Outlook: Enron - the exception that proved Marx wrong?

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The Independent Online

No one in financial markets much likes meddlesome Government regulation, but where there's none of it, things do seem to have a nasty habit of going disastrously wrong. The latest instance of it is Enron, a company that fought long and hard to keep the regulators out of energy trading, and was largely successful in doing so, too. Whether Enron's $30bn collapse was due to an absence of regulation is hard to know, but for a change this is not one of those insolvencies that can be laid squarely at the door of incompetent regulators. Enron's activities went largely unseen and untouched by Government authority.

Bizarrely, all the other checks and balances supposedly there to prevent catastrophic loss failed to work either. This week, Joseph Berardino, the chief executive of Andersen, has spoken of "a crisis of confidence" in the accountancy profession following the collapse. Others are more specific. In fact, there's a crisis of confidence in Andersen, they say, which failed in its duties as an auditor.

"Andersen will have to change.... The accounting profession will have to reform itself. Our system of regulation and discipline will have to be improved," Mr Berardino told a Congressional Committee investigating the collapse. Yes indeed, if there were no regulators around when they were needed, there's a veritable army of them crawling all over the affair now. Andersen's chief "professional misjudgment" was in its treatment of one of Enron's special purpose entities, which was essentially a ruse for keeping a great chunk of debt off the group's balance sheet.

Mr Berardino admitted to "erring" in allowing this to happen, but he was determined Andersen shouldn't be made the fall guys. In fact, he said, Andersen had warned Enron's audit committee of possible "illegal acts" within the company. So here's another failure – the audit committee. It also gives the whole affair a British connection, for the audit committee included John Wakeham, a former Secretary of State for Energy and latterly an Enron non-executive director. For the time being, Lord Wakeham is saying nothing, which is generally the habit of non-executives when things go disastrously wrong. Lord Wakeham is also chairman of the Press Complaints Council, which at least allows him to complain to himself if he thinks we are being unfair in citing him.

So why wasn't Enron subject to more vigorous regulation? Simple. In theory at least, Enron was just an ordinary company, not a financial services company at all. As such, it was subject to ordinary company regulation, but not to the more demanding solvency, capital and trading practices regime that would surround anyone operating in financial services.

This is hardly surprising, since that's what Enron originally was – a humble natural gas and electricity company. With deregulation of energy markets in the 1990s, there came the opportunity for energy trading. Once physical energy could be traded it was only a matter of time before futures and other derivative contracts started to trade on top.

Enron made these new markets its own and by the time of its collapse it had more than a quarter of the total market in the US and Europe. The tail soon came to wag the dog. The gas pipelines and power stations became secondary to Enron's wheeler dealing in energy contracts, and that's where the trouble began.

Enron slipped easily through the net. Regulators knew about banks, insurance, securities trading and the rest, but they weren't equipped to deal with these new markets, some of which, like energy, were dealt entirely online by and through companies that fell outside the traditional stamping grounds of financial regulators.

Enron is by no means unique. In the late 1990s, it was hedge funds that were the big area of concern, particularly after the collapse of Long-Term Capital Management, which demonstrated that these largely offshore, unregulated, poker playing ne'er-do-wells had the capacity to put the entire financial system at risk. The LTCM affair resulted in much hand wringing and debate, but nothing was done, and whenever regulators broached the subject of how to deal with burgeoning activity in over-the-counter derivative markets, Enron and others were there with their lawyers and political contacts to see them off.

Strictly speaking, Enron cannot be compared with the hedge fund crisis since it was not in the business of proprietary trading. Even so, the parallels are obvious. When Enron went under, it is said to have had nearly $20bn of contracts still on the books, which insolvency experts are now painstakingly trying to untangle.

Financial markets have become so sophisticated, so vast and apparently impenetrable that regulators find it a struggle to keep up. In theory, they don't have to worry about derivatives, since the whole purpose of a derivative is to reduce and spread risk. In practice, they don't know what to think. One area of concern highlighted by the Bank of England this week in its half-yearly Financial Stability Review is the fast-growing market in credit derivatives. It barely existed three years ago but is now said to be worth $400bn annually.

The value of derivative contracts as a whole slopping around the world's financial system is thought to have risen 10-fold during the last 10 years to nearly $60 trillion. Again, the effect in theory is to disperse risk much more widely than in the past, but nobody knows for sure, and it may well be that, as with Enron, the risk is simply becoming concentrated in less conventional repositories.

Credit derivatives provide a useful illustration. A credit derivative is essentially an insurance policy which allows banks and other creditors to insure against the risk of default. Britain's Barclays Bank is listed as Enron's largest single unsecured creditor, but one reason the bank may have been able to take such a relaxed view of its exposure is because the risk has been insured through the credit derivative market. The effect is to transfer what has traditionally been a banking risk to others that may be less well equipped to cope with it – insurers, pension funds and anyone else willing to write the business.

It's never easy to know where to draw the line with regulation. Most market practitioners regard all regulation as a tiresome and costly nuisance which we'd do much better without. But the truth of the matter is that regulation only exists at all because of capitalism's propensity, when left unfettered, to crisis, fraud and generally bad behaviour.

The financial markets have been forced to concede ever greater and more intrusive levels of Government oversight if only because the alternatives are so much worse – the total collapse of economic and social order that Marx and other 19th century polemicists foresaw. Marx was wrong because he failed to see how effective capitalist democracies would be at regulating themselves in the wider public interest. So we have our safety nets, our deposit protection schemes, our capital adequacy rules, our market abuse regimes and all the rest, and on the whole it works quite well.

At the end of every boom, something comes along to remind us all of just what happens when things are allowed to go entirely unchecked. Greed and hubris take over, managers, investors and, yes, regulators too, become oblivious to risk and established norms and then, hey presto, up pops something like Enron.

j.warner@independent.co.uk

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