The Ascent Of Money –Blowing Bubbles

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 The Ascent of Money –Blowing Bubbles

Another great innovation of modern history is the invention of the joint-stock limited-liability
company. It allows individuals to pool resources while not having to risk their entire personal
fortune. In spite of the theory that vigilant shareholders hold control over the management
through a non-executive directory, the practice is that millions of shareholders will continually
buy and sell the infinitesimally small part of the company, thereby estimating the future cash
flows it will realise. This results in a kind of collective ‘mood’ on the stock exchange. Usually it
follow 5 paths:

1. Displacement, where a shift in the economic environment creates profitable

opportunities.
2. Euphoria: a feedback loop of buyer creates ‘overtrading’
3. Mania: the bubble is created by buyers not having a clue
4. Distress: the exorbitance becomes clear to the well-informed
5. Revulsion: the bubble bursts and especially the uninformed sell off in large quantities

A number of factors will typically facilitate this process, such as information asymmetry towards
insiders, easy credit and the free flow of capital. What is also very common is the short duration
of the investors’ memory, helping to create the next bubble rapidly. Nevertheless, over the long
run it has shown profitable to invest in stock rather than bonds, especially in the US.

John Law was the first one to ever create a stock market bubble. He learned the stock market
dynamics in Amsterdam, where the United East India Company (VOC) had come to existence in
1602. Its shares, and dividends, were widely traded in the years after. By 1650 the VOC,
monopolizing the trade of goods from the East Indies, was a very large profitable company
governed by the modern concept of management and ownership. Surrounded by this financial
innovation, Law sought to combine the monopoly of a company and the sole issuance of notes
by an institution like the Bank of England.

France, fighting off enormous war debts, was the country he could try his idea out. Under his
impulse, a private bank was erected which had the monopoly of issuing notes that were
payable in gold for a 20 year period in 1716. This injection of capital revived the French
economy and centralized the royal debt, delegating its management to a trading company
(Banque Royale). Law later gained the permission of developing the French overseas Mississippi
delta (the Company), to the example of the Dutch and English trading companies, to collect all
the revenue from tobacco and later acquired the Senegal Company. By then it became the first
French central bank. Because he was a major shareholder, he allowed an ample monetary
expansion. More and more, new shareholders had to be attracted by promises of future profits
and higher face values. By printing extra paper money, share prices soared and Law was
creating his bubble, while controlling vast parts of France’s economy. The first signs of distress
appeared and at first the value of the share was guaranteed. Any downward adjustment of the
shares had a very substantial impact.  The notes issued were representing 4 times the reserve in
gold and thus the exchange of it into gold became prohibited. After some legislative and
regulatory turmoil by a self-serving absolutist and centralistic government, the inflation soared,
the share of the Company plummeted and Law was placed under arrest and later fled the
country. France’s economic revival fell back, discouraged development of the stock market, left
the monarchy in fiscal crisis and laid the foundation of the Revolution.

Great Britain had a similar South Sea Bubble, but because this company never had control over
the Bank of England, and the latter increased the borrowing conditions, the consequences were
less grave and, ruined fewer people and did not do systemic damage to the stock market.

On 29 October 1929, the worst stock exchange crash ever occurred. For the next 3 years, DJIA
dropped 89%, only reaching its 1929 level in 1954. Mainly the US and Germany were hit by the
biggest depression ever. Unemployment soared and world trade shrank because of
protectionist measures.  It is unclear what the direct cause for this was. The occurrence of
major dips in stock markets are much more frequent than what a standard normal statistical
model predicts. Apart from the psychological and emotional dimension, the chronic production
overcapacity after the world war together with the increased union power made it hard for
countries to expand. Especially in the US an increased portion of the sales was financed by
credit. The Fed did little to fight the credit crunch banks imposed on the rest of the economy
(10,000 banks went bust). Only in 1932 did it directly interfere with market operations, which
had a positive impact. Since then credit needs to be expanded and direct market operations are
desirable to avert depression. Something that Alan Greenspan had done in 1987, thereby
unwillingly provide so much cash that a bubble was allowed to form in mid ‘90s.

Enron was in the middle of that bubble as it was promising, very analogous to John Law’s
Company, huge returns at no risk. It wanted to revolutionize the energy sector when it became
deregulated. Stock prices went times five and management was very lavishly remunerated. But
both profit statements and market prices were massaged and fraudulently over-inflated. Profits
were reported because dodgy constructions were set up to hide the losses. When this came
out, the 4th largest US enterprise also appeared to have not 13 but 38 billion USD in long term
debt. Stock prices fell from 90 USD to 40 cents and some top managers were sent to jail. On top
of that, and just like with John Law’s Company, thousands of people lost all their savings.

Findings:
• The Joint-Stock, Limited Liability Corporation: One of the most fundamental institutions
of the modern world.
• The stock market, not shareholders, disciplines the companies and corporations. “Hourly
referendums on the companies whose shares are traded there.”
• “Irrational Exuberance” of surging stock prices.
• Bulls and Bears
• Pattern of Financial Bubbles: Displacement, Euphoria (overtrading), Mania (bubble),
Distress , Revulsion (Discredit)
• Three other recurrent features of a bubble: Asymmetric Information (insider info), cross-
border capital flows (make bubbles more likely), [too] easy credit (fault of central banks)
• How Humans can’t seem to learn from history
• Performance of the American Stock Market
• Stocks have outperformed Bonds--& carry more risk
• The Crash of 1929…US stock market declined 89% from Oct 1929-July 1932…Asset price
deflation coincided with/caused the worst depression in US History. Output dropped
33%, unemployment hit 33%, World trade shrank 66%.
• Crisis’ Psychological Dimension & Financial Misconduct
• Roots in post WWI overproduction…drove prices down, low prices = harder for
countries to pay off debts…increased power of organized labor…technological &
business innovation in USA was a double-edged sword & led to a bubble.
• Too-easy credit (“Buying on margin”)
Ponzi scheme :
A Ponzi scheme is a fraudulent investment operation where the operator, an individual or
organization, pays returns to its investors from new capital paid to the operators by new
investors, rather than from profit earned by the operator. Operators of Ponzi schemes usually
entice new investors by offering higher returns than other investments, in the form of short-
term returns that are either abnormally high or unusually consistent.
Ponzi schemes occasionally begin as legitimate businesses, until the business fails to achieve
the returns expected. The business becomes a Ponzi scheme if it then continues under
fraudulent terms. Whatever the initial situation, the perpetuation of the high returns requires
an ever-increasing flow of money from new investors to sustain the scheme.
The scheme is named after Charles Ponzi, who became notorious for using the technique in
1920. The idea, present in novels (for example, Charles Dickens' 1844 novel Martin
Chuzzlewit and 1857 novel Little Dorrit each described such a scheme), was actually performed
in real life by Ponzi who with his operation took in so much money that it was the first to
become known throughout the United States. Ponzi's original scheme was based on
the arbitrage of international reply coupons for postage stamps; however, he soon diverted
investors' money to make payments to earlier investors and himself.

Characteristics:
Typically, extraordinary returns are promised on the original investment and vague verbal
constructions such as "hedge futures trading", "high-yield investment programs", or "offshore
investment" might be used. The promoter sells shares to investors by taking advantage of a lack
of investor knowledge or competence, or using claims of a proprietary investment strategy
which must be kept secret to ensure a competitive edge.
Ponzi schemes sometimes commence operations as legitimate investment vehicles, such
as hedge funds. For example, a hedge fund can degenerate into a Ponzi scheme if it
unexpectedly loses money (or simply fails to legitimately earn the returns promised and/or
thought to be expected) and if the promoters, instead of admitting their failure to meet
expectations, fabricate false returns and (if necessary) produce fraudulent audit reports.
A wide variety of investment vehicles or strategies, typically legitimate, have become the basis
of Ponzi schemes. For instance, Allen Stanford used bank certificates of deposit to defraud tens
of thousands of people. Certificates of deposit are usually low-risk and insured instruments, but
the Stanford CDs were fraudulent.
Initially the promoter will pay out high returns to attract more investors, and to lure current
investors into putting in additional money. Other investors begin to participate, leading to a
cascade effect. The "return" to the initial investors is paid out of the investments of new
entrants, and not out of profits.
Often the high returns encourage investors to leave their money in the scheme, with the result
that the promoter does not have to pay out very much to investors; he simply has to send them
statements showing how much they have earned. This maintains the deception that the
scheme is an investment with high returns.
Promoters also try to minimize withdrawals by offering new plans to investors, often where
money is frozen for a longer period of time, in exchange for higher returns. The promoter sees
new cash flows as investors are told they cannot transfer money from the first plan to the
second. If a few investors do wish to withdraw their money in accordance with the terms
allowed, their requests are usually promptly processed, which gives the illusion to all other
investors that the fund is solvent.

Unraveling of a Ponzi scheme:

When a Ponzi scheme is not stopped by the authorities, it sooner or later falls apart for one of
the following reasons:

1. The promoter vanishes, taking all the remaining investment money (which excludes
payouts to investors already made).
2. Since the scheme requires a continual stream of investments to fund higher returns,
once investment slows down, the scheme collapses as the promoter starts having
problems paying the promised returns (the higher the returns, the greater the risk of
the Ponzi scheme collapsing). Such liquidity crises often trigger panics, as more people
start asking for their money, similar to a bank run.
3. External market forces, such as a sharp decline in the economy (for example, the Madoff
investment scandal during the market downturn of 2008), cause many investors to
withdraw part or all of their funds.
 "bubble" that looks like this:

Prices go way up, then they crash back down. Look at any long-term plot of any asset price
index (stocks, housing, etc.) and you're likely to see some big peaks like this. That's what I call a
"bubble." It's also the definition used by Charles Kindleberger in his book Manias, Panics, and
Crashes.

Some people believe that bubbles are merely responses to changes in expected fundamental
value of an asset (the "fundamental value" is the expected present value of  the income you get
from owning an asset). According to this view, the NASDAQ bubble happened because people
thought that internet companies were going to make lots and lots of profit, and when those
expectations didn't materialize, prices went down again. This view is held by many eminent
financial economists, including Eugene Fama, the most cited financial economist in the world.

If bubbles represent the best available estimate of fundamental values, then they aren't
something try to stop. But many other people think that bubbles are something more sinister -
large-scale departures of prices from the best available estimate of fundamentals. If bubbles
really represent market inefficiencies on a vast scale, then there's a chance we could prevent or
halt them, either through better design of financial markets, or by direct government
intervention. For a discussion on theoretical reasons to believe or disbelieve that bubbles =
departures from market efficiency, see this email exchange between Eugene Fama and Ivo
Welch. Very good stuff.

But in the end, empirical reality has to have the last word. And here's the problem to answer
the question by looking at the data: It's nearly impossible to know what fundamentals really
are. So in 1988, Vernon Smith (now a Nobel laureate) had the idea of using lab experiments to
study bubbles. In a lab experiment, the experimenter knows what the fundamental value is, so
whether the price exceeds the fundamental can be known with a high degree of confidence.
So Vernon Smith and his co-authors put groups of subjects in a lab, gave them some cash, and
let them buy and sell a computer-generated financial asset. The asset payed dividends to
whoever held it, so its fundamental value was equal to the expected value of the dividends it
paid (or less, since people might be risk-averse). So not only did the experimenters know the
fundamental value of the asset, but the subjects themselves were told everything they needed
to know to calculate the fundamental!

And guess what happened? Prices rose way above the fundamental value, and then crashed at
the end of the market. Check out this graph of the prices from one of their experimental
markets:

The black stair-step line is the fundamental value (it goes down, since the market has a fixed
finite lifetime). The dots are prices at which subjects exchanged the asset. As you can see,
prices went way above the expected value of the asset in periods 3 and 4, then crashed back
down somewhere around periods 9 and 10.

You are looking at a bubble that is also a market inefficiency. It is real. It exists.

the market in this lab experiment was the same as real-world financial markets, this graph
would spell death for the Efficient Markets Hypothesis. Done. Kablooie.

But of course, we do not know that this market is the same as a real-world market. This market
is 8 inexperienced college kids in a lab, trading about $200 worth of an asset that is very
different from real-world assets, over a period of maybe an hour. Real-world markets are made
up of thousands or millions of experienced traders trading trillions of dollars worth of assets,
with plenty of time to make their decisions. In other words, the Smith, Suchanek, and Williams
experiment does not instantly explode all of efficient-market financial economics, because it
may lack external validity.

But if it does have external validity, it's the most important empirical result in all of financial
economic history.

A lot of work has gone into figuring out whether the Smith-Suchanek-Williams result has
external validity. On one hand, it's reliably true that when the same group of traders - or even
part of the group - repeats the market 3 times in a row, there's no bubble. On the other hand, if
you take those "experienced" traders and run the experiment with a different fundamental
value process, the bubbles come back.

The Smith-Suchanek-Williams type experiment has been run with professional traders. It has
been run with large numbers of traders. It has been run under various different market
institutions - allowing short selling, using different kinds of markets, under various rules,
etc. Always, the bubbles come back. As the list of "things that don't prevent lab bubbles" grows,
so does the nagging feeling that this type of inefficient bubble may be a universal phenomenon.

But there is one critique of the Smith experiment that has never really been put to rest. What if
subjects just fail to understand the fundamentals? Maybe subjects simply learn by doing.
Maybe you can tell them the fundamentals, but they don't really understand and believe in the
fundamentals until they've had some experience with seeing the dividends roll in. In fact, there
is research to support this critique. For example, when you let the subjects watch the dividend
process  before they trade, or when you explain the fundamental value in a different way, the
bubbles disappear.

Nobody is really interested in a bubble that only happens because subjects are confused. It's
easy to confuse a bunch of college kids. So this critique has limited the degree to which the
"bubble experiment" literature has turned the financial econ world upside down.

That's where my job market paper comes in, actually. My experiment was about determining
demand for assets in experimental markets - i.e., figuring out why people buy assets, not just
whether markets lead to bubbles. Instead of the normal market setup, where all the traders
trade with each other, I had traders who simply watched the prices that were produced by such
a market, and then let them trade at those prices without affecting the price (think of this as
one guy sitting at home buying and selling on E*trade; he's too small to move the market, but
we can learn a lot from watching how he makes his decisions).
And one of the things I did was to ask my subjects how much dividend income they thought
they would get from holding a share of the asset (i.e., the fundamental value). So I was able to
tell who understood the fundamental value and who didn't. So I could tell if people who
understood the fundamentals would knowingly overpay for the asset.

People who understood exactly how much the asset was worth were overwhelmingly likely to
pay, say, 60 yen for a share of the asset (the experiment was run in Japan), even when the most
dividend income they could possibly get for it was only 40 yen. They gave up certain gains.
(Why on Earth did they do this? Well, that's what the rest of the paper is about, and is a subject
for at least two other long blog posts.) So this result really answers one critique of the Smith
bubble experiments: understanding what's going on is not sufficient to make subjects act like
the "rational arbitrageurs" in financial economics models.

Now, that's only one critique of bubble experiments. It's impossible to answer them all. But
science is a process of excluding causes one by one. The more uninteresting causes of bubbles
we exclude, the closer we get to finding whatever interesting causes may exist.

To sum up: If we believed that Vernon Smith type bubble experiments could reliably show us
how real financial markets work, the finance industry would be falling over itself to do a billion
lab experiments, and both business and government would have to seriously rethink policies
that depend on markets being efficient (e.g., stock options for executives). But the jury is still
out. Still, the bubble result of Smith, Suchanek, and Williams (1988) is one of the most
important experimental findings in the history of economics, and a research effort to which I
am happy to (attempt to) contribute.

Identifying asset bubbles:

CAPE based on data from economist Robert Shiller's website, as of 8/4/2015. The 26.45
measure was 93rd percentile, meaning 93% of the time investors paid less for stocks overall
relative to earnings.
Economic or asset price bubbles are often characterized by one or more of the following:

1. Unusual changes in single measures, or relationships among measures (e.g., ratios)

relative to their historical levels. For example, in the housing bubble of the 2000s, the
housing prices were unusually high relative to income. For stocks, the price to earnings
ratio provides a measure of stock prices relative to corporate earnings; higher readings
indicate investors are paying more for each dollar of earnings.
2. Elevated usage of debt (leverage) to purchase assets, such as purchasing stocks on
margin or homes with a lower down payment.
3. Higher risk lending and borrowing behavior, such as originating loans to borrowers with
lower credit quality scores (e.g., subprime borrowers), combined with adjustable rate
mortgages and "interest only" loans.
4. Rationalizing borrowing, lending and purchase decisions based on expected future price
increases rather than the ability of the borrower to repay.
5. Rationalizing asset prices by increasingly weaker arguments, such as "this time it's
different" or "housing prices only go up."
6. A high presence of marketing or media coverage related to the asset.
7. Incentives that place the consequences of bad behavior by one economic actor upon
another, such as the origination of mortgages to those with limited ability to repay
because the mortgage could be sold or securitized, moving the consequences from the
originator to the investor.
 8. International trade (current account) imbalances, resulting in an excess of savings over
investments, increasing the volatility of capital flow among countries. For example, the
flow of savings from Asia to the U.S. was one of the drivers of the 2000s housing
bubble.
9. A lower interest rate environment, which encourages lending and borrowing.

The Mississippi Bubble was an economic bubble in France in the early 1700s that developed in
parallel with Britain’s disastrous South Sea Bubble. The mastermind behind the Mississippi
Bubble was John Law, a Scottish financier, gambler and playboy who ascended into the upper
echelons of French public finance through his friendship with the Duke of Orléans. Law became
the French government’s primary financial advisor and used this power to establish the Banque
Générale, a bank with the authority to issue “paper” money, as well as the Mississippi Company
(later called "the Compagnie des Indes"), which was granted a monopoly on the development
of France’s vast Mississippi Territory in North America. When investors started salivating over
the supposedly immense bounty of resources in the Mississippi Territory, including gold and
silver, they bid Compagnie des Indes shares up to astronomical heights. Unfortunately, the
company’s prospects turned out to be little more than empty promises and the shares crashed
back down to earth, taking down France’s stock market and public finances with it.

Events Leading Up to the Mississippi Bubble:

The Mississippi Bubble saga began in 1715, when the French government was teetering on the
verge of insolvency under the burden of debts incurred during the War of Spanish Succession.
In time, the government defaulted on a portion of its debt, lowered its interest payments and
raised taxes to very high levels, all of which served to depress the French economy and caused
the value of its gold and silver-backed currency to fluctuate wildly. The French government,
then led by a group of regents because King Louis XV was only five-years old, desperately
scrambled to find a solution to the nation’s fiscal and economic woes. The Duke of Orléans, the
leader of the group of regents, soon decided to seek the council of his friend, John Law, who
was an early theorist of monetary economics.

John Law hailed from Fife, Scotland, where he was born into an affluent family of bankers and
goldsmiths. Law became his father’s apprentice at age fourteen and studied the banking
business until his father’s death three years later. Soon after, Law travelled to London in pursuit
of adventure and earned a living as a gambler thanks to his keen mathematical abilities. In
London, the twenty-three year old Law became involved in a duel over a lady friend in which he
swiftly killed his opponent and was charged with murder and sentenced to death. John Law
spent a brief time in prison before he escaped to mainland Europe, where he studied high
finance in cities such as Amsterdam, Venice and Genoa. In 1705, Law published an academic
paper in which he argued against the use of precious-metal backed currency in favor of “paper”
or fiat currency, claiming that the use of fiat currency would stimulate commerce (Smant,
2001). Due to these distinct views, Law is often considered to be an early Keynesian-style
economist.
When the desperate Duke of Orléans came looking to John Law for help, Law viewed it as an
opportunity to put his monetary theory into action. In 1716, Law received the French
government’s permission to establish a national bank, the Banque Générale, which took in
deposits of gold and silver and issued “paper” bank notes in return. The bank notes issued by
Banque Générale were not legal tender but were accepted as such by the French public
because they were redeemable in official French currency. Banque Générale built up its bank
reserves through the issuance of stock and from profits earned through the management of the
French government’s finances.

Source: Nova Scotia’s Electric Scrapbook

In 1717, John Law used his growing rapport within French society to acquire a struggling trading
company, the Mississippi Company, which he renamed to “the Compagnie d’Occident” (the
Company of the West) and was granted a monopoly on trade with and development of France’s
North American colonies along the Mississippi River. These territories (see chart above)
spanned a wide swath of area from present-day Louisiana up to Canada and were considered to
be valuable for their abundance of resources such as beaver skins and precious metals (which
later proved to be untrue). As Law’s influence continued to grow, the Compagnie d’Occident’s
name was changed to “Compagnie des Indes (“Company of the Indies”) and according to David
Smant, “expanded to monopolize all French trade outside Europe. In July 1719 the Compagnie
purchased the right to mint new coinage. In August 1719 the Compagnie bought the right to
collect all French indirect taxes and in October 1719 the Compagnie took over the collection of
direct taxes. Finally, a plan was launched to restructure most of the national debt, whereby the
remainder of existing government debt would be exchanged for Compagnie shares.” By this
time, John Law had amassed an incredible amount of power as his companies now controlled
both France’s foreign trade and its finances.

The Bubble Phase

Chart Source: HenryThornton.com
In January 1719, the Compagnie des Indes offered shares to the public for 500 livres per share
(livres were France’s currency at that time), which were bought and paid for with Banque
Générale bank notes or with government debt. Compagnie shares soared to an incredible
10,000 livres per share by December 1719 as investors began to lust over the company’s
potential value of trade with the supposedly gold and silver-rich French colonies. With share
prices at such high levels, John Law had gone from a broke gambler to one of the wealthiest,
most powerful men in Europe. People of all social classes invested in Compagnie des Indes
shares, causing many paupers to become very rich in a short span of time. Incidentally, the
French word “millionaire” originated as a result of the many people that were made wealthy as
Compagnie shares soared (Moen, 2001).

Explosive demand for Compagnie des Indes shares caused the total amount of “paper” money
bank notes in circulation to increase 186% in one year due to the fact that Banque Générale
issued as much bank notes as the public demanded. This expansion of the money supply
resulted in a powerful inflationary episode in which the price of goods doubled between July
1719 and December 1720. A good portion of Compagnie des Indes share price gains were due
to this inflation as well (Smant, 2001). Paris experienced a “bubble economy”-type boom as real
estate prices and rents soared twenty-fold and wealthy speculators clamored to buy luxury
goods (Sebastian, 2011). According to Charles Mackay, “New houses were built in every
direction, and an illusory prosperity shone over the land, and so dazzled the eyes of the whole
nation, that none could see the dark cloud on the horizon announcing the storm that was too
rapidly approaching.”

Soon, Banque Générale had issued vast quantities of bank notes even though they did not have
an equivalent amount of gold and silver-based legal tender for everyone who eventually wished
to redeem their notes. It is likely that John Law had expected to fulfill Banque Générale’s
precious metals deficit with gold and silver imported from North America by the Compagnie des
Indes.

The Crash:

In January 1720, Compagnie des Indes shares began to fall as some investors decided to take
their profits in the form of gold coins. John Law tried to curb the sell-off by limiting payments in
gold of more than 100 livres (Moen, 2001). A scandal ensued in May 1720, when John Law
decided that Compagnie shares were overvalued, causing him to start devaluing shares. In
addition, Banque Générale notes were devalued by 50%, presumably due to the bank’s
precious metals deficit, which was unable to be fulfilled by Compagnie des Indes’ operations in
North America because the Mississippi Valley region lacks meaningful deposits of precious
metals (the discovery of which resulted in major investor disappointment). Law’s devaluation of
shares and bank notes caused an intense public uproar, which resulted in a compromise in
which the bank notes’ value was restored but payment in precious metals was stopped. Despite
the compromise, the French public was outraged against the Compagnie and its near-worthless
paper bank notes.

The combination of aggressive investor selling and Law’s devaluations caused Compagnie des
Indes shares to collapse from 10,000 livres to 1,000 livres by December 1720 (Moen, 2001).
Compagnie investors were financially-ruined and many former millionaires became paupers. By
the end of 1720, John Law was viewed as a scam artist and his rivals were given control over
two-thirds of his companies’ shares. Share prices further deflated to 500 livres in 1721 (Moen,
2001). Soon after, John Law escaped France, disguised as a woman for his own safety, and
spent the rest of his life as an impoverished gambler in various parts of Europe. The collapse of
Banque Générale and the Compagnie des Indes, which coincided with the popping of
Britain’s South Sea Bubble, plunged France and other European countries into a severe
economic depression and laid the groundwork for the French Revolution that occurred later on
in the century.
Although traditionally considered a bubble, the Mississippi Bubble wasn’t actually a bubble, in a
precise technical sense. A bubble is primarily caused by widespread mania and speculation,
followed by a brutal collapse in asset values. In contrast, the Mississippi Bubble was the result
of failed monetary policies that caused excessive money supply growth and inflation.

The Enron scandal:

The Enron scandal, revealed in October 2001, eventually led to the bankruptcy of the Enron
Corporation, an American energy company based in Houston, Texas, and the dissolution of
Arthur Andersen, which was one of the five largest audit and accountancy partnerships in the
world. In addition to being the largest bankruptcy reorganization in American history at that
time, Enron undoubtedly is the biggest audit failure. It is ever the most famous company in the
world, but it also is one of companies which fell down too fast.

it analysis the reason for this event in detail including the management, conflict of interest and
accounting fraud. Meanwhile, it makes analysis the moral responsibility From Individuals’ Angle
and Corporation’s Angle.

Review of Enron’s Rise and Fall Throughout the late 1990s, Enron was almost universally
considered one of the country's most innovative companies -- a new-economy maverick that
forsook musty, old industries with their cumbersome hard assets in favor of the freewheeling
world of e-commerce. The company continued to build power plants and operate gas lines, but
it became better known for its unique trading businesses. Besides buying and selling gas and
electricity futures, it created whole new markets for such oddball "commodities" as broadcast
time for advertisers, weather futures, and Internet bandwidth. Enron was founded in 1985, and
as one of the world's leading electricity, natural gas, communications and pulp and paper
companies before it bankrupted in late 2001, its annual revenues rose from about $9 billion in
1995 to over $100 billion in 2000. At the end of 2001 it was revealed that its reported financial
condition was sustained substantially by institutionalized, systematic, and creatively planned
accounting fraud. According to Thomas (2002), the drop of Enron's stock price from $90 per
share in mid-2000 to less than $1 per share at the end of 2001, caused shareholders to lose
nearly $11 billion. And Enron revised its financial statement for the previous five years and
found that there was $586million in losses. Enron fall to bankruptcy on December 2, 2001. One
of the lessons of the Internet boom is that it's often difficult for analysts to understand and
evaluate new kinds of businesses. And executives like Mr. Skilling, who once swore at an analyst
during a conference call for asking a pointed question about Enron's balance sheet, don't do
much to foster the kind of open inquiry that could lead to better information. But the Enron
debacle is also emblematic of another problem that has become all too evident in the last few
years: Wall Street's loss of objectivity. Investment banks make far more money from
underwriting or merger deals than they do from broker fees. Analysts at these firms often face
conflicting loyalties. They can be put in the position of having to worry as much about whether
a chief executive might find a report offensive as whether an investor might find it helpful.

The Causes of Enron’s bankruptcy

Truthfulness The lack of truthfulness by management about the health of the company,
according to Kirk Hanson, the executive director of the Markkula Center for Applied Ethics. The
senior executives believed Enron had to be the best at everything it did and that they had to
protect their reputations and their compensation as the most successful executives in the U.S.
The duty that is owed is one of good faith and full disclosure. There is no evidence that when
Enron’s CEO told the employees that the stock would probably rise that he also disclosed that
he was selling stock. Moreover, the employees would not have learned of the stock sale within
days or weeks, as is ordinarily the case. Only the investigation surrounding Enron’s bankruptcy
enabled shareholders to learn of the CEO stock sell-off before February 14, 2002 which is when
the sell-off would otherwise have been disclosed. Why the delay? The stock was sold to the
company to repay money that the CEO owed Enron—and the sale of company stock qualifies as
an exception under the ordinary director and officer disclosure requirement. It does not have to
be reported until 45 days after the end of the company’s fiscal year. (The Conference Board,
Inc., 845) 2.2 Interest It has been suggested that conflicts of interest and a lack of independent
oversight of management by Enron's board contributed to the firm's collapse. Moreover, some
have suggested that Enron's compensation policies engendered a myopic focus on earnings
growth and stock price. In addition, recent regulatory changes have focused on enhancing the
accounting for SPEs and strengthening internal accounting and control systems. Review these
issues, beginning with Enron's board. (Gillan SL, Martin JD, 2007) The conflict of interest
between the two roles played by Arthur Andersen, as auditor but also as consultant to Enron.
While investigations continue, Enron has sought to salvage its business by spinning off various
assets. It has filed for Chapter 11 bankruptcy, allowing it to reorganise while protected from
creditors. Former chief executive and chairman Kenneth Lay has resigned, and restructuring
expert Stephen Cooper has been brought in as interim chief executive. Enron's core business,
the energy trading arm, has been tied up in a complex deal with UBS Warburg. The bank has
not paid for the trading unit, but will share some of the profits with Enron.

Enron and the reputation of Arthur Andersen The revelation of accounting irregularities at
Enron in the third quarter of 2001 caused regulators and the media to focus extensive attention
on Andersen. The magnitude of the alleged accounting errors, combined with Andersen's role
as Enron's auditor and the widespread media attention, provide a seemingly powerful setting to
explore the impact of auditor reputation on client market prices around an audit failure. CP
investigates the share price reaction of Andersen's clients to various information events that
could lead investors to revise their beliefs regarding Andersen's reputation.( Nelson KK, Price
RA, Rountree BR, 2008) Perhaps most damaging to Andersen's reputation was their admission
on January 10, 2002 that employees of the firm had destroyed documents and correspondence
related to the Enron engagement. For a sample of S&P 1500 firms, CP reports that in the 3-day
window following the shredding announcement (0, +2), Andersen clients experienced a
significant −2.03% market reaction, and this reaction was significantly more negative than for
Big 4 clients. Andersen's Houston office clients, where Enron was headquartered, experienced
an even stronger negative market reaction than Andersen's non-Houston clients.2 Overall, CP
concludes the shredding announcement had a significant impact on the perceived quality of
Andersen's audits, and that the resulting loss of reputation had a negative effect on the market
values of the firm's other clients. In this study, Report new findings that shed light on whether
this event study evidence is consistent with an auditor reputation effect. In so doing, do not
suggest that auditor reputation does not matter. As discussed above, there is ample evidence
that reputation is important to auditors and their clients. Rather, our purpose is to determine
whether client returns around Andersen's shredding announcement and related events can be
considered evidence of a reputation effect, or whether the results are confounded by other
effects.

An important factor: accounting fraud

Mark to market As a public company, Enron was subject to external sources of governance
including market pressures, oversight by government regulators, and oversight by private
entities including auditors, equity analysts, and credit rating agencies. In this section recap the
key external governance mechanisms, with emphasis on the role of external auditors. This
method requires that once a long-term contract was signed, the amount of which the asset
theoretically will sell on the future market is reported on the current financial statement. In
order to keep appeasing the investors to create a consistent profiting situation in the company,
Enron traders were pressured to forecast high future cash flows and low discount rate on the
long-term contract with Enron. The difference between the calculated net present value and
the originally paid value was regarded as the profit of Enron. In fact, the net present value
reported by Enron might not happen during the future years of the long-term contract. There is
no doubt that the projection of the long-term income is overly optimistic and inflated.

SPE—Special Purpose Entity Accounting rule allow a company to exclude a SPE from its own
financial statements if an independent party has control of the SPE, and if this independent
party owns at least 3 percent of the SPE. Enron need to find a way to hide the debt since high
debt levels would lower the investment grade and trigger www.ccsenet.org/ijbm International
Journal of Business and Management Vol. 5, No. 10; October 2010 Published by Canadian
Center of Science and Education 39 banks to recall money. Using the Enron’s stock as collateral,
the SPE, which was headed by the CFO, Fastow, borrowed large sums of money. And this
money was used to balance Enron’s overvalued contracts. Thus, the SPE enable the Enron to
convert loans and assets burdened with debt obligations into income. In addition, the taking
over by the SPE made Enron transferred more stock to SPE. However, the debt and assets
purchased by the SPE, which was actually burdened with large amount of debts, were not
reported on Enron’s financial report. The shareholders were then misled that debt was not
increasing and the revenue was even increasing. 3. Prisoner’s dilemma shown in Enron’s case At
the time of the firm's collapse, Enron was engaged in a wide range of activities including energy
production and the trading of energy-related commodities and derivatives. As such, many of its
activities were potentially subject to oversight by the Commodities and Futures Trading
Commission (CFTC) or the Federal Energy Regulatory Commission (FERC). The CFTC's primary
mission is to ensure that the commodity futures and options markets operate in an open and
competitive manner, while the FERC regulates the interstate transmission and market for
energy products. Of course, the primary source of federal oversight for publicly traded firms is
the Securities and Exchange Commission (SEC). In the zero-sum game, each party is trying to
secure more gains for themselves even if the best outcome is cooperating with each other.
Obviously, to pursue maximum profits, wrong doings like accounting fraud will harm the
shareholders’ interests. Arthur Andersen, as auditor but also as consultant to Enron, has to be
responsible for both managers and shareholders since the provided accounting information has
a direct influence on economic benefits of both parties. Clearly, the managers and Arthur
Andersen chose betraying the shareholders to maximize their self interests.

Who was morally responsible for the collapse of ENRON?

From Individuals’ Angle As corporate acts originate in the choices and actions of human
individuals, it is these individuals who must be seen as the primary bearers of moral duties and
moral responsibility. The then chairman of the board, Kenneth Lay, and CEO, Jeffrey Skilling, to
allowed the then CFO, Andrew Fastow, to build private cooperate institution secretly and then
transfered the property illegally. The CFO, Andrew Fastow, violated his professional ethics and
took the crime of malfeasance. When the superior, the chairman of the board of Kenneth Lay
and CEO Jeffrey Skilling, ordered conspiratorial employees to carry out an act that both of them
knowing is wrong, these employees are also morally responsible for the act. The courts will
determine the facts but regardless of the legal outcome, Enron senior management gets a
failing grade on truth and disclosure. The purpose of ethics is to enable recognition of how a
particular situation will be perceived. At a certain level, it hardly matters what the courts
decide. Enron is bankrupt—which is what happened to the company and its officers before a
single day in court. But no company engaging in similar practices can derive encouragement for
any suits that might be terminated in Enron’s favor. The damage to company reputation
through a negative perception of corporate ethics has already been done. Arthur Andersen
violated its industry specifications as a famous certified public accountant.

From Corporation’s Angle The acts of a corporation's managers are attributed to the
corporation so long as the managers act within their authority. However, the shareholders of
Enron didn't know and realize this matter from the superficial high stock price. Therefore, the
whole corporation was not of responsibility for this scandal. Actually, if the board and other
shareholders paid more attention to those decisions made by the chief, CEO, CFO and those
relevant staffs, ENRON can avoid this result.

The warning of Enron’s scandal

There should be a healthy corporate culture in a company. In Enron’s case, its corporate
culture played an important role of its collapse. The senior executives believed Enron had to be
the best at everything it did and the shareholders of the board, who were not involved in this
scandal, were over optimistic about Enron’s operating conditions. When there existed failures
and losses in their company performance, what they did was covering up their losses in order
to protect their reputations instead of trying to do something to make it correct. The “to-good-
to-be-true” should be paid more attention by directors of board in a company.
A more complete system is needed for owners of a company to supervise the executives and
operators and then get the idea of the company’s operating situation. There is no doubt that
more governance from the board may keep Enron from falling to bankruptcy. The boards of
directors should pay closer attention on the behavior of management and the way of making
money. In addition, Enron’s fall also had strikingly bad influence on the whole U.S. economy.
Maybe the government also should make better regulations or rules in the economy.

“Mark to market” is a plan that Jeffrey Skilling and Andrew Fastow proposed to pump the stock
price, cover the loss and attract more investment. But it is impossible to gain in a long-term
operation in this way, and so it is clearly immoral and illegal. However, it was reported that the
then US Security and Exchange Commission allowed them to use “mark to market” accounting
method. The ignorance of the drawbacks of this accounting method by SEC also caused the final
scandal. Thus, an accounting system which can disclose more financial information should be
created as soon as possible.

Maybe business ethics is the most thesis point people doing business should focus on. As a loyal
agent of the employer, the manager has a duty to serve the employer in whatever ways will
advance the employer's self-interest. In this case, they violated the principle to be loyal to the
agency of their ENRON. Especially for accountants, keeping a financial statement disclosed with
true profits and losses information is the basic responsibility that they should follow.
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