Chapter 9 Enron: Poster Boy for Ultra-Capitalism

The rich and powerful too often bend the acts of government to their selfish purposes, many of our rich men have not been content with equal protection and equal benefits, but have besought us to make them richer by acts of Congress.^[1]

President Andrew Jackson, 1830

Enron moved on many fronts in a wild ride of undisciplined capitalism to its record bankruptcy in 2001. Besides the original gas business formed in 1985 with the merger of several companies, Enron became the biggest trader in energy contracts and expanded into other commodities, including natural gas, paper, metals, crude oil, petroleum products, plastics, and strange areas like advertising, weather, and credit. This was the “asset light” business that CEO Ken Lay hired Jeffrey Skilling to manage. At the same time, Lay entrusted Rebecca Mark with selling, building, and managing major projects around the world, including gas, water, steel, and power. The internal reason for Enron’s failure, thus was Lay’s incompetence, for he committed Enron to an oversized task beyond their capacity to manage. The Board of Directors failed to recognize this imbalance and so failed to protect the shareholders.

After 1996, annual losses on many projects caused already thin profit margins almost to disappear. Chief Financial Officer Andrew Fastow was challenged to find ways to hide the losses, protect the high stock price and investment grade rating, and keep the borrowed money flowing in. Enron’s true financial condition became apparent in 2001, the same year that both the stock market and oil prices were going down, and the company imploded. The outside auditors, Audit Committee of the Board, rating agencies, and stock analysts, all failed to provide early warning of the deteriorating financial condition.

The external reason for Enron’s failure was that government regulated banks kept pumping billions of dollars of good money into bad loans and bad deals at Enron. Easy credit and lack of sensitivity to the quality of loans had become dramatically worse during the last quarter of the twentieth century when the banking system was deregulated, market disciplines suspended, excessive volatility and liquidity introduced by government mistakes (see chapter 7), and electronic banking mushroomed in size, speed, and variety.

A nation supports economic growth by controlling currency and credit for the benefit of the general welfare by keeping money neutral, nonvolatile and patient. This mission can be accomplished through either free banking, national banking, or a combination of private and public banking. Free banking is monitored by market disciplines, and it had worked that way in Scotland at the time of Adam Smith when bad loans were punished locally, quickly, and visibly. Governments, however, do not trust private bankers with the opportunity to concentrate wealth for personal benefit, so they establish national banking in which the government has direct control of currency and credit. Private bankers, however, do not trust government with the opportunity to print money and debase the currency and use the need of their lending in times of crisis to influence government. Because private banking in the United States was not able to prevent recurring capital crises, the banking system was made partly public in 1913 with the establishment of the Federal Reserve Board. By the end of the twentieth century this compromise resulted in a banking system that was the worst of both worlds. On the one hand, the bankers had growing privileges to concentrate wealth in record amounts, on the other hand, the government assumed the obligation to bail out the bankers after the inevitable crises.

Financial crises are inevitable when two economic principles are violated. The neutral, nonvolatile, patient capital specified by Adam Smith, as prerequisite for economic freedom to function properly, is not now provided by either free banking or by the government’s fiscal, monetary, and regulatory policies. Instead, privileges allowed to finance capitalists cause wealth to become concentrated in the hands of a few. In the United States these principles have been violated since the founding of the Republic, but they multiplied and became ultra-capitalism during the last quarter of the twentieth century. When money is dominant, not neutral, the market cannot find equilibrium, repetitive crises occur, and then, the government violates the second economic principle by bailing out the private interests, thereby causing greater disequilibrium and more crises.

Enron is a case study in how unregulated easy credit allowed this misadventure in corrupted capitalism to happen. Enron is also a case study in how “structured financing” has allowed both lenders and borrowers to move debt off of the balance sheet and hide it from the scrutiny of shareholders. Financial expert and author Martin Meyer regretted the loss of traditional bankers who were more fiscally reliable:

(Traditional bankers were) trained to ask boring questions about how the investment of the money they lent would pay back the loan and to follow up at regular intervals. An expanding business had to return repeatedly to its bank to finance its growth. The conditions of the loan forbade the entrepreneur from cashing in his stock while the bank stayed on the hook.^[2]

Meyer went on to compare this basic banking to the age of ultra-capitalism ushered in by Congress:

The guiding principle of the New Deal legislation was that sunshine is the best disinfectant, and that is still true. Chanting the mantra that big boys can take care of themselves, Congress in the 1980s and 1990s made it possible for consenting adults to do financially awful things behind closed doors.^[3]

The highly visible bankruptcy of Enron is an opportunity to examine the specific government policies that allowed ultra-capitalism to come to dominate our economy, and cause its reversal. Enron also has a political dimension that should assure continued examination until the 2004 presidential election. Many in Congress, both Republicans and Democrats, posturing for the TV cameras, were the same politicians who had responded to corporate and Wall Street lobbying to pass the laws favoring ultra-capitalism during the quarter century that led up to the problem in the first place.

Citizens can learn about ultra-capitalism and how to apply democratic pressure to purge it from society by understanding the fundamental errors of those who support ultra-capitalism and the collectivists who try to micro manage the economy. In the argument between the so-called “market fundamentalists” and the so-called “liberals,” neither the terms nor the argument can survive careful examination, so unless citizens insure that the quality of the debate improves, ultra-capitalism will continue to dominate.

In the latter part of the twentieth century, the Chairman of the Fed, and the Secretary of the Treasury contributed to the domination of the economy by ultra-capitalism. They believed that there could never be too much deregulation or too much liquidity. Consequently, they supported the abrogation of market disciplines necessary to prevent bad loans, and they supported the lobbying by Wall Street that diverted the government from oversight of hedge funds like Enron. These actions, in combination, caused repetitive economic problems, but instead of being red flags that attracted attention to the errors, they were used in support of additional abrogation of market disciplines in an effort to prevent systemic failure. Gradually the government’s function changed from regulator to protector of ultra-capitalism.

In 2002, Paul Volcker was picked to head the damage-control committee at Enron’s disgraced auditors, Arthur Andersen. The selection of Volcker was ironic because the root cause of the Enron scandal was not bad auditors, although they added to the problem, but rather bad banking practices that were encouraged by Volcker’s own bailing out of Continental Illinois, in 1984, on the “too big to fail” principle (see chapter 7). The argument for bailouts is that the whole system is threatened, but the threat is not used as a reason to raise the bank reserves proportionate to the risk, and stop the bailouts, subsidies, and insurance. Until the system allows market disciplines to punish banks for bad loans, and until the leverage is taken out of speculation, Enrons will continue to happen.

The failure and bailout of unregulated hedge fund, Long Term Capital Management, in 1998, was another unheeded warning of the damage to come from unregulated hedge fund Enron. The Chairman of the Fed advised Congress that hedge funds did not need regulation because they got their money from banks, and banks were regulated.[4] Despite persistent, demonstrable evidence that the banks were not fulfilling this responsibility, the Chairman made this extraordinary statement.

Ultra-capitalism scored another impressive victory in 1999 when the Glass -Steagall Act was repealed. This law, signed by FDR in 1933, was passed to separate basic banking, especially the lending of money, from investment banking, especially the making of deals. It was passed because of evidence that mixing the two created a conflict of interest and contributed to economic damage. This conflict was demonstrated again at Enron when beneficiaries of the repeal of Glass-Steagall, such as Citigroup, made multi-billion dollar loans at the same time they were obtaining the investment banking contracts for many of Enron’s worldwide deals. Citigroup made bad loans to fund Enron’s bad business in order to manage the bad deals that eventually brought Enron down.

The special privileges nonetheless continued to flow from Congress when the Commodities Futures Act of 2000 was passed with additional opportunities for hedge funds to speculate with borrowed money. The Economist reviewed this history as follows:

J.P. Morgan and Citigroup, two financial conglomerates exist in their current form and provide the range of financial services they did to Enron, only because of the abolition of the Glass-Steagall Act. This imposed statutory barriers between commercial banking, investment banking, and insurance, and was introduced in 1933 following public protests about conflicts of interest on Wall Street in the aftermath of the 1929 stock market crash. Rivals on Wall Street now whisper that conflicts of interest at these two banks may have played a role in Enron’s collapse.^[5]

These whispers will not rise to the level of uproar of reformation until the voters, their elected representatives, and honorable people in government realize that the problem at Enron was not merely greedy executives, but the entire ultra-capitalist banking, investment, and governance system of the United States. In ultra-capitalism these monster financial services companies, courtesy of the U.S. government, mix money lending, deal making, and touting the stock of the same company. William Grieder explored this triple play in the following words:

J.P. Morgan and Citigroup provided billions to Enron while also stage-managing its huge investment deals around the world. The larger and more dangerous conflict of interest lies in the convergence of government-insured commercial banks and investment banks, because this marriage has the potential not only to burn investors, but to shake the financial system and entire economy.^[6]

Grieder went on to describe how these major houses of Wall Street play the game of doing deals and making loans to companies “while their stock analysts are out front whipping up enthusiasm for the same companies’ stock.”^[7]

Capitalism depends on a flow of nonvolatile, patient money to fund greater growth. One of the vital aspects of capitalism is the responsibility of the bankers to determine that the money they lend serves the economy well, and not go to speculators who will waste it. Bailed out, subsidized, insured bankers, who are motivated by stock price and options, have done a disgraceful job for the last quarter century and have contributed to the dominance by ultra-capitalism. I have described the evidence of this dominance in chapter 7 in terms of the over funding of South American countries in the 1980s, Mexico and South East Asian countries in the 1990s, LTCM in the late 1990s, and finally Enron. In each case, the bankers failed in their judgment on the quality of loans because they were not clear about how much money was being borrowed from other sources, what the money was to be used for, and what was the overall relationship between short-term money, “hot money” and long-term patient capital. The record indicates that they did not care.

For centuries, empirical evidence has been convincing that excessive liquidity flows to speculation and high-risk projects. Demonstrably. the more volatile and impatient capital is, the greater the opportunities to make more money on money. In the United States, the empirical evidence is that bank regulation does not provide the discipline requisite to direct money to the economic growth. Rather, the money is used for speculation, and causes economic swings that slow economic growth and hurt people. The repeal of Glass Steagall also illustrates government’s disinterest in both easy credit and in the size of these financial empires. The new threat of “globalization” comes not from large companies that compete on product quality and price but, rather, from the huge financial services companies that have already caused great havoc in the world’s economies and are being allowed, nevertheless, to acquire more companies and grow even larger. Both internationally and domestically, the fundamental error is the same: the use of free market principles to spread ultra- capitalism, while the market disciplines and government control structure that the free market depends upon are increasingly compromised.

Stock options are ultra-capitalism’s coupling device between Wall Street and corporate executives because stock options motivate the corporate executive to short-term goals and deals. Senator Joseph Lieberman (D. Conn.) is out in front getting great TV exposure on the Enron investigation as the Chairman of Governmental Affairs Committee, but, between 1991 and 1994, it was Lieberman who was out in front leading the charge when Congress prevented FASB from issuing new standards on stock options that would have provided a needed discipline by incurring a charge against earnings. According to a New York Times editorial:

In 1994, 88 members of the Senate voted for a “sense of the Senate” resolution in which they informed the FASB that its proposed standard would have grave economic consequences for entrepreneurial ventures. At one point in the debate, Senator Lieberman introduced a bill that would have effectively destroyed the FASB’s authority to set the standards for financial reporting.^[8]

In the 1997-1998 session, Congress reviewed FASB’s efforts to get control of derivatives. Hearings were held on the collapse of LTCM but Congress backed away from “controlling currency and credit for the general welfare” and instead added to its record of encouraging ultra-capitalism. The New York Times editorial commented further:

Congress paved the way for the current crisis. Congressional involvement in financial standard setting has been pure politics, fueled by a system of campaign financing that distorts the pursuit of the nation’s legislative agenda. If members of Congress are sincere about identifying and correcting weaknesses in the standards used for financial reporting, then they should investigate the old-fashioned way: follow the money. They are likely to find a trail that leads to the nearest mirror.^[9]

The answer to the Enron blame game question then is this: the United States Government itself! We Americans deplore “cronyism” in the commerce of other cultures, while at home we allow ultra-capitalists to dump huge amounts of money in various ways into the pockets of politicians, in return for which politicians dutifully pass laws and enact policies that result in more and more privileges for the few. Such is the mutual, interactive corruption of both capitalism and democracy.

Are not the citizens in a democratic republic responsible for their government? If democracy and capitalism are both being corrupted, is not the reform of both the responsibility of the citizens? “Of course,” anyone will answer, but that obvious answer is not enough to move system out of its gridlock between the few who benefit from the special privileges, the political right that favors them, and the political left who, for lack of understanding, do not propose reforms that go to the root of the problems. This corruption of capitalism and democracy has gone on so long, and has now gained such power, that reform cannot come from within government itself. It can come, now, only from a collaboration of intellectuals, civic groups, universities, the media, and new politicians. Reform might more readily come from the institutional investors who are in charge of investing the collective wealth of America’s working men and women, but to date the financial representatives of the wage earner have not evidenced an understanding of their democratic power and fiduciary obligation for reform. None of these groups have far to go in search of an appropriate reform agenda, for it is ready-made in a synthesis of the works of Adam Smith, Karl Marx, and John Stuart Mill that I detail in this book under the name of “democratic capitalism.”

Enron: How Greedy People Hurt Employees and Shareholders Because of a Faulty Government Structure.

Ken Lay was an economics professor before he became Deputy Undersecretary of Energy in the Interior Department. In both jobs, he was an evangelist for free markets and deregulation. Lay joined Humble Oil in Houston and in 1984 became CEO of Houston Natural Gas, later known as Enron, whose business was pumping natural gas through thousands of miles of pipelines across the United States. Natural gas became popular because it both filled the rising demand for energy and was an environmentally clean alternative to petroleum products.

Houston Natural Gas was under attack by a famous takeover player, Irwin Jacobs, and Lay’s first job was to keep the company away from Jacobs. Lay did this by acquiring Florida Gas, Transwestern Pipeline, and then negotiated a merger with Nebraska based Internorth. While Internorth was the larger company, within the year Lay became the CEO of the consolidated company. Lay then got rid of Jacobs by paying “greenmail,” that is, a premium over the market price of the stock. The money

came from borrowing $230 million from the pension fund, and junk bonds organized by the famous Drexel Burnham junk bond king, and later convicted felon, Michael Milken.^[10]

In early 1986, Lay with the help of a New York based consulting firm, decided to change the name of the newly consolidated company to “Enteron.” They later changed it to “Enron” when someone belatedly checked and discovered that “Enteron” meant ‘alimentary canal” or “digestive tract.” [11]

Ken Lay’s first effort in the trading business with hedge fund Enron Oil, located outside of New York City, was a disaster. After adding big profits to Enron’s bottom line for a couple of years, Enron Oil was found to be cooking the books, went broke, and the top executive went to jail. Despite these early warnings about ultra-capitalism, Lay pushed on and committed the same crimes that had caused the collapse of Enron Oil. In 2001, Enron became the largest bankruptcy in U.S. history, but, as ultra-capitalism was self-destructing, that record only lasted a few months until World/Com fell apart.

As Enron’s $90 stock went into free fall down to 26 cents, Enron became a national scandal and a major media event because the insider few took out hundreds of millions of dollars and left their employees and shareholders with virtually nothing. Many shareholders were also wage earners whose money had been invested in Enron through institutional investors.

After the fall of Enron, ten different Congressional committees were organized to determine blame and compete for TV exposure. There were so many candidates in the blame game that it will be easy for Congress to avoid blaming themselves and the bankers. Few recognize the Washington-Wall Street nexus as fundamentally responsible for the Enron failure.

Let me tell you a story of greedy people managing assets with limited intrinsic value up to extraordinarily high artificial levels. The greedy people included the officers of the company, wealthy private investors, partners of the banks, and government officials. The company was run by people whose total concentration was the price of the stock. Every one of the participants benefited by the stock price going up and from the opportunity to leverage their investments with extremely easy credit. In time, short-sellers drove the share price down. Most of the wealthy got out with big gains while most of the ordinary investors were devastated. This is not only the story of Enron in 2001, but it is also of the story of the South Sea Bubble in Great Britain in the 1720s.^[12] Fiscal and monetary policies have been in the hands of the wrong people for a long time!

Economic disasters are caused by greedy people and there will always be some greedy people. In the republican spirit of the American Founders, we need to structure the system with the checks and balances that prevents greedy people from exploiting the economy and hurting people. Every economic disaster thus far in American history has resulted from a structural failure of government to protect the people. The structure is one that must control currency and credit for the general welfare instead of providing easy credit for the speculators and risk takers to do their damage. Freedom is functional only with discipline. Economic freedom depends on a structure in which money is a simple medium of exchange, not a marauding monster dominating commerce.

Enron was a symptom of a capitalism that subordinated everything, including integrity, to the price of the company’s stock; a banking system that provided too much money for too many bad investments; and a government whose monetary, fiscal, and regulatory policies encouraged this short-term and greedy capitalism. Enron was a house of cards precariously balanced on an high-multiple stock price and an investment grade rating. As losses developed in various misadventures, Enron had to find ways to hide them or report weaker earnings and watch the house of cards collapse. Once companies have sold their soul to Wall Street, they have to deliver the earnings that Wall Street wants or be penalized by a drop in their stock market value by hundreds of millions, sometimes billions of dollars. Enron played the game by fabricating EPS of 87 cents in 1997, then $1.01 in 1998, $1.18 in 1999, and$1.47 in 2000. In 2001, when the company was falling apart, they still managed to fabricate earnings for the first two quarters that annualized to $1.87.

Criticism can begin with a management that bet the shareholders and employees money on ventures where the size of the risks and the size of the bets kept rising. At the very least, management was incompetent in balancing risk and reward and slipped into illegality trying to hide the losses. The Board of Directors failed the shareholders as they ignored the decline in profit margins, the ballooning debt, and the erosion of business disciplines and corporate ethics. The Audit Committee of the Board failed in their more specific responsibility to assure integrity in the numbers and in the process. The outside auditors failed in their more comprehensive responsibilities to assure integrity in the numbers and procedures. Wall Street analysts failed to advise investors of deteriorating circumstances; instead, they continued to recommend Enron as a desirable investment until a few weeks before bankruptcy was declared. The bond rating agencies failed to alert lenders or investors of the increasing risk and finally downgraded their investment grade rating a few days before bankruptcy. Banks that loaned billions of dollars to Enron failed to determine the quality of loans, used the artificial stock price as collateral for real money, and kept funding the game until it imploded. The institutional investors failed in their fiduciary responsibility to judge Enron as a bad investment. The lawyers failed in their public trust by structuring the partnership scams that allowed Enron to move debt off the balance sheet and to add fictitious profits to earnings. The financial press failed to find truth and inform the public.

Enron has been described as a hedge fund sitting on top of a gas line. It was a specially privileged hedge fund, however, for its 28 lobbyists in Washington, a multi-million budget for other lobbyists, and millions in campaign contributions to hundreds of politicians, allowed it to beat back efforts by the Commodities Futures Trading Commission to gain oversight of its trading activities. The hedge fund oversight, proposed in 1998 after the failure of LTCM, would have been similar to bank oversight by the FED, and broker oversight by the SEC. The oversight proposal was defeated by Fed Chairman Alan Greenspan, Secretary of Treasury Robert Rubin, other government officials, and the lobbying efforts of Enron. New legislation instead, further freed Enron from government oversight and was passed in 2000 by the Senate Banking Committee, chaired by Senator Phil Gramm ( R. Texas). Senator Gramm had received substantial political contributions from Enron, and he was the husband of Dr. Wendy Gramm, formerly head of the Commodities Futures Trading Commission, a Director of Enron, and a member of its Audit Committee.^[13] As chair of the CFTC in 1992, Dr. Gramm “exempted energy swap derivatives from public scrutiny,”^[14] another benefit for Enron.

Thus free of government oversight, Jeffrey Skilling launched the world’s largest energy trading activity by building up Enron North America, the trading company within the Enron company. Skilling, a Baker Scholar graduate of Harvard Business School, and later a consultant with McKinsey, set up the trading operation, and then he became president in 1997, and CEO, in 2001. Skilling’s career path mirrors the importance and apparent success of the trading operations, while also mirroring the growth of debt, erosion of profit margin, proliferation of bad deals, and increasing practice of fabricating profits.

Under Skilling’s direction, the trading business in Enron North America grew from $20 billion in 1999, to an astounding $80 billion one year later, trading growth that catapulted Enron into the top ten of U.S. companies in terms of revenues. Anyone who questioned Enron’s high-flying trading growth was described by Skilling as “assholes”^[15] who didn’t “get it.” Chairman Lay talked about matching buyers and sellers in long-term energy contracts through innovation, flexibility, and Lay’s word, “optionality.” Record trading activity was supported by a weak balance sheet, but one nevertheless, that had the crucial investment-grade rating from Standard & Poor’s and Moody’s.

Deals, deals, deals-- most of them bad!

Adam Smith conditioned the success of free markets on control of the “prodigals and projectors” as he called them. Enron’s Lay, Skilling, Mark, and Fastow were “prodigals and projectors,” and worse, they were not good at it. They deflected capital in the wrong direction and then messed up so many deals that they had to resort to illegality to hide the damage.

Typical of Enron’s misadventures was the work of ECT Securities, launched in 1996 as Enron’s in house investment bank. ECT contributed to Enron’s catalogue of bad deals by investing in “a $650 million project to redevelop a steel mill in Chonburi, Thailand.” ECT was involved in financing the company known as NSM, lent them $20 million, and then took a seat on the Board. “NSM went bankrupt without ever completing the project.”^[16]

ECT Securities registered with the SEC as a securities dealer to “conduct business as an investment-banking firm,” structuring M&A deals, underwriting debt and equity offerings, and even doing financial advisory work. Revenues peaked at $30.4 million in 1998^[17] and then dropped to $8.3 million in 2000. ECT’s 20 traders in Houston, 5 in London that speculated in the shares of other companies were Skilling’s top talent from his “intellectual capital,” 150 MBAs recruited each year.^[18] ECT is an indicator of the incredible hubris of Enron management in their willingness to give financial advice to others.

Enron habitually overextended itself in foreign countries where Enron executives did not understand the people, cultures, or the size and complexity of the projects. Most of these deals were managed by executive Rebecca Mark, another graduate of Harvard Business School, who was allowed to get into water way over her head. Besides bad deals in the United States, other bad deals were made in England, Brazil, Bolivia, Panama, Ghana, Malaysia, Columbia, Thailand, Nigeria, Malaysia, and Argentina.

Enron’s Power Purchase Agreement with India’s Congress party was particularly egregious. This was the first private power project that India had attempted and proceeded under Enron management, partly insured by American taxpayers, to give both America and capitalism a bad name in India. A year after it was signed, the power project was so controversial that it was the only issue to be voted on in the Indian state of Maharashtra. After the opposition won the election, they scrapped the Enron agreement having “accused the Congress party government of taking a $13 million bribe.”^[19]

Chairman Lay and dealmaker Mark rushed to India and apparently spread around more millions for “education” of the new generation of politicians and succeeded in getting the project reinstated at even better terms. Enron executives also involved the United States government back home to help pressure for re-ratification of the contract and in this they were assisted in India by ambassador Frank Wisner, later a director of an Enron operation. Reporter Arundhate Roy described the renegotiated deal as follows:

In August 1996, the government of Maharashtra signed a fresh contract that would astound the most hard-boiled cynic. The “renegotiated” power purchase agreement makes Phase II of the project mandatory and legally binds the Maharastra State Electricity Board to pay Enron the sum of $30 billion! It constitutes the largest contract ever signed in the history of India. The power that the Enron plant produces is twice as expensive as its nearest competitor and seven times as expensive as the cheapest electricity available in Maharastra.^[20]

The power plant, that had enough capacity to power two million U.S. type homes, included $1.5 billion from Indian banks. Two elements crucial to India’s economic growth, electricity and capital, were wasted by Enron’s combination of greed, incompetence, and connections in high places. Later: “The state disputed the amount it owed the plant, saying it was being overcharged for the power. The acrimony finally led to the plant being shut down in the middle of 2001." In 2002, the multi-billion dollar power plant was described as: “idle and rusting in the salty air of the Arabian sea.” ^[21]

Enron’s appetite for high-risk adventures included Mariner Energy Inc., a 1996 investment in deepwater drilling. Mariner apparently had been profitable, then as it was shuffled among Enron entities, it gained a reputation as another “tool for earnings management.”^[22]

In 1997 Enron added to its catalogue of bad deals with a $400 million loss in a British natural gas transaction, and a $100 million loss involving a fuel additive.^[23] An investor lawsuit claimed that 75 power plants and pipeline projects under Ms. Mark’s management failed to report expenditures because, according to Enron’s chief accountant, Jeff Skilling would not allow reporting these costs because “corporate did not have room to take a write-off as doing so would bring Enron’s earnings below expectations.”^[24]

The bad deal in Argentina managed by Rebecca Mark was arranged through Enron’s Azurix division, which contracted to build a water and wastewater system in the province of Buenos Aires. “Azurix won the 30-year concession, in June of 1999, with a bid to pay the province $439 million, more than three times the offer from the second place contender.”^[25] The contract dispute over the water deal is ongoing in 2002 between a bankrupt company and a bankrupt government. Argentina capped water rates allegedly at too low a level to make a profit. They also did not pay their bills, which is not surprising for a country that defaulted on billions of dollars of foreign debt.

In 2002, the slow grinding legal process was identifying “Enron Alleged Corruption Abroad”[26] with comments such as: “Claims of corruption in Enron power or water projects have arisen over the years in many countries.” The article described Federal prosecutors investigating Enron violating the Foreign Corrupt Practices Act by bribing foreign government officials to win contracts. Along with the alleged bribes, Enron was favored in these foreign projects with more than $ 4 billion in U.S taxpayer loans and guarantees:

Among the lenders were the Overseas Private Investment Corp., Export-Import Bank, and the U.S. Maritime Administration. Enron got $ 3 billion more from other sources, including the World Bank, European Investment Bank, and U.K. export-credit agencies.”[27]

Demonstrating that their affinity for bad deals was not limited to foreign adventures, Enron not only traded in fibre-optics but also invested $1.2 billion in a network just before others in the industry realized how overbuilt the networks were and the whole market tanked. Enron executives further enhanced their reputation in 2000 with Braveheart. This deal with Blockbuster, the largest peddler of videos in the United States, was to deliver thousands of movies to consumers via pay-for-view TVs, purportedly on Enron’s broadband network. The SPE (Special Purpose Entity) created for this project was the usual Enron razzle-dazzle with borrowed money and guarantees on the loans where Enron consistently violated the rules requiring 3% outside capital. Enron borrowed $115.2 million for Braveheart from CBIC World Markets, the investment-banking arm of Canadian Imperial Bank in Toronto, promising CIBC almost all of the earnings for ten years. The venture was barely getting off the ground in late 2000, when in another audacious accounting move, Enron claimed profits from Braveheart of $53 million in the fourth quarter of 2000, and $57.9 million in the first quarter of 2001.^[28] An Enron employee was quoted on the transaction: “ I was just floored, I mean I couldn’t believe it!”^[29]

At analyst meetings in early 2001, Lay and Skilling predicted a $126 stock price, and they described the benefit to their broadband services from Braveheart. Blockbuster treated it as a pilot program and were amazed that Enron was anticipating revenues and profits in their financial results. A few months later, in March of 2001, Braveheart was on the rocks and Enron’s end was near. The end must have been nearer than Enron was letting anyone know, for they were faking a $57.9 million profit at the very time that the deal, that was the source of the alleged profit, went belly-up.

Laser focus on EPS

Enron had a ”laser focus,” as Skilling called it, on E.P.S (earnings per share) growth. Along with an investment grade rating, Enron’s growth was based on a rising stock price that was used as collateral to regularly move debt off the balance sheet, and this enabled Enron to borrow more and more money from eager bankers. Although Enron’s business had become 80% trading, its officials convinced a willing Wall Street that Enron deserved its price-earnings multiple that peaked in 2000 at 70, compared to a 17 P/E multiple for a top-quality trading company like Goldman Sachs. Enron officials pointed to the reports of steady earnings improvement to demonstrate that they did not have the volatility associated with trading. Most Wall Street analysts ignored the evidence that the steady record was fabricated.

In the Alice-in-Wonderland world of ultra-capitalism, a high stock price and a high P/E ratio serve to do more than satisfy individual greed. They can be important tools in managing increased earnings. High P/E companies can acquire lower P/E companies and by that act alone improve profits; many are on acquisition binges for that reason. This is one of the many structural imperfections of the system. The bankers generally do not care whether they are getting collateral based on a 15 multiple stock price or a 70 multiple, although a prudent regulatory system would require significantly higher reserves for the obviously higher risk.

Enron had special ways to fake profits. Along with the partnerships used as ways to manufacture profits, Skilling built a culture in which traders would change the assumptions and thereby seem to generate new profits. This was usually done at the end of a quarter when Enron was preparing to release their financial results and had to find the profits to meet Wall Street EPS expectations. At that crucial time traders were expected to “crank the dials,” an expression used by a trader who said that his trading portfolio was taken away from him because he did not manipulate the market values sufficiently to fake more profits. ^[30] Traders reportedly “cranked the dials” as follows:

Reported profits were based on long-term trades that would not actually generate cash for many years. 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. In a system where there was no established public market to set prices, a trader had to decide on a price curve.^[31]

Under this pressure for profits, the traders learned how to “blend and extend,” that is, to package and add years to the life of a deal and then take the profit increment into the report of current earnings. When Enron went bankrupt, the trading book value had fallen from $12 billion to $7 billion. According to a deposition by Enron’s new president, that value had shrunk even more dramatically to $1.3 billion by January 2002.^[32] How much of the enormous shrinkage was due to the earlier cooking of the books to produce needed profits is not clear, certainly the effects of the distress sale environment substantially added to the shrinkage.

The Wild Ride of Enron: 1996-2001

The following is a review of the six year period during which, despite Enron’s operating profit margin shrinkage from 5.1% to 1.3%, its total market value increased from $12 billion to $70 billion! This disappearing operating margin happened despite Enron’s best efforts to “cook the books.” It is difficult to understand how all of the agencies responsible for protecting the shareholders and employees missed this dramatic profit erosion, it was there for all to see.

1996: Operating margin was disappearing, but nobody was paying attention!

Enron was valued by the stock market at $12 billion with a P/E ratio below the market average; Enron sales were about $13.3 billion; the operating profit margin dropped from 5.1% to 3.8% in the year; and reported long-term debt increased from $2.8 billion to $3.3 billion.^[33]

Jeffrey Skilling became President and Chief Operating Officer, continuing as president of Enron Capital and Trade Resources. Rebecca Mark, CEO of Enron Operations Corp., makes a power project deal in India.

1997: Big disappointment at Enron, the price of the stock was down!

Despite the determination of Skilling and Lay, Enron’s stock price went down for a time while the whole market was going up. Sales were up to over $20 billion but the market value and the P/E multiple had improved little. For anyone who bothered to look, however, trouble signs were clear: the profit margin during the year fell from 3.8% to 2.6%, while the reported debt went up from $3.4 to $5.8 billion.

Besides shrinking profit margins and rising debt, Enron was faced every year with the problem of what to do with the latest losses on bad deals. In November 1997, Enron’s top executives found new ways to manage earnings. Lay, Skilling and CFO Fastow attended “a meeting that would help put the energy-trading giant on a fateful and ultimately dangerous course.”^[34] A new partnership called LJM2 was put together in a hurry because if Enron reported their real numbers their stock price would have dropped. Enron got the money for LJM2 from their friendly bankers, J.P. Morgan, Citigroup, and Merrill Lynch; that is, the money came from both the institutions and personal investments from the partners. Allowing Enron according to The Economist to report fictitious profits:

The Enron virus spreads still through Wall Street beyond J.P. Morgan, Chase, and Citigroup, whose roles as lenders and advisers to the firm have come under scrutiny. Nearly 100 executives at Merrill Lynch invested a combined $16 million in LJM2 an Enron off-balance-sheet partnership.^[35] Within seven days of the money coming in from the banks and the banking executives, Enron shifted a series of assets off its books in sales to LJM2. Those assets included a 75% interest in a Polish power plant and a 90% interest in an natural gas system in the Gulf of Mexico.^[36]

SPEs, (Special Purpose Entities) were not invented by Enron. Financial devices frequently have an honest beginning that are later turned into ways to fool the shareholders In theory, a SPE match companies with more opportunities than money, with companies or individuals with more money than opportunities. SPEs are covered by regulation 140 of FASB that specifies how to move assets off the balance sheet by giving up control.

The practice of bundling or securitizing loans to sell them to a third party was also an innovation of ultra-capitalism that began in the late 1980s in order to get more leverage than the balance sheet would normally allow. By 2001, this financial innovation in the U.S. had grown to over $1.3 trillion dollars! In earlier, simpler times the quality of a company’s balance sheet could be judged by such standard measurements as the relationship of debt to equity. If the debt percentage was too high, indicating an over leveraged company, then new money would be harder to obtain and at higher cost. SPEs and securitization of debts makes this examination irrelevant because the reported figures do not give any sense of this relationship between debt and equity.

Besides hiding the extent that a company was over leveraged, the problem of securitization of assets was compounded by the successful lobbying by Wall Street, and companies like Enron, to avoid better disclosure of these practices. Shareholders need transparency in order to ascertain an increase in risk. If one cannot examine debt and equity the old-fashioned way, at least one could check the footnotes of the financial reports to find out what the additional debt was and what implied guarantees had been given to get this debt off the balance sheet. In Enron’s case such a requirement would have exposed that the required 3% outside capital and the securitized assets were explicitly guaranteed and might as well have been pure debt.

Government officials did try for better control in this matter:

In late 1997, the Federal Reserve, the Office of the Comptroller of the Currency, the Office of Thrift Supervision, and the Federal Deposit Insurance Corp. proposed strengthening rules that required banks to set aside additional capital against possible losses on risky securitization deals. Such reserves, in addition to limiting a bank’s freedom to make more loans, would have signaled investors that a lender was assuming greater risks.^[37]

Because of political resistance, FASB’s best effort was a watered down version of higher reserves but, by that time, at least five banks had failed from problems of improper accounting for securitization.^[38] The FDIC paid out several billion dollars of taxpayers’ money for these failures, but nowhere in the decade long struggle was the ordinary taxpayer well represented. The lobby power of Wall Street, and corporations like Enron, was too powerful and in this case the best efforts of government officials did not have enough democratic support. The reformers who claim to represent the peoples’ interests did not feature this subject on their agenda.

That same year, Enron launched yet another new enterprise to bundle wholesale energy delivery and risk management services, Enron Energy Services (EES), signing up contracts for $209 billion in two years.[39]

1998: Another tough year at Enron

Enron executives must have been disappointed in 1998 when again, the stock price and P/E ratio had only slight improvement. Enron’s P/E multiple was up to 24.8, which is good compared to the market’s sixty year average of 15, but it was below market average in 1998 and compared poorly to GE’s 30.3. GE, however, was gaining market value on performance, whereas Enron was trying to do it with smoke and mirrors. GE’s15.3 % profit margin in 1995 improved to 16.8% in 1998, while Enron’s 5.2% eroded in 1995 to 2.2%! GE slashed their long-term debt while Enron’s continued to climb up to a reported $7.4 billion, despite Enron’s slight-of-hand in moving debt off the books. Enron’s executives wanted GE’s multiple without GE’s performance; in time, Wall Street gave them that and more.

The use of outside partnerships built momentum in 1998, Chewco was presented to the Board managed and partly owned by CFO Fastow. These vehicles were usually located in either the Cayman Islands, or other tax friendly places, and a portfolio of risky assets was dumped into them, accomplishing the seemingly difficult task of getting rid of problems while making money at it. By 2000, partnerships were providing 40% of Enron’s pre tax income of $1.4 billion and more for Wall Street insiders.

Despite the rising debt, Enron continued to ignore other fundamental protocols of cash management. Although they were trying to be a high growth, go-go company they continued to pay out a large percentage of the alleged earnings in dividends. Back in the 1980s, when Enron was a gas company, they paid out dividends with yields of 5-6%, typical for utilities. In the late 1990s, their high growth time, they paid hundreds of million of dollars in dividends with cash they did not have; consequently, they further escalated the debt.

1999: Enron finally on a roll!

Now things were clicking for Enron. However they managed to do it, and Wall Street did not care, Enron was now producing steady earnings improvement and were rewarded with a P/E multiple of 31.8; a stock price up 55%; doubling Enron’s market value to $32 billion! GE’s multiple, however, was still higher at 35.9.

During the year, Enron’s Board waived Enron’s Code of Ethics on two occasions in order to expedite the addition of outside partnerships managed by Enron executives.

Enron’s deal making included an electricity-producing barge to be anchored off the coast of Nigeria. When Enron needed to improve 1999 earnings, they got their friends at Merrill to “invest” $7 million in the deal. Enron got their money, managed their profits, and, in a few months, another Enron partnership bought the project from Merrill, who pocketed $775,000 for arranging the deal. LJM2 was then bought and sold several times with the “lazy Susan” technique of passing around assets that mysteriously gained in value each time they changed hands. In the less sophisticated 1970s, during the S&L scandal, this practice had been called “flipping assets.”

2000: Enron in the promised land!

In 2000, Lay, Skilling, and Fastow had accomplished what, with the right government structure, should have been impossible. Incredibly, Enron’s stock was up 87%, and their market value had doubled again to $68 billion! Equally incredible, the reported debt had grown to over $10 billion, and the profit margin had almost disappeared at 1.3%, but, hey, who’s looking. Enron was on a roll with an average P/E for the year of 50, which, for the first time, beat GE’s 40.1. Enron’s peak multiple for the year was an astronomical 70! Enron’s sales were now over $100 billion; and Fortune magazine reported it as America’s sixth biggest company.

Rebecca Mark had once been part of Lay’s “Office of the Chairman,” and a competitor of Skilling for the top job. Poor results at Azurix, and other deals, gave Skilling the opportunity to push her out,.[40] consoled by her generous severance contract and gross proceeds of over $82 million from sale of Enron stock.[41]

But by the end of 2000, however, the difficulty of manufacturing earnings was stretching the creativity of the accountants and the auditors. The accountants were struggling to keep another SPE called Raptors afloat. The problem was $500 million of Raptors’ losses that, unless a place was found to hide them, would have to be subtracted from Enron’s profits; an event that would have dropped the stock price like a rock and destroyed the investment grade rating that the trading depended upon. Raptors was financed indirectly with Enron’s stock, and any drop in that value would start an unraveling process like a margin call in a dropping market-the lower the price, the more money had to be found. Under pressure the accountants become even more creative, and just before the end of the first quarter they managed to refinance Raptors and hide the losses by “using a series of fragile transactions that were still vulnerable to further declines in Enron’s stock price. But the transactions-none of which were disclosed to investors-merely put off the inevitable.”^[42]

2001: Enron continues to present fabricated profits while the company is dying!

In the strange world of ultra-capitalism, companies do not build a product and then try to make a profit, instead, they figure what earnings Wall Street wants to support continued enthusiasm for the stock, and then give it to them. In 2001, a few months before the company imploded, Enron reported a cosmetically attractive 20% plus improvement in profit, with 47 cents a share for the first quarter, followed by 45 cents a share in the second, compared to 40 cents and 34 cents in the same quarters a year earlier. Enron’s reported debt was up to $13 billion, plus many additional billions if the stock price dropped. Despite this debt load, Enron paid the regular dividend. Most shareholders had no way of knowing that the dividend was the last value they would receive from Enron.

In early 2001, Lay, Skilling, and Fastow had to have known that the accountants were running out of tricks. As late as this, Enron management might have bitten the bullet and made a major restructuring effort, including a massive write off to get all of the junk off their books. Such a move takes courage to face and considerable expertise to execute. Enron’s stock would have dropped and trading would have slowed, but the stock market is very forgiving of onetime corrections, considering them a bump in the road while anticipating good following year results partly due to the extent of the write-offs. This would have been the only action possible to rescue some value for the general shareholders. Management did not choose that approach, however, Lay retreated and a few months later Skilling quit.

A few had a clear view

Besides the short-sellers, others in 2001 suspected that things at Enron were bad. Sharon Watkins, V.P. Corporate Development, was the whistle blower who wrote her now famous letter to Lay describing her nervousness that the company would implode from accounting scandals. Peddlers of credit protection were also onto Enron at that same time. The title of a Forbes article described them: “Someone Knew, the Enron Belly Flop Stunned Almost Everyone, but a Select Group of Wall Street Pros had an Early Warning System You Cannot Access.”^[43]

It is an obscure electronic-trading market where banks and other big players buy and sell credit-protection contracts as an insurance policy against loans that might go bad. On August 15, the day after Enron Chief Jeffery Skilling abruptly resigned, Enron’s stock barely budged, closing just above the $40 mark. But on the same day, the price of an Enron credit contract jumped 18%...By October 25, as the troubles sparked headlines, Enron stock had dropped more than 50%, while the credit contract had soared in price to $900,000 per $10 million annually. Even at the much higher price it was a great deal. Citigroup used the credit protection approach to insure $1.4 billion in loans to Enron.^[44]

In this crazy world of ultra-capitalism, Citigroup was pumping excessive liquidity into Enron to speculate and engage in high-risk ventures at the same time that Citigroup could afford to pay for insurance on these loans. Why care about the quality of loans? Take out credit protection and relax!

Citigroup is special because they had been put together in anticipation of the repeal of Glass Steagall. In 2001, CEO Weil’s compensation was $26.7 million, excluding options. In approving this compensation, the Board commented, “Management had performed exceedingly well under these unusually difficult circumstances.” It was also reported that, “Citigroup was one of the biggest lenders to Enron Corp. and the bank has been forced to write down much of its exposure to the collapsed Houston energy company,”^[45]that is, they were forced to reduce profits based on anticipated losses on the loans to Enron.

During the 1990s, bank earnings were growing at a double-digit rate, but by 2002, banks were finding it hard to continue to produce earnings from administrative savings. After 1998, banks began to destroy capital, like Enron they were not covering the cost of capital and began to feed on themselves. A chart in Fortune shows that “Banks Burned Through Capital at a rate of $20 to $30 billion a year starting in 1998.”^[46]

Citigroup was not alone in funding Enron, nor in finding ways on their own balance sheets to get around bank regulations, some of which backfired on them:

They didn’t want to do it, but they had no choice: J.P.Morgan, Citigroup,

Bank of America and other banks shelled out unsecured loans of $3 billion to

the doomed Enron Corp. in October, weeks before the firm collapsed into

Chapter 11 amid accusations of fraud, self-dealing, and a cover-up.^[47]

Just as Enron was moving debt off its balance sheet by shady deals, these loans were not shown on the banks’ balance sheets, “instead, the ill-advised promises were listed in the footnotes.”^[48] These contingent loans were to be activated if Enron, and others, lost their financing from other sources. Something that was not supposed to have happened did happen. Apparently the capital division of corporations such as GE and Ford could sense troubled loans while the banks were ignoring it. The banks were forced to fulfill their promise to lend money to companies in the process of going broke.

Hundreds of billions of dollars of these bank obligations exist but cannot be seen by examining their balance sheets. Citigroup is distinguished by leading the list of these “off-balance-sheet commitments with a staggering total of $171.8 billion which is 15.7% of all of Citigroup’s loans outstanding.”^[49]

Citigroup and the other big lenders are major targets for the contingency lawyers in the Enron scandal. These lawyers know how to find the “deep pockets,” and they will inspect the corruptions of ultra-capitalism in great detail in numerous dispositions. Citigroup will be sued for their involvement in the questionable partnerships, sued for participation in the amazing number of bad deals around the world, just as Citigroup’s Solomon Smith Barney operation was sued in 2002 for having misled unsophisticated investors. I find it bizarre that capitalism cannot be reformed by the democratic process, but rather has to be reformed, or at least punished, by short-sellers and contingency lawyers.

Bright financial engineers could design a comprehensive, integrated fiscal, monetary, and regulatory policy to serve the general welfare. If it were presented to American citizens, and compared to the present structure of privileged law, the pressure for reform would be overwhelming. Perhaps a few Enrons will stimulate the democratic process to an examination and reformation of ultra-capitalism. The action for reform will

have to come from a renewed democratic process, for the post-Enron “reforms” coming out of Washington are cosmetic and an additional insult to the American people.

A Reform Agenda:

I propose the following agenda for such democratic examination and action. These structural corrections, I believe, address the root problems with nearly fail-safe solutions, that is, they will discipline the system whether it is managed by good people or greedy, immoral people. They begin with Adam Smith’s economic freedom that can eliminate material scarcity if money is neutral and speculators are under control.

I draw my next agenda item from Karl Marx who argued that social progress depended on movement to a superior economic system. Marx described this superior system that motivated each individual to maximum development, maximized surplus as the sum of this development, and distributed wealth broadly, a necessary outcome to sustain both individual motivation and the economic growth dynamic. One would think that by now, these theses would be believed as a priori tenets of economic faith, instead, there are ignored by policy makers. They have been validated by improvement in the lives of millions but they continue to be ignored because the requisite structure has never been in put place for the system to function at full potential. Few debate the benefits of freedom, but many are confused about which disciplines are necessary for free markets to lead the world to full economic and social potential.

Enron is a case study in what is wrong structurally and philosophically with the present political-economic system in the United States and in the world. What can be done to prevent another Enron? The answer to that question is the same as the answer to this question: What can be done to eliminate the corruptions of ultra-capitalism? Or this: What can be done to eliminate concentration of wealth due to special government privileges? Or this: What can be done to control currency and credit for the general welfare? Or this: What can be done to design monetary, fiscal and regulatory rules by the democratic process, rather than by special interests.

The answer to all of these questions and the subsequent action to be taken by the voting public will determine if the United States government can couple capitalism and democracy in a synergistic way in their own country, and then lead the world to peace and plenty through economic common purpose. If America fails in this ultimate test of its historic role to free people of want and oppression, it will have failed, to its great shame, in the essential Constitutional purpose. The following are the reforms necessary to reactivate that Constitutional purpose:

Reform #1: Democratization of Capitalism through large dividends

A rededication by companies to paying large dividends, encouraged by more

favorable tax laws, would be the fastest and most effective way to move away from the corruptions of ultra-capitalism towards the worldwide benefits of democratic capitalism. Dividends return the surplus to the economy, thereby stimulating economic growth, a sound annual income from dividends encourages the spread of employee ownership plans and thereby improves productivity; ownership plans with large dividend income on a global level would add more spendable income to workers in emerging markets and make free trade a universal benefit. The reform needed is a departure from exclusive focus on EPS, the short-term and greedy capitalism, to the capitalism that balances appreciation, income, and long-term security.