Friday, April 12, 2002

If you want to keep your faith in the probity of what goes on in Wall Street, then by all means avoid reading the thirty-page affadavit of New York AG Eliot Spitzer describing what his staff found in email they seized from the Merrill Lynch internet group, describing massive conflicts of interest in the group. The emails show the group was particularly focused on touting stocks of companies that Merrill itself was dealing with, particularly its investment banking clients; in private, analysts described the same stocks in stark terms, "crap" being on the mild side. Merrill itself claims that the remarks quoted were "taken out of context." Figuring out the context in which people issuing honest recommendations, completely independent of the firm's investment banking activities, nevertheless opine that

the whole idea that we are independent from banking is a big lie


We are losing people money and I don't like it. John and Mary Smith are losing their retirement because we don't want Todd [Tappin, CFO of] to be mad at us.

is left as an exercise for the interested reader.

Interestingly, at least one blogger with some reputation as a financial expert has argued that Enron's notorious partnerships can't be such a big deal because large Wall Street firms like Merrill were involved, and they couldn't possibly be involved in shady dealings. (Sure, Michael Milken's escapades at Drexel Burnham got him personally slapped with a $600 million fine, and Ivan Boesky got a $100 million fine and jail time --- but that was the '80s. Evil has not been seen, heard or spoken on Wall Street since). And even though Enron's current CEO has long since acknowledged that jail time is likely for some of the principals, this guy's still at it, throwing mud at the plaintiffs' lawyers in the Enron shareholder lawsuits.

There's more to be said about Enron, of course. Like its incredible shrinking trading book --- the value of the deals secured by the trading operation which was once touted as the beating heart of the business, which was estimated at $12 billion last fall before the abortive merger talks with Dynergy, $7 billion after, and more recently in January, just $1.3 billion.

All of these figures, including the last, are guesses --- specifically, guesses about how much money Enron will actually receive on net for transactions it committed to some time ago, but which were, and are still, in the future. Enron's "mark to market" accounting required traders to project prices forward years in the future so they could make these guesses (the genteel word is "estimates") of the future cash flow stemming from the contracts, which Enron then booked immediately as revenue. So Enron's revenue in the current quarter (say, 3Q 1999) was directly affected by its traders' guesses about what prices would be years in the future --- on the "price curve", in the parlance of the trade. But far enough in the future, almost any guess can be made to seem plausible. And sure enough:

Some traders took advantage of this subjectivity to set unreasonably high curves, and later to change those curves to establish even higher values, which they could report as profits immediately, a former manager on the trading desk said.

"The curve moved constantly," this manager added, "especially toward the end of the quarter, to generate reported income."

Other executives note that Jeff Skilling, while head of Enron's trading operation, liked this sort of thing, specifically encouraging a form of the practice called "blend and extend". It's also noteworthy that there really were guesses involved; the deals were on Enron's books as "open", meaning that Enron would need to make new deals to cover its commitments or realize its gains --- gains which had already been booked as revenue. We're not talking accounts receivable here.

In general "mark-to-market" accounting can be defensible, in stable markets for liquid commodities. And in fact, trading operations like Enron's are often defended with the claim that they promote price stability. So there's something peculiar about the people involved in those operations continually placing ever-higher bets on the future prices of the commodities they trade.

But beyond that, consider what this means for Enron as a whole. Last year at this time, its public face was as a trading colossus. It had started out by applying financial wizardry to energy trading in America, but that was only the beginning. It had branched out, both engaging in energy projects overseas (the Dhabol project in India being one famous example), and moving into new areas of business, like its highly touted broadband trading venture. And when news of Enron's troubles first broke, it was possible to question whether such a large, important (and, it must be said, politically connected) firm could really be involved in shady dealings.

Well, all that other stuff has fallen apart and fallen away. The broadband trading desk, it turns out, never traded much, and lost money on what it did (a lot of which were "lazy susan" deals and similar chicanery). Most of the overseas deals were likewise huge money-losers; in fact, the notorious LJM partnerships seem to have been largely used as a mechanism for keeping the losses from broadband and foreign operations off Enron's own balance sheet. But through it all, the corporation's defenders could say that whatever else was going on, at least the core energy trading operation was soundly conceived and profitable. If that wasn't the case, you have to wonder; through the boom of the late '90s, was Enron ever engaged in much legitimate, profitable business?


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