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Thread-Topic: "Oh, the Games Enron Played" (from the Knowledge@Wharton website)...
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From: "Martin, John D." <J_Martin@baylor.edu>
To: "David Martin (E-mail)" <dmartin@imperialcapital.com>,        "Vince Kaminski (E-mail)" <vkaminski@aol.com>
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-----Original Message-----
From: Garven, James R.  
Sent: Monday, November 26, 2001 10:47 AM
To: Martin, John  D.
Subject: FYI: "Oh, the Games Enron Played" (from the  Knowledge@Wharton website)...
Oh, the Games Enron Played 
In the 1990s, Houston's Enron Corp. was Wall Street's darling. It had  thrown out the energy-industry playbook, remaking itself from a staid gas  pipeline company to a high-tech trading firm that created exotic securities for  betting on everything from gas prices to the number of hot days in  summer.
Share prices soared from $30 to $90 between 1998 and 2000, as  sales increased from $31 billion to more than $100 billion. Enron executives  gained reputations as the energy industry's visionaries.
This fall it all  came apart. Share prices have fallen by 90% this year, including a plunge from  just below $40 to less than $10 this fall. In October, Enron reported a  third-quarter loss of $618 million. The company's massive debt was downgraded to  near junk-bond status, and the CEO and CFO were expelled. Shareholders sued and  the Securities and Exchange Commission launched an  investigation.
Finally, the humiliated company, which employs more than  20,000, agreed Nov. 9 to be taken over by smaller cross-town rival Dynegy Inc.  for about $9 billion in stock and $13 billion in assumed debt. It is not certain  the merger will take place since it is subject to regulatory approval and could  be blocked on antitrust grounds. And some news accounts suggest that major  Dynegy shareholders could derail the merger over concerns about inheriting  liabilities from current or future lawsuits by Enron shareholders.
The  Enron story is not simply a case of a lone company that played with fire and got  burned. Enron was able to take enormous risks while keeping shareholders in the  dark because it could exploit accounting loopholes for subsidiaries that are  available to most publicly traded companies. Companies like Enron can legally  conceal massive debts because rules require a full accounting of a subsidiary's  balance sheet only when the parent company owns more than half of it.
"If  I'm a shareholder of Enron and I want full and fair disclosure, I would want  information about the entities Enron controls," says Wharton accounting  professor Robert E. Verrecchia. Yet Enron shareholders have never received such  a report.
Enron's fate is crucial to the energy industry and other  markets it serves, points out Paul R. Kleindorfer, a professor of public policy  and an expert on deregulation at Wharton. Producers and users of gas, oil,  electricity and other forms of energy rely on Enron's system for trading  futures, forwards, options, swaps and other contracts to get the best prices and  control costs far into the future. Without such a system, deregulation simply  cannot work.
"If Enron's trading platform were to go down it would not be  a minor loss," Kleindorfer says. "It would be a huge loss for the industry?.In  the early 1990s the company single-handedly produced the backbone infrastructure  that has led to a whole industry of broker intermediation."
To some  extent, Enron appears to have been a victim of sagging securities prices and  volatile energy costs in 2000 and 2001, and it has lost hundreds of millions by  laying fiber-optic cable for which there is no demand. But although those  factors may have determined the timing of the company's troubles, they were not  the chief cause. Enron appears to have lost enormous amounts of shareholder  money by gambling at its own roulette wheels.
"In hindsight, we made some  very bad investments in non-core businesses that performed worse than we ever  could have conceived," Chairman Kenneth Lay told analysts last week.
How  did Enron get into this mess?
Becoming a Market Maker
When  it was created in 1985 by the merger of Houston Natural Gas and InterNorth,  parent company of Northern Natural Gas, Enron's chief business was the operation  of thousands of miles of natural gas pipeline. Lay became chairman in Feb. 1986.  Then early in the 1990s, the federal government took key steps to deregulate the  energy industry.
Previously, large regulated utilities were vertically  integrated, giving them control from wellhead to consumer, Kleindorfer says.  Deregulation effectively broke apart the production, long-range transmission and  local distribution functions, leaving each to a different set of players. A  factory owner, for example, can now buy gas or electricity from number of  producers.
To function, a free market such as this needs brokers, or  intermediaries, to create, buy and sell contracts for production and delivery,  and it requires a market maker to facilitate trading, just as the big Wall  Street firms and exchanges facilitate trading in stocks. Enron created that  marketplace. "This intermediation activity, or brokerage activity, just  revolutionized the marketplace," Kleindorfer says.
Since utilities and  other energy users must line up dependable supplies for many months in the  future, they rely on various forms of contracts specifying quantities, prices  and delivery dates. But before the commodity is delivered, prevailing prices may  go up or down, and a supplier may find it has promised to sell at a price that's  now too low, while a purchaser may find that it could have bought for less than  it had agreed to pay.
Suppliers and purchasers therefore use a variety of  derivative contracts to benefit from prices that move in their favor and hedge  in case prices move against them. A company that has contracted to buy a  shipload of liquefied natural gas at a specific price in three months, could,  for a much smaller sum, buy an options contract giving it the right, but not the  obligation, to buy a shipload at a lower price. And it could buy an option  giving it the right to sell at a higher price. Thus it is protected regardless  of whether prices move up or down.
This was the business Enron invented.  By permitting competition and price discovery far into the future, it brought to  the marketplace the most efficient pricing and allowed energy users to predict  and stabilize costs far into the future, Kleindorfer says. "Having that  information historically, as well as projected into the future, could  revolutionize how you plan your business," he said. 
At the heart of  Enron's business strategy was the belief that it could be a big energy player  without owning all the power plants, ships, pipelines and other facilities  involved. Instead, it could use contracts to control the facilities in which  other companies had invested, says Ehud Ronn, director of the Center for Energy  Finance Education and Research at the Red McCombs School of Business at the  University of Texas at Austin. The Center trains masters candidates in the use  of energy securities. (Enron is one of the center's eight corporate  sponsors.)
Enron, he says, evolved into something akin to a Wall Street  firm. "Enron thought of itself in very similar terms as an investment banker  that wanted to tie up as little capital as possible."
By 2001, Enron had  evolved into a market maker for some 1,800 different products, many of them  energy- or Internet-related contracts or derivatives the company had created  itself. They included products allowing customers to buy, sell, hedge or  speculate in markets ranging from traditional commodities like coal, oil, gas  and electricity to cutting edge markets for Internet bandwidth, pollution  emissions, semiconductors, wind energy and many others. Prices for many of these  products were available on the company's free website, giving the energy markets  unprecedented price transparency.
Betting on the Weather
To  see how these products could be used, consider one of Enron's "weather risk  management" products meant for utilities, energy distributors, agricultural  companies and financial institutions. A gas utility, for example, might use a  "floor" to protect its revenue in the event of a mild winter. In exchange for a  premium similar to that paid on an insurance policy, Enron will compensate the  utility for every day between November and March on which the temperature rises  above a set level. The payments would make up for reduced gas sales.
In  another form of contract called a swap, or collar, Enron will pay the gas  company a given amount if the number of warm days exceeds a set level. But if  the number of cold days exceeds a threshold, the gas company will make a  payment to Enron. The utility would not have to pay a premium as it would with  the floor, and if it had to pay Enron, the money would come from the extra  revenue received by selling more gas in a colder-than normal winter.
To a  layman this might look like betting. "We never use that word," says Ronn. "The  worst we say is to 'have a view.'"
In practice, other parties are often  involved in such transactions, taking over the contractual obligation created by  Enron. So, in addition to placing its own bets, Enron serves as a middleman, the  way a stockbroker stands in the middle of a securities trade.
Like many  middlemen, Enron has to be in a position to make good on any transaction should  either party default. Otherwise, it would be hard to make a market in these  products. In addition, says Ronn, Enron often has to pay out money before  receiving payment from another party. Finally, Enron needed large amounts of  capital to trade products in its own account, just as a Wall Street firm invests  in stocks on its own in addition to executing customers' trades. To accomplish  all this, Enron needed vast amounts of capital. "You do need to have liquidity  in huge numbers," Ronn says.
This created a dilemma. A public company can  raise capital by selling additional shares, but current shareholders don't like  that because the new shares dilute the value of their holdings. The alternative  is to borrow, but large debts hurt a company's credit rating, forcing it to pay  higher interest rates on its loans.
Andrew S. Fastow, who became the  company's senior vice president of finance in 1990, found innovative ways to  issue new shares without dilution and to raise capital by selling old-fashioned  assets like power plants and pipelines.
"He has invented a groundbreaking  strategy," Ted. A. Izatt, senior vice president at Lehman Brother's Inc., told  CFO Magazine in the fall of 1999. Or, as Enron president and CEO Jeffrey  K. Skilling told the magazine: "We needed someone to rethink the entire  financing structure at Enron from soup to nuts. We didn't want someone stuck in  the past, since the industry of yesterday is no longer. Andy has the  intelligence and the youthful exuberance to think in new ways. He deserves every  accolade tossed his way."
Fastow, named chief financial officer in March  1998, told the magazine: "We transformed finance into a merchant  organization?.Essentially, we would buy and sell risk positions." A key to the  strategy: Move many of Enron's transactions "off the balance sheet." In part,  this involved exploiting a loophole in the securities and accounting  regulations. As noted earlier, debts accumulated by subsidiaries, partnerships  or other "entities" can be kept off the parent company's books so long as the  parent does not own more than 50% of the entity incurring the debt.
By  using so-called unconsolidated subsidiaries, "you do not make transparent either  the nature of the investment or the relationship between the parent and the  subsidiary," said Verrecchia. Heavy hitters such as Wall Street analysts and  major shareholders may have the clout to get a company to provide additional  information on subsidiaries. "But if you're just an investor picking up Enron's  annual report, you are stuck," Verrecchia added.
A Pattern of Sketchy  Details 
It has long been clear from company statements and SEC  filings that Enron's off-balance-sheet transactions were enormous, but details  were sketchy because Enron did not have to report them, and chose not to. By  this fall, however, it became obvious these transactions involved huge risks  when Enron acknowledged it had improperly kept some activity off its books.  Putting those debts and losses into Enron's financial statements last month  meant reducing shareholder equity by $1.2 billion. Corrected statements reduced  net income by $96 million for 1997, $113 million for 1998, $250 million for 1999  and $132 million for 2000.
At issue were so-called "special purpose  entities," or SPEs, set up for a variety of transactions for Enron's benefit.  Enron conceded some of these entities did not meet the accounting standards to  be kept off of Enron's books. In one case, for instance, the entity had  "inadequate capitalization" for such treatment.
In 2000, Enron had  created four entities known as Raptor I, II, III and IV to "hedge market risk in  certain of its investments," according to an Enron filing with the SEC. Enron  acquired notes receivable from the Raptors in exchange for an obligation to  issue Enron shares to the entities. But Enron had improperly included the value  of the notes receivable on its books without accounting for the cost of the  shares it would have to issue. In correcting this violation of accounting rules,  Enron said it had overstated its shareholders equity by $1 billion in March and  June 2001.
Enron was particularly embarrassed in acknowledging that two  special purpose entities, limited partnerships LJM Cayman and LJM Co-Investment,  had Fastow as the managing partner. Fastow, who according to Enron made in  excess of $30 million in this role, was forced out of the company in October. An  internal committee and the SEC are investigating the use of the  partnerships.
Obviously, Fastow's role was a problem. If the partnerships  were truly independent entities, he was in a conflict of interest. If he was  running them on Enron's behalf, they were not independent.
Despite the  write-downs and disclosures this fall, many analysts complain they still do not  have a full picture of Enron's activities. Enron, for instance, has not fully  described other partnerships it believes it can properly keep off the balance  sheet. Nor is it clear to what extent Enron's losses are due to bad bets it had  made through highly-leveraged derivatives. While a stock market investor can  simply hang on to shares to wait out a downturn, options and other derivatives  typically have expiration dates. If the bet has not turned out as hoped, the  entire investment can be lost.
"New disclosure was modest and management  did not resolve concerns," Goldman Sachs analysts David Maccarrone and David  Fleischer wrote in an Oct. 24 report to clients. Though Enron had long faced  such criticisms, investors had tended to give the company the benefit of the  doubt "because of its strong growth in earnings and acknowledged industry  leading capabilities?," the two analysts said.
In other words, when stock  was soaring, investors didn't require details on how it was done. Now they are  crying foul, and a number of shareholder suits have been filed. Essentially,  they claim the company inflated its stock price by filing false financial  statements. Investors who bought shares at those high prices have suffered huge  losses.
For years, the Financial Accounting Standards Board, which sets  accounting rules, has had a draft proposal for improving disclosure of  subsidiaries' activities and numbers. Essentially, it would move toward a more  qualitative evaluation of whether the parent controlled the subsidiary even if  it owned less than 50% of the stock. Control could be exerted by holding board  seats or through contracts that effectively make the subsidiary a unit of the  parent.
"What the FASB has promulgated seems to me to be sensible,"  Verrecchia said, noting that the whole purpose of accounting is to give an  accurate view of a company's inner workings and true earnings. To conceal  obligations, risk and debt, as Enron and others do, undermines that goal, he  said.
But, facing heavy opposition from accountants and corporations, the  FASB has not acted on the draft proposal, citing insufficient support on its  board. So for the time being, off-balance-sheet transactions will continue to be  a common practice among American corporations.