The Death of an Energy Giant: Enron (1985-2002)

In September of 2000, Enron was the nation’s 7th largest corporation with a market capitalization of nearly $60 billion. Less than 14 months later, its stock was worthless and the business was forced to file for Chapter 11 bankruptcy protection from creditors. Such an astonishing collapse has not only raised eyebrows, but also outraged investors, policymakers and much of the public.

To describe this descent into financial oblivion as a “scandal” is no perversion of language. Prior to a report issued on October 16th that contained $1.2 billion in equity losses relating to off-balance sheet investments known as LJM Cayman and LJM2 Co-Investment, Enron had never reported a negative quarter. In fact, in the quarterly earnings report that immediately preceded the October revelation, Enron announced a 40 percent rise in earnings and a 93 percent increase in the profits of its wholesale energy trading unit.

Yet, less than four months later, Enron revised its financial statements from 1997 to 2000 by an eye-popping $591 million in profit reductions and $628 million in debt. Such a suspicious about-face reeks of accounting gimmickry and possible illegality. Needless to say, both Enron, and its auditor, Andersen, (formally Arthur Andersen) have a lot of explaining to do, as executives from both corporations may face criminal indictment and class action awards totalling hundreds of millions of dollars.

But while headline-starved politicians and under-informed media personalities pretend as though this financial scandal is black and white and easy to digest, it is best to attempt to understand truly the forces behind the collapse and their ramifications on public policy. Like Shakespeare’s Coriolanus, Enron has only itself to blame for its fall, but the particulars of the demise are not easily understood, and open to much debate.

The Fall

Beginning with the October 16th disclosure of $1.2 billion in lost equity, Enron’s stock price began a free-fall from about $35 a share to less than $1. Since the end of the historic bull market, Wall Street analysts assigned to Enron had become disenchanted with the company’s accounting practices and believed that its financial disclosures lacked transparency. The October 16th disclosure heightened these fears and gave them reason to believe that Enron was concealing poor financial performance through limited partnerships that allowed accountants to keep mounting debt off of Enron’s balance sheet.

While technically separate businesses, many off-balance sheet undertakings were run by Andrew Fastow, Enron’s Chief Financial Officer. As these businesses piled up debt, Enron promised to compensate those losses with common stock in the future, a fact which was not disclosed to shareholders. It was only when the equity losses relating to this compensation were made public that analysts began to downgrade the stock.

The stock downgrade and subsequent fall in the share price caused a ripple effect, from which Enron would never recover. The dip in share prices caused bond rating agencies Moody’s and Standard and Poor’s to downgrade Enron’s credit worthiness, which triggered debt repayment clauses written into Enron partnerships and off-balance sheet ventures. It was Enron’s inability to repay these debts that ultimately led to its insolvency.

While it has become fashionable to blame Enron’s collapse on these off-balance sheet vehicles and the unscrupulous – and possibly illegal – accounting practices that hid them from public view, this really is only half the story. Neither Moody’s nor Standard and Poor’s had recognized Enron’s impending collapse. The October 16th disclosure led Moody’s to drop Enron’s credit merely to Baa1, which was still investment grade. It was not until rival energy firm Dynergy pulled its merger offer that the credit agencies officially downgraded Enron’s credit to junk.

This is particularly troubling because these agencies were not only responsible for issuing ratings for Enron, but also for the hidden off-balance sheet ventures that started the company’s downward spiral in the first place. These agencies probably had a better overview of Enron’s financial position than any investor and were still unable to comprehend the corporation’s calamitous financial condition. Since highly skilled, independent credit analysts could not see the writing on the wall, even with information not accessible to the public, it is hyperbole to suggest that had everyone been privy to this information that the entire episode would not have taken place.

In reality, Enron’s operations were so complicated that very few could make sense of them, even if they were blessed with all of the information in the world. EnronOnline was the world’s biggest web-based transaction system. Its primary focus was to allow energy producers and utilities to hedge risk through derivatives, enter bilateral forward energy swap contracts, and buy over 2,000 energy-based financial products. To further complicate matters, EnronOnline was structured so that Enron was a counterparty to every transaction. This distinguished EnronOnline from a traditional exchange, like the NASDAQ, which serves as a neutral forum and simply matches buyers and sellers.

While this part of the operation was Enron’s strength, once investments in facilities, infrastructure, energy futures, and credit derivates went south, Enron tried to make the money back through unethical – and possibly illegal – debt-leveraged creativity. Eventually the house of cards came tumbling down, but as the bankruptcy proceeding demonstrates, even the businesses participating in the credit guarantees and energy futures swaps were not certain what they were purchasing, or who would bear the credit risk in the event of financial collapse.

After all, it is not as if investment banks JP Morgan and Citigroup have become institutions on Wall Street thanks to their naiveté, yet both had huge exposure to Enron. In addition to energy trades, JP Morgan used Enron derivative instruments as a form of insurance to transfer its risk of credit default. It seems ludicrous that seasoned Wall Street veterans would share the risk of default with the now bankrupt Enron, but that they were willing to do so is perhaps the best evidence of the sheer complexity, and near incomprehensibility, of Enron’s various operations.

Policy Ramifications

Calls for new regulations on every conceivable economic activity related to Enron are to be expected. Reflexive liberalism runs rampant immediately following such episodes, but new Securities and Exchange Commission (SEC), or Commodity Futures Trading Commission (CFTC), regulations can do little prospectively to benefit consumers and investors.

Enron’s stock was a bubble, like the dot-com fiasco before it. Enron’s physical assets were never valued at more than $12 billion, yet, at its height, its stock price valued the firm at five times that. As investing guru Warren Buffet has famously admonished, “never invest in a stock you don’t understand.” Those who bid up Enron’s stock price to five times the value of its physical assets did so based on their valuation of derivative transactions that perhaps even those making the trades did not understand.

As with all financial debacles, investors will guard against getting burned in a similar fashion. Since Enron’s collapse, investors have become wary of the market for credit derivatives and speculative swaps contracts. In addition, Enron competitors Dynergy, Reliant, and Duke, among others, have seen their share prices and borrowing capability fall as investors have become more critical of the sector’s operations.

But more importantly, these companies have taken steps to increase their transparency by making more financial information available to reassure skeptical investors and analysts. There is practically no information that they are unwilling to hand over because concealing information is now a bigger liability than even the most glaring financial misstep. As usual, new regulations to increase transparency are a step behind the market. To institute them now would straightjacket new voluntary disclosure practices and may actually lead to less information being available as corporations adhere to government standards instead of what is demanded by investors.

It will take time for investors to better understand forward energy swaps and some of the financial instruments Enron invented. But the trades Enron facilitated provided convenient and cost-effective risk management. To restrict, or regulate, these trades would deprive the industry of the flexibility to manage risk and erase the rationale for these instruments in the first place. The frontiers of financial management are best settled through the market discovery process, not interventionism.

Perhaps the pro-regulatory case with the most merit is for new restrictions on the ability of corporations to restrict 401K-plan investment to its own stock and bonds. While Enron employees saw their life savings dissipate as their retirement savings were linked to their company’s equity value, the top 29 Enron executives exercised an estimated $1 billion in stock options.

While such a divergence in fortunes is tasteless and lamentable, executive compensation packages often include stock options. To exercise them when the stock price is above rational levels – as judged by discounting expectations of future cash flow – is nothing out of the ordinary. The bull market of the late 90s made many executives very rich as they cashed in on inflated stock prices. Enron executives simply took advantage of their own price bubble. If that bubble was inflated by earnings misstatements – as is likely the case – Enron executives will be held accountable by criminal and civil courts.

Moreover, new regulations to deny corporate flexibility in structuring their employees retirement packages could have unintended negative consequences. For example, preventing a firm from using its 401-K offerings to shore up its own share price may needlessly limit the generosity of matching funds, or discourage firms from sharing profits with employees. The tragedy of those Enron employees who lost their life-savings due to the collapse should not be minimized, but if Congress is interested in passing legislation to guard American’s retirement security, it should pass partial Social Security privatization instead of compromising corporate 401-K flexibility.

Political Ramifications

It is difficult, if not impossible, to identify any political dimension to the scandal, or any course of action elected officials can take to ameliorate the situation. With a criminal investigation and numerous class action civil suits already underway, Congressional investigations will do little more than earn headlines and provide a platform for political mudslinging and irresponsible charges

Thus far, the most oft-repeated accusation is that something must be amiss because Enron was President George W. Bush’s top campaign contributor and Enron officials placed calls to cabinet secretaries Donald Evans and Paul O’Neill before the bankruptcy. At this point, it is unclear whether or not Enron Chief Executive Kenneth Lay explicitly asked for federal assistance, but his company’s subsequent implosion makes it clear what the answer was if he did.

Yet, campaign finance crusaders, and administration opponents, argue that whether or not Enron was offered a bailout is immaterial because Enron had access to the “corridors of power.” Virtually every misdeed alleged to have been committed by the firm – from opaque accounting methods to failed energy trades – could be attributed to this access, and probably will be in the coming weeks.

As unseemly as they may appear, Enron’s political contributions to Bush, as well as its $2.25 million in soft money donations to both political parties since 1992, are relatively modest considering the industry in which the company operates. 93 percent of Enron’s business is (was) energy trading: connecting energy producers to utilities and natural gas suppliers to generators. While natural gas pipelines and extraction has been deregulated, the rest of the industry, for the most part, has not. Thus, Enron’s core business was dependent on competitive energy markets and deregulated electricity generation.

While some may attempt to characterize this as “buying influence,” Enron was attempting to pry open energy markets from the government monopolies that have gouged consumers for decades. While some free market advocates may disagree with some of the policy initiatives Enron pursued – open access to electrical transmission facilities, for instance – there is no question that its fortunes were inexorably linked to the end of pervasive electricity monopolies and consumer choice.

The electricity monopolies Enron challenged were among the most profitable businesses in the nation, thanks to their cozy relationship with politicians. If anyone doubts this, they need look no further than a 1993 report from the National Association of Regulatory Utility Commissioners, which examined the stock performance of electric and telephone monopolies from 1972-1992. The study found that based on internal rate of return accounting, electric utilities outperformed the S&P 400 over 87 percent of the time. Yet, the profits and revenues of monopoly utilities were not the product of free market exchange, but the result of negotiations between the corporations and political bodies. Far beyond buying influence, the political maneuvering of Enron’s energy industry antecedents actually determined their revenue, costs, and profits.

Resistant to competitive markets that would eliminate this free ride, electric utilities fought – and continue to fight – deregulation tooth and nail. In most states where deregulation has occurred, the incumbent utilities succeeded in recovering “stranded costs” through inflated consumer electric bills and manipulated the laws to guard against unfettered competition. It should surprise no one that a business predicated on prying open these regulatory fiefdoms to competition must fight for its interests in the public policy arena, and help to finance some campaigns in the process.

Ironically, some accuse the Bush administration of acting improperly because they did not extend a federally backed line of credit to Enron. Such action would not only have been scandalous, but inimical to the free market, which demands that risk be borne privately. Those who favor government interventionism may wish Bush interceded to protect shareholders, but this would have done more to undermine capital markets than the collapse itself.

There is little doubt that the Enron scandal will continue to make headlines in Washington as both parties try to use it to their political advantage. A hearing before the Senate Banking Committee is scheduled for February 12th, but this may be the first in a series of public rebukes, as four other committees are investigating as well.

With criminal indictments possible, and a huge class action award likely, the legal mechanisms already in place to regulate business practices will do more to punish wrongdoing and protect shareholders than any action taken by elected officials. But the show will go on nonetheless.

Like the tragedy of Coriolanus, the tragedy of Enron should make for great theatre. Imagine the hilarity when sanctimonious Senate investigators pretend that they understand what the most highly trained professionals in the financial services industry could not, and then assign blame accordingly. Let us just hope the entertainment value of this farce will outweigh its expense to taxpayers.

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