Infectious Greed

by Frank Partnoy

  Enron completed more than 5,000 weather-derivatives deals, with a value of more than $4.5 billion. Those numbers were impressive, but Enron’s weather-derivatives business suffered the same fate as the rest of EnronOnline: revenues increased, but as the market became competitive, margins declined.

  Enron Energy Services, the division of Enron known as EES, was even more of a letdown than EnronOnline. EES sought contracts to reduce the energy costs of individual and corporate customers by improving their energy efficiency. For example, EES might claim that it could change the way a company used lightbulbs to save it $1 million per year. EES would enter into a contract to do this, and then book all the revenues from the contract upfront—another example of how mark-to-market accounting stressed opinions about profit over facts about cash. Not surprisingly, EES deals were very difficult to value upfront, and EES employees were constantly trying to correct their mistaken over- and under-valuations. EES used these difficulties to its short-term advantage. According to one trader, when EES officials found that they had misvalued a winning deal, they added the correction to Enron’s financial statements. But when they found that they had misvalued a losing deal, they simply put it on a list. The losses at EES steadily accumulated, hidden from view. According to one source, EES lost $700 million in 2001.

  EES was a good example of how Ken Lay had not followed through on his promise to implement the “best risk management and control system, not just in our business, but in any industry.” Traders from different regions sent in hundred-page faxes listing the details of trades, and the numbers were keyed by hand into a Microsoft Excel spreadsheet. Up until 2000, Enron was running the multibillion-dollar operation out of Microsoft Excel, which was not designed for such purposes. According to one former employee, the system was so inefficient that some billing reports cost more than $10,000, and the average cost of an invoice for a new customer was $7—a significant percentage of a typical energy bill.

  Incredibly, investors and securities analysts continued to rave about EnronOnline and EES. Enron’s annual report for 2000 prominently featured both businesses. They were important to Enron’s managers, because shareholders valued technology businesses more than they valued trading firms. But the reality was that the new businesses were losers, and were supported by Enron’s huge and hidden profits from derivatives trading. Just as Andy Krieger had feigned betting that currencies would fall when his real bet was that they would rise, Enron was pretending to be a technology company when its real business was derivatives trading.

  The billions of dollars Enron lost in virtually all of its new businesses should not have been fatal, because Enron was making up for the losses in its North American natural-gas and electricity derivatives-trading operations. Enron disclosed more than $1 billion of income from trading in 2000; but, in reality, the firm’s traders were making much more money than they were disclosing. The true numbers may never be known, but several sources established that Enron made billions of dollars trading in 2000 and 2001. Total trading profits for 2001—Enron’s final year—were estimated at $3.8 billion.

  In fact, Enron was making so much money trading derivatives that its traders decided to implement precisely the opposite scheme that Cendant and other companies had used to front-load their profits a few years earlier. Enron’s traders actively manipulated their accounts to reduce their profits, which were embarrassingly large. Ironically, it remains unclear whether Enron’s top officials were aware of this fact or, instead, whether Enron’s traders were duping Ken Lay and Jeff Skilling at the same time those men were trying to persuade investors that Enron was a technology firm, not a trading firm.

  There were several reasons for Enron’s traders to want to reduce their reported profits. One was to “manage” Enron’s earnings by shifting profits from trading to Enron’s other ailing businesses. Another was to smooth Enron’s trading profits over time, so that they appeared less volatile. But the most important reason, in late 2000, was the California energy crisis. California officials claimed that Enron had been manipulating energy markets and profiting at the state’s expense. If Enron disclosed huge trading profits for 2000, it would only fan those flames.

  In all, Enron reduced its trading profits by as much as $1.5 billion in late 2000 and early 2001, during the peak of the crisis in California.47 Enron’s internal trading records state that the firm lost over a billion dollars trading during a three-day period in December 2000—$550 million on a single day. It remains unclear whether these losses were real (from market volatility) or imagined (from manipulation of reserves). Either way, the short-term swings in trading profits were larger than any ever reported, by any company. The story of how Enron’s traders hid their profits is one of the least known and understood aspects of the Enron scandal.

  During Enron’s last few years, the main trading floor at its headquarters in Houston (the sixth floor) was less of a zoo than a typical Wall Street trading floor, in part because the traders were in laid-back Texas, not Manhattan, and in part because business was so good. Yes, Enron’s traders ogled their secretaries and staged eating contests. Yes, they gambled on sporting events and frequently blasted AC/DC or some other hard rock band. Yes, they mercilessly pursued trading profits and drove expensive cars. But the machismo at Enron was muted. Traders wore casual clothes—khakis and blue shirts were the uniform—and they politely tossed Nerf footballs across the trading floor. Morale and pay were high, and there was no need to engage in the gratuitously blood-thirsty antics that were typical among Wall Street firms. When one Enron trader vomited on the floor after failing to eat ten large hamburgers on a bet—an easy feat for a well-trained Wall Street trader—everyone actually felt sorry for the guy.

  John Lavorato was one of the more intense traders at Enron. Lavo, as he was known, was in his early 30s, just under average height, with a stocky ex-football player’s build and auburn hair. Although his gaze seemed perpetually fixed, he had a nervous tic, repeatedly grabbing the corner of his shirt when he spoke.

  If Lavo was nervous about his trading, other traders didn’t know it. He had moved to Houston after a successful stint running Enron’s trading operation in Canada, and he quickly became one of Enron’s most profitable traders, earning multimillion-dollar bonuses.

  According to fellow traders, Lavo was known for making huge profits and then keeping those profits in reserve for the future. One day his profit-and-loss statement would be zero, and then, suddenly, a multimillion-dollar gain would appear. These practices were unremarkable to other traders, who shrugged them off, saying only, “Oh, Lavo’s doing something again.” Indeed, Enron and Lavo argued that taking such reserves was standard practice.

  In fact, Lavo was far from alone. Numerous Enron traders hid their profits, saving them for the future. Their primary motivation in doing so was to smooth their trading profits over time. If they tucked away some profits, they could make a few million dollars of gain magically appear at some point in the future, to offset losses in a bad quarter. Traders who made smooth, consistent profits received bigger bonuses, because they were perceived as making more money per unit of risk. In aggregate, a trading operation that made smooth, consistent profits would be more highly valued in the market, for the same reason.

  The primary measure of the riskiness of Enron’s trading operation was Value At Risk, the statistical measure of the greatest amount of money Enron would expect to make or lose from all of its trading operations in a day, with a 95 percent level of confidence. For 2000, Enron reported a Value-At-Risk number for its trading operations of $66 million, meaning that investors could expect Enron to make or lose no more than $66 million on 95 percent of its trading days. Unfortunately, because VAR was based on historical data, it often understated risks, as Long-Term Capital Management’s use of VAR had demonstrated. Even worse, Enron’s VAR measure was based on the inordinately smooth profits its traders reported; in reality, the volatility of its trading operation was much greater. In fact, traders frequently made
and lost more than their reported VAR; on a single day during 2000, traders made $500 million.48 On December 12, 2000, they lost $550 million.

  Enron’s traders used two basic methods to manipulate their profits. Here is how they worked.

  First, some Enron traders used dummy accounts, called prudency reserves, to hide profits. Enron’s derivatives traders kept records of their profits and losses in a spreadsheet format. For some trades, instead of recording the entire profit in one column, traders split the profit into two columns. The first column reflected the portion of the actual profits the trader intended to add to Enron’s current income. The second column—labeled “prudency reserve”—included the remainder.

  To understand this concept of a prudency reserve, suppose a derivatives trader earned a profit of $10 million from a trade. Of that $10 million, the trader might record $9 million as profit today and enter $1 million into “prudency.” A trader might have prudency reserves of several million dollars.

  Enron’s prudency reserves did not depict economic reality, nor could they have been intended to do so. Instead, prudency was a slush fund that could be used to smooth out profits and losses over time. The portion of profits recorded as prudency could be used to offset any future losses.

  In essence, the traders were saving for a rainy day. Prudency reserves would have been especially effective for long-maturity derivatives contracts, because it was more difficult to determine a precise valuation as of a particular date for those contracts, and any prudency cushion would have protected the traders from future losses for several years going forward.

  As luck would have it, some of the prudency reserves turned out to be quite prudent. In one quarter, some derivatives traders needed so much accounting profit to meet their targets that they wiped out all of their prudency accounts.

  Saving for a rainy day is not necessarily a bad idea, and it seems possible that derivatives traders at Enron did not believe they were doing anything wrong. Prudency reserves, properly used, can be an accurate measure of the portion of the traders’ profit that they might not be able to collect from trading counterparties. However, that is not how Enron was using prudency reserves. Instead, its traders were misstating the volatility and current valuation of their trading positions, and thereby misleading the firm’s investors. Such practices thwarted the very purpose of Enron’s financial statements: to give investors an accurate picture of a firm’s risks.

  Even after numerous civil and criminal cases, it remains unclear who at Enron was aware of the use of prudency reserves. Traders said Enron’s president, Greg Whalley, was aware of the practices. Enron’s chief accounting officer, Richard A. Causey, claimed that he had informed Enron’s directors about prudency reserves, but the directors denied any such knowledge, as did Lay and Skilling.49 If Lay and Skilling did not know that their traders were hiding profits, they may genuinely have believed that Enron’s future profits would come from other areas, including its new technology business. On the other hand, how could Lay and Skilling have thought Enron was still profitable during the second and third quarters of 2001, as they claim to have believed, if they did not know about the huge profits from trading?

  The second method of misreporting derivatives positions at Enron was less brazen than prudency, and remains largely a mystery. In simple terms, Enron’s traders misstated their profits by mismarking forward curves—the various rates at which commodities were trading for delivery at specified future dates. For example, a natural-gas derivatives trader could commit to buy natural gas to be delivered in a few weeks, months, or even years. The rate at which a trader could buy natural gas in one year was the one-year forward rate. The rate at which a trader could buy natural gas in ten years was the ten-year forward rate. The forward curve for a particular natural-gas contract was simply a graph of the forward rates for all maturities.

  Forward curves are crucial to any derivatives-trading operation because they determine the value of a derivatives contract today, much as interest rates determine the value today of money to be received in the future. Like any firm involved in trading derivatives, Enron had risk-management and valuation systems that used forward curves to generate profit-and-loss statements.

  Forward curves in some markets were easily susceptible to manipulation; others were not. For example, the forward curve for short-term natural-gas contracts traded on NYMEX was publicly available every day. Anyone who wanted to check whether a trader had mismarked a NYMEX trade could simply look in the newspaper. In contrast, natural-gas contracts with a term of more than six years were traded in an over-the-counter market with no transparency, and only infrequent trading. Just as years-earlier traders at Wall Street banks such as Bankers Trust and Salomon Brothers had misvalued derivatives without being caught, Enron’s traders did the same in long-term natural-gas markets. At Enron, some forward curves remained mismarked for as long as three years.

  Moreover, because Enron’s natural-gas traders were compensated based on their profits, traders had an incentive to hide losses by mismarking forward curves. In some ways, prudency reserves and forward curves were two sides of the same coin. Traders who had made money might use prudency reserves, to reduce gains, in order to save profits for the next year; traders who had lost money might mismark forward curves, to create gains, in order to offset their losses. The extent of mismarking at Enron remains unclear, although several traders said the inaccuracies were more than a billion dollars.

  In some instances, a trader would simply manually input a forward curve that was different from the market, just as the officials from Cendant had typed false numbers into their spreadsheets. For more complex trades, a trader would tweak the assumptions in the computer model used to value the trades, in order to make them appear to be more valuable. Complex computer models were especially susceptible to mismarking, as had been illustrated by the 1994 collapse of Askin Capital Management, the firm that had used such models to value mortgage derivatives.

  Some traders even mismarked forward curves to understate their profits, as they had using prudency reserves. For example, one trader who already had recorded a substantial profit for the year, and believed any additional profit would not improve his bonus, reduced his recorded profits for that year, so he could push them forward into the next year, which he wasn’t yet certain would be as profitable.

  Enron’s auditors from Arthur Andersen did not carefully audit Enron’s forward curves. Instead, they took the forward curves as a given, and simply spot-checked the day-to-day change in the values of trades. Even then, the auditors failed to catch traders who suddenly moved forward curves by as much as three cents in one day—an adjustment that might not have seemed significant, but that nevertheless could impact profits by as much as $20 million.

  These rigged-valuation methodologies and false profit-and-loss entries were systematic, and occurred over several years, beginning as early as 1997. Like many employees of public corporations during the late 1990s, Enron derivatives traders faced intense pressure to meet quarterly earnings targets imposed directly by management, and indirectly by securities analysts who covered Enron. Enron’s risk-management manual instructed them that accounting numbers were more important than economic reality. It is not surprising, then, that traders manipulated the reporting of their “real” economic profits and losses in an attempt to fit the “imagined” accounting profits and losses that drove Enron’s increasing stock price.

  Interestingly, although Enron sought to avoid disclosing huge gains during the electricity crisis in California, the bulk of Enron’s trading gains were not from traders in its West region. Enron traders made more money trading in the Northeast, and made hundreds of millions of dollars in other regions. Nevertheless, it obviously was important to Enron officials that they not be perceived as profiting from the plight in California.

  Even given the inflated prudency reserves, Enron reported a profit increase of one-third during the last quarter of 2000, the peak of the California energy crisis.
Few people believed Jeff Skilling when he told analysts on a conference call, on January 22, 2001, “Now for Enron, the situation in California had little impact on fourth-quarter results. Let me repeat that. For Enron, the situation in California had little impact on fourth-quarter results.”50

  More than a year later, it was discovered that, in fact, Enron traders around the country had been profiting from trading strategies that took advantage of the situation in California. The fact that these strategies had names like “Death Star” and “Fat Boy” didn’t help Enron’s public relations, but experts concluded that the strategies were perfectly legal. For example, Enron traders sold California electricity out of state, where it was more valuable; they created the false appearance of congestion, which increased prices; and they bought power in California, sold it to out-of-state parties, repurchased it, and then sold it back into California at higher prices. One Enron trader, Timothy N. Belden, was charged with manipulating these markets in October 2002, and the Department of Justice was busily deposing other traders at the end of 2002.

  California officials expressed horror at these practices and disparaged Enron’s “greedy” traders. But being greedy was what traders were paid to do, and the opportunities for trading profits were created by legal rules in place in California, in particular, a cap on the price of in-state electricity. The poorly constructed regulatory system didn’t excuse illegal behavior, but it did explain its rationale. As one Enron trader put it, “It’s like if you were trying to sell your car and California puts a cap on car prices. But you’re thinking, ‘Hey, it’s worth more than that. There’s a guy in Nevada willing to pay three times as much.’ There’s no law in California against selling in Nevada. So what are you going to do? Suck it up and sell it in California? No.”51

  Notwithstanding the accounting games, Enron’s trading operations remained hugely profitable on paper—right up until the end. According to one source, Enron’s North American trading operations were up $2.9 billion during the first eight months of 2001, when Jeff Skilling resigned. Several sources confirmed that Enron made more than $1 billion in 2001 trading natural-gas derivatives alone. One trader, John Arnold, made an incredible $750 million in 2001—nearly three times Andy Krieger’s profits for Bankers Trust.52 Ironically, most of Arnold’s profit came during the third quarter of 2001, when Enron’s stock price was declining, as investors began to lose confidence, and when energy prices in California were falling, as the crisis calmed; fortunately for Arnold, he had bet billions of dollars that prices would fall.