WEBVTT

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Prof: Let me give a
forward to you of today in

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relationship to the week
afterward.

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Today we have Jim Alexander on
Enron,

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and we'll do this as a
conversation,

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except that at a certain point
he's going to just do a little

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straight lecturing on some
basics related to unfamiliar

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ideas in the HBS case,
or potentially unclear ideas.

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This is a--the Enron case is
arguably the most important

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meltdown in modern history of
American capitalism.

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It is certainly the one which
had riveted the world's

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attention more than any other,
and Jim was there at the

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beginning--
not at the beginning,

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but there in an almost perfect
vantage point.

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So we're fortunate to have him
today.

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Before I go further I should
say it's his birthday,

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and he, I think he doesn't want
me to tell you how old he is.

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Student: Happy
twenty-eighth!

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Jim Alexander:
Thank you.

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I needed that.

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Prof: On Monday we'll
have Richard Medley,

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founder of Medley Global
Advisors, and that case is about

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his selling--
Medley selling Medley Global

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Advisors and quitting.

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The question is:
How could a business have tens

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of millions of dollars worth of
value when it is in entirely

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framed around the personality of
one person?

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The answer is he got it done,
and he will be a very

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interesting guest.

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He's completely unpredictable
and he is famous,

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or infamous,
for George Soros' attack on the

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pound sterling.

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This was nearly twenty years
ago, when Soros' famous hedge

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fund decided it was going to
attack the pound sterling,

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and Richard Medley was then
working for Soros and Medley had

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inside information about the
behavior of the central banks of

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continental Europe,
and was able to predict their

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behavior.

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So Soros--the Soros fund made
well over a billion dollars on

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one transaction in an attack on
the value of the pound.

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The attack was controversial
and Medley's role in it was

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controversial,
and we'll have some fun with

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him about that.

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You should begin now reading
Posner;

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the pages are small,
but it's a dense book.

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It's a challenging book,
and you'll need it for

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Wednesday of next week when we
have Will Goetzmann in as a

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guest.

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Will is the director of the
Yale International Center for

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Finance,
and like Jim,

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a Yale College alum,
and again like Jim,

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something of a renaissance man.

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He's going to be talking about
the crash of 2008,

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which is a pretty intricate
story, and the Posner is easily

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the best book written about it,
though not easily the easiest

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book written about it.

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Without further ado,
Jim is a 1973 graduate of Yale

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College and let's talk to him
about your life after Yale.

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There is life after Yale
College and how it began for you

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and how it carried forward until
the date you arrived at Enron.

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Jim Alexander:
I'll shorten the version.

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The details get to be sort of
tedious.

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Prof: Only for you,
not for us.

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Jim Alexander:
Okay, well anyway,

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I went to HBS because all the
smart people were going into law

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or medicine.

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I had a primitive sense of
markets and I knew that I should

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avoid the smart people,
much as I did in my classes.

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I then, from HBS went to Aetna
Life and Casualty,

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investing their money,
bond investment department;

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till my then wife announced
either we could leave Hartford

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or she could leave Hartford,
at which point I sort of

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started searching for a job in
New York,

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and landed one at a venerable
old firm called Kuhn,

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Loeb & Co.,
may it rest in peace,

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which promptly merged out of
existence about nine months

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after I joined it.

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At the time it merged into
Lehman Brothers,

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at the time I listened to my
uncle, who was a client of

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Lehman, and avoided Lehman.

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And I went to work at First
Boston;

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another may it rest in peace
actually, sort of firm.

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Then in an astonishing move of
true idiocy,

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I went to back to Lehman in
1981 in their energy department

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because I was interested in
energy,

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until Shearson acquired Lehman
and it had all the human

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characteristics of Lehman,
and the economic

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characteristics of Shearson;
i.e., the worst of both worlds.

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Then I, being the flying
Dutchman of finance,

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went to Drexel until it went
poof and it went broke in 1990.

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I then had one last job in
conventional investment banking

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with a New Orleans firm till the
head of the firm announced that

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I had an "uneconomic
attachment to quality,"

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which was about the worst thing
he could say about anyone,

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so I took my quixotic approach
and became a consultant charging

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sort of minimum wage by
investment banking standards

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and--
Prof: Which is maximum

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wage by college professor
standards.

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Jim Alexander:
I don't know.

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Economic college professor
standards it's not--I think

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Steve Ross makes a lot of money.

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Prof: He doesn't make it
here or at MIT though.

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Jim Alexander:
That's a separate issue.

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Anyway--so I was--one of my
past clients,

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and I was there,
actually, at the start of

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Enron,
because I was there--we helped

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refinance Enron's huge amounts
of debt that were about to go

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into default until we had done
something when the--

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when Enron was created in 1984
or 1985,

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I think.

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One of my clients who had been
at Enron,

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I became an
investment--conventional

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investment banking--
I became a consultant to Enron,

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started working on their
attempt to roll up their

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aggregate into one legal entity,
all of their foreign projects.

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After a while the complexities
were such that virtually no one

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had the institutional memory
required to be able to complete

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the deal except for one or two
people and they needed someone

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who knew what their--
knew the story to be able to

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really stay on with the company,
and they asked me if I wanted

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to do that and I ended up
agreeing.

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Then I was there a full nine
months until--

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this was in 1994,
I was there about nine months

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before I,
the general counsel and the

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controller,
all resigned in the fall of

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1995.

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Prof: So you spent those
nine months, all of them,

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I think, as Chief Financial
Officer of Enron Global Pipeline

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& Power?

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Jim Alexander:
Yes I was--those nine

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months were spent at the
subsidiary level as the CFO of

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this one little subsidiary
company of theirs.

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But during that time anyone who
walked the halls of Enron could

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pick up lots of information,
and the only issue was whether

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you wanted to ignore it or not,
and of course a lot of people's

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excellent livelihoods depended
on their ignoring the

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information freely available in
the halls,

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which turned out generally to
be quite accurate.

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Prof: Was the ethical
texture of Enron noticeably

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different from the general mind
run of investment banking as you

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had experienced it?

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Jim Alexander:
Well that's an excellent

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question.

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The problem is there--you can
either trace a declining curve--

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constantly declining curve in
investment banking from the time

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I entered investment banking in
1975,

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or postulate a somewhat easier,
sort of old style investment

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banking and new style.

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The old style really was a
gentleman's game,

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I'm not talking about pre-SEC,
pre-1929 crash,

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but certainly when I entered
there was an old generation that

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was quite ethical,
upright, and gentlemanly.

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Of course those people died out
or were pushed off the edge and

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were replaced by people quite a
different ilk,

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who were much more like Enron.

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Prof: Much more like
Enron?

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Jim Alexander:  Yeah.

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Prof: So Enron is a very
young entity,

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and grew up in the period after
the fall, so to speak?

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Jim Alexander:  Yes.

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Prof: would you let them
off the hook a little about that

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or not?

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Jim Alexander:
Enron off the hook?

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Prof: Yeah.

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Jim Alexander:
In--by what?

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Prof: I don't think you
will.

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Jim Alexander:
By saying,

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how would I let them off the
hook, by the way?

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Prof: Well you'd say
they were brought up by wolves

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and therefore behave like
wolves.

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Their--all the advice they got
was--

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Jim Alexander:
Well if you are a wolf you

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are typically brought up by
wolves.

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Prof: That's correct.

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Jim Alexander:
The--one of the things as

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I've been listening to your
course,

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all the lectures and looking at
the readings,

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one of the things that I've
been trying to piece in my own

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mind together is:
What went wrong?

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When did, in the course of
development of the theory of

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capitalism,
did the theoreticians decide

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there was no need for morality,
and when did morality get

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replaced by efficiency?

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At Enron it would be a
situation where the ethical

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extremes--
the ethical environment was so

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completely different that it
begs the question of what is

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morality?

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And what do we base it on?

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Because the people who work
there would find any concepts of

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morality laughable and merely a
trap for the unwary.

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Prof: Fascinating.

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The case has lots of jargon in
it that is business speak,

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and Leslie Hough and some
others have suggested that it

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might be useful to go through
some of that background language

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before we do the case,
and I'm going to descend to the

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audience and take in the
lecture.

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Jim Alexander:  Lecture!?

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Well--anyway--well Enron,
like a number of other firms,

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got very involved in
commodities and commodity

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financing, and commodity
contracts.

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If you're the typical commodity
small producer--

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often times over leveraged,
hand to mouth existence,

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really can't take a big flying
leap and then hope to make a lot

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of money--
what you typically start to do

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is, in the case of an oil and
gas producer,

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let's say gas producer in
particular,

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I have a general view as to
what I'm going to produce each

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month.

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These are prices not production
amounts, but I have a general

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idea of what I'm going to
produce in January,

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February and on and on.

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It's very hard to shut down a
gas well,

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it's typically not really done,
you typically just produce flat

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out and then try to do the best
you can with your price

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realizations.

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When I know I'm going to be
producing a certain amount,

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and the first question is okay
do I take a flyer or not?

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Most people who have a lot of
debt or are squeezed for other

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reasons don't take a flyer,
so what they do is they can go

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to a commodities broker and say,
what price will you give me for

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each month for the rest of the
year?

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Or else they can go to a
commodities exchange and get the

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same result.

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What they do is they'll say,
okay, I'll sell you the

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equivalent of 1,000 barrels of
oil and gas terms in January for

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$5,
equivalent price in February,

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and it'll be slightly declining
in spring as a result of

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expected lack of demand for gas,
than it'll level out in summer

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and then it'll start going up.

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The commodities broker will
commit to buy a certain amount

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each month.

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Now if you're the producer
though,

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there's only one problem:
you don't--

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you expect to be able to
produce, but what if something

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goes wrong with your well?

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Well if something goes wrong
with your well you're committed

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to sell each month.

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What often times will happen is
that instead of actually

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committing to sell a certain
amount each month,

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the producer will buy a put so
that in case the price does go

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down he can make money but he's
not obligated to sell a certain

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volume.

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What you start doing is having
many variations on a theme of

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helping producers and consumers
who are on the other side,

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who also want to hedge,
they want to determine their

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costs of goods sold.

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You start having very many
types of mechanisms,

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contractual mechanisms to allow
producers to fix to varying

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extents the likelihood of
certain outcomes for their firm

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for the year,
and they get hugely complex.

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This is just the start.

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There are huge numbers of
variations on the theme;

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ways that you can lock in
certain types of spreads,

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ways that you can hedge all
sorts of variables beyond just

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the price in south Louisiana.

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That's what Enron got in the
business of doing.

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If you look at it the first
twelve months there's a very

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broad,
liquid market,

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whether it was done by the
commodity exchanges,

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or competing traders,
everyone--a very clear forward

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market,
everyone can see this.

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If you're looking at taking
positions as an Enron,

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to the extent they relate to
widely traded commodities,

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in short periods of time going
into the future,

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it's very obvious what you have.

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You can tell whether you're
making money every day by what

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happens to the commodity
relative to the risk positions

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you've put yourself in.

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That's--if Enron had stayed
with this type of situation,

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they wouldn't have made a lot
of apparent money,

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but they'd be alive today.

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It's a tough business,
it's a low margin business,

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but you can make a lot of money
in it if you stick to your

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knitting.

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If you want to make a lot of
money very quickly,

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you start looking at other
approaches.

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If you sort of look--and this
is for a trading company,

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and manufacturing companies
have different types of

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situations--
but you start with the lowest

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risk type of asset and that
would be cash.

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Presumably fairly highly rated,
short-term loans to the best

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types of corporations,
or ideally the U.S.

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Government;
that's great but that's a very

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low return asset.

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Marketable securities,
still very liquid,

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but you're starting to increase
the volatility of the returns,

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and you can make more money
here, but it's another place

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where you have to--
you really have an information

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advantage.

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What we're doing is we're
descending--we're going from

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things that are easily valued to
more and more difficult.

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Exchange traded derivatives,
that's the type of thing I was

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talking about where you have a--
it's called a forward market

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where people can sell or buy
commodities for very clear

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prices,
and it's very well known what

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exactly the market is,
although the farther you go out

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on the forward market,
the less liquid it is.

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Even here we're starting to get
to a situation where I know that

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I've committed to--
say, if I'm an Enron I've

18:24.756 --> 18:28.466
committed to buy the equivalent
of a million barrels of oil a

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year out;
well, how do you value that?

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You get one value if you're
saying well, I'm going to

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liquidate it,
and another value if you're

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saying how much would someone
pay for it.

18:41.568 --> 18:44.458
So even there you're starting
to have divergences in terms of

18:44.463 --> 18:46.783
how you look at value,
which can be exploited.

18:46.779 --> 18:50.729
Then we started going--as we
get further down in terms of the

18:50.733 --> 18:55.253
levels of certainty,
you have certain types of

18:55.250 --> 18:59.170
derivatives like options,
which might,

18:59.170 --> 19:02.610
instead of being a year out,
might be five years out.

19:02.608 --> 19:06.088
People can take these sorts of
algorithms,

19:06.088 --> 19:10.748
useful in inferring--or infer
the algorithm from the existing

19:10.753 --> 19:15.073
trading of short-term options,
apply them to long term

19:15.073 --> 19:18.813
options, and you get a value
which is plausible.

19:18.808 --> 19:23.838
So it's based upon clear market
inputs, but a result which is

19:23.838 --> 19:28.868
not self evident because there
is no clear trading market.

19:28.868 --> 19:32.318
Finally, and this is what Enron
really got into,

19:32.316 --> 19:35.906
you have an unimaginably
diverse one off deals.

19:35.910 --> 19:37.170
I'll give you an example.

19:37.170 --> 19:40.330
A family wishes to buy price
protection twenty years out

19:40.327 --> 19:42.737
against increases in Yale
tuition costs.

19:42.740 --> 19:47.240
That sounds farfetched but
that's the sort of thing that

19:47.243 --> 19:50.753
Enron was doing--
not with Yale tuition costs but

19:50.751 --> 19:54.091
taking very exotic situations
and then pricing them.

19:54.088 --> 20:01.098
I sort of took an example
$40,000 $50,000 $60,000 $70,000

20:01.097 --> 20:04.077
a year,
year's out, and I'm sure we'd

20:04.075 --> 20:07.635
all have a point of view as to
how Yale's tuition is going to

20:07.644 --> 20:08.184
go up.

20:08.180 --> 20:11.450
I mean if it continues constant
it goes up probably about

20:11.445 --> 20:15.785
inflation plus 2% or 3% a year,
you'd have a curve but it would

20:15.789 --> 20:18.639
be very judgmental,
there would be some

20:18.644 --> 20:22.484
plausibility to it,
but who knows and no one else

20:22.477 --> 20:24.837
is making a market in this.

20:24.838 --> 20:29.138
If you're Enron and you've
staked a huge amount of money,

20:29.140 --> 20:32.120
for example on this one trade,
how do they decide how much

20:32.123 --> 20:34.063
money they've made in a given
year?

20:34.058 --> 20:37.538
Well the answer is they use
their own curves,

20:37.537 --> 20:41.877
and if they want to make more
money they just change the

20:41.884 --> 20:43.154
assumptions.

20:43.150 --> 20:45.160
Who's to say they're wrong?

20:45.160 --> 20:49.400
No one, and that was what was
happening.

20:49.400 --> 20:56.740
You have one off assets,
risk positions,

20:56.740 --> 20:59.220
which were nearly impossible to
value,

20:59.220 --> 21:04.600
where the ability to recognize
income could be affected with

21:04.602 --> 21:06.612
the stroke of a pen.

21:06.608 --> 21:12.718
If you're able to recognize
income pretty much any way you

21:12.721 --> 21:16.461
want,
perversely your view of the

21:16.462 --> 21:21.252
risk of that type of asset--
it'll slowly start creeping

21:21.250 --> 21:25.130
into your mind that it's a low
risk asset because it always has

21:25.131 --> 21:28.951
this wonderful profitability
that never seems to go down,

21:28.950 --> 21:30.140
never problematic.

21:30.140 --> 21:34.390
Now normally you would expect
external auditors to question

21:34.394 --> 21:37.924
these assumptions,
but Arthur Andersen was making

21:37.917 --> 21:40.997
$50 million bucks a year off of
Enron;

21:41.000 --> 21:43.450
are they going to question
anything?

21:43.450 --> 21:44.870
No.

21:44.868 --> 21:49.058
They could basically create
income any time they want.

21:49.058 --> 21:51.338
The problem,
though, is you end up having

21:51.337 --> 21:54.697
increasing divergence between
the income you're creating and

21:54.700 --> 21:56.160
cash,
real cash flow,

21:56.163 --> 21:59.683
and you're having increasing
divergence between what I might

21:59.675 --> 22:03.305
call the intrinsic risk of an
asset category and the risk that

22:03.308 --> 22:06.698
you perceive based upon your own
manipulative control over

22:06.702 --> 22:08.492
recognition of profits.

22:08.490 --> 22:14.930
That becomes the source of
Enron's own downfall is that

22:14.925 --> 22:21.235
they--right at the start of each
transaction they were

22:21.242 --> 22:24.702
manipulating the numbers.

22:24.700 --> 22:27.830
It wasn't a top down type of
adjustment like Worldcom,

22:27.828 --> 22:30.698
where basically all the people
at the subsidiary level were

22:30.701 --> 22:33.141
doing honest things,
and then at the top they

22:33.144 --> 22:35.104
started monkeying with the
results.

22:35.098 --> 22:38.968
At Enron every single
transaction was gamed to figure

22:38.969 --> 22:42.559
out how it could create income,
maximize income,

22:42.557 --> 22:46.757
short term income,
but once you start doing that

22:46.759 --> 22:50.609
it starts becoming harder,
and harder, and harder to

22:50.612 --> 22:52.272
figure out,
well, where should I be

22:52.266 --> 22:53.216
investing my money?

22:53.220 --> 22:56.480
Where should I be placing
my--how should I be adjusting my

22:56.478 --> 22:57.448
risk portfolio?

22:57.450 --> 22:59.120
How much debt should I take on?

22:59.118 --> 23:01.268
Because no one has any idea
what the risk is,

23:01.273 --> 23:03.823
and no one has any idea what
the profitability is.

23:03.818 --> 23:08.598
That sounds crazy but that's
what it was.

23:08.598 --> 23:13.008
One of the things--so you have
on the asset side of the

23:13.011 --> 23:17.831
business where you're actually
taking risks on behalf of the

23:17.832 --> 23:22.982
firm and working with outsiders
and making money that way,

23:22.980 --> 23:24.580
that was all screwed up.

23:24.579 --> 23:25.729
They had another problem.

23:25.730 --> 23:31.350
We have basically--every public
company has to provide annually

23:31.349 --> 23:36.789
something called a balance
sheet, and an income statement.

23:36.788 --> 23:41.398
The balance sheet is supposed
to represent the market value,

23:41.400 --> 23:45.290
but in general terms,
the market value of what you

23:45.285 --> 23:49.165
own and the obligations you have
to outsiders,

23:49.170 --> 23:53.120
which offset some of those
assets and give you a net

23:53.115 --> 23:55.785
result,
which is what the stockholders

23:55.792 --> 23:57.382
really have in the firm.

23:57.380 --> 24:01.360
You might have a $1,000 worth
of assets, you might have debt,

24:01.356 --> 24:04.266
long-term debt,
and it could be a mortgage to

24:04.273 --> 24:05.603
someone of $500.

24:05.598 --> 24:09.158
You subtract that and you get
stockholder's equity because

24:09.162 --> 24:12.722
stockholders own the residual
when a firm is liquidated of

24:12.723 --> 24:15.353
$500,
so assets always by definition

24:15.348 --> 24:18.108
equal the sum of debt--
of liabilities and

24:18.111 --> 24:19.531
stockholder's equity.

24:19.528 --> 24:23.838
You may say well--if you're
Enron--well, I don't want to

24:23.843 --> 24:25.493
show all that debt.

24:25.490 --> 24:28.570
What you can do,
and I think the techniques

24:28.566 --> 24:32.516
would take too long today--I
mean I wasn't set up to go

24:32.521 --> 24:34.501
through the techniques.

24:34.500 --> 24:37.520
I can if people really want,
but it would have to be another

24:37.521 --> 24:37.831
day.

24:37.828 --> 24:44.828
Basically the accounting rules,
like the Internal Revenue Code,

24:44.828 --> 24:48.588
have this series of precise
procedures,

24:48.588 --> 24:53.878
criteria tests for determining
how accounting will work.

24:53.880 --> 25:01.200
The problem with that is that
if you are really smart you can

25:01.201 --> 25:08.161
figure out how to end up with
the economic equivalent of a

25:08.155 --> 25:15.225
given treatment but have it
appear just the way you want in

25:15.232 --> 25:17.432
the account.

25:17.430 --> 25:22.810
Right here, I could take this
debt and I could move it and

25:22.811 --> 25:28.291
associated assets $500 out of
each column and I end up with

25:28.288 --> 25:33.198
$500 of assets and $500 of
stockholder's equity;

25:33.200 --> 25:35.620
smaller firm,
to be sure, but no debt.

25:35.618 --> 25:40.378
There are techniques which
exploit loopholes,

25:40.380 --> 25:44.490
so that something that is in
economic terms a debt suddenly

25:44.488 --> 25:48.558
disappears,
or that if I want to be able to

25:48.564 --> 25:53.544
sell assets to myself I can
create an alter ego,

25:53.538 --> 25:57.288
something that looks a little
bit like an independent company

25:57.288 --> 25:58.038
but isn't.

25:58.038 --> 26:01.008
I can recognize gain on the
sale even though I'm really

26:01.009 --> 26:04.089
selling it to myself,
and that's because the

26:04.094 --> 26:08.674
loopholes in the accounting
allow you to achieve form over

26:08.666 --> 26:09.706
substance.

26:09.710 --> 26:13.980
To break the code though you
have to have a complacent

26:13.982 --> 26:17.512
auditor,
and in the case of Arthur

26:17.508 --> 26:19.698
Andersen,
over half of their services

26:19.700 --> 26:22.550
weren't even auditing services,
they were consulting services,

26:22.546 --> 26:24.446
so they were completely bought
off.

26:24.450 --> 26:29.540
You also have to have--
Prof: Can you rub that

26:29.539 --> 26:30.789
point in a little more.

26:30.789 --> 26:32.069
Jim Alexander:  Well--
Prof: Make sure they

26:32.068 --> 26:32.778
don't miss that.

26:32.779 --> 26:35.709
Jim Alexander:
Okay, so the way the

26:35.714 --> 26:38.724
system worked when I started in
finance,

26:38.720 --> 26:46.230
you had people of high
reputation who were the--

26:46.230 --> 26:49.170
you might call them sort of the
trust gatekeepers.

26:49.170 --> 26:53.120
They would have included major
accounting firm,

26:53.124 --> 26:57.344
high quality law firm,
and a high quality board of

26:57.336 --> 26:58.536
directors.

26:58.538 --> 27:06.318
The problem is that very often
the reality of the--put it

27:06.316 --> 27:13.536
another way--the perception of
reputation, and trust,

27:13.537 --> 27:18.117
and quality lags the reality.

27:18.118 --> 27:20.528
In other words,
if you want to make a lot of

27:20.534 --> 27:23.984
money in a short period of time,
you take a firm that has

27:23.977 --> 27:28.727
existing good reputation,
and you use that reputation to

27:28.727 --> 27:34.077
be able to generate high profits
in the short-term.

27:34.078 --> 27:37.448
The way you do that is you say,
Arthur Anderson,

27:37.451 --> 27:41.541
well the high quality firm,
so I don't have to worry about

27:41.539 --> 27:43.979
funny stuff in the accounting.

27:43.980 --> 27:45.740
I don't have to worry if I'm a
reader of those financial

27:45.740 --> 27:47.010
statements,
an investor,

27:47.009 --> 27:50.559
I don't have to worry about
whether they're basically

27:50.564 --> 27:54.534
disguising debt or whether
they're basically creating their

27:54.527 --> 27:59.277
own earnings out of thin air,
because Arthur Andersen is a

27:59.279 --> 28:00.879
high quality firm.

28:00.880 --> 28:04.090
Generations of people could
have built up the reputation of

28:04.094 --> 28:06.794
the firm,
but maintaining a reputation,

28:06.788 --> 28:10.948
like maintaining a building,
requires a lot of ongoing

28:10.950 --> 28:11.940
investment.

28:11.940 --> 28:14.600
And if you really want to get a
lot of cash flow in a short

28:14.603 --> 28:17.613
period of time,
you just let it start to

28:17.614 --> 28:20.594
disintegrate,
but people won't notice what's

28:20.588 --> 28:22.948
really going on for a long
period of time,

28:22.950 --> 28:27.820
and while you're fooling them,
you if you're Arthur Andersen,

28:27.818 --> 28:30.538
and Enron, one of their
clients, can make a lot of

28:30.536 --> 28:30.976
money.

28:30.980 --> 28:32.380
Because this is easy money.

28:32.380 --> 28:34.310
This is easy,
because basically you don't

28:34.310 --> 28:37.780
have to create value,
you merely have to engage in an

28:37.784 --> 28:42.044
exchange with another member of
the capitalist society who

28:42.038 --> 28:44.998
thinks they're informed,
but isn't.

28:45.000 --> 28:48.370
That's--I mean when we think
about how capitalism creates

28:48.366 --> 28:51.666
value, to my way of thinking,
its part--it's a series of

28:51.673 --> 28:53.903
informed and voluntary
exchanges.

28:53.900 --> 28:57.790
What does it mean to be
informed?

28:57.788 --> 29:02.938
One of the problems with
capitalism as it exists and not

29:02.938 --> 29:08.648
as I read some of these crazy
economists, is--almost no one is

29:08.647 --> 29:11.547
true rational economic man.

29:11.548 --> 29:13.768
There are probably a few
geniuses that are,

29:13.769 --> 29:16.989
but most people don't have the
time,

29:16.990 --> 29:19.440
don't have the intellect,
or don't have the cynicism to

29:19.440 --> 29:21.120
understand what they're up
against.

29:21.118 --> 29:23.888
So they say,
well, a good firm I don't have

29:23.890 --> 29:25.210
to worry about it.

29:25.210 --> 29:28.220
Well the answer is you do have
to worry about it.

29:28.220 --> 29:31.800
That's why, in my view,
this all came a cropper in the

29:31.798 --> 29:36.378
last ten or twenty years,
is that the self imposed

29:36.375 --> 29:42.525
restrictions which limited
short-term self interest kept

29:42.534 --> 29:47.464
the whole system stable for many
decades.

29:47.460 --> 29:50.710
Once people started to say,
"Well I don't have to

29:50.710 --> 29:53.950
worry about ethics,
I mean that's--I just have to

29:53.949 --> 29:57.789
worry about being rational and
realizing my own goals,"

29:57.794 --> 30:01.574
well the answer at that point
is the whole system starts to

30:01.573 --> 30:04.093
go,
and this is a perfect example

30:04.090 --> 30:07.650
because these are people,
the people who engaged in this

30:07.653 --> 30:10.853
sort of deception,
did not have any ethics and

30:10.846 --> 30:13.906
would actually view ethics as
laughable.

30:13.910 --> 30:17.240
That's really important to
realize what people are up

30:17.238 --> 30:20.008
against and that is--
their view is if they're

30:20.006 --> 30:23.136
creating economic efficiency
even though they lost sight of

30:23.136 --> 30:25.356
that too,
who cares about ethics?

30:25.358 --> 30:27.328
Ethics is another constraint of
the little man.

30:27.328 --> 30:36.458
Prof: Let's just make
sure you link this to off

30:36.461 --> 30:40.771
balance sheet accounts.

30:40.769 --> 30:42.259
Did you see the connection
there?

30:42.259 --> 30:46.659
Jim Alexander:
The techniques

30:46.655 --> 30:49.705
are--they're intricate.

30:49.710 --> 30:56.530
I was going to bring a piece of
paper and have it xeroxed but

30:56.529 --> 31:03.459
it's a diagram of a transaction
among eight different entities

31:03.462 --> 31:08.922
involving probably 1,500 pages
of documents.

31:08.920 --> 31:16.160
To be able to exploit every
loophole possible to create an

31:16.162 --> 31:20.992
alter ego entity which you
control,

31:20.990 --> 31:25.890
but what looks independent
enough to be able to shuffle off

31:25.893 --> 31:29.363
maybe a billion dollars worth of
debt,

31:29.358 --> 31:30.648
a billion dollars worth of
assets.

31:30.650 --> 31:37.950
I didn't--it's one of these
things where here's the problem:

31:37.948 --> 31:44.008
in modern finance one of the
tools of the trade is

31:44.009 --> 31:45.989
obfuscation.

31:45.990 --> 31:54.600
The transactions are meant to
be mind bogglingly complex so

31:54.596 --> 31:59.586
lesser people,
lesser intellects who rely on

31:59.592 --> 32:04.112
reputation to simplify their
lives will fall for it.

32:04.108 --> 32:06.658
They'll say,
"I don't understand this

32:06.660 --> 32:10.270
stuff, but I know that guy on
the board, now he's a quality

32:10.269 --> 32:11.139
guy."

32:11.140 --> 32:14.740
The problem then is,
well, how do you know?

32:14.740 --> 32:17.310
"Well I've asked Joe,
Joe says he's a quality

32:17.309 --> 32:17.939
guy."

32:17.940 --> 32:18.920
Well how does he know?

32:18.920 --> 32:21.560
How can you ultimately
investigate all these things?

32:21.558 --> 32:24.218
Well the answer is,
you don't have the time,

32:24.220 --> 32:25.850
and you may not have the
intellect,

32:25.848 --> 32:28.748
and you certainly don't have
the money to be able to hire

32:28.751 --> 32:29.531
people to do.

32:29.528 --> 32:33.718
That's how you can start to
game this whole system because

32:33.720 --> 32:37.910
there are a lot of people who
expect that the old rules of

32:37.911 --> 32:41.861
reputation and quality,
which were developed after the

32:41.856 --> 32:45.376
1929 crash as part of an overall
change in our system,

32:45.380 --> 32:46.590
still prevailed.

32:46.588 --> 32:49.248
They didn't,
because basically everyone

32:49.252 --> 32:53.112
started being lulled into this
strange sort of idea that

32:53.106 --> 32:56.986
markets are perfect,
and rational people will always

32:56.987 --> 33:00.007
come up with the most
economically beneficial

33:00.006 --> 33:00.826
solution.

33:00.828 --> 33:04.568
I agree with that,
if, in fact,

33:04.566 --> 33:08.656
there are some limits,
because the fact is,

33:08.661 --> 33:10.821
when I think of capitalism
creating value,

33:10.818 --> 33:13.608
I think of it getting around
constraints.

33:13.609 --> 33:15.579
What types of constraints?

33:15.578 --> 33:20.118
The constraints are physical
constraints, or maybe legal

33:20.115 --> 33:25.145
constraints where the law really
is sort of a dead letter or a

33:25.146 --> 33:26.216
bad idea.

33:26.220 --> 33:29.950
Like creating the wheel,
you have a--getting around some

33:29.952 --> 33:33.352
of the constraints of gravity,
or creating writing,

33:33.347 --> 33:35.857
getting around other
constraints.

33:35.858 --> 33:40.068
I mean those are--those in my
way of thinking are very

33:40.074 --> 33:43.974
beneficial ways of solving--of
problem solving.

33:43.970 --> 33:48.190
The other constraints that
people have started to view as

33:48.188 --> 33:53.158
just a minor problem for lesser
people, are ethical constraints.

33:53.160 --> 33:58.230
Prof: So there's an
intersection between sheer

33:58.234 --> 34:01.754
complexity and ethical
relaxation?

34:01.750 --> 34:07.520
A year ago when things got
really ugly,

34:07.519 --> 34:12.419
Steve Schwartzman put together
a little roundtable which I

34:12.416 --> 34:16.956
attended in New York,
and Nancy Peretsman made the

34:16.963 --> 34:22.023
most interesting point,
which is the one you just made,

34:22.021 --> 34:26.241
that if there are asset
categories which are so

34:26.240 --> 34:31.010
intricate that nobody has really
worked through,

34:31.010 --> 34:35.040
nobody has really worked
through all the mechanics of the

34:35.041 --> 34:39.501
thing in a way that allows them
to understand the impact of all

34:39.503 --> 34:44.753
the variables of the system,
then the--all the sort of

34:44.753 --> 34:51.423
market mechanisms which enforce
a degree of rationality are

34:51.420 --> 34:55.560
disconnected from the
instrument.

34:55.559 --> 34:58.779
Jim Alexander:
Yes, I agree that if

34:58.784 --> 35:02.704
there's--
if you had accountants and

35:02.704 --> 35:08.674
boards of directors who,
in effect, did not give traders

35:08.666 --> 35:13.446
the benefit of the doubt,
it probably would be okay.

35:13.449 --> 35:18.429
But the fact is most people
will give the benefit of the

35:18.427 --> 35:23.857
doubt to people they view as
smarter, and that is--that's the

35:23.858 --> 35:25.938
road to extinction.

35:25.940 --> 35:28.710
Prof: Right,
that is the road to extinction.

35:28.710 --> 35:31.530
Let's talk about the road to
Houston.

35:31.530 --> 35:34.730
You--the book,
Smartest Guys in the

35:34.731 --> 35:38.971
Room, where you are referred
to, at one point,

35:38.971 --> 35:43.991
as the fly in the ointment from
Enron's point of view.

35:43.989 --> 35:49.179
The most conspicuous characters
there are Lay,

35:49.184 --> 35:51.844
Skilling, and Fastow.

35:51.840 --> 35:56.540
Tell us a little bit about
those guys.

35:56.539 --> 36:01.869
Jim Alexander:
Well Lay was someone who

36:01.869 --> 36:06.039
always operated from 30,000
feet,

36:06.039 --> 36:10.329
a big picture guy,
super--all about strategy,

36:10.329 --> 36:13.589
never got into the operating
details,

36:13.590 --> 36:15.920
never really wanted to know
anything.

36:15.920 --> 36:18.600
If you produced consistent
results, there were absolutely

36:18.596 --> 36:19.596
no questions asked.

36:19.599 --> 36:23.299
He didn't want to know.

36:23.300 --> 36:25.470
Prof: Decent guy in your
impression?

36:25.469 --> 36:30.249
Jim Alexander:
He was at least as nice as

36:30.250 --> 36:32.840
most people I met,
yeah.

36:32.840 --> 36:39.200
Prof: How do nice and
decent connect in your mind?

36:39.199 --> 36:42.619
Jim Alexander:
Not at all but--

36:42.619 --> 36:46.339
Prof: Okay so he was--
Jim Alexander:

36:46.340 --> 36:48.490
--decent,
decent I mean

36:48.489 --> 36:53.419
that's--interpersonally he was
not abrasive that's one way.

36:53.420 --> 36:55.010
Prof: Okay.

36:55.010 --> 37:05.350
Jim Alexander:
Skilling was the genius,

37:05.347 --> 37:16.807
true genius who spanned a huge
range of intellectual

37:16.809 --> 37:20.179
expertises.

37:20.179 --> 37:24.919
There are a lot of people in
life who can only look at the

37:24.916 --> 37:28.236
details, but are very good at
details;

37:28.239 --> 37:31.739
and there are other people who
seem only to be able to grasp

37:31.740 --> 37:34.530
the big picture,
but then cannot convert it into

37:34.530 --> 37:36.370
actual specifics of action.

37:36.369 --> 37:39.949
Skilling was able to move
seamlessly from the most

37:39.954 --> 37:43.684
detailed aspects of each
transaction to the broadest

37:43.684 --> 37:48.224
reach of corporate vision in a
way I've never seen before.

37:48.219 --> 37:51.569
He was very, very skilled.

37:51.570 --> 37:53.500
Prof: So he was,
quite literally,

37:53.503 --> 37:55.043
the smartest guy in the room?

37:55.039 --> 37:57.269
Jim Alexander:
Yes, I think he was.

37:57.269 --> 37:59.809
Prof: As for Fastow?

37:59.809 --> 38:04.409
Jim Alexander:
Arthur Andersen has been

38:04.413 --> 38:10.023
killed off, so one cannot--one
can without legal risk say

38:10.016 --> 38:14.416
whatever you want about Arthur
Andersen.

38:14.420 --> 38:20.460
There are others that--there's
another party that I'll leave it

38:20.458 --> 38:25.328
as the elephant in the room,
that helped Fastow.

38:25.329 --> 38:29.949
Let's just say that the
professionals who should have

38:29.949 --> 38:34.389
been showing some small degree
of allegiance to the

38:34.393 --> 38:39.553
shareholders instead helped
Fastow concoct all these gnarly

38:39.547 --> 38:42.417
schemes,
because he himself was

38:42.423 --> 38:44.393
completely unable to do so.

38:44.389 --> 38:48.569
He was just someone who was
a--like Rosencrantz and

38:48.570 --> 38:52.250
Guildenstern,
one of the indifferent children

38:52.248 --> 38:53.668
of the earth.

38:53.670 --> 39:01.030
Prof: He was not a peer
of Skilling's?

39:01.030 --> 39:02.770
Jim Alexander:
No, he was a joke.

39:02.769 --> 39:04.359
He was a joke.

39:04.360 --> 39:06.250
He was a foil.

39:06.250 --> 39:09.660
All he was--he was--you had to
have somebody that was basically

39:09.659 --> 39:13.069
in there in addition to the
professionals from the outside,

39:13.070 --> 39:17.670
and he was there but he didn't
do anything.

39:17.670 --> 39:20.500
Prof: Fastow gets
positioned on both sides of many

39:20.496 --> 39:22.006
transactions,
was his story.

39:22.010 --> 39:27.650
And they talked their way
through the obvious conflict of

39:27.646 --> 39:34.086
interest by claiming his special
expertise justifies the role.

39:34.090 --> 39:36.220
Jim Alexander:
They were able to get

39:36.215 --> 39:39.075
deals done much more quickly
because he knows the assets so

39:39.083 --> 39:39.533
well.

39:39.530 --> 39:43.390
Prof: Now--
Jim Alexander:

39:43.391 --> 39:45.021
So they waived the
corporate conflict of interest

39:45.023 --> 39:45.703
policy in his case.

39:45.699 --> 39:52.549
Prof: Now if Skilling
and Lay had been able to program

39:52.547 --> 39:58.477
you entirely as they wished
would your role have been

39:58.481 --> 40:02.021
analogous to Fastow's role?

40:02.018 --> 40:03.028
Jim Alexander:
Sure, sure,

40:03.025 --> 40:03.235
sure.

40:03.239 --> 40:11.559
Skilling asked me to--in effect
to be Fastow when I started at

40:11.563 --> 40:13.453
EPP,
and I just said,

40:13.452 --> 40:17.012
"No I was hired to be CFO
of EPP and that's all I'm going

40:17.014 --> 40:17.894
to do."

40:17.889 --> 40:22.959
Prof: Okay,
so let's talk about the early

40:22.956 --> 40:27.806
days when you're in the role of
CFO at EPP.

40:27.809 --> 40:32.899
How does the--what's it like
when you get up in the morning

40:32.900 --> 40:36.850
and go to work,
and the phone rings and you're

40:36.849 --> 40:39.569
off to the day's adventure.

40:39.570 --> 40:42.340
Jim Alexander:
Well, all right,

40:42.344 --> 40:46.074
so EPP was 51% owned by Enron,
49% by the public.

40:46.070 --> 40:53.270
The--while I was the CFO and
then later President of EPP,

40:53.266 --> 41:00.456
the CEO and Chairman of the
Board was Rod Gray who was an

41:00.463 --> 41:06.093
executive at Enron;
the parent is where he made

41:06.085 --> 41:09.535
most of his money from the
parent.

41:09.539 --> 41:16.129
What would happen is that Rod
would come up with some new

41:16.125 --> 41:22.585
scheme for Enron to be able to
dump some expenses on the

41:22.592 --> 41:25.792
minority--
on EPP, but really I wasn't

41:25.791 --> 41:28.071
concerned about Enron,
I was concerned about the

41:28.065 --> 41:28.885
minority shareholders.

41:28.889 --> 41:31.839
Minority shareholders,
which was not theirs to pay in

41:31.835 --> 41:35.465
my view,
and maybe once a week he would

41:35.472 --> 41:41.802
come up with some new scheme and
maybe over the first six months

41:41.802 --> 41:48.032
it probably totaled $50 or $75
million dollars worth of schemes

41:48.030 --> 41:52.450
that we just had to keep
shooting down.

41:52.449 --> 41:56.379
Of course once he did that,
every time Enron wanted to sell

41:56.376 --> 42:00.456
us a project,
the process being so tainted,

42:00.456 --> 42:06.236
we had to trade very hard
because in effect I was trading

42:06.242 --> 42:08.312
with my own boss.

42:08.309 --> 42:20.039
Prof: What risks did you
feel yourself exposed too in

42:20.039 --> 42:23.419
that situation?

42:23.420 --> 42:27.520
Jim Alexander:
Well I didn't worry about

42:27.523 --> 42:31.893
legal risks because I was doing
the right thing.

42:31.889 --> 42:34.309
I just assumed I had no career,
I was going to have no career.

42:34.309 --> 42:40.079
But on the other hand,
it was a little company,

42:40.079 --> 42:44.789
and I had helped father this
little company that Enron was

42:44.786 --> 42:48.836
trying to tear apart,
and so I would be goddamned if

42:48.844 --> 42:53.204
they were going to get away with
it until they finally announced

42:53.199 --> 42:56.379
they were taking away my
accounting staff,

42:56.380 --> 42:59.890
and than they were going to
bill me for the cost but have

42:59.893 --> 43:02.783
them report to Skilling's group
and that's--

43:02.780 --> 43:03.770
Prof: That's a
convenient--

43:03.768 --> 43:05.378
Jim Alexander:
That was very convenient.

43:05.380 --> 43:08.030
At that point the general
counsel, the controller and I

43:08.025 --> 43:08.755
all resigned.

43:08.760 --> 43:16.370
By the way, the only disclosure
of a resignation was mine.

43:16.369 --> 43:18.719
They never disclosed the fact
that general counsel resigned or

43:18.724 --> 43:19.734
the controller resigned.

43:19.730 --> 43:26.030
The person who replaced me
ultimately indicted--

43:26.030 --> 43:28.730
I'm not sure whether she was
sent to jail,

43:28.730 --> 43:33.650
indicted, paid a big fine,
and I think turned state's

43:33.648 --> 43:34.688
evidence.

43:34.690 --> 43:37.340
Prof: There was one more
sentencing to prison this very

43:37.335 --> 43:37.635
week.

43:37.639 --> 43:39.779
Jim Alexander:
I saw that.

43:39.780 --> 43:41.120
Yeah I know I thought it was
all over.

43:41.119 --> 43:44.959
Prof: Now Spinnaker
Exploration was the next chapter

43:44.961 --> 43:46.421
for you, am I right?

43:46.420 --> 43:51.340
Jim Alexander:
Yeah, I helped start

43:51.336 --> 43:56.016
Spinnaker the year after I got
fired--

43:56.018 --> 43:58.338
or actually that--my position
is I was fired,

43:58.340 --> 43:59.650
their position is I quit at
Enron.

43:59.650 --> 44:05.040
It was a--just as Enron was
based on making money off of

44:05.043 --> 44:09.453
false information,
Spinnaker was an attempt to

44:09.454 --> 44:13.284
make money off of good
information.

44:13.280 --> 44:17.430
It's completely different ways
of playing information.

44:17.429 --> 44:20.029
Prof: Give us the
capsule of the business model

44:20.032 --> 44:20.822
for Spinnaker.

44:20.820 --> 44:23.390
Jim Alexander:
It was a--it was engaged

44:23.393 --> 44:27.153
in exploration for oil,
mostly gas in the Gulf of

44:27.146 --> 44:32.196
Mexico, with the basic strategic
point of view that most

44:32.199 --> 44:35.689
independent oil and gas
companies,

44:35.690 --> 44:39.390
whether through the
overconfidence of their CEOs or

44:39.387 --> 44:42.647
macho man mentality,
systematically undervalue

44:42.646 --> 44:45.636
information,
and would rather drill ten dry

44:45.643 --> 44:49.753
holes than spend 10% of the
money buying a good data set.

44:49.750 --> 44:54.700
So we got the best data we
could, seismic data which allows

44:54.697 --> 44:59.637
you probable inferences about
the structures underneath the

44:59.643 --> 45:04.593
earth and sometimes some direct
insight into whether gas is

45:04.590 --> 45:05.700
around.

45:05.699 --> 45:07.369
Anyway, we bought a lot of
seismic data,

45:07.369 --> 45:09.349
spent a lot of time with
processing,

45:09.349 --> 45:13.119
spent a lot of time making sure
we had the best exploration

45:13.115 --> 45:17.665
group we could find,
and went into business on that

45:17.666 --> 45:18.376
basis.

45:18.380 --> 45:24.410
Consistent with our view that
information is key,

45:24.409 --> 45:27.989
not only do we try to get the
best external information,

45:27.989 --> 45:32.109
but we also made sure that
internally there was a free flow

45:32.105 --> 45:34.635
of information so that,
for example,

45:34.641 --> 45:37.931
every Monday we had a meeting
with all the employees where

45:37.931 --> 45:40.011
everything was up for
discussion.

45:40.010 --> 45:43.660
There were no questions barred
and all the answers were candid

45:43.659 --> 45:47.369
on the basis that it doesn't do
any good to have great external

45:47.367 --> 45:50.477
information if the internal
flows are not good,

45:50.480 --> 45:54.360
and the internal flows won't be
good unless you truly care about

45:54.362 --> 45:55.782
what employees think.

45:55.780 --> 45:59.860
Prof: Spinnaker was
actually--was and is a quite

45:59.858 --> 46:01.518
spectacular success.

46:01.518 --> 46:03.548
Jim Alexander:
Well it was bought by

46:03.548 --> 46:06.288
Norsk Hydro a couple of years
ago but it was a multibillion

46:06.286 --> 46:08.596
dollar company certainly when it
was bought,

46:08.599 --> 46:12.059
and it was started in a $50
million dollar venture capital

46:12.056 --> 46:13.266
deal at the start.

46:13.268 --> 46:19.078
Prof: Spinnaker,
I've heard you say,

46:19.083 --> 46:27.663
that Spinnaker was the inverse
of every decision rule common to

46:27.664 --> 46:29.054
Enron.

46:29.050 --> 46:30.950
Jim Alexander:
Whenever we weren't sure

46:30.947 --> 46:32.677
what to do, we thought what
would Enron do,

46:32.679 --> 46:33.629
we did the reverse.

46:33.630 --> 46:42.240
Prof: Well that's--let's
finish we've got about 90

46:42.242 --> 46:43.782
seconds.

46:43.780 --> 46:51.330
Let's finish with--Jim is a
scholar of the Old Testament at

46:51.333 --> 46:54.853
the Yale Divinity School.

46:54.849 --> 46:57.259
Jim Alexander:
Scholar is a little

46:57.260 --> 46:58.320
strong--student.

46:58.320 --> 47:03.510
Prof: I don't know many
people who have read as many

47:03.514 --> 47:08.534
sources on arcane aspects of the
Old Testament as you.

47:08.530 --> 47:10.100
I think you're pretty serious.

47:10.099 --> 47:12.459
Jim Alexander:
I like esoterica of all

47:12.460 --> 47:12.880
types.

47:12.880 --> 47:14.860
That's why I was in project
finance.

47:14.860 --> 47:23.140
Prof: Give us--are we
all--is American capitalism in a

47:23.143 --> 47:29.913
state of advanced moral and
ethical decay or--

47:29.909 --> 47:30.769
Jim Alexander:
Not necessarily.

47:30.768 --> 47:34.438
If people can grasp the
requirements,

47:34.438 --> 47:39.738
the need for ethics just to
keep the system going.

47:39.739 --> 47:42.689
If people don't come to grips
with that I think it's just

47:42.693 --> 47:44.333
going to get worse and worse.

47:44.329 --> 47:47.009
Prof: There's a big
point there.

47:47.010 --> 47:52.180
Think now back to Smith's
invisible hand,

47:52.184 --> 47:59.564
and to Hayek and the creative
powers of a free society.

47:59.559 --> 48:05.749
All of that thinking has built
into it at the very most basic

48:05.753 --> 48:12.053
level, an assumption about truth
telling and access to broadly

48:12.052 --> 48:14.532
correct information.

48:14.530 --> 48:23.530
And every single tenant of the
tradition which runs from Adam

48:23.530 --> 48:31.330
Smith through modern economics
is founded on that.

48:31.329 --> 48:35.329
And for Smith the ethical side
was explicit with a theory of

48:35.329 --> 48:36.549
moral sentiment.

48:36.550 --> 48:41.460
The way economics is taught,
and the way business management

48:41.458 --> 48:46.448
is taught, the emphasis on an
ethical commitment to prove has

48:46.449 --> 48:48.779
been somewhat submerged.

48:48.780 --> 48:55.240
It doesn't have the simple
status for us intellectually

48:55.242 --> 48:59.672
that it did for Smith's
generation.

48:59.670 --> 49:01.900
I think that's a fair statement.

49:01.900 --> 49:08.140
Jim this has been,
as it always is,

49:08.139 --> 49:15.479
very illuminating,
and even inspiring.

49:15.480 --> 49:19.400
Thank you very much.

49:19.400 --> 49:24.000