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.

You get a really tidy tell into how most people think when you hear news anchors and politicians saying how Enron should have warned employees, so that way "everybody" could have gotten out before the stock went down.


Gotten out by selling to whom, Martians?


If the Enron employees had decided to sell (which they never would have, believe me, I worked at Intel, and these people's religion is to double up on dips), then the scandal would have been "Greedy Enron Texas Oil Employees use insider trading to dump stock on unwary public" - or something.


On a different note, one day I was in a commodity office where they provided customers with chairs and screens. A new customer was fretting over one of his first charts. One moment he wanted to go long - wait - now it looks like it's going to go down! A lightbulb finally lit up above his head, and he asked the broker, hey, how about if I buy one and sell one at the same time!?


Human optimism is interesting to see how he could picture the ticket he had sold making a profit when the market went down, and he could picture the buy ticket showing a profit when the market went up, but he conveniently overlooked how the other ticket would lose exactly the same amount. This story really happened, by the way, and it pretty well explains why women all over the country (and 90% of all women are disappointed in their own husbands) would vote for Bill Clinton to take care of their children for them.


Oh, by the way Wild Bill, no laws will be passed, at least not any laws that matter. It will be like the airline security bill, where all this and that is called for to make politicians look good on TV, but hardly any of it ever will or even could realistically be implemented. It's like campaign finance reform, totally unconstitutional, Supreme Court has called it DOA. This is not about changing laws - they could care less about some accountant somewhere or protecting "the little guy" - it's about throwing the kitchen sink at George W in time for mid-term elections.


And if anything sticks, the only real law that will change is your taxes will go up. But so far as government screwing up business, remember it was actually poilitical "free market" arrogance on the Republican side that screwed up the stock market with decimalization and Rule Whatchamacallit (numbers - 314? 421? - the letter "A") in Nasdaq stocks.


leroy


P.S. I predicted some serious ruin of energy counterparties in the fall of 1999, and many times since - as I had long predicted all companies who touch half-baked new electronic marketplaces, as they are currently being structured, would get burned - after reading this article in Forbes:


http://www.forbes.com/forbes/1999/1115/6412132a.html


(name: eLROY password: eLROY, the article is entitled "Web Powerhouse" and talks about Altra Energy)


Most "cutting-edge" electronic marketplaces are designed by the buy-one-sell-one-at-the-same-time crowd in one form or another. They miss the entire point of a marketplace, not order matching once supply and demand are already fixed, but non-redundant information/capacity/inventory/consumption coordination. But that's just the point: You can't "design" marketplaces, and nobody understands them.

Hi wildbill,


I enjoyed reading your ENE commentary.


Sadly, I agree that this will not be the position that bubblevision, or the politicos will put forth.


Since ENE spread so many $$$ around to each party, we'll most likely see a lot of smoke and mirrors, and little else. I do hope eLROY is incorrect, but if there is a way to get more money to Washington, he may be right.


Here's a line from the Daily Reckoning that might fit:


"Investors don't get what they expect, but what they deserve"...B. Bonner


Steve B

Good post. I still think having a 60% Enron allocation in the 401k plan was criminal though. Granted, many of the employees would have ruined themselves anyways buying Enron stock outside of their 401k, but you shouldn't help them along that path.

Employees of Enron had to have known that by investing whatever portion of their salaries into a 401k that buys their own companies' stock, they were taking a risk. In gamblers terms, they may have been increasing their expectation, but by investing in an area so heavily (they were employees as well as share-holders) they are also increasing their variance. No commentators ever mention that the reward for getting "free" money (the matching funds in 401k's) the people were accepting a higher risk.


The value did not dissapear as it would have in a natural disaster or something; for every person that lost a dollar in their plan, someone else (who sold a little earlier) made a dollar.


Did not the employees of Enron have the ability to hedge their risk by buying put options in Enron? Where no such options traded?

Interesting, but...


...if having those credit lines was so fundamentally important to this company's business model, and if those lines could be pulled up so quickly and easily (for what I think you claim are inappropriate reasons) then this is exactly the sort of information that should be made available (in screaming boldface, no less) to investors, isn't it?

Well they might have done just that, however that is the way of the business world today isn't it? Since when do you hear a CEO or CFO say "well we had a great quarter, but you know if everyone stops buying our stuff our credit will be shot and our business model sucks." I don't think Enron had any reason to think this would have happened because quite frankly bankers sell this model all the time and its never happened before. In the future it obviously will be watched and people will take note of it, however that doesn't make it right. All credit is not equal and I think the credit agencies went out of their way to shut this company down. This is the nature of "bond guys". They always act like the 100 year storm is a once every 3 month thing. After all it would take something like every natural gas company in the country to say "I ain't paying another bill" for Enron to have truly been at risk. The end result of all this is that every one of us will be paying for it in a less efficient energy marketplace. Enron set up a nice market like EBay where just about everyone came to do business. Now energy companies have to go back to the terrible inefficient old ways of calling everyone up and buying insanely inefficient long-term contracts just in case there isn't a market functioning when they precisely need it. Look what CA did, they are paying 300% more (on average) than they need to for their electricity because they felt like the market wasn't efficient enough to insure they could keep enough supply going. Sure someone (energy companies) are benefitting, but that middleman is someone getting fat at the expense of the whole world because CA companies are truly global players and what affects them affects economies worldwide.

can only comment on one aspect of this, shredding:


most plaintiffs' attorneys prefer proof of the intentional destruction of evidence to the actual "smoking gun." I assume the partner at AA conducted some sort of cost benefit analysis before cranking up the shredder, but it is probably as stupid a move as there is. The plaintiff probably is entitled to have a jury draw the most adverse possible inference as to what was containded in the documents as a minimum remedy for their intentional destruction. plus, it probably guarantees a punitive damage award. if the subpoena was issued, he could do time.


Finally, you can't create a privilege by giving a document to an atty. If it was prepared at the request of the atty, to communicate with the atty, it is probably privileged. if it is a regular business record, it is not privileged (as atty-client) and possession of the document as no bearing on the question.

niatross

I'm a little disappointed that you would call long-term contracts inefficient, and so quickly assume that new electronic marketplaces are better than old ones, and that people will always, by some magic, know in advance what the demand for natural gas will be at some moment in the future.


The reason EBay works is because nobody bases a production decision on it. It simply reallocates out-of-production products - for which the supply is already fixed - to whomever has the greatest utility for them. But you cannot run a production-based marketplace without time-axis visibility and non-redundant coordination - usually created by middlemen and friction.


It is no coincidence that the Nasdaq marketplace became, like EBay, a junk warehouse. You can either A) trust me on this, B) continue to be wrong, or C) delve into some of the many hundreds of essays I have written in an attempt to save people from such foolish thinking.


Can you imagine, Jay Walker consciously built a marketplace for unsellable airline seats? What kind of an efficient world does that forebode? Or, I remember when one of these online semiconductor auction marketplaces advertised like over 6 million items listed. Meaning, 6 million pieces of garbage that were manufactured at a cost greater than the price where they were offered, and still couldn't sell.


People don't know the meaning of "liquidity" - it's a dance, not an abundant junkheap - and some are even still suckers for this failed-every-time theory of "critical mass." The last thing you want is unsatisfied limit orders, and the only reason many-to-many physical exhanges for unplanned counterparties such as the CME emerged spontaneously throughout history is because of geographic and economic friction, and basically in order to bleed off malcoordination.


leroy

On the A-C privilege:


"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!"


Doesn't work that way. The privilege protects attorney-client communications, not other documents the client wants to hide. (One way of enlarging the scope of the privilege, however, is to involve the attorneys at the outset. Still, if the information is communicated to an outsider the privilege is blown, and courts have been known to see through the scam, as the tobacco companies learned).


The document destruction is incredibly damning as it gives rise to additional criminal and contempt liability and can create a presumption in favor of what the other side would otherwise have to prove. It's even more alarming given the recent stories from insiders claiming that it was going on after proceedings had begun, even after court orders had been entered prohibiting it. It's the sort of thing that happens when people are either very unsophisticated or worried about something worse than mere financial ruin.