A few weeks ago I purchased The Smartest Guys in the Room, a book about the rise and fall of Enron. I found the book in the bargain bin for $10, which was about roughly 65% off list price—a great example of what one should do as a value investor: look for great things selling at great bargains!
As I began to read, a lot of things stand out in just the first 80 pages, mostly the business practices that the home loan and financial industries mirrored in the past five years that eventually brought about this current crisis.
For example, the compensation structure of Enron’s international division and the home loan industry are quite similar in that both were fatally flawed and both structures eventually helped lead each to their downfall. Enron International made money by building power plants and energy-related infrastructure to developing nations. However, the fatal flaw was the compenstation structure:
Developers got bonuses on a project-by-project basis. The developers would calculate the present value of all the expected future cash flow from a project…. When the project reached finanancial close—that is, when the banks lent money but before a single pipe was laid or foundation poured—they were paid. No wonder the developers were so eager to move on to the next deal; they had no financial incentive to follow through on the one they’d just completed…. The more deals Enron International did, and the bigger they were, the richer the developers got. The system encouraged international executives to gamble without risk.
Just like the compensation structure of Enron’s international division encouraged volume regardless of quality, so did the compensation structure of the mortgage and home loan industry. This structure also helped bring about the downfall of many lenders, banks, and financial institutions. Whether you’re in the energy infrastructure business, insurance underwriting, or home loan business, a compensation structure that values volume over quality seems to eventually lead to financial hardship or ruin over the long term.
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