The Smartest Guys in the Room: The Amazing Rise and Scandalous Fall of Enron (25 page)

No.

“Is there even a
little
bit of a chance of it coming back?” asked Causey. “Do you want to look at it again?”

Finally the executive took the hint—and the deal was declared undead. Enron deferred the hit for another quarter. “You did it once, it smelled bad,” says the executive. “You did it again, it didn’t smell as bad.”

Enron also generated earnings through tax-avoidance schemes. Beginning in 1995, the company executed 11 mind-numbingly complex tax transactions that allowed Enron to bank some $651 million in profits. The deals were cooked up in Enron’s tax department, whose head count grew to 250. The department was run by a grizzled tax lawyer named Bob Hermann, who had begun with Houston Natural Gas back in 1981. The first of the deals, dubbed Project Tanya, involved setting up a special entity to manage deferred compensation and benefit programs, which then issued preferred stock that was transferred back to Enron. It generated $66 million in earnings.

The point man on the special tax deals was a conspiratorial CPA and lawyer named R. Davis Maxey, who quietly traveled the country meeting with tax specialists at banks and law firms to come up with new ideas. One by one, he teed up deals, which often took as much as a year to develop and were supposed to generate savings that stretched over a period of as long as 20 years. Enron’s high-priced tax advisers—a law firm might earn a fee of $1 million for a single transaction and a bank could earn as much as $15 million—had urged the company to keep a low profile on the schemes, lest they attract the ire of the Internal Revenue Service. But after Skilling became Enron’s COO, the company increasingly turned to its tax department to act like just another profit center—and help the company hit earnings targets by taking more and more of the tax savings early. “In effect, we have created a business segment for Enron that generates earnings,” Maxey wrote in an e-mail.

Whatever the propriety of these maneuvers, they all had one clear effect:
they rolled Enron’s problems further into the future, where the issues slowly accumulated.

 • • • 

Like many companies during the bull market, Enron began to invest in other businesses—a few dozen private and public companies. Skilling called this part of the business Enron’s merchant investment portfolio. Not surprisingly, as the company’s holes grew larger, the equity portfolio became yet another earnings-management vehicle.

Take, for instance, Enron’s investment in Mariner Energy, a privately owned Houston oil and gas company that did deepwater exploration. Enron took control of Mariner in 1996 in a $185 million buyout. Private-equity investments are often tricky to value since they’re not publicly traded; and deepwater drilling is highly speculative. In the years that followed, this made the precise value of the company uncertain. Enron exploited this uncertainty by periodically marking up the value of Mariner as needed to fill earnings holes. Such valuation increases could immediately be booked as mark-to-market income through an aggressive approach called fair-value accounting that Enron began using about that time.

When Enron got in an earnings bind, says one Enron vice president familiar with the situation, “People were asked to look and see if there’s anything more we can squeeze out of Mariner.” And squeeze they did. Indeed, Mariner served as a sort of piggy bank for Enron earnings. By the second quarter of 2001, Enron had Mariner on its books for $367.4 million, by any reasonable measure, an absurdly high amount.

Mariner was a prime example of how Enron executives made a mockery of the RAC process. A postbankruptcy review by Enron’s new chief accounting officer concluded that the company’s Mariner investment was really worth less than a third of what Enron had claimed. (This resulted in a write-off of $256.9 million.) In fact, even while the Mariner investment was being marked up to book profits, RAC analysts consistently challenged the valuation. According to the accounting review, Enron, during much of 2001, justified its inflated figure using “a model that was not supported by RAC” and was rigged with outlandish assumptions. Enron carried Mariner on its books throughout this period for about $365 million; its own internal-control group placed its value in a broad range between $47 million and $196 million.

The review noted: “The accounting for Mariner in the second and third quarters of 2001 used valuations not endorsed by RAC in accordance with the Company’s internal control system.” It added that there was “no documentation justifying this control override” and that “this exception to the established internal accounting control procedures [was] not brought to the attention of the Audit and Compliance Committee for consideration or review.” In fact, according to RAC executives, their own boss, Rick Buy, refused to press the matter of Mariner’s inflated valuation with Enron’s top executives. Buy, a former energy banker, certainly knew the investment well: Enron had appointed him to the Mariner board.

There was also a part of the merchant portfolio known as the Industrial Group. The twenty or so deal makers who made up this group were led by an Enron executive named J. Kevin McConville. Their job was to make equity investments outside the energy industry but with an eye toward energy-intensive businesses, where Enron might be able to cut related deals to provide their plants with electricity, coal, or gas.

Beginning in 1997, McConville’s group cooked up a series of such complex deals. They bought equity in a paper manufacturer called Kafus, a steel maker named Qualitech, and a Thai steel mill company called NSM, among others. Ultimately, the only thing the Industrial Group’s deals had in common was this: they all lost money.

Every Monday morning, a team of RAC analysts met to examine how Enron’s investments were performing. The list of portfolio assets was color-coded: green meant okay, yellow meant the deals needed work, and red meant big trouble. Increasingly, McConville’s investments were turning up red. In several cases, Enron hadn’t just bought equity in each of these companies; it had invested in other ways as well. Take NSM, a $650 million project to redevelop a troubled steel mill in Chonburi, Thailand. Enron not only bought 52 million shares of NSM stock and taken a seat on the NSM board; it also swallowed at least $20 million of a private $452 million junk-bond offering. Long before the plant could be redeveloped, though, the company went bankrupt, generating extensive litigation. Kafus and Qualitech were disasters too. Yet even as his deals deteriorated, McConville was promoted to managing director.

McConville, a veteran Enron executive, attributes much of the criticism about his deals to jealousy over his rapid promotion. He says that if the energy-supply portion of the projects is considered—on which Enron routinely booked profits—about 30 percent of them made Enron money. He acknowledges that several, such as NSM (“a horrible failure”), turned into disasters.

What really made his deals look worse than they were, says McConville, was that Enron recorded gains on the private-equity investments to book profits, just as it did with Mariner. “Every one of them was written up [in value],” he says. This meant the paper loss Enron faced was bigger than the cash investment the company had made. And Enron, of course, was loath to acknowledge any losses.

That had always been the case with Skilling, who loved the gains his private-equity investments could generate but hated having to record the hit when they went south, as was supposed to be done under mark-to-market accounting. As early as 1996, when ECT had moved from merely financing energy companies to making equity investments in them, Skilling fretted over this very issue to his portfolio management advisory committee. One of Fastow’s deputies, then known as Sherron Smith (she later rose to postbankruptcy fame, after getting married, as Sherron Watkins) recalls Skilling saying: “I don’t want to be the one to go tell Enron’s board we’ve had a big loss when we’re supposed to be such great risk managers.”

Skilling was always looking for a hedge—even an imprecise “dirty hedge”—for Enron investments that, by normal standards, couldn’t be hedged. In one such case, he tried to protect a gain in some securities that couldn’t be sold by ordering Enron’s traders to buy S&P 500 puts. At one point, Watkins recalls, Skilling tried to hire an expert to develop new hedging techniques for locking in gains on Enron’s private-equity investments. After meeting with everyone involved, the candidate refused to take the job, explaining that the venture was doomed to failure because Skilling wanted to accomplish the impossible. “It’s called equity
risk
for a reason,” he told Watkins.

For McConville, the day of reckoning arrived in 1999 after RAC toted up the industrial portfolio’s losses: they came to more than $400 million. McConville soon left the company. Belatedly, Skilling decided to pull the plug on new industrial investments. “We understand oil and gas a whole lot better than the steel business in Thailand,” he told his subordinates. “We learned our lesson pretty expensively.”

Still:
$400 million!
Even for Enron, that was a big hole, not easily papered over. How was it ever going to be able to cover that amount without wrecking earnings? Deep inside the company, there was another team working on that very problem.

Reported earnings follow the rules and principles of accounting. The results do not always create measures consistent with underlying economics. However, corporate management’s performance is generally measured by accounting income, not underlying economics. Therefore, risk management strategies are directed at accounting, rather than economic, performance.

—Enron in-house risk-management manual

When, exactly, did Enron cross the line? Even now, after all the congressional hearings, all the investigative journalism, all the reports, lawsuits, and indictments, that’s an impossible question to answer. There have been accounting frauds over the years where companies created receivables out of whole cloth or shipped bricks at the end of a quarter instead of products. In such cases, someone at a company has to consciously consider the fact that he or she is about to commit a crime—and then commit it.

But for the most part, the Enron scandal wasn’t like that. The Enron scandal grew out of a steady accumulation of habits and values and actions that began years before and finally spiraled out of control. When Enron expanded the use of mark-to-market accounting to all sorts of transactions—was that when it first crossed the line? How about when it set up its first off-balance-sheet partnerships, Cactus and JEDI, with such reputable investors as General Electric and CalPERS? Or when it categorized certain unusual gains as recurring? Or when it created EPP, that “independent” company to which Enron sold stakes in its international assets and posted the resulting gains to its bottom line?

In each case, you could argue that the effect of the move was to disguise, to one degree or another, Enron’s underlying economics. But you could also argue that they were perfectly legal, even above board. Didn’t all the big trading companies on Wall Street use mark-to-market accounting? Weren’t lots of companies moving debt off the balance sheet? Didn’t many companies lump onetime gains into recurring earnings? The answer, of course, was yes. Throughout the bull market of the 1990s, moves like these were so commonplace they were taken for granted, becoming part of the air Wall Street breathed.

Besides, the big Wall Street investment banks, not to mention the nation’s giant accounting firms, had a huge vested interest in the kinds of moves Enron was making to create accounting income. Even before the dawning of the 1990s bull market, a new ethos was gradually taking hold in corporate America, according to which anything that wasn’t blatantly illegal was therefore okay—no matter how deceptive the practice might be. Creative accountants found clever ways around accounting rules and were rewarded for doing so. Investment bankers invented complex financial structures that they then sold to eager companies, all searching for ways to make their numbers look better. By the end of the decade, things that had once seemed shockingly deceptive, such as securities that looked like equity on the balance sheet but for tax purposes could be treated as debt, now seemed perfectly fine. Securitizations exploded, with everything from lotto winnings to proceeds from tobacco lawsuits being turned into securities that could be sold to the investing public.

In the wake of Enron’s collapse, the mood changed virtually overnight, and creative became a very bad word, synonymous with deceptive. But it’s impor-
tant to remember that it wasn’t always that way. That statement in Enron’s risk-management manual perfectly captured the sentiment of the times. In fact, the material in the manual, developed with the help of a consulting firm, was used throughout the energy-trading industry.

Of course it wasn’t
only
the times that caused Enron to get ever more creative. It was also necessity. A company like General Electric might employ a little financial ingenuity to hit its earnings target on the nose quarter after quarter (as, indeed, it did), but even without such strategies, GE had a hugely profitable business. That wasn’t true of Enron. Especially in the latter part of the 1990s, Enron didn’t have anywhere near enough cash coming in the door. Eventually, the whole thing took on a life of its own, with an insane logic that no one at the company dared contemplate: to a staggering degree, Enron’s “profits” and “cash flow” were the result of the company’s own complex dealings with itself. At which point, of course, there could hardly be any doubt: Enron had most certainly crossed the line.

But if it’s impossible to mark the moment Enron crossed the line, it’s not hard at all to know who led the way. That was Andrew Fastow, the company’s chief financial officer. He was 28 years old when he first joined Enron in late 1990, hired as one of Skilling’s early finance guys at ECT. Skilling wanted him precisely because he knew how to set up complicated financial structures, specifically securitizations. Fastow became Enron’s Wizard of Oz, creating a giant illusion of steady and increasing prosperity. Fastow and his team were the financial masterminds, helping Enron bridge the gap between the reality of its business and the picture Skilling and Lay wanted to present to the world. He and his group created off-balance-sheet vehicles, complex financing structures, and deals so bewildering that few people can understand them even now. Fastow’s fiefdom, called Global Finance, was, as Churchill said about the Soviet Union, a riddle wrapped in a mystery inside an enigma that was Enron’s string of successively higher earnings. “Andy was a master at walking in, always at the end of the quarter or the end of the year,” says Amanda Martin. “The fat was in the fire and about to ignite. He’d say, ‘give me the ball,’ and he’d come through every time. That’s why Jeff and Ken loved him.” Like everyone at Enron, Fastow was handsomely rewarded for this work. But for him it wasn’t enough. So over time Fastow found other ways to pay himself. Some of these ways his superiors knew about. Others they didn’t know about—but should have.

 • • • 

Andrew Fastow grew up in New Providence, New Jersey, a suburb about 25 miles from New York City. His father, Carl, was a buyer for drug-store and supermarket chains; his mother Joan worked as a real-estate broker once the children were grown. The second of three sons, Fastow was a huge
Star Wars
fan and played tennis and trombone; he was well liked enough to be elected student council president his senior year of high school.

Even as a high school student, Fastow burned with ambition. It was an odd kind of ambition, though: not necessarily to be the best but to be
seen
as the best. A high school English teacher later described him as a “wheeler dealer” because he would try to negotiate better grades. He was also part of a group that lobbied the New Jersey Board of Education to have a student named to the board. Fastow was that student. (After graduation, he came to one board meeting smoking a pipe.)

Fastow seems to have never had a moment’s doubt that he was destined for business, specifically for finance. At Tufts, where he went to college, Fastow majored in economics and Chinese—the latter because he thought it would aid his business career—and graduated summa cum laude in December 1984. Tufts is where Fastow met his wife, Lea Weingarten. She was a sophomore and had come a week early to serve as a host adviser for the incoming freshman, one of whom was Fastow. Upon sighting him, she confided to a friend, “God, I think he’s cute, but he’s only a freshman. Should I date him?” The two soon started dating.

Weingarten is a name many Texans know instantly. For decades, the Weingartens have been one of Houston’s wealthiest and most prominent families. Lea’s great-grandfather founded a supermarket chain that dominated southeast Texas; though the family sold the business to Grand Union in 1980, an offshoot, the publicly traded Weingarten Realty Investors, owns shopping centers throughout the Southwest. (Jack Weingarten, Lea’s father, worked for the chain but never ran it.)

Despite her wealth—or, perhaps, because of it—Lea Weingarten had a far more difficult childhood than her future husband. Her mother, Miriam Hadar, whom Jack married in 1961, was a beauty queen who had been named Miss Israel and was a semifinalist in the 1958 Miss Universe contest. In 1968, when Lea was six years old, her parents’ marriage disintegrated, and they became enmeshed in an ugly divorce that consumed the better part of three years. Miriam accused Jack of being physically and verbally abusive, dependent on drugs and alcohol, and “unstable emotionally”; Jack countered that Miriam missed the “glitter and high living” of her previous life and was guilty of “misconduct with other men during her entire marriage.” The divorce was granted in late 1970, with Jack Weingarten getting custody of Lea and her brother, Michael. The judge said that the children should grow up in Houston, a city “in which their name is associated with the finest of Jewish example and tradition.” Miriam moved back to Israel.

In high school, Lea Weingarten was a sensitive and insecure girl who struggled with her weight. In college, she was still heavy but dressed well and appeared to be upbeat and happy. As she got older, she slimmed down and became a woman whom friends describe as “unpretentious” and “gracious.”

Just three months after graduating from college, Andy Fastow married Lea Weingarten in a low-key Houston ceremony. (Years later, the two renewed their vows at the Elvis Wedding Chapel in Las Vegas.) The newlyweds then headed to Chicago, where both were enrolled in the training program at Continental Bank, a midlevel commercial bank that was just emerging from one of the biggest business scandals of the 1980s, the so-called Penn Square scandal. (It revolved around bad loans made to the oil patch during the oil boom of the early 1980s.) Rather than work a few years then take a few years to go to business school—the normal route to an MBA—the two accelerated the process. They both earned MBAs at Northwestern’s Kellogg Graduate School of Business, which they attended at night, after work.

Fastow was instantly unpopular with his peers at Continental. He came off as arrogant, ambitious, and more than a bit of a dandy, wearing Hermès ties and Gucci shoes. Had he worked at a New York investment bank, none of these traits would have been remarkable, but at a quiet, Midwestern commercial bank like Continental, Fastow stood out. “He invoked a lot of jealousy because he was clearly on the make, almost nakedly so,” says a former boss, who also thinks there was another element to the dislike: “Both Andy and Lea were smart and gorgeous.”

In early 1987, Fastow took a short, unsuccessful detour. He left Continental for a small, publicly traded company called CCC Information Services, which maintained a computerized database to help insurance companies set a value on cars that had been stolen or involved in accidents. Founded in 1980, CCC had almost 300 employees by the time Fastow joined and was growing like mad. “CCC couldn’t hire people fast enough in those days,” recalls one former employee. Around the time Fastow joined the company, the stock hit a high of almost $15 per share.

That August, CCC cut a deal to sell itself for almost $100 million. But the deal fell through, and by late 1987, the stock had dropped to $6 a share. The following January, the company was sold to another bidder, a privately held company, for roughly $80 million, and Fastow beat a hasty retreat back to Continental. Although he’d been at CCC for less than a year, he claimed on his résumé that he had “launched and managed an automotive industry database management company. First year operating profit of $1 million on revenues of $7 million,” which would have represented a significant amount of CCC’s profits and revenues during that time period. Yet CCC’s financial documents don’t even mention Fastow’s operation, and former senior officials say there was nothing remarkable about his brief tenure there.

It was during his second go-round at Continental that Fastow found his calling. Rehired as a loan officer, he sat across the credenza from a small team of executives who were doing pioneering work in securitization. He immediately gravitated to that team and maneuvered to become its newest member. He was like a “pig in shit,” recalls one of his former bosses.

This same man claims that Fastow was “incredibly talented” at securitization, but that is hardly a unanimous view. “He was a good average performer, but you weren’t held in awe of his intellect,” says another former Continental executive. “You didn’t marvel every day at what smart things he came up with.”

What is certainly true was that Fastow loved being on the cutting edge of finance and reveled in the work. In the late 1980s, securitization was just getting started and Continental was doing deals the likes of which no one had ever seen before. A deal led by a Continental banker named Michael Woodhead was named one of
Institutional
Investor
magazine’s “Deals of the Year” for 1989. Woodhead had figured out a way to bundle the outstanding debt from leveraged buyouts and sell a fresh security backed by the interest on those bonds. This, in turn, freed up capital for the banks involved in the LBO game to make new loans. The deal was known as FRENDS.

What people noticed about Fastow, even then, was how willing he was to push the limits. Because securitization is so complex and so ripe for abuse in the wrong hands, hundreds upon hundreds of pages of rules were being written to mandate what was allowed and what was not. Fastow, says one of his former bosses, “was rules-driven from day one.” By that, he meant that the future Enron CFO took it upon himself to figure out if he could accomplish his goals while following the precise letter of the rules, even if it meant violating their intent. “Andy was really into just pushing the parameters of the possible,” this person says. “I don’t know that he ever had a moral compass.” While at Continental, Fastow never crossed the line, but that was largely because his superiors were far more risk-averse than he and turned down his ideas if they thought he went too far. To this former boss, it was easy enough to see how things could have gotten out of hand at Enron: “You put Andy in an environment where he is on the same side as his manager, with the same objectives, it’s a Molotov cocktail.”

On his resume, Fastow bragged about FRENDS and took full credit for himself. (“Created and sold first security backed solely by senior LBO bank debt. . . . Sourced assets from ten banks and placed securities with investors in 23 countries. . . . Directly responsible for pretax profit contribution of $12.8 million.”) But this, too, was an exaggeration. “Andy was the number two guy in a two-man group, but it was not his idea and he was the follower not the leader,” says a former Continental hand.