The Smartest Guys in the Room: The Amazing Rise and Scandalous Fall of Enron (30 page)

In congressional hearings, both J. P. Morgan Chase and Citigroup denied that prepays were, technically speaking, loans, adding that Arthur Andersen had signed off on Enron’s accounting—and that in any case they weren’t responsible for Enron’s accounting. (Chase Manhattan merged with J. P. Morgan on December 31, 2000. J. P. Morgan’s dealings with Enron over the years were dwarfed by Chase’s relationship with the company.) Another institution that transacted prepays with Enron, Credit Suisse First Boston (which acquired Donaldson, Lufkin & Jenrette in 2000), was concerned at one point about what its bankers called the “reputational risk” of one deal. Enron promised that its treasurer or CFO would sign off on it. So CSFB went ahead. Later, one banker described the prepay in an e-mail as “Ben’s pet project.”

But their internal e-mails and discussions leave no doubt that the banks understood what Enron was doing with prepays—and why:

“Enron loves these deals,” wrote a Chase banker in a 1998 e-mail, “as they are able to hide funded debt from their equity analysts. . . .” And a Chase banker in a 1999 e-mail: “They are understood to be disguised loans and approved as such. . . .” In a deposition taken in a lawsuit that resulted from these transactions, a J. P. Morgan Chase employee recalls a senior Chase executive named Bob Mertensotto referring to the prepays as “smoke and mirrors.” Citigroup understood the deals the same way Chase did. “E gets money that gives them c flow but does not show up on the books as big D Debt,” a Citigroup banker wrote in a 2000 e-mail.

And both banks worked to reduce their own risk to Enron. Chase entered into some $1 billion worth of insurance contracts that were supposed to pay in the event Enron didn’t. (After Enron’s bankruptcy, J. P. Morgan Chase sued the insurance companies when they refused to pay. The insurers said that they hadn’t known that the transactions were really loans.) For its part, Citigroup sold its risk to public investors through a series of notes. In its internal calculations of Enron’s total debt, Citigroup included the prepays. But when it came to selling the risk to investors, it used Enron’s financial statements—which were supposed to comply with GAAP accounting—and lumped prepays in with trading liabilities. Thus, while Citigroup didn’t want to assess its own risk without seeing the full picture, it was perfectly willing to sell investors a more pleasing image. GAAP accounting, noted Citigroup internally, was the “least conservative analysis.” (“Legal but sleazy” is what one senior Wall Streeter says.) Citigroup ultimately issued over $2 billion worth of such securities. From Enron’s perspective, this was highly desirable, because now Citigroup could lend it even more money.

In contrast to structures like Whitewing, the prepays were very hush-hush, and Enron went to great lengths to keep it that way. An internal Enron presentation of one of the Citigroup deals touts its “unique ‘black box’ feature” and talks about “limiting disclosure.” At one point, an institutional investor who bought the Citi securities learned something about the offshore entity Delta and began to make phone calls posing troublesome questions. An Enron e-mail to Citi read: “We need to shut this down.”

How was Enron, which was perennially short of cash, going to pay off these loans, which had to be repaid on an ongoing basis? In theory, the company would use future cash flows from outstanding trades to pay them back. But that does not appear to have happened. Instead, Enron used fresh prepays to replace earlier ones. One executive says that before Kinder’s departure in 1996, prepays never got above $200 million. After he left, they exploded. At the end of 1998, Enron had $1.3 billion in outstanding prepays; at the time of Enron’s bankruptcy, it had almost $5 billion in outstanding prepays. In 1999, Enron’s cash flow from operations would have been negative without prepays and Project Nahanni. “The banks liked it because Enron got addicted,” says one former risk executive. “Enron had to repay the loan, but the cash flow didn’t materialize. So it snowballed.” Another Global Finance executive argues that as discrete transactions, the prepays make sense: “The problem is, Enron did them on steroids.”

Actually, the problem was that nobody inside Global Finance thought any of this was a problem. Though the company was piling up truly astounding levels of debt—by the end, Enron owed some $38 billion, of which only $13 billion was on its balance sheet—the executives who made up Fastow’s team seem to have barely thought about it. They certainly never added it all up, though that’s precisely what responsible finance executives are supposed to do. Instead, the Enron finance executives thought about how much smarter they were than everybody else in American business. They also convinced themselves and their accountants that they were complying with GAAP accounting, though the mental gymnastics required to get there were often tortured, to say the least.

Indeed, they thought their work was giving the company a competitive advantage. In an in-house memo written toward the end of 1999, Kopper listed Glisan’s goals for the year 2000. The only thing he mentioned was the need “to continue to provide innovative mechanisms for raising capital for Enron.”

In another telling in-house memo, an executive named Joe Deffner, who was in charge of the prepays and became known as Enron’s cash czar, wrote a self-evaluation in 2000 to his boss. Cash flow, he noted, “is probably the single most critical and difficult metric for Enron to achieve to maintain its BBB+ rating.” (BBB+ is several notches higher than the minimum for a company to be considered investment grade.) He then noted that of the aggregate $9.7 billion of operating cash flow reported by Enron for 1995 to 2000, the SPE transactions he had worked on had accounted for 56 percent.

“To maintain our credit rating, if Enron were to finance itself primarily or solely through simpler on-balance-sheet reported structures, 40 percent of each transaction would be funded by the issuance of new debt and 60 percent through retained earnings or new equity,” Deffner wrote; “. . . for 2000 I was responsible for the Global Finance team that generated approximately $5.5 billion of overall off-balance-sheet financing, which at a 60 percent equity allocation would have required $3.3 billion of new equity capital in 2000 to support a BBB+ rating. The value of avoiding . . . equity dilution is difficult for me to quantify although, as a shareholder, I know it’s reflected in the valuation. . . .”

Far from worrying that he was helping Enron misrepresent the business, Deffner clearly believed that he deserved a big bonus.

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Is it clear by now that Fastow and his Global Finance group could not have done what they did without plenty of help? They needed accountants to agree that prepays were a trading liability. (“Enron is continuing to pursue various structures to get cash in the door without accounting for it as debt,” an Arthur Andersen employee wrote in 1998.) They needed lawyers to sign off on deal structures. They needed the credit-rating agencies to remain sanguine in the face of frightening levels of off-balance-sheet debt. Most of all, though, they needed the banks and the investment banks to help them carry out their machinations. Every bit as much as the accountants at Arthur Andersen, the banks and investment banks were Enron’s enablers.

At the top of the list were two of the biggest banks in the country, Chase Manhattan and Citigroup. Enron’s relationships with the two giant banking institutions went back practically to the company’s beginnings. Chase had helped finance the merger between HNG and InterNorth that created Enron. Marc Shapiro, Chase’s vice chairman in charge of finance and risk management, was well acquainted with Ken Lay; in the 1980s, he headed Houston-based Texas Commerce Bank, which Chase acquired in 1987. (Lay sat on the board of Texas Commerce for a period.) For its part, Citi helped Ken Lay fend off the corporate raider Irwin Jacobs back in 1987 by loaning Enron part of the $350 million it needed to buy out Jacobs’s stake in the company.

It wasn’t just Enron that had changed dramatically since those days; so had the two banks. They were both eager participants in the ongoing process of bank consolidation that swept the country throughout the 1990s, a process that created a small handful of giant national financial institutions. Chase, for instance, had been formed through a series of acquisitions that included three of the largest banks in New York: Chase Manhattan, Chemical Bank, and Manufacturer’s Hanover. Citigroup, the parent company of Citibank, had transformed itself into the largest financial institution in the world; it included Travelers Insurance Group and the Salomon Smith Barney brokerage house.

More to the point, perhaps, both banks could offer their corporate clients not only loans but a full range of investment banking services, including stock underwriting and research. For decades, the Glass-Steagall Act had prevented banks and investment banks from encroaching on each other’s turf, but during the 1980s and 1990s, Glass-Steagall had gradually been chipped away until Congress, in the face of furious lobbying, finally repealed it in 1999. Once that happened, the nation’s big banks began using their lending prowess to land investment banking deals.

Few banks were as aggressive as Chase and Citigroup. From the banks’ point of view, this made perfect sense: lending, though the most fundamental of banking activities, had devolved into a low-profit, low-margin enterprise, while investment banking, with its outsized fees, was one of the most profitable endeavors known to man. And few clients were as profitable as Enron. Fastow and his team were always in a hurry to complete a deal, and their deals were always far more complicated than a plain-vanilla underwriting. And there were so many of them. “There was something to play in, if you wanted, every month,” says one banker who did business with Enron. “Behind every closed door, there was a deal going on at Enron,” says another. The result was that Enron was willing to pay fees that few other companies would contemplate. By the late 1990s, Enron had become one of the largest payers of investment banking fees in the world. According to the company’s own calculations, it paid out $237.7 million in fees in 1999 alone. By the end, Citi was reaping some $50 million a year from Enron.

This increased competition for investment banking fees made the banks not just eager to land business but practically desperate. Objectively, the party that should have felt desperate was Enron; it simply had to have a steady infusion of capital just to keep operating. But there were so many banks clamoring for those Enron fees that Fastow could keep them on a string just by playing them off against each other. This he did brilliantly. He tapped into their own greed, pitting banks against one another, forcing them to curry favor with him, and in so doing, he crafted one more Enron illusion. He made it appear that he was the one who held all the cards.

Part of the banks’ desperation stemmed from Enron’s place in the Wall Street nexus. Investment bankers, as a rule, tend to think they’re a lot smarter than the company executives they’re advising, but they didn’t feel that way about those they were dealing with at Enron. Global Finance executives acted just like investment bankers. They spoke the same language. And the Enron people were just as smart as the bankers, or so the bankers believed. Since on Wall Street you are known by the people who choose you to do their business, it thus became a badge of honor to have a piece of the Enron account. “You weren’t an energy banker if you weren’t banking Enron,” says one.

It was also true that the ethos of many investment banks was not all that different from the essential Enron mind-set. The ethics of their deals with Enron were never much of a concern among the bankers. “In investment banking, the ethic is, ‘Can this deal get done?’ ” says a banker. “If it can and you’re not likely to get sued, then it’s a good deal.” In their internal correspondence, it’s almost impossible to find an instance of investment bankers’ worrying about the propriety of what they were doing. When they worried at all, they were concerned about the perception. An e-mail from the head of risk management for Citigroup’s investment banking division warned about one deal: “The GAAP accounting is aggressive and a franchise risk to us if there is publicity.” The deal was done anyway.

Fastow worked exhaustively to squeeze everything possible from Enron’s—and his own—relationship with the banks. This prerogative he guarded jealously, screaming at any Enron executive outside his fiefdom who dared to initiate contact with a bank without his permission. Baxter, in particular, chafed at this restriction; it was one of the key reasons for his animosity toward Fastow. Eventually both he and Dave Maxey, the hunter of lucrative tax deals, were allowed to call bankers without clearing it with Fastow.

In managing the banks, Fastow never missed an angle. He and his group knew how to hint that another had already agreed to do a deal, which of course made the bankers even more eager to land the business. He sometimes cast deal proposals as a “favor” that would be rewarded with more lucrative business later. He did not take no graciously. As CSFB banker Osmar Abib wrote after turning down an Enron deal: “I am about to . . . get my head taken off by Michael Kopper and Kathy Lynn at the charitable dinner tonight sponsored by Enron . . . we should all expect a blistering call from Fastow once he gets the feedback. . . .” And there was no mistaking that Fastow was the man they had to please. Skilling would sometimes drop in on meetings Fastow was holding with bankers, but he was mostly window dressing. His appearances, says one banker, were mainly meant to convey “I know the answer, and I’m right. I’m Jeff Skilling. And I’m Enron—are we all clear here?” (Skilling later told people, “I’m not particularly interested in the balance sheet. It seemed to be doing well. We always had money.”)

Fastow’s most aggressive tactic was his internal ranking of the 70 or so banks that did business with Enron. Fastow had his minions keep meticulous track of the number of deals each had done with Enron and how much they’d received in fees. The Global Finance team would look at the capital the banks had extended versus the investment-banking fees that they had earned. Enron saw the investment-banking fees not as the price for advice—Enron, after all, didn’t need advice—but as a return on the capital. Then he divided all the banks into three categories—Tier 1, Tier 2, and Tier 3—based on their willingness to do his bidding.