In Conversation with Former Enron CFO Andy Fastow Part Two

Richard Kramer:

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. 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, bust, 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:

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 in part one, as a student sitting in a room of two professors of financial accounting, the story of mark-to market accounting and turbines, Andy, made me think of razors and razorblades. Maybe I could lose money selling razors, but book future income from razorblades and show a very profitable company, provided 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 two 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 were about to go into a financial crisis. And the banker replies 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:

Yeah. There are also a lot of analogies between the financial crisis in Enron. In fact, 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. 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 1, 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 1. Okay. Now, 16 to 1 sounds like a lot of leverage, but it's not for a bank. This is fractional banking system, and that makes sense.

Will Page:

I got a dollar, I can lend 10.

Andy Fastow:

But 75 to 1 is a whole different matter. Literally, if your asset values changed one and a half percent, you may be technically insolvent. What made the leaders of these banks think that kind of leverage was manageable? 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 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 1, to 75 to 1 leverage overnight, I suspect what happened is this, in the mid '80s, the banks changed their incentive structure.

The banks used to be valued as a multiple of book or a multiple of assets. 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?

Will Page:

There's more wiggle room.

Andy Fastow:

You can sell assets, reduce your assets, or you can increase leverage. Probably what they did, well, they did some of both, that's when loan syndication began in earnest, in the mid '80s, I guess. They were trying to keep a skim off of each loan and get more velocity. But the other way you get more earnings is by leverage, reduce the amount of equity in your EPS calculation, so that same amount of earnings translates to more EPS. Does that make sense?

Will Page:

Correct.

Andy Fastow:

Okay. All right. So they started increasing leverage. Now the banks like Enron were constrained in this manner, they had to be sensitive to their credit rating. You can't just increase leverage exponentially without risking a decrease or decline in your credit rating. But if you do it off balance sheet, and this is one of those strange anomalies in our system, you would think it shouldn't exist, if you finance off balance sheet, the banks count that leverage differently than they count leverage on the balance sheet. In the last episode I talked about that operating lease, so the billion dollar acquisition of a pipeline. It was a billion dollars of debt, but it was off balance sheet. Instead of the rating agencies adjusting this in their analysis to say, "But that's really a billion dollars and we have to factor it into their credit ratios," they only counted 10% of that billion in their analysis. So it was a very inexpensive way to increase earnings.

Now, I can't explain why they don't count at all. Now they do because the rule has changed. But there's example after example of this type of disconnect between reality, because of the accounting and what shows up on the financial statement. The banks were able to increase their leverage without having their credit ratings go down. Now, if you do that one quarter and you get that extra penny of EPS and hit your target on Wall Street, what do you do the next quarter? Now you've got a hole you have to fill. Not only the penny you're missing by, but the penny you added on.

Will Page:

Hello hamster wheel.

Andy Fastow:

And so, they had to increase it, so it probably just kept inching up. And the smartest brains in the world didn't see it. But when the financial crisis happened, it all came tumbling down because of that leverage. Here's another way to think of it, every decade there's some major asset class that-

Richard Kramer:

It's invented. Innovation.

Andy Fastow:

Explodes. Southeast Asian, the silver market, Russian debt, Petro debt, savings and loans, there's always an asset class that collapses. Why is it that those prior asset collapses didn't cause the major banks to become insolvent? It's because the banks had so much more equity. When you're leveraged 75 to 1, you can't absorb that shock any longer, so they weren't seeing that risk. It's just how the brain works. And that's the challenge for executives, it's not choosing between right and wrong, ethical versus unethical, it's being self-aware enough that when you're doing these types of transactions, that you're injecting more risks than your brain is seeing.

Richard Kramer:

But I'll tell you one thing that this really brings back to me. Before I set up my independent research firm, which has no conflicts of interest, and we've been doing independent analysis of equities for 23 years, I worked at Goldman Sachs from '96 to 2000. And that was the period when it went from being a partnership to a public company. And if you're a partnership, you collectively as the partners, and I wasn't a partner, so I wasn't one of those august 200 or so people that were personally wearing all the risk. But when you're a public company, you sell your equity to somebody else and you diffuse that risk among not a few 100 people that all know each other, but thousands or potentially millions of shareholders. And there's a very different approach to that, that self-awareness, when it is a small group of people that can fit in a hotel conference room and talk to one another than when it's this nebulous mass group of shareholders.

I have to imagine just listening to you tell all that, that when you watched The Big Short, which is a brilliant movie, you said, "And I've seen that movie before." And all the scene where Steve Carell and Jeremy Strong are sitting in with the woman from the rating agency, who I think is played by Susan Sarandon, and she's saying, "Well, look, if I don't give that rating, they'll go down the street and somebody else will." It shows that there's not that awareness that, what we're asking for to be rate of the 10% is somehow, that doesn't seem right. It's, "Hey, if someone will give you 10%, why not take it when it's better than having to show the 100?" Now, one of the things I really was dying to ask you about was about the theory that, George Stigler who won a Nobel Prize for Jane Mayer described it brilliantly in Dark Money, but regulatory capture theory, the idea that the people who are supposed to be making the rules and watching out over these new innovations, over the whole financial system were somehow captured by, or frankly came from inside the system.

Did you think the regulators were just one step behind? Did you think they were simply unable to keep up with the pace of innovation you were coming up with at Enron? Or did you think they were part and parcel of the system and really what they wanted to do was leave the regulator and get a job with you because they can make so much more money? How do you reflect on that notion, that theory of regulatory capture that seems to be so prevalent and it's not just in the financial industry, it's in so many other industries that we see and leads to very bad consequences?

Andy Fastow:

That's another good question. Look, I'm sure regulatory capture occurs whether it's consciously or unconsciously, it occurs. But I will tell you that I tend to be a person that likes to think the best of people and give them a benefit of the doubt, so I would say that, I think it is less a case of regulatory capture and more a case of the fact that there's an entire industry, bankers and accountants and attorneys who do nothing, except help companies figure out ways to get around the rules. And I would bet that both the resources and the brain power is far greater in the private sector than in the government sector in keeping up with this. Look, everyone understood that operating leases were really debt. It took them 30 years to change the rule to reflect that. It's just a very slow moving process. It is subject to external pressures and regulatory capture, but you're always going to find smart people who could figure out ways around the rules. You're not going to, in my opinion, ever come up with a regulatory framework that is going to prevent this type of behavior.

Will Page:

But on Richard's point, there's got to be a game theory element here of, is it a finite game or a continuous game? And I know that some of the most outspoken people arguing about big tech in America and Britain, "Big tech needs to be regulated. Big tech needs to be curtailed," also have their resumes into big tech companies hoping to get that senior vice president job in policy. This is happening. And it was described to me in America, as a very American expression, which is, "We've all got mortgages to pay, Will." That is, you go where the money is. Go fishing where the fish are. And that does undermine over time, again, a continuous game, not a finite game, the ability to regulate markets.

Andy Fastow:

Yeah. Will, I agree with that, but I'd say this, again, I think that tends to lead to a discussion of good versus evil, black versus white.

Will Page:

Agreed.

Andy Fastow:

That people are consciously making decisions to do the wrong thing. And I don't think that's where the risk lies. Again, I believe in people in general, and I would say that, if you were to present every decision as, "This is the right thing to do and this is the wrong thing to do," 99.999% of people would always choose the right thing to do. They don't want to do the wrong thing. They don't want to be evil, they don't want to be unethical. They want to be good members of their community, they want to be good employees, they want feel good about themselves. That isn't the challenge. It's that our brains know what the answer is, and our brains are very good at finding creative ways to get to the answer we want.

And the amazing thing is, you could do it without breaking the rules. I remember we used to joke at Enron when we'd see companies intentionally breaking a rule and getting caught, and we'd joke about, pardon the word, how stupid those people were, because you don't have to break the rules to get to the answer you want. Sit down with your bankers and accountants and attorneys and you could structure a way around the rules, find that loophole to get to your answer without breaking the rules.

Will Page:

I don't want to disagree with you on the pod, but what you're saying for me is a very private sector perspective, that can maybe offer a public sector perspective. I think what happens in the public sector here, is not the black or white of how do we interpret rules, but just, "Can I brush that problem away for another day?" On an earlier podcast, we had Feargal Sharkey, a famous Pop Star in his time, now doing phenomenal efforts to try and fix the problem of our water companies, our privatized water utilities polluting our rivers and oceans.

And it sounds to me like what the regulators end up doing is, they've got their one eye on, "I want to get a job in the private sector and earn 3X my salary." And another eye saying, "Well, how do I brush this problem away for another day? Shove it under the carpet and somebody else can deal with it." And I think that's what goes on in regulatory capture theory, which is, "I don't need to tackle a problem now, and if I don't, I increase my chances of flipping into the private sector, triple-X-ing my salary and someone else can fix that problem later." And to use my grandmother's expression, "A stitch in time saves nine." In your history, and what we've seen in recent history, that stitch in time hasn't been sew up.

Richard Kramer:

Another guest we had on our podcast was Jesse Eisinger, who is Pulitzer Prize winning Journalist who wrote a book called, The Chickenshit Club. And he was trying to explain why it is that, after Enron with the banking crisis in 2008 and beyond that, we saw all these deferred prosecution agreements. Exactly like you said, the executives followed the incentives, they made as much money as they could, they went right up to the line of the rules and maybe they thought they were adhering to them, but they found very clever ways. And then when caught, they said, "We're going to pay a fine. It's a cost of doing business." And unlike yourselves who took responsibility for their actions, they deferred it and they signed a deal.

And Jesse attributes that to the guys who are working for the federal authorities, the DOJ. They all want to get high paying jobs as defense attorneys at Sullivan & Cromwell or White & Case or somewhere like that, and get their kids into private schools in Georgetown or live in brownstones in Brooklyn. They realize that they don't want to hold these companies to account too much and they can't change the incentives in the system, so how do you craft rules, given that the regulators can be captured or can be swayed, how do you craft rules that curb the worst of our incentives to keep juicing our EPS numbers or keep signing the off balance sheet deals that make numbers look good? How can you craft incentives that better constrain our instincts when you've seen how many executives fall on the wrong side of those instincts?

Andy Fastow:

Well, I don't have an answer for that question, Richard. And I'm skeptical that you'll find an answer, because I don't think what you're talking about there is business. I think you're talking about human nature, and we're human. But I'm going to say something that will probably sound very counterintuitive, but imagine if we had no accounting rules and no securities laws and there were just one rule, you must publish a financial statement that is not misleading, I think the lawyers would be so afraid of lawsuits that they'd actually publish much simpler, clearer financial statements. [inaudible 00:18:39].

Richard Kramer:

And the lawyers would've a full employment program deciding what was misleading or not.

Andy Fastow:

Well, that's right.

Richard Kramer:

Yeah. I guess the next thing I was really curious about, and again, you straddled these eras, you mentioned back in the days of working for money center banks or where 16 times leverage was normal, was the most you'd want to go to. You passed through this period that was a confluence of explosion of capability and technology and finance. And how much do you think it was that explosion of tech capability that allowed Enron to, in a world when broadband was just expanding, when trading technology was exploding, when volumes in the stock market were going ballistic compared to what they'd been even a decade before, how much do you think technology enabled some of what you were able to get yourselves into at Enron and then clearly supercharged the global financial crisis that came after it?

Andy Fastow:

Well, I think technology had a huge impact in the finance field, but in other ways as well. Let me focus on two to answer your question, I'd say first of all, structured finance would not even really be possible without the technology of personal computers. [inaudible 00:20:09], it enabled people to do these incredibly complex deals where you're carving up cash flows and other types of risks and modeling them and analyzing the model. So it's like in a way, the analogy with banking would be going from actually assessing the character of one of your borrowers to doing a Monte Carlo simulation.

And so there's good and there's bad associated with that. But probably the more dangerous aspect of technology is the way people view technology. Things that are new are very exciting and they tend to lead to bubbles. But what's interesting about technology is, most people don't even really understand the underlying technologies, so that led to the tech bubble in the late '90s, cryptocurrencies. How many people who invest in cryptocurrencies could actually explain what blockchain is even? And so it's the way markets tend to react to technology. I remember when Skilling decided Enron was going to start trading broadband capacity.

Will Page:

I remember that in the book.

Andy Fastow:

And him saying that, "One of the reasons was that they'd view us as a tech company and give us at least a component of our stock price would get a tech multiple." Which was a much higher multiple than an energy or even an energy trading company. It's how the market reacts to those new technologies, that's perhaps even more salient for this discussion of bubbles than the actual technology itself.

Will Page:

It reminds me very quickly of the Keynesian Beauty Contest dilemma. When asked, "Which of these five beauty pageants do you think is most attractive?" You answer from your gut, but if there's money involved, "Which of these five beauty pageants do you think is going to win the competition?" You, [inaudible 00:22:11], view to the judges, "I think the judges are going to go from number three." Even if I think number one, I want to go with the judges who pick number three, and see if I can show off my odds. I want to take the conversation in a slightly different direction because in part one, you made a distinction between a financially engineered number and a harsh economic reality, so what I wanted to do is unpick the idea that economics presents reality and not take a look at financial accounting, but take a look at government accounting.

And it's an example that was inspired in my book by a scene in the film The Big Short, which Richard is cited earlier, and I don't even know if you remember the scene, it wasn't exactly the most cleanest scene of the film, but it was set in a lap dancing club. And Steve Carell was in the private booth with a lap dancer and he's talking about her mortgage mortgages and he's not admiring her assets, pun intended. And there's this line where she talks about the teaser mortgage rate expiring on all of her properties with an S on the end and and Steve Carell says, "You said properties plural. Why did you say properties?" "Well, I got five houses and one condo." So she had six properties and she's a lap dancer. And that's when he realized, "Hold on a second, this entire American economy is running towards a cliff edge faster than it needs to and there's no turning around."

Now in the book I really explored a concept of this rather wonky term called imputed rents. And I remember back at the time of the financial crisis speaking to people who are running nightclubs who had six properties on self-registration loans from the banks. "How much do you own?" I'll just pretend to guess how much I own so I can get the loan from the bank, self-certification, it was called. And I asked, "How do we measure a property in the GDP?" Well, GDP is our measure of flow of payments, not a stock. You can't say, "Real estate in the US economy is worth X based on the valuation of real estate." You have to invent a flow of payments to capture the value of real estate, which is done by some proxy, [inaudible 00:24:11], survey involving three figure, four figure sample base.

And I guess, so Andy Fastow lives in the house, he probably owns a house, I'm going to invent a rental payment that you have to pay to live in that house and add that to GDP. Now, long story short, Andy, this invents, in the UK, 10.3% of GDP and in the US, 11.6% of GDP. I'm going to repeat to you, the economic rules invent 11.6% of your economic value from thin air. It doesn't exist, it doesn't happen. You don't pay that rental payment and it doesn't contribute. But it contributes a double figure sum of GDP to US economy. When you hear, and I'm bridging the story quite fast, but when you hear of stuff like that, do you worry about how the government is measuring its own value? Nevermind how the accountants and the SEC are measuring the value of companies. Are we getting it wrong on the government side? Do we actually know how much we're worth?

Andy Fastow:

Well, that's a great question and not an expert on government reporting or the things you referenced. Let me give you two responses to that question. The short answer is this, that I'm worried that we'll reach a tipping point and companies like governments tend not to worry enough that they'll reach a tipping point, especially when they're adding leverage and injecting more risk into the system. People think that things are always going to continue the way they've continued, so in the US we could continue adding more debt.

Will Page:

Debt time bomb.

Andy Fastow:

There won't be any consequences because we're the United States. That's the mentality. But it's a similar mentality, especially in big public companies that things will continue the way they've always continued. I think that was the case at Enron until mid 2001. And maybe that's the reason, I don't know, but maybe that's the reason Skilling left when he realized it couldn't continue the way it was going to continue. I don't know. Well, let me give you two examples about the government in the US and accounting. If you look at pensions, public pensions in the United States-

Will Page:

This is big.

Andy Fastow:

These are, for the most part, massively underwater. Now, I'm putting social security aside, just look at state pension plans, and they have to report on these every year. And they report something called the unfunded or overfunded, if there's such a case, liabilities. Now to do that, they have to make certain assumptions about the future, in other words, and that liability means the amount they'll have to pay in the future that they haven't already set aside reserves for, so that would be an unfunded pension liability. But how do you calculate that? We have to make assumptions, how long are people going to live? What rate of return are you going to earn on the assets that you've got in your portfolio over that period of time? Now, what you'll see is a wide range, and incomprehensibly, a wide range of assumptions. Now, the accounting rules allow that. And so often what cities and states do public entities in the US is adjust their assumptions to make the numbers come out okay.

Does it make the risk go away if they change an assumption to reduce their unfunded pension liability? No. There are studies that are done and you can look them up which show that the true unfunded pension liability of cities and states in the US, is far in excess of what they're reporting. Now, you can maintain that for a period of time, but in my view, ultimately the bill comes due. As a very wise person once said to me when he was trying to explain to me what happened at Enron, and at the beginning I really couldn't understand what had happened, he said, "You can only defy gravity for so long. Gravity's the strongest force in the universe, it will win." And he said, "Andy, what you were doing at Enron with your financial engineering was defying gravity. The business guys were doing deals that may have been showing up as profitable, but they were uneconomic. And you were able to defy gravity, making it look better for a period of time, but eventually gravity won."

Now, I think the same thing will happen with some of our public finances in the United States, and that's a risk that we hear politicians talking about, but very few politicians getting serious about. I'll give you one other little anecdote, going back to Enron days. Back when Enron was around, the Enron had an advisory board of non-Enron people, just industry people, economists, people like that, people like Gavyn Davies, the Former Chief Economist at Goldman, Larry Lindsey, the Former Vice Chairman of the Fed and Bob Zoellick, now Head of the World Bank. These are guys, smart guys and they'd come in a few times a year, and they would give us an overview of macro trends in the market, things like deregulation or political risks, things like that.

And then often Enron business people would give a presentation about some of the things we're doing to try to capture these trends in the market, if you will. And I remember I was having lunch with Larry Lindsey, the Former Vice Chairman of the Fed, and I was telling him a lot about the structured finance deals we were doing at Enron. And at the time I was very proud of this. I'm not proud of it now, but at the time I was very proud of it. I was thinking this was genius, not evil. Now I think the opposite, of course. And so I'm going through all these deals and he's like, "Yeah, this is really impressive stuff." And when there was a pause, he said, "You guys are really good at this, but you're not the best." And I have to admit, because there's a little too much ego involved on my part, I was like, "Really? Who's better?" He said, "The US Government."

Will Page:

I think you've given us a headline for this show.

Andy Fastow:

This is the Former Vice Chairman of the Fed, and he knew the financial engineering that the government does to understate its liabilities and because that's politically easier.

Will Page:

Well, if I can quickly put a pin in the imputed rent story for you, and I think you'll find this quite amusing. So when the boot came out, the folks at the Office of National Statistics were a little bit upset that I took them to task on this concept of imputed rents. And I had to answer to them and they're like, "Come on, that was hard. You're not really supposed to delve into that. You're not supposed to open that can of worms." I have to. How can a government invent 10% of GDP? My department in government, Culture, Media and Sport is, 7% of GDP. And we do stuff, we set up Olympics, we have copyright, we have culture, but you can invent part of the economy that's even bigger than the stuff that we actually do.

There was a very heated conversation at the very end. I asked my colleague at UNS, "All right, maybe I upset a few people calling that one out, but I want to know why you do it? Why do you invent numbers? Why? Just tell me why and I'll back off." He said, "We've got to, otherwise we'd be smaller than the French." So the theory was because the French do it, we have to do it too, that way our GDP can be bigger than the French. That's why we invent 10% of Gross Domestic Product in our country. Egos. We are going to take a quick break then back for more with Andy Fastow. Stay tuned

As we get a telegram from the King, for reaching a ripe old age of a 100, welcome to Bubble Trouble. We're in for a doubleheader that is all killer and no filler. Today we continue our two-part conversation with Andy Fastow, Former CFO or Chief Loophole Officer of Enron.

Richard Kramer:

The way we like to end our podcast is, we ask our guests for a couple smoke signals, the things that when you're observing companies or anything in the finance field, the things that make you go, "Uh-huh." Or, "That's going to cause trouble." What are things people should look out for? Are there a few things that, especially when you know that Enron will be taught as a case study in business schools and you want to go in and speak to all these young and impressionable potential finance professionals, the things that you tell them, "This is what you ought to look out for. When you hear someone say this or that you really want to take a step back and pause for breath."? What are the smoke signals you would tell our listeners to look out for in companies or finance professionals speaking about what they do that really get your hackles up?

Andy Fastow:

I get asked this question a lot, and I get asked a similar question because I do a lot of talks and teach some classes at graduate business schools and the students are always thinking about the job they're going to get and how do they avoid being at the wrong company. And so let me answer both of those questions. The first question, the smokescreen is, believe it or not, when I was released from prison, I received calls from hedge funds, particularly short sellers, and they would want to talk with me or hire me to look at company's financials and detect those, what they call the Enron-like things, those accounting maneuvers or structured finance deals that might be technically legal, but that also are probably hiding somewhere. Because of course, short sellers want to expose the hidden risks or the hidden problems.

And so I've developed a program, if you will, where I evaluate a wide range of factors at companies when I'm invited to do this. And they range from hard accounting things like, "Can you actually track the cash? Or what's in this footnote or what's not in the footnote that I would expect to see?" Sometimes it's the missing word that's more important than the included word. So the hard stuff on one end of the spectrum, all the way to the other end of the spectrum to soft cultural things. And there are a lot of great forensic accountants out there that are much smarter at accounting than me. But one of the red flags is, if you see companies entering into these complex and expensive structured finance deals with banks, there's usually an uneconomic motive and it's more likely that there's a financial reporting motive associated with it. That would be one end of the spectrum. Try to find those, figure out if there's a clue word in there that suggests they're doing that.

Or if you can't find the actual cash, but they've got funds flow from operations, if you can't figure out how to explain that gap, probably a reason you can't explain that gap. On the other end of the spectrum, and this gets to the question I get from students, I say, "You're not financial analysts, you're not forensic accountants, so you're not going to be able to necessarily find those things." I say, "Sometimes, all you have to do is listen to an earnings call. And if the people talking, the CEO, the CFO, Chief Operations Officer, if they sound like politicians, that are trying to spin what's happened this quarter, you've got an indication. But if you hear a CEO, a CFO, a COO talking about what went wrong and what they have to do to fix it, it's a very different culture. It's a very different approach to decision making and risks."

Sometimes it's that easy to know which companies you should spend some extra time looking at. I ask this question, "Where do you have your employee offsite? If it's in the conference room at the ballroom, at the Marriott Hotel in Downtown Cleveland, that's one thing, if it's in Las Vegas, it's a different thing. Or if you're doing a party in Greece, like who was it? Kozlowski did or something from Tyco, for a million dollars, that's another thing."

Will Page:

At Spotify, they flew 350 of us to Cuba.

Andy Fastow:

I'm not suggesting that there's anything wrong with Las Vegas, but what we probably could all agree on, is that in Las Vegas, there's a greater risk that your employees will do something stupid than in a conference room in Downtown Cleveland. And so again, that's very soft, it doesn't really mean anything, but it just gives you a little insight into the way they evaluate risk.

Richard Kramer:

Yeah. And I'll tell you, in my experience, and I listened to dozens of analysts earnings calls, and I've done that for 30 years, today, companies have scripted their calls and are so cautious about what they say, that they won't really discuss the real aspects of the business. All of the large tech companies consider the earnings call as a marketing event. They pre-select the analysts to ask questions. It's as we say, [inaudible 00:38:08], it's, "Congratulations on a great quarter." And a pre-agreed question will be asked with the number one analyst in internet from Goldman Sachs prefaces every question to management with, "How should we think about..." The, we, being that, "I'm already on your team, me and you, the analyst and the company are together and I am an empty vessel, a highly paid professional, but an empty vessel, please fill me with how I should think of you."

Will Page:

Tip my neck back and pour the Kool-Aid down it.

Andy Fastow:

The analysts I met were very smart people. And I didn't meet any that, in my opinion or my interactions with them were the type of people that would intentionally do the wrong thing. Okay. Same with accountants, at Arthur Andersen, they were all incredibly brilliant people, and I can't think of one that would've intentionally broken a rule or done the wrong thing. Same with the attorneys that I worked with. But here's the thing, in the case of the analysts, they understand that if they have a sell rating or even a hold rating on a company, the investment bankers on the other side of that hypothetical Chinese wall aren't going to be lead underwriter, [inaudible 00:39:29]. Okay. And so whether they're consciously doing it or unconsciously doing it, they're marketing. And we just need to understand it's the reality of it. And again, in no way am I casting aspersions on these people, their brains are telling them what the answer is, and they're finding a way to get to that answer without breaking a rule or in their mind, being unethical or dishonest in any way.

Will Page:

Andy, when I was a Government Economist at the Treasury, our Chancellor of the Exchequer was Gordon Brown or Gordon Brown, and he always had this expression, he said, "Economists, you should adhere to evidence-based policymaking and avoid the temptation of policy-based evidence making." That's a very important play of words. [inaudible 00:40:20], lots of evidence and justify this by rating is not evidence-based policymaking, that's decision based evidence making.

Richard Kramer:

And I think the process, as you say, for the smartest guy to understand, that even if in the back of the report it says, "No part of the analyst compensation will be derived from investment banking revenues," they will still know that if the bank does those offerings and gets the mandates for M&A transactions, the bank will make more money and they will too. So even this, [inaudible 00:40:53].

Andy Fastow:

Yeah. I know when Enron went down there was, I forget which analyst it was, oh, it was the Merrill Lynch analyst, he complained that Enron had had him fired from the account. And no one at Enron ever asked for him to be removed from-

Richard Kramer:

His bankers.

Andy Fastow:

The account. You know who got him removed from the account?

Richard Kramer:

Yeah, of course.

Andy Fastow:

Merrill Lynch's investment bankers.

Will Page:

Whoa.

Andy Fastow:

You know why? Because-

Will Page:

Foxes in the henhouses.

Andy Fastow:

I remember we were doing a zero coupon convert deal and they wanted to be lead on it, but had a sell on Enron, or a hold or sell, I can't remember. And the banker wanted to be the lead, and I said, "How can we have you on a league? Your analyst who's going to help you sell the offering is saying don't buy it." It'd be like if you had a guy at the local Ford dealership saying, "Don't buy a Ford. Go buy a different car that's a better quality."

Richard Kramer:

The day before the Enron collapsed, there was the Goldman report saying, "Putting a high price target on it and recommending people to buy the stock, just like Goldman 23 years later had a buy on Silicon Valley Bank a couple of weeks before it went under."

Andy Fastow:

Yeah, by the way, when Goldman had that buy on, they secretly sold the half a billion dollars worth of Enron, [inaudible 00:42:17].

Richard Kramer:

So, "Watch what I do, not what I say."

Will Page:

Andy, I go back to when I first met you in that heatwave of 2015 at the Financial Times, friend of the show at Alphaville Conference, can I ask you to recollect succinctly the story of when you gave the University of Colorado a lecture about an anonymous company that took stuff off balance sheet, just to challenge your moral high ground taking critics of the Enron story? You told this beautiful story, then asked the audience a question at the end. Let me just give you the microphone to walk us through this, because it's just a beautiful way of reminding us about people in glass houses shouldn't throw stones.

Andy Fastow:

Yeah. I haven't thought about that story in a long time or told it in a long time.

Will Page:

I can recite it to the letter. It hit me that hard.

Andy Fastow:

The whole point of this exercise was to help the students become more self-aware. Now remember, it wasn't telling them to be better people or to be ethical versus unethical. It was to highlight that our brains do this without us realizing it. We don't see the cognitive dissonance, we don't see the risk associated with it. This is what happened, so actually, I got out of prison in 2011 and I had no intention of doing public speaking, but I got a call from the dean of the business school at the University of Colorado and he said, "Look, we not only have a good business school program, but we have an institute called the Center for Ethics and Social Responsibility, and we try to embed ethics into every class that we have. And I'm wondering if you'd be willing to come and talk to our students?"

And so I thought about it and I wanted to focus them on this gray area,, about how the subconscious bias our brains has to get to the answer we want, whether we realize it's happening or not. And that's key. We typically don't realize it's happening, that's why they call it bias. All right. And so what I did for the students is I gave them a short exercise, I took the financials from an entity and we did a quick credit analysis of the basic key ratios that a rating agency would look at, and it looked pretty conservative. And I asked them what they thought about this company. And they used all these glowing adjectives, which, "Transparent and it's conservative and it's reputable and it's something I'd invest in." And they went on and on about how good it was.

But then I dug into the footnotes of the company, and I showed them that some of the things in the footnotes, what they really were. And I asked the students whether or not we should add it back into the credit analysis of the company. And typically they'd say, "Yes, that would make it more truthful." And after we did that, the ratios had changed dramatically. It went from looking like investment grade to being a junk box. And I asked them, "Now, what do you think about this company?" And they said, "It's despicable, it's reprehensible. It looks like Enron. I'd never invest in this company."

Will Page:

Glass houses and stones.

Andy Fastow:

"Should've put the executives in prison like you were in prison." And I said, "Okay." But then I revealed to them that these were actually the financial statements of the University of Colorado. Okay. And after the students laughed for a moment like that, Will, they got a little indignant and they said, "Wait a minute. This administration is a bunch of hypocrites. They're preaching honesty and transparency, and they're making us take these ethics classes, but they're doing exactly what you did at Enron." It wasn't exactly, but that's how the students saw it. And one of the students... Now remember, this is an ethics class, so what is their brain's objective in ethics class? To be perceived as the most ethical person right?

Will Page:

Yeah.

Andy Fastow:

That's how you get an A in ethics class. So one of these students proposes they write a letter to the board of trustees, the chancellor or head of the school and the board of trustees saying that they need to take all of this stuff that's off balance sheet and put it back onto balance sheet, that, "We should make University of Colorado the model for everyone, that we should be the gold standard, that we should be the most ethical institution out there." And they voted unanimously to send this letter to the board of trustees. But then I explained to them that, if all this debt that was in the footnotes were back on the balance sheet, it would raise the borrowing costs to the school. And that means tuition and fees would go up by 10%. It took them one minute. It took them one minute, and they voted unanimously not to write the letter.

And I said, "Wait a minute. You all just said this was unethical and you're writing a letter. The only thing that's changed is a few thousand dollars and you're willing to ignore it." I said, explain to me why?" And they said, "The rules allow it. Other institutions and universities do the same thing. If we don't do this, we'd be at a big disadvantage." And why did that happen? Because their brains had a new objective, "I want to pay the lowest cost possible. I don't want to have to pay $3,000 more a year." Or whatever the number would be. So they looked at the same set of circumstances. And now were there any students in that class who were saying, in their heads were thinking, "I'm willing to be unethical and do the wrong thing for $3,000."? No, I'm sure not. These are good kids, they're good people. I didn't know them personally, but I'm sure they weren't consciously thinking that. It said, "Our brains know what the incentive is. We know the answer, and we find ways to get there by rationalizing it and justifying it."

And it probably makes you incredulous to hear this, but when I was at Enron, it never even dawned on me that I was committing fraud. It should have, but it didn't. It never dawned on me that I was being unethical. My brain was saying to me, "This is how the game's played, be the best at it." And so it's human nature we're talking about. And I really think we're not going to solve that problem with more rules and regulations, we're going to just solve it by hopefully having a new generation of young people who are a little more self-aware. And again, not convincing them to do right versus wrong, because they already want to do right, but convincing them that when they make these types of decisions, there are risks they're not seeing, and those risks can come back to bite you and your company, whether it's Enron or all the major banks or Silicon Valley Bank or General Electric or Boeing or any of these companies that had major destruction in shareholder wealth.

Will Page:

Wow, Andy, how do I land this plane and bring this podcast to a close? I was so nervous going into it, I'll just be very honest with the audience. I've wanted this conversation for...

Richard Kramer:

For days. He was nervous.

Will Page:

Rich has been trying to give me sedatives to calm me down. It's been very special reuniting with you since 2015. Maybe the first thing I should thank is Bethany McLean and Peter Elkind for their book, The Smartest Guys in the Room, and Alex Gibney for the documentary. That's what introduced me to your story. But to have you here on the podcast to tell it... There's two or three things I want to pick up on. Let's just go back to the University of Colorado story, if we don't do it, then others will do it and we'll be uncompetitive. Perhaps the only documentary I rate above The Smartest Guys in the Room, this is a complete tangent, is 9.79, the Ben Johnson story, the story of that famous race in Seoul, where Ben Johnson set the world record for the 100-meter sprints and Calvin Smith persist to this day that he was the only clean athlete on the track. And the expression the 100-meter sprinters had was, "If you don't take it, you won't make it."

And I wonder whether that applies to how you bend the rules in financial accounting? If you don't bend rules, you won't make it to the finishing line. It's a competitive market. You got to take the juice if you're going to make it to the finishing line. A second thing is just going back to that fine line between tax evasion and tax avoidance. I just think that's really interesting. That's one thing that's going to stick with me at the end of this show is, what determines whether you're doing tax evasion or tax avoidance. One is clever tax planning, the other could end up in jail. And again, it's that fine line.

And weirdly, I'm thinking of rugby. We just finished the Rugby World Cup, I know it's not a big sport in America, but the rest of the Commonwealth it is, the greatest rugby player of all time is seen as, Richie McCaw, New Zealand All Black. And if you ask New Zealanders, they'll say, "Ultimately he's the greatest rugby player." If you ask the Australians, they'll say, "He's the greatest cheat." Because he looks at the rules and he bends the rules. And that's how he wins, by looking at the rules and saying, "How far can I lean against the wind without falling over?" And he was great at leaning against the wind without falling over.

And the third thing is just, what's come off this two hours of conversation, Andy, is just the word reciprocity. Everyone's involved. The smartest guys and girls in that room were not just Enron executives, they were everybody. The Andersen accountants, who are shredding in Edinburgh, by the way. Back home in Edinburgh, people doing internships that Arthur Andersen were shredding, thanks to what happened with your company.

But the reciprocity, and maybe closing off on one line, which comes from the music industry, which is in the back of a music manager's business card, are words, "My mission is your commission." I wonder if those words were in the back of the Merrill Lynch banker's business cards when there were putting buy ratings on Enron in 2001 as well. My mission is your commission. My mission is not to do good or do what's right, my mission is to charge commission off somebody else's game. And that's where we fail to see around corners. I don't know if that does this conversation justice. That's my best effort of bringing it to a close. Andy Fastow, we've wanted this for a long time. Thank you so much for giving two hours of your precious time to come on the show.

Andy Fastow:

Thank you Will. Thank you, Richard.

Richard Kramer:

If you're new to Bubble Trouble, we hope you'll follow the show wherever you listen to your podcasts. Bubble Trouble is produced by Eric Newsom, Jesse Baker and Julia Nat at Magnificent Noise. You can learn more at bubbletroublepodcast.com. Until next time, from my Co-host, Will Page, I'm Richard Kramer.