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Published with several edits as "Numbers That Didn't Add Up" in the September 2002 issue of Financial World.

Another Chapter in the Continuing Story:
Enron and the Banks


Ross M. Miller
Miller Risk Advisors
2255 Algonquin Road
Niskayuna, NY 12309 USA

August 2002

While researching and writing What Went Wrong at Enron, I found convincing evidence that Enron was above all else a victim of its own fatally flawed business strategy. The company failed when a confluence of events in 2001 that included the collapse in California electricity prices, oversupply of digital bandwidth, and the failure of its Dabhol Power Plant overwhelmed its ability to hide the truth from the marketplace any longer. As the Enron debacle first unfolded, attention was initially drawn to Enron’s use of special-purpose entities (SPEs) to hide debt and inflate earnings. This initial focus on SPEs drew Enron’s accountant, Arthur Andersen, into the picture because it had signed off on these transactions. While Andersen mostly claims to have been misinformed by Enron as to the true nature of these deals, it has admitted to making mistakes in approving some of Enron’s less sinister transactions.

When a Houston jury convicted Andersen of obstructing justice on 17 June 2002, it not only doomed the accounting firm but offered prosecutors little on which they could build a case against Enron. Hence, the focus of investigations in Enron began to shift from the role of its accountants to that of its bankers. Indeed, because the more than $50 million in fees that Andersen received from its auditing and consulting relationship with Enron was dwarfed by the hundreds of millions of dollars fees raked in by Enron’s two main bankers, J.P. Morgan Chase and Citigroup, the potentially corrupting influence of such vast sums was difficult to ignore. With the large financial institutions already wallowing in bad press because of their role in the fueling of the Internet bubble, they were effectively stripped of the shield that their good reputations had previously provided.

Before the month of June was out, the intention of the U.S. Justice Department to target bankers was becoming clear. It brought wire fraud charges against three former employees of the National Westminster Bank, who were accused of diverting funds from an Enron SPE to their own pockets while Natwest was in the process of being acquired by the Royal Bank of Scotland.

Enron’s financial aspirations

The combination of Enron’s size with its aspirations to become a financial powerhouse in its own right made it natural that it would develop close relationships with the world’s largest and most influential bankers. Indeed, Enron’s model for its expansive future was GE, a company that used its industrial base as the foundation for the world’s largest non-bank bank, GE Capital. Indeed, shortly before Enron’s collapse, CEO Jeffrey Skilling told analysts that he expected to "see GE in our [Enron’s] rearview mirror." Skilling’s first major project with Enron, which lured him there from his engagement at Enron as a McKinsey consultant, was the creation of Enron’s "Gas Bank." Had it not been sidetracking a series of poor investments in hard assets, Enron could very well have become the preeminent non-bank bank.

What Went Wrong at Enron notes in passing some interesting parallels between Jeffrey Skilling and another Harvard MBA with a distinguished consulting background, Michael Carpenter. Just as Jeffrey Skilling served for many years as the key strategist to Enron’s Chairman Kenneth Lay, Michael Carpenter served as chief strategist to Jack Welch at GE. Michael Carpenter left GE under a cloud of scandal in 1994 when after being named to head Kidder, Peabody (GE’s ill-fated investment-banking acquisition that Carpenter oversaw) a bond trader named Joseph Jett was found to have been manufacturing profits by gaming the company’s accounting system for U.S. Treasury securities. While Jett and his immediate supervisors were sanctioned for their actions (and inactions), Carpenter escaped disciplinary action and went on to work at Traveler’s Group for Sandy Weill, which merged with Citicorp to form Citigroup. In 2002 Mr Carpenter was named Vice Chairman and head of its investment and corporate banking operations, which included Salomon Smith Barney, Citigroup’s prestigious investment bank. Michael Carpenter had staged an impressive comeback and was near the top of the short list to succeed Sandy Weill as chairman of Citigroup.

The movement of Citigroup and its investment-banking subsidiary Salomon Smith Barney to center stage in the Congressional hearings that surrounded the Enron scandal was a gradual process. Although the hearings, which started in earnest in February 2002, had their occasional moments of high drama, they were largely boring affairs that gave the appearance that members of Congress cared more about getting their time in front of the camera than in working on legislation that might help prevent another Enron from happening. Two key witnesses, Enron chairman Kenneth Lay and CFO Andrew Fastow, exercised their constitutional right not to incriminate themselves while Kenneth Skilling, who was CEO for the critical six months early in 2001, professed his ignorance of any malfeasance to a disbelieving audience. Even Sherron Watkins, whose previously anonymous memo tried to alert Kenneth Lay to Enron’s problems with some of the SPEs created and managed by Andrew Fastow, gave testimony that disappointed her interrogators. Portrayed by the media as a whistleblower, Ms Watkins could provide no concrete evidence of wrongdoing. Furthermore, she testified that Ken Lay, whom she had urged in her famous memo to clean up Enron’s financial mess as quietly as possible, was very likely unaware of the unsavory nature of some of Enron’s SPEs.

The $20 million stock analyst

Interest in Congressional hearings was revived in the wake on the WorldCom’s accounting problems that surfaced at the end of June 2002. Soon after the news broke, the House Committee on Financial Services held a full-day hearing with the clever title "Wrong Numbers: The Accounting Problems at WorldCom" on 8 July 2002. While the WorldCom executives thought to be responsible for the company’s problems invoked their right not to incriminate themselves (though former WorldCom CEO Bernard Ebbers created some consternation when he read an opening statement and then refused to testify further), the committee did get to hear from Jack Grubman.

Mr Grubman, who was already being targeted by class-action lawyers and government investigators for his role in creating the bubble in Internet stocks, would bring his employer Salomon Smith Barney and its parent Citigroup with him into the eye of the unfolding financial scandals. Leaving his Manhattan townhouse the morning the WorldCom news broke, Mr Grubman found himself involved in an amazing bit of street theatre that was televised around the globe. Lying in wait for Mr Grubman that morning was CNBC correspondent Mike Huckman. Mr Huckman had to resort to chasing Grubman down the street in order to get him to answer some basic questions about WorldCom. If Jack Grubman had wished to dispel any notion that he was being evasive, he was not succeeding.

At the Congressional hearings there was nowhere for Jack to run. The questioning of Mr Grubman focused on how his laudatory research opinions about WorldCom and other telecommunications firms that continued all the time their bubble was bursting may have been influenced by his and Salomon’s investment-banking relationship with WorldCom. The committee’s members seemed to have difficultly dealing with the fact that Mr Grubman was being paid more than $20 million a year to proffer what they saw as misleading research to Salomon’s clients while conveying the impression that he felt he deserved every penny of his compensation.

Mahonia and the Prepays

While all the investment banks that rated Enron gave it a rating of Buy or better until the bitter end, Congress would employ a different line of attack when it came time to connect the dots between Enron and its bankers. An early indication as to where Enron’s banks might be vulnerable surfaced as the consequences of Enron’s bankruptcy were first being worked out. It turned out that J.P. Morgan Chase had purchased more than $1,000 million in surety bonds against an Enron default from insurers that included Chubb, St. Paul, Liberty Mutual, and Citigroup’s own Traveler’s Insurance.

The insured transactions were prepaid swaps, known more simply as prepays, involving Mahonia, an offshore company in the Channel Island of Jersey effectively created by Chase in 1992. In their most basic form, prepays are forward contracts that are prepaid, i.e., payment is made at the time that the contract is entered into rather than on the delivery date. Hence, in a legitimate prepay a company such as Enron can get cash now for natural gas that it will deliver in the future, with the discount to the expected delivery price being greater the longer the time until delivery. The purchaser of the prepay assumes both the risk the seller will default on the contract and the risk that the price of the commodity to be delivered will decline.

Mahonia was necessary so that Chase could structure its prepays in a way that it would never be on the hook for the physical delivery of commodities such as natural gas. Because the insurance companies claimed the prepays that J.P. Morgan Chase arranged with Enron were purely financial transactions that did not involve the possibility of physical delivery, they claimed that they did not have to make any payments on the surety bonds when the Enron failed.

While the Mahonia transactions received little attention when they first became public knowledge early in 2002, they were the main topic of hearings into "The Role of Financial Institutions in Enron’s Collapse" that were held on 23 July 2002 by the Permanent Subcommittee on Investigations of the Senate Government Affairs Committee. Democrat Carl Levin of Michigan, who did the bulk of the questioning, chaired the hearings. At issue was whether Enron’s bankers enabled it to cook its books by creating prepays that not only were kept on Enron’s balance sheet as price-risk management liabilities rather than debt, but also generated much-needed operating cash flow that showed up on the company’s income statement.

These hearings differed from the earlier Congressional hearings into the wrongdoings of Enron, Arthur Andersen, and WorldCom in a fundamental way--none of the witnesses came from the senior ranks of their companies. While the early hearings involved testimony (or the exercise of the right not to testify) of Chairmen, CEOs, and CFOs, these hearings were limited to the lowly managing directors and even a mere vice president from J.P. Morgan Chase and Citigroup. Some have speculated that because a key figure at Citigroup, Vice Chairman Robert Rubin, had previously been Treasury Secretary in the Clinton Administration, the Democrat-controlled Senate did not call him before the subcommittee. Sandy Weill and Michael Carpenter were also not called to testify. The Senators clearly had to tread most carefully, the repercussions of destroying an energy trading or accounting firm might be manageable, but precipitating the downfall of the two largest banks in the U.S.--each of which alone might be considered "too big to fail"—was not something that the Senate cared to trigger.

Senator Levin’s line of questioning of a group of J.P. Morgan Chase bankers led by Jeffrey Dellapina, Managing Director in the Credit and Rates Group, was crafted so as to demonstrate that J.P. Morgan Chase knowingly made loans to Enron that were disguised as prepays to aid Enron in keeping its debt sufficiently low to preserve its investment-grade credit rating. Mr Dellapina and his associates maintained throughout the hearings that the Mahonoia deals were legitimate prepays in the face of an avalanche of evidence that Senator Levin presented to the contrary. Numerous internal e-mails and memoranda from J.P. Morgan Chase clearly indicated to the Senators that the bank controlled Mahonia and viewed the prepays as debt. One internal memo that was difficult to explain away included the line: "Enron loves these deals as they are able to hide funded debt from their equity analysts because they (at the very least) book it as deferred revenues or (better yet) bury it in their trading liabilities." When presented with this raft of evidence, Mr Dellapina and colleagues claimed that the documents were "loose and inaccurate" and at one point even debated the meaning of the word "debt," claiming that it really meant "credit." One almost expected Monica Lewinsky to walk into the hearing room at any moment. Even more incredible was the revelation that for a period of four years Mahonia, which was critical to the transactions not being classified as debt, was somehow "accidentally" omitted from the prepay agreements.

Enter the Citi

The story told by the Citigroup crew led by Richard Caplan, a managing director and co-head of the credit derivatives group at Salomon Smith Barney, was very different from that told by J.P. Morgan Chase coterie. Salomon had originated a series of prepays known as Yosemite. These deals involved used an offshore entity known as Delta Energy, which was virtually identical to Mahonia except that it was domiciled in the Caymans. Mr Caplan was not so eager to insist that his deals were authentic prepays, only that he thought that they were at the time that Citigroup arranged them. He could conveniently point the finger at Enron’s accountant, Arthur Andersen, for signing off on their accounting treatment, especially now that Andersen was in no position to defend itself.

The obvious reason that Citigroup would put a much different spin on its prepays than did J.P. Morgan Chase is that because Citigroup’s insurance division, Traveler’s, issued a $300 million surety bond to cover Enron’s default on Morgan’s Mahonia transactions. It was therefore in Citigroup’s interest to have Enron’s prepays classified as financial transactions to give it a way out of the surety bonds. Otherwise, the arguments made by the bankers from J.P. Morgan Chase and Citigroup were remarkably similar. In both cases, the "oral agreements and understandings" that Enron had with both banks that would have altered the accounting treatment of the deals if they had been legally binding were never included in the deal packages. Furthermore, both Mr Dellapina and Mr Caplan when confronted with clear indications that the prepays failed to satisfy the basic requirements for Enron to avoid booking them as debt replied, "I am not an accountant." These were the exact same words that Jeffrey Skilling repeatedly uttered nearly five months earlier during his appearances before Congress. As the story of Enron and its banks continues to unfold, these are words that we are likely to hear many more times.

Copyright © 2002 by Ross M. Miller. All rights reserved.