The Smartest Guys in the Room: The Amazing Rise and Scandalous Fall of Enron (43 page)

When a company was trying to decide which investment-banking firm to choose for an IPO, for instance, analysts would accompany the bankers, and help pitch the business. More important, analysts would promise to produce favorable research on the company once it went public. Without question, an analyst who made this promise was betraying investors to help his firm land banking fees. And in the aftermath of the bull market, analysts were raked over the coals for having done so. (Both Blodget and Grubman were fined millions of dollars and barred from the securities industry for life.) But in the late 1990s, any analyst who spent much time worrying about the obvious conflict wouldn’t be a Wall Street analyst for very long.

Over time, many companies came to
expect
buy recommendations from analysts; it was often a prerequisite for getting banking business. And the more banking business a company did, the more leverage it had over the analysts who covered it. Enron, which paid some of the highest investment-banking fees in corporate America, had an immense amount of leverage, which it used shamelessly. “Enron has a simple attitude: ‘We do over $100 million of investmentbanking business a year. You get some if you have a strong buy,’ ” says one analyst. Among investors and analysts, one story in particular became part of the Enron legend. It was a cautionary tale about what happened when an analyst refused to play along.

The analyst in question was John Olson; in the late 1980s, he covered Enron for Credit Suisse First Boston. Although CSFB did a good deal of banking business with Enron, Olson had stubbornly stuck a hold rating on the stock—which, as everyone on Wall Street knows, is a polite way of saying sell. Olson also had a habit of asking persnickety questions that made his feelings about the company clear, which Enron also didn’t like.

Ken Lay had complained to the CSFB investment bankers—led by a man named Rick Gordon—about Olson, but the issue didn’t explode until the fall of 1990, when
Forbes
published Olson’s five top stock picks. Enron was not one of them. “They weren’t earning enough to pay their dividend,” Olson recalls. Lay was furious that Olson hadn’t recommended Enron to
Forbes,
and Gordon, who did not think that Olson was an “effective advocate of the [Enron] story,” made it clear that he wanted things to change. Gordon today denies pressuring Olson, but others saw it differently. “At First Boston, the analysts knew they’d get whacked if they got out of line,” says a former member of Gordon’s team. Although Olson felt he had the support of senior executives, he also knew that the growling from the investment bankers would make his life miserable. So when Goldman Sachs came calling, he leaped at the opportunity.

Olson stayed at Goldman for less than two years before receiving a lucra-
tive offer from Merrill Lynch. It was an ill-fated move. In March 1993, some six months after Olson was hired, Merrill hired Rick Gordon and his team of Houston-based energy investment bankers, including his top deputy, Schuyler Tilney. “He ran from us and we caught him!” says the former member of Gordon’s team gleefully. Gordon quickly became one of a handful of the most influential Merrill executives; he knew Ken Lay socially. But Olson was still lukewarm on Enron, and as a result, Merrill got less than its proportionate share of Enron business. Even so, at the time, Merrill still had a reputation for protecting its analysts from its bankers. Olson kept his job.

He kept it, that is, until 1998, when Merrill was about to be left out of one of Enron’s last equity offerings. On the evening of April 17, Fastow called Gordon and Tilney to give them the news. He said that the decision to leave Merrill out was “based solely on the research issue and was intended to send a strong message as to how ‘viscerally’ Enron’s senior management” felt about John Olson, according to a Merrill Lynch memo. The Merrill bankers felt that it would be deeply embarrassing to be excluded from a deal that size.

The next day, Gordon and Tilney wrote a memo to Merrill’s president, Herbert Allison, complaining about Olson. “He has a poor relationship with Jeff [Skilling] and, particularly, Ken [Lay],” they wrote. “John has not been a real supporter of the company, even though it is the largest, most successful company in the industry.” Enron, they added, complained that Olson’s research was “flawed” and said that Olson often made “snide and potentially embarrassing remarks” about the company. Gordon and Tilney also pointed out that every firm that was going to get a fee from the equity offering had a buy rating on the stock. Allison quickly called Lay, and Merrill got a slice of the business. “We never leaned on Olson,” insists Gordon. “Frankly, having worked with him at First Boston, it wouldn’t have worked anyway.” But that summer, Olson was fired. (Tilney soon took over the energy group from Gordon, who was retiring.)

As for Olson, he wound up at a small Houston firm called Sanders Morris Harris, where he remained mostly skeptical about Enron’s prospects. On the wall of his office is a framed letter sent by Ken Lay in early 2001 to Olson’s boss, Donald Sanders. “Don—John Olson has been wrong about Enron for over 10 years and is still wrong. But he is consistant [
sic
]. Ken.” (Olson says, “I may be old and worthless, but at least I can spell the word consistent.”) At Merrill, Olson was replaced by an analyst named Donato Eassey—who, while more cautious about Enron than many of his peers, started his coverage with an accumulate on the stock. Though Eassey did downgrade the stock when he felt it was warranted, he also wrote paeans to Enron’s “culture that stresses innovation, competition, and unrelenting drive . . . an impressively deep resource of some of the best and brightest minds around.”

“Enron had Wall Street beaten into submission,” says one portfolio manager. “You know that term, ‘regulatory capture’?” asks Andre Meade, who covered Enron for Commerzbank. “ ‘Analyst capture’ is probably a legitimate term.”

 • • • 

On a human level, it’s understandable, though still troubling, that analysts and investors lost their heads as Enron’s stock price spiraled ever upward. It takes discipline not to develop a rooting interest in a stock you own or follow. But there was one group of watchdogs that should have had that discipline, that should have been able to remain aloof from Enron’s rising stock price and even unimpressed by it. Those were the analysts who work for the nation’s two major credit-rating agencies, Moody’s and Standard & Poor’s. Credit-rating analysts are not supposed to care about stock prices or about earnings per share or about astronomical revenue growth. They’re supposed to care about one thing only: the ability of a company to generate enough cash to pay back its debt. How could they have failed to point out the risks in Enron’s jerry-built financial structure?

To understand how important the rating agencies were to Enron, you first have to understand a little about the odd role that they have come to play during their nearly one hundred years of existence. A 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. And that’s not all. Credit ratings have become woven into the very framework of the capital markets. The office of the comptroller of the currency uses them to determine the capital adequacy of banks. Certain money-market funds and pension funds use ratings to determine which bonds are safe to own.

If a bond falls below a level known as investment grade, some investors
have
to sell it. A downgrade by the agencies can cause a company to default on its loan agreements with its banks; it may also act as a trigger in structured finance deals that requires the immediate repayment of debt. (This was the case, for instance, in Enron’s Whitewing transaction.) Precisely because a downgrade can have such dire consequences, the credit rating agencies are often slow to act, critics say; many times, the market passes judgment long before the rating agencies do. The agencies respond that their job is to take a long-term view rather than react to every vicissitude. Even so, their analysts are supposed to be ever-vigilant for signs that a company is running into trouble. Unlike stock analysts, they have no built-in conflict of interest. That’s what they’re paid to do.

For Enron, maintaining an investment-grade credit rating was even more important than getting buy recommendations from Wall Street analysts. Enron’s credit rating was the lifeblood of its trading business. Whalley later said that Enron’s “business model [did not] exist below investment grade.” By doing business with Enron, all its counterparties were, in effect, accepting its credit. After all, if you enter into a ten-year gas swap with a company, you want to know that company is going to be around for ten years. It is virtually impossible to operate a trading business without an investment-grade credit rating; to do so would require providing enormous amounts of collateral. Most Wall Street firms have, at a minimum, an A rating. (The best rating, held by about a dozen companies, is AAA.) As early as October 1993, Enron’s board discussed the “importance of achieving an A debt rating” to support its trading operations.

But to get an A rating would have meant, at the very least, cutting debt, controlling costs, and funding fewer big enchiladas, and that Enron was not willing to do. The highest rating Enron achieved was BBB+, just a few notches above junk-bond status. And though Enron told the agencies that it would do whatever necessary to boost its credit rating, the truth is that the company deliberately walked a dangerous line. As Skilling told employees in October 2000, in a rare moment of candor about the company’s debt rating: “We want to be as leveraged as we can be and still keep that credit rating . . . last year, we were on the ragged edge, as we are every year.”

Of course, that wasn’t the story Enron told Moody’s and Standard & Poor’s. Fastow and other members of Global Finance made repeated visits to New York over the years to urge the agencies to upgrade Enron. In a January 29, 2000, presentation given by Jeff McMahon, Enron offered a David Letterman–like top-ten list of why it deserved an upgrade. The number one reason: “Enron’s credit rating is critical to the maintenance and growth of its existing dominant market share business.” (Translation: It’s important to us; therefore we should have it.) Enron also cited its “no secrets policy” with analysts, investors, and credit officers and added that it “proactively manages its balance sheet to achieve target rating.”

It’s not unusual for companies to meet with the credit-rating agencies. What was unusual is the extent to which Enron saw the agencies as just another part of the system it could game. Agency analysts have certain criteria they use to measure a company’s health, ratios such as cash flow to interest expense and total debt compared with total assets. If a ratio was in balance, it was easy for the analysts to simply check it off and move on to the next one. In fact, a big part of the reason Enron used structured finance was to show the credit analysts the ratios they wanted to see. And if the analysts didn’t ask precisely the right question to get under the smooth surface, well, then, Enron wasn’t about to give a meaningful answer.

A presentation that Ben Glisan and another Global Finance executive gave as an educational seminar to accountants at PricewaterhouseCoopers offered a perfect illustration. It was entitled “Enron: Managing Off-Balance-Sheet Financing.” The “key takeaways”: “Equity and debt analysts generally ‘appreciate’ structures. Debt analysts understand credit effects—can give ‘equitylike’ credit for ‘debtlike’ transactions. Equity analysts understand income statement effects—can give favorable recommendations based on strong ratios/profits. However, the best off-balance-sheet transactions are ‘seamless’ (e.g., the public is not even aware of the full benefits/ramifications).”

Later, the rating agencies said that Enron duped them. S&P analysts claimed that they didn’t know that Enron’s prepays—which were a huge tool in showing the agencies the cash flow they wanted to see—were really just disguised loans. Moody’s analysts claimed that they didn’t know about the existence of the prepays at all; if they had, Enron would have had a junk rating. The rating agencies also point to an Enron document called the “kitchen sink” analysis, which they say was supposed to contain a list of all of Enron’s off-balance-sheet debt. The prepays are not included. The S&P analysts also claimed that they didn’t know about LJM or Fastow’s involvement in the fund. When investigators pointed out that both of those items had been disclosed in Enron’s publicly filed 1999 proxy statement, the S&P analysts responded, incredibly, that they had not read the document. At least the Moody’s executives didn’t make that claim; to Enron executives, one Moody’s analyst used to privately joke about LJM, calling it “Andy’s secret fund.”

Enron executives heatedly dispute the notion that they misled the rating agencies. “Lying sons of bitches,” says one former senior Enron executive. He claims that the credit analysts knew full well what the prepays were and how they were booked; he also says that the kitchen sink analysis, despite the name, was not represented as showing all of Enron’s debt.

In any case, the agencies had no illusions about Enron’s substantial off-balance-sheet debt or its “aggressive use” of structured finance, a term used by S&P analyst Ron Barone (no relation to the equity analyst Ron Barone who covered Enron). Nor did they have any illusions about the complicated nature of Enron’s business. In fact, Enron used to joke about it with the agencies. One slide in that January 2000 presentation features a cartoon character saying: “Can they make a more confusing annual report? Hmmm . . . off-balance-sheet debt, structured finance, nonrecourse debt, guarantees.” And if the agencies didn’t know about all of Enron’s off-balance-sheet debt, they knew about a great deal of it. They rated it, after all.

The agencies argue that Enron’s BBB+ rating appropriately reflected all of these risks, that it was Enron’s lies that caused the problem. But even that doesn’t excuse their optimism. They are supposed to scrutinize a company’s publicly filed financial statements, footnotes included. And if they didn’t understand some-
thing, they certainly had the leverage to get more information. “We are hard-pressed to recall a situation where the rating agencies held so much sway over a company and had such commanding leverage to extract information and yet were so ineffective at doing so,” Glenn Reynolds, the CEO of an independent credit-research firm called Credit Sights, later told Congress. Yet even as Enron’s debt ballooned, as the related-party disclosures in its financial statements grew longer and more incomprehensible, as the numbers got ever bigger, as more and more profits came from the inherently volatile trading operation, the agencies didn’t sound the alarm.