Guest Post: Enron Redux – Have We Learned Anything?
Submitted by Sue McNamara and Bruce Corneil of Beutel Goodman,
Greed; corporate arrogance; lobbying influence; excessive leverage; accounting tricks to hide debt; lack of transparency; off balance sheet obligations; mark to market accounting; short-term focus on profit to drive compensation; failure of corporate governance; as well as auditors, analysts, rating agencies and regulators who were either lax, ignorant or complicit. This laundry list of causes has often been used to describe what went wrong in the credit crunch crisis of 2008- 2010. Actually these terms were equally used to describe what went wrong with Enron more than twenty years ago. Both crises resulted in what at the time was the biggest bankruptcy in U.S. history — Enron in December 2001 and Lehman Brothers in September 2008. Naturally, this leads to the question that despite all the righteous indignation in the wake of Enron's failure did we really learn or change anything? Taken together with recent revelations about Goldman Sachs gaming the aluminum storage market and fines on market manipulation levied against Barclays and JP Morgan for electricity trading, the answer appears to be a resounding "NO!"
Both Enron and U.S. financial institutions benefited greatly from deregulation of their respective industries. Enron started its corporate life as an owner of regulated natural gas pipelines. With the deregulation of first the natural markets and then the electricity industry, the company evolved into a massive energy trading firm. Deregulation essentially allowed the commodization of electricity and unintentionally created the conditions where corruption, greed and deception flourished. Similarly, in the U.S. financial industry, the seminal moment was the Gramm-LeachBliley Act which repealed the Glass-Steagall Act that prohibited mixing investment and commercial banking This allowed financial institutions to become financial supermarkets and also become Too Big Too Fail, requiring massive amounts of taxpayer dollars to be spent on rescuing them during the financial crisis. Another important piece of deregulation was the 2003 Federal Reserve determination that certain commodity activities are complementary to financial activities and thus permissible for bank holding companies owning trading assets like oil storage tanks or metals warehouses.
Power & Commodities Market Manipulation
After the bankruptcy of Enron, regulators released documents that demonstrated that traders at the company used strategies codenamed: Fat Boy; Ricochet; Get Shorty; Load Shift; and Death Star to increase Enron's profits from trading in the California power market. These strategies added to electricity costs and congestion on transmission lines; led to rolling blackouts and nearly bankrupted two utilities. Recent investigations undertaken by the U.S. Federal Energy Regulatory Commission (FERC) has led to fines being levied against Barlcays and JP Morgan for manipulation in the California, Northwest and MidWest power markets. In July 2013, FERC fined Barclays (and the 4 traders involved) US$470 million for manipulating California's electricity markets. The company is accused of manipulating spot power prices to benefit the bank's derivatives positions. The bank has stated that it plans to fight the penalties in court. On July 30, 2013, FERC accused JP Morgan traders of engaging in twelve manipulative bidding strategies in the California and Pacific Northwest markets that generated tens of millions of dollars at rates far above market prices in 2010 and 2011. FERC stated that the company made bids designed to create artificial conditions that forced the independent system operators to pay JP Morgan outside the market at premium rates. JP Morgan did not admit to or deny the allegations, but agreed to pay a civil penalty of US$285 million payable to the U.S. Treasury and to disgorge US$125 million in unjust profits. FERC has similar investigations ongoing against BP and Deutsche Bank. One positive from the Enron scandal was that it gave new powers to the FERC whereby the regulator can interpret that what might otherwise be permitted under the letter of market regulations can nonetheless be considered unlawful and in FERC's view manipulation.
The alleged abuses are not isolated to the power markets. A recent news expose in the NY Times has highlighted that Goldman Sachs has gamed the aluminum storage market business for profit. In order to comply with aluminum storage standards set by the London Metal Exchange (LME), Goldman moved aluminum from warehouse to warehouse, prolonging the time in storage, rather than delivering the product to the end user. By lengthening the time it takes to deliver the metal from its warehouses, Goldman exacts a greater profit as the financial institution earns more rent the longer the metal stays in the warehouse. However, it appears to be quite an elaborate strategy for just adding incremental storage fees. It is more likely that the company was creating a perception of scarcity in the commodity to perpetuate a profitable commodity curve strategy called "cash and carry". Traditionally, commodity futures markets are in what is called backwardation — the price of the futures is less than the spot. If a commodity curve is in contango, it means that the futures price is greater than the spot price. One arbitrage strategy that can be used to profit from a curve that is in contango is as follows: (1) buy the commodity at the spot price; and (2) short the futures price. This trade works because the returns from the short futures position is greater than the cost of storage and the financing cost to finance the purchase of the physical position, especially in world of repressed interest rates where financing is extremely attractive. It is therefore advantageous for the arbitrageur to keep the futures curve in contango. One way to keep the market in contango is to create a perception of scarcity that induces the long only futures buyers to keep supporting the trade.
While Goldman Sach's storage practices comply with the letter of the law, it does appear to game the spirit of the law and increases the cost to end consumer. With the delay in receiving aluminum, the end user may be forced to secure the commodity directly from the producer, most likely at a higher price. An official at MillerCoors told a Senate committee that the difficulty in getting metal supplies had cost it and other companies approximately US$3 billion last year. While the Goldman Sachs accusations are limited to the aluminum market, there is increasing concern that similar storage scarcity strategies could be used by other financial institutions to game other commodity curves in markets, where the financial institution owns the storage warehouse, refinery or tanker.
The aluminum warehouse shift is somewhat similar to power trading strategies that Enron employed in California. The state had imposed a price cap on power generated within its borders. In the ricochet strategy, Enron bought power under the cap within the state, sold it to another company in a neighbouring state and purchased it back from the company for resale into California, now exempt from the cap and therefore at a higher price. With the "Death Star" strategy, Enron was able to profit from the state's congestion rules. The company created the appearance of congestion on transmission lines and then received congestions payments from the state to relieve congestion that they fabricated. Under the rules, congestion payments were extremely high and profitable. The same way that Enron benefitted from the financialization of the electricity market, major financial institutions are currently benefitting from the financialization of the commodity markets, at the expense of the traditional commodity buyers and sellers.
Enron helped create the global market for energy based derivatives, shifting from bricks and mortars infrastructure asset owner to massive trader active in everything from natural gas and oil to weather and broadband. What first surfaced with Enron in its derivatives reporting was the opaqueness of the market and the lack of transparency. In testimony to Congress in January 2002 on Enron and derivatives, Professor of Law at the University of San Diego, Frank Partnoy, highlighted how Enron's employees seem to have misstated systematically their profits and losses in order to make their trading businesses appear less volatile than they were. They were able to do so because the Over-the-Counter (OTC) derivatives market was opaque and unregulated. With derivatives that had long maturities and no liquid benchmarks, Enron's calculations to determine the company's Value At Risk (VAR) were therefore subject to interpretation and manipulation. For example, at the time, NYMEX natural gas had a forward curve that extended 6 years in duration. Enron would put in place hedges with longer maturities than 6 years and would therefore calculate its own long-term forwards curve, showing its positions to be profitable. In addition, abstract derivatives like weather and bandwidth were valued with a healthy dose of discretion. In the wake of the demise of Enron, there was already a call to regulate the OTC derivatives market which at that time had notional amount outstanding of approximately US$92 trillion.
Flash forward to the credit crisis, and despite the ill-fated attempts by former head of the Commodity Futures Trading Commission, Brooksley Born, trading in the over-the-counter market was neither registered nor systematically reported to the market. There was also no regulatory responsibility for the market and therefore no enforcement of market abuse. Transparency was also significantly lacking in the market as trading of OTC derivatives was bilateral, so no one participant knew the identity of traders or clients, the size or price of orders or the size of the market in aggregate. The derivatives mess that aided the downfall of Bear Stearns, Lehman Brothers, AIG and the others occurred because of a regulatory vacuum where none of the players were required to post collateral to back up their positions or to disclose to investors the size of their huge derivatives positions. That lack of oversight spawned a financial crisis that would reverberate through the global economy for years to come. While the Dodd-Frank financial reform and recent actions by the CFTC have attempted to address some of the opaque weaknesses in the OTC derivatives market, the issue of counterparty risk remains acute. As of December 31, 2012, according to ISDA, the size the amount of total notional outstanding derivatives was US$632.6 trillion, approximately 9x times the size of Global GDP.
Off Balance Sheet Transactions
One of the major contributors to the demise of Enron was its use of accounting tricks to hide debt. Enron used Special Purpose Entities (SPEs) to move debt off-balance sheet as well as to park troubled assets that were falling in value. This seems somewhat similar to what Lehman Brothers did with their "Repo 105" transactions. Lehman was able, in the short-term, to move a significant amount of debt off its balance by using repo transactions that Lehman was able to account for as a sale of assets rather than a loan. That was especially effective over a month-end or quarter-end. The Lehman bankruptcy examiners report determined that Lehman Brothers ramped up its use of Repo 105 deals to reduce its leverage by $38.6 billion in the fourth quarter of 2007, by $49.1 billion in the first quarter of 2008 and $50.4 billion in the second quarter of 2008.
Enron used its political connections and lobbying dollars to advantageously shape both the deregulation of the natural industry as well as the electric power industry. The company targeted contributions not only to Congress but also to bureaucrats, and state and federal regulators. In the most blatant example, Enron lobbied and secured from the Commodity Futures Trading Commission, then chaired by Dr. Wendy Gramm, for certain regulatory exemption for futures trading in energy derivatives, which later became Enron's most lucrative business. At the time, Enron was one of the largest contributors to Dr. Gramm's husband, Phil Gramm's senate campaign. Soon after Gramm stepped down in 1993, she was appointed to Enron's board. While Dr. Gramm was on Enron's Board, Phil Gramm was the ranking minority member and Chairman of the Senate Banking Committee. In 2000, Senator Gramm played a central role in writing and lobbying for the passage of the Commodity Futures Modernization Act. The Act which essentially opened the door to unregulated trading of credit default swaps also included a provision that was known as the Enron loophole — that largely exempted energy trading on electronic commodity markets from legislation. Enron and its employees were the largest contributors to George W. Bush's campaign and Ken Lay was a personal friend of the Bush family.
In the wake of the credit crisis, the most substantial piece of reform to "prevent this from happening again" was the Dodd—Frank Wall Street Reform and Consumer Protection Act. Since its introduction, Wall Street has tried to delay, soften, derail, re-write, and create loopholes in the law. The reform's Achilles heel is that it leaves the tough work of writing the actual regulations to federal agencies such as the Federal Reserve, Securities Exchange Commission and the newly formed Consumer Financial Protection Commission (CFTC). Three years after the passage of Dodd-Frank, only 148 of the 398 proposed rules have been finalized. The big five commercial banks have spent US$56.6 million and US$61.5 million in 2010 and 2011, respectively on lobbying fees and sent 406 lobbyists to Capitol Hill. Specifically, senators on the Senate Banking Committee received US$522,088 from JP Morgan, the same committee that Jamie Dimon testified before in the wake of the London whale trading scandal. In one of their perceived most significant victories, the opponents of Dodd-Frank successfully defeated the appointment of Elizabeth Warren to head the Consumer Financial Protection Bureau, which she had worked diligently at building from scratch. Ms. Warren was to us a vocal and staunch opponent of Too Big to Fail financial institutions. We note that it is quite ironic that instead of fading back to academia, Ms. Warren won the senate seat in Massachusetts and sits on the Senate Banking Committee where she is now effectively challenging Wall Street.
Collusion - Credit Rating Agencies & Investment Banking
Both events highlighted some of the inadequacies of the credit rating industry. Enron was rated investment grade until November 28, 2001 and then filed for bankruptcy on December 4, 2001. In subsequent investigations, credit analysts admitted that they had no idea how Enron made its money. It is likely that credit rating agencies were reluctant to downgrade Enron to below investment grade as it would likely have accelerated the company's spiral into bankruptcy. The success of Enron's off balance sheet obligations was in part reliant on Enron maintaining investment grade ratings. Additionally, debt obligations and collateral calls would be triggered by a downgrade to below investment grade. The credit crisis brought to light the flaw in the rating agency model for securitizations. The rating agency analysts were not as independent and unbiased as they were expected to be. They were intricately involved with the investment bankers in designing and creating the several of tranches mortgage backed securities and collateralized debt obligations. The incentives for the rating agencies to do so were strong, as the fees the rating agencies received from rating a structured product, were a multiple of the fees they would receive from rating a traditional bond. These erroneous ratings assigned in both incidents created a false sense of security for investors.
Likewise, both crises brought to light the conflict of interest inherent in having one entity control both the investment banking as well as the commercial banking businesses. In the Enron case it appears that investment banks overlooked credit lending standards in order to win investment banking business from Enron, highlighting the conflict of interest as investment banks acted as both creditors and advisors for Enron. Equity analysts' recommendations were also likely influenced by investment banking pressure not to inhibit fee generation from the investment banking side. Enron paid approximately US$200 million in investment banking fees per annum in its prime. Of the seventeen analysts that followed Enron in September 2001 (two months before bankruptcy), sixteen had buy or strong buy recommendations on the stock. Some of the investment banks were also complicit in helping Enron design the off balance sheet structures. For example, the SEC charged JP Morgan with aiding and abetting Enron's securities fraud. The complaint alleged that between December 1997 and Enron's demise in 2001, JP Morgan and Enron engaged in seven transactions in order to disguise loans as commodity trades, thus achieving Enron's desired accounting and reporting objectives. JP Morgan as well as Merrill Lynch and Citigroup all paid fines to the SEC, but admitted no fault.
In the present commodity controversy, there has been cause for concern, as banks might be able to take unfair advantage of their access to important information, garnered in trading in physical markets allowing them to benefit themselves when they trade commodities in financial markets. It is also likely that aluminum end users companies such as Coca-Cola deliberately avoided an open confrontation with Goldman because it was a Wall Street powerhouse with which they had — or hoped to establish — important credit and financial-advisory relationships.
Unlike the subprime crisis, there were several convictions in the Enron case. In total, 19 former Enron executives either pleaded guilty to fraud and other related charges or were convicted. Those convictions included Enron's Chairman, Kenneth Lay; CEO, Jeffrey Skilling and former CFO, Andrew Fastow. Enron's accountant, Arthur Andersen was central in the accounting fraud and was also convicted (although later reversed) for obstruction of justice for shredding documents. Ultimately, Arthur Andersen was forced to surrender its accounting licenses and sold its operations to competing accounting firms. So far, the major players in the credit crisis have proven "too big too jail."
On July 23, a subcommittee of the Senate Banking, Housing, and Urban Affairs Committee heard testimony on whether financial companies should continue to be allowed to store, ship, and own physical assets such as metal and oil. At the hearing, Senator Elizabeth Warren, stated that the notion that superbanks are adopting a business model that was pioneered by Enron suggests this movie does not end well. The Federal Reserve has announced that it is reviewing its 2003 decision that allows regulated banks to trade in physical commodity markets. JP Morgan announced it is considering the sale of its physical commodities business. The company said that it does plan to keep the traditional banking activities in the commodity markets such as gold vaults and commodity derivatives. Morgan Stanley put its commodity business up for sale last year and despite entertaining a few offers has yet to secure a deal. Regardless of these post facto efforts, the common thread linking Enron, the credit crisis and the current commodity manipulations is that consumers/taxpayers are being negatively affected, whether it be through higher electricity costs, higher input costs, or taxpayer funded bailouts. Lessons from the failure of Enron have not been heeded. Markets cannot self regulate. Liquidity provided by OTC derivatives comes with significant risks (counterparty offset). Gaming and manipulation will happen. R. Martin Chavez, a former head of risk management at Goldman Sachs told the New York Times that "The whole reason for the existence of traders is to make as much money as possible, consistent with what's legal. I lived through this: if you didn't manipulate the market and manipulation was accessible to you, that's when you were yelled at."
We are left with one nagging question — is the best use of consumer deposits at Too Big to Fail financial institutions to backstop balance sheets to be levered up and take on riskier businesses? Perhaps it is best to bring back Glass-Steagall.