It just amazes me that no one admits their mistakes. Of course, on Wall Street there are penalties for failure, but none so severe as the penalty for lying. Enron is the latest expiring fibber.
The capital-formation engine known as the stock market runs on full disclosure. Tell us how you are doing, we’ll chew on it for a bit, and then bid up or bid down your stock. We trust management, but still make them file reports every quarter, and make them hire accountants to prove they aren’t lying. The Securities and Exchange Commission sets the rules, with the help of the Financial Accounting Standards Board. But still, you can drive a Mack truck through the gray area, as a string of liars from Cendant to Sunbeam to Lernout & Hauspie did. They were each successful, but wanted more.
Enron maneuvered through the gray area like Formula One champion Michael Schumacher. The sad part about Enron is that it was really on to something. It looked at energy as a financial concept, rather than just generators, pipelines or colorless gas. As such, they could mangle it into any form, to be sold forward, hedged, borrowed against, and broken into infinite pieces. As deregulation of utilities took hold, this monetizing was key in attracting new capital to build out a new competitive market. In effect, they became traders, minimizing the grease and grime under their fingernails.
But trading is volatile. It is no place for cowboys. On Wall Street, the formula is quite simple: Figure out what your customers are doing, trade ahead of them, then apply leverage to magnify your gains. Don’t make any big directional bets — no need to ride the bucking bronco, lest you be tossed like Salomon or Barings.
Early on, Enron had it made. It knew who most of the customers were, and could set up nice, clean, low-risk trades. The stock took off in 1998 when deregulated energy markets came of age.
Somehow Enron was able to take the volatility out of trading. From 1996, operating profits were up and to the right. In its annual report, bold letters yell out “In volatile markets, everything changes but us.” Enron had mastered the Wall Street model. Or had it?
As the stock rose, Enron got on the treadmill: It could raise more capital, which meant more leverage, new tradable markets like telecommunications, which increased earnings, got the stock higher, and around they went. Water? Sure we can do water. A stake in water company Azurix was bought with debt secured by derivatives secured by Enron shares staying above $35 in one case and $60 in another. Transportation, satellite capacity, video-delivery networks — Enron made big directional bets with the house account, and told investors they were all successful. Man, these guys were good.
It seems that in November 1997, someone who thought the Star Wars “force” was with them set up two side funds, Joint Energy Development Investments LP (JEDI), and Chewco. In 1999, another fund was created named LJM Cayman. It will take forensic accountants years to figure this all out; I am basing my quick and dirty analysis on their latest 10-Q disclosure statement, filed just 10 days ago with the SEC.
Using a loophole in regulations that disallow a company from reporting profits or losses from the sale of its own stock, these side funds were set up with derivatives based on Enron’s shares. Investments would be bought back with Enron’s shares, so the company could do anything it wanted in these funds and without negatively affecting the parent’s earnings. It looks like a performance clause was put in — in other words, any trades or deals that created profits above some level would flow back to Enron; below the threshold Enron would issue shares to make up the loss.
Investments in outside companies, such as the spinoff of retail energy company Newpower Holdings, whose stock dropped from $10 in March to 90 cents today, and Rhythms NetConnections, a now bankrupt telecom company, were held in these side funds. In June 2000, as the bottom starting falling out in telecom, $100 million of dark fiber was moved into one of these funds. Investors in these funds collected fees galore, including former CFO Andrew S. Fastow, who took out $30 million. Turns out these side funds were a sham, the gray area turned black and earnings are now being restated, Enron’s book value cut by $1 billion.
Earnings were overstated by $140 million in 1998, $250 million in 1999, and another $140 million in 2000. Nothing was going to get in the way of increased earnings and a rising stock price, but perversely, the ability to hide these losses lay in derivatives based on Enron’s stock price.
It is still unclear what pricked this bubble of lies. This summer’s end of the rolling blackouts and electricity price spikes in California certainly changed the ability to mark up forward contracts. But also damaging was the 95%-plus drop in broadband prices. Gigabit fiber connections were hundreds of thousands of dollars a month a couple years ago; now you can buy gigabit ethernet in New York for $5,000 a month. If you are on the wrong side of that trade, no amount of hedging can save you.
As the stock market began to slide last year, it became harder to hide these losses. The last quarter of 2000 saw Enron’s earnings drop, ending the stock’s spectacular run. As investors lost confidence, the stock began dropping, which unwound more hedges, which sent the stock down further — the Wall Street treadmill in reverse.
A fire sale of assets raised some capital, but not enough. Crosstown rival Dynegy bid for Enron, but canceled the deal, probably when it read the fine print on these derivatives, including the trigger of $1 billion in debt due on that Azurix stake.
Similar to Long-Term Capital Management in 1998, hubris made managers believe they were invincible. Unlike then, don’t expect a bailout. But the magnitude of the losses means that many different assets are mispriced as Enron unwinds hedges, desperate to raise cash. Markets hate uncertainty, but don’t be surprised to see a rebound in many of the markets Enron played in as its carcass is dissected and the true liabilities assessed.
Lessons are all over the place. Insist on more transparency and disclosure from companies, actually read the filings, always question trading profits, leverage is an addictive and dangerous drug, and never invest in a company if you can’t figure out how it really makes money.
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