By Jim Schutze
By Rachel Watts
By Lauren Drewes Daniels
By Anna Merlan
By Lee Escobedo
By Eric Nicholson
Comparisons between Enron and the Old Colony Foreign Exchange are, of course, imperfect.
Like Ponzi, Enron wouldn't own up to its failure. When the company's top executives discovered they couldn't trade water or high-speed Internet access like oil and gas, they formed partnerships to keep losses off the balance sheets. Failed businesses were shifted onto the partnerships' accounts, which triggered loans that Enron booked as earnings. The loans were funded by Enron's investors--such as J. P. Morgan--and backed by assets, which included a water plant and a broadband unit, that Enron had moved into the partnerships. Enron then recorded the loans as earnings on these assets. The actual value of those assets, however, was considerably less than the earnings put on the books, which is why Enron had to restate its earnings when the partnership schemes were uncovered.
This, however, isn't called a Ponzi scheme. It's derivative financing, or more precisely, a debt-equity swap that allowed Enron to borrow from itself to cover losses and keep shares trading at a premium. Meanwhile, executives told investors the sun would rise twice tomorrow.
When Enron filed for bankruptcy on December 2, shareholders finally learned the company had created more than 870 off-balance-sheet subsidiaries.
From the formation of the first of those partnerships in 1997, 29 Enron executives and board members sold $1.1 billion in company stock. In the wake of the company's collapse, shareholders--untold numbers of retirees and pension fund investors, including Enron's own employees--are down $70 billion.
It may turn out to be a coincidence that the brass began cashing out at precisely the time Enron's insider trading of derivatives--unregulated futures contracts, or "structured financing," as the company called it--started to spin out of control.
But long before that, back in the beginning, there was just the Enron idea that made perfect sense. Trying to become the premier trader in new commodities--broadband, water, power production, pipeline capacity and more--would take more than a mastery of this new marketplace.
Commodity and derivative dealings had been restricted by government, and for good reason. Enron, to realize its dreams, would have to first master the finer art of political influence in the highest places. When that time came, Enron chief Ken Lay was more than ready.
Lay had been developing political friendships since the 1970s, when he was a minor Washington lobbyist for a Florida gas company. By the time he ascended to the helm at Enron in 1985, Lay had become a friend to Vice President George H.W. Bush and an energy adviser to the Reagan White House.
In 1985, around the time Houston Natural Gas and Internorth were merging into Enron, the Reagan-Bush administration deregulated the natural-gas industry by ordering pipeline companies to sell excess capacity to whomever wanted it.
When then-Texas Governor George W. Bush "restructured" the state's power markets in 1999, he was following a trend Lay had inspired in Washington and relentlessly pursued to a successful end in two dozen states.
Lay and his contributions had cultivated many political connections, but his wisest investment was in the political future of Texas Senator Phil Gramm and his wife, Dr. Wendy Lee Gramm.
Common ground was plentiful. All three emerged from modest backgrounds and went on to earn doctorates in economics. Their professional interests meshed with their philosophical sharing of a passionate distaste for government interference of any type with commercial enterprise.
The Gramms have never been known to coexist with a government regulation if they could choke the life out of it instead.
Some of the regulations they despised the most dealt with commodity markets, which traditionally had been regulated by the government. Such exchanges post prices, maintain bid-driven markets and enforce credit standards to protect the players. The Commodity Futures Trading Commission regulates these exchanges.
The commission has less authority in dealing with over-the-counter commodity trading. Those buyers and sellers negotiate derivative contracts with banks, securities firms and broker-dealers. The terms and prices don't have to be reported to the exchanges.
Derivatives were once known as leverage contracts, which had been the tools of trade for notorious foreign-exchange scams known as bucket shops. (A bucket shop is a type of phony derivatives trading operation that runs off with the investor's initial payment on the commodity; foreign-exchange rate swings were often the commodity supposedly being traded.) Randall Dodd, director of the Derivatives Strategy Institute in Washington, D.C., explains that exchanges regulated by the government, such as the New York Mercantile Exchange, have avoided major collapses through oversight.
"They trade these same derivatives contracts on the NYMEX," Dodd says. "Those markets work fine because everyone is holding capital, there is government surveillance, there are reporting standards--all these safety provisions that prevent it from failing."
Congressional action in 1978 locked the over-the-counter market down to three companies limited to the unregulated speculation in precious-metal futures.
The Gramms and other deregulation supporters argue that over-the-counter derivatives constitute capitalism at its purest. In fact, in the traditional open-cry pits found at the Chicago Board of Trade and NYMEX, Enron wouldn't have found a market for hangar slots. But off-exchange, the theory goes, if someone can turn something into a commodity, the buyers and sellers will appear.