Q: What's The Difference Between GE and Enron? A: GE Got Bailed Out
I am going to oversimplify, but the essence of bank risk is that they borrow short-term and invest/lend long-term. This is a money-making strategy in that one can often borrow short-term much cheaper than one can borrow long term. This spread between long and short term rates is due to people valuing liquidity. You probably have experienced it yourself when buying a certificate of deposit (CD). The rates for 5 or 10 year CD's are higher, but do you really want to tie your money up for so long? What if rates improve and you find yourself locked into a CD with lower rates? What if you need the money for an emergency? Your concern for having your money locked up is what a preference for liquidity means.
So banks live off this spread. But there are risks, just like you understood there are risks to locking your money in a long-term CD. Imagine the bank is lending for mortgages and AAA corporate customers at 6%. To fund that, they have some shareholder money, which is a long-term investment. But they make the rest up with things like deposits and commercial paper (essentially 90-day or shorter notes). We will leave the Fed out for this. There are two main risks
- Short term interest rates rise, such that the spread between their short term borrowing and long-term investments narrows, or even reverses to negative
- Worse, the short term money can just disappear. In panics, as we saw in the last financial crisis, the commercial paper market essentially dries up and depositors withdraw their money at the first sign of trouble (this is mitigated for small depositors by deposit insurance but not for large depositors who are not 100% covered).
These risks are made worse when banks or bank-like institutions try to improve the spread they are earning by making riskier investments, thus increasing the spread between their borrowing and investing, but also increasing risk. This is particularly so because these risky investments tend to go south at the same time that short-term credit markets dry up. In fact, the two are closely related.
This is exactly what happened to GE. Via MarketWatch:
GE’s news release announcing its latest and greatest reduction of GE Capital summed up the move beautifully, saying “the business model for large wholesale-funded financial companies has changed, making it increasingly difficult to generate acceptable returns going forward.â€
“Wholesale-funded†refers to GE Capital’s traditional reliance on the commercial paper market for liquidity. The problem with this short-term funding model for a balance sheet with long-term assets is that during a financial crisis, overnight liquidity tends to dry up as it did for GE late in 2008. When the company had difficulty finding buyers for its paper, the Federal Deposit Insurance Corp. stepped in and through its Temporary Liquidity Guarantee Program (TLGP) was covering $21.8 billion of GE commercial paper. GE Capital registered for up to $126 billion in commercial-paper guarantees under the TLGP.
If you have a AAA credit rating, you can always, always make money in the good times borrowing short and investing long. You can make even more money borrowing short and investing long and risky. GE made their money in the good times, and then when the model absolutely inevitably fell on its face in the bad times, we taxpayers bailed them out.
Which leads me to think back to Enron. Enron is associated in most people's minds with fraud, and Enron played a lot of funky accounting games to disguise its true financial position from its owners. But at the end of the day, that fraud was not why it failed. Enron failed because it was essentially a bank that was borrowing short and investing long. When the liquidity crisis arrived and they couldn't borrow short any more, they went bankrupt. Jeff Skilling didn't actually go to jail for accounting fraud, he went to jail for making potentially inaccurate positive statements to shareholders to try to head off the crisis of confidence (and the resulting liquidity crisis). Something every CEO in history has done in a liquidity crisis (back in 2008 I wrote an article comparing Bear Stearns crash and the actions of its CEO to Enron's; two days later the Economist went into great depth on the same topic).
So the difference between GE and Enron? The government bailed out GE by guaranteeing its commercial paper (thus solving its problem of access to short term funding) and did nothing for Enron. Obviously the time and place and government officials involved differed, but I would also offer up two differences:
- Few really understood what mad genius Jeff Skilling was doing at Enron (I can call him that because I actually worked with him briefly at McKinsey, which you can also take as a disclosure). With Enron so opaque to outsiders, for which a lot of the blame has to be put on Enron managers for making it that way, it was far easier to ascribe its problems to fraud rather than the liquidity crisis that was well-understood at Bear or Lehman or GE.
- Enron failed to convince the world it posed systematic risk, which in hindsight it did not. GE and other big banks survived 2008 and got bailed out because they convinced the government they would take everyone down with them. They followed the strategy of the Joker in The Dark Knight, who revealed to a hostile room a coat full of grenades with this finger ready to pull the pins if they didn't let him out alive.
Artist's rendering of 2008 business strategy of GE Capital, Citicorp, Bank of America, Goldman Sachs, GMAC, etc.
Postscript: For those not clicking through, I though this bit from the 2008 Economist article was pretty thought-provoking:
For many people, the mere fact of Enron's collapse is evidence that Mr Skilling and his old mentor and boss, Ken Lay, who died between hisconviction and sentencing, presided over a fraudulent house of cards. Yet Mr Skilling has always argued that Enron's collapse largely resulted from a loss of trust in the firm by its financial-market counterparties, who engaged in the equivalent of a bank run. Certainly, the amounts of money involved in the specific frauds identified at Enron were small compared to the amount of shareholder value that was ultimately destroyed when it plunged into bankruptcy.
Yet recent events in the financial markets add some weight to Mr Skilling's story"â€though nobody is (yet) alleging the sort of fraudulentbehaviour on Wall Street that apparently took place at Enron. The hastily arranged purchase of Bear Stearns by JP Morgan Chase is the result of exactly such a bank run on the bank, as Bear's counterparties lost faith in it. This has seen the destruction of most of its roughly $20-billion market capitalisation since January 2007. By comparison, $65 billion was wiped out at Enron, and $190 billion at Citigroup since May 2007, as the credit crunch turned into a crisis in capitalism.
Mr Skilling's defence team unearthed another apparent inconsistency in Mr Fastow's testimony that resonates with today's events. As Enronentered its death spiral, Mr Lay held a meeting to reassure employees that the firm was still in good shape, and that its "liquidity was strong". The composite suggested that Mr Fastow "felt [Mr Lay's comment] was an overstatement" stemming from Mr Lay's need to "increase public confidence" in the firm.
The original FBI notes say that Mr Fastow thought the comment "fair". The jury found Mr Lay guilty of fraud at least partly because it believed the government's allegations that Mr Lay knew such bullish statements were false when he made them.
As recently as March 12th, Alan Schwartz, the chief executive of Bear Stearns, issued a statement responding to rumours that it was introuble, saying that "we don't see any pressure on our liquidity, let alone a liquidity crisis." Two days later, only an emergency credit line arranged by the Federal Reserve was keeping the investment bank alive. (Meanwhile, as its share price tumbled on rumours of trouble onMarch 17th, Lehman Brothers issued a statement confirming that its "liquidity is very strong.")
Although it can do nothing for Mr Lay, the fate of Bear Stearns illustrates how fast quickly a firm's prospects can go from promising to non-existent when counterparties lose confidence in it. The rapid loss of market value so soon after a bullish comment from a chief executive may, judging by one reading of Enron's experience, get prosecutorial juices going, should the financial crisis get so bad that the public demands locking up some prominent Wall Streeters.
Our securities laws are written to protect shareholders and rightly take a dim view of CEO's make false statements about the condition of a company. But if you owned stock in a company facing such a crisis, what would you want your CEO saying? "Everything is fine, nothing to see here" or "We're toast, call Blackstone to pick up the carcass"?
