The Smartest Guys in the Room: The Amazing Rise and Scandalous Fall of Enron

by Bethany McLean

  Whalley was another “guy with spikes.” He was unusually blunt for a corporate executive; indeed, that was part of the reason the traders adored him. “Whalley was very rough around the edges,” says someone who used to work in the Enron executive suite. “If his mind thinks it, his mouth says it.” Those who disliked him—and there were many outside the trading floor—criticized him for being arrogant and immature. (“He is just a jerk,” says someone who dealt with him at corporate functions.) He could usually be found wearing rumpled khakis and a casual shirt, and he liked to hang out with fellow traders at a Houston bar named Kenneally’s, drinking beers and debating.

  At work, he forced the traders to defend their ideas, even when he already agreed with them. He took that same approach even when he wasn’t working. It didn’t seem to matter to him which side of an issue you took; Whalley leaped to the other side, even on such contentious political subjects as abortion, gun control, or gays in the military. He would say, “I love the NRA” or “people who own guns are idiots,” then abruptly switch sides if someone agreed with him too quickly. It was as if he had no particular moral beliefs himself; it was just a big game. He had zero patience for those he felt lacked the kind of pure intellect he admired and could instantly reduce just about anyone to red-faced, quivering shame. “Whalley had a vicious intelligence to him,” says a former colleague. “If you didn’t know what you were talking about, he would pick you to pieces.”

  Whalley was also a gambler. In the mid-1990s, before he left for London, he ran an NCAA betting pool from the trading-room floor. Many of the Enron old guard put money in the pool, including Pai and Rice. So did outsiders, including some of the McKinsey consultants assigned to the Enron account. The pot grew to more than $100,000. Whalley and others claimed that the pool was an intellectual exercise designed to teach young traders about risk and reward. But when Lay found out, he was furious. At the next PRC, there was a fierce debate over whether Whalley should be denied a promotion for running a betting pool. He wasn’t.

  As Whalley rocketed through Enron, he brought along a handful of acolytes. One was a Canadian named John Lavorato, or Lavo, as everyone called him, who eventually ran trading in North America. He was known for his aggressive attitude and his odd physical tics, which included grabbing onto the shoulders of his shirt, twitching, and scratching. Lavo “played pretty loose” with the rules, as Skilling once put it. Not that this tendency ever concerned his bosses at Enron; Lavo rose through the ranks even as he was being investigated for manipulating power prices in Canada. (He was later cleared of the charges.) Lavorato was another who saw the world as a place where everything was tradable; it came as a major shock to him to learn that Enron’s venture-capital investments in small private companies couldn’t be sold at a moment’s notice. Another Whalley aide was John Sherriff, a former gas trader who ran Enron Europe. The Sherriff legend was that he had made an enormous amount—tens of millions—in a single bet on short-term gas prices back in the mid-1990s, when the business was still in its early stages and such a windfall was not believed possible. All the members of Whalley’s core group shared a short-term mind-set, and all of them reveled in taking huge risks.

  One thing the traders all loved about Enron was the sense they had of operating in the purest environment that had ever been created in corporate America. By pure, they meant that the trading floor operated strictly by the dictates of the free market. The company’s credo had always been that free markets worked best, of course. But the traders grabbed onto that belief with a cultlike fierceness. They could be positively self-righteous about it. They loved the idea that they were inserting competition—and not just any competition but brutal, Enron-style competition—into such formerly sleepy industries as the utility business. They believed that free markets made the world a fairer place, one where price dictated deals, rather than relationships or other “noneconomic” factors. To them, the lines were clearly drawn: it was visionaries versus Neanderthals. “Enron,” says a former trader, “was all about changing the world, showing up every day to be a pain in the ass to every incumbent.”

  More than that, though, they believed that the market was the ultimate judge of their work and their worth. The market created a true meritocracy: you either made money because you made good trading decisions or you lost money because you made bad ones. Enron traders didn’t concern themselves with ethics or morality apart from the unyielding judgment of the markets. Maximizing profit was not inconsistent with doing good, they believed, but an inherent part of it, and the judge of good and bad was the immediate consequence of a split-second trade. The highest compliment a trader could pay a colleague was to call him intellectually pure. The worst insult was to accuse someone of making a deal that wasn’t economic.

  There was another component, too. Because the traders thought they were creating a new world, they looked upon existing rules not as guidelines to be respected but as mere conventions to be gotten around in whatever creative fashion they could devise.

  Whalley was so intent on trying to remove the human element from trading that he once had a robot programmed to trade futures contracts. He wanted to see whether a market with enough liquidity could run on autopilot. He even gave the robotrader a name: George. Skilling was entranced with Whalley’s experiment and would wander down to the trading floor every few hours to see if George was making any money. “How’s George doing?” Skilling would ask. “Down another $50,000,” Whalley would reply. George lost about a million bucks before Whalley finally pulled the plug.

  The traders’ belief system did not make the Enron trading floor a warm and cuddly place. “We were an enormous collection of Type A personalities,” says an ex-trader. “We were very competitive, and we just didn’t feel that we could fail a lot.” An executive named Bill Butler used to stalk the floor with an eight-foot-long black bullwhip in hand, jokingly threatening traders who didn’t seem to be spending enough time on the phone. Their esprit was such that the traders took great pleasure in outsmarting other parts of Enron, and they didn’t show much mercy for one another, either. “If you showed any weakness, the antibodies would attack,” says a former trader. “Life at Enron,” says another, “was the purest form of balls-out guerrilla warfare.”

  This sense of the world as an endless competition, a chance to one-up someone else, permeated the trading floor. Betting was a way of life and not just during March Madness. Traders would make bets on whether someone could down a sack of Big Macs or make consecutive free throws or eat two slices of bread (without water) in under a minute. Sometimes the stakes got very high. Every year, on the annual retreat to the Hyatt Hill Country Resort in San Antonio for vice presidents and above, a group of traders would play a poker game called Omaha (where the lowest hand and the highest split the pot) at the same table in the lobby of the hotel. The pot was usually around $1,000, but in the final year it was played—2000—three players thought they had good odds of winning. The pot grew to $33,000, as the crowd gathered and the tension built into the early morning hours. One player had both the high hand and the low hand. He bought a new BMW. The other two—one of them London chief John Sherriff—were out $11,000 each.

  • • •

  The one member of the old guard the traders admired was Skilling himself. Though they cringed when he said things like “we’re on the side of the angels”—what an emotion-laden thought!—they agreed wholeheartedly with the underlying sentiment. “What Skilling did so well was to motivate other people to his vision,” says a former Enron trader. “I still believe in a lot of the things he said.” Several of the traders did think that some of Skilling’s personal habits, such as hanging out in Houston dive bars until the wee hours, were strange. But they liked that in a way, too. “Enron people, who cares about normal?” asks another former trader. “We don’t like normal. People at Enron didn’t want a typical CEO.” And in a way, Skilling was just like them. He too had a penchant for taking business gambles. As Whalley himself once put i
t, “The biggest gambler of them all sits on the fiftieth floor.”

  Still, it gnawed that Skilling refused to publicly acknowledge the traders’ importance to the company’s profits. They were proud of their success as speculators. But Skilling continued to tell Wall Street what he always had: that Enron was a logistics company and that its trading profits were merely a predictable function of the volume of energy it sold to customers. There was a kernel of truth to this, but it became increasingly less true over time. By the late 1990s, origination, which had been the impetus behind the creation of the trading desk, had started to wither away. Part of the reason was that some of the big, old origination deals had turned into massive headaches. “Half of what kept origination in business was cleaning up their own messes,” says one former executive in a typical comment.

  The Sithe deal was a classic example. Under the original terms of the 20-year deal, Sithe and Enron had set up something called a tracking account, which reflected amounts owed either side as energy prices fluctuated. It was assumed that over the long haul, the tracking account would never get too far out of balance. Over time, though, the tracking account became extraordinarily unbalanced, to the point where Sithe was projected to owe Enron about $1.5 billion over the life of the contract. Yet the only collateral was a share of the cash flow from the plant and the plant itself, which RAC estimated were worth just over $400 million. In other words, Enron was not going to be able to collect some $1 billion it was owed. Under mark-to-market accounting, that should have been reflected on both the company’s balance sheet and in a charge to reported profits. Yet according to a postbankruptcy review conducted by Enron’s new chief accounting officer, that charge was never taken.

  In the meantime, Enron was also losing money on various pieces of the contract. Restructuring Sithe became a regular endeavor; every few years or so, the giant Sithe contract would land on some hapless young associate’s desk, and he was told to figure something out.

  Besides, origination required so much work and for so little payoff. Competition in the industry was brutal and margins had plummeted. Old-fashioned origination had become, in the opinion of the traders, noneconomic. “Origination,” sighs a former executive. “You’d bust your balls for six months and make $2 million or $3 million. A junior trader was swinging that in just a few days. The trading shop was making so much money that everything else was a waste of time.”

  So while Whalley was running the trading shop, another Young Turk named Dave Delainey took over origination and made it more closely resemble trading. He and his team turned power plants themselves into a kind of trade, building then quickly flipping them for a profit. They also bought hundreds of millions of dollars worth of turbines, which are the biggest expense in a power plant, then quickly resold them to power developers. (“We were going to corner the turbine market,” says one former RAC employee.) Both these efforts were supremely successful, and Delainey became a star. In 1999, Enron did do one old-fashioned deal, signing a five-year contract to supply People’s Gas & Electric of Chicago with all its gas. Executives would cite that as an example of the sort of deals Enron did. In fact, by that point, People’s was one of the few new deals of its kind. Instead of customers, the new Enron had counterparties.

  Yet the fiction persisted. One trader remembers watching Skilling and Ken Lay on CNBC on December 13, 2000. When CNBC anchor Maria Bartiromo brought up Enron’s trading prowess, Skilling quickly responded that “trading is just a small portion” of the company’s business. The week before, there had been an Arctic air mass over Canada moving toward Texas; the traders called it the “polar pig.” Many were long gas, expecting the ensuing cold weather to drive prices upward. Instead, the pig petered out and prices unexpectedly plummeted. On December 12, the day before Skilling and Lay appeared on CNBC, the traders lost $550 million, according to one report, and $630 million, according to another report that was sent to both men. If a Wall Street firm lost that kind of money, the news would make headlines. There wasn’t so much as a peep outside Enron. Inside was a different matter. “There wasn’t anybody in the company who thought we weren’t speculators,” says one former trader. An internal document explaining the loss chalked up part of the reason to “weather conditions ease—blizzard expected to hit the North East does not arrive.” Logistics, indeed.

  Not even Lay seemed to really believe that the Enron traders were indifferent to commodity prices. Once, Lay was asked at an employee meeting if he regretted the sale of Enron Oil and Gas, whose stock had bounced back since Enron had gotten rid of the company. “No,” Lay said. “We’ve made manyfold more money out of the rise in gas prices through our wholesale business in the last six to nine months than we ever could have owning EOG.”

  In late 2000, a 26-year-old superstar trader named John Arnold—who was revered for being able to do complex mathematical equations instantly in his head—hit a bad losing streak and went from being up $200 million to being down $200 million in the space of less than a month. On Wall Street, such a performance might well have gotten Arnold fired. But when Skilling heard what had happened, Whalley told him that everything was cool. And so Skilling came down to the thirty-second floor, where the traders worked, and put his arm around Arnold in a public show of support.

  On the trading floor, where the two pieces of required reading were When Genius Failed, about the collapse of the giant hedge fund Long-term Capital Management, and Reminiscences of a Stock Operator, about the adventures of a turn-of-the-century speculator, Skilling’s “we’re just a logistics company” spin was a source of both amusement and annoyance. “Logistics company? Complete freakin’ lie. Biggest crock ever,” says a former trader. “Logistics company?” says another. “That’s complete and utter bunk.” But they understood why he was doing it. In the early years, whenever the traders complained to him about how little credit they were getting, Skilling would explain that he was positioning the business in the way that was best for Enron’s stock. In the latter years, nobody needed to ask; they understood. “Jeff couldn’t let go of ‘we’re just a logistics company,’ because if you did, the stock was going to get nailed,” says a former senior originator. “People found it incredible, but we thought, more power to Jeff if he can sell it to the Street,” adds another former executive. Then he pauses. “But it was fundamentally misrepresenting the business to the people who own it: the stockholders.”

  The Enron board was also aware of the increasing amount of speculative risk the traders were taking. Remember the old Enron Oil days, when the Enron directors were so fearful of trading losses that they instituted a $4 million trading-loss limit? That era was long gone. But the board still had to approve every increase in trading limits. As the head trader, Whalley pushed hard to get the limits increased—and the board repeatedly went along. Even at the end of 1998, a presentation to the board shows, Enron was willing to risk, as a percentage of its net income, more than five times the amount that Morgan Stanley would. By the end of 2000, the board roughly tripled the amount of capital the traders were allowed to risk, according to one key measure; the following year, it was raised again. By the end, Enron was willing to risk losing some $3 billion over the course of a year, according to one knowledgeable risk manager.

  And even those increases couldn’t keep up with the risks the traders were actually taking. According to a document prepared by RAC, in the first six months of 2000, the traders committed 64 “limit violations . . . where no tangible action was taken to adjust commercial personnel views regarding the importance of a risk management framework and risk control environment.” In other words, Enron’s traders were violating the trading limits frequently—with absolutely no meaningful consequences.

  • • •

  Trading, as we’ve noted earlier, begets trading. That’s true not just of stocks and natural-gas futures but also of baseball cards and rare books and just about anything that someone believes has value. If enough people want to trade a commodity, a market will develop. �
��If you have a puff, then another puff, then you have a gale, then you have a tornado,” says the chief credit officer of a top Wall Street firm. “It feeds on itself.”

  In leading the charge into trading gas and electricity, Enron didn’t just create a different kind of energy company; it created an entire industry. Other energy companies jumped in to take advantage of this new profit-making activity. They had names like Dynegy, El Paso, and Mirant. They all traded energy derivatives with one another and with the handful of Wall Street firms that also got into the business. They marked-to-market their trading gains, just like Enron. Most of the companies in this new industry were based in Houston, just like Enron, where they operated in the long shadow of the industry leader. They took to calling Enron the “evil empire.”

  Enron executives chalked up such talk to jealousy, and in large part they were right. Despite the new competition, Enron remained, by far, the most powerful force in the business. It constantly came up with new wrinkles that its competitors were forced to copy. Several institutional investors say that Dynegy CEO Chuck Watson used to tell them that his company’s strategy was to keep tabs on Enron. If a new Enron idea appeared to be working, he’d have the same business up and running six months later.