Enron

I always wanted to know what all the story of the collapse of Enron consisted of. I had some vague idea but then I watched the documentary ‘Enron – The smartest guys in the room’. I will try to give my recollection of the same.

Firstly, why the name of the documentary as it is? Since that is what the people at Enron were called by others. And why am I asking these questions? Since the tag line of Enron was ‘Ask why?’ and as one of the ex-employees said in the documentary, this is precisely what was not done.

Enron was basically started with investment in some natural gas assets (like pipelines etc.). They wanted to trade natural gas and had some traders to engage in these activities. The entire basis of the vision of trading etc. was to have a deregulated market where the prices of all products (especially the energy related ones) to be determined “efficiently” by market forces. For this the executives used their contacts in the government and lobbied to have laws being made (or in some cases, avoid passage of laws) which would help them in following their vision.

The traders took huge risks and made millions for the company. The risks involved were much above what maximum they were allowed to take. Even when the management came to know of this, rather than taking action against the traders, they were appreciated for the money they had made. As you would guess, one day the traders lost almost all the money of the company.

Then a new idea was brought in “rather than be bound by the physical flow of the pipeline, Enron would become a kind of stock market for natural gas … transform energy into financial instruments that culd be traded like stocks and bonds” (direct quote from the documentary). The problem with this was that there can be scope for manipulation if the stock market actually owns a large part of the assets of the underlying commodity.

Then a big fault from the regulators; they agreed on the use of mark-to-market accounting by Enron. The auditors, Arthur Anderson signed off and the SEC agreed. That way Enron can book potential future profits on the very day the deal was signed (no matter how little cash actually came in). Thus now the company can show profits as much as they want.

The culture at the company was made very competitive and everyone was driven solely by money, no ethics, and no scruples. They had a strong liking for the stock market price of their company, as a large part of the compensation was being paid in the form of stock options. Thus, they came up with one story after another just to ensure that investors have faith in the company and the stock price continues to go up.

Meanwhile, some of the projects started making losses. For example, the Dabhol power project in India was by no means a success. However, the culture made it impossible to accept failures and they tried everything from buying companies to entering into newer markets like leasing of broadband lines. But the mark-to-market accounting methodology came in handy each time and any unsuccessful venture can still be shown as a profitable one.

At this time some of the people started smelling something fishy, though even they had no idea of how huge the fraud was. Any kind of speculation was blown off as mere criticisms which accompany a success.

However, as Enron suffered losses, it had to have cash flow from some place. So, it borrowed a lot. However, it cannot borrow more than a certain amount before people start driving them off. So, they had the problem of showing a lot of debt on their books. The way out was some “creative” accounting. They took refuge in some fake companies where the debt and losses can be buried. The big investment banks turned a blind eye on these wrong doings and agreed to fund these companies who further pumped in money into Enron. The collateral was Enron’s stock, increasing their dependence on stock prices remaining high.

A special event happened which was actually the first hint of the forthcoming earthquake. In an analyst conference call on 17^th April, 2001, an analyst asked “You‘re the only financial institution that can’t produce a balance sheet or cash flow statement with their earnings.” The reply from the CEO was “You, you, you … Well, uh … thank you very much. We appreciate it … a$$h***.” It said that something was bothering the CEO which he did not want to share.

And then was the whole issue of California. As I mentioned before, if Enron has control on a large proportion of assets for some particular commodity and you are also involved in the trading of this commodity, then there is a hell lot of a scope for price rigging. So, what Enron did was stopped generating electricity in California (they could do this since they owned one of the power producing companies and had successfully made the government pass the law for deregulation of the power markets). As a result, the power prices shot up and Enron was able to sell power at a much larger price. At the same time its traders had betted on power prices going up and Surprise! Surprise! the bets went in their favour.

The above issue has the whole angle of ethics where money was being made at the expense of the sufferings of people. The traders were involved and their conversations showed how inhumane they were. (There’s a reference to Milgram’s experiment about giving electric shocks to individuals, wherein it was observed that “… 50% of the subjects were willing to shock to the death so long as commands came from a seemingly legitimate source …”).

The result was price caps being introduced in California and Californians electing Arnold (The Terminator) as their Governor (as the former Governor had to face the wrath of the power-deprived Californians).

After that, suddenly the CEO resigned; the confidence plummeted; the stock price went down. The accounting frauds (related to the fake companies) started surfacing and only then did SEC wake up. Enron, along with companies like Arthur Anderson (auditors), Vincent and Alkans (law firm) tried their best to cover up but to no use. All companies collapsed (bankruptcy) as a pack of cards (in a matter of weeks).

Finally, think of the people who lost their money. And I am not just talking about the debtors. All money from the pension funds, retirement funds were lost. An employee of a company owned by Enron says that he had 348,000$ at the peak which he had to sell for 1,200$.