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OTC derivatives also allow institutions like insurance companies and pension funds, as well as wealthy, sophisticated individual investors, to assume more risk. They can invest in newly created markets or play more aggressively in familiar ones.
Enron's transformation from a pipeline company began in 1989, when it and other companies began lobbying to open up the over-the-counter derivatives market. Lay's strongest ally was in a prime position to help: Then-President George H.W. Bush had just appointed Wendy Gramm to chair the Commodity Futures Trading Commission. She quickly issued a lengthy report that argued to reduce CFTC oversight of certain commodity trading.
Two years later, Gramm led the push to open the door for Enron even wider by heading the effort to exempt over-the-counter derivatives from commission control. That allowed Enron to break free of the spot market for natural gas. Spot market contracts are standard contracts dealing with the price of the commodity that day--natural gas, for example--and are used to buy commodities that are required every day, such as a power plant's need for natural gas. Over-the-counter derivatives contracts are futures contracts like those traded on regulated exchanges. The rule change Gramm pushed through allowed Enron to enter the over-the-counter market for natural gas, where the company negotiated private, customized contracts with customers who wanted to protect themselves from increases in the price of natural gas.
Wendy Gramm had previously announced she would be leaving the commission. A week after delivering the rule change for congressional approval, she departed.
Five weeks later, Gramm had a new position: Lay appointed her to Enron's board of directors. The position paid about $30,000 a year, plus stock options. One CFTC member called the timing "horrible." Lay told The Washington Post that it was "convoluted" to suggest Gramm was brought on board for any reason other than her brilliance.
"Her knowledge of the derivatives market is a big plus for Enron," Lay said. "There aren't that many people who really understand that business."
The corporation itself, however, would soon be wondering how well it understood business in the vastly broadened markets delivered through deregulation.
Enron's extended leg room in the over-the-counter market brought it trouble almost immediately. In 1993, TGT, an Enron subsidiary in Great Britain, entered into a "take or pay" contract with companies pumping natural gas from the J-Block field in the North Sea. A take-or-pay contract is a form of derivative for the actual delivery of the commodity. Enron was trying to lock down a long-term price for gas from the J-Block field, even though the pipeline hadn't been completed yet, and agreed to take 260 million cubic feet of gas per day for 10 years to supply one of its own power plants and to sell to others.
But when the contract matured and Enron had to take delivery, demand for natural gas was down and the price had dropped by half--less than what Enron had agreed to pay in its contract. In the derivatives game, that's called tough luck--Enron should have bet the other way on the future price of gas. The company tried to litigate its way out of the mess, but a British court ruled that the meaning of "take or pay" was pretty clear.
The failed deal cost Enron $537 million in 1997. Bob Young, a derivatives consultant with New York-based ERisk, says the massive loss should have raised concerns inside the company.
Young believes that trading in the "short end," meaning locking in prices for three to five years, is a safe bet because everyone has the same idea about what the commodity will cost in that time frame. But he explains that there are no markets for pegging prices in the more distant future, such as 15 years out.
"No one knows what the price is going to be," he says, "so you have to base it on expectations, which can change."
In retrospect, the J-Block debacle appears to be just one of many problems Enron faced in 1997. After all, that's when it formed the first of its subsidiaries to shield transactions from the balance sheet. One of the more famous was called LJM, for the initials of CFO Andrew Fastow's three children.
The J-Block contract suggested to Young that Enron wasn't managing its trading books closely enough. Traders are supposed to adjust the value daily on long-term contracts, a practice called mark-to-market accounting. A responsible trader will watch for price decreases that reduce the long-term value of contracts. If that happens, the trader will try to hedge the lost value by making another trade that promises a better outcome.
The flaw in such accounting of unregulated derivatives was the potential for a harried or unscrupulous trader to inflate long-term contract values, knowing no one outside the company would have access to the information. Traders for any company might decide to impress their bosses or increase their bonuses by setting unrealistic future prices, then simply ignoring any subsequent changes in the commodity's price.
"It's a real conflict of interest," Young says. "A trader can set the market almost however he wants, then manipulate the market value to his own benefit. He just tells his boss the trade has been booked and he wants to be paid for that value now."