The New “ENRON”

How a Homebuilder Beat All the High-Flying Tech Stocks of the 1990s…

Home sales are collapsing…

Existing home sales fell 3.4% in May. That’s the fourth straight month of declines. Inventory is growing fast, too. It’s up 1.2 million units, an increase of 12.6% from last year.

Growing inventory and falling sales mean home prices are likely to decline.

Two things are killing the market – higher mortgage rates and home prices that have reached levels that are simply not affordable for most buyers.

The average 30-year mortgage rate is now over 5.5%, the highest rates since before the last housing crisis. And, as you surely know, home prices soared during the pandemic.

Those two factors combine to impact the real-world cost of buying a home: affordability is now virtually the lowest it has ever been in U.S. residential real estate.

The Wall Street Journal’s headline says it all: America Faces A Housing Bust.

“All ingredients seemed in place at a 2022 start for a continued housing boom, but now the market has priced itself for a sharp reversal… It seems as if, disappointing as some of the recent housing data have been, it will only get worse in the months ahead… It is difficult to imagine a revival in the housing market unless homes get a lot more affordable. The boom brought on by the pandemic was nice while it lasted. Here comes the bust.”

— The Wall Street Journal, June 21, 2022

And Lennar, a leading national homebuilder, reports that demand fell rapidly after March.

“… the weight of a rapid doubling of interest rates over six months, together with accelerated price appreciation, began to drive buyers in many markets to pause and reconsider. We began to see these effects after quarter end. The Fed’s stated determination to curtail inflation through interest rate increases and quantitative tightening have begun to have the desired effect of slowing sales in some markets and stalling price increases across the country.

— Stuart Miller, Lennar Corp Executive Chairman, June 20, 2022

Homebuilding, then, would probably be among the last places investors should look to make money this year…

Likewise, very few investors would ever want to own an “Enron.”

That’s what makes this secret so compelling…

Enron’s 2001 collapse was the fastest destruction of wealth in modern corporate history. It unfolded in just weeks. It was also, at the time, the biggest bankruptcy ever ($60 billion).

Enron was a total disaster. It was a business that was so poorly run, the word “Enron” is now synonymous with criminal self-dealing and corporate greed run amok.

But there’s a secret about Enron not many investors understand. And that same secret has been used by a homebuilder to create massive amounts of wealth.

In this week’s letter we will explain why buying the new “Enron” of housing, during a crisis, could likely end up being the best investment you’ll ever make.

We don’t think there’s another investment, in any other well-established business, that could outpace the gains of buying the new Enron of housing.

In fact, we expect to see 10x returns in the near term.

And that’s only the beginning…

What You Don’t Know About Enron

Enron, for good reason, is the ultimate corporate “bogeyman.”

The story goes like this. Andy Fastow, Enron’s CFO, destroyed the company by using dozens of special purpose entities (SPEs) to hide losses. As the losses piled up in Enron’s “merchant accounts” (investments in other companies, like volatile Internet stocks) and its international divisions (direct investments in power plants, like the Dabhol power plan in India), Fastow set up structures that used more and more of Enron’s own stock to cover up the losses — and did so with the approval of Jeff Skilling and Ken Lay.

He further defrauded the company by using his own private equity fund (LJM) to buy assets from Enron for pennies on the dollar, while charging Enron huge fees for the “privilege.” This is how Fastow and a handful of his accomplices in Enron’s accounting department looted the company.

There’s no question what Fastow did was unethical and contributed to Enron’s collapse.

But… was it a crime?

Let’s break it down.

The board of directors at Enron gave Fastow multiple ethics waivers allowing him to negotiate the sale of Enron’s assets to his own private equity fund. These transactions were disclosed and were approved by the board of directors and Enron’s outside lawyers and accountants.

Fastow didn’t reveal that he was making millions from these transactions. But the board also never asked about his compensation from the fund. The fact that virtually all of Fastow’s actions – including his looting and accounting shenanigans – were disclosed and had been signed off on by the board and the outside accountants and law firms is not only hard to explain, but it made it hard for the government to prove a crime had taken place.

So as schemes go, this one had a lot of participants. And some surprising legal complexities.

Of course, it had some things Fastow did that were clearly illegal too. Like bribing members of Enron’s accounting staff. He did this by cutting them in on his illicit deals to make sure they didn’t blow the whistle.

Now, let’s look at a couple of other things most people don’t know about Enron’s collapse…

First, while the scope of the fraud Fastow perpetrated was immense – Fastow and his accomplices stole millions from the company, perhaps as much as $100 million in total – those losses do not explain how a $60 billion business collapsed.

Enron didn’t collapse because of what Fastow stole, in other words.

What hurt Enron far more was bending accounting rules and hiding losses. Nobody at Enron realized how poorly the company was performing, or even knew how much debt the company was really carrying…

It was over $30 billion, not the $12 billion that was on Enron’s balance sheet.

You see, Fastow didn’t set up the basic systems Enron required, like simply knowing when various short-term obligations were coming due.

What ultimately destroyed Enron were bad business decisions. Decisions that were enabled by the company’s absurd accounting.

Enron’s worst decisions involved the billions it lost on bad investments in its international division. These investments were both huge and very likely to fail from the beginning.

The Dabhol power plant is a good example. Enron built it in the mid-1990s. Who in their right mind would’ve bet $300 million on an enormous construction project in a country as poor and as unstable as India?

India wasn’t able to pay even half of its bills, from the very first day. The Dabhol plant still can’t pay its bills and has been shut down and “restructured” numerous times.

Or how about buying the municipal water system in Buenos Aires, Argentina?

Enron bid twice as much as any other bidder. But apparently did almost no due diligence on the status of the business, or its I.T. systems. The investment was a complete loss, $600 million, from day one. The entire company had been looted; its computer systems destroyed. Enron had no way to bill its customers for the water systems it “owned.”

To cover these losses, and dozens of others like them in places like Brazil and Guatemala, Enron sold two of its most valuable U.S. assets, Enron Oil and Gas and the InterNorth pipeline. The pipeline, one of the most valuable pieces of infrastructure in the United States, was sold to a group (Kinder Morgan) headed by Richard Kinder, Enron’s former President, for $60 million.

Today Kinder Morgan (NYSE: KMI, $16.74) is worth almost $40 billion.

The Enron Oil and Gas deal was even worse. Enron swapped its ownership in what is now EOG for $600 million in cash and ownership of some of EOG’s assets in China and India. The foreign assets never amounted to much.

But EOG went on to become the best U.S. shale oil driller — pioneer of the Bakken oil play. It’s now worth $64 billion.

It’s easy to question why Enron made these decisions. But there was a strategy. Enron didn’t just want to sell its best assets. It wanted to sell virtually all its capital-intensive businesses.

In the summer of 2001, just days before its collapse, Enron arranged to sell all of its international assets to Sheikh Zayed, the Emir of Abu Dhahi. The deal was done — it just didn’t close on time because Zayed was sick. And then he died of a kidney ailment.

If he hadn’t died and Enron had received the $7 billion in cash it was promised, it probably wouldn’t have gone bankrupt — despite the Fastow crisis.

The bottom line: Enron went bankrupt because it made some terrible business decisions. It borrowed way too much money to buy very risky assets… from Internet stocks to foreign power plants. These were financial disasters.

Then it had to sell some of its very best assets to generate cash to cover these losses.

Despite all the dumb things it did, Enron might’ve survived, because it did one thing brilliantly…

Enron pioneered an entirely new kind of energy business model.

Enron’s CEO, Jeff Skilling, figured out Enron could earn far higher returns on assets and invested capital by not owning oil and gas properties or energy infrastructure.

Instead, he cut deals to help finance oil and gas drilling. Doing so bought the rights to a percentage of the production. Likewise, Enron would bid for pipeline access when it needed to transport oil or gas, renting what it needed, when it needed it. This allowed Enron to sell energy — both oil and gas, and later electricity — in various U.S. markets without actually owning the underlying assets.

No one in the world was better at understanding the market dynamics of energy in America than Enron — nobody else came close. Enron could guarantee long-term, fixed rate prices for natural gas, for example, to energy companies across the U.S., allowing them certainty of supply and price. It could also generate big profits by moving natural gas from one spot market to another, when prices spiked. Or by selling electricity from a cheap power grid into an expensive one, like California’s.

In 2001, when Enron went bankrupt, its top natural gas trader, John Arnold made the company $750 million on his trades alone. He was given an $8 million bonus that year.

After Enron went bankrupt, he set up a hedge fund — essentially Enron’s old trading floor. Arnold’s firm made 150% returns in 2005. And John Arnold became youngest billionaire in American history. He retired from trading in 2012 when he was only 38 years old.

Had Enron survived the crisis of 2001, we believe it’s likely they would’ve become something like the Goldman Sachs of energy. And Ken Lay and Jeff Skilling would’ve been seen as visionaries, not crooks.

But Zayed kicked the bucket. And Enron went straight down the toilet.

Enron Failed. But Was That a Crime?

Rather than throwing the book at the people who were looting the company, Andy Fastow and his accomplices in the accounting department Michael Kopper and Ben Glisan, prosecutors instead accepted negotiated guilty pleas with these criminals and cut their jail terms in exchange for testimony against less culpable actors, a practice known as “flipping down.”

It’s something prosecutors usually try to avoid, because the result is that the more culpable actors fare better than those below them.  It feels unjust.  In the case of Enron, Fastow would serve less than 10 years.

As part of their guilty pleas, Fastow and his accomplices agreed to testify, under oath, against people who had nothing to do with the underlying fraud or embezzlement — like the entire Arthur Anderson accounting firm and four bankers at Merrill Lynch — who simply bought some barges as a favor for a client (Enron) and made a profit for Merrill Lynch.

They had no duty to ensure that Enron was accounting for the sale of these barges accurately. And they had no knowledge that Andy Fastow’s private equity firm was defrauding Enron when he repurchased these barges from Merrill six months’ later. Yet, they ended up in prison.

And so did Jeff Skilling.

Fastow was supposed to have Skilling sign off on all the deals his private equity fund negotiated with Enron. If he had done his homework, Skilling would’ve known about the graft and, we surmise, would’ve stopped it.

But Jeff’s signature isn’t on any of the documents — not one.

Skilling clearly wasn’t aware of what Fastow was doing. And Fastow’s misconduct didn’t come to light until months after Skilling had left the company. There’s also no evidence whatsoever that Skilling knew that any of the accounting was fraudulent or that he ever tried to enrich himself at the company’s expense. But that didn’t seem to matter to the prosecutors.

The primary issue was whether or not Enron’s executives, by making bad business decisions, had committed a crime.

The government alleged Skilling and others had defrauded investors by not providing “honest services.” But the way the statue was written, to commit this crime required that someone receive some inducement — like a bribe or a kickback.

There’s no evidence of that anywhere. In fact, Skilling owned one-million shares of Enron when it collapsed. He lost a fortune.

And he was never accused of taking a bribe or being involved financially in any of Fastow’s schemes. Likewise, in the case of Arthur Anderson, they may have given Enron terrible advice. But they didn’t do so in a way that benefitted their firm or their partners illegally.

The Enron prosecutions resulted in the collapse of the accounting firm, Arthur Anderson… the conviction and jail terms for the team of bankers at Merrill Lynch… and of course, the convictions of both Jeff Skilling and Ken Lay.

And many of these convictions were later overturned, including Jeff Skilling’s.

“So what” you might say, “Enron and everyone associated with it was a crook in one way or another.”

True, the folks working at Enron did a terrible job from a fiduciary standpoint. They deserved to lose their jobs and perhaps their stock options — and they did.

But sending people to jail who did not break the law, as it was written at the time, is a dangerous precedent.

The lawyers of the government’s Enron Task Force should have been censured and fired.

But is that what happened?

No, of course not. The Enron Task Force would, more or less, run the Department of Justice for the next decade or so.

When Alaska Senator Ted Stevens was falsely accused of receiving a bribe in July 2008, he lost his Senate seat. That shifted the delicate balance of power in the Senate and set the stage for the narrow approval of Obamacare. It also ruined the career and the reputation of man who’d served his country in World War II and had been in the Senate for 40 years.

But was Stevens guilty of anything at all?

No. He was the target of the Justice Department, which simply wanted to remove him from power.

Later, in 2009, the judge would throw the case out, saying the indictment was “the worst case of prosecutorial misconduct he’d ever seen.” He also initiated a criminal contempt investigation of six members of the prosecution team and appointed a special prosecutor to investigate because he didn’t trust the Justice Department’s own Office of Professional Responsibility.

Any idea who was most responsible for the false prosecution of Senator Stevens?

According to the special investigator’s report, it was the acting assistant attorney general of the Criminal Division of the Department of Justice, Matthew Friedrich. He’d just been promoted from his previous role as chief prosecutor on the Enron Task Force.

And when Bob Mueller was appointed to lead the Justice Department’s investigation of Trump’s supposed ties to Russia, you’ll never guess who Mueller picked as his top deputy?

Andrew Weissman, who was the head of the Enron Task Force.

It was Weissman’s decision to bring charges against the entire Arthur Anderson firm. The conviction was overturned because of Weissman’s improper jury instructions. But by then Arthur Anderson had been destroyed.

It’s an interesting thought experiment to wonder what would’ve happened if the Enron prosecutors, rather than being lauded and promoted for sending Skilling to jail and Lay to his deathbed, had instead been held to account for their convictions being overturned.

What if they had been censured for their reprehensible deal making with the convicted criminals?

Ted Stevens wouldn’t have lost his Senate seat. Obamacare would have never happened. And maybe the Russia-Trump nonsense would have never happened either.

So… maybe there’s more we can learn from Enron than most people understand.

Either way, the key lesson we take from the Enron debacle is that honest accounting is paramount. Companies that try to cook their books can fool investors for a little while, but ultimately they end up fooling themselves.

And the other thing we’ve learned from Enron is that businesses that can capture the profits that flow from major capital investments – without owning them – can  make enormous returns…

And that brings us to the homebuilders whose stocks have been crushed so far this year.