Books will be written about the
saga. The magnitude of the financial carnage resulting from Enron's demise is unprecedented in both speed and scope.
In only a few months, $70 billion of equity and at least $20 billion of debt were reduced to a few billion dollars, the market value of its debt securities. This was no Internet-bubble stock that soared on hype and a small float. This was
, pillar of the Houston business community and darling of Wall Street for many years.
The details will emerge slowly. Right now, only a small fraction of the story has been revealed. With the stock near zero and with bonds the only remaining investment play in what will be one of the most complex bankruptcies ever, the public may well lose interest. That would be a shame because it could teach us much more about markets, banking and the role of investor confidence than any lessons learned from
Barbarians at the Gate
It didn't have to end like this. A little forthrightness when Enron's problems first surfaced in late October could have easily defused the crisis. Enron didn't fail because its assets became impaired or because it incurred a massive liability. It failed because its leveraged balance sheet required the ongoing confidence of its lenders and shareholders. And Enron lost that crucial confidence through its own ham-handed obfuscation on the
morning of Oct. 23.
The death spiral began Oct. 16, with Enron's
third-quarter earnings report. While shareholders and lenders were at least vaguely aware that Enron had moved many assets off its balance sheet into separately financed vehicles, no one -- except prescient short-sellers like Jim Chanos and Rich Grubman -- was too concerned. Enron's value was not perceived to be in pipelines, storage infrastructure and generation assets, but rather in its dominant energy-trading business.
Its earnings release downplayed the disclosure of a $1 billion writedown of equity due to one of the partnerships, and it was barely discussed on the ensuing conference call. Only after the call ended did further details begin emerging in the press about some of the more heinous off-balance-sheet vehicles: secret insider-controlled partnerships set up to take even more Enron assets off the balance sheet.
The problem lay in perception: The general partner of these entities was Enron's then-CFO, Andrew Fastow, who along with others made millions from this scheme. Obviously, that was money due the shareholders if these vehicles didn't exist. The dollars diverted likely numbered in the tens of millions -- real money, clearly, but pennies, at most, per Enron share. If the real desire was to stuff Fastow's pockets, the company could've simply granted him an outrageous cash bonus or stock grant. No red flags would've been raised.
The Big Mistakes
At first, Enron seemed to act responsively. Management convened a conference call to deal with the growing controversy, which had driven its shares from the mid-$20s to the high teens. But Enron's fate was sealed during that Oct. 23 call, when it refused to answer any questions about the details of the partnerships. Holding a conference call to quell investors' fears and then refusing to address the crucial issues were the biggest mistakes that a company at the front end of a crisis could make.
Somehow, this didn't occur to Enron's leadership. Right when investor confidence was most crucial to Enron's viability, the company got hostile, refusing to answer basic questions about the purpose of the off-balance-sheet vehicles, debt balances and assets. The market could only conclude that Enron was hiding something hideous.
Then its credit rating came into play. Enron's financing of several off-balance-sheet vehicles required redemption if rating agencies lowered Enron's debt rating below investment grade. Enron had sensibly included provisions that allowed any deficiency beyond the value of the assets that secured these vehicles' debt to be made up by issuing Enron stock.
Unfortunately for Enron, there was no minimum share-price provision. When your stock is at $50, death spirals aren't at the forefront of your thinking. But with a share price in the teens and falling, and with credit downgrades on the horizon, a death spiral was precisely what ensued.
You can't turn back the clock. But I strongly believe that if Enron had gone into detail on that fateful conference call -- explaining why each vehicle was set up, who had a financial interest in it, which assets were in each vehicle and the approximate value relative to the debt balances -- the equity markets would have been appeased, and the share-price decline would have abated.
This would've bought Enron the needed time to leisurely seek a large equity infusion from a private equity firm or to do a public convertible preferred deal.
, a firm that had its own liquidity crisis a year ago, has deftly worked its way to financial safety employing this strategy.
As the fear of massive equity dilution drove the common stock lower, Enron's equity financing options disappeared. With few assets left to encumber, debt issuance became less viable. As a trading firm, the declining perception of Enron's solvency began to impair its business, further hastening the decline.
Retailers in financial distress face a similar dynamic: If suppliers get wind of a liquidity crisis, they stop shipping. No one wants to hold a large unpaid balance the day a retailer files for bankruptcy -- it turns out you've sold your goods for 20% of what you thought. Retailers starved for inventory become compelled to file for bankruptcy in a self-fulfilling prophecy.
Enron found itself in similar straits: The perception of its problems began to cause massive actual problems as counterparties stepped back from creating incremental exposure to a wounded Enron. It also did nothing to improve the situation until a call held weeks later, on which management finally came clean on the issues it refused to discuss in late October. But by then, it was too late. The downward spiral had begun, and it was intensifying.
If the rating agencies hadn't suspended their scrutiny in the hope that a
deal would save the day, Enron would have collapsed weeks ago. Despite what seemed to be a heroic effort by Enron, Dynegy,
, the rating agencies and J.P. Morgan Chase, the patient died.
The full extent of lessons from Enron will only become apparent with time and the full revelation of the past month's events. But one lesson is already crystal clear: Leveraged companies that depend on investor confidence, where a liquidity crisis can erupt by actions beyond the issuer's control -- rating-agency downgrades in this case -- are accidents waiting to happen.
David Brail is the president and portfolio manager of Palestra Capital, a Manhattan-based hedge fund that focuses on risk arbitrage, and has been an investor in risk arbitrage and bankruptcy securities since 1987. At the time of publication, neither Brail nor Palestra held positions in any securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Brail appreciates your feedback and invites you to send any to