What Was the Heart of Enron Keeps Shrinking
The New York Times
April 6, 2002
By MICHAEL BRICK
When the Enron Corporation
filed for
bankruptcy last December, its hopes
for salvation rested largely on how
much value it could extract from its
old trading desk, the source of nearly
all of its profits. Despite everything
else that had happened, Enron said,
its previous deals were still highly
valuable.
But every time Enron looks inside the trading book that holds its most important
secrets, it sees deals that are worth less and less. At the time of the bankruptcy
filing, Enron said the book's value had fallen from $12 billion to roughly $7 billion
after merger discussions with Dynegy (news/quote) broke down. That was plenty to
get a $1.5 billion loan from J. P. Morgan Chase and Citigroup
to help the company sustain itself for a while.
Since then, however, the book has become even thinner. While certain positions
have been sold, generating perhaps $570 million in cash, some creditors have been
shocked by just how much has vanished. The value, in fact, appears to have fallen
to a mere $1.3 billion in late January, according to a confidential deposition from
Jeffrey McMahon, Enron's new president, that was read aloud by an Enron lawyer
during a public hearing, but largely ignored and unreported at the time.
The book's value shrank so much, in part, because of changes in the market
during the fall and winter, including the removal of Enron as an active player. But
a factor at least as important is that the Enron energy trading desk, the envy of an
industry the company largely created, estimated the worth of its deals at levels that
were sometimes arbitrarily high for the sake of inflating profits, those who once
worked there now say.
Confidential documents produced by Enron for the
bankruptcy court show that the company's plans for
reorganizing, including paying debts created during the
bankruptcy, revolve almost entirely around generating
cash from Enron North America, the unit that housed the
trading desk and that still owns the book.
Over an 18-month period that began in January, Enron
said that it planned to generate about $3.6 billion,
including $3.1 billion from liquidations of Enron North
America's assets.
Enron has sold the trading desk to the Swiss bank UBS
for a percentage of the profits it generates, rising from 33
percent to 45 percent over 10 years. The Blackstone
Group, Enron's adviser on the deal, has estimated that
Enron's stake could be worth as little as $40 million or as
much as $2.87 billion.
Then there is the book, filled with an undisclosed number
of swaps, collars, futures contracts and other deals that
the traders entered on Enron's behalf before the sale to
the UBS Warburg unit of UBS.
Some creditors hold out hope that Enron is merely trying
to lower expectations with its estimates of the book's
value. "It doesn't hurt them to lowball it, to set everybody's
expectations low," said Daniel W. Sklar, a lawyer for
several energy companies.
The shrinking book is particularly confounding because
when Enron North America filed its own bankruptcy
petition, it actually appeared to be solvent. It had $13.7
billion in assets and $8.8 billion in debts. The debt
disclosure included a footnote that said the figure did not
reflect off-balance-sheet and contingent obligations.
Mr. McMahon said in his confidential deposition,
according to the company's lawyers, that at the time the
book included 768 open contracts worth $1.3 billion. By
open, he meant contracts that Enron had identified as
risks it must make new trades to cover.
In all, the trading book retained by Enron contains "tens
of thousands of contracts of varying lengths on the entire
spectrum of commodities, including natural gas, power,
paper, metals, crude oil, petroleum products, plastics,
etc.," Eric Thode, an Enron spokesman, said in a written
response to questions. The next indication of the book's
value may come from an auction of certain contracts that
Enron has scheduled for later this month.
The shrinkage in the value of the book has left many of
Enron's trading partners frustrated. "We don't know who's
running this book," said George K. Hickox, chief executive
of the Wiser Oil Company , an oil and gas
producer based in Dallas that had 15 delivery contracts
with Enron, which were worth $6 million at the time of the
bankruptcy filing. "We don't know who's running Enron
North America."
An employee who worked on the trading desk is
re-evaluating the book, examining each deal and making
new, lower estimates based on a variety of factors,
according to former trading desk workers. Mr. Thode said
that "there are a number of employees involved in the
various activities related to our trading book."
Trading companies keep their books secret because the deals represent obligations
to buy and sell energy in the future - details that traders hope to use to their
advantage as they manage their portfolios.
Even before the bankruptcy, some of Enron's traders realized that the book's value
was about to plunge. At an emergency meeting in October, two top executives,
Mark A. Frevert and Greg Whalley, said that the trading desk had to change its
accounting practices because the company was perilously short of cash. At the
time, the two men formed Enron's office of the chairman with Kenneth L. Lay, the
former chairman and chief executive. Mr. Whalley, who now runs the trading
operation for UBS Warburg, declined to comment. Mr. Frevert, who also has left
Enron, did not return calls seeking comment.
Until then, according to former traders and trading desk managers, some of whom
work for other energy trading companies, including the new desk at UBS Warburg,
the desk had focused on generating reportable net income. It structured deals to
that end - sometimes at the expense of generating immediate cash, and in the
process sometimes inflating the value of trades.
"Mark Frevert said, `Before, cash flow wasn't important, it was always earnings,' " a
manager on the trading desk who attended the meeting said. "Now we were going
to have to have a whole new paradigm."
Standard practices in energy trading gave Enron considerable latitude in valuing
deals.
First, reported profits were based on long-term trades that would not actually
generate cash for many years. Second, the value of those trades was largely based
on the traders' own speculation, in an environment where the traders' bosses were
rewarded for higher reported profits.
The trading desk used mark-to-market accounting, a system in which a potential
long-term stream of revenue can be booked immediately and counted toward net
profits.
Because Enron was dealing in commodities where there was no established public
market to set prices, a trader had to decide on a price curve - the expected
direction of prices in the future - on which to value each deal in the present.
"The further out you go on a forward curve, the values are less known," one trader
said. "The further out you go, there is some potential that there's a less objective
value."
Some traders took advantage of this subjectivity to set unreasonably high curves,
and later to change those curves to establish even higher values, which they could
report as profits immediately, a former manager on the trading desk said.
"The curve moved constantly," this manager added, "especially toward the end of
the quarter, to generate reported income."
Mr. Thode, the Enron spokesman, did not deny that Enron engaged in such
conduct. "Rumors of this nature are included in various lawsuits, and regulatory
and Congressional investigations," he said. "Enron is cooperating with these
investigations and providing the necessary data through required disclosures in
the lawsuits."
One routine practice was known as blending and extending - effectively adding
years to the life of a successful long-term deal by forgiving short-term obligations. It
allowed the traders to report higher profits right away for all of the extra future
value they created by extending a deal.
The practice was encouraged, company executives said, by Jeffrey K. Skilling, who
ran Enron's trading operation before rising to president in 1997 and ultimately
chief executive last year. The practice, however, involved a good deal of risk because
it basically turned a demonstrably successful trade into a speculatively promising
loan.
"We did it over and over," one former trader said, "because Skilling said cash flow
doesn't matter." A spokeswoman for Mr. Skilling, Judy Leon, declined to comment.
At UBS, many of Enron's old traders have a new home with a solid credit rating.
Still, to resume operations, they must sign credit agreements with trading
partners; one obstacle is that many large trading companies are owed money by
Enron.
"Our focus is on re-establishing the business, and that's going as expected," said
David Walker, a UBS spokesman.
As for the old book, Mr. Thode said, "Enron is working with our creditors to
maximize the value of all Enron assets."NY Times: What Was the Heart of Enron Keeps Shrinking
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