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

by Bethany McLean

  Then there was the issue of the “market” in mark-to-market pricing. To value some trades, companies could look at price indexes printed by the trade press (such as Gas Daily and Inside FERC), much the same way an investor might look at a quote for shares of IBM. But the indexes for energy prices were a lot less solid than the price for a share of IBM. Individual traders could tell the trade press anything they wanted—and they did. Sometimes, they made up spreadsheets showing pricing for trades that never happened. They did it to make their own books look better, and they did it because everyone in the industry thought everyone else was doing it. Valuing long-term trades was even murkier. Companies used their own proprietary models to estimate the value of trades. But they didn’t use the same models. If company A declared $100 million in profits resulting from a trade with company B, company B didn’t necessarily declare a $100 million loss.

  Enron, partly thanks to EOL, which provided market prices for many trades, played these games less often than smaller players did. But it is impossible to know how real the values on EOL were, either. Although the Enron traders mocked the rest of the industry for its lack of intellectual purity, they were part of the same industry, with some of the same issues. For instance, at one point, Enron’s biggest contract was a long-term deal it had with TXU Europe, which by mid-2001 was valued at almost $2 billion. Prices had moved dramatically in Enron’s favor, but one former RAC employee familiar with the contract says that Enron still overvalued its gains by hundreds of millions. More important, much of the gain turned out to be illusory: TXU Europe declared bankruptcy shortly after Enron did. In truth, the entire new industry that Enron helped create was built on a quicksand of assumptions, which helps explain why all energy traders struggled just to survive after Enron’s bankruptcy.

  What’s more, just because the traders were reporting earnings under mark-to-market accounting, it did not necessarily follow that cash was coming in the door. As North American gas and power trading became increasingly short term in nature, there was more immediate cash, but the same was not true of the other things Enron traded. The net result was that the trading floor was also dependent on Andy Fastow’s machinations. “I called it cashless prosperity,” says a former risk manager.

  Not that this was anything any of the traders ever thought about. At Enron, it was bookable accounting profits, not dollars coming in the door, that mattered. “People did not know the difference between mark-to-market earnings and cash,” says a former trader. “No one ever talked to me about cash,” says another. “It wasn’t on our annual review or included in our targets. It had nothing to do with how we were measured for our bonus. It was nothing we were paid for, so who cares?” He adds: “I knew we had no cash and that our earnings were susceptible to manipulation. This is a game. I know that, everyone knows that. But it was a game we were winning.”

  There was one final issue. Even though trading was an enormously volatile business, Skilling nonetheless expected the traders to generate steadily increasing earnings every year. Vince Kaminski, Enron’s probability guru, used to warn Skilling that he shouldn’t have earnings expectations when it came to the trading business; in any given year, profits were as likely to go down as to go up. Skilling would respond that people always told him that, but the traders had always come through. And he assumed they’d keep coming through. So every year, trading was handed a budget that was substantially higher than the year before.

  In 2000, the traders were told they needed to make $1.4 billion. When Cliff Baxter saw that number, he hit the ceiling. “There’s no way,” he told Skilling. “And if I do make the number, I want to be paid!” Though he’d had responsibility for the trading operation for less than a year, he was deeply unhappy with the job. Baxer had little power. Among other things, he lacked the authority to promote employees in his division or even to set their compensation. For someone who cared so deeply about status, the whole situation was humiliating.

  One day, early in the summer of 2000, during a meeting of about 25 top Enron executives, Baxter complained to Skilling about Pai’s compensation, always a sore point with him. Skilling turned to Dave Delainey and said, “Is he right about that?” Baxter, always sensitive to perceived slights, was offended; as he later told an investigator, he felt that Skilling had publicly undermined his authority.

  After obsessing over the matter, Baxter decided to leave both his post and Enron. But Skilling talked him out of quitting the company, offering him the title of chief strategy officer, and later Enron’s vice chairman.

  By the end of 2000, Greg Whalley had become the chief operating officer for the entire wholesale business. That meant that aside from EES, broadband, and the pipelines, Greg Whalley, the ultimate trader, now had day-to-day oversight for all of Enron’s businesses.

  CHAPTER 15

  Everybody Loves Enron

  At practically every employee meeting in the late 1990s, Ken Lay would trot out what he once described as “one of my most favorite slides.” The slide compared Enron’s stock performance against that of the S&P 500 during the 1990s. It was, unquestionably, a glorious sight to see, and one that only got more glorious with almost every passing quarter. By May 1999, Enron had returned over 600 percent to its investors, one and a half times the return of the market’s most important index. By early 2000, Enron’s return had hit 1,000 percent. And by October 2000, Lay’s favorite slide showed that Enron had returned a stunning 1,400 percent since 1990, more than three times the gain of the S&P 500.

  Enron’s stock slump of 1997 was ancient history. In the heady days of the late bull market, it was hard to recall a time when Enron’s stock hadn’t gone straight up. In August 1999, with the stock closing in on $88 a share, the company announced a two-for-one split, its first since 1993. For the year, Enron stock returned a startling 58 percent.

  Enron’s ever-rising share price, of course, was serving as the underpinning for the many special-purpose entities Andy Fastow and his Global Finance underlings were devising to help the company raise capital and hit its quarterly earnings targets. It had a number of other consequences as well. At the tail end of a bull market that had run for nearly a decade, any company with a flashy stock chart and an eye-popping price-to-earnings ratio took on an aura of invincibility, none more than Enron. “Enron is literally unbeatable at what they do,” raved David Fleischer, a securities analyst at Goldman Sachs. “The industry standard for excellence,” chimed in Deutsche Bank’s Edward Tirello. “Enron is the one to emulate,” wrote the Financial Times.

  Any remaining vestiges of skepticism were washed away in the torrent of praise that showered over the company and its top executives. Enron’s nearly incomprehensible financial statements? Nobody worried about them. The related-party transactions buried in the footnotes? Who bothered with footnotes? That Skilling himself sometimes seemed unable to give a coherent explanation of Enron’s business—at times, he got by with saying “We’re a cool company”—bothered no one. All that mattered was that the stock was going up. Because the stock was rising, Enron’s executives were seen as brilliant. Because they were viewed as brilliant, all their new ideas had to be winners. “They had the aura of whiz kids, of golden boys who could do no wrong,” says Thomas Kuhn, the president of the Edison Electric Institute, the powerful trade association for the nation’s electric utilities. Skilling and Lay found themselves mentioned in the same breath as GE’s Jack Welch, Microsoft’s Bill Gates, Apple’s Steve Jobs, and the very small handful of other celebrity businessmen.

  The people inside Enron were as caught up in the frenzy as any outside investor. It was fun to read the stories about how smart they all were. Because the market rewarded every new move they made, Enron’s employees started to think they couldn’t make mistakes. One top executive says, “We got to the point where we thought we were bulletproof.”

  Enron was hardly the only company to see its stock ascend on a cloud of hype as the 1990s came to a close. But it was different from most such companies
in one critical respect. The circle of people who knew—or should have known—that Enron’s glittering surface masked a different reality was surprisingly large. Much of what Enron did—such as generating billions in off-balance-sheet debt—was out in the open. Many of the analysts knew full well that the company’s earnings far outstripped the cash coming in the door. The bankers and investment bankers, who worked for the same firms as the analysts, certainly understood what Enron was doing; indeed, they made Fastow’s deals possible. The credit-rating agencies knew a lot. The business press, which could have looked more closely at Enron’s financial statements, couldn’t be bothered; the media was utterly captivated by the company’s transformation from stodgy pipeline to new economy powerhouse. And of course there were any number of Enron’s own employees who could see for themselves how the company was making its numbers. And yet, they all chose not to make the logical leap, to see where it was inevitably headed. Instead, they all chose to believe.

  Everyone loved Enron.

  • • •

  Start with the analysts. The securities analysts who covered Enron knew a great deal about how the company really operated. Here, for instance, is a J. P. Mor-

  gan analyst named Kyle Rudden, writing in mid-1999: “ENE is not a cash flow story. . . . Enron has significant flexibility in structuring contracts and hence booking earnings . . . contracts can be structured to recognize the economic value of projects long before they are operational and cash is coming in the door. . . . This has two effects: front-end loaded earnings that bias the denominator in the PE ratio, and a timing disconnect between projects’ cash and earnings effects. . . .” (ENE was Enron’s stock symbol.)

  Rudden noted, for instance, that a plant Enron built had not become operational until 1999, but Enron had booked the income it expected to generate from it two years earlier. In other words, the analyst saw clearly that Enron’s stated profits had more to do with its accounting than with the reality of its business. The analysts also knew that Enron had an enormous amount of off-balance-sheet debt, which they occasionally mentioned—but never stressed—in their reports. From time to time analysts would quiz Enron’s investor relations department about the LJM partnerships, which were, after all, disclosed in Enron’s financial documents. But they refrained from pointing them out in the reports they issued to investors.

  Analysts who worked for Wall Street banks later claimed that they had been deceived by Enron. But if they were indeed victims, they were willing ones. “For any analyst to say there were no warning signs in the public filings, they could not have read the same public filings that I did,” Howard Schilit, an independent analyst who is the president of the Center for Financial Research and Analysis, later told Congress.

  For a securities analyst working in late 1990s, there was no percentage in making much of such potential problems. Wall Street research had changed a great deal during the previous two decades. Once a sleepy backwater, research departments had evolved into one of Wall Street’s glamour professions. Top-ranked analysts made millions of dollars. Their calls—that is, their upgrades or downgrades of individual stocks—moved the market. Some of the most prominent analysts, such as Henry Blodget, who covered Internet stocks for Merrill Lynch, and Jack Grubman, Salomon Smith Barney’s telecom analyst, became even better known to the public than the CEOs whose companies they covered.

  But analysts got to be rich and famous only if they were bullish. That’s what got them appearances on CNBC, not to mention loving profiles in The New Yorker, an honor accorded Morgan Stanley’s famed Internet analyst Mary Meeker. As the market rocketed upward, bearish analysts who dared to buck the crowd were putting their jobs in jeopardy. Many were replaced by more bullish souls. In Internet chat rooms, individual investors flamed analysts who downgraded their favorite stocks. Even sophisticated institutional investors—the analysts’ primary clients—often became angry at research analysts who turned bearish on stocks they held. It didn’t matter if the analyst’s insight was correct or perceptive; all that mattered was that he or she had hurt the stock.

  In truth, many Wall Street researchers had largely stopped doing anything that resembled serious securities analysis. That was a second way the role of a Wall Street analyst had changed during the bull market. Once upon a time, an analyst saw his job as trying to assess a company’s long-term prospects. The modern analyst, however, was more a marketer than a researcher and was almost entirely consumed by short-term considerations. Above all else, analysts focused on earnings per share. They regularly consulted with the company’s investor relations executives, who quietly gave them what came to be known as earnings guidance. Using that guidance, the analysts came up with their earnings estimates for the next quarter (or the next year), which they would then market to their big institutional clients. The estimates of the various analysts were also fed to an organization called First Call, which blended them together to form the consensus earnings estimate. That consensus earnings figure was the number companies needed to meet or beat to keep Wall Street happy—and ensure that their stock would keep going up.

  The crucial point is this: so long as a company met or beat its earnings-per-share estimate, nothing else mattered. Cash didn’t matter. Off-balance-sheet debt didn’t matter. Even on-balance-sheet debt didn’t matter. And meeting or beating its quarterly estimates was exactly the game Enron had mastered. In the giddiness of the bull market, no analyst was going to spoil the party by asking tough questions about how it had pulled this off.

  Analyst Curt Launer, who was then at Donaldson, Lufkin & Jenrette, told CNN in May 1999 that “the growth rate of Enron is 15 percent to 18 percent per year, very reliable, visible earnings growth.” Of course, Enron’s earnings growth was hardly visible, nor, beneath the surface, was it even reliable. But no matter.

  Launer was a longtime, well-respected natural-gas analyst. But by the late 1990s, his career had become a perfect example of the rewards an analyst could reap by playing the game according to the new rules. In his reports, he didn’t seem to have any particularly deep insights into Enron’s business. His understanding of the business was such that he told at least one investor that Enron was “a ‘trust-me’ story.” Some at the company didn’t think much of him. “He loved going to lunch with Skilling and Lay,” recalls one former top executive. “He was never into the numbers. And he didn’t understand the trading business even after we spent years explaining it to him.” But he pounded the table for a soaring stock. In both 1998 and 1999, Launer was named Institutional Investor magazine’s number one–rated natural-gas analyst, largely on the strength of his “longstanding buy signal on Enron.” Number one–rated analysts tended to make $1 million a year or more.

  Why were analysts so maniacally focused on quarterly earnings estimates? In large part, because that’s what many of their most important clients cared about. The bull market brought with it the rise of a new breed of institutional investor: momentum investors, who bought stocks primarily because they were rising and whose stock-picking discipline was built solely around whether a company beat its earnings-per-share number. With its rapid earnings growth, Enron had become a classic momentum play by the late 1990s. The company’s single largest investor was Denver-based Janus, which operated a high-flying family of mutual funds, most of which invested in the fastest-growing companies their fund managers could find. At the peak, Janus owned some 8 percent of Enron’s shares.

  The problem with momentum investors is that they don’t necessarily understand the business and at the first sign of trouble, they don’t stick around to hear explanations. Just as they can help drive a stock higher with their buying, they can also accelerate a downward push with their panic selling. Convinced that Enron’s stock would never go down, neither Skilling nor Lay was worried about the influx of momentum players. As Lay put it during one employee meeting, “Increasingly it [Enron’s stock] is being bought by the growth portfolio managers, and of course even the momentum portfolio managers. But this i
s probably the world we are in now. And I would rather be in this world with a 50 PE than in that more stable world with a 20 PE.”

  What if an analyst tried to get beyond Enron’s pat explanation of its business? Executives would imply that they were slow and stupid, and most of the other analysts would agree with that assessment. “If you weren’t with Enron, you were against them,” is how one former investor sums it up. Plus, Enron’s business was all so new, which provided another perfect excuse for the lack of clarity. As analyst Jeff Dietart at Simmons phrased it at the time, “It’s more the nature of the business than Enron not giving analysts the information they need.”

  Skilling, in particular, was infamous for dividing the world into those who “got it” and those who didn’t. Internally, it was part of the company’s code; Enron itself was divided between those who got it (the traders; the deal makers) and those who didn’t (the old-line pipeline executives). Outsiders who came into regular contact with Skilling hungered to be included on the list of those who got it. This was especially true of Wall Streeters, who pride themselves on their smarts. On the rare occasions when Skilling was pressed, he would react with scorn. “He did not want to be crossed in any manner, shape, or form,” says one major investor. “He had a good McKinsey trick,” says another. “If you asked a question that he didn’t want to answer, he would dump a ton of data on you. But he didn’t answer. If you were brave and said you still didn’t get it, he would turn on you. ‘Well, it’s so obvious,’ he’d say. ‘How can you not get it?’ ” So the analysts and investors would pretend to get it even when they didn’t.