Do you know what will be all the rage in 2008 in the wake of the subprime crisis? “Rating cliffs” and “credit cliffs” when firms that have seen a slow erosion of their credit will all of a sudden drop like a stone. As I devoted a whole chapter to the subject back in 2003 when drawing some lessons from Enron’s demise, I decided to revive it for your enlightenment. Here it is from
Paul Jorion, Investing in a Post-Enron World, McGraw-Hill, 2003.
“Chapter 13: The perils of cliffs
Once upon a time, a company named Enron was a utility, of sorts. It owned pipelines, and fuels flowed through them. It thought of itself as a utility, and more or less behaved like one.
Then, in August 1999, Enron started trading contracts on future delivery of energy. A psychological shift accompanied the strategic shift. Enron began thinking of itself as a financial company. This was gratifying, because it meant the company had moved into the fast lane – where the drama, excitement, and money were. Goodbye to the plodding old days of being a regulated utility; hello to the Big Time.
One of the most successful divisions of Enron, it turns out, was a hedge fund called ECT Investments. “The hedge fund, the brainchild of Enron’s former chief executive officer, Jeffrey Skilling, did quite well,” according to a report in The Wall Street Journal, “averaging annual returns of more than 20% after it was launched in 1996. In that period, the Dow Jones Industrial Average had returns of 11%. The hedge fund’s gains amounted to as much as 8% of Enron’s overall earnings in recent years. . . ”
But the transformation to a financial company also meant that Enron became susceptible to all the fragilities to which financial companies are vulnerable. One of the most pernicious of these is the Confidence Factor: How much confidence do your clients and shareholders have in you today? How much will they have tomorrow? Absent a Three Mile Island-type disaster, the Confidence Factor doesn’t vary much for a utility. But it bounces all over the place for a high-flying financial company, especially if the main financial product that the company is trading in is its own stock.
The business depended, in large part, on the stock being constantly on the rise – or at least not losing value. The reason was leverage, which has the unpleasant capacity to go from positive to negative overnight. Enron was perched on the edge of what Standard & Poor’s calls a “credit cliff,” meaning that any drop in its credit rating would materialize in a deterioration of its debt, leading in no time to a further downgrading. Although Enron’s financial health was an exercise in brinkmanship, what actually brought it down in just over six weeks was little more than a glitch, which on its own merits should have been survivable. The rest, as its former CEO would say, was only a “run on the bank.”
So the point of this chapter is to help you, the investor, understand and recognize a credit cliff, as well as its equally daunting sibling, a “rating cliff.” I’m confident that when you spot a company living on these cliffs, you’ll decide to stay away.