Enron: 90s Inc.

In the summer of 2001, I was talking to a family friend who worked as an accountant at one of the Big Five. As I did with every single adult I knew at the time, I asked him for stock tips. “E-N-E. Enron.” I don’t think he told me what business they were in, but he assured me the company was doing great.

I read the 10-K, and convinced myself it was some weird combination of boring (power plants, gas pipelines?) and complicated (what’s the deal with all those weird joint ventures? How does the trading business even work?) so I dropped it.[1] But I kept paying attention to Enron, to see if the stock tip would pan out after all.

Obviously, things turned out differently. Enron blew such a big hole in the corporate establishment that the Big Five became the Big Four.

Once the books started coming out, I read them all: Pipe Dreams, Conspiracy of Fools, Power Failure, and Smartest Guys in the Room. The last was the best, and, after I saw a story about Jeff Skilling’s release from prison, I reread it.

Anyone who has looked at their old high school yearbook knows that whatever feels new now will look dated soon, and Enron is no different. At the time, it was fresh! Exciting! Futuristic!

And today, everything they did is so 90s.

Enron owned lucrative gas pipelines, which it slowly liquidated because hard assets are lame. It had a (basically fake, though the losses were real) broadband division that planned to deliver streaming videos on-demand, and another division that planned to manage companies’ electricity needs to save them money (once again, fake except for the costs). And, in a part of the story that didn’t quite make it into the popular narrative, Enron did have a profitable, growing business — as a prop-trading shop focused on gas and electricity futures.

Enron was a deregulation story, and it actually validated the prudent view of deregulation. When natural gas rules loosened up, it massively increased the volatility of Enron’s business. It’s still unclear whether deregulation was a win or a loss for them. But when electricity was partially deregulated, Enron made an astounding amount of money, mostly by ruthlessly smuggling between the regulated and laissez-faire portions of the market. If you’d asked Milton Friedman, that’s broadly what he would have expected: some winners, some losers, lots of excitement, with the big catastrophes happening at the border between the deregulated and still-regulated parts of the industry.

Even the money involved feels pretty 90s. Enron’s executives certainly got rich, but compared to the scale of the company they didn’t do as well as modern ultra-wealthy. They banked tens of millions, in a few cases hundreds of millions, but imagine talking up a business success story that didn’t put a single person on the Forbes 400.

(Two Enron alumni have made the list, for things they did after Enron. One made his money in pipelines, one in gas trading.)

Prehistory: Enron Before the Scam

When Ken Lay and Jeff Skilling joined Enron, it was a dowdy gas pipeline company. Gas pipelines can be exciting, but usually in a bad way. They’re middlemen between companies (utilities and factories) and wildcatters. When the business was tightly regulated, this meant that the business plan was:

  1. Build a pipeline, sign some contracts.
  2. Take a long nap.
  3. Wake up once a quarter to cash some checks and pay a dividend.

It gets interesting when pipelines start taking price and credit risk: they can agree to pay a fixed amount for gas over a long period, and then sell it at the market price, or vice-versa. Gas is quite volatile; during a cold winter, prices will soar, while they’ll plunge if weather is unseasonably mild. And the credit risk is even more exciting. Wildcatters tend to be pathological optimists; they’ll convert any available cash into holes in the ground. (This dynamic exacerbates the price variability, since any spike in gas prices leads to an immediate increase in exploration activity, but gas production lasts a lot longer than any given extra-cold winter. Result: supply changes lag demand changes, then wildly overshoot.)

So, early Enron had fairly boring operations, with serious earnings volatility when they got caught on the wrong side of prices, or when low prices drove their suppliers into bankruptcy.

Ken Lay was mostly a politician who happened to do a long stint in industry (in 2001, just before the collapse, his plan was to gracefully retire by running for mayor of Houston). Jeff Skilling, who joined Enron a bit later, was — not a politician. In his Harvard Business School admissions interview, his autobiography was “I’m fucking smart.”

Skilling was an ideas guy and a financial engineer. Not the most prolific of Enron’s financial engineers, but he cast the mold. He’s a fascinating, Mephistophelean character. Clearly brilliant, incredibly ambitious, willing to dream big and work hard to make those dreams real. It’s too bad about all the fraud; if he’d been about 5% less ambitious, he could have done everything he’d hoped for.

Skilling originally joined Enron by way of McKinsey, where he’d advised the company on some clever ways to hedge risk. His basic plan was that Enron should function like a bank, with gas rather than dollars as currency. Take deposits (long-term purchase contracts), make loans (long-term sale contracts) and hedge whatever risk is left over. This was a very Big Shot Consultant approach. He didn’t want them to change their entire business, just to boil it down to the kind of essence that fits into an Excel spreadsheet.

The Theory of Enron was that the smartest, most sophisticated managers would continuously crank out brilliant new business plans, enabling Enron to hit ever-higher earnings per share numbers.

Enron’s EPS was a bit like China’s GDP growth: it wasn’t an output from measuring reality, but an input defining how reality should look. Enron would ask analysts what EPS number would make their stock go up, then they’d order their divisions to produce those profits. For natural resource extraction, this does not exactly work. If you drill for oil and you don’t find oil, your revenues are zero.

But for the more abstract and financialized parts of Enron’s business, it was gameable. Suppose you’ve signed a contract to deliver gas for ten years. The value of that contract is based on gas prices over the next ten years. And gas futures aren’t too liquid that far out, so you have to make an educated guess. If your division is a million dollars short of its revenue goals, you might reeducate yourself until your guess yields a pricing curve that produces a million dollars more in profit.

The Fraud

Over time, Enron started flexing its balance sheet muscles in different ways. The company made investments, at first in energy and power generation, later in pre-IPO tech companies. Some of these investments turned out poorly, and some turned out well. But Enron’s management noticed that investors aren’t very excited about lumpy businesses. If you’re up $100 million one quarter and you lose $20 million the next, people start to wonder if you know what you’re doing, and they start to ask how bad a bad quarter can be.

Their solution started out clever and quickly evolved into fraud. The clever part was to use joint ventures to convert lumpy results into stable results. Instead of taking the risk itself, Enron would raise money from outside investors, and operate the project in exchange for a stable slice of the long-term profits. In purely financial terms, they switched from owning equity to owning something closer to preferred stock — steady returns unless something really bad happens.[2]

In the late 90s, things took a darker turn. Enron had invested $10 million in a small startup, Rhythms Netcommunications. In 1998. In 1999, the company went public, and Enron’s stake was worth some $300m. A 3,000% return is not bad, but it’s hard to pull off without taking serious risks, so Enron decided to sell out.

Unfortunately for them, they were prohibited from selling due to a lock-up provision in the IPO. They could sell in six months, but even in 1999 people understood that volatility goes in two directions. Who wants to take a $290m writeup in one quarter and then a $200m write-down two quarters later?

So here’s what they did: they found someone who was willing to sell Enron a put option, i.e. to provide insurance against Rhythms’ price dropping. Who is willing to sell a put option on a huge chunk of the outstanding stock of a volatile Internet company?

Enron was: they formed a special-purpose entity, sold the put option to themselves, and that allowed them to safely book a profit.

This entity was collateralized with Enron’s own stock.

This is an ugly, freaky ouroborous of a financial structure. The possible outcomes are that if either Enron or the startup performs well, the structure makes money. If they both do badly, Enron loses a lot. And if Enron’s stock is down, that’s probably when they need the money. So Enron booked a safe profit in an accounting sense, while they were economically doubling-down on their existing bet.

It’s completely crazy that this was legal, and it’s also crazy that Enron’s accountants at Arthur Andersen let them get away with it.

But that’s not actually the craziest thing they did.

Enron, remember, owned a bunch of gritty companies involved in tasks like drilling giant holes in the ground and extracting hydrocarbons. This is a difficult business, with lots of volatility and technical uncertainty. Sometimes, it’s probabilistic: you try to achieve something, and it’s harder than you expected, or physically impossible.

So, Enron did not want to own those assets.

They were assets that could generate cash flow over time — lumpy cash flow, yes, but cash flow nonetheless.

So, Enron hit on an idea: why not take their more volatile businesses, and sell them to somebody who cares about the long-term and can withstand short-term pain? Enron’s public; they want to hit their quarterly number. But a private equity owner cares more about the long term, and they’re indifferent to accounting profits as long as the cash shows up on time.

This is something lots of companies do. Over the past few decades, many of America’s lumpiest, funkiest businesses have been divested by public companies and taken private.

Enron put a different spin on it: they raised a private equity fund called LJM, and put their CFO in charge.

This is, to put it mildly, completely insane. The CFO’s job includes deciding what assets to dispose of; the job of the PE fund manager is to buy assets at a good price. The CFO has a salary and stock options that theoretically give him an equity stake of well under 1% in the company. The manager of the fund collects a standard 20% of profits.

So, obviously, all of Enron’s best assets found their way into LJM, which delivered monster returns, enabling him to raise additional money from investors. And who were these investors? Largely, they were the investment banks that did a lot of business with Enron. At first, they assumed the fund was there to buy garbage assets, and that what they’d lose on investment returns they’d make up in fees. They were pleasantly surprised to see healthy returns. And they didn’t ask many questions.

Enron’s relationship with LJM is a fascinating arbitrage. There were basically two risk-seeking investment constituencies in the 90s: the ones who cared about reported earnings, and the ones who cared about cash flow. ENE’s investors were fixated on reported earnings, while Fastow and his limited partners wanted cash flow. So any Enron asset that threw off cash but didn’t report a GAAP profit (an asset whose depreciation exceeded its maintenance cash flow, for example), or whose results were volatile (an exploration and production project, say) would go to LJM, which would structure the deal so ENE showed an accounting profit.

Once again, the accountants somehow let this slide.

Later on, there were instances of outright theft: Enron made side bets that turned out profitable, and senior accounting employees sometimes swiped the profits. But in the grand scheme of things, these were a small share of the losses — more an indicator of how out of control the company was than a proximate cause of its eventual collapse.

Smartest Guys in the Room shows three reasons this happened:

  1. Sometimes Fastow lied. The board would say “That’s only okay if the accountants accept it,” and the accountants would say “That’s really bad, and we’ll only let you do it if the board approves.” Then he wouldn’t ask either, and they’d both forget about it.
  2. Some of the deals were optimized around very specific accounting rules that happened to be prone to abuse.
  3. There was a bit of a boiling-frog dynamic. Enron’s early deals were complex but not fraudulent. Over time, they titrated up the fraud content.

Trading: A Good Business, and an Evil Business

People ask the moral question about Enron: How could anyone think it was okay to rip off shareholders and fellow employees to the tune of billions of dollars? But there’s also a practical question: if Enron was such a garbage company, how did they keep the fraud going for so long?

The answer is trading: Enron ran a lucrative business betting on asset prices. Initially they focused on gas, then moved into electricity, and eventually they tried their hands at metals (through an acquisition, which they wrote down by 90% in short order), paper, and broadband (which was not, technically, possible, but sounded incredibly cool).

Enron had two meaningful trading businesses: gas, and electricity.

The gas trading business was great. Enron’s traders made big, bold bets; they acquired all sorts of legal information in clever ways; they eventually became a big enough part of the market that they could profit from knowing how everyone else was positioned, and betting accordingly. Enron’s trading platform was so popular that competitors’ marketing collateral would show photos of the trading floor — where everyone was trading with EnronOnline.com.

Since it’s Enron, we have to ask: was this whole thing fake? It’s theoretically possible, but not that likely. After the company collapsed, one of the traders got the old band together at his own hedge fund. He traded for a decade, and retired at the top of his game — with compound annual returns of 130%.

The electricity business was not quite that. It wasn’t a high-risk prop trading business where skilled gas analysts made bold bets that ultimately paid off. It was actually basically the world’s most lucrative black-hat hacking operation.

In 2000, California deregulated their electricity market. Or “deregulated” it. They required utilities to charge consistent rates, but required them to source power through a byzantine system. If it was a hot summer day in and PG&E didn’t have enough capacity to power every air conditioner in the state, they could buy power from somebody else. The Enron electricity traders were middlemen between power plants with surplus power and power plants that needed more.

It wasn’t really a market, though; it was a complicated rule book. If you offered too little power, for example, the rules said that the utilities had to pay you extra to send them the amount they needed. If you tried to route power in a way that wasn’t physically possible, you got paid to reroute it. Enron basically went through the rules and converted them into an ATM: they constantly submitted bogus power plans, then got paid a premium to do things sensibly. Basically, California wrote a bunch of code, pushed it straight to production, and said “We have a billion-dollar bug bounty, payable by the state’s utilities. Please find every single bug in our product.”

This, coupled with an unusually hot summer, more or less bankrupted California’s electrical utilities, and led to the infamous spate of rolling blackouts. It’s no wonder the tech industry was so shell-shocked for so long after the bubble. They spent the 90s living in the future, and by 2000 they didn’t have any money and spent hours a day living in a pre-electricity past.

It’s hard to argue that Enron was anything but evil here. The closest you can get is amoral, like when a teenager hacks into a company and deletes all their data just to see what will happen. But these weren’t dumb kids. They were just grown-up sociopaths.

Enron’s trading operations, good and evil, provided the profits and cash the company needed to keep the lies going. At first, trading was a small business, eventually it was dominant. At first, Enron just let the traders trade, but eventually they used trading profits to paper over bigger and bigger holes in the rest of the business.

This is a pattern with frauds of all kinds. Pure frauds tend to get caught early — in the thousands or low millions, not billions. A big fraud, though, starts with something real and exaggerates. I’m not tempted to use performance-enhancing drugs to put up better times on my gym’s stationary bike, but Lance Armstrong was so close to number one that a little blood-doping could get him to the top. So he did it.

One question you might ask here is: if this business was so good and so profitable, why didn’t Enron just shut down the scummy stuff and focus on gas trading? The answer is valuation: Enron’s story was always that they were in the logistics business, not the prop trading business; when they made money on gas, it wasn’t from buying low and selling high so much as buying here and selling there — an honorable, low-risk profession. That wasn’t true at all; there are plenty of stories of Enron banking hundreds of millions of dollars on directional natgas bets. But they made so much they were able to squirrel away money to report smooth results.

There are public companies that make their money from making financial bets, but they tend to trade at a little above book value, and the market is skeptical of high returns on capital.

So the math for Enron was something like this: earn a million dollars prop trading, call it a million dollars, and it gets capitalized at 8x earnings by the market. Or earn a million dollars trading, say half of it was from streaming video or whizz-bang power efficiency projects, and it gets capitalized at 50x earnings.

This, however, set them up for a collapse. Trading is a business where people routinely make multi-million dollar commitments based on a phone call, and nobody trusts a company that’s about to go bankrupt. So as soon as the problems with Enron’s illegitimate businesses came home to roost, the traders couldn’t trade and the whole thing fell apart. In this sense, the collapse of Enron was like what happened to Drexel Burnham, and what almost happened to Salomon Brothers: no matter how profitable your trading business is, if you ever have trouble rolling your commercial paper it’s all going to disappear in an instant.[3]

This fuels the Enron Apologist argument that what destroyed Enron was a classic run on the bank, not fraud. This is sort of like arguing that if you drive at a hundred and twenty miles an hour because you’re drunk, the real problem was that you forgot to put on a seat belt.

The End and the Aftermath

Just like the saying goes, Enron went bankrupt in two ways: slowly, then all at once. After the market peaked in 2000, their stock started drifting down. They were still making plenty of money trading. 2000 was the year of the rolling blackouts, and there was an end-of-year scramble to hide reporting how much money they’d made causing that.

As the stock dropped, those special-purpose entities’ collateral got more dicey. The partnership that hedged Rhythms Netcommunications had lost money on its put option, and it had lost money on its collateral, too. Somehow, Andersen let Enron consolidate the off-balance sheet entities so the healthy ones could prop up the weaker ones.

Meanwhile, short-sellers were asking question. Questions like “How does Enron make money?” and “Really? That’s what you’re going with?” This put further pressure on the stock.

Then, 9/11 happened, the market dropped some more, and Enron ran out of options. They took writedowns on their fake hedges. They took a separate writedown because the accountants messed up a totally unrelated part of the math and accidentally overstated shareholder’s equity by $1.2bn. (Happens to the best of us.)

Enron got hit with ratings downgrades, so they couldn’t raise cash to sustain their trading, and trading counterparties demanded collateral, which Enron didn’t have. They negotiated a sale to a competitor, took another writedown, negotiated another sale at less than half the price, and couldn’t complete the deal. On December 2, 2001, they went bankrupt.

The aftermath: in the year after Enron collapsed, several other high-profile accounting frauds also unwound. Worldcom, Tyco, and a host of smaller players. A few major Enron players went to prison: their CEO, Ken Lay, died of a heart attack days before he was to report to prison; Jeff Skilling just got out; Andy Fastow now delivers unpaid lectures on corporate ethics.

But, in the end, it actually looks like we fixed the precise problem Enron represented. Nobody I know looks solely at GAAP financials; everybody ultimately models based on free cash flow. We’re much more averse to companies that set up a deliberate conflict of interest between management and shareholders. While there still are public companies that have unseemly relationships with companies controlled by management, it’s seen as a huge red flag worthy of a giant discount on the stock.

I’ve seen lots of short pitches for stocks, but people don’t even bother to call a company “the next Enron,” even if there are accounting issues. Most accounting problems are less brazen and less catastrophic, and when companies do collapse due to accounting, it’s increasingly happening outside the US.

There have been financial scandals and accounting problems since then, but they’re of a different nature. The Great Financial Crisis was a straightforward case — the driver wasn’t that companies were hiding what they were doing so much as it was that they were fundamentally making bad loans. The pure frauds that collapsed around that time were literal ponzi schemes, not Enron’s esoteric ponzi scheme of using accounting gimmicks to produce fake profits that would lower their cost of capital.

The general problem is still unsolved. Any combination of greed, dishonesty, and opportunity will produce fraud. And doubtless, we’ll see some exciting accounting fireworks the next time there’s a recession. But we won’t see anything quite like Enron. A business that always hits its GAAP EPS number, can’t generate cash flow, and keeps booking profits from opaque deals with semi-related parties? Ditch the Nokia and hang up your JNCOs, dude — the 90s are over.

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[1] I wound up losing my money in a much simpler and more straightforward scam, a company called Actrade Financial Technologies that went from about $20 to around $35 to roughly zero over the next two years.

[2] This is a completely legitimate model, in the abstract. There are plenty of public companies today that separate something difficult and lumpy, like manufacturing a product, from the stable cash flows of licensing technology to manufacturers.

[3] That’s also what got Madoff, although it was the Great Financial Crisis rather than 9/11. He slowly bled out money for a long time, and then after 2008 he couldn’t meet the withdrawal requests and confessed his fraud.