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December 09, 2001

The Bubble Implosion: Enron, Argentina…who's next?
by William Thomson

The detritus of the financially naughty nineties continue to wash ashore as the greatest financial bubble in modern times unwinds. This week saw the implosion and largest bankruptcy of a US corporation, Enron - a Texas wheeling 'n dealing leveraged hedge fund masquerading as an energy company - and Argentina, an erstwhile wealthy South American country and supposedly reformed bankrupt, in all but name. Is there more to follow? We would hazard a guess that we are just seeing the tip of the iceberg and the good ship RMS Titanic is likely to suffer further damage in the months ahead.

Enron in the 1980s was a boring old natural gas pipeline operating in a tightly regulated industry with financial rates of return to match. But as the industry liberalised, Enron's management saw opportunities in private power development that could be traded to the highest bidders. In developing countries it seized on similar opportunities and meeting energy shortfalls from national power companies by building plants for developing countries on a build-operate and transfer basis.

Enron's foreign operations, in particular, were characterised by the most extraordinarily heavy political lobbying using the most prominent US (frequently Texan) politicians. They were particularly successful in closing financially attractive deals in countries where the concepts of transparency and probity do not translate into the local dialect. Rumours of payoffs accompanied many of their deals; the most famous of which was the Dabhol plant in India. The whole flavour of their operations failed the smell test.

But in the fevered atmosphere of the financial markets of the nineties these peccadilloes were ignored in favour of the holy grail of earnings per share or even more obscure and irrelevant criteria of financial success. No one bothered to ask what were the risk management tools and how such results could be obtained by simple trading without incurring excessive risks. The lessons of Long Term Capital Management - only three years old - had been conveniently brushed aside. No one bothered to examine the incestuous webs of conflict of interest and eventually outright fraud. One year ago Enron had a market capitalisation of almost USD 70 billion, even three months ago its market capitalisation was USD 60 billion and it was the seventh largest corporation in America. Today it is bankrupt. Thousands of employees have lost their jobs and millions of shareholders have been ruined.

Enron is a classic example of bull market greed getting in the way of common sense. There will now be post mortems aplenty and the closing of barn doors after the horses have fled. But this will be to little or no avail. Rules will be changed to try and assure better corporate governance. In Enron's case, the auditors and the outside directors, if not incompetent, were compromised with conflicts of interest. But the essential lesson of caveat emptor will remain the watchword for future investors.

The Argentina story is well known and the final countdown to devaluation and or default is now on. In the face of a bank run, a bank holiday has essentially been declared with cash withdrawals limited to US$ 250 a week. This will be maintained for 90 days while the Government works out what to do. Pesos deposits have been converted to dollars at the prevailing one to one exchange ratio and are subject to the withdrawal limit. External capital controls have also been declared making a joke of the convertibility claim.

The economy will slide further into depression whilst the country will go back to what it knows best - operating a variety of different exchange rates of the black market. Dollars abroad, dollars in the bank in Argentina, greenbacks, pesos notes, patacones and other provincial quasi-currencies will all trade at different rates. Meanwhile, the government will have to negotiate a restructuring of its debt. If it chooses the devaluation route, then hyperinflation could also return eventually if the present Government falls.

Once again bondholders have been pretty well wiped out. Since Argentina was one of the largest of the emerging markets issuers, the asset class in general has taken another blow following those of the Asian, Russian and Turkish crises. But the vulture funds will also be circulating sensing opportunity amongst the carnage. The financial markets, whatever their other faults, are blessedly short of sentimentality.

The losses from both Enron and Argentina will have knock-on effects. Some US banks, particularly J.P. Morgan Chase, the US bank most exposed to derivatives, will take substantial losses. But Enron's corporate customers will be particularly affected and some may be driven to bankruptcy themselves because of Enron's knavery. In Argentina's case, the banks will also take a knock but Spanish banks are likely to be hit harder proportionally.

As the bubble unwinds will there be further disasters? We fear so. Japan's credit keeps being downgraded. It will not default but it could easily set of massive ructions in the markets if it is forced to liquidate its holdings of US Treasuries to meet a crisis. At the very least it will cause considerable volatility in the markets as the yen and interest rates adjust to more realistic levels.

And then there is the US. It has a debt mountain larger than the Himalayas. Admittedly mostly in its own currency but to keep the economy afloat the government has been irresponsibly asking the citizenry to spend the equity in its houses. In the course of that action it has used two government sponsored enterprises, Fannie Mae and Freddie Mac, both mortgage intermediaries with derivatives books that make Enron and Long Term Capital markets look like pikers in a child's playground by comparison.

Stay tuned. We are not yet out of the wilderness!

Once again the wisdom of holding some gold in the portfolio is justified. Ask the Argentinian whose bank account is blocked, facing devaluation and he is effectively prevented from taking his money abroad. (Of course, the wise politicians will have had their overseas bank accounts pre-established.) Gold ownership, however, was not blocked so the wise Argy gold holder will at least have that security blanket to fall back upon.

William R. Thomson
Chairman of Private Capital Ltd.

William Thomson, Chairman of Private Capital Ltd., an advisory company in Hong Kong. He is also a senior adviser to Franklin Templeton in Hong Kong and Axiom Alternative Funds in London.

Mr. Thomson is not a registered advisor and does not give investment advice. His comments are an expression of opinion only and should not be construed in any manner whatsoever as recommendations to buy or sell a stock, option, future, bond, commodity or any other financial instrument at any time. While he believes his statements to be true, they always depend on the reliability of his own credible sources. Of course, we recommend that you consult with a qualified investment advisor, one licensed by appropriate regulatory agencies in your legal jurisdiction, before making any investment decisions, and barring that, we encourage you confirm the facts on your own before making important investment commitments.

Copyright © 2001-2008 William R. Thomson

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