Have We Learned Nothing?

Eight years after the Enron debacle, Wall Street was supposed to have learned its lesson about creative accounting, excessive risk-taking and corporate greed. Government regulators and ratings agencies were supposed to be chastened, too. Instead, the rules never really changed, and we are now facing far deeper crises, according to financial author Bethany McLean. What's worse, she says, is that regulators are now encouraging accounting practices similar to those that contributed to Enron's fall. McLean first reported on the shady dealings of the Texas-based energy giant and later coauthored a best-selling exposé about the firm, "The Smartest Guys in the Room." Now a contributing editor at Vanity Fair, she is at work on a new, yet-to-be-titled book about the current bailout (or, if you prefer, rescue). NEWSWEEK's Kathy Jones asked McLean to weigh in on the fury and fog permeating the economic mess. Excerpts:

NEWSWEEK: Congressional leaders say the bailout bill the Senate passed has more transparency about how the industry will spend taxpayers' $700 billion. But at the same time, it appears the government may be acting to reduce transparency, by banning short-selling and relaxing some accounting rules regarding how banks value their mortgage assets. It seems "Alice in Wonderland "-like.
Bethany McLean: I think it's exactly "Alice in Wonderland." The notion that short sellers are to blame: it's a total reversal of cause and effect. They short a stock because they suspect the company is unsound—they do not cause the company to be unsound. Show me the gun that short sellers held to Wall Street executives that made them buy bad mortgages. And there's probably an argument to be made that the [Dow’s 777.68-point] decline would have been less if short sellers had been in the market because they step in and buy stocks when they cover their short positions.

Some members of Congress say the debt we're buying is basically worthless. But banks say it'll go up in value in the future. On Oct. 1, the SEC and Financial Accounting Standards Board sided with the ban ks, saying they can value this debt at what they think it'll be in the future — so they don't have to "mark-to-market." Institutional investors and auditors say this will "deprive investors of critical financial inf ormation when it is needed most." What do you think?
I haven't been on the inside of any of these transactions, obviously, but when they claim "mark-to-market" is forcing you to value assets at unfairly low prices, I haven't seen any anecdotal evidence that that's the case. If firms like Lehman and AIG were being forced to mark these securities at ridiculously low levels, potential buyers would have said, "Wow, there's a bargain here" ... There are no buyers because firms aren't willing to sell at a low-enough price.

Who do you trust to value this stuff more: the banks who have been wrong all along or potential buyers?
The problem is not too much pessimism but too much optimism. I don't think this is deliberate obfuscation, but because they are hard to value, there's an element of wishful thinking. If you wanted to know what the price of IBM is, you could look it up. There's no way to do that with these securities. They trade privately ... there's no real sense of what these things are worth because they are tied to home prices, and no one knows where home prices are going.

So how can the government make a wise decision about how much money it should spend on these assets?
Good question. Bill Gross [chief investment officer of PIMCO, the world's largest bond fund] had an argument for why the taxpayers can make money on the bailout. He knows far more than I do, but I have trouble understanding it. If the government buys these securities at prices where they can make money, chances are they are going to be buying at a lower price than Wall Street has on their books. The firm that sells will face a giant capital hole, and that continues the problem. The only way to really bail out these firms is to buy them at a price equivalent or higher. So I don't understand how the taxpayer is going to make any money.

A commenter on one financial blog reacted to the accounting change this way: "I know I'm going to be chomping at the bit to buy stock in companies whose balance she ets are incomprehensible by design. Look how well it worked with Enron!" Do you think investor confidence overall will be hurt by this?
If you're a financial-services firm, one of the most important things you can do is manage your risk. If you're not telling investors where you are marking these mortgage-related assets, there are two possibilities. One is that you are keeping two sets of books. I don't think any investor likes [that] possibility. The other is you are not doing any internal analysis, and that's not very good news for investors either. Everything that has happened, from the banning of short sellers to [altering] mark-to-market is a move away from the free market and transparency. Maybe some could say that's a good thing, and all these things we cherished in the past are not right. But suffice it to say, it's been in the span of three months that people have dropped all these principles that they've held dear. Either we weren't doing the right thing when we celebrated the free market and transparency, or we're doing the wrong things now. You can't have it both ways.

Does this feel like Enron d é j à vu ?
On the subject of mark-to-market, Enron was castigated, and rightfully so, for using this method of accounting to make up its numbers. But allowing financial institutions to pretend that mortgage-backed securities haven't declined in value isn't any better. In essence, you have the government saying, "It's OK! Make up your numbers with our blessing!" And then it's funny looking at the rating agencies: They had Enron rated investment-grade until four days before its collapse, and Congress held hearings about the problems with the ratings agencies. Here we are—however many years later— and the rating agencies stamped their AAA ratings on these financial instruments and then they blew up, and now Congress again held hearings on the problems with the rating agencies. Does that qualify as progress? It's déjà vu in a very scary way.

How do you compare the scale of what's happening now to Enron?
A good ruler is Enron's market capitalization at its peak—around $65 billion. If you compare that to losses that will be taken on mortgage-related securities, some say it might be in the trillions. It's just a totally different order of magnitude. With Enron, the employees lost their jobs, and investors lost money. A lot of people were relatively unscathed, but this is going to hit everybody. There are going to be layoffs, and the economy is going to shrink, I don't see how we avoid having higher taxes eventually. It's everybody's problem.