Given the current state of the financial markets, I’ve found myself buying and reading books that help me understand either how we achieved these states or how we’ve muddled through similar crises. Two that are on my Amazon Kindle today are:

• A Conspiracy of Fools: A True Story, the story of creation, corruption, and destruction of Enron, and
• When Genius Failed: The Rise and Fall of Long Term Capital Management, the story of one of the first real hedge funds that nearly caused the collapse of world financial markets in 1998.

Both books are wonderfully educational and remind me that we’ve experienced and weathered significant market crises before. But more importantly, I think they illustrate another important idea:  in complex markets, business people — even those who caution us to read prospectuses before buying — often don’t understand the products they are buying and selling. And these books actually have some lessons for those of us working in the Anywhere Economy as well.

I found the Long Term Capital Management (LTCM) crisis retold in the first book wonderfully illuminating. Here was a company that was founded by economists who had developed a formula—The Black Scholes equation— to price options and evaluate their risk. This formula was so fundamental and important to options pricing that Robert Merton and Myron Scholes, the economists who developed it, were awarded the Nobel Price in Economics in 1997 (co-creator Fischer Black was dead by then, so he couldn’t be awarded the prize, but his name lives on in the name of the formula). Long Term Capital Management was founded to exploit this new insight through arbitrage and it made billions of dollars doing so.

However, the Black-Scholes equations are based on several very limiting assumptions. Among those are the assumptions that trading in securities is continuous and that there are no transaction costs or taxes, both assumptions which are not true in the real world. Yet, LTCM both refused to publicize these limitations and in fact assumed that these factors just didn’t matter; there was just too much money to be made. The passage from the book sounds eerily up-to-date:

One offshoot—largely unintended—of this tremendous growth was that banks’ financial statements became increasingly obscure. Derivatives weren’t disclosed in any way that was meaningful to outsiders. And as the volume of deals exploded, the banks balance sheets revealed less and less of their total obligations. By the mid-1990s, the financial statements of even many midsized banks were wrapped in an impenetrable haze.

The bankers were too busy making money to bother about the risk or the shoddy disclosure of this fast-growing business. The few that did voice caution … were ignored.

Sounds like it could have been written last month, doesn’t it? But in reality, this was the case more than 10 years ago.

A Conspiracy of Fools was even less comforting. It illustrated how Enron’s aggressive attempts to snowball its success in oil and gas distribution into other industries led its executives to bend and break countless laws instead of admitting that those efforts actually failed. The problem wasn’t just that executive egos were out of control, but that maintaining a false image of success was more important to those egos than avoiding jail. And it wasn’t like no one noticed; people within the firm knew many of the financial schemes they hatched made no sense. Here’s one excerpt that illustrates how the company lied to itself about its strategy and earnings:

Butts laid out the deal structure, explaining how Enron would contribute its own stock—now with a value of about $250 million—to some outside fund, which would then sell a put option on Rhythms stock to Enron.

Kaminski still struggled with the idea. “One problem. Who’s writing the option? Because I don’t understand how they’re going to protect themselves from a price decline.”

Butts’s response was matter-of-fact. “The option’s being written by a partnership set up by the finance group.”

The finance group? Fastow’s finance group? A thought shot into Kaminski’s head—a few years back, Fastow running retail, asking him to come up with a way to hedge against operating losses. The man was an idiot! He didn’t understand hedging.

…

If the market won’t provide something, Kaminski thought, there’s usually a darn good reason. And there was. No one—no one—would sell a put option on a volatile stock without taking precautions against a possible price fall. Essentially, that would mean setting up another hedge by establishing a short position—borrowing shares and selling them in a bet that the share price would go down. But for the stock to be shorted, it had to be heavily traded. There would have to be plenty of shares available for borrowing, and with Rhythms, there weren’t.

…

Plus the economics of the deal were laughable. Enron was taking $250 million in stock out of its own pocket and putting it into the fund’s pocket. Then the fund would give the money back if Rhythms’ price went down. But the fund owed the money either way! Enron would receive nothing that the fund wasn’t already obligated to surrender.

Suddenly it hit him. A moment of clarity.

Fastow put this together assuming Enron’s stock price would go up, no matter what. Such an increase would give this fund the ability to pay Enron for any losses in Rhythms and ultimately pay back the $250 million.

Kaminski shook his head. This was just a massive bet on Enron’s stock price. The company’s top managers might as well have gone to Las Vegas and placed a few hundred million dollars on black.

Want to make that quote even more poignant? Replace the phrases “hedge” with Credit Default Swaps (the weapon of mass financial destruction in today’s financial crisis) and “Enron’s stock price” with “housing prices”, and you have a pretty good description of what bankers have been buying into worldwide for the last 6 to 8 years.

So what is the lesson for companies now attempting to succeed in the Anywhere Economy? Despite its currently poor reputation, Wall Street has a saying that captures it perfectly:

Never confuse brains with a bull market.

When markets are going up, almost any strategy works. But when markets are going down, only the strong and those that truly understand what they are selling and what its value is survive.

The last decade has been great for companies building and capitalizing on Anywhere Networks. But with credit tight and consumer pocketbooks tighter, things will be tougher going forward, as we noted in our recent analysis, Will the Anywhere Economy Slow Down. Companies that have built their empires on financial slight-of-hand and debt financing of so-so products will discover that those strategies won’t sustain them in this new tougher marketplace. Those that stick to the fundamentals of cash accounting, profitable products, and good customer service will be fine.

As the book title notes, even if you’re a genius, there are times when genius fails. It’s at those times that your business’s  best comfort is cash in the bank — and lots of it.