The Smartest Guys in the Room: The Amazing Rise and Scandalous Fall of Enron (29 page)

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There are several different ways to think about Andy Fastow’s deals. One is in terms of what was disclosed. Contrary to popular belief, many of the entities Enron created to play its financial games were not only revealed in the company’s publicly filed financial documents but were things Fastow was only too happy to boast about. Wall Street analysts often mentioned the company’s “innovative” financing tools in their reports. Credit-rating agencies knew about much of Enron’s off-balance-sheet debt. But there were other deals in which the circle of outsiders in the know was small—and the disclosure in Enron’s financial documents was purposely vague—because Enron knew that real disclosure would raise too many questions. And finally, there were deep, dark secrets that no one knew about except Fastow and his closest associates, including Kopper and Glisan.

A second way to think about the deals is in terms of their purpose. 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. What made Enron’s transactions so bewildering was not their purpose so much as their sheer multiplicity. Enron would mutate every vehicle it created to strip more and more accounting benefits from it and would often use one vehicle as a building block for another, so that unraveling one transaction would mean unraveling a half-dozen others. “It looks like some deranged artist went to work one night,” is how Enron’s postbankruptcy CEO, Steven Cooper, summed up the resulting tangle.

To see how Enron used these building blocks—and how they mutated in complexity—consider a structure called Whitewing. Whitewing began life in December 1997 as something called 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. Enron borrowed $579 million from Citigroup and then raised another $500 million, mostly debt from an entity affiliated with Citi, plus a sliver of equity from other investors. Whitewing, in turn, used this money to buy $1 billion in Enron preferred stock. (The remaining $79 million was used to help pay the investors their return.)

The Whitewing structure was not a secret—it was disclosed in Enron’s financial statements—but the $500 million showed up on the financial statements not as debt but as a minority interest in a joint venture. “The primary purpose of the transaction had been to convert debt to equity” is how corporate treasurer Jeff McMahon later described the transaction to Enron’s board. That was true only in a technical sense. The $500 million hadn’t been converted; it had only been disguised. Enron was still responsible for paying the money back. This was one of the first times that Enron used its stock—the value of the preferred shares in Whitewing—to support an off-balance-sheet financing. It was not the last.

This time, the bet on Enron stock was highly successful. Within a few years, the value of the preferred stock Whitewing owned had risen substantially. So Fastow’s team decided to pay back Citigroup, issue yet more debt, and remove Whitewing from Enron’s balance sheet altogether. It did so in a fall 1999 deal that Ben Glisan put high on his list of accomplishments for that year. In order to move Whitewing off its balance sheet, Enron needed more independent equity. So it created an entity called Osprey, which, through yet another entity, raised $100 million in “equity” (actually, certificates that paid a fixed return) from various banks and insurance companies. At least $1 million of that supposedly independent money came from a handful of investment bankers at Donaldson, Lufkin & Jenrette, the firm that was paid to sell the deal. Then, Osprey sold another $1.4 billion in debt to institutional investors. That $1.5 billion was used to buy a “limited partnership interest” in Whitewing. Under accounting rules, Whitewing now qualified for off-balance-sheet treatment: it was partly owned by that ostensible third party, Osprey. About one-third of the new money went to pay back Citigroup’s original Whitewing loan. The remainder was set aside to purchase assets from Enron. Whitewing was precisely the kind of vehicle that Fastow’s Global Finance team marketed internally to help business units meet their financial goals.

And what was supporting that $1.4 billion in debt? (Which was also not a secret: in fact, the credit rating agencies
rated
that debt.) Mainly, it was the value and dividends from the Enron preferred stock plus the value of the assets Whitewing bought. But that wasn’t all. Enron also promised that if the assets in Whitewing weren’t sufficient to pay back the money—which would come due in early 2003—it would make up the difference by issuing stock. And if it couldn’t issue enough stock, it would pay cash. There were also triggers built in to reassure investors: If Enron’s credit rating fell below investment grade and, in addition, its stock fell below $28, the investors could demand to be paid back immediately. In other words, although the Osprey debt was technically off-balance-sheet, investors and rating agencies knew that the obligation ultimately belonged to Enron. As if there was any doubt about whose debt it really was, all they had to do was flip open the Osprey offering document, which is all about . . .
Enron.
Later, in 2000, Osprey sold approximately $1 billion in additional debt. As part of the inducement to new investors, Enron raised the trigger price on its stock to $59.78.

Thus was Enron stock supporting a pool of debt that was being used to buy Enron’s assets and create cash flow. If that sounds like impossibly circular logic, in commonsense terms it was. According to the court-appointed examiner in the Enron bankruptcy case, the company used the Whitewing structure to buy at least $1.6 billion in assets from various divisions in the company. The examiner also says that Whitewing was, in effect, used to refinance hundreds of millions in Enron debt.

Another kind of minority-interest transaction took place toward the end of 1999, when Enron was desperate to show cash flow. In a deal called Project Nahanni, Enron, in essence, borrowed $485 million from Citigroup and raised a sliver of equity ($15 million) through a minority-interest financing, used that money to buy Treasury bonds, sold the Treasury bonds, and booked the proceeds as cash flow from operations under the pretext that buying and selling bonds was part of Enron’s day-to-day business. That $500 million represented a staggering 41 percent of the total $1.2 billion in operating cash flow that Enron reported that year. Then, right after the first of the year, when the camouflage was no longer necessary, Enron repaid Citi. Over the years, there were many more minority-
interest financings, with names like Rawhide, Choctaw, and Zephyrus, all done with Wall Street’s help, that allowed Enron to pretty up its financial statements.

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A second tool Enron relied on was Skilling’s old friend, securitization (which is also known by the accounting statute, FAS 140, that governs it). By the late 1990s, securitization was no longer considered an exotic form of financing. All kinds of companies were using securitizations for all kinds of purposes. Banks, of course, securitized credit card loans, and retail companies securitized receivables. Composers were also securitizing song royalties; states were securitizing the proceeds from tobacco litigation. Anything, it sometimes seemed, could be securitized. The point of the exercise had not changed: 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 gained popularity, new wrinkles developed. One of the most important ones was 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.

But if the companies themselves set up the SPEs, what exactly constituted independence? Amazingly, the rules developed by the accounting gurus stated that as long as 3 percent of the capital in the SPE came from an independent source and was truly at risk—meaning that it could all be lost if the deal went awry—the SPE qualified as independent. In other words, even if 97 percent of the capital consisted of debt raised by the company selling the assets, the company didn’t have to include that debt on its balance sheet. (Don’t search for the logic behind the 3 percent threshold. There isn’t any. For years, there were some, including a few high-ranking accountants at Arthur Andersen, who argued that 3 percent was absurdly low.) Ken Lay later told investigators that while he could read a balance sheet, he did not understand the accounting requirements for SPEs until October 2001.

But though most of Enron’s SPEs technically included the 3 percent of independent money, in fact, its entities were rarely truly independent. Enron gave implicit—sometimes explicit—guarantees that it would take care of the lenders. In addition, Enron often tossed a derivative called a total return swap into the mix. This security, in essence, meant that Enron guaranteed the investor a debtlike return; in exchange, Enron kept almost all of the real return. (Adding a classic Enron twist, the company would then mark-to-market the estimated value that it expected to receive from the asset.) To put it another way, Enron had “sold” something and booked earnings and cash flow from the “sale.” But the asset wasn’t truly gone; now there was a big slug of additional debt that had to be paid back within a few years. The court-appointed bankruptcy examiner later concluded that much of Enron’s liquidity was the “result, in effect, of loans to Enron for which Enron retained the ultimate liability.” He also contends that Enron did not properly disclose that liability to investors. People in RAC called these deals “boomerangs.”

Over time, Enron securitized just about everything that wasn’t nailed down—fuel-supply contracts, shares of common stock, partnership interests—and even some things that
were
nailed down. For instance, Enron securitized the profits it expected to generate from many of Rebecca Mark’s international assets, including plants in Puerto Rico, Turkey, and Italy. In total, from 1997 to 2000, according to one analysis, Enron booked $366 million in net income from such power-plant securitizations.

Securitization, at least the way Enron did it, provided a great short-term boost. But as with so many other Enron deals, it created ticking time bombs of debt, debt that was rarely supported by the true value of the asset, because it was often based on unreasonably optimistic assumptions about what would happen over a period of years. “It was a purported sale, but it looked and smelled like a financing,” as a former Enron International executive puts it. It also created holes for the future. After all, 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,” says one Enron executive. “If shareholders understood the extent to which the future was being mortgaged . . .” ponders another. At the time of its bankruptcy, Enron had over $2 billion in off-balance-sheet debt related solely to securitizations.

While securitizations generated both cash and earnings, cash was too critical to the company to be a mere by-product. So Global Finance had a separate area that specialized in creating cash flow. As early as 1997, for instance, Enron came up with a convoluted way to raise cash by “selling” some of the gas stored in its huge Bammel facility to an SPE backed by Enron guarantees. The result: $152 million in cash, 72 percent of the total cash that Enron’s operations generated in 1997.

The most important of Enron’s cash-generating devices, though, was something called a prepay. The Enron bankruptcy examiner later called prepays the company’s “quarter to quarter cash flow lifeblood.” While there were many variations on the theme, here’s how a typical one worked: Enron would agree to deliver natural gas or oil over a period of time to an ostensibly independent offshore entity that was, in fact, set up by one of its lenders. The offshore entity would pay Enron up front for these future deliveries with money it had obtained from the lender. The lender, in turn, agreed to deliver the same commodity to Enron; Enron would pay a fixed price for those deliveries over a period of time.

On the surface, these looked like separate transactions. But in reality, the commodity part of the deal canceled out, leaving Enron with a promise to pay a lender a fixed return on money it had received. In other words, it looked suspiciously like a loan with interest. Nevertheless, Enron listed prepays not as debt but as trading liabilities that were supposedly offset by trading assets. And although there are Enron finance executives who to this day claim that prepays
were
trading liabilities, one would be hard pressed to find an independent observer who would agree that they shouldn’t have been classified as debt on Enron’s books. The Enron bankruptcy examiner certainly didn’t view them as legitimate. “These delivery requirements went from party to party around a circle with the result that the apparent assumption of price risk was illusory,” he wrote in a report released in March 2003. “Thus, the transactions were in substance debt, funded by either large financial institutions or institutional investors.”

Enron, which began using a version of prepays as early as 1992, quickly got hooked. According to an analysis done by the Senate Permanent Subcommittee on Investigations, Enron engaged in $8.6 billion (and possibly much more) of these transactions, mainly with a Chase Manhattan–sponsored entity located in the Channel Islands known as Mahonia and a Citigroup-backed entity called Delta. Not incidentally, these were lucrative deals for the banks: the
Wall Street Journal
estimated that Chase earned as much as $100 million in fees and interest from these deals.