End Of An Era
We live in a world of increasing Economic uncertainty and turmoil following the 2008 Crash, and its important that we keep an eye on the developments around the World that impact the Global Financial system.
So we’ll be posting regular articles on the happenings at Wall Street in our new ‘Wall Street Chronicles’ segment which we set off with the story of Enron, the biggest financial collapse of the time that preceded the 2008 recession, and was perhaps a sign of things to come.
In 1985, after federal deregulation of natural gas pipelines, Enron was born from the merger of Houston Natural Gas and InterNorth, a Nebraska pipeline company. In the process of the merger, Enron incurred massive debt and, as the result of deregulation, no longer had exclusive rights to its pipelines. In order to survive, the company had to come up with a new and innovative business strategy to generate profits and cash flow.
Kenneth Lay, CEO, hired McKinsey & Co. to assist in developing Enron’s business strategy. It assigned a young consultant named Jeffrey Skilling to the engagement. Skilling, who had a background in banking and asset and liability management, proposed a revolutionary solution to Enron’s credit, cash and profit woes in the gas pipeline business: create a “gas bank” in which Enron would buy gas from a network of suppliers and sell it to a network of consumers, contractually guaranteeing both the supply and the price, charging fees for the transactions and assuming the associated risks. Thanks to the young consultant, the company created both a new product and a new paradigm for the industry—the energy derivative.
Lay was so impressed with Skilling’s genius that he created a new division in 1990 called Enron Finance Corp. and hired Skilling to run it. Under Skilling’s leadership, Enron Finance Corp. soon dominated the market for natural gas contracts, with more contacts, more access to supplies and more customers than any of its competitors. With its market power, Enron could predict future prices with great accuracy, thereby guaranteeing superior profits.
Ken Lay Jeff Skilling
WALL STREET DARLINGS
Coincidentally, but not inconsequentially, the U.S. economy during the 1990s was experiencing the longest bull market in its history. Enron’s corporate leadership, Lay excluded, comprised mostly young people who had never experienced an extended bear market. New investment opportunities were opening up everywhere, including markets in energy futures. Wall Street demanded double-digit growth from practically every venture, and Enron was determined to deliver.
In 1996 Skilling became Enron’s chief operating officer. He convinced Lay the gas bank model could be applied to the market for electric energy as well. Skilling and Lay traveled widely across the country, selling the concept to the heads of power companies and to energy regulators. The company became a major political player in the United States, lobbying for deregulation of electric utilities. In 1997 Enron acquired electric utility company Portland General Electric Corp. for about $2 billion. By the end of that year, Skilling had developed the division by then known as Enron Capital and Trade Resources into the nation’s largest wholesale buyer and seller of natural gas and electricity.
MARK-TO-MARKET ACCOUNTING: THE FRAUD FACILITATOR
Enron incorporated “mark-to-market accounting” for the energy trading business in the mid-1990s and used it on an unprecedented scale for its trading transactions. Under mark-to-market rules, whenever companies have outstanding energy-related or other derivative contracts (either assets or liabilities) on their balance sheets at the end of a particular quarter, they must adjust them to fair market value, booking unrealized gains or losses to the income statement of the period. A difficulty with application of these rules in accounting for long-term futures contracts in commodities such as gas is that there are often no quoted prices upon which to base valuations. Companies having these types of derivative instruments are free to develop and use discretionary valuation models based on their own assumptions and methods.
The Financial Accounting Standards Board’s (FASB) emerging issues task force has debated the subject of how to value and disclose energy-related contracts for several years. It has been able to conclude only that a one-size-fits-all approach will not work and that to require companies to disclose all of the assumptions and estimates underlying earnings would produce disclosures that were so voluminous they would be of little value. For a company such as Enron, under continuous pressure to beat earnings estimates, it is possible that valuation estimates might have considerably overstated earnings. Furthermore, unrealized trading gains accounted for slightly more than half of the company’s $1.41 billion reported pretax profit for 2000 and about one-third of its reported pretax profit for 1999.
Enron, like many other companies, used “special purpose entities” (SPEs) to access capital or hedge risk. By using SPEs such as limited partnerships with outside parties, a company is permitted to increase leverage and ROA without having to report debt on its balance sheet. The company contributes hard assets and related debt to an SPE in exchange for an interest. The SPE then borrows large sums of money from a financial institution to purchase assets or conduct other business without the debt or assets showing up on the company’s financial statements. The company can also sell leveraged assets to the SPE and book a profit. To avoid classification of the SPE as a subsidiary (thereby forcing the entity to include the SPE’s financial position and results of operations in its financial statements), FASB guidelines require that only 3% of the SPE be owned by an outside investor.
Under Fastow’s leadership, Enron took the use of SPEs to new heights of complexity and sophistication, capitalizing them with not only a variety of hard assets and liabilities, but also extremely complex derivative financial instruments, its own restricted stock, rights to acquire its stock and related liabilities. As its financial dealings became more complicated, the company apparently also used SPEs to “park” troubled assets that were falling in value, such as certain overseas energy facilities, the broadband operation or stock in companies that had been spun off to the public.
Transferring these assets to SPEs meant their losses would be kept off Enron’s books. To compensate partnership investors for downside risk, Enron promised issuance of additional shares of its stock. As the value of the assets in these partnerships fell, Enron began to incur larger and larger obligations to issue its own stock later down the road. Compounding the problem toward the end was the precipitous fall in the value of Enron stock. Enron conducted business through thousands of SPEs.
By April 2001 other skeptics arrived on the scene. A number of analysts questioned the lack of transparency of Enron’s disclosures. One analyst was quoted as saying, “The notes just don’t make sense, and we read notes for a living.” Skilling was very quick to reply with arrogant comments.
What Skilling and Fastow apparently underestimated was that, because of such actions, the market was beginning to perceive the company with greater and greater skepticism, thus eroding its trust and the company’s reputation.
IT ALL COMES TUMBLING DOWN
In February 2001 Lay announced his retirement and named Skilling president and CEO of Enron. In February Skilling held the company’s annual conference with analysts, bragging that the stock (then valued around $80) should be trading at around $126 per share.
Throughout the spring and summer, risky deals Enron had made in underperforming investments of various kinds began to unravel, causing it to suffer a huge cash shortfall. Senior management, which had been voting with its feet since August 2000, selling Enron stock in the bull market, continued to exit, collectively hundreds of millions of dollars richer for the experience.
On August 14, just six months after being named CEO, Skilling himself resigned, citing “personal reasons.” The stock price slipped below $40 that week and, except for a brief recovery in early October after the sale of Portland General, continued its slide to below $30 a share.
Also in August, in an internal memorandum to Lay, a company vice-president, Sherron Watkins, described her reservations about the lack of disclosure of the substance of the related party transactions with the SPEs run by Fastow. She concluded the memo by stating her fear that the company might “implode under a series of accounting scandals.” Lay notified the company’s attorneys, Vinson & Elkins, as well as the audit partner at Enron’s auditing firm, Arthur Andersen LLP, so the matter could be investigated further. The proverbial “ship” of Enron had struck the iceberg that would eventually sink it.
On October 16 Enron announced its first quarterly loss in more than four years after taking charges of $1 billion on poorly performing businesses. The company terminated the Raptor hedging arrangements which, if they had continued, would have resulted in its issuing 58 million Enron shares to offset the company’s private equity losses, severely diluting earnings. It also disclosed the reversal of the $1.2 billion entry to assets and equities it had made as a result of dealings with these arrangements. It was this disclosure that got the SEC’s attention.
After a failed rescue merger with competitor Dynegy Enron’s stock was downrated to junk status. On November 30 the stock closed at an astonishing 26 cents a share, and the company filed for bankruptcy protection on December 2.
The Enron story produced many victims, the most tragic of which is a former vice-chairman of the company who committed suicide, apparently in connection with his role in the scandal. Another 4,500 individuals have seen their careers ended abruptly by the reckless acts of a few.
In the end workers lost their Retirement Savings and Enron Executives were imprisoned with Ken Lay dying in Prison.
Arthur Andersen, Enron’s Accountants who were once considered amongst the leading Accounting Firms in the World closed its doors and a malaise spread throughout Wall Street.
It would seem the lessons from the Enron debacle were not heeded however because Wall Street continued to use the highly specialised leveraging instruments i.e. Derivatives that had driven Enron to Bankruptcy, and this time it would pose a threat to the entire Global Economic Order in 2008.
Bethany Maclean’s Book ‘Enron: The Smartest Guys In The Room’ is an excellent expose of the Enron story and exposes both the human and Financial dimensions of the Enron collapse. It was made into a documentary and it remains in my top 10, and you can check it out it below:
Enron: The Smartest Guys In The Room
Join us for the next installment of Wall Street Chronicles as we look at other Wall Street stories bearing witness to the fragility of this Economic age.
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Links & Credits
Rise & Fall Of Enron: https://www.journalofaccountancy.com/issues/2002/apr/theriseandfallofenron.html
Bethany Maclean: Enron: The Smartest Guys In The Room