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Over time, consulting became the tail that wagged the dog. Consulting divisions—which included not only computer assistance but business strategy and risk management, among other things—grew much faster than the auditing divisions, which at many firms became practically loss leaders to help get the consultants in the door.
In December 1997, after several years of open warfare, the consultants voted to split off entirely. The auditors demanded over $14 billion; in 2000, a judge ruled that they would get just $1 billion. The Andersen accountants, left with a slow-growing audit business—it was the smallest of the Big Five accounting firms—began aggressively building a new consulting arm of their own.
In Finance 101, there are only three ways for companies to fund their growth. They can take on debt, issue stock, or draw from their existing cash flow.
how Enron issued off-balance-sheet debt, backing it up with Enron stock. This was the tactic that later triggered Enron’s final crisis.
All the structured-finance deals Fastow and his team cooked up were meant to accomplish a fairly simple set of goals: keep fresh debt off the books, camouflage existing debt, book earnings, or create operating cash flow. At their absolute essence, the deals were intended to allow Enron to borrow money—billions upon billions of dollars that it needed to keep itself going—while disguising the true extent of its indebtedness.
a minority-interest transaction, which took advantage of various accounting rules governing the way business ventures with third parties are reported in a company’s financial statements.
instead of waiting for money to trickle in over time, the owner of the asset estimated the value of the future cash flow, sold it off to investors at a discount, and pocketed the money it took in from the sale. To use a word Skilling loved—and that became a term of the art at Enron—it was a way to “monetize” assets. As securitizations
the use of so-called special purpose entities, which were set up by companies specifically to purchase the assets being securitized. The original idea behind SPEs was to isolate risk by setting up an independent legal entity that owned just one asset—say, credit card receivables. The investors who controlled the independent entity would reap the gain, but they would also have to accept the risk of something going wrong. In any event, the asset was isolated from the rest of the company’s business risks.
if you’ve generated earnings and cash from selling something, you can’t claim those earnings or cash flow the next year or any year afterward. “Enron borrowed from the future until there was nothing left to borrow,”
At the time of its bankruptcy, Enron had over $2 billion in off-balance-sheet debt related solely to securitizations.
(Chase Manhattan merged with J. P. Morgan on December 31, 2000.
Credit Suisse First Boston (which acquired Donaldson, Lufkin & Jenrette in 2000),
Though the company was piling up truly astounding levels of debt—by the end, Enron owed some $38 billion, of which only $13 billion was on its balance sheet—the executives who made up Fastow’s team seem to have barely thought about it.
Chase, for instance, had been formed through a series of acquisitions that included three of the largest banks in New York: Chase Manhattan, Chemical Bank, and Manufacturer’s Hanover. Citigroup, the parent company of Citibank, had transformed itself into the largest financial institution in the world; it included Travelers Insurance Group and the Salomon Smith Barney brokerage house.
Because wind farms provide alternative energy, they enjoy a legal status as qualifying facilities (QFs). QFs get certain government-mandated benefits, such as higher rates from electric utilities, which are required to buy power from them. However, those benefits disappear if the QF is more than 50 percent owned by a utility.
breaking the grip of the utility industry, creating a new world where consumers would be able to choose their own energy provider.
one state did enact a law to deregulate energy at the retail level. That state was California; the new law was set to go into effect in 1998.
Despite several months of intensive marketing, Enron signed up just 50,000 households in California, about 1 percent of the market. Contrary to Ken Lay’s expectations, consumers weren’t willing to go to the trouble of switching from their reliable old utility, even with Enron’s offer of a rate discount. All that grassroots outrage about monopoly power that Lay talked about, the pent-up rage at the utilities—it simply didn’t exist.
Not that Enron was about to back away from EES—how could it, after Skilling and Lay had touted it to Wall Street and the company had sold a piece of the division to some highly reputable investors? No, Enron would just have to shift strategies, that’s all. Instead of targeting homes, it would target businesses, from hospitals to fast-food chains to big corporations with scores of office sites around the country. And instead of just selling them power, it would subcontract to take care of all of their energy needs.
Just as consultants had cropped up to handle the complicated computer needs of large corporations, saving them money in the process, Enron was promising to do the same with energy. Its ability to lock in prices on the trading floor would eliminate the worry that volatile energy costs would blow a hole in a company’s budget.
Depending on the size and term of the contract—some ran as long as 15 years—EES was promising savings of anywhere from 5 percent to 15 percent. The more perplexing question is why this would be an alluring idea for Enron. The commodity part of this new business—providing electricity and gas at a discount to customers—was often a money-loser at the retail level because most states were still refusing to deregulate retail energy. That meant the only way Enron could cut the cost of energy for a customer was to buy electricity from a local utility and resell it at a loss. Amazingly, Enron was
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Pricing energy costs for customers was especially tricky. In a typical long-term EES deal with a large corporation, Enron had to establish models with multiyear tariff curves—predictions about how dozens of factors would affect electric rates—for every utility in every locale the customer had a business site.
Enron invited the analysts who covered the company to Houston for an annual meeting with the company’s top executives. As part of the event, Enron officials gave the analysts a tour of the company’s operations, including EES.
There, they beheld the very picture of a sophisticated, booming business: a big open room, bustling with people, all busily working the telephones and hunched over computer terminals, seemingly cutting deals and trading energy.
On the day the analysts arrived, the room was filled with Enron employees. Many of them, though, didn’t even work on the sixth floor. They were secretaries, EES staff from other locations, and non-EES employees who had been drafted for the occasion and coached on the importance of appearing busy.
Shockingly, Pai’s team was allowed to establish pricing curves that were different from the ones used by the wholesale traders. In other words, different parts of Enron were making different long-term pricing assumptions, then booking millions in mark-to-market profits based on those different guesses.
Portland General was one of several utilities that had jumped into the telecom business with the idea of using their existing right-of-way to lay a fiber network—a system of glass strands that acts as an underground highway for moving Internet data at high speeds.
Enron’s traders had gotten enthused about the idea of trading bandwidth—capacity on the fiber-optic networks that Enron and others were building. It made at least theoretical sense: Internet data moved along fiber networks that crisscrossed the country, just like natural gas and electricity. Why couldn’t Enron trade bandwidth capacity in the same way it traded natural gas?
the deal involved two commodity trades between Enron and Merrill in something called heat-rate swaps. The paired trades were perfect mirror images of one another, but they had different accounting treatments. As a result, Enron would book the profits it needed immediately on the first trade while deferring a loss on the mirror-image trade until later.
something called a tracking account, which reflected amounts owed either side as energy prices fluctuated. It was assumed that over the long haul, the tracking account would never get too far out of balance.
EOL was a brilliant innovation, but it had a hidden cost. Because Enron was involved in every trade, it dramatically increased the capital requirements of the trading business. Just how dangerous this was would become all too apparent—much later.
The company’s single largest investor was Denver-based Janus, which operated a high-flying family of mutual funds, most of which invested in the fastest-growing companies their fund managers could find. At the peak, Janus owned some 8 percent of Enron’s shares.
The problem with momentum investors is that they don’t necessarily understand the business and at the first sign of trouble, they don’t stick around to hear explanations. Just as they can help drive a stock higher with their buying, they can also accelerate a downward push with their panic selling. Convinced that Enron’s stock would never go down, neither Skilling nor Lay was worried about the influx of momentum players.
“He had a good McKinsey trick,” says another. “If you asked a question that he didn’t want to answer, he would dump a ton of data on you. But he didn’t answer. If you were brave and said you still didn’t get it, he would turn on you. ‘Well, it’s so obvious,’ he’d say. ‘How can you not get it?’
rating from Moody’s and Standard & Poor’s is an absolute necessity to sell most forms of debt; in fact, in certain cases, it’s a legal requirement.
For their work in 2000—the last full year before Enron went bankrupt—each of the top 200 employees made over $1 million; 26 executives made over $10 million. In 2001, the year Enron went bankrupt, at least 15 employees made over $10 million.
All around the globe, water utilities operated as small local businesses, usually run by municipal governments. A small chorus of experts were saying that the world’s water woes would not be solved until the industry was privatized because municipalities lacked the money and the expertise to provide solutions on their own.
Water is also regulated at the local level, which makes the politics much different and much closer to the bone.
Vivendi and Suez had been in the business since the days of Napoleon III, who put the French water industry into private hands. What made Azurix think it could outsmart them?
equity certificates—basically, stock that paid a fixed return—to
Azurix was notified that it had won the rights to the Buenos Aires concession. Though Azurix bid for the right to manage two regions—2.1 million people—while most competitors bid for smaller pieces, the company’s offer was more than three times higher than the next contender.
The transmission route Belden had chosen begins at the Beowave geothermal energy facility in Nevada, where steam is pulled from subterranean cauldrons into a huge turbine, generating electricity.
Enron exported power from California and brought it back in when the ISO was desperate and had to pay far higher prices. (This strategy, which was used by all the power traders, was more widely known as “megawatt laundering.”)
the energy trading world, “talking your book”—lying about your position in order to get the market to move your way—was common practice.
Statewide blackouts were narrowly averted at the last minute when U.S. Energy Secretary Bill Richardson imposed a state of emergency, requiring marketers to sell to California. Incredibly, around the same time, Ken Lay telephoned Richardson and asked him to use his emergency powers to deregulate the nation’s electricity transmission grid.
The crisis didn’t end until the summer of 2001. In April, Pacific Gas & Electric filed for bankruptcy. Two months later, the FERC finally decided to reverse course and instituted price caps across the Western market.
During the crisis, California paid some $40 billion for electricity, more than quadruple the cost during a similar period a year earlier.
Enron took a huge amount of trading profit—upward of $1 billion, says one former executive—and booked it as a reserve against the potential liability it faced in California. This was not disclosed anywhere in Enron’s books, although the company did repeatedly tell investors that it was “fully reserved” for any problems in California.
At the time, purchasing bandwidth was an inflexible, expensive proposition, requiring business customers to lease a special dedicated line—usually for a year or more—with far more capacity than they needed.
as a practical matter, the kind of real-time switching Enron envisioned was impossible. Transferring high-capacity bandwidth meant sending workers out to change connections by hand, a process that took days—if it was possible to switch them at all.
