The Spreading Enron Stain (How Many Enrons Are Out There)

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The Spreading Enron Stain
By Robert Hunter

ON WEDNESDAY AFTERNOON, my editor and I got together to think of a fresh way to approach the Enron (Other:ENRNQ) scandal for my column this week. We wanted to try to offer investors some guidance as the sordid details of Enron's off-balance-sheet activities continue to unfold.

I decided that I would argue that while the Enron blowup is a shocking example of greed, cunning and guile, it was an isolated incident. The underpinnings of our financial system are still fundamentally sound.

Now, I'm not so sure.

It's true that Enron was unlike any company that makes its living or a big chunk of it in the derivatives markets. Derivatives? Wasn't Enron primarily an energy trader? Yes, but many energy trades involve forward sales (akin to futures) and options. And Enron dealt in dozens of other, more exotic derivatives markets, from credit to weather to advertising. Derivatives were a bigger part of Enron's revenue stream than they are at any other publicly traded company that deals in them, even powerhouses like Goldman Sachs (NYSE:GS - news), Lehman Brothers (NYSE:LEH - news) and Morgan Stanley (NYSE:MWD - news).

Yet Enron didn't resemble other derivatives dealers in the least. Wall Street firms that are active in these highly sophisticated, highly lucrative and highly risky markets have elaborate risk-management systems in place to prevent Enron-like disasters from happening. Ever notice that most of the derivatives blowups you've heard about in the past from Orange County to Procter & Gamble (NYSE:PG - news) to Gibson Greetings involved relatively unsophisticated investors being burned by Wall Street bandits? (The delicate term for that on the Street is ripping someone's face off.) Yes, Barings Bank and Kidder Peabody were brought down by derivatives but those cases involved rogue traders circumventing their company's risk-management systems for fun and profit. Because derivatives can blow up in their faces, dealers pay slavish attention to the risk they undertake. Risk managers are some of the best-paid people on Wall Street. Their job is to keep their companies from going boom and by and large, they succeed.

Some years ago, as scandals started becoming more common, derivatives became something of a four-letter word. Wall Street came up with an ingenious fix, one that just happened to add some safety to the derivatives world: In the early 1990s, dealers began creating AAA-rated offshore subsidiaries that do some of their bidding for them. (No big investment bank carries that rating, or anything close.) To get those ratings, the subs had to be incredibly well capitalized and maintain impeccable books. That helped allay certain nervous counterparties, as well as institutional investors permitted to deal only with triple-A-rated entities. Even in the unlikely event that, say, Goldman Sachs imploded, its triple-A sub would still have the cash on hand to settle its bets, which often mature far into the future. Nowadays, big banks and insurers often have several of these entities. And that helps them lower their overall risk profiles. Everyone wins: The corporate trader gets to deal with a safer partner, while the bank's positions, on an aggregate level, are less risky. In the derivatives world, subsidiaries exist solely in the service of the corporate parent.

Enron was an entirely different story. While many of the infamous LJM partnerships engineered and managed by Andrew Fastow, Enron's then-chief financial officer, were set up to help Enron manage its risk, they were woefully undercapitalized, and ended up adding to Enron's aggregate risk rather than mitigating it. Many of the special-purpose vehicles Enron created were capitalized largely through Enron's own equity. When Enron's stock price fell below certain levels, that triggered huge equity payments to the private entities. The result: The entities that were set up to help Enron manage its risk exposed Enron's shareholders to even more risk because of the trigger mechanisms. Rather than serving the company proper, they ultimately destroyed it. Credit-rating agency Standard & Poor's calls such trigger deals ``insidious.''

The question is, was Enron so unique? On Dec. 20, S&P said that four energy traders in particular NRG Energy (NYSE:NRG - news), PG&E National Energy Group (NYSE:PCG - news), TXU (NYSE:TXU - news) and Williams (NYSE:WMB - news) faced the possibility of damaging trigger deals. Dynegy (NYSE:DYN - news) and Calpine (NYSE:CPN - news) decided to raise cash to shore up their balance sheets after Enron blew up. Were they frightened by what newly skeptical investors might find in their income statements? While there's no evidence of Enron-like shenanigans at any of these companies, the existence of equity-diluting trigger deals is troubling.

Before Friday, I thought it unfair to tar other companies because of what happened at Enron. Then I saw a document obtained by Staff Editor Matthew Goldstein that undermined many of my assumptions about the case. When Enron was unraveling, the story being told on Wall Street was that no one knew what was going on, and that, in any event, Enron's depravity existed in a vacuum. Now I know that isn't true.

According to LJM2 partnership documents from 2000, the cast of characters involved in Enron's off-balance-sheet activities is much bigger than previously thought. Limited partners included Chase Capital, G.E. Capital, J.P. Morgan Capital, Merrill Lynch (NYSE:MER - news), Dresdner Bank, AON, Credit Suisse First Boston, Morgan Stanley and First Union Investors, an all-star list of Wall Street insiders. Given the porous walls separating equity research from investment-banking operations, the suggestion that analysts at these firms knew nothing about the LJM partnerships before they blew up simply isn't credible. On Oct. 22, the day Enron announced that the Securities and Exchange Commission was inquiring about its third-party transactions, CSFB maintained its Strong Buy rating. Were analysts trying to keep Enron's stock high enough to prevent other trigger events?

Equally troubling, those documents revealed that LJM2's auditor was PricewaterhouseCoopers. That means that at least two of the Big Five accounting firms had intimate knowledge of the goings on inside Enron or its outside partnerships. (Arthur Andersen was Enron's auditor.) The implications of all of this for the U.S. accounting system are staggering. Enron's off-balance-sheet activities weren't the mystery they've been portrayed to be.

And that, unfortunately, leads me to wonder how many other Enron-like disasters are lurking in the shadows of corporate America. What's striking is how long Enron was able to get away with these transgressions without someone blowing the whistle. People at Wall Street's biggest firms had intimate knowledge of these dealings, yet no one said a word. When Jeffrey Skilling, Enron's then-CEO, resigned in early August once Enron's stock fell below the trigger level for at least two LJM2 entities Raptor and Osprey no one said a word. When Enron wrote down shareholder equity by $1.2 billion in October, no one said a word. Wall Street can keep a secret far better than anyone could have imagined.

How many other secrets is it keeping?