the CAMP ENRON Report

... gateway to the next Progressive Era?

Some say it's nothing but a train wreck ... roll in the big cranes, clear the track, see what the crew's been smoking. If I thought so, I'd not be writing this ... and if they thought so, they'd not be drumming so hard.

For a brief orientation, see this
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Camp Enron Archives
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(2) All "major" articles of older material have now been imported, some with updates worth perusing. We'll keep it all on the main page for a while, will add a few loose pieces of history, will trim the main page and index the archives for convenience later.


free agent, loose cannon, pointy stick ... taking an imposing analytic toolkit out of the box, over the wall and into the street ... with callous disregard for accepted wisdom and standard English

reading the tea leaves from original angles, we've led with uncannily prescient takes on the federal surplus, the dotcom crash, the "Energy Crisis", the Afghan campaign, the federal deficit.

More where those came from ... stay tuned.

For brief orientation, see this
Welcome to CP

... gateway to the next Progressive Era?

For a brief orientation, see this
Welcome to Camp Enron

Many thanks to Tony Adragna and Will Vehrs, still shouting 'cross the Potomac at QuasiPundit. Early Camp Enron material can be found in QP's Dispatches department.
Sunday, March 10, 2002

--- Insurance-Mediated Audit Engagement ---

Prof. Joshua Ronen of NYU Stern School of Business floats an intriguing market-oriented solution to the auditor independence problem, in a 2002-03-08 NYT op-ed.

In Ronen's scheme, corporations would purchase "financial statement insurance". To rate the insured risk and set rational premiums, the insuror would employ auditors. Disclosure of coverage and premiums would signal the public as to the relative quality of financial disclosures, and would presumably exert elastic pressure on management to eschew the less transparent financial structures (some scams, some wishful thinking, mostly legit but mind-boggling).

[Other proposals now in play would have the stock exchanges engage the auditors, as a condition of listing ... or attach the auditors to a broader self-regulatory organization ... or even a public agency.]

Poking holes in Ronen's net seems easy enough:
  1. It may be difficult to define the indemnified events (misrepresentations). Big-ticket frauds are rarely simple frauds -- writing down a '7' instead of a '1'. Exactly when do the terms of an off-book trust's derivative contract cross the line into material misrepresentation?

  2. It may be difficult to standardize these definitions across the market, so that "we're insured" means what it appears to mean, preventing collaborative low-bid insurors from surrendering in the footnotes whatever assurances they advertise on the title page.

  3. It may be difficult to agree in applicable cases that a covered loss has occurred, and to quantify damages. It seems to come down to a contest of opinions re material representations ... you can't just base it on lost market capitalization, for instance, since that usually happens for other reasons.

  4. A single claim might produce a huge loss, perhaps three orders of magnitude greater than Lloyds of London would underwrite. Coverage would necessarily be in token amounts, pennies on the dollar, and premiums might dwarf current audit fee structures. This would seem to exacerbate an existing problem, in that auditors' potential liability losses are perhaps too big for anybody to stay in business in the long run.

  5. Claims history would be sparse and large-grained, with statistical fluctuations towering over the "law of large numbers" effects on which the insurance game is premised.

  6. Covered risks are correlated ... the worst kind. Misrepresentations rarely engender losses in boom times; in slack times, the leakiest boats all run aground at once.

  7. Massive reserves would be required, and must be invested ... where?

Classic insurance market issues must also be considered. In this case, moral hazard -- the propensity of the insured to act less risk-averse -- doesn't look like a major problem. Neither does adverse selection -- the propensity of bad risks to buy more insurance -- or does it? The propensity of insurors to enter the business with optimistic lowball premiums, and then find themselves unable to cover the ensuing claims, is a more serious concern (usually addressed through regulatory oversight).

It's far from "easily implemented" (as Ronen suggests), but the principle deserves further consideration. Can we synthesize decision-theoretic incentives to tilt the tables in favor of higher quality information flow, and drain some of the risk and remorse that currently attaches to believing your eyes when you read a financial statement? Can we apply the same principle to other markets for professional examinations and expert opinions, such as securities analysts and bond rating services?

[2002-03-10 2:44 pm UPDATE: Ronen indicates a forthcoming paper will address these questions, and hints that "easily implemented" is NYT editorial shorthand for "all the news that fits, we print".]