Enron and Bear Stearns: History Repeats Itself?
What a week it has been. The collapse of Bear Stearns stirred up memories of another corporate collapse not too long ago. Does the name Enron ring a bell? I remember Bruce Willis’s character remark in Die Hard II, “How can the same thing happen to the same guy twice?” How can the same guy find himself rescuing hostages on two separate occasions and how can two multibillion dollar corporations collapse due to financial instruments that are not what they appear to be? The first part of this is easy: Hollywood doesn’t have to explain anything. The second part is somewhat more complex.
Enron and Bear were both involved in valuing financial instruments using mark-to-market accounting. What that means is each company would list items on its balance sheet based on estimates of value. A general rule in the finance world is that valuation is more art than science and ultimately the only true value of anything is what a buyer and seller agree on. So what happens when you do not have a buyer and seller? You estimate the value using one of several methods of valuation. More often than not, the method employs a technique whereby the returns of the asset are projected many years into the future. Basically, they look at what will be earned or what cash will be generated each year over the course of many years. Then, they use a discount factor to assess what these projected funds would be worth in today’s dollars. The total of these discounted projections forms the value of the asset. In the case of Enron, they were estimating returns from oil and gas rights over many years and in the case of Bear, they were estimating returns from mortgage based derivatives. Well guess what? When the projections appear overly aggressive, the overall value is called into question as is the entire capital structure of the company. This can cause creditors, vendors, customers and shareholders to panic. And what starts as a debate over accounting estimates turns into an entire company collapse.
To be fair, Enron was doing things far more insidious than misstating values which is why the company not only collapsed but several of the individuals responsible for this are now in jail. At this point, Bear can only be accused of not truly understanding what it did and did not have. But there are some striking similarities in that both companies were presenting a picture of their financial performance based on some very aggressive assumptions. So Hollywood does not have to explain anything and it would appear that neither does corporate America.