Wikinvest Wire

Enron and Home Equity Wealth

Tuesday, December 20, 2005

Sometimes when a trend continues for a long enough period of time, people come to accept the trend as just another fact of life. Despite initial skepticism, if events continue to unfold in the same manner month after month, year after year, people tend to forget their initial misgivings.

After repeated positive reinforcement, new beliefs become entrenched and the current reality is projected into the future. Regardless of its enduring qualities, what at first seemed unbelievable, becomes believable over time.


Enron is a good example of this phenomenon. Living in California during the rolling blackouts of 2000 and 2001 and reading news reports about the energy crisis, it became clear that Enron had mastered the business of trading just about anything that could be traded.

With a partially-deregulated energy market, the State of California and its hapless Governor were hopelessly outclassed by savvy Enron traders - Enron's stock soared as California's lights dimmed.

Named "America's Most Innovative Company" by Fortune Magazine, Enron traded such exotic items as internet bandwidth and weather derivatives while earning record profits. They led the way with sophisticated financial instruments such as derivatives and employed innovative accounting practices such as special purpose entities.

At the height of their success in late 2000, as the NASDAQ stock market bubble was bursting, Enron's star shone bright. At the end of 2001, things began to unravel quickly, and in 2002 the company was exposed for what it was - a fraud.

Stock and bond holders were aghast, as the entrenched belief of Enron success was laid bare to reveal few enduring qualities. Vindication for California's governor was much too little and came far too late.

Home Equity Wealth

Like Enron's rise in the late 1990s, the rise in home prices in many parts of the country has occurred over many years - until recently, it has been a gradual process. In 2001 and 2002, as the Enron meltdown progressed, mortgage lending rates plunged, spurring wave after wave of home refinancing - home prices began to rise more quickly.

Slowly, year after year, millions of homeowners became accustomed to rising home prices, and they became more aware of the latest "market value" of their home. Initially, many homeowners reacted to this simply by feeling more secure in their financial condition.

An "equity cushion", as Fed Chairman Alan Greenspan has called it, had begun to grow larger, faster, and that made household balance sheets more secure - job loss or family emergencies were no longer viewed as devastating financial events because an increasing amount of "emergency money" was there at the ready.

A year or two later, as home prices rose more quickly, a funny thing started happening. Long time homeowners of otherwise modest means, began driving nicer cars and taking better vacations.

Everyone seemed to be remodeling something - additions, swimming pools, landscaping, granite counter tops. Rising tuition costs were less of a problem and elective medical procedures became more and more common. People ate out more often.

Soaring real estate prices over the last few years combined with the newfound ease of home equity withdrawal have led many homeowners to spend money like they've never spent money before in their lives. When measured by consumption and the material goods that they have acquired, these homeowners have become "wealthy" far beyond what they could have imagined just five or six years ago.

Their standard of living has markedly improved.

But, excluding the market value of their home, many of these newly "wealthy" homeowners have a balance sheet that is in worse shape than it was just a few years ago - newly purchased goods lose value quickly after their purchase. It is only with high and still rising home values that overall net worth remains substantial, as wages have risen at a sluggish pace, many have discontinued saving, and other expenses have continued to rise.

The positive reinforcement of rising home prices over a period of years has caused many homeowners to believe that rising home prices, or at least the current value of their home, is something that can be projected into the future. And why not? Nothing in the last ten years would lead anyone to believe that home prices do anything but go up.

What If?

But what if the real estate market of 2005 turns out to be a lot like the energy trading market of 2001?

After many successful but unspectacular years, Enron rose toward the heavens on the back of "new era" thinking. Within a period of just a year during 2001-2002, they failed spectacularly causing much anguish and pain for many who became true believers on the way up.

In the end, their business model was revealed to be fundamentally flawed - it was fraudulent and unsustainable.

There are those who argue that the business model behind today's real estate market is fundamentally flawed. Derivatives offsetting risk in asset backed securities are new and innovative. And, when 82 percent of home purchase loans in the state of California last year were either interest-only or negatively amortizing loans, that should cause potential homebuyers to question the prices that are being paid these days - to question how sustainable current real estate trends are.

But beliefs about real estate and home equity wealth are now entrenched after many years of positive reinforcement. Beliefs change slowly, and most people are reluctant to cast doubt on something that has been so good to them over the last few years.

Like the hourly Enron worker with a million dollar retirement account in 2001, the hourly California worker with a million dollar home in 2005 looks to the future with every expectation that what they've come to believe in recent years will continue.


Anonymous said...

I started buying enron in the late '90's through their dividend reinvestment program. In the mid-2000 timeframe, it just got too pricey, so, I stopped buying and, just as the stock started going down at the beginning of what eventually became its death spiral, I decided I needed a new car more than I needed this stock and sold it.

My tax accountant said I was the only person he knew who made a profit in enron (albeit a small one).

My heart goes out to the thousands who decided they needed the stock more than a new car.

desi dude said...

my story was little in reverse. In 1998 I started investigating companies for DRIP program. SBC, ATT, GE, WALMARt, PFIZER were some that I shortlisted and ENRON was also there heaving read the FORTURE magzine article.

Thank my luck/diligence/whatever, I stuck with WALMART, GE and PFIZER.

Waymee said...

I was just talking to someone this weekend about investments, and he told me how he got burned by Enron. His broker got burned worse. The broker mortgaged his house and put all of the equity into Enron.

A broker who spent his entire day pushing a stock like Enron must have thought it was infallible. I wonder how many realtors in southern Cal will have the same thing happen to them vis-a-vis real estate investing.

Anonymous said...

The last big real estate bust as with ENRON happened with the helping hand of deregulation. The Savings and Loans were deregulated with the final outcome being thousands of homes and office space being sold at rock bottom prices with the US tax payer picking up the loss. I expect this bust to end up the same when fanny mae goes under.

Marinite said...

The following come to mind:

"If it is too good to be true, it probably isn't."

"A sucker is born every minute."

GRL said...

Speaking of RE, I was in Oklahoma in '86-87, during the oil price crash, which led to a RE bust in that state.

Three memories stand out from that time:

1. Rents were extremely cheap. When I first moved there, I rented a 1 bedroom in the most expensive complex in town for $335 a month. Later, I moved down the street a couple of blocks and rented a 1 bedroom in a different complex for $235 a month, which was later lowered to $210.

2. I remember reading in the paper an ad placed for a house in foreclosure in a lower middle class neighborhood. Asking price was $10,000 (that's right, four zeros, not five). Your typical condos went for $35-40,000, and homes in nice middle class neighborhoods (not in foreclosure) went for around $100,000.

3. I remember driving down a major street one morning and looking off to the east at a tall building. You could see the sun shining through the windows of the building from the other side -- a "see-thru skyscraper." There were a lot of those in Oklahoma City at the time.

Can it happen here? I doubt it, but you never know, especially if the *right* commodity or industry crashes the way oil did in Oklahoma in the '80's.

Caveat Emptor said...

What if "the right industry" turns out to be real estate itself?

Anonymous said...

No analogy is perfect.

Yours breaks down right now, energy prices in California right now are as high as during the Enron manipulation in 2001.

It is hard to tell how many hedge funds are speculating in CA energy today because there isn't just one primary bad actor as in 2001.

Anonymous said...

another fine essay - kudos!

chubbyray said...

Dooood! let's quote Sir John T:

The four most expensive words in the English language are ... "this time it's different."

Anonymous said...

That was a on the fly version of why Enron collapsed. It really had nothing to do with the California "energy crisis". It wasn't because Enron's business model was fraudulent as you suggest. Enron also didn't cause California's energy crisis. California's energy crisis came about for a variety of reasons. Three come to mind as the primary reasons. NIMBY, dot-com boom, and flawed regulation (called deregulation, but was really nothing of the sort). Energy merchants like Enron took advantage of the market. The same ethos pervades California's housing market. There are a lot of distortions in the market. Prop. 13, land-use regs, development restrictions, etc. but California's problems would be easier to overcome if its elected leaders to basic refresher courses in economics...

Anonymous said...

Just before Enron tanked what were the insiders doing? Selling! Check this out: According to Thompson Financial, REIT (Real Estate Investment Trust) insiders sold $427 million of their shares in 2005. How much did they buy? $3 million. Nuff said.

Real Estate Investment said...

Looking for real estate investment blogs I just landed on yours. I think your blog is cool and am wondering if there is any chance to find some real estate investment related articles soon? Thank you,
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Tim said...

You can type "real estate" into the search box at the top of the page for past articles. I write about real estate about once a week or so.

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