Infectious Greed (56 page)

Andy Fastow and LJM2 certainly were not chumps. Instead, LJM2 was persuaded to pay an inflated price for the dark fiber, because Enron entered into a
make whole
derivative deal with LJM2: protecting it from a loss by agreeing to pay LJM2's investors with additional Enron stock. In other words, when the dark fiber inevitably declined from its inflated value, the LJM2 investors wouldn't care, because Enron would make them whole.

This meant that Enron retained the economic risk associated with the dark fiber. As the value of dark fiber plunged during 2000, Enron would be obligated to deliver more stock to LJM2, offsetting Enron's illusory gain from the original sale of dark fiber to LJM2. Yet, because LJM2 was an SPE—like Chewco and JEDI—Enron would not have to report the loss on its make-whole derivatives contract—that remained hidden inside LJM2. Instead, Enron would report only the gain from its purported sale of dark fiber to LJM2 at the inflated price. Thus, Enron and LJM2 became a financial hall of mirrors, where Enron looked profitable regardless of which way investors looked.

In all, Enron committed to deliver almost $4 billion worth of its own stock in make-whole derivatives deals.
⁴⁴
With the stock price near its highs, these obligations amounted to just a few percent of Enron's outstanding shares. But if Enron's stock price fell, the obligations would increase, substantially diluting the holdings of Enron's shareholders by requiring Enron to give more shares to its partnerships. Because the deals were unregulated derivatives with SPEs, Enron would not need to report the details of these transactions in its financial statements.
⁴⁵

Enron's sale of dark fiber to LJM2 also magically generated the appearance of a fair market price, which Enron then could use in valuing any
remaining
dark fiber it held. Enron could pretend that the sale to LJM2 was just like any other sale in the market. LJM2 had, in a sense, “validated” a higher price for the dark fiber in Enron's inventory, and Enron could then use that inflated price to make its assets appear more valuable.

Suppose Enron sold one unit of dark fiber to LJM2 for $30—triple its actual value—using this scheme. Now, Enron had an argument that each remaining unit of dark fiber also was worth $30. If Enron's assets were difficult to value—as dark fiber was—Enron could inflate the value of its assets in reliance on the “market” prices established by the deals between Enron and LJM2.

Legally, the valuation might be defensible. Economically, the valuation was preposterous, and Enron, eventually, would need to recognize a loss to offset the false profit it had booked. Until then, as Enron's risk-management manual had instructed, accounting numbers were more important than economic reality.

The inflated value of the dark-fiber deal between Enron and LJM2 would be the basis for a much larger, $500 million dark-fiber swap between Enron and Qwest Communications, the dominant telephone company in the western part of the United States.
⁴⁶
During the second quarter of 2001, Enron had been negotiating to sell its dark-fiber capacity to a
real
company—not one of its Related Party partnerships—so that it could
really
avoid a loss on its foolish telecommunications investments. However, talks with Qwest and Global Crossing had broken down. Late during the third quarter of 2001, Qwest finally became desperate for a deal that would generate some reported revenue. On September 10, Qwest had reduced its profit forecast by half a billion dollars and, by the end of September, it was obvious that it wouldn't meet that lower estimate, either.

On September 30, 2001—the last day of the quarter—Enron and Qwest agreed to the swap. Qwest would buy $308 million of Enron's dark-fiber capacity, including lines running from Salt Lake City to New Orleans. Enron would buy some of Qwest's lines for $196 million. It was unclear why Qwest—which had just announced plans to fire 4,000 employees—needed the new 5,500 miles of dormant capacity, especially in New Orleans, far away from its primary customers. But it was absolutely plain why Qwest was doing the deal: it booked $86 million of the amount Enron paid as revenue in the third quarter. Enron recorded
the revenue from its sale of dark fiber, just as it had done on the previous deal with LJM2. It was all eerily similar to MicroStrategy's swap a few years earlier.

Arthur Andersen, which audited both Enron and Qwest, blessed this accounting treatment, and both Enron and Qwest marked to market the value of their positions, recording an accounting profit even though they were not receiving any cash. It appeared that both companies were planning to record the expenses related to these deals in later quarters, but neither would survive for long enough to know for sure. (In late 2002, Qwest would admit to other swaps and reduce its reported profit even more.) The Enron-Qwest swap illustrated the accounting professor's admonition that profit is an opinion, but cash is a fact.

 

 

A
ccounting numbers were especially important at EnronOnline and Enron Energy Services, two Enron businesses that appeared to generate revenues and profits but, in reality, were losing money. EnronOnline was Enron's Internet platform for computerized trading of virtually any commodity. Compared to Enron's SPE schemes, which were abstrusely disclosed, EnronOnline was transparent. Nothing at EnronOnline was off balance sheet; indeed, the point of EnronOnline was that everything was
on
balance sheet, including “revenues” that arguably didn't belong.

The idea of EnronOnline was simple: Enron would set up a website for trading various commodities and derivatives, and its clients would use it. Enron would use the website to match buyers and sellers, just like an exchange, except that the transactions would take place on-line with Enron. It was like eBay for commodities, except that Enron would act as counterparty to each trade.

Enron booked many of EnronOnline's trades as revenue, even though the money paid by buyers went directly to sellers. It was this “revenue” that propelled Enron to seventh on the Fortune 500 list of top U.S. companies, which was based on revenue, even though most experts agreed that revenue was a poor measure of the true size of a company (profit or share value were better). Without EnronOnline's sham revenues, Enron would have been perceived to be a much smaller company.

EnronOnline was the brainchild of Louise Kitchen, a junior Enron executive who had worked after hours developing the Internet platform with key employees in Enron's commercial, legal, and technical departments. Kitchen's secretive approach to EnronOnline made sense given
the mercenary culture at Enron, where an aggressive manager might try to steal a good idea, and where top employees such as Kitchen were encouraged to pursue new business lines on their own. Kitchen even protected herself by obtaining patents for the trading system—in her name.

Just a few weeks before she was ready to launch EnronOnline, Kitchen finally told Jeff Skilling about it. He was enthralled, and immediately took credit for the idea, launching EnronOnline on November 29, 1999. A year and a half later, when the site had completed its one millionth transaction, Skilling would proudly proclaim: “With the power of the Internet, we believe the potential for extending our business model to new markets is limitless.”

Like much of Enron's dealings, EnronOnline functioned outside the scope of U.S. financial regulation. EnronOnline was exempt under U.S. law because all of its trades were judged to be “bilateral contracts” between the two parties trading on Enron's website, and such over-the-counter derivatives were unregulated, thanks to the new law passed by Congress in December 2000, with Senator Phil Gramm's involvement, cementing the derivatives exemption Wendy Gramm had pushed through in 1993. It was a sign of Enron's political influence that U.S. legal rules permitted the firm to set up an unregulated website to trade energy derivatives when prosecutors were bringing cases against other firms doing precisely the same thing with other financial instruments. (Recall from Chapter 6 that, in 2002, federal regulators shut down just such a website set up by Mitchell Vazquez, the former Bankers Trust salesman who had covered Gibson Greetings.)

The theory behind EnronOnline was that trading networks based on long-term relationships among a small number of market participants were too costly. Instead, EnronOnline was an open, transparent market, which—it was argued—would be cheaper and fairer than alternatives. Any member of the network could offer to buy and sell any amount of any trade at any time, and all trades would be posted on the website.

Unfortunately, the theory was flawed. Trading networks often failed
because
they were transparent. Numerous studies showed that electronic trading networks were more expensive than exchanges run by human beings, and sophisticated investors—given the choice—frequently chose less automated systems. For example, the clean and computerized Tokyo Stock Exchange had higher trading costs than the loud and frenetic New York Stock Exchange and, in both markets, when sophisticated investors
wanted to sell large blocks of shares, they typically did it privately, through a Wall Street bank, not with the stock exchange. Notwithstanding the advances in computer technology and artificial intelligence, trading networks seemed to work best when real people were directly involved. Even eBay, the Internet auction site, allowed for human interaction.

Moreover, even if EnronOnline succeeded, and lowered the costs of transacting, it was unclear why it would generate profit for Enron. If anything, it would sabotage Enron's other profitable trading operations by commoditizing Enron's businesses. Enron might capture more trading “revenues,” but its profits from trading would decline.

Nevertheless, EnronOnline sounded good, and investors and securities analysts seemed to like the idea. Enron's employees stressed EnronOnline's flexibility. A presentation by EnronOnline manager Mike McConnell began with Charles Darwin's quote: “It is not the strongest of the species that survives, nor the most intelligent, but the one most responsive to change.”

EnronOnline could have used more strength and intelligence. Without much serious thought, Enron first used the EnronOnline model for natural-gas trading, and then copied it to cover the trading of virtually any commodity. It was simply a matter of creating another link on the website. First, traders branched out from oil to steel to plastics, commodities that already were traded on various exchanges in Chicago. In these cases, the only significant advantage of EnronOnline over the exchanges was its ability to avoid U.S. regulations. Not surprisingly, EnronOnline's revenues increased, but its profits narrowed. In response, traders began searching out more exotic markets to trade—retail energy services, fiber-optic bandwidth, and, finally, weather derivatives—which they hoped would have higher margins.

Ironically, on-line bets on the weather (which the media later mocked as a sign of Enron's murky dealings) were one of the few successes of EnronOnline. Weather derivatives—essentially, bets on changes in the weather over a period of time—already were traded in the over-the-counter markets among private parties. These contracts might have seemed like lunacy at first, but they actually fulfilled an important economic function. Many businesses—such as farming, leisure, insurance, and travel—faced risks based on the weather. Weather derivatives allowed parties to hedge risks they previously had not been able to hedge.

Trading in weather-related contracts had not become standardized in
any way, and Enron was a leader in creating a standardized trading platform. The contracts were based on the minimum or maximum temperature, the inches of rainfall or snowfall, the amount of streamflow or storm activity, or the level of perceived temperature (wind chill or heat index). With Enron, if you wanted to bet that the temperature in Houston on August 1 would be above 100 degrees, you could do so.

Enron completed more than 5,000 weather-derivatives deals, with a value of more than $4.5 billion. Those numbers were impressive, but Enron's weather-derivatives business suffered the same fate as the rest of EnronOnline: revenues increased, but as the market became competitive, margins declined.

Enron Energy Services, the division of Enron known as EES, was even more of a letdown than EnronOnline. EES sought contracts to reduce the energy costs of individual and corporate customers by improving their energy efficiency. For example, EES might claim that it could change the way a company used lightbulbs to save it $1 million per year. EES would enter into a contract to do this, and then book all the revenues from the contract upfront—another example of how mark-to-market accounting stressed opinions about profit over facts about cash. Not surprisingly, EES deals were very difficult to value upfront, and EES employees were constantly trying to correct their mistaken over- and under-valuations. EES used these difficulties to its short-term advantage. According to one trader, when EES officials found that they had misvalued a winning deal, they added the correction to Enron's financial statements. But when they found that they had misvalued a losing deal, they simply put it on a list. The losses at EES steadily accumulated, hidden from view. According to one source, EES lost $700 million in 2001.

EES was a good example of how Ken Lay had not followed through on his promise to implement the “best risk management and control system, not just in our business, but in any industry.” Traders from different regions sent in hundred-page faxes listing the details of trades, and the numbers were keyed by hand into a Microsoft Excel spreadsheet. Up until 2000, Enron was running the multibillion-dollar operation out of Microsoft Excel, which was not designed for such purposes. According to one former employee, the system was so inefficient that some billing reports cost more than $10,000, and the average cost of an invoice for a new customer was $7—a significant percentage of a typical energy bill.