PRECISELY a year ago, Enron unveiled its master plan for domination of the universe. Not content with changing from an obscure gas-pipeline concern into the world's biggest energy trader, Enron's bosses set their sights higher. Jeffrey Skilling, then president, vowed to skyrocket past ExxonMobil to become the world's leading energy firm—quite an ambition, given that Exxon had just posted a quarterly profit of over $4 billion. But even that was not enough for Mr Skilling. He had a business insight so powerful that it would transform Enron into the world's leading company, period: the “disintegration” of the traditional corporation.
Mr Skilling believed that deregulation and market forces would force traditional, asset-heavy companies to break up into thousands of niche players. Rather than being vertically integrated, companies would be “virtually integrated”—by enterprises such as Enron that would “wire those thousands of firms back together cheaply and temporarily.”
As things have turned out, it is Enron that has disintegrated. The company filed for Chapter 11 bankruptcy on December 2nd. The story behind the most spectacular corporate roller-coaster ride in memory is impossible to tell in full detail yet, thanks to the secrecy and opacity for which Enron is notorious. The principal actors involved are staying mum, though the dozens of lawsuits and official investigations now under way should eventually shine a fiery spotlight on Enron's murky doings. Even so, a rough outline is now clear.
What drove Enron into bankruptcy in what seems like just a matter of weeks? In fact, signs of trouble had surfaced much earlier. Rebecca Mark, a rising star in the 1990s, launched Enron on ill-fated forays into asset-heavy businesses overseas such as the Dabhol power project in India and Wessex Water in Britain. During the first half of this year, Enron's shares fell to around half their peak of $90, after the firm was burned in the fallout from California's botched power deregulation and from losses on its investments in such exotica as bandwidth trading.
These events raised questions about Enron's direction under the brash Mr Skilling, who had become chief executive in February. But he disliked criticism: when, during a conference call, one analyst dared to ask a pointed question, Mr Skilling snapped that he was an “asshole”. Unable to take the heat, and perhaps seeing an even worse financial crisis ahead, he unexpectedly resigned in August. That forced Kenneth Lay, the chairman, to take back day-to-day control of the company he had founded a decade and a half ago.
Shareholders hoped that the return of Mr Lay, who promised more financial disclosure, would revive Enron. But within weeks, it was mired in a financial scandal that rapidly ran out of control. By October, it was on the brink of collapse, and had to accept a most unpalatable notion: a takeover by Dynegy, a smaller energy-trading rival based down the road in Houston.
The biggest crack in the façade came with the release of third-quarter results in mid-October that showed a $1 billion write-off on broadband, water and other bad investments. Worse, Mr Lay slipped in the news that Enron had taken a $1.2 billion reduction in equity capital, stemming from a hedging deal with a related private-equity fund. Almost nobody outside Enron was aware of the terms of the deal with this “structured-finance vehicle”, which turned out to be just one of many off-balance-sheet devices. Enron's failure to offer details about the risks from these murky partnerships led many to fear the worst about its finances.
Accounting for growth
The bad news kept coming. Enron's chief financial officer, Andrew Fastow, who had set up and profited from some of these partnerships, was pushed aside. The company restated its accounts for the past five years, and in the process wiped out nearly $600m of profits, about a fifth of the total. The news triggered an investigation by the Securities and Exchange Commission. Yet the firm still refused to come clean. More than any actual financial liability, that obfuscation proved the last straw.
Once investors and counterparties started to doubt—even slightly—that Enron was profitable, its survival became an immediate issue. Enron had been able to raise loans because its debt was rated as investment grade; but the loans had clauses requiring Enron to make additional payments if it was downgraded. As this prospect loomed nearer, the idea of this highly leveraged company having to raise fresh money scared off even more customers.
The proposed merger with Dynegy should have restored confidence, and thus halted the unwinding of Enron's trading book. In the event, Dynegy took a closer look inside Enron's black hole and decided not to proceed—making the downgrading of Enron's debt and its bankruptcy inevitable. Chuck Watson, Dynegy's boss, argues that even another $1.5 billion would not have saved Enron, given the management's refusal to be open about its financial position even with its rescuer. “It is incredible that they continued in this manner...Enron never understood that business is not just about numbers and the balance sheet: it's about your brand, and the confidence you inspire.”
How did Enron manage to pull off its confidence trick?
This potted history may tell what happened, but it raises a question: how did Enron manage to pull off its confidence trick? The key to understanding its collapse is contained in its annual report for 2000. The company, the report says, “is laser-focused on earnings per share (EPS), and we expect to continue strong earnings performance.”EPS is a number that is watched obsessively by investors and analysts, and so is often crucial to share performance. It is also relatively easy to manipulate.
It now seems clear that growth in EPS became ever harder for Enron to deliver. So its laser focus switched to looking for accounting fiddles that would make it look as if EPS was going up, and also hive debt off its books. To that end, several off-balance-sheet entities were set up. These were not wholly independent of Enron, but were judged sufficiently separate that their profit or loss did not have to be consolidated into the company's results. Assets, or portfolios of assets, were then “sold” to these entities.
For example, swaps were created on Enron's balance sheet that would compensate the buyer of assets in the event of an unexpected loss. Sometimes the quality of the assets sold was doubtful (a block of Internet shares, say); sometimes the third-party entity would pay using a loan from Enron, which then booked the interest on the loan as income. For illiquid assets, Enron had considerable discretion in deciding what constituted a fair price. According to Off Wall Street, a consultancy, around 28% of Enron's EPS in 2000 came from gains on sales of securitised assets, mostly to third parties connected with Enron.
Andersen, Enron's auditors, may have allowed these transactions because they were considered too small to be material. But a combination of bigger losses to hide and the success of the disguise meant that the partnerships soon grew so big that it now seems surprising, to put it no stronger, that the auditors did not revisit their accounting treatment and legality.
The thorniest question of all is why Enron ever had to resort to these financial shenanigans. Perhaps evidence of simple, criminal activity will be found. Yet greed was surely not the only factor. Although Enron's accounts remain a black box, there are growing suspicions that even its energy-trading business—the jewel that Dynegy wanted so badly—may not have been as impressive as it seemed.
This is not to deny that Enron's traders were formidable. Harvey Padewer of Duke, an American utility that was a big rival of Enron's, concedes that “Enron had the biggest and strongest energy-trading business in North America.” The company accounted for 15-20% of gas and power trading in the region. John Martin, an economist at Baylor University, reckons that the internal risk management of the trading business was basically sound.
But did high volumes really add up to big profits? At first, yes. However, partly as a result of Enron's success in expanding competitive markets, dozens of rivals flocked into trading. There proved to be few barriers to entry in energy trading; and Enron's skilled employees were snapped up in droves by rivals.
One indication of Enron's growing difficulties was the declining returns on extra revenues. Revenues grew by $10 billion from 1998 to 1999, and then jumped by another $60 billion to $100 billion in 2000. Profits before tax, on the other hand, rose by $1 billion in 1998, and by rather under $500m in both 1999 and 2000. Enron's return on capital was only 6.6% in 2000, less than rivals such as Williams and Dynegy.
More pointedly, notes Cary Wasden of Reed Wasden, an investment firm that has long been sceptical of Enron, the firm's trading margins collapsed, from 5.3% in early 1998 to less than 1.7% in the third quarter of this year. He notes that “margins have fallen in spite of the company's practice of selling fixed assets (ie, generation plants) and booking the gains as operating revenues.”
Whether Enron pumped up its trading revenues is a crucial question. As chart 2 shows, the spectacular growth of the past year or so was due almost entirely to Mr Skilling's embrace of the “disintegrated”, asset-light trading model. Dean Girdis of the Petroleum Finance Company, a consultancy, points to other possible wheezes. He reckons Enron may have used limited partnerships and other financial vehicles to inflate profits. Another technique he points to is the lumping of assets such as pipelines into its trading business. In fact, profits from hard assets may have masked the shrinking margins of Mr Skilling's virtual trading business and encouraged him to bet the company on his radical, risky view that Enron could create markets in just about anything.
With margins shrinking, Mr Skilling tried to stretch the brand into new areas. Enron grew to have contracts with some 8,000 counterparties, in hundreds of business lines ranging from credit insurance to metals trading. In practice, this meant taking ever bigger bets, such as trading telecoms bandwidth.
As these bets started to go horribly wrong all at once, Enron may have felt compelled to pump up its revenues and profits using ever more ingenious tactics. Dynegy's Mr Watson puts it this way: “Enron tried to be a worldwide commodities broker and market maker to the world, open 24 hours a day, with just a BBB rating, unlike banks, which have a much stronger balance sheet—and the market fell for it.”
The limits to markets
In one sense, the saga is far from over. In bankruptcy, Enron can borrow from banks, which know that fresh loans will be senior to old ones. The plan now seems to be to sell what assets it can (the ownership of its main gas pipeline is disputed by Dynegy), so as to keep alive the core trading business and the Internet operation, EnronOnline, perhaps with a view to selling them to a bank.
Yet it looks unlikely that Enron can stay alive, even in truncated form. A buyer of its trading and online operations would surely ditch such a besmirched brand. In any case, the company may be crippled by lawsuits that are likely to drag on for years. A better strategy for a would-be buyer might simply be to hire away Enron's best staff and start a new business.
That points to the most ironic twist of all in this morality tale. Mr Lay had always described himself as “passionate about markets”. That fervent belief in the invisible hand led him to spot one of the most powerful trends of the past decade: the deregulation of commodity markets. He would often forge ahead fearlessly into newly deregulating markets, bully recalcitrant regulators into speeding reforms and develop clever financial vehicles that pressed to the very edge of the law. In the end, though, Enron appears to have overstepped the mark. The resultant backlash comes as a bitter reminder that the market forces that Mr Lay once worshipped can prove a dou