The Smartest Guys in the Room by Mclean

Ref: Mclean & Elkind (2004). The Smartest Guys in the Room: The Amazing Rise and Scandalous Fall of Enron. Penguin.

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Summary­

  • For the most part, the Enron scandal grew out of a steady accumulation of habits and values and actions that began years before and finally spiraled out of control. When Enron expanded the use of mark-to-market accounting to all sorts of transactions—was that when it first crossed the line? How about when it set up its first off-balance-sheet partnerships, Cactus and JEDI, with such reputable investors as General Electric and CalPERS? Or when it categorized certain unusual gains as recurring? Or when it created EPP, that “independent” company to which Enron sold stakes in its international assets and posted the resulting gains to its bottom line?

  • Corporate scandals that had come to light in the wake of Enron: Tyco; WorldCom; Adelphia; HealthSouth; Martha Stewart and ImClone.

  • The larger message is that the wealth and power enjoyed by those at the top of the heap in corporate America demand no sense of broader responsibility. To accept these arguments is to embrace the notion that ethical behavior requires nothing more than avoiding the explicitly illegal, that refusing to see the bad things happening in front of you makes you innocent, and that telling the truth is the same thing as making sure that no one can prove you lied.

  • In the end, Enron was suffering from “a complete loss of investor and creditor confidence,” “no access to capital,” maturing debt that exceeded its cash flow, and “too much leverage tied to stock price.” Enron had borrowed too much and issued too little equity, blown the money on bad investments, and suffered from “possible control failure.” The off-balance-sheet debt, structured-finance deals, and prepays were all detailed.

  • By the end, Enron owed some $38B, of which only $13B was on its balance sheet.

  • Enron was zealotry to greed to arrogance to demise.

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Enron

  • Enron’s Nefarious Business Model

    • Setup Projects designed to make profit.

    • Book Millions in profit before the project had generated a penny in actual revenues.

    • Pay the sales team up front with booked profits.

    • Promise the shareholders EPS growth of 15%/yr.

    • Borrow additional money to disguise debt by keeping the debt off the books, camouflaging existing debt, booking earnings, and creating operational cash flow (what Fastow’s department did).

      • Setup Investments (Marlon, Osprey, Raptor) that pays Enron if their value declines, offsetting losses (Enron booked >$1B this way).

      • Special Purpose Entities (SPEs): Established by companies specifically to purchase the assets being securitized in order to isolate risk by setting up an independent legal entity that owned a single asset.

  • Enron couldn’t put too much debt on its balance sheet because that would hurt its credit rating (and banks would stop lending if Enron’s debt ratios got out of whack). Nor could it use existing cash flow, since Enron didn’t have much real cash flow. And although the equity market was available, Skilling had made it clear that he didn’t want to tap it often.

  • How Enron would Fail (Buy)

    • Investors announce that Enron would miss its quarterly-earnings target, triggering a massive stock sell-off.

    • Enron’s balance sheet collapses, because it forces the unwinding of all the off-balance-sheet vehicles that were capitalized with Enron stock.

    • Enron’s credit rating is downgraded, triggering the material adverse change clauses in the company’s trading contracts, causing trading partners to start demanding that Enron post cash collateral, which it doesn’t have.

    • All of this wipes out Enron’s liquidity and destroys investor confidence.

  • Failed Projects

    • Vietnam: Enron invested ~$18M to build a power plant. The project was canceled.

    • Dabhol: Enron invested ~$900M. Dabhol sits silent, a gigantic, wasted marvel of modern technology.

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Economics

  • How Companies Fund Growth

    • Take on Debt (Borrow).

    • Issue Stock (Fundraise).

    • Draw from Existing Cash Flow (Use Savings).

  • Trading begets more trading. As a market becomes liquid—meaning that it’s easier to find a willing buyer or seller—it attracts more participants. That further increases the liquidity, which further attracts new participants.

  • Core Rule of Trading: Information is even more important than brains.

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Misc Quotes

You can’t build a company on brilliance alone. You need people who can come up with ideas, and you also need people who can implement those ideas and are well compensated for doing so.

A business that had stable and predictable earnings that’s primarily engaged in the trading of commodities is a contradiction in terms.

In investment banking, the ethic is, ‘Can this deal get done?’ If it can and you’re not likely to get sued, then it’s a good deal.-Banker.

I knew that what I was doing was misleading, but I didn’t think it was illegal. I thought: That’s how the game is played. You have a complex set of rules, and the objective is to use the rules to your advantage.-Fastow to a Vegas Crowd.

In many cases, Skilling felt it was better (his personnel) didn’t get along, since it created a level of tension that he believed was good for helping people come up with new ideas.

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People

  • Jim Chanos (1957- X): First to short Enron’s stock after reading Jonathan Weil’s story of Enron in Fall, 2000 and reviewing the company’s finances. 

    • Chanos had made a fortune researching- then shorting- telecom stocks.

  • Kenneth Lay (1942-2006): Enron CEO and Chairman. Lay’s management style was described as “Ready, fire, aim.” Lay had the traits of a politician: he cared deeply about appearances, he wanted people to like him, and he avoided the sort of tough decisions that were certain to make others mad.

  • Jeff Skilling (1953-X): CEO of Enron during its fall and sentenced to 24y in prison.

    • Skilling expected people to behave according to the imperatives of pure intellectual logic, but of course nobody does that.

    • Skilling had a way of turning practical disagreements into abstract arguments and could out debate just about anyone. “It was difficult to disagree with Jeff because he would elevate the disagreement to an intellectual disagreement, and it was hard to outsmart him.”

  • John Wing (1946-2015): Principal architect of Enron’s power development business.

    • Wing was grandly manipulative with his own staff. He’d periodically tell even trusted subordinates they were failures, strip them of their titles, or make them report to someone junior. “We were all fired at least ten times,” recalls one member of the team. Those who worked directly for Wing never quite knew where they stood. Which, of course, was the idea.

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Terminology

  • Asset Monetization (Skilling): Estimating the value of the future cash flow of a project and selling it off to investors at a discount and pocketing the money, instead of waiting for the money to trickle in over time.

  • Credit Derivatives: Financial contracts that are triggered when a company’s credit rating is downgraded.

  • Credit Rating Agencies: Assess the ability of a company to generate enough cash to pay back its debt. The US has two major agencies- Moody’s and S&P’s.

  • Greater Fool Theory: Companies bid on a resource and more often than not, the winning company takes the initial up-front risk, with plans to extract some quick profits by selling off pieces to other buyers once the project was under way. In some ways, that was prudent business: it was a way to diminish the risk. Yet that kind of business plan is predicated on the belief that someone else would always be willing to pay a higher price.

  • Kynikos: Named after a sect of ancient Greek philosophers that believed the key to life was self-discipline and independence of thought.

  • Mark-to-Market Accounting: Requires portfolio managers to mark their holdings to market every day to show their investors precisely how much they’ve made or lost. Potential problems include:

    • A mismatch between profits and cash- just because a company can book 20y worth of revenues and profits in one fell swoop doesn’t mean it actually has the money in hand.

    • With mark-to-market accounting, there is often a large discrepancy between the profits the company is reporting to its shareholders and the cash it has on hand to run the business. When the initial deals are cut and all the potential profits are immediately posted, a company using mark-to-market accounting appears to be growing rapidly.

  • Momentum Investors: Investors who sell or buy at the first sign of trouble or promise.

  • Restatement: How a company admits mistakes, confessing to the world that its previous financial statements were wrong. Restatements trigger big stock declines, SEC inquiries, and shareholder lawsuits.

  • Securitization: The practice of pooling loans together and selling them to outside investors in the form of a security.

  • Short Sellers: Investors who make money by betting that a stock will go down. They do this by selling stock that they don’t actually own—betting that they will later be able to buy it at a lower price and pocket the difference.

  • Tilting the Curve: Pricing contracts that show money loss followed by a wildly optimistic price curve with steep profits at the end, making up for all the losses.

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Chronology

  • Summer, 2010: The USG enacts the Dodd-Frank Wall Street Reform and Consumer Protection Act.-Smartest Guys by McLean.

  • 5 Jul, 2006: Death of Kenneth Lay from heart attack, while vacationing with his family in CO (famous-trials.com).

  • 2006: The USG enacts the Credit Rating Agency Reform Act.-Smartest Guys by McLean.

  • 18 Feb, 2004: A grand jury in Houston indicts Jeff Skilling on 35 counts, including charges of fraud, insider trading, and conspiracy (famous-trials.com).

  • Summer, 2002: The USG enacts the Sarbanes-Oxley Act (Public Company Accounting Reform and Investor Protection Act) imposing new accounting and reporting obligations on American businesses.-Smartest Guys by McLean.

  • 23 Jan, 2002: Lay resigns as Enron’s chairman and CEO (famous-trials.com).

  • 2 Dec, 2001: Enron files for Ch. 11 Bankruptcy (famous-trials.com).

  • 28 Nov, 2001: Enron’s stock price falls to $.61/share (famous-trials.com).

  • 30 Oct, 2001: Enron’s credit rating is downgraded (famous-trials.com).

  • 22 Oct, 2001: Enron announces it will have to restate its earning from 1997-2000, to correct accounting violations (famous-trials.com).

  • 14 Aug, 2001: Enron CEO Skilling resigns. Lay assumes the job as CEO (famous-trials.com).

  • 28 Feb, 2001: Enron stock falls to $68.50 (from $82).-Smartest Guys by McLean.

  • 2001: Fortune magazine reports skepticism of Enron.-Smartest Guys by McLean.

  • 31 Dec, 2000: Merger of Chase Manhattan & J. P. Morgan.-Smartest Guys by McLean.

  • Nov, 2000: James Chanos begins shorting Enron.-Smartest Guys by McLean.

  • 2000: Enron leadership including Lay and Skilling begin selling off large shares of Enron stocks.-Smartest Guys by McLean.

  • 1999: Enron CFO Andy Fastow forms two limited partnerships, LJM Cayman and LJM2, for the purpose of buying Enron’s poorly performing assets (famous-trials.com).

  • 1996: Bolivia auctions its state oil and gas company.-Smartest Guys by McLean.

  • 1992: Enron becomes the largest seller of natural gas in N. America (famous-trials.com).

  • 30 Jan, 1992: The SEC allows Enron to use mark-to market accounting instead of traditional, accrual accounting, allowing Enron to begin reporting fast-growing profits (famous-trials.com).

  • 1991: Enron closes the Cactus Deal bundling some $900M of the money it had promised to front for gas producers. Enron sells shares on those deals, as a package, to a group of high-powered investors, including GE. Under the terms of the deal, the group would then sell the gas back to Enron, which would resell it to wholesale customers. As a result of Cactus, the debt was eliminated from Enron’s balance sheet and ECT was handed cash to accelerate its growth.-Smartest Guys by McLean.

  • 1 Aug, 1990: Jeffrey Skilling assumes the position of Chairman and CEO of Enron finance (famous-trials.com).

  • 1985: Enron is founded by Kenneth Lay after merging Houston Natural Gas and InterNorth (famous-trials.com).

  • 1983: The New York Mercantile Exchange begins trading crude oil futures, the contract still theoretically came with the obligation to deliver, or receive, oil in some future month. But now that there was a standard contract, it could be traded many times over before anyone had to receive any oil. Market Oil trading increases dramatically.-Smartest Guys by McLean.

  • 1901: The Spindletop oilfield triggers the first Texas oil boom.-Smartest Guys by McLean.

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