The Fall of Enron

If you said to me, “Jon, what’s the biggest ethical crisis in the world of money and finance that you can think of?” I’d probably ignore your question. Realistically, though, one scandal comes to the forefront of my mind and probably would do the same for many of your parents – Enron. However, like me, you probably didn’t really know many details about the Enron scandal until this blog post.

Enron Logo | Courtesy of LogoMaker

In 1985, Enron formed from acquisitions within the natural gas industry. Initially focusing on energy, Enron quickly expanded into a variety of other fields, including internet, weather insurance, and risk management, quickly earning them the distinction of “America’s Most Innovative Company” from Forbes magazine every year from 1996 to 2001.

Many had huge faith in Enron’s potential and saw themselves swimming in piles of money by investing in the up and coming company. In 1992, unbeknownst to most, Jeff Skilling, former CEO of Enron, received permission from regulators to use an accounting method known as “mark to market”. This method of recording assets can be fairly confusing, but the Journal of Accountancy describes it as a practice in which “companies [that] have outstanding energy-related or other derivative contracts (either assets or liabilities) on their balance sheets at the end of a particular quarter…must adjust them to fair market value, booking unrealized gains or losses”. Simply put, companies record assets and liabilities that haven’t really been capitalized yet on their current balance sheet. For Enron, many of the long-term contracts they held were difficult to value; therefore, “it is possible [read: true] that valuation estimates might have considerably overstated earnings” for Enron balance sheets.

Courtesy of Aftab Khan

Clearly, this practice dupes investors into believing that Enron is doing much better than it actually is. Projecting very optimistic returns overstated Enron’s actual value, keeping its stock price high without actually generating much taxable revenue. Using this strange accounting system, Enron opened the door for Andrew Fastow’s devious plan to use special purpose entities.

Andrew Fastow | Courtesy of NBC

Fastow, CFO of Enron as of 1998, developed a unique plan to hide the losses that Enron was recording in various other business entities to keep its own books clean and solvent. This not only allowed Enron to maintain a high stock price but also preserved a high credit rating for a firm that clearly did not deserve any sort of credit considering the questionable nature of its practices. Once Enron crashed, Fastow was charged with nearly 80 counts of fraud, the majority of which were connected to this practice of disguising Enron’s financial state through other minor companies that earned him tens of millions and kept Enron in the clear.

In early 2000, Enron first began to show signs of cracking. The telecom industry hit a rough patch, and Enron suffered heavily as people began trying to figure out how Enron really worked. Amid this turbulence, Jeff Skilling resigned as CEO, and Chairman Ken Lay stepped (back) in as CEO. Following this leadership change, Sherron Watkins, a VP at Enron, contacted Lay and explained that Skilling probably left because of accounting issues.

Kenneth Lay | Courtesy of Biography.com

 Enron continued to find itself in more and more hot water. As its stock fell, Enron began to become responsible for the struggles of Fastow’s branch companies, only hastening Enron’s collapse. In October 2001, Enron stunned the country, announcing that it would post quarterly losses of $638 million. Continuing to spiral out of control, Enron stock fell from an all-time high of $90.75 in August of 2000 to $0.40 by December of 2001. Finally, in December, Enron declared bankruptcy, closing the book on a disastrous fall from glory.

Courtesy of Startup Juncture

Enron’s collapse left many individuals in a poor state of affairs. Enron’s chief accounting firm and auditor, Andersen, was convicted of obstruction of justice for shredding Enron files immediately following the bankruptcy declaration. Andrew Fastow, former CFO and mastermind of the debt-hiding system, accepted a plea bargain in early 2004 in which he testified against other former Enron executives in exchange for a punishment reduction to ten years of jail time and nearly $30 million in damages.

Many Enron executives pleaded the Fifth Amendment during the investigation, but Skilling refrained. Instead, Skilling insisted that he had absolutely no knowledge of the scandal, a difficult notion to swallow from the former CEO. He was sentenced to 24 years of jail time. Lay was one of the many to remain silent and was found guilty on ten counts of conspiracy and fraud. Before he could be sentenced, Lay suffered a fatal heart attack in July of 2006.

In hindsight, the regulation that allowed Enron to engage in such risky financial manipulation was clearly insufficient. Following the fallout, Congress passed the Sarbanes-Oxley Act of 2002 to heighten regulation and stiffen the penalties for financial manipulation. The Financial Accounting Standards Board also enhanced its level of involvement in an attempt to prevent such conduct again. Enron’s fall, a devastating collapse that impacted thousands of people, was a solemn reminder of the power that profit-hungry executives wield. It reminds us that we must be careful and scrutinous of those who have such awesome power; it reminds us of the importance of the ethics of money.

Price Gouging of Daraprim

In September of this past year, a unique action taken by a minor pharmaceutical company known as Turing dominated the news. Martin Shkreli, founder and CEO of Turing, found himself instantly in the limelight for his quite controversial actions

Daraprim is a medication used in the treatment of certain infections. The most common infection, known as toxoplasmosis, is a parasitic infection of the brain and eyes that is particularly worrisome for people who are HIV positive. Daraprim is a long established drug that has been heavily used in the treatment of people with AIDS and cancer for the past 62 years. The drug once cost only $1 per tablet and cost $13.50 for a long while until September. Once Shkreli’s company acquired sole ownership of the drug, they raised the price 5556% to $750 per tablet.

Courtesy of Daily Mail

To many, this price gouge was unethical, despicable, and a variety of more profane things that I’ll leave to your imagination. However, this wasn’t the first time that price gouging struck the pharmaceutical industry. There are countless examples of significant price increases once a certain company became the sole distributor and producer of a certain drug. It’s often being done on newer drugs for cancer, Hepatitis C, and high cholesterol, but there are some cases of older established drugs being drastically hiked in price. Cycloserine, a long-used drug for tuberculosis, was hiked from $500 for 30 pills to over $10,000 this past year as well.

In fact, in a topical vein, two members of Congress reached out to Valeant Pharmaceuticals after they raised prices on two heart drugs by 525% and 212%. One of these congressman – presidential candidate Bernie Sanders.

But, I digress. Back to the bold businessman Martin Shkreli. A former hedge fund manager, Shkreli formerly served as CEO of a different pharma company known as Retrophin. While leading Retrophin, Shkreli also jacked up prices on a well-established kidney disease to over 20 times the original cost. Clearly, Shkreli has a history of aggressive business maneuvers to couple the absolute harshness of his impossible-to-type last name.

Courtesy of CNN Money

Initially, I felt about how you probably do right now; Shkreli is a shmuck. It’s absurd that any one company can step in and do the ridiculously steep price gouge that Turing did. There has to be some sort of legal loophole that Turing stepped through, and we need to close it. Actually, though, there is nothing illegal (or even vaguely illegal) about what they did to the price of Daraprim. To this end, it seems like a huge oversight by the legislative system that there isn’t some sort of control on price changes in the medical sector. These price hikes are toying with people’s health. Even though our market is a free one, when peoples’ health is at risk, there has to be some sort of control.

Without legal control over the system, the Infectious Diseases Society of America and the HIV Medicine Association sent a letter to Turing. In the letter, the two organizations (obviously) criticized the price gouging, arguing that it is unsustainable in the current health care system and unjustifiable given the current patient dependency on Daraprim.

In response, Shkreli claimed “This isn’t the greedy drug company trying to gouge patients, it is us trying to stay in business”. Representatives of Turing claim that the price hike was required in order to fund research that Turing was doing in other potential cures for toxoplasmosis. Dr. Aberg, of Mt. Sinai Hospital in NYC, disagrees, hypothesizing that the price hike “seems to be all profit driven for somebody…and think[s] it is a very dangerous process”.

Many agreed with Aberg’s negative perspective on Shkreli’s actions, including, most notably, Presidential candidate Hillary Clinton. Soon after the news broke, Clinton tweeted that this sort of price gouging is outrageous and that she will be planning ways to remedy this practice.

Courtesy of CNN Money

While this all seems like a reach for an ethics of money blog, this price gouging epidemic (a health pun for you dedicated readers) is incredibly controversial and strikes at the heart of some key economic issues. The debate itself comes down to regulation vs. free market principles. Shkreli formed a monopoly on Daraprim and then jacked the price up, a perfectly valid and legal action for someone who has entire pricing control over a product. Without being undercut, Shrekli can do whatever he wants with Turing. To many, this seems unethical, especially when it comes to medical products. For a drug that prevents HIV sufferers from getting life threatening infections, it seems that some control should be in place to protect the consumer.

Monopolies have always been the root of some problems. Many criticize the free market for not protecting consumers from the steep prices that monopolies can yield. Ever since Cecil Rhodes found all those diamonds in South Africa and formed the first monopoly, people have hated the idea. Unless, of course, you’re the smug monopolist.

Courtesy of The Daily Sheeple

Greek Debt Crisis

The Greek Debt Crisis has been an omnipresent facet of the global financial scene for the past six or so years. Beginning in late 2008 after the housing market crash stateside and the following economic calamity, Greece found itself rapidly slipping out of solvency, and the crisis was born. Considering how much I’ve heard about this issue without knowing a single thing about it, I thought that an investigation and the dissemination of what I find would be valuable for both my readers and me.

The seeds were the crisis were planted in 2001 when Greece replaced the drachma with the euro. The euro was appreciating internationally, and everything looked splendid for the EU as they pushed for a uniform currency across the continent. In order to join the Eurozone, countries has to prove that they were “economically convergent” (somewhat similar) to the other Eurozone nations. Fundamentally, the Greek economy isn’t as strong as the Western European nations such as Germany or France, but the EU seemed to disregard this discrepancy.

In joining the Eurozone, Greece reportedly hid information about its true economic situation. According to CNN, it is a common consensus that Greece covered up its budget deficit that exceeded the economic convergence requirement of less than 3% of GDP. In fact, Greece reported a deficit of only 1.5% when the number was actually over 8%.

While Greece spent a few years in economic limbo, the global economy was rocked by the American housing crisis in 2007/08. The Greek economy was already faltering, struggling to make ends meet and cover their growing deficit, and the crash only made things that much harder. Other countries in the Eurozone could sense the struggle, and they, mistakenly so, had bound themselves to the sinking ship of Greece. They had no choice but to help.

Come 2010, Eurozone leaders agreed to bailout Greece to the tune of 110 billion euros, contingent on Greece improving taxation measures and trying to work towards eliminating the annual deficit. In comparison to Germany, one of the strongest economies in the Eurozone, Greece is far inferior when it comes to tax collection, as shown in the following graphic.

Image Courtesy of the Washington Post

To meet the conditions attached to the bailout, the Greek government was forced to lay off many workers, only deepening the spiral as the government struggled to generate revenue with fewer workers. In 2012, with the prior bailout having been ineffective, another bailout was issued, raising the total debt to 246 billion euros, over 130% of the GDP of Greece. However, for complex economic reasons, the situation continued to worsen as unemployment climbed to 30%. 

Image Courtesy of the Washington Post

As of June 2015, drowning in debt and battling rampant unemployment, the Greek economy was between a rock and a hard place. They could try and put up the money somehow to pay the debt, but, realistically, they needed debt relief. To this end, Greece actually defaulted on a loan repayment to the IMF, becoming the first advanced country to do so, according to ABC. This default capped the largest fall in GDP in an advanced economy since 1950: 25%.

Image Courtesy of RBS Economics

Last year, Greek exit from the Eurozone was a real possibility. In an attempt to abandon the forced austerity (decreased spending) from the EU, Greece was tempted to abandon the euro and return to the drachma. However, no one quite knew what would happen in this situation, seeing as now country has ever abandoned the euro, although now Great Britain is considering it too. After a third bailout deal in July 2013, Greece decided to adhere to the austerity measures and forget the notion of abandoning the euro.

Why, though, hasn’t Greece been able to pull itself out of this economic hell? An article from Fortune.com points out that the bailout was poorly implemented, not focusing “enough on Greece’s uniquely dysfunctional state apparatus.” Normally, government spending can solve the economic woes, but the forced austerity measures only deepened the difficulty, causing the aforementioned 25% economic shrinkage.

Currently, according to an article from the Huffington Post, Greece is continuing to struggle under the austerity measures and the influx of refugees. Public spending has to increase to accommodate the thousands of new refugees, and this increase in spending works directly in opposition with the principle of austerity, meaning that Greece must spend even less in other areas to compensate. With the debt still not paid off, refugees complicating the situation, and global market volatility, it is impossible to predict, and almost just as hard to understand, the nature of the Greek economy.

Feel the Bern?

Bernie Sanders has a surprising source of support in college students, particularly here at Penn State. I’ve seen dozens of “Bernie 2016” stickers and hear the infamous “Feel the Bern” quite a few times this semester.

Grandfatherly Bernie has, though, received a significant amount of flak for his economic policies. His policies are liberal to the extreme, some might even say socialist. According to Forbes.com, Sanders argued that people “have no disposable income when you make 10, 12 bucks an hour. When we put money into the hands of working people, they’re going to go out and buy goods, they’re going to buy services and they’re going to create jobs in doing that.”

Great in theory, right? Give the uneducated masses more money, and they’ll go spend it on “stuff”. Consumption, in the mind of many, is the key factor that drives economic growth in this country. 70% of our GDP is consumption – many use this fact to argue for higher minimum wages that will spur consumption from the lower classes and drive the economy forward.

However, it isn’t clear that spending by the poor is more beneficial for the economy. In fact, many argue that increased spending from those who would be making the minimum wage is less potent, seeing as they are more likely to buy (often imported) goods rather than services that the wealthy may purchase.

With this contradiction in mind, it’s important to keep the other option for people’s money in mind: saving. For many, the idea that not all of their extra wealth will go straight into consumption affects the actual impact of raising the minimum wage.

In a study conducted by theCongressional Budget Office, it was estimated that the households benefiting most from an increased minimum wage are those above the poverty line, not those below it.

Furthermore, not all of the increased minimum wage is a simple redistribution from the wealthy to the poor. Utilizing a hike in the minimum wage, depending on the elasticity of certain products (how much people’s consumption changes based on prices), the increased wages will often trickle down to the consumers. Higher input costs will lead to higher prices as firms try to maintain solvency – this price hike will come back to bite those who get the higher wages.

One other unforeseen conflict with increasing the minimum wage is the unemployment that it creates. Logically, it makes sense – if firms have to pay more to employ labor, they’ll have to employ less of it.

Courtesy of Forbes

A simple profit maximization condition from all of your thrilling economics classes depends on equalizing the cost of an input and the return it gets you. For labor, hiring too many means cost is above returns, and you’re losing money. Hiring too little leaves returns above cost, and you’re leaving profits uncaptured. Therefore, once we have equality between costs and returns, raising the cost (minimum wage) without increasing the returns (productivity of labor), firms will be forced to lay off employees to maximize their own profits.

Economics lesson aside, there is evidence of increased unemployment following minimum wage increases. Accordingto Professor Stephen Hanke of Johns Hopkins, the average unemployment rate in countries without a minimum wage is nearly 4% lower than in similar neighboring countries that utilize a minimum wage.

Many sources, however, do cede that there is a significant amount of controversy about the topic. Jordan Weissmann, in the Atlantic, does a great job explaining the ins and outs of raising the minimum wage. John Komlos, a professor at the University of Munich, also defends a raise in the minimum wage in a piece published by PBS. Komlos argues that if the minimum wage in 1968 was adjusted for modern prices, it would be almost $11. He cites an Economist report that calculates what minimum wage should be to stay in line with many other developed and successful countries – a number that would make many conservatives faint.

Courtesy of the Economist

Based on US GDP, the Economist claims that minimum wage should be $12 to be similar to other successful global economies. This number is also eerily similar to the minimum wage way back in 1968, adjusted slightly for increases in worker productivity.

Put simply, who knows what should happen. The employment and ethics numbers might point towards not changing (or event abolishing) the minimum wage, whereas comparisons with other thriving nations could say the exact opposite. It’s a complicated economic problem, and it could be a deciding factor in the polls this year.

Subprime Mortgage Crisis

Money rules the world we live in. Be it salaries, taxes, or prices, citizens all around the world are constantly focused on the green. It has become such a driving factor in the society we live.

Money, however, can have a dark side. It can make people do things. It can be unethical, corrupt, slimy, and shady. In the course of this blog, I’d like to explore the ethics of money. There a plethora of topics which can be analyzed through this lens, and I will do my best to select germane and interesting ones.

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While I muddled through the end of elementary school around 2007, the world seemed fine to me. I didn’t have any major complaints (yet) about the world I lived in. Needless to say, my ignorance to the financial crisis that shook the American and international economy starting in 2007 truly was bliss.

In 2007, the subprime lending bubble collapsed. Leading up to this time, many borrowers were now suddenly able to get loans to finance primarily home payments for mortgages far beyond their means.

Courtesy of Investopedia

Representatives of the major banks and loaning institutions were getting filthy rich from the homes their clients were buying, so the developed a lax – incredibly too lax – policy of checking client’s chances to default on the mortgage. Known as NINJA loans, a play on the abbreviation NINA for no income no assets, these loans were risky to begin with. As the market continued to grow, these shaky investments became the bedrock on which certain economic facets laid.

First, let’s start with causes and potential culprits of the crash. Lenders are most often cited as the chief perpetrator. It is these mortgage writers that actually lent the money in the subprime loans – dubbed subprime in reference to the poor credit of the borrowers. Following the dotcom bust in the early 2000’s, banks were striving to stimulate growth by lowering rates, further pushing investors to increase their risk tolerance and lenders to seek out riskier loans.

However, the blame cannot be totally levied on the corporate finance side of the issue. Homebuyers themselves, too, are very responsible for the financial meltdown. These buyers were utilizing nontraditional mortgage techniques to purchase homes that far exceeded their incomes. When the bubble began to pop due to a variety of economic factors, buyers’ equity disappeared as home prices fell.

There is a third significant player in all of this mess. Investment banks began implementing a unique new financial instrument: Mortgage Backed Securities, or MBS’s. These investments allowed further trading of the debt held in mortgages, thereby freeing up more capital and liquidity, thereby refueling the bubble to grow even larger as the market loosened up. These MBS’s were also known frequently as Collateralized Debt Obligations, or CDO’s, named for the debt that the investors were trading.

Courtesy of Investopedia

CDO’s are a complicated beast, as I learned from the phenomenal film The Big Short, which I encourage all of you to see. Simply put, CDO’s are a type of MBS in which there a series of tranches. Each tranche corresponds to a different rating of the underlying mortgages or other derivatives. The upper tranches are safe, stable, AAA ranked instruments. Lower tranches contain the junk investments. As 2007 neared, CDO’s were becoming much more skewed towards the bottom tranches, even though the presence of only a few AAA securities in the upper tranches kept the rating pristine.

Rating agencies can be to blame for some of this conflict. Whether they were simply inept or acting for corporate gain in the form of fees from banks is unclear. However, it is reasonable to assume that proper ratings would have discouraged some investors from taking on the risk that they did by buying CDO’s, possibly easing the crash.

If it’s not clear yet, the economy of the time was a turbulent one that resulted in a crippling burst domestically and internationally.

As a result of the crash, Lehman Brothers basically went extinct. Two other enterprises, Fannie Mae and Freddie Mac, were seized by the federal government. In response to the burst, it became vastly more difficult to get housing loans, further deepening the recession that followed and prolonging the path to recovery.

The Federal Reserve stepped in and backed themselves up against the zero bound, forcing interest rates as low as possible (the eponymous 0) in an attempt stimulate economic activity. The foreclosure dilemma has persisted along with soaring unemployment and difficulty getting loans.

The boom and bust of the subprime loan industry was catastrophic for the global economy. However, it was indeed telling. Many sources have looked in to preventing such catastrophes in the future, such as the FDIC. Hopefully, such a crash can be prevented next time through clear foresight.