This chart demonstrates four key facts. First, the recent and dramatic increase in Enron's overall non-derivatives revenues - the statistic that supposedly made Enron the seventh-largest U.S. company - was offset by an increase in non-derivatives expenses. The increase in revenues reflected in the first line of the chart was substantially from EnronOnline, and did not help Enron's bottom line, because it included an increase in expenses reflected in the second line of the chart. Although Enron itself apparently was the counterparty to all of the trades, EnronOnline simply matched buyers ("revenue") with sellers ("expenses"). Indeed, as non-derivatives revenues more than tripled, non-derivatives expenses increased even more.
Second, a related point: Enron's non-derivatives businesses were not performing well in 1998 and were deteriorating through 2000. The third row, "Non-derivatives gross margin," is the difference between non-derivatives revenues and non-derivatives expenses. The downward trajectory of Enron's non-derivatives gross margin shows, in a general sense, that Enron's non-derivatives businesses made some money in 1998, broke even in 1999, and actually lost money in 2000.
Third, Enron's positive reported operating income (the last row) was due primarily to gains from derivatives (the fourth row). Enron - like many firms - shied from using the word "derivatives" and substituted the euphemism "Price Risk Management," but as Enron makes plain in its public filings, the two are the same. Excluding the gains from derivatives, Enron would have reported substantially negative operating income for all three years.
Fourth, Enron's gains from derivatives were very substantial. Enron gained more than $16 billion from these activities in three years. To place the numbers in perspective, these gains were roughly comparable to the annual net revenue for all trading activities (including stocks, bonds, and derivatives) at the premier investment firm, Goldman Sachs & Co., during the same periods, a time in which Goldman Sachs first issued shares to the public. The key difference between Enron and Goldman Sachs is that Goldman Sachs seems to have been upfront with investors about the volatility of its trading operations. In contrast, Enron officials represented that it was not a trading firm, and that derivatives were used for hedging purposes. As a result, Enron's stock traded at much higher multiples of earnings than more candid trading-oriented firms.
The size and scope of Enron's derivatives trading operations remain unclear. Enron reported gains from derivatives of $7.2 billion in 2000, and reported notional amounts of derivatives contracts as of December 31, 2000, of only $21.6 billion. Either Enron was generating 33 percent annual returns from derivatives (indicating that the underlying contracts were very risky), or Enron actually had large positions and reduced the notional values of its outstanding derivatives contracts at year-end for cosmetic purposes. Neither conclusion appears in Enron's financial statements.
IV. Conclusion
How did Enron lose so much money? That question has dumbfounded investors and experts in recent months. But the basic answer is now apparent: Enron was a derivatives trading firm; it made billions trading derivatives, but it lost billions on virtually everything else it did, including projects in fiber-optic bandwidth, retail gas and power, water systems, and even technology stocks. Enron used its expertise in derivatives to hide these losses. For most people, the fact that Enron had transformed itself from an energy company into a derivatives trading firm is a surprise.
Enron is to blame for much of this, of course. The temptations associated with derivatives have proved too great for many companies, and Enron is no exception. The conflicts of interest among Enron's officers have been widely reported. Nevertheless, it remains unclear how much top officials knew about the various misdeeds at Enron. They should and will be asked. At least some officers must have been aware of how deeply derivatives penetrated Enron's businesses; Enron even distributed thick multi-volume Derivatives Training Manuals to new employees. (The Committee should ask to see these manuals.)
Enron's directors likely have some regrets. Enron's Audit Committee in particular failed to uncover a range of external and internal financial gimmickry. However, it remains unclear how much of the inner workings at Enron were hidden from the outside directors; some directors may very well have learned a great deal from recent media accounts, or even perhaps from this testimony. Enron's general counsel, on the other hand, will have some questions to answer.
But too much focus on Enron misses the mark. As long as ownership of companies is separated from their control - and in the U.S. securities market it almost always will be - managers of companies will have incentives to be aggressive in reporting financial data. The securities laws recognize this fact of life, and create and subsidize "gatekeeper" institutions to monitor this conflict between managers and shareholders.
The collapse of Enron makes it plain that the key gatekeeper institutions that support our system of market capitalism have failed. The institutions sharing the blame include auditors, law firms, banks, securities analysts, independent directors, and credit rating agencies.
All of the facts I have described in my testimony were available to the gatekeepers. I obtained this information in a matter of weeks by sitting at a computer in my office in San Diego, and by picking up a telephone. The gatekeepers' failure to discover this information, and to communicate it effectively to investors, is simply inexcusable.
The difficult question is what to do about the gatekeepers. They occupy a special place in securities regulation, and receive great benefits as a result. Employees at gatekeeper firms are among the most highly-paid people in the world. They have access to superior information and supposedly have greater expertise than average investors at deciphering that information. Yet, with respect to Enron, the gatekeepers clearly did not do their job.
One potential answer is to eliminate the legal requirements that companies use particular gatekeepers (especially credit rating agencies), while expanding the scope of securities fraud liability and enforcement to make it clear that all gatekeepers will be liable for assisting companies in transactions designed to distort the economic reality of financial statements. A good starting point before considering such legislation would be to call the key gatekeeper employees to testify.
Congress also must decide whether, after ten years of steady deregulation, the post-Enron derivatives markets should remain exempt from the regulation that covers all other investment contracts. In my view, the answer is no.
A headline in Enron's 2000 annual report states, "In Volatile Markets, Everything Changes But Us." Sadly, Enron got it wrong. In volatile markets, everything changes, and the laws should change, too. It is time for Congress to act to ensure that this motto does not apply to U.S. financial market regulation.
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