A Nation of Enrons

An understatement: We are living through a time of considerable market and economic turmoil. Since we stand to see trillions of dollars' worth of assets vaporize in the ensuing mess, we ought to take a look at history to see how we got into it, and how investors can get out.

Half a decade ago, the entire nation was shocked when award-winning "innovator" Enron turned out to be little more than a cash-shredding pyramid scheme. The crucial failing for investors was Enron's use of opaque, "mark-to-market" accounting. The problem comes when the market is batty (or doesn't exist), so you instead mark your assets to a model, especially one that's wrong, either because you made an error or because you based it on exceedingly generous assumptions.

In the end, we learned that Enron's accounting was pretty much mark-to-fairy-tale, with the company booking enormous gains from assumed future profits on schemes (like bandwidth trading) that sounded great, but had little chance of producing anything besides headlines.

Andy Fastow, meet Fred and Ethel
You might think we'd learned our lessons about fantasy accounting after Enron, but you would be wrong. Things actually got worse. The infection moved to the comfy-sounding "homeownership" market. Against a star-spangled, feel-good backdrop touting the "American Dream," our recent mark-to-model mania tripped up a lot more than one big company. In fact, it swept through the entire banking world. (Bear Stearns (NYSE: BSC  ) is not the first to choke on lousy, poorly modeled mortgage-backed securities "income," and I'll eat a Miami condo if it's the last.)

But more dangerous yet was the way this mania also infected millions of aspiring real-estate moguls. The most widespread mark-to-model fantasies were actually committed not by some easy-to-blame Wall Street suit, but by Fred and Ethel down the street.

It was flawed models (and the habit of booking earnings on these models) that enabled financial companies to concoct the elaborate securities that funded the bubble. And yes, the bank CEOs who paid themselves handsome bonuses ahead of the hurricane deserve a public flogging. But they weren't the only ones making out like bandits. While Wall Street was booking fantasy profits on bad assumptions about real estate, Fred and Ethel down the street were operating under their own mark-to-model dreams.

Really ...
In their model, house prices always go up. In their model, you can pay any price for a home, so long as you can make the monthlies with a teaser-rate ARM, never mind the upcoming adjustment to 9%. In their model, you avoid that via a refinance down the line with an equity cash-out to boot. In their model, it's OK to buy on a less-than-forthcoming, Alt-A "liar's loan," because there's no real punishment for lying on a mortgage application -- particularly if everyone's doing it. With this model, it makes sense to buy three other homes, in order to flip them later. And it makes sense to extract HELOC cash from the home, based on fantasies about continually increasing "equity."

This is not so different from what Enron was doing. Fred and Ethel were marking up the value of their assets (the home) to a model (their belief that real estate prices always go up) and then spending the "income" immediately, on iPods, Hummers, $250 jeans, and fancy vacations. This happened all over the country, and millions of people behaved the same way. In fact, the American Fantasy of owning a home (for no money down) that would provide leveraged, 10% annual returns for a decade, is precisely what enabled those Wall Street suits to do what they did. It takes two to tango, folks. And this was the biggest dance party in economic history.

Last year's model got ugly
Alas, this dream's "income" wasn't actually matched by real cash flows, just bank loans -- precisely the problem at Enron. The "income" was all hot air. And now that the "income" from home appreciation has turned negative, it must be supported by cash mortgage payments. But many people can't pay those bills, the mortgages are defaulting in huge numbers, and now, we are all paying a price, even those of us who didn't throw our money into a flimsy, overpriced McMansion.

Stocks have been creamed. The losses at those companies most directly victimized by their own housing-bubble ineptitude -- Bear Stearns, Citigroup (NYSE: C  ) , and Wachovia (NYSE: WB  ) -- are easy to understand. But, of course, the losses have extended much further than that. Even mighty Apple (Nasdaq: AAPL  ) has dropped like a rock, as investors wonder how many iPods can be sold in Foreclosureville, U.S.A. And if they can't afford their beloved iPods, what will they buy? That's the thinking that has crushed everything from trendy togs-sellers like Zumiez (Nasdaq: ZUMZ  ) to carmakers like GM (NYSE: GM  ) . Consumers are spending less, and we appear to be headed directly into a recession.

So ugly it's cute?
By now, it ought to be clear that I have been, and remain, one of the most vocal econo-bears you will find on these pages. I am certain that systemic failure has steered us into a terrifying run at the ditch, to be followed by a painful, protracted rough patch. It was all spawned by greed gone amok on Wall Street and Main Street. Yet I believe history will prove this to be one of the best times to have invested in stocks, especially attractive-priced small caps. Here's why:

  • The market is in panic mode, and when markets panic, no one's thinking.
  • Small caps have been crushed more than the rest of the market, as investors seek "safe" large caps.
  • Over time, value-priced small caps produce some of the most amazing returns in the market. Really.
  • There are loads of small caps out there poised for years, if not decades, of fantastic growth, but the market is pricing them as if they are dead and buried.

The not-so dead and buried
Take oven-maker extraordinaire Middleby, down 20% so far this year, despite amazing returns on equity and capital, and its leading position in a megatrend -- the global move toward dining out. Or consider the abovementioned Zumiez, which has a growing brand, a solid balance sheet, and huge growth potential, yet is priced for a decade of subpar growth. Yes, the uncertainty ahead means a rough ride, and some of the small caps out there won't survive, which is why, at Motley Fool Hidden Gems, we advise opportunistic buying of cash-strong companies, long-term holds, and, above all, a steady temperament.

At Gems, we're on the dig, 24-7, for solid small caps with the capital to survive the downturn, and the superior businesses destined for major growth once things turn -- and they always do. In the next issue, we'll be reviewing the recommendations and finding the best bargains for new money.

If you'd like to take advantage of the market's panic and lay the groundwork for some great future gains, a free trial is just a click away.

Seth Jayson, a top-10 CAPS player, is also co-advisor at Motley Fool Hidden Gems. At the time of publication he was short Apple puts, but had no positions in any other company mentioned here. View his stock holdings and Fool profile here. Middleby and Zumiez are Hidden Gems recommendations. Apple is a Stock Advisor pick. Fool rules are here.


Read/Post Comments (19) | Recommend This Article (242)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On March 20, 2008, at 7:29 PM, lagrandpro wrote:

    There aren't going to be any calm nerves until the SEC rescinds its repeal of the uptick rule. The bear raids will continue unabated, and will be successful because they contribute to the skittishness in the markets.

  • Report this Comment On March 20, 2008, at 7:30 PM, billstraw wrote:

    I agree that the mark to market resulted in disaterous results,but I think (and would like comments) that the real origin of our financial problems were started by adjustable rate and interest only mortgages.

    With all the supposed brains in Washington I don't understand why they could not have seen what would occur.I also feel that the Federal Reserve must be included as an at fault party.

  • Report this Comment On March 20, 2008, at 8:13 PM, ReillyDiefenbach wrote:

    I'm perfectly happy to be in cash while the market stampedes from one emotional extreme to the other. I have no faith at all that our economy is in good condition and a safe place to invest or even to buy anything I don't absolutely need. The current administration is quite content to spend several trillion dollars in Iraq, all of it borrowed, which is destroying our economy, not to mention our prestige in the world. So while I might glance once in a while at the picks in these pages, I'll pass until I see some stability, thanks very much.

  • Report this Comment On March 20, 2008, at 11:59 PM, nuf2bdangrus wrote:

    And there is much more bad stuff to come....

    ttp://www.minyanville.com/articles/fitch-baltic-dry-fdx-loan/index...

  • Report this Comment On March 21, 2008, at 12:05 AM, marquiseduchatel wrote:

    We'll need to be very patient to see if anything lasting is NOW learned.

    The Enron model is exactly the accounting model that has swept into daily business ideology, from tiny startups to the largest LBOs.

    The best place to be for now is in cash...wait and see whose fundamentals are REAL.

    Also there needs to be a return to investments in goods and service that are in fact used and needed by the largest percentage of real consumers. Emerging Markets and so called Frontier Markets have honest developing needs.

    Motley Fool Global Gains is agreat tool!!

    matthew victor

  • Report this Comment On March 21, 2008, at 11:18 AM, FourthAxis wrote:

    Oh Snap! We got comments! I was gonna post this on caps, but hey.

    Seth, I gotta hand it to you, this concept is brilliant. I read the article, told FLBuilder to read it, then forgot about it...or so I thought. I just can't get past the concept...it's dead on. All these families were just marking to someone else's model. Now...even though the money faucet is on, the credit faucet is off. All of these homes will get marked to market and it's going to be one painful "market" correction.

    Thanks for the perspective.

  • Report this Comment On March 21, 2008, at 11:49 PM, MrMadagascar wrote:

    Fred and Ethel need a new hobby--consumption has gone out of style.

    http://www.martialdevelopment.com/blog/two-investment-picks/

  • Report this Comment On March 22, 2008, at 4:08 PM, engineer8 wrote:

    In the go-go years of the late 90's when they were all talking "new paradigm" for valuations, President Clinton and the Congress repealed the Glass-Steagall Act of 1933. That act had been implemented to prevent the same sort of financial collapse of banks that brought on the depression.

    Oops.

    http://en.wikipedia.org/wiki/Glass-Steagall_Act

  • Report this Comment On March 22, 2008, at 4:37 PM, carbonates wrote:

    I agree completely, and think you might add another player: the Fed. If you look at the US markets in stock or real estate in terms of foreign currency, you will see that what both the US stock and real estate market has mistaken for a growth period has really been a long-term bear market as a result of deflation of the US dollar. If you graph out the S

  • Report this Comment On March 22, 2008, at 6:22 PM, PALH wrote:

    I wish there was some less business-jargon way of saying ``mark to market.'' Seth's analysis has crystallized this whole mess in a way the mainstream media hasn't been able to do, probably because they never really grasped the Enron disaster well enough to explain what happened in a meaningful way. Come to think of it, the Iraq War is sort of a mark to model train wreck of its own.

  • Report this Comment On March 24, 2008, at 1:25 PM, dbjella wrote:

    Wow! These comments appear to take on a tone of the government or administration should have known or companies knew what was going on. We need somebody to ride in and fix it! I am glad someone didn't step in when a lender offered me 150k 5/1 IO loan for a payment of $540. I am sitting pretty good.

    I can't understand how this is any different than the tech bubble. Euphoria is euphoria and what one person perceives as risk another percieves as opportunity.

    If we need to change accounting rules, then let us change them. If someone broke the law, then lets punish them. But please don't blame administrations and try to make this out than anything more than market corrections. In my case, I am still paying my loan and when it recasts I know I have a decision to make.

  • Report this Comment On March 28, 2008, at 9:33 AM, leohaas wrote:

    Great explanation, Seth!

    Maybe a more appropriate title would have been: "A Nation of Morons"

  • Report this Comment On March 28, 2008, at 9:38 AM, mablt wrote:

    II think everyone is overlooking that this adventure in real estate was financed by the Federal Reserve's complicity in financing the US middle east police actions. To pay for these quasi-wars the US government needed money. Selling war bonds (promises of a ROI) to obtain existing money to pay for it is passe. Today we pay by selling new money and leveraging benefits from controlled inflation. We couldn't get the rest of the world to help buy our moeny, so we sold the money to our own people. When the Fed put lots of dollars on sale with a super low prime rate there was a mad-rush to get them. Lucrative "points" to all the middlemen brokers along the way . . . and you know the rest. Paying for the middle-east has disrupted our economy, the value of our dollar, and it will continue to do so. IMHO All US based businesses are at risk until the US figures out how to get Iraq to use its own oil money to pay for us policing them.

  • Report this Comment On March 28, 2008, at 1:21 PM, tylee100 wrote:

    Seth,

    I think most people missed the point of your article and instead went off on political agendas or even worse witchhunting.

    Your point was to buy now. I agree. I put all my cash into the market in early March. So far I am up a tidy sum. Please preserve these other comments to go back and laugh at while you and I are enjoying 5 or 10 or 20 baggers!!!!

  • Report this Comment On March 28, 2008, at 4:50 PM, cbuckman wrote:

    As long as stockholders and investors continue to support incompetent often criminal CEOs and other high level executives this syndrome will continue to flourish...Even overpaid professional athletes are fired when they fail to perform...It is just the opposite with corporate America where failure is often rewarded with obscene bounuses.

  • Report this Comment On March 28, 2008, at 7:26 PM, oldogartist wrote:

    As right as many contents of this article are, there are a few biggie points missing. Were the defaulted mortgages, known and to come, the full extent of the problem, we would likely be looking at a much lower figure. Like the CMOs of yore, they took the CDOs and SIVs of today and leveraged them 20 and 30 times. That, fellow pundits, is where the wheels were destined to come off and where regulators should have made a stand. That is also exactly where the Street got greedy and stupid.The same might apply to the cancellation of the uptick rule for shorting stocks.Sounds good until circumstances and human nature show their underside.

    Letting both of these financial trainwrecks in the making happen shows all of us that complancency and trust in those who make money from us,rather than with us, is not a good thing.This can be said for many more issues.

    This also should serve as a warning shot across the bow and some who came up with all of this mess should lose both personal fortune and freedom for awhile, and MBA students should be seriously penelized for sleeping through important lessons, as too many obviously did.

    Bests, Ol'D

  • Report this Comment On March 29, 2008, at 2:17 AM, uch wrote:

    EXCELLENT SUMMARY (SIMILAR TO A "STATE OF THE UNOIN ADDRESS" FOR OUR ECONOMY) CARL UCHTMANN

  • Report this Comment On March 30, 2008, at 8:00 AM, wtdean wrote:

    Seth,

    This was a great article. You give a pretty good explanation for a complex problem. I agree with tylee100 . Now is the to invest in small cap solid performers. Keep up the good work.

  • Report this Comment On September 09, 2008, at 1:49 PM, Epiphany11 wrote:

    To blame the appalling lack of corporate ethics on "Fred and Ethel" is just plain wrong. I work in Silicon Valley and having been called at home by SEC regulators and stockholder attorneys regarding companies I worked for, I can assure you that MANY companies commit fraudulent practices (i.e., options back-dating). The reason? Because they are allowed to. How many corporate executives can you name that actually did jail time for such activities? I rest my case. Mostly they pay minor fines and continue to live the good life in large McMansions. I have been employed by company after company where the 6 guys at the top exploit the company for personal gain without regard to national pride or care for employees and are rewarded with obscene amounts of options and bonuses, to the tune of hundreds of millions of dollars each. NO ONE is worth that much. Most of these people were simply in the right place at the right time, but they immediately sport the sense of entitlement that such largesse brings. You have to actually WORK for these entities before you can speak to the truth of what has happened in America. The time for Reagan-Bush lassez-faire economics is over folks. This country's corporations are shamefully corrupt. Where else can you ruin a company and still get rewarded by "golden parachutes," etc.? We need REAL regulations that disallow such practices as golden parachutes, the ability for corporate officers to sit on the Board of Directors, et al. Grow up. American is rapidly becoming the laughing stock of the planet through mismanagement and unabated corporate greed. Meaningless regulation is absurd, but REAL regulation that accomplishes investor protection is necessary. And how will this occur? I think it was Ben Franklin that said "Democracy is a way of insuring that you get the kind of government you deserve." And that's why not a week goes by that I don't email my legislators. That's what it takes - action on the part of citizens. We need to take back our country from those whose mind-set is to enrich themselves at the expense of their company and their country.

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