Enron’s Web of Complex Hedges, Bets

As accountants and investigators begin poring over Enron Corp.’s books, they are likely to collide head-on with a factor that makes its finances particularly impenetrable--the extent to which the company relied on financial instruments known as commodity derivatives to inflate income, hide losses and misrepresent the true nature of its business.

Although to this day Enron is generally known as an energy trading company, a close review of financial records and interviews with accounting experts show that at its heart it had become a massive trading operation in derivatives, which are financial contracts that can entail significant risks.

Missteps in such trading have cost highly sophisticated investors billions in past years. Among other cases, derivatives trading was behind Orange County’s bankruptcy filing in 1994 and the failure of Barings Bank in 1995.

Derivatives, which come in many forms, allow investors to bet with other investors on changes in an underlying asset or index, such as stocks, interest rates, weather or electricity prices. Properly used, derivatives are effective at hedging against an almost infinite variety of business risks ranging from crop failures to changes in interest rates and oil prices. But they can sharply exaggerate market gains or losses.

There are signs that, in the company’s hands, derivatives evolved into more than risk-hedging devices. They became tools of fiscal concealment and manipulation, some experts say.

Among other things, derivatives allowed Enron to inflate the value of its assets and transactions while understating their risks and obscuring their real nature, they say.

“Enron used derivatives to manipulate accounting standards and tax reporting,” said Randall Dodd, head of the Derivatives Study Group, an economics watchdog. “They used them to fabricate income. It was a bit of a shell game.”

Enron spokesman Mark Palmer on Wednesday declined to discuss the company’s accounting. He said the issue “is being investigated by a special committee of our board, the Securities and Exchange Commission and the Department of Justice. They may reveal facts that may lead us to take further action.”

It is still unclear to investors and government investigators how big a role losses on these contracts played in Enron’s collapse. Nor is the full extent of the damage yet known. Some analysts believe the company still may be losing money on some contracts.

Much Derivatives Trading Unregulated

Enron could engage in its complex trading strategy without fear of regulatory intervention because the government explicitly exempted much derivatives trading from oversight. That’s at least in small part because of a ruling by the Commodity Futures Trading Commission’s former chairwoman, Wendy L. Gramm, just five weeks before she joined the Enron board in 1993. Gramm is the wife of Sen. Phil Gramm (R-Texas).

The trading market for the contracts has blossomed in the last decade, with nearly $100 trillion traded worldwide as of last June, according to the Bank for International Settlements.

Most of these were so-called over-the-counter or OTC derivatives--those not traded on a registered futures or options exchange, but rather contracts between big investors.

Enron did not entirely conceal that aspect of its business. As early as October 1999, its then-chief financial officer, Andrew S. Fastow, told CFO Magazine that the company’s finance business would “buy and sell risk positions.”

“Enron may have been just an energy company when it was created in 1985,” said Frank Partnoy, a law professor at the University of San Diego who testified before the Senate last week. “But by the end it had become a full-blown OTC derivatives trading firm.”

The world of derivatives was almost tailor-made for the aggressively secretive Enron. Accountants still have not settled on a consistent way to represent their value and risk on a company’s books. The relevant standard set by the Financial Accounting Standards Board, an independent agency that sets guidelines for corporate auditors, is Rule 133--a behemoth that stands at more than 800 pages.

Enron’s derivatives-related assets soared to $21 billion in 2000 from $3.1 billion the year before, according to the company’s 2000 annual report. This enormous growth, apparently related to its Internet trading system, Enron Online, made it the fifth-largest commodity derivatives dealer in the U.S., according to figures compiled by Swaps Monitor, a market research firm.

Nevertheless, the company also reported last year that its net financial exposure to derivatives was only $66 million. Although that figure tripled from the year before, analysts contend that it is absurdly low, considering that a large portion of the contracts covered long-term energy deals subject to dramatic price fluctuations.

“Clearly these values are no longer credible,” said Robert McCullough, a Portland, Ore., energy consultant.

Enron’s accounting treatment of these highly complex transactions, including stock options and loan guarantees, raises the possibility that millions more in liabilities lie concealed in transactions yet to be unwound.

In one deal alone, a financing arrangement with a partnership called Whitewing, formed to hold a melange of Enron assets including a Brazilian utility and European power plants, Enron’s exposure to losses may be as much as $2.1 billion rather than the $600 million the company has disclosed.

“These are transactions evolving daily, but disclosed only periodically,” said McCullough, who analyzed the deal. “This is a bucking bronco by any investment standard.”

Moreover, because trades in OTC contracts are entirely unregulated, “OTC derivatives dealers don’t have to register, report, maintain a capital base,” Dodd said. “You could set up a lemonade stand and run a $250-billion derivatives book.”

Former regulator Gramm’s ruling covered only a small category of swaps negotiated between two parties. But it helped open the floodgates to a huge variety of derivatives contracts, which were labeled “swaps” to fit within the ruling.

Still, it was unclear whether all OTC derivatives could remain unregulated indefinitely.

Banks, hedge funds and traders, including Enron and its fellow energy trading companies, strove desperately to keep government hands off. They argued that the participants in the market were mostly huge institutions savvy enough to protect themselves from fraud without government help.

When the Commodity Futures Trading Commission proposed in 1998 regulating the OTC market, “the large derivative interests, including Enron, went up in arms,” recalled I. Michael Greenberger, then the commission’s director of trading and markets and now a law professor at the University of Maryland.

The traders won the battle in December 2000, when Congress passed a law rendering OTC derivatives permanently exempt from regulation.

Around that time, Enron’s participation in the market mushroomed.

Enron’s ability to keep losses off its books through complex swaps and option contracts is demonstrated in its deal with Raptor, one of the investment partnerships about which Enron Vice President Sherron S. Watkins raised questions in a now-famous anonymous letter in August to Chairman Kenneth L. Lay.

Enron had transferred to Raptor ownership of $1.2 billion in shares in Rhythms NetConnections, a high-tech company whose stock had rocketed in value after Enron invested in it. Enron recorded the transfer as a financial gain, but did not clearly disclose that it also entered a derivatives contract that required it to cover Raptor’s losses if Rhythms declined in value, as it eventually did.

Inside the web of this transaction, hundreds of millions of dollars in losses in Rhythms fell through the cracks, unrecorded on Enron’s books. The complexity confounded Watkins.

“I can’t find an equity or debt holder that bears that loss,” Watkins told Lay. Nevertheless, she suspected the truth--that the losses belonged on Enron’s books. “If it’s Enron,” she wrote, “then I think we do not have a fact pattern that would look good to the SEC or investors.”

In at least one case, Enron apparently used derivatives to help inflate the value of an asset as it was transferred off its books. This may have allowed the company to revalue similar assets that remained in its hands, using the inflated value as a benchmark.

The asset in question was “dark” fiber-optic cable that Enron transferred in June 2000 to LJM2, a partnership managed by Fastow, then its own CFO. At the time the real value of dark fiber--installed data lines not yet equipped to carry traffic--was conjectural. About 40 million miles of fiber optics had been installed in the U.S., but within a year a glut would bankrupt several communications companies.

LJM paid $100 million in cash and credit to Enron, which promptly claimed a $67-million profit on the deal, suggesting that the real value of the fiber was $33 million.

LJM subsequently transferred most of the fiber to yet another Enron-associated partnership, this time for $113 million. This step implicitly revalued the fiber at more than triple its original value.

Supporting the second sale, however, was a derivative issued by Enron, in effect covering any loss the buyers might incur if the fiber’s value collapsed, as it did during 2001.

Eventually Enron would have to declare the loss on its own books. But Watkins’ letter suggests that this would not happen until the partnerships were closed out in 2002 and 2003--years after Enron reported a profit from the original sale.

‘Not the Only One of Its Kind’

Analysts suspect deals like this were more common than Enron has disclosed.

“It seems likely that the ‘dark fiber’ deal was not the only one of its kind,” Partnoy said last week in testimony before Congress.

He and others also believe that Enron traders may have manipulated their profit and loss figures by improperly valuing derivative contracts in illiquid markets--that is, those in which there is so little activity that a small transaction can move prices sharply. These include contracts to deliver energy at some point far in the future; indeed, the company disclosed that at year-end 2000, it held about $13 billion in energy contracts denominated in terms of up to 24 years.

Palmer, the Enron spokesman, rejected any suggestion that the company’s traders manipulated energy prices. “This is stuff that’s in the past and been investigated by half the Western world,” he said, referring to probes of West Coast electricity price spikes during the power crisis last year. “We need to look ahead, not engage in this sort of proctology.”

Accountants are well aware that such derivatives are prone to “mismarking.”

“We recognize that some fair values are more difficult to set than others,” said Timothy S. Lucas, director of research and technical activities for the Financial Accounting Standards Board. “In some cases, we may not have a really good idea of fair value.”

To some professionals this is only a further sign that Congress erred in removing OTC derivatives from regulatory oversight.

“OTC derivatives are as powerful as futures and securities,” Greenberger said. “If there’s anything we’re learning, it’s that the big boys maybe can’t take care of themselves.”