Infectious Greed (58 page)

Interestingly, although Enron sought to avoid disclosing huge gains during the electricity crisis in California, the bulk of Enron's trading gains were not from traders in its West region. Enron traders made more money trading in the Northeast, and made hundreds of millions of dollars in other regions. Nevertheless, it obviously was important to Enron officials that they not be perceived as profiting from the plight in California.

Even given the inflated prudency reserves, Enron reported a profit increase of one-third during the last quarter of 2000, the peak of the California energy crisis. Few people believed Jeff Skilling when he told analysts on a conference call, on January 22, 2001, “Now for Enron, the situation in California had little impact on fourth-quarter results. Let me repeat that. For Enron, the situation in California had little impact on fourth-quarter results.”
⁵⁰

More than a year later, it was discovered that, in fact, Enron traders around the country had been profiting from trading strategies that took
advantage of the situation in California. The fact that these strategies had names like “Death Star” and “Fat Boy” didn't help Enron's public relations, but experts concluded that the strategies were perfectly legal. For example, Enron traders sold California electricity out of state, where it was more valuable; they created the false appearance of congestion, which increased prices; and they bought power in California, sold it to out-of-state parties, repurchased it, and then sold it back into California at higher prices. One Enron trader, Timothy N. Belden, was charged with manipulating these markets in October 2002, and the Department of Justice was busily deposing other traders at the end of 2002.

California officials expressed horror at these practices and disparaged Enron's “greedy” traders. But being greedy was what traders were paid to do, and the opportunities for trading profits were created by legal rules in place in California, in particular, a cap on the price of in-state electricity. The poorly constructed regulatory system didn't excuse illegal behavior, but it did explain its rationale. As one Enron trader put it, “It's like if you were trying to sell your car and California puts a cap on car prices. But you're thinking, ‘Hey, it's worth more than that. There's a guy in Nevada willing to pay three times as much.' There's no law in California against selling in Nevada. So what are you going to do? Suck it up and sell it in California? No.”
⁵¹

Notwithstanding the accounting games, Enron's trading operations remained hugely profitable on paper—right up until the end. According to one source, Enron's North American trading operations were up $2.9 billion during the first eight months of 2001, when Jeff Skilling resigned. Several sources confirmed that Enron made more than $1 billion in 2001 trading natural-gas derivatives alone. One trader, John Arnold, made an incredible $750 million in 2001—nearly three times Andy Krieger's profits for Bankers Trust.
⁵²
Ironically, most of Arnold's profit came during the third quarter of 2001, when Enron's stock price was declining, as investors began to lose confidence, and when energy prices in California were falling, as the crisis calmed; fortunately for Arnold, he had bet billions of dollars that prices would fall.

After October 2001, Enron's trading operation finally floundered, as banks refused to extend them credit. When Enron sold its derivatives-trading business to UBS, the Swiss bank, Enron kept the billions of dollars of derivatives its traders already had purchased. John Lavorato, having received a $5 million bonus for 2001, left to run the trading operation at UBS, where he would be just as successful as he had been at
Enron. The derivatives profits lingered at Enron even after its bankruptcy, when all of its derivatives traders were gone. The derivatives Enron retained after Lavo and his colleagues departed steadily paid off; and, by July 2002, the bankrupt company was awash in an incredible $6 billion of cash, according to a reporter at the
New York Times
—a reminder that although the company had died, its heart had been healthy throughout.

 

 

U
nfortunately, even these massive trading profits weren't enough, and Enron ultimately was forced into bankruptcy. Even given the extensive media coverage, it was difficult to capture the breathless pace of the firm's collapse. From an insider's perspective, the last few days were a blur.

October 23, 2001, was a relatively quiet day throughout most of Houston. Harris County officials announced the successful test of a new $25 million electronic voting system for the upcoming elections. At Enron Field, the Houston Astros were interviewing candidates to replace Larry Dierker, the baseball manager who had resigned the previous week after leading the team to four National League Central Division titles in five years.

It had been just six weeks to the day since the terrorist attacks of September 11, and the 1.8 million residents of Houston were numb to bad news. A Texas National Guard office was closed after an officer discovered white powder on a stack of papers, but few people were alarmed and the powder tested negative for anthrax. The Union of Concerned Scientists released a long-awaited report projecting a seven-degree temperature increase in fifty years, but after another 100-degree summer, no one really believed Houston could get any hotter.

Meanwhile, at 1400 Smith Street, Enron's headquarters, all hell was breaking loose. For Ken Lay, it was the beginning of the end.

Lay spent much of the morning on a conference call with investors and analysts, trying to explain some recent troubles. During a previous Enron conference call, months earlier, investors had asked some heated questions about Enron's finances, and Jeff Skilling had responded to one analyst, Richard Grubman of Highfields Capital Management, by saying, “Well, thank you very much, we appreciate that. Asshole.” Skilling had resigned in August, citing personal reasons. Now, Ken Lay was the target.

For many of the listeners, Enron had been a solidly performing investment. During 2000, as high-flying Internet stocks had lost almost all of their value, Enron's stock had stayed in a range of more than double its
1999 price. Enron hit its all-time high of $90.56 in August 2000, and closed the year at $80.

Then, the California energy crisis struck and, by summer 2001, Enron's stock price had been cut in half. California officials blamed Enron for everything from price gouging to manipulating the price of electricity. Just before Skilling resigned, he was mobbed by angry protestors, one of whom hit him in the face with a pie. Many investors assumed that California was the primary reason for the decline in Enron's stock price. California regulators had taken over some electricity contracts, and fewer people were trading electricity, all of which should have meant lower profits for Enron. Investors did not know that Enron was having a record year trading natural-gas and electricity derivatives, notwithstanding the problems in California. During the summer, several analysts finally focused on the cryptic disclosures in Enron's annual report about its dealings with various “Related Parties.” They noticed disclosures, from months earlier, that Fastow and his partnerships were the Related Parties, and that Fastow was paid based on how the LJM partnerships performed. Anyone who closely read Enron's public filings from 2000 and 2001 would have spotted the description of Fastow's involvement and compensation.

The analysts were furious, and demanded that Enron remove Fastow from the partnerships and end the firm's relationships with LJM and LJM2. Lay asked Vinson & Elkins, the firm's primary outside legal counsel, to investigate these issues; and, in an October 15, 2001, letter to Enron's general counsel, the law firm wrote, “The facts disclosed through our preliminary investigation do not, in our judgment, warrant a further widespread investigation by independent counsel and auditors.” According to its lawyers, Enron's actions were legal.

The next day—Tuesday, October 16—Enron announced that it was removing Fastow from the LJM partnerships, and taking a $35 million charge related to “early termination” of its dealings with those partnerships. The firm also announced a $1.01 billion one-time charge to reflect losses in its broadband, retail-electricity, and water investments. These announcements were portrayed as terrible news, which undoubtedly would cause Enron's stock price to plummet.

Instead, Enron's stock price went
up
about two percent that day. Sophisticated investors didn't seem to care much about Enron's announcement of a billion-dollar charge. Enron's stock price didn't budge on Wednesday, either, and trading was calm. By this time, at the latest, the price of
Enron stock should have reflected all of the information related to the LJM partnerships and the billion-dollar charge. The information was out, and markets usually don't take very long to react to news. In an efficient market, a few minutes is a lifetime, and most news is reflected in stock prices within seconds. But in Enron's case, the markets didn't react immediately to the news; instead there was a two-day calm before the storm.

Finally, on Thursday, October 18, Enron's stock price began spiraling down, out of control. On Thursday, trading volumes in Enron's stock doubled, and the price dropped to $29. On Friday, volumes tripled, and the stock dropped $3 more. On Monday, 36.4 million shares traded—more than any other stock that day, more than double Friday's volume, and more than any other single day in Enron's history—leaving Enron's closing price at around $20, a quarter of its value nine months earlier.

What accounted for the frenzied trading and nosedive in price? Enron gave investors a partial answer on Monday, when it disclosed an “informal inquiry” by the Securities and Exchange Commission into transactions between Enron and the LJM partnerships. Investors shuddered at the words “informal inquiry.” If the SEC started digging, who knew what they might find? Ken Lay began calling in his political chits. Enron officials had meetings with Vice President Dick Cheney's staff, and Lay called his good friend, Commerce Secretary Donald Evans (although both men later claimed they did not discuss any of Enron's problems).

But none of this helped, and Lay had no choice but to arrange the October 23 conference call. As the call began, the participants asked what Lay was going to do about the fact that the stock price, which months earlier had fallen from $90 to a plateau of $35, was now falling off a cliff.

The stock analysts listening in on the call had issued buy recommendations on Enron stock, and were even more upset than the investors. (In October 2001, sixteen of seventeen securities analysts covering Enron called it a strong buy or buy.)
⁵³
Given recent allegations about conflicts of interest among analysts—specifically, that they were making unjustified buy recommendations in exchange for lucrative investment-banking business for their firms—they wanted to be sure they got accurate information about companies they were covering. No one had questioned the analysts' conflicts as stocks were rising, even though they consistently rated nearly every stock a buy. But now that prices were falling, investors and regulators were raising eyebrows. Now, analysts
were subject to greater scrutiny—a few had even been fired, and New York attorney general Eliot Spitzer had begun investigating various analysts and their firms. He was about to file an affidavit describing incriminating e-mails from Merrill Lynch. The analysts wanted to be sure they were making an accurate call on Enron.

In fact, the analysts' ratings finally looked like they made some sense. Enron might not really have been a strong buy at $80 just a few months earlier, but at $20 it seemed to be reasonably valued.

During the call, Lay admitted that having a chief financial officer run partnerships that did business with Enron was an “inherent conflict of interest.” But he defended Enron, saying the company had set up procedures, which officials rigorously followed, to ensure that shareholder interests weren't compromised. He said, “There was a Chinese Wall between LJM and Enron,” and noted that Enron was not obligated to do deals with the partnerships. Indeed, Lay said, the partnerships only did deals when it was in
Enron's
best interests.

From the analysts' perspective, the phrase “Chinese Wall” was the last straw. Wall Street investment banks had defended themselves for years with “Chinese Walls” between businesses that were subject to conflicts of interest. For example, analysts were not supposed to talk to investment bankers about confidential information. “Bringing someone over the wall” was supposed to be a significant event, when a person finally was entitled to learn secrets associated with a company or transaction. In reality, “Chinese Walls” were about eighteen inches high; bankers often compared them to the miniature Stonehenge in the movie
This Is Spinal Tap.

Lay's use of the “Chinese Wall” defense raised suspicions about other partnerships and investments. Analysts asked about arrangements with Whitewing, Atlantic Water Trust, and other SPEs Enron partially owned. Enron officials assured listeners that the company had access to enough capital to carry out normal operations, although they warned of the risk that the credit-rating agencies might downgrade Enron's debt. Any mention of credit ratings always created a hush among the crowd, and the explanations of these commitments in particular were cryptic, and seemed to involve several triggering events. When pressed, Lay finally told callers he was limited in what he could say about the LJM partnerships because of the SEC inquiry.

Having earlier demanded Andrew Fastow's resignation from the partnerships, the analysts listening to Lay began demanding Fastow's head.
David Fleischer, an analyst from Goldman Sachs, said Enron's credibility was seriously in question, and called on Lay to do everything in his power to explain to investors that Enron's dealings were “aboveboard.” He said, “I, for one, find the disclosure is not complete enough for me to understand and explain all the intricacies of all those transactions.” Jeff Dietert, an analyst from Simmons & Co. International in Houston, said, “I had hoped to get a little bit more out of the call.” For many others, that was an understatement.