In Conversation with Former Enron CFO Andy Fastow Part Two

**Richard Kramer** (0:01)
Welcome back to Bubble Trouble, conversations between our real life double act of the independent analyst Richard Kramer, that's me, and the economist and author Will Page, that's him. And this is what we do, laying out inconvenient truths about how business and financial markets really work. So today we take you back with one of the biggest bubbles bursting in living memory, Enron, which went from America's seventh largest company to bankrupt within a year at the turn of the millennium. How many booms, busts, frauds, and financial irregularities have we witnessed since then? We lost count. Today we continue our two-part conversation with Andy Fastow, former CFO of Enron.
More in a moment.

**Will Page** (0:44)
Welcome back to the second part. We received our telegram from the king, in that we've passed the fine, ripe age of 100
And we've been podding with Andy Fastow, somebody who was top billing for the guest list for this podcast, but actually inspired the podcast. To repeat, we wanted to do this podcast not for money, but to educate ourselves and our audience about why we keep on getting into bubbles and keep on finding ourselves into troubles. The children's story of the boy who cried wolf rings loud and true today, just like it rang back in 2001, when America's biggest corporation went bankrupt. And then part one, as a student sitting in a room with two professors of financial accounting, the story of Mark to Mark accounting and turbines, Andy, made me think of razors and razor blades. Maybe I could lose money selling razors, but book future income from razor blades and show a very profitable company, providing those razor blades maintain value. And I did shave before this podcast, I was so excited to do this with you. And then before I hand over to Richard, before we look at regulatory capture, Andy, I do think after hearing what I've heard, I have to tell you our favorite joke in Bubble Trouble, which the origins relate to comedians, Bremner, Bird and Fortune. During the financial crisis, where a financial journalist asked an investment banker, let's just imagine this is me asking Jeffrey Skilling, what do you have to say about the moral hazard? This of course is when the banks were wobbling and we're about to go into a financial crisis. And the banker applies by saying, well, I understand what the second word means, but you have to give me the definition of the first.
A nice way of maybe thinking about how do you follow the rules?

**Andy Fastow** (2:22)
Yeah, there are also a lot of analogies between the financial crisis and Enron. In fact, you know, what the banks were doing, they were doing some of the same deals that we were doing at Enron to make their financial statements look better. In the case of the financial crisis, also, as in the case with Enron, it was a case of leverage. And I keep coming back to this concept of risk that people aren't really seeing. When I'm a lot older than you, and so I remember banking back in the 1980s when it was the major money center banks were levered about 16 to one. That was considered prudent leverage.
By the time the financial crisis rolled around in 2008 or so, the banks were levered, no one really knows the number, but something like 75 to one.
Okay, now 16 to one sounds like a lot of leverage, but it's not for a bank. This is fractional banking system, and that makes sense.

**Will Page** (3:27)
I got a dollar, I can lend 10

**Andy Fastow** (3:29)
But 75 to one is a whole different matter. I mean, literally, if your asset values change one and a half percent, you may be technically insolvent.
What made the leaders of these banks think that kind of leverage was manageable? I mean, these are the smartest financial minds on the planet. Why weren't they seeing that risk? And I don't know exactly, but I've kind of learned how our brains work. When you're technically following the rules, your brain shuts off and stops thinking about the risk. Now look, these banks didn't go from 16 to one to 75 to one, leverage overnight. I suspect what happened is this. In the mid-80s, the banks changed their incentive structure.
Okay, so the banks used to be valued as a multiple of book or a multiple of assets. So banks wanted to become big. They were doing traditional lending.
I don't remember what year it was, but in the mid-80s, the valuation of banks changed to a different model. It was EPS-based, earnings-based. What are the ways that the banks could juice earnings?