401(k) or IRA from investing more than 15% of retirement assets in one company or 20% in one industry. Investors could still do so elsewhere, but not with tax-favored retirement funds.

And Congress should continue to prevent people from using their 401(k) accounts to invest in their homes, despite suggestions that lifting the ban would prop up the housing market. Housing assets already make up too large a percentage of Americans' savings.

As the economy heads into a possible downturn, calls will grow for prosecutions. But no government punishment will stop companies and markets from being imperfect collections of fallible human beings.

This piece originally appeared in Investor's Business Daily

This piece originally appeared in Investor's Business Daily