When the Free Market Failed

On this day in economic and financial history ...

Enron's stock price peaked at $90 toward the end of the year 2000. Just over a year later, it was worthless, and the financial world was reeling from revelations that Enron had inflated its income by over half a billion dollars and had hid billions of liabilities with opaque financial gimmickry over the previous few years. On Dec. 2, 2001, Enron filed what was then the largest bankruptcy in history. It has since been surpassed by both the WorldCom and Lehman Brothers bankruptcies. However, Enron's impact on the American financial and securities industries is arguably at least as important as Lehman's.

Fortune magazine had named Enron "America's Most Innovative Company" from 1996 to 2001, but it turned out that its real innovations were in its financial statements. The company had been operating as an energy broker, with huge gambles on energy prices that turned into losses worth $32 billion. The debts for these bad bets were hidden in various partnerships, concealing Enron's true financial picture for years. Arthur Andersen, Enron's auditor, was later found guilty of obstruction of justice as a result of its complicity in hiding these debts.

Enron's collapse had far-reaching effects beyond Arthur Andersen's subsequent dissolution. The Sarbanes-Oxley Act, intended to more stringently enforce proper accounting procedures, became law the following year. By this point a number of companies faced greater scrutiny over their accounting practices. Andersen client Waste Management (NYSE: WM  ) had an accounting scandal of its own in 1998, when SEC investigators discovered a $1.7 billion earnings exaggeration. In the weeks before Enron's collapse, the SEC also warned Xerox   (NYSE: XRX  ) to stop booking sales revenue for leased machines. General Electric (NYSE: GE  ) , which had famously steady earnings growth, also earned fresh scrutiny  over a massive income boost from its pension plan investments during a period of broad market declines. Investors now know that this steady growth was an illusion. Immediately following Jack Welch's retirement in 2000, GE's earnings began to fluctuate in a far wider range.

A PBS Frontline special  produced six months after Enron's collapse found that more than 700 companies were forced to correct misleading financial statements during the 1990s. These ethical failures -- when combined with Enron's bankruptcy and the major failures in the months afterward -- cost investors an estimated $200 billion. In the years that followed, Enron's creditors managed to extract more than $5 billion in a "mega-claims" lawsuit against Citigroup (NYSE: C  ) and 10 other banks and brokerages. Citi's $1.66 billion settlement was the largest of the group, but the total amount gave Enron's creditors only $0.37 per dollar they had put into Enron to begin with.

The weight of the dot-com crash, the Enron-fronted accounting scandals, and 9/11's aftermath contributed to keep the Dow Jones Industrial Average (INDEX: ^DJI  ) in a depressed state for some time. Although the index remained above 10,000 for the early months of 2002, it declined to a low of 7,500 and would not consistently exceed the first post-Enron closing value of 9,764 until the end of 2004.

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Hoover tried (but Hoover failed)
A year after the start of a devastating market collapse, President Herbert Hoover took the drastic (for Hoover) step of asking Congress to appropriate $150 million for a massive public works program. It was one of the key proposals in a wide-ranging economically focused message presented on Dec. 2, 1930, just over a year after the Dow reached an all-time high. By this point the index had lost more than half of its value.

As part of his message, Hoover provided a sobering series of statistics on the Great Depression's devastation. All of the following are as a percentage of the same result from 1928:

  • Department-store sales value: 93%
  • Manufacturing production volume: 80%
  • Mineral (mining) production volume: 90%
  • Factory employment: 84%
  • Bank deposits: 105%
  • Wholesale prices of all commodities: 83%
  • Cost of living: 94%
  • Total economic activity: between 80% to 85%

Hoover pointed out another sobering statistic as well: 3.5 million, the total number unemployed and underemployed, as of that April's census.

Still, Hoover believed at the time that the "fundamental strength of the nation's economic life [was] unimpaired." He blamed global problems for the lack of recovery, claiming that "the major forces of the depression now lie outside the United States, and our recuperation has been retarded by the unwarranted degree of fear and apprehension created by these outside forces." Sound familiar?

"Economic depression cannot be cured by legislative action or executive pronouncement," Hoover stated firmly. "Economic wounds must be healed by the action of the cells of the economic body ... recovery can be expedited and its effects mitigated by cooperative action." However, he proposed that "the best contribution of government lies in the encouragement of this voluntary cooperation."

To this extent, he proposed that wages be kept at pre-recession levels while simultaneously spreading employment opportunities to as many men as possible; that construction projects be increased, especially by public utilities and railroads and other large capital-intensive entities; that government construction projects, particularly of highways and airports, be increased to the highest levels in American history (this is where the $150 million comes in); that loans be given to distressed farmers so that they might maintain their farms; that electric utilities and railroads be regulated, but that antitrust statutes also be loosened to allow weakened large corporations to merge; that the capital gains tax be reduced; and that immigration be curtailed and illegal immigrants be deported en masse.

Hoover hoped that the depression's end would allow for some reflection on the proper role of government. "We shall need to consider," he said, "a number of other questions as to what action may be taken by the government to remove possible governmental influences that make for instability and to better organize mitigation of the effect of depression." These considerations would be undertaken, in ways Hoover had not considered, by Hoover's successor, Franklin Delano Roosevelt. Hoover's actions during the Depression's onset are now widely considered to be ineffectual at best and destructive at worst.

The Cat in the stock exchange
Deep in the midst of a devastating crash, one industrial superstar dared to defy the market bloodbath. On Dec. 2, 1929, Caterpillar (NYSE: CAT  ) joined the New York Stock Exchange. Traders were not so inclined to trade this new tractor-focused stock, and only 400 of the company's 1.9 million outstanding shares changed hands on its first day.

According to Caterpillar's 80th anniversary press release from the same date in 2009, an investor who had held onto a share bought on Dec. 2, 1929, for $56.25 would have an investment worth $20,320 eight decades later. Total returns, including dividends, were more than 36,000%, for an annualized growth rate of 7.6%. The company deserves such growth. In 1929, its annual revenue was $51.8 million, and profit was $11.6 million. In 2009, Caterpillar earned $895 million in profit (a recessionary low point) on $32.4 billion in revenue. From the most destructive modern economic downturn to the latest such decline, Caterpillar's revenue increased 62,450%, and its profit grew 7,600%.

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A society of savers
The oldest savings bank in America opened its doors on Dec. 2, 1816. The Philadelphia Savings Fund Society, or PSFS, so named as to avoid the negative connotations of the word "bank," took its inspiration from the numerous savings banks already operating in Great Britain. At the time, there were 182 savings banks in Scotland, with 7,000 depositors between them. In the early 1800s, American banks operated on the merchant banking model, which involved an early form of what we now call private equity.

PSFS didn't adopt its formal name for another two days, which must have been confusing for its earliest customers. By midmonth, PSFS put out its first public announcement, which began:

To promote economy and the practice of saving among the poor and laboring classes of the community -- to assist them in the accumulation of property that they may possess the means of support during sickness or old age -- and to render them in a great degree independent of the bounty of others -- is a duty incumbent upon all, who by their services or advice have it in their power to effect so desirable an end. 

Advertisements took a long time to get to the point in the early 1800s.

PSFS grew slowly, but after the Civil war it boomed. It was the largest bank by depositors, and the second-largest by total deposits, a century after its establishment. PSFS remained the second-largest by deposits after World War II ended, with nearly $600 million in its coffers. However, banking deregulation in the 1970s and afterward opened PSFS to new opportunities and new risks. It became a more freewheeling financial institution in the 1980s and changed its name to Meritor Financial Group in 1985 in recognition of its broadened focus. The savings-and-loan crisis hit Meritor hard, and by the end of 1992 most of its remaining assets had been sold to Mellon Bank, now BNY Mellon (NYSE: BK  ) .


Read/Post Comments (6) | Recommend This Article (1)

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  • Report this Comment On December 02, 2012, at 1:12 PM, whereaminow wrote:

    So at what point in your article do you cite evidence that the Free Market failed?

    David in Libertya

  • Report this Comment On December 02, 2012, at 1:13 PM, whereaminow wrote:

    Libertya... that's my Italian handle...

  • Report this Comment On December 02, 2012, at 1:27 PM, TMFBiggles wrote:

    @ whereaminow -

    I guess that depends on whether you feel weak regulation is evidence of a "free market" or of government inadequacy, or something else. In regards to the Depression segment, it was intended more as an inflammatory allusion than a direct statement of fact. It's a more attention-grabbing title than "Enron Goes Under," or something similar.

    - Alex

  • Report this Comment On December 02, 2012, at 2:58 PM, whereaminow wrote:

    ---> I guess that depends on whether you feel weak regulation is evidence of a "free market" <---

    It's not.

    David in Liberty

  • Report this Comment On December 02, 2012, at 4:58 PM, jonpete69 wrote:

    Hoover shoud have done NOTHING. That is what Harding did in 1921 during the Depression of 1920 - 1921. Hoover was his Secretary of Commerce and recommended what would become the failed policies of the Thirties. Harding rejected his advice, did nothing and ushered in the Roaring Twenties.

  • Report this Comment On December 02, 2012, at 10:36 PM, dorinay wrote:

    And no mention of the FED?

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