Just before the end of last year, J.P. Morgan Chase & Co. announced that it was not on the hook for a $900 million loss from the Enron debacle, as it had previously stated. No, the exact dollar amount was $2.6 billion. When bankers miscalculate how much money their company has lost by 10 digits, something is terribly wrong.
Not to worry. Team J.P. Morgan Chase was on the case. In an accompanying press release, the bank announced that it would sue several of its insurance companies, which, said the bank, were refusing to honor their obligations to cover this staggering loss. Two of the insurance companies were owned by Citigroup — also said to be on the hook for $800 million in Enron-related losses. (For the record, that $800 million figure was a preliminary estimate. The final number will probably be much higher.)
Which is why a team of bankers at Citigroup was trying to arrange financing to reliquefy Enron’s energy-trading operations. Getting that plan going might generate some cash that would at least partially alleviate the financial pain — for both the banking side and the insurance side. But the negotiations were bogged down by mistrust, uncertainty, and anger. Could you trust these people from Enron on anything? That was the question. Sitting at the table with Citigroup — indeed, serving as co-underwriters of the proposed bailout — was J.P. Morgan Chase.
As of this writing, neither Citigroup nor J.P. Morgan Chase nor any of the other Enron lenders has anything close to a complete picture of Enron’s financial situation. And they’re not likely to get one anytime soon. Kenneth L. Lay, Enron’s chairman and chief executive, admitted that the company’s tangled finances were “opaque and difficult to understand.” And Andersen, Enron’s auditing (and consulting) firm, has admitted to destroying Enron documents and is under investigation. So don’t look to the accountants to clear this up.
What’s frightening about Enron’s collapse is that no one knows which financial bombs and bomblets might go off in the months ahead. The company traded in every imaginable “swap” and financial-derivative instrument. Now that it’s bankrupt — now that it has gone from seventh on the Fortune 500 list to the biggest belly-up of modern times — the question that haunts the markets is, What happens when Enron’s contracts come due in April, May, June, and beyond? Will the nonhonoring of those contracts cause other contracts to come undone, leading to a mini-meltdown of contracts that could eventually bankrupt a financial institution, which would set another lot of mini-meltdowns in motion, leading next to the insurance industry? No one knows.
What do we know? And what can we learn from this?
What happened was relatively straightforward. Six years ago, Enron was a pipeline company. On the great divide of the “business of things” and the “business of information,” it was a business of things. Over the course of the ensuing six years, Enron transformed itself into a business of information and in doing so caught the Internet wave just as it was surging. Traditional investors liked Enron because it still owned a lot of things, such as power plants and pipelines. New-economy-minded investors liked Enron because its management repeatedly claimed that it was committed to becoming a business-of-information company.
Enron’s stock rose. Earnings, on average, grew at a phenomenal annual rate of 24%. Cash flowed in. Enron’s management invested the cash in some risky (to put it politely) enterprises. One of them, for example, was a corporate confection called the NewPower Co. NewPower said that it would sell gas and electric services to residential customers across the United States — a nonstarter from the get-go, given the regulatory environment. NewPower imagined itself as a kind of Amazon.com for a broad sweep of services and products, from energy to appliances. The company burned through $100 million in no time and has all but disappeared. Many other Enron-backed ventures met a similar fate.
Theoretically, such enterprises would eventually be written off as a charge against earnings. Not at Enron. There, troubled enterprises were reconfigured as “private partnerships” and recollateralized by Enron stock. This maneuver had the dual benefit of enriching Enron senior managers (through grants of stock to the partnerships that they created and directed) and making red ink magically disappear from the company’s balance sheet (since private partnerships are technically “off the books”). Hundreds of millions of dollars down the tubes blemished no Enron spreadsheet. What could be better than that?
As more and more investments and deals turned sour, more and more SPEs (special-purpose enterprises, or private partnerships) were created. Enron’s earnings remained untouched and continued to impress. Its stock rose steadily and occasionally spiked. The greater the value of the stock, the greater Enron’s capacity for leverage. Banks lined up to lend the company money. On and on it went until markets began to ebb and the supposedly virtuous circle suddenly switched its rotation. Then the unraveling began.
Once that started, there was no stopping it, although Enron (seventh on the Fortune 500 list!) did manage to forestall the inevitable longer than one might have guessed. The company did this by using the time-honored tactic of lying through its management’s collective teeth. Just over a year ago, then-president and CEO Jeffrey K. Skilling told anyone within earshot that Enron’s stock (selling at roughly $80 at the time) should hit above $120. Then he began selling it as fast as his broker could place the orders. He sold a ton of it. Shortly thereafter, his resignation was accepted because his credibility on Wall Street had reached absolute zero. Lay returned to try to right the ship, but by then, it was too late. The short sellers came in for the kill. By the first week of December, Enron was gone.
The interesting thing about Enron’s demise is that it didn’t have to happen. What made it happen was that Enron’s management contradicted the basic principle of the business of information: Transparency is not fungible.
In the past, transparency was something that buyers (and sellers) had to work hard to acquire. But in the Internet Age, there are hundreds of millions of dollars’ worth of supercharged servers and microprocessors that are collecting and collating and comparing hundreds of millions of bits of information and then sorting them to a buyer’s or a seller’s exact specifications. Want to know what the cheapest flight to London is? There are about seven services that will provide you with that information, free of charge.
The more mature the business category, the greater the transparency. Enron’s category — energy trading and related markets — was growing up quickly. The more transparent the market, the harder it is to maintain price discipline (the ability to charge premium prices). Look at the automobile market, which is a very mature business of things that is now hard-wired to the Internet. For more than three months at the end of last year, auto dealerships were selling cars at or a tiny bit above cost (and in some cases below cost), with 0% financing. The pressure on price created by transparency is tremendous.
Enron never seemed to understand that. Indeed, its management simply would not acknowledge that by enabling and enhancing transparency in a number of markets, it was therefore creating downward price pressure. That’s not to say that market-making a global-energy trading business will eventually become the grocery business. It won’t, necessarily. But it’s not a business of 24% earnings. The margins get thinner as the marketplace expands and becomes ever more transparent.
Enron’s deranged notion that it could lie itself out of its pickle is emblematic of how little the company really understood the underlying principles of the new economy. Principle one is transparency. Principle two is opportunity. Principle three is speed.
Enron grew at an astonishing speed. It seized a tremendous opportunity (creating a futures market for any number of basic services). But it never understood the most important principle: A business of information requires transparency. And so, Enron failed. Good riddance.
John Ellis (firstname.lastname@example.org) is a writer and consultant based in New York.