Op-Ed: The Enronization Of The Banking Industry

By J. Edward Ketz, Associate Professor of Accounting

"Those who cannot learn from history are doomed to repeat it." We frequently utter those words of Santayana, yet we commit the same mistakes.

The ashes of Enron are not a decade old, but we have forgotten the sources of this debris. Instead of sweeping out the rubbish, we cover it up and are surprised to encounter a growing trash pile. Yesterday it was Enron and WorldCom; today it is the banking sector. Who will it be tomorrow—the federal government?

The Bush administration has proposed a $700 billion bailout of Wall Street, which would be the largest wealth transfer from the middle class to the rich. Before we accept this or any other proposal, let's recall the lessons from Enron and WorldCom.

Enron was a bright star in the energy industry. Unfortunately, the firm disintegrated in 2001, leaving many investors empty handed. We learned that the company was a house of cards with jokers for managers.

Four factors sum up the problems surrounding Enron. With few constraints, top managers engaged in self-dealing, including high salaries, huge stock options, and lots of perquisites to themselves. Managers employed aggressive accounting methods to hide their problems and inflate profits. Regulators and watchdogs didn't do their jobs. And Congress stifled real reform by enabling corporate managers to abuse the system and incur few penalties. Let's review these problems and compare them with today.

Enron managers had salaries much higher than the average worker. They had stock options that were supposed to reward them for good performance, but were written so that they enjoyed their millions whatever the performance. They acted as if they were the sole proprietors of the organization. When CEO Jeff Skilling left Enron, his severance package was worth millions.

Ditto for the banking industry. Top managers are consistently overpaid. If they actually delivered value, then maybe they would earn their salaries and stock options. As bank executives have failed us in this subprime mess, why are they receiving these huge salaries and outrageous stock options? And when they screw up, they leave with severance packages in the tens of millions of dollars. If only we had corporate directors who would rein in these undeserved remunerations.

Enron engaged in aggressive accounting behavior, including inappropriate applications of fair-value accounting and incorrect accounting for special purpose entities. Enron misapplied fair-value accounting when it overstated the value of its assets and concomitantly its net income. Enron also used special purpose entities with which to transfer resources, but accounted for these transactions as if the special purpose entities were independent entities.

Banks have been doing the same thing. Banks routinely have overstated the fair value of their loans and investments until recently. They also used special purpose entities to engineer their balance sheets and income statements. When will the SEC and bank regulators eliminate these corrosive practices?

Several accounting scandals occurred in the 1990s; however, the SEC did not enforce the laws. Even when it took action, it fined the managers paltry sums. For example, it fined the CEO of Sensormatic Electronics $50,000 for falsifying income. I'm sure he had no problem paying the fine after receiving his millions in stock options. Enron managers observed that even if they got caught, odds were that the fines would be small. While not true in their case, it is true in many other cases.

Bankers engage in various deceptions, but what is the SEC trying to do? It worries about the short sellers who discovered the shenanigans instead of prosecuting the criminals. Don't expect much change until the SEC starts enforcing the laws. For example, Allied Capital inflated its fair values and the SEC did nothing. Who can understand this lack of enforcement?

In the 1990s, Congress enacted various measures of "litigation reform," which actually made it harder for aggrieved shareholders to sue wayward managers. Congress was not on the side of investors. In like manner, Congress deregulated the banking industry and no longer requires a separation between commercial and investment banking. The consequence of this legislation is greater risk to the country's wealth and liquidity.

Forget the bailout—let's first address these issues. We need to rein in the hyperinflation of manager salaries. We need better accounting. We need regulators to enforce the laws against criminals masquerading as managers. And we need a Congress that is willing to help the middle class in action as well as in election-year rhetoric.

Please, let's learn our history lessons this time. We cannot afford the tuition at the college of hard knocks.

This essay reflects the opinion of the author only.