The Smartest Guys in the Room: The Amazing Rise and Scandalous Fall of Enron (48 page)

By that point, Enron was also planning to sell Portland General for $2
billion—Skilling had decided he no longer needed the hard asset to trade electricity—and so everyone thought they would soon be awash in cash. The Global Finance team believed the smartest thing to do with the money was to pay down debt to make the ratings agencies happy. Ben Glisan also observed in handwritten notes that the sale would get rid of the project finance debt associated with EI, which, he wrote, Moody’s considered “a large overhang.” Glisan also hoped the cash would allow Enron to sweep away some of the structured finance deals. “Scary places gone,” he noted.

Still, Skilling had one final item on his agenda before the international assets went away. He was determined to show the board, once and for all, what a dis-
mal failure Mark had been as the head of International. The Arabs might value EI at over $7 billion, but he wanted Enron’s directors to understand that the assets weren’t worth anything close to that amount. That summer, Skilling assigned an in-house accountant the task of evaluating the International division, and he personally supervised the work. The analysis the accountant came up with showed that Mark’s business was earning a mere 2 percent return on equity—a pathetic amount, given the capital Enron had expended and the risks it had taken. And that didn’t even include the huge potential liabilities associated with some projects, such as Enron’s guarantees of debt.

When Mark learned what Skilling was up to, she promptly got her own numbers cruncher, who sat down the hall from Skilling’s accountant, to work up a competing set of numbers. Mark’s analysis showed, not surprisingly, that the international business had been a success, producing over $1 billion of cash and earnings and making a 12 percent compound annual return over its history.

It is astonishing, of course, that two high-ranking executives, working for the same company, sitting on the same board, and evaluating the same business,
could come to such wildly varying conclusions. It spoke volumes about the murkiness of Enron’s numbers, about the way this company viewed earnings and margins and all the other financial benchmarks by which we gauge American corporations. It also said a great deal about the inability of top executives at Enron to work together or even communicate. Everything was perception; nothing was real.

“Figures lie, liars figure,” says one of the accountants who worked on the analysis. He adds that “if it had been Skilling that was being measured, he would have found a way to show a 20 percent return.” Yet the accountant went on to note an even more astonishing fact: viewed through their respective prisms, they were probably both right. Skilling evaluated the international assets based on what they’d cost, how much they were earning at that moment in time, and what the market value was. He didn’t include any of Andy Fastow’s funny business: the accounting structures that were designed to book earnings from the international assets. On that basis, the returns were unacceptably low.

But as Mark never tired of pointing out, there
was
funny business, lots of it. Enron played the same accounting games with its international assets as it did with every other part of the business. Over and over again, Enron had monetized its power plants and other overseas projects, either through securitizations or by selling stakes in them to one of its many off-balance-sheet partnerships, including LJM, then booking the sale to its bottom line. Her analysis included some of these profits.

Although the company didn’t break out International when it reported its earnings, both Lay and Mark used to boast about the division’s importance to the company’s bottom line. In 1997, according to one internal analysis, Enron booked $152 million in international earnings; the following year, earnings rose to $246 million. But those numbers didn’t reflect ongoing profits; rather they were a case of stealing from the future. Because of these financing techniques, Mark’s assets did bring cash into Enron, cash that her loyalists say was plowed into the enchiladas like EES and broadband. Her assets, she bitterly told one friend, “were just cannon fodder to feed the machine.”

But the Enron board wasn’t about to get into a debate on the subject. Skilling was still viewed as a man building great, profitable businesses, while Mark was viewed, suddenly, as a loser, a failure at a company that simply didn’t believe that it could fail.

The climactic board meeting took place on Tuesday, August 8, 2000. As late as 6:30 Sunday evening, Mark had tried to argue her case privately to Lay. Lay, furious about Azurix, didn’t want to hear it. At the board meeting, Skilling disemboweled Mark, laying out his case in clear, damning detail—the poor return on her assets, the projects that hadn’t worked, the years of stumbles and mistakes.

When Mark asked for the chance to respond, nobody on the board would even look at her. They all looked down at the floor. Mark told the board that if there were better places to put the money—like broadband and EES—that was fine, but she didn’t agree with Skilling’s analysis. And then she left the boardroom, citing another meeting she had to attend. Later, it wasn’t Skilling who made the harshest comments about Rebecca Mark: it was Ken Lay.

Lay spent the next weekend in Aspen and, after a brief business trip in the early part of the following week, went over to the Azurix offices to meet with Mark. That’s when he told her that it was time for her to leave both Azurix and Enron. Mark agreed. But she insisted that she be paid the remainder of her $710,000 Azurix contract. Lay paid her.

And the Middle Eastern buyer? All summer long, the negotiations dragged on. Mark’s old deputy, Joe Sutton, had found the prospective buyer and was planning to leave Enron and help the Arab investors manage the assets. If Sutton negotiated the deal for Enron, he would have an obvious conflict of interest, not unlike the conflict Fastow had with LJM. But in this case, Skilling wasn’t about to look the other way; he brought in Cliff Baxter to finish the negotiations. There was a huge internal uproar when Sutton managed to get a guarantee from Lay that the international team’s options would vest upon completion of the sale. Typically, Lay didn’t bother to ask what the number was; when Skilling discovered that it came to $300 million, he threw a fit.

But he was ready to do the deal anyway. Skilling and Lay had the final papers drawn up, and Skilling even met with two Enron public-relations executives to prepare a press release. The last round of negotiations—which would culminate with the signing of the papers—was set to take place in London.

Then a final piece of bad luck: during that final round, the scion of the family making the purchase became deathly ill. Without his permission, no one had the authority to guarantee the purchase. The deal fell apart.

In October 2000, Joe Sutton was asked to leave. Over the course of the next few months, other international executives were fired, too. The irony was that their options all vested once they were let go and they were able to cash out, winding up with the same $300 million they would have received if Project Summer had gone through.

The following February, the company’s international developers were summoned to Houston and told that Enron International was being shut down. If they wanted to stay at Enron, they needed to find new jobs at either EES or broadband. A few weeks later, EES held a job fair at the Hyatt—a typically lavish affair with a baseball theme, including fake grandstands and peanut salesmen. Many international employees ended up working for one of the two big enchiladas.

 • • • 

In the end, Rebecca Mark was one of the lucky ones: even though it hadn’t been her choice, she got out at the top. Soon after she started Azurix, she had begun selling her Enron shares; by spring 2000, she had sold her entire stake, over $80 million worth. Had she stayed, that stake would have been worth nothing.

But she could never quite bring herself to see it that way. Instead, she continued to boil over about what Skilling and Lay had done to her. Without her projects, Enron would have been exposed years earlier, she would say; her deals gave the company real assets. Those were the assets the company put into its off-balance-sheet vehicles, thereby raising cash. Yes, the rate of return on some of her projects may have been low, but her side of the company was real, unlike Skilling’s. Even Azurix, for all its problems, always made a profit, a
real
profit.

“My stuff was discounted because it
could
be analyzed,” Mark told one friend. Skilling’s team, she added bitterly, “lived off us for so many years, sucking our blood.”

Mark also never stopped believing that success was just around the corner, and this was especially true of her tenure at Azurix. If only Enron hadn’t been so eager to pull money out of the company . . . if only Skilling hadn’t been such an impediment . . . if only Enron had been willing to commit more capital and given it more time.

“It just needed time,” she told a friend years later. “With time, it would have all been fine, just fine.”

Aside from his age, Tim Belden didn’t fit the profile of a typical Enron trader.

Thin and slightly balding, he favored the rumpled look of the academic researcher he’d once been. He had a master’s in public policy from Berkeley and spent five years working as a researcher at the Lawrence Berkeley National Laboratory, where he coauthored papers on energy markets and lost money investing in environmentally friendly wind projects. His Enron colleagues called him a tree hugger because he rode his bike to work. He was 30 when he joined the company in 1997.

But looks can be deceiving. Not only was Belden an Enron trader, he was one of the leaders of a group of hyperaggressive West Coast electricity traders who operated out of Portland General, the Oregon utility Enron purchased in 1997. He was, as they liked to say at Enron, intellectually pure—a trader who believed in the beauty of free markets and had no scruples when it came to exploiting inefficiencies to make money. He struck others in the industry as very knowledgeable, and while he was affable enough to outsiders, he had traces of Enron mean. (He once asked an interviewee named Lynn Brewer what the square root of 363,000 was.) It wasn’t long before Belden caught the notice of Whalley and the other top trading executives in Houston; within a year and half, he was named an Enron vice president.

Belden had always had a bit of the mad scientist in him, and in the late spring of 1999, he began working on an intriguing idea. Deregulation of California’s energy market had gone into effect the year before, creating an enormous opportunity for energy traders, who were suddenly in the position of buying and selling a huge portion of the state’s electricity. The sheer complexity of the rules governing deregulation seemed to make them exploitable in another way as well. Clever traders could find loopholes in the thousand or so pages of rules and game the system in much the same way Andy Fastow’s team gamed the accounting rules. For instance: what would happen if a trader sold energy to the state for the next day but scheduled it in such a way that the electricity couldn’t possibly be delivered? What would a move like that do to the price of electricity? That’s what Belden wondered and what he set out to learn with his little hands-on experiment.

 • • • 

California.
Outside of Washington, D.C., was there any place Enron spent
more time maneuvering than California? California was so big, so important, so influential—and this big, important, influential state was also moving more quickly than most others to deregulate its retail energy markets.

Enron hired lobbyists by the bushelful. It doled out tens of thousands of dollars in campaign contributions to California politicians. Lay and Skilling made stump speeches touting deregulation’s benefits. In one appearance before the California Public Utilities Commission (CPUC), Skilling claimed that the state would save $8.9 billion a year: “Let me tell you what you can buy every year,” he said. “You can triple the number of police in Los Angeles, San Francisco, Oakland, and San Diego, and you could double the number of teachers.”

Then, after energy deregulation took place in California, Enron’s EES division spent millions more in an attempt to make itself into a high-profile energy retailer, selling electricity directly to consumers. Though that effort was a bust, deregulation still gave the company a tremendous vested interest in the state. And, finally, once the California experiment became an out-and-out debacle, bankrupting the state’s largest utility and wreaking havoc on its economy, Enron had yet one more reason to focus on California: to defend itself from the near-universal belief among Californians that Enron was the company that turned out the lights. Although the accusations were only partially true—many of the other parties involved in this mess behaved no better—Enron’s size and its undisguised disdain for the state’s suffering made it the prime target.

In truth, for all Enron’s lobbying, the new rules accompanying California’s deregulation were a far cry from what the company had hoped to see enacted. As always, Enron had pushed hard for a completely deregulated marketplace, in which companies could cut whatever deals suited their needs. But there were so many powerful competing interests jockeying for advantage that the CPUC, which was in charge of designing the new rules, was never going to allow a completely free market.

For example, the state’s three investor-owned utilities—Pacific Gas & Electric, San Diego Gas & Electric, and Southern California Edison—all had long-term contracts to buy power at high rates. If the state was no longer going to set electricity rates based on their costs, they wanted compensation for the losses that would inevitably ensue. Politicians, meanwhile, wanted guarantees that consumers would get their rates reduced. Otherwise, what was the point?

The result was a convoluted mishmash of compromises featuring more rules and regulations than ever. The utilities were forced to sell off their generating facilities and buy their power on the open market. They were also forbidden from entering into any significant long-term contracts; instead they had to purchase power in the spot market
every day.
This was supposed to lead to panic selling, thereby driving prices down. At the same time, though, the rates consumers were charged weren’t deregulated, at least not in the short term. Instead, they were cut 10 percent, then frozen for five years. Because the CPUC was convinced that spot-market power prices would drop substantially more than 10 percent after deregulation, it wanted the utilities to be able to use the difference to recoup the losses on their long-term contracts. (Indeed, if the utilities recovered their losses before five years were up, consumer rates would be unfrozen. This actually happened in San Diego.)

But the true nightmare—and the opportunity for traders like Belden—lay in the market itself, which was really a handful of markets layered together in incredibly complex ways. To some extent, the very nature of electricity made that necessary. Getting electrons to go where you want them to go isn’t a matter of loading them on a truck, driving them someplace, and letting the extra ones sit around until a buyer arrives. It’s an engineering feat, one involving something that’s essential to modern life. Supply has to be lined up ahead of time; and the path the electrons will take to get from Point A to Point B also has be planned ahead of time, because transmission lines have a limited amount of capacity. It’s also impossible to store electricity; electrons can travel only in real time. So there also has to be a way to make sure that supply and demand match at all times.

This is complicated stuff to begin with, and California made it even more complicated. The state’s new rules created two quasi-governmental agencies. One was called the California Power Exchange (Cal PX). Its job was to set hourly prices for electricity through auctions conducted the previous day and on the day of delivery. Sellers received (and buyers paid) the highest price needed to satisfy all the demand in any given hour. The second agency, the Independent System Operator (ISO), was in charge of managing the state’s network of transmission lines to ensure reliability. It also conducted its own real-time auctions, which were just supposed to correct last-minute supply-and-demand imbalances and ensure adequate reserves.

The logic behind many of the new rules could be difficult to fathom. One example: when the ISO purchased last-minute power that was generated in California, the price was capped in early 2000 at $750 per megawatt hour. But if the power came from out of market, there was no price cap. Of course, the price caps could also easily turn into price targets: people knew just what the ISO was willing to pay.

Another example: if too much electricity was scheduled to flow on a transmission line—and the line became “congested”—the ISO would pay fees to whichever power company agreed to relieve the apparent congestion. There was no way to check if there was even enough real demand to cause the congestion in the first place. The potential for abuse was obvious. As early as 1996, a man named Eric Woychik, an adviser to the CPUC in the 1980s and later an ISO board member, wrote that gaming the market would be like “shooting fish in a barrel—not great sport, but lucrative.” Even Belden himself, in an internal presentation he gave in May 2000, noted that “the ISO and the PX have a complex set of rules that are prone to gaming.”

The new rules went into effect on April 1, 1998. At first, deregulation seemed to be a roaring success. It did exactly what everyone hoped it would do: it caused prices to drop substantially. There was so much competition among suppliers that electricity was actually free between 1
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and 2
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For most of the next two years, wholesale costs averaged around $33 per megawatt hour—well below the old regulated rates. They also stayed safely below consumer rates, allowing the state’s big utilities to recover billions of dollars.

But to those in the guts of the market, it was clear almost immediately that some suppliers were not going to play nice. On July 9, 1998, just three months after the new rules went into effect, ISO employees were stunned to see the price for reserve power, which had been a dollar, suddenly spike for no apparent reason to $2,500 per megawatt hour, then to $5,000. Four days later, it happened again: the price soared to $9,999 per megawatt hour.

What had happened? Dynegy had simply offered to supply standby power at that price—and under the rules, since there were few other offers and the ISO was expecting high demand, the ISO was forced to take Dynegy’s price. Jeffrey Tranen, then the CEO of the ISO, later told the
Sacramento Bee,
“All of us saw those numbers and realized . . . there was nothing to stop someone from bidding to infinity.”

By any objective measure, Enron had a powerful self-interest in seeing the California experiment succeed. It had preached for years that deregulation would cause prices to go down and make life better for everyone. The Enron belief was that once California deregulated and showcased the virtues of a free market in retail electricity to the rest of the nation, other states would have no choice but to follow suit.

But if deregulation was a failure, Enron would be badly hurt. As an internal Enron memo put it, “If Enron doesn’t do well in California, Enron will have a difficult time convincing anyone outside of California that they are capable of and committed to providing power services.” Just as importantly, if the California experiment failed—no matter what the reason—other states were hardly likely to follow it into the abyss. A California failure could put an end to the push for broad, national power deregulation.

Yet from Ken Lay on down, Enron executives simply refused to see that their best interest lay in helping the state succeed. That kind of larger consideration was utterly foreign to the company’s what’s-in-it-for-me culture. This was especially true of the traders, who viewed such thoughts as lacking intellectual purity. Besides, everyone at Enron was annoyed at the way California had put deregulation into effect; the state hadn’t followed the company’s long-held position that a completely free marketplace was the only thing that made sense. Having failed to listen to Enron, the state therefore deserved whatever it got.

“If they’re going to put in place such a stupid system, it makes sense to try to game it,” says one former senior Enron executive, in a comment that perfectly summed up the prevailing attitude inside the company. That their actions might cause turmoil and hardship, that they might affect businesses up and down the state, well, from the point of view of the Enron traders, that was California’s problem, not theirs. “It was the traders’ job to make money, not to benefit the people of California,” says another former Enron executive.

Thus, right alongside their rivals at Dynegy and elsewhere, Enron’s West Coast traders began searching for loopholes. There were ultimately a hundred West Coast traders; they operated out of the Portland World Trade Center, where the company had built a copy of its Houston trading floor, down to the plasma TV screens and Nerf footballs. Belden, who was leading the effort to find exploitable loopholes, put in 14-hour days learning the arcane rules of California deregulation. By the spring of 1999, he thought he saw a flaw he could exploit. But first, he had to conduct his experiment.

Here’s what Belden did: on May 24, 1999, at 6:10
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he submitted four bids to sell a total of 2,900 megawatts—enough to run a city the size of Fresno for a day—to the Cal PX to meet demand in the peak hours the following day. At 7:01
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the PX notified Belden that his bid was successful. At 7:29
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Belden identified a transmission route called Silverpeak as the means for getting the electricity to the state.

The transmission route Belden had chosen begins at the Beowave geo-
thermal energy facility in Nevada, where steam is pulled from subterranean cauldrons into a huge turbine, generating electricity. The electricity is carried across Nevada to a terminal in Silverpeak, a ghost town in the desert, where lines then transmit it over the Last Chance mountain range into Southern Califor-
nia. Here’s the key point, though: the Silverpeak transmission lines can only carry 15 megawatts at a time.

In other words, Belden had scheduled 2,900 megawatts on a line that could only absorb a tiny fraction of that amount. Because the transaction was physically impossible, alarm bells went off in the offices of the ISO, which was responsible for both the transmission lines and for correcting supply-and-demand imbalances. At 11:17
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an ISO scheduler called Enron to find out if there had been a mistake. Belden was expecting the call, which was immediately transferred to him.

BELDEN
:
Um, there’s a—there—we, just, um—we did it because we wanted to do it. And I don’t—I don’t mean to be coy.