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 very
few years the markets truly surprise us, and 2001 was one of those
years. The company that Fortune magazine selected as the
most innovative in America six years in a row — Enron —
filed for bankruptcy.
The company
was hailed as a new-economy company, a truly innovative firm that
would be a model for others to follow. But its demise may have reminded
you of a number of players in the past few years that have used
sophisticated financial instruments to soar to incredible heights
only to crash later. Long Term Capital Management (LTCM) and several
other hedge funds that imploded come to mind.
It's somewhat
ironic that these companies get a lot of favorable press early in
their lives, a testament to the notion that ideas really matter.
They are often touted as businesses that took a theory from the
textbooks and turned it into a profit-generator. In Enron's case,
the theory was that anything could be turned into a commodity.
Enron, of course,
widened the definition of commodity to include electric power, bandwidth,
credit risk, advertising space, and weather derivatives — among
others. In principle, anything that could conceivably be modified
and traded would fit the definition.
The benefits
of this wide inclusion were obvious; Enron could hedge against adverse
market conditions by, for example, buying a contract guaranteeing
you 1000 KWs at a given price at the end of September. In theory,
the sellers would also be better off or they would not enter the
contract voluntarily. As the major organizer and market maker, Enron
would be there to take a slice of every trade. The greater the volume
of transactions, the greater Enron's profits would be.
But the problem
for Enron began — and has begun for any company built on this
model — when it started trading for its own accounts. This
is an important position to understand, and it brings us into the
fantasy realm of perfect foresight and certainty.
Arbitrage (Webster's:
"The often simultaneous purchase and sale of the same or equivalent
security, as in different markets, in order to profit from price
discrepencies.") insures that the future production costs will
not exceed the implied cost of storing (in this instance) the oil
and gas used to generate the future electricity. The carrying costs
are directly related to interest rates. Using computers, companies
can figure out these carrying costs. Also, the futures markets add
another set of inputs from which the implied future prices can be
derived. Thus, through the use of computer models, market prices
for final commodities, and other various inputs, one could derive
a number of arbitrage opportunities. (This is much like a trading
program used by investment managers and large brokerage houses to
arbitrage discrepancies in the major indices.)
Early in the
process, as the arbitrage innovation is introduced, profit opportunities
may exist. Also, the number of players arbitraging the inefficiency
may be small enough so as not to impact the market-clearing price
in a significant way. The arbitrage profits booked in a current
period do not actually get realized until the transaction is completed
or unwound. And the profit depends critically on market equilibrium
conditions. If the number of arbitrageurs is small enough, market
conditions will not change and the profits realized will be exactly
the same as the profits booked. Accounting for these profits is
a fairly straightforward task.
A major factor
limiting potential profits is the scale of the arbitrage operations.
One way to increase the scale of the operations is through leverage.
So, early in the process, a company can increase profitability by
using leverage. However, over time, new entrants come into the market,
players become more sophisticated, and profit margins get squeezed.
A normal equilibrating process will eventually lead to a complete
elimination of the excess rate of returns.
So, in an attempt
to prevent a reduction in profits, these companies increase their
leverage factor. This simple process illustrates how, under some
general conditions, a company involved in the arbitrage business
will ultimately increase its level of investments and debts, and
use ever more complicated accounting techniques to book profits.
And a slight mistake could lead to the unraveling of the whole process.
Of course,
in a perfect world, and with a true arbitrage process, such a mistake
can never occur. But this is the real world. What happens when the
world is not exactly as it is being modeled?
The possibility
always exists that some unforeseen event will take place, so companies
incorporate risk-control strategies (such as insurance) and plan
for the best. But a company's upside is not the concern here. The
more interesting case is what happens when the shock unforeseen
by the risk-control strategy is an adverse one?
The immediate
response is to cover the position. In some cases that requires reversing
or unwinding some of the hedges and going into the market. Now here
is where size matters. If the hedging entity is a small and un-influential
player it will have no market impact. However, if large, it will
effect the equilibrium prices. The attempt to cover the position
will induce the price to move further away from the original market-clearing
price.
The possibility
of the hedging company crashing is clearly present, and to the extent
that they are large enough, their impact on the market could destabilize
other companies and the overall market.
This is a plausible
explanation that relates the financial crisis originated by companies
like LTCM with the fate that Enron has experienced. Almost all press
accounts attribute the failure to bad investments, mountainous debts,
and in some cases dubious accounting. Yet, as one looks deeper into
the various failures, these are symptoms — and they are, in
fact, the result of Enron's failure to understand the concept of
general equilibrium.
The arbitrage
process, even under certainty, will result in leverage (i.e., debt)
and complicated accounting. As an operation gets larger and larger,
it will no longer be a price taker; it will impact market prices.
The bad investments Enron made can be attributed to their failure
to model the world correctly and their ignorance of their own impact
on the financial markets' equilibrium process. Enron needed to incorporate
feedback on their actions in the arbitrage process.
This is especially
important as they try to unwind a position. Their actions will influence
the market-clearing price, so in effect they will now be chasing
a moving target. This type of logic suggests that traditional accounting
for booking of profits, which assumes that the arbitrageur is a
price taker, is no longer appropriate. That is the common element
in all these failures.
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