Lessons from the Enron Financial Disaster

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Lessons from the Enron Financial Disaster

30/04/2013

How come no-one saw it coming?

Enron began as a producer and distributer of natural gas, and by the 1980s evolved into one of the world’s largest energy trading companies, before collapsing with enormous debts in 2001 and creating the largest bankruptcy case in US history.

By modelling the finance industry’s trading of money as a commodity, Enron came up with the idea of a “Gas Bank”. Trading natural gas as a financial commodity, they argued they could reduce the level of risk and uncertainty for all the parties involved. Enron then went further, and traded contracts (promises to buy or sell gas at a particular price) just like oil futures which allowed Enron to make money on every transaction.

The shift from gas producer to trader

As a result of the increasing emphasis on these kinds of trades, Enron began to possess an increasingly larger portfolio of contracts, rather than fixed assets. For Enron, delivering gas was no longer about the physical ability to do so, but a financial commitment that could be sold, insured, hedged and traded.

Such was the desire to generate more profit, that even though in some cases the actual gas had not yet been found, or the infrastructure to produce and distribute it not been developed, the company still pursued this course of action.

New accounting system assumed future profits

The next innovation introduced by Enron was a new form of accounting called mark-to-market, which allowed it to record all estimated future profit from contracts on the day the contract was signed.

This was very different to the historical cost-accounting that everybody else in the energy industry used.

Imagine how a sudden huge profit would improve Enron’s stock price (which was actually the point). Enron argued this was OK, as showing future profits is what shareholders really want to know.

Enron’s accountants began using a foot note, “recognised by unrealised income”. They developed a language to legitimise their accounting practices.

Board and regulators approved new practices

The Enron Board approved the mark-to-market method in 1991, and then asked the regulator (Securities and Exchange Commission [SEC]) to do the same. The SEC agreed to Enron’s request in the following year.

As is often observed with many unruly technologies, formal rules follow practice that had already evolved: the trading and accounting practice appeared to be working (for the time being).

The new accounting method created a never-ending demand for more and more contracts to be signed for larger amounts each subsequent year to satisfy stock market expectations, and to hold Enron’s share price up.

Expanding trading into riskier areas

Gradually, Enron extended the mark-to-market accounting to areas where future prices were even harder to estimate.

As they were a gas producer first, trading was originally a small part of Enron. But in 1992, Enron convinced a New York power company to build a new gas-fired station, instead of using coal. The traders at Enron booked four (4) billion dollars in future profits immediately.

Enron’s value and stock price increased year on year, but this was a false indication. As time passed, there was an ever-increasing risk of the “bubble bursting”.

Where was the regulator while all this was going on? Passively accepting and approving changes to the rules, bit by bit.

Role of the risk department

Enron had its own Risk Department, as they knew that Wall Street and the SEC wanted to see a strong system of internal controls. The Risk Department reviewed all deals Enron made that were over half a million dollars, and was the centre-piece of every market presentation.

The Risk Department had 150 talented staff and a $30m budget. Their role was to question all assumptions, test models used, check price curves and monitor portfolios.

Wall Street analysts often commented that Enron was defined by the way it managed risk. Enron could, supposedly, play fast and loose with deals because “it’s risk management was so tight”.

In truth however, the Risk Department never declined any deal. Perception was more powerful than reality!

What about others with roles in oversight and control, such as the banks that invested or loaned money to Enron? Or the accounting firms who took millions of dollars in fees and signed off on Enron’s accounts?

All parties had a vested interest in Enron continuing to be successful and had little choice but to keep a “buy” rating on Enron, despite any misgivings or suspicions which they may have had.

Third of Enron now traders

By the late 1990s, a third of the 18,000 employees at Enron were involved in trading. Still, Enron didn’t have enough money coming in, and as a result the “profits” and cash flow were increasingly becoming the result of complex dealings with itself, and not new business.

Enron had a long series of complex deals with “time bombs” of unpayable debt, as most deals did not have any underlying value, but merely a deal to start a project, not an asset.

Squeezing blood from a stone

When trading was not enough, Enron put pressure on its traders to re-assess the value of past contracts to transfer more “profit” onto the books and meet targets.

In 2000 Enron started trading electricity and then broadband internet, just as the internet bubble burst.

Enron declared bankruptcy in December 2001, and numerous executives were charged with criminal offences.

If you want to learn more about what this financial disaster has to do with workplace safety and preventing major accidents, then call Gary Rowe or one of our team on T. 03 9690 6311 or book a place in one of our safety leadership courses, where we expand on this and many other fascinating topics.

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