The Enron truth, very long but worth reading

I have gotten sick and tired of every columnist and politician trying to make hay out of Enron when most have NO CLUE what happened in it. Ask them what happened and they tell you two things. 1. Some execs got rich selling stock as it fell. 2. Auditors shredded evidence. End of story. Do these fools even understand what exactly happened? Well for those that have wondered and want to truly learn lessons for the future, then I will go about it here. It takes awhile to explain and there are probably points that I missed because quite frankly, I don't read much about. This comes from my business/accounting experience and reading a few people's reports that I do trust. Don't trust what a columnist writes, they just want to call everyone greedy and blame someone. None of them blame the true final culprit and that is the MARKET! The market decided Enron's stock is worthless and they are the ones that "absconded" off with most of people's retirement funds, not executives. So here goes:


1. Off-Balance Sheet financing

Sounds sinister, but its not. In fact its legal and quite a few companies do it. Here is how it works. Say you are a company and want a loan. If you are like most companies your two most valuable assets are your inventory and your accounts receivable. Plant and equipment is tailored to your business so its not worth as much, but current inventory is generally easily salable (at a discount) and of course A/R is cash. So what you do is line up a loan against these two iteams. In the case of receivables what you do is create another company, the sinister off-balance sheet devil. This second company exists solely to handle this loan or line of credit, nothing more. The reason for it is that this is your collateral. Should you default on the loan, your creditor immediately takes possesion of this company and in that way collects because all A/R payments that are pledged are supposed to be paid through this second company. As long as the loan is in good standing, you get the proceeds. Second it goes bad, the creditor gets it and hopefully for him recovers what you owe him. Simple enough. Enron did this on a massive scale. Reason why has nothing to do with why most companies borrow money. The reason Enron took these loans is so they could be a market. Being a market in this case is fairly simple. Enron would have a customer call and say I need 1,000 watts of energy (simplistic example) in El Paso. Enron has a source willing to sell 1,000 watts of energy to deliver in Dallas. Enron makes a deal to get energy from Dallas to El Paso on its lines or it pays someone for the right to use its lines. Thing is Enron has to pay for the energy and the line use up front and the customer won't pay until the energy gets to them. This time of float is what requires the loans. Enron needs to borrow lots of money for this float simply because this is the nature of its business and no company keeps the kind of cash on hand that they would have needed to cover the float themselves. So these myriad of off-balance sheet loans were just a business need of any market maker. NYSE and NASDAQ are in a similar boat, except their rules are you have to settle the funds at the same time for both sides. They don't have float, but are insured for it by bank loans that they generally don't have to tap. Enron did have to tap theirs on a regular basis. So what happened? Well Enron was following accounting principles because these types of companies they set up are not supposed to be included in your financial statements. Why? Because they don't really control them. GAAP dictates that the true control of these companies wasn't in Enron's hands even though it involved their assets. Enron couldn't make any decisions for these companies, that was in the hands of others. What did become a bit messy is that Andrew Fastow, their former CFO was lazy and just made himself the chief of a lot of these "companies" because its a perfectly legal activity, it just doesn't look so clean. They could have hired independent people to "run" them (not much has to be done to run them), but that costs money and is an extra layer of work. So far so good, everything is completely normal and there are thousands of these around with even the most reliable companies using them because interest rates are very low when you secure a steady stream of A/R and only borrow say 50% of the value of it.


2. Credit agencies

These are some real culprits here, yet no one blames them. They are in the dark about all this because everything is legally done and Enron doesn't feel its that necessary to tell the world that they have these very short term and secured loans out there that are being regularly used, yet really aren't a major risk. After all Enron is dealing with tons of customers. They didn't have exposure risk to any particular customer, just they were functioning as a market which required very short term borrowing. Well the ratings agencies saw it differently. To them a loan is a loan, hell a line of credit is like a fully utilized loan. They freaked when they reviewed all the loans Enron had and downgraded their credit ratings quickly. This causes a big problem. When you are a market maker, you almost have to have perfect credit. Reason why is others could do what you do, just not as extensively or efficietly as you. If you have less than perfect credit you might not get loans (Enron lost some of its credit outright) or you have to pay higher fees for your loans which crimp your market maker margin so much that someone else could do your job cheaper. So what starts happening is Enron loses its competitiveness. Worse yet they made business plans with a high rating and that means they reserved capacity for transporting whatever they sold in their markets that is now idle because someone else can do it cheaper or they have to charge a price high enough that their customers don't buy the product. Losing business just makes things worse and worse. People stop coming to Enron first and for the customers they do still get they are getting squeezed worse on the float because they want to deal only in upfront cash, not loan guarantees or anything less than cash in the bank. The company then quickly sees almost all its businesses evaporate and there isn't a thing they can do about it. They have almost no business in their market and of course the stock is tanking. So when you look on it, the people Enron really needed to inform better were the credit rating agencies, not really Wall St.


3. The investigation

This is the biggest crock of them all. Money is lost and everyone looks for a way to blame and maybe get it back. Well damn someone had to be responsible. Notice no one every raised a finger at the credit agencies? They have very stiff numbers and rules and they rarely relax them even if there is clear supporting evidence that the loans aren't truly overextending a company. If Enron was taking its loans and spending it stupidly that would be one thing, but there was no evidence of that. Sure some execs made money in the market, but thats market money, not Enron money. Politicians and the media seem to forget the market is the market. That is people deciding what businesses are worth and in no way implies what money a company is or isn't making. Enron was making plenty of money up to the point of implosion. I saw a columnist say "well their margins were going down, that should have been a sign". Listen you idiot, their margins could have been going down for a hundred reasons, the main reason was that they were doing what all companies do, they were sacrificing margin to build new markets and gain future market share. Its beyond me how someone who is supposedly such an expert will now crucify what is a pretty standard business practice for almost all growth companies. And these are the people the media and politicans listen to!


4. The shredding

Granted this whole incident looked really bad. We all will want to know what went on here. No doubt in my mind what happened. You have to remember audit firms aren't like regular companies, they are limited partnership. This particular partner probably saved himself a ton of money. You see he lost his job and its earnings, but what must have been in that paperwork was so damning it probably saved him a lot more money. If the firm had a judgement against it of a large amount, the partners would have had to pony up the money, this guy included. What I would guess was in the shredded papers was evidence that Arthur Andersen reviewed or even discussed the whole off-balance sheet numbers. I really don't think much came out of the whole auditor/consultant deal, I just think they saw what the credit agencies saw. Auditors would talk about it and say "well it looks terrible, but you know that is how GAAP tells you to do it." Someone does an analysis and sees how bad their ratios are and presents it, but in the end they sign off on it because its technically correct. All this paperwork could have been a bonanza for a lawsuit and the partner knows it. He chooses to attempt to save his ass and that of his fellow partners and takes one for the team so to speak. AA people might still testify with damning evidence in the future, but nothing can be as damning as paperwork that said that the company had a huge loan exposure, no matter what its true reason. My mother said her boss in the past faced a similar situation and was smarter about it. What he did was gave the papers to his attorney before a court order for them came. Then they are under client-attorney priviledge and unobtainable! This partner with a clear head should have done that, but hey he faced a lot of pressure and didn't think it all through.


5. The aftermath

Undoubtedly these politicians will see to it that laws are passed, unnecessarily I might add. What are they going to do, make it illegal for a stock to go down? Tell credit agencies how to grade companies? Tell people they can't have off-balance sheet companies for simple loan purposes like this? Worst of all, tell auditors they can't ever consult for a company? Government needs to stay out of business here. I don't want to hear another politico telling us "well government has to have compassion for the people that lost their money". Sure its bad, but for every person that lost their retirement at Enron there must be 500 that got rich on such retirement plans at other companies before! Maybe you should make those people give some of their wealth back to the unlucky at Enron??? If anything else, I want all those reading this to agree with me that government has no business in this at all. Its a market occurence, not something that legislation could ever do anything about. All it will do is screw things up in the future. Investing will always have risks, but we run bigger risks with government in control of anything related to these issues. Imagine the dangers if government, not the industry or the market dictated accounting rules. That would be corruption and special interest city! Every time high tech was having bad quarters, they would just go ask their senators to pass a ruling or approve a friendly regulator that would make a ruling to improve their numbers. What a frickin mess that would be, yet I hear a lot of people on TV clamoring for government oversight of accounting. Unbelieveable, I hope they all look past that because that would be the real tragedy of this whole incident. I feel something for those that lost their savings, but nothing illegal happened here and to have 8 committees reviewing everything and have talking heads everywhere trying to get their piece out of it does no good whatsoever.


I leave with this last thought. People act like Enron was a no good for nothing. How about the profits they did make for people in the stock during its rise? How about the value of the innovation they brought, the idea of markets for more than just stocks? How about the efficiencies they brought to many ancilliary companies? Enron may not have had a happy ending, but people are looking far past its contribution to the economy while it was going. It was truly a one-of-a-kind company and it brought to light many ideas that people and other companies will benefit from for a very long time.