Enron's deep inner meaning: The world's biggest bankruptcy teaches some very old lessons

What are the lessons to be learned from the Enron debacle? There are plenty--for managers, for investors, for regulators, for everybody--including lenders. In all, the Enron bankruptcy serves as a useful reminder of some pretty profound truths in the lending business. Here are some of the most notable:

1. Know management well--and trust it. Face it, regardless of any changes that occur as a result of the Enron fiasco, there will always be businesses whose accounting is opaque, arcane, or just plain hard to understand--just like Enron's was. It does not necessarily follow from that, however, that the companies in those businesses are always bad credit risks. (Would you turn down the opportunity to place a loan to Goldman Sachs if you had the chance? You ought to get a load of its books sometime!) So what's a lender to do? One thing for sure: Make certain you are very, very, very comfortable with the borrower's management. You might not understand a company's books as well as you'd like, but you can certainly expect that that company's management does. It's an old bromide in the banking business, of course, that the integrity of borrowers is as important as their competence. One of the lessons of Enron, I believe, is that it's incumbent on lenders to be highly confident that their customers have both.

2. Your best relationships aren't necessarily your best customers. Enron is the latest, most egregious instance of a phenomenon I've seen again and again in my 20 years of covering the banking business: Too often, a lender's worst credit crackups come from its oldest or biggest customers. Part of the reason for this, I believe, is that somewhere along the way in the loan approval process, force of habit replaces solid underwriting. ("We've been doing business with these guys for 20 years! Give 'em the $100 million!"). Too often that's a recipe for disaster. Remember, it's not the first $10 million that hurts the most when a borrower defaults; it's the last $10 million.

3. Don't just look at earnings; remember cash flow, too. Some things are so obvious that they shouldn't even need to be written down--yet they are so easily forgotten! Earnings don't service debt, cash does. And Enron didn't generate nearly as much cash as its P&L implied. In 2000 the company reported $979 million in net income. Unfortunately, that $979 million included $1.4 billion in noncash items. Sure, it's obvious now that the company was an accident waiting to happen. But even a year ago, a close observer could have gone through Enron's since-restated financials and seen that the company's cash flow was awfully weak. That should have set off alarm bells.

4. High leverage and rapid growth can be a combustible combination. It is always and everywhere an eternal truth that extreme financial leverage can turn relatively small operating problems at a company into big, life-threatening ones. It is also profoundly true that the unceasing pressure to "reach for growth" to meet quarterly earnings expectations can cause managements to do imprudent things. If the management of a highly levered company consistently makes imprudent decisions in order to make its numbers, you end up with... an Enron.

5. When the storm finally hits, prepare for an overreaction. Particularly, that is, by the refs. Train wrecks of the magnitude of an Enron don't occur without ratings agencies and regulators deciding that they ought to, well, do something to make sure that this sort of thing can't happen again. So they write new regulations, insist on tighter standards, mandate higher reserve levels, and in general make lenders jump through a bunch of new hoops. In the end it won't be entirely clear that the new rules will do too much, other than constrict credit in general and put added pressure on existing borrowers. Think of it as sort of a borrowing-and-lending version of chaos theory: A butterfly fluttering its wings outside Enron 's headquarters in Houston causes a machine-tool maker in Cleveland to postpone a plant expansion.

Are there other things to be learned? Of course. But if you keep these five lessons in mind, you can go a long way toward preventing any Enrons in the future from happening to you.

Brown is a managing director of a hedge fund and cofounder and CEO of bankstocks.com, New York, New York.

RELATED ARTICLE: Seven Surprises for 2002 excerpted from bankstocks.com Subscriber Update, January 24, 2002

1. The economic recovery will be substantially stronger in 2002 than the consensus expects. There are a couple of reasons why. First, the monetary easing in 2001 was much more aggressive than any that's occurred in the postwar era. The Fed cut interest rates 11 times, and in the process drove them down to their lowest level in two generations. Second, the economy's basic credit-creation machinery is intact--a rarity at the bottom of a recession. Take a look: There's no S&L industry on life support, no money-center banks having near-death experiences, no imploding junk bond market, and no Long-Term Capital Managements. The liquidity pump is working, and the pipes are unclogged! Combine current record-low interest rates with an infrastructure that can deliver credit to individuals and business, and you have-or will have-shortly booming demand.

2. Hostile takeovers will come back in a very big way. You're thinking, "Oh, so '80s"--but you're wrong! 2002 has all the ingredients necessary to produce a riot of unfriendly deals: 1) Cheap, abundant credit, 2) A regulatory and cultural climate that won't frown on unsolicited bids, 3) Attractive valuations in a number of sectors, and 4) The likelihood of economic growth near term. All that, plus an accounting change that doesn't saddle acquirers with costly goodwill amortization.

3. Auto lending will become a respectable business on Wall Street again. A number of players have exited the business entirely, which will presumably ease the competitive burden for those who remain. And the recession is apparently ending on schedule, and without any of the bears' more extreme scenarios coming to pass. Instead, the key players not only survived this downturn, many thrived. Non-hallucinatory investors will shortly appreciate that fact and will do the rational thing: They'll fatten up the valuations of the leading players.

4. Property & casualty insurers will consistently post better earnings than Wall Street expects. The conventional wisdom says that the current strong P&C pricing environment won't last long; the new capital flooding into the business will soon return the industry to its old, price-cutting habits. Hooey, I say. Too many balance sheets were substantially under-reserved before 9/11; post-9/11, fuhgeddaboudit. The only way for most companies to build reserves quickly will be to hold the line on pricing. Many will have no choice but to stand firm. Plus, the eventual total cost of the attacks will likely be substantially higher than the Street admits even now. Meanwhile, most P&C analysts literally have never experienced an extended period of strong pricing. They literally don't know how to model for it. Thus their earnings estimates for the industry will consistently be too low.

5. The brokers and investment banks will produce a spate of better-than-expected earnings, too. This is, of course, a nonsurprising follow-on to Surprise #2. But there will be other things going for the brokers in 2002 as well. The P0 market is in better shape than most people realize, for one thing. And retail volumes at a number of the online brokers have stayed surprisingly strong. No, the industry isn't in for a replay of 1999. Then again, expectations are low, even as the basic pieces are in place for a modest turn in the business.

6. The accounting industry becomes the target of a regulatory free-for-all. The Enron debacle will have more far-reaching effects on the accounting industry than people realize. The first casualty: the industry's traditional system of self-regulation. The coming regulatory reform will be a high-level fracas that will include the SEC, the Fed, the AICPA, and Congress. Everybody's going to want a role in keeping an eye on the accountants. Once the dust settles, CPAs will face severe restrictions in the services they'll be allowed to offer their audit clients. That will be bad for the profitability of the big accounting firms, I suppose. But it will be good for investors, who can expect to have a whole lot more confidence in the numbers they read in companies' filings. Oh, and the Big Five will shortly become the Big Four.

7. The technology sector will again generate murderous returns for investors. Tech stocks won't just underperform this year--they'll get scalded. Why? Because the recession taught investors an unpleasant lesson about the nature of demand growth in the tech sector. Tech industry growth isn't infinite and open-ended, the way the people used to think. Rather, it's merely very high, and is--uh-oh--extremely cyclical. Once investors fully absorb that awful truth, they'll see tech companies for what they are: gussied-up machine tool makers. And they'll value the stocks accordingly.

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