Can Enron Happen Here?

Several state and local investment funds took a beating in the Enron debacle. It could have been much worse.
April 2002
John E. Petersen
By John E. Petersen  |  Columnist
John E. Petersen was GOVERNING's Public Finance columnist. He was a Professor of Public Policy and Finance at the George Mason School of Public Policy.

It's hard not to be immersed in the spectacular collapse of Enron these days. The power giant's $63 billion crash into bankruptcy has us not only reviewing our own investment portfolios but also our presumptions about and faith in the corporate world and the financial markets it depends on.

Both are issues for state and local governments. In myriad ways, they depend on the integrity of the markets and the firms that inhabit them. On the investment side, for instance, many state and local agencies took a beating in the Enron debacle and its aftermath. Public pension systems got tagged with big losses, some $1.5 billion in public pension money that was invested in Enron equities is gone. That figure is sure to grow as the firm's aggressive borrowing via derivatives, future power sales and limited-partnership programs unravel. In Connecticut, the state's waste-to-energy agency was caught on the wrong side of easy-money energy contracts that proved to be loans to Enron. As a result, garbage-dumping fees will be going up to cover the millions in losses.

That said, it could have been worse. One reason it wasn't is the difference in motivation and reward for finance officers in the private versus the public sector. The mechanics of finance are much the same for both. A finance officer, whether he or she works for a county or for a telecom, reads the same financial pages, enters the same markets and tries to get the best possible terms on an investment. The divergence comes in how the "bottom line" is measured and what the opportunities are to personally share in it. Tying measures of success to gyrations of the stock market, where insiders can manipulate results and personally benefit, is a prescription for disaster. Because they can't be insiders, public officers get a lot less personal reward, and the public takes a lot less risk.

Management and accountability are also different. Unlike the private sector, the directors in the public sector--legislative councils and boards--are either elected by the public or directly accountable to those that are elected. The legislative "directors" are always in the face of executive management, from approving budgets to dealing with constituent complaints to being potential opponents. The elected "directors" can be a pain, and the system does not always work smoothly or fairly. But by and large, it's pretty effective at protecting the public interest.

There's another protection in the public sector: oversight. The use of independent auditors has been in effect for years as an amulet against potential public-sector mismanagement. As Enron illustrates, the word "public" in the term Certified Public Accountant can be ambiguous, more of matter of a business license than an expression evidencing public trust. The nettlesome rotation requirements, competitive bidding and non-conflict rules governments live under are often inefficient, but they help prevent fraud and preserve competition.

For both sectors, there needs to be financial transparency and honesty. Governments certainly don't have a clean bill of health on this score. Balancing budgets in the face of reduced revenues while continuing vital services can lead to fiscal gimmickry. But the chances for really cooking the public's books are limited. The personal economic gains are paltry, and the penalties can be severe.

An appalling feature of the Enron debacle was the operation of the firm's 401(k), which crammed employees' pensions into a single-asset cattle car, locked the doors and watched it go over the cliff. Public employees don't face the same fate. They don't load up on their government's debt. Since most of it is tax-exempt, a tax-sheltered retirement plan has no interest in holding the securities of a state or local government. Rather, these governments must go out in the market and compete to borrow funds. The blatantly bad economics of borrowing directly from captive employee funds has been a useful constraint in the public sector.

These observations and comparisons are not intended to absolve governments or to condemn private markets. The two are inextricably married, each having a crucial role to play if markets are to be fair and efficient, and if both public and private needs are to be financed. In both sectors, size, power and steroid-assisted performance should always be subject to scrutiny and skepticism. Governments have an important role to play in protecting markets from waste, fraud and abuse so they work efficiently and fairly.

Short-term private economic interests and the huge impact of emotions in markets need to be recognized as threats and dampened. To preserve our successful lottery economy--with its big winners and the rest doing at least OK--and its self-righting buoyancy, someone must watch the spinning roulette wheel to make sure it isn't rigged. The job of defining and enforcing the rules is a high calling. It's what the public sector is there for.