Failure and Fraud

1. Failure and Fraud Enron’s Place in the Pantheon Baird & Picker - Enron Seminar 2002

2. Senator Fitzgerald to Ken Lay • “Mr. Lay, I’ve concluded that you’re perhaps the most accomplished confidence man since Charles Ponzi. I’d say you were a carnival barker, except that might not be fair to carnival barkers.” Baird & Picker - Enron Seminar 2002

3. Is this right? • We want to locate Enron. • What kinds of firms does it most resemble? • Was Enron a reprise of Ponzi et al.? • Or was it merely a spectacular failure? Baird & Picker - Enron Seminar 2002

4. Charles Ponzi sees an Arbitrage Opportunity • In 1920, you could buy a postal reply coupon you can send with your letter to another country. • The person who gets the letter can redeem the coupon in his country’s stamps or currency • The exchange rates were fixed in 1906, and these have change a lot in the interim. • The differential creates an opportunity if you can figure out a way to buy them and redeem them at low cost in large quantity. Baird & Picker - Enron Seminar 2002

5. Charles Ponzi sees an Arbitrage Opportunity • Business Plan • Pretend to find a way to buy and redeem coupons. • Promise investors a fabulous return. • Pay-off old investors with part of the money raised from new investors. Baird & Picker - Enron Seminar 2002

6. Charles Ponzi sees an Arbitrage Opportunity • Problem • Payment obligations to investors increase geometrically over time. • Professional con artists never use “Ponzi” schemes for exactly this reason. • Well-executed frauds include a method for “cooling out” the mark. • If you do this right, your victims never even know they have been defrauded. Baird & Picker - Enron Seminar 2002

7. Prototypical Con:The Spanish Prisoner • My Situation • I am broke, but my friend has a lot of money in a Swiss bank account • He is now in prison in Spain. His guards can be bribed, but they won’t take an IOU and the Swiss bank will release the money only if my friend appears in person. • If you come to Spain with me and give me the cash, I’ll bribe the guards and the three of us will go to Switzerland. You’ll get one-third. Baird & Picker - Enron Seminar 2002

8. The Spanish Prisoner • Problem • The guards take our money and double-cross us (in large part because you didn’t do what I told you). • In the confusion, my friend is shot dead, and I am wounded. The two of us barely escape with our lives. • Life Lesson • It was your fault. Be more careful next time. Baird & Picker - Enron Seminar 2002

9. OPM Equipment Leasing • Business Plan • The tax benefits of owning equipment can’t always be enjoyed by people who need it • We maximize the gains from this opportunity by finding: • businesses that need one machine. • investors who can derive tax benefits from owning 10 machines • law firms with associates who don’t understand the deal and won’t notice that the numbers don’t match. Baird & Picker - Enron Seminar 2002

10. OPM Equipment Leasing • Problem • You have to pay rent for 10 machines, but you receive rent for only one. • Even if you can raise additional cash, the fraud works only as long as no one asks any questions • Sooner or later someone will ask questions Baird & Picker - Enron Seminar 2002

11. Equity Funding • Business Plan • We are in the 1960s. Investors would like to have the tax benefits of life insurance and the growth potential of a mutual fund • Investors buy our mutual fund, and we lend them the money (with their shares as collateral) to buy insurance • Eventually it can pay off the loan with the appreciated mutual fund shares Baird & Picker - Enron Seminar 2002

12. Equity Funding • Problem • The bull market of the 1960s ends and investors start to withdraw their funds and are less inclined to invest in the first place • To maintain the price of the stock, its managers need to resort to “aggressive accounting” (i.e., fraud) Baird & Picker - Enron Seminar 2002

13. Equity Funding • “Aggressive accounting” includes: • Treating as cash received revenues that will come when an identified person makes the first payment on a policy we have issued • Treating as cash received revenues that will come if an identified person agrees to buy a policy, and passes the medical test, etc. • Treating as cash received revenues that will come if an individual existed, agreed to buy our policy, passed the medical test, etc. Baird & Picker - Enron Seminar 2002

14. Equity Funding • “Aggressive accounting” makes possible additional revenue. E.g.: • Selling to a reinsurer policies that we may issue • Selling policies that we would issue if the insured existed and wanted insurance • Collecting death benefits from the reinsurer when our nonexistent insureds die unexpectedly. Baird & Picker - Enron Seminar 2002

15. Equity Funding • Problems • Reinsurers expect us to turn over premiums from all living insureds, regardless of whether they ever existed. • Auditors ask to see files, medical histories, etc. of our insureds • Producing these in a timely way turns out to be labor intensive. • It gets harder to ensure the loyalty of our expanding workforce. Baird & Picker - Enron Seminar 2002

16. Long-Term Capital Management • Over the long term, the amount of volatility in securities markets centers around a particular value. • The probability that the stock market goes up or down over a long enough time period remains constant • The spread between the fixed interest rate and the floating interest rate is, over the long run, also the same. • When these become too high or too low from a short-term fluctuation, an arbitrage opportunity exists • By buying the right derivatives in different markets when short-term departures appear, we can diversify our risks and ensure a large return. Baird & Picker - Enron Seminar 2002

17. Long-Term Capital Management • Basic Flaw • But the convergence to “true” values takes time and you need to be liquid enough to ride the storm in the mean time. • But to make money from such investments, Long-Term Capital needed to be highly leveraged. • The forces that create the spreads may exist across markets. Hence, their portfolio only appears to be diversified. • Result • In the summer of 1998, LTC’s bets were off by $2.9 billion. Baird & Picker - Enron Seminar 2002

18. Long-Term Capital Management • Bottom Line: • LTC was merely a spectacular failure; no allegation of fraud • Skilling claimed that Enron was the same. • By his account, Enron collapsed because a liquidity problem, not a flaw in the underlying business. • Is Enron merely a spectacular failure like LTC or is it like Equity Funding, but got caught before fraud became rampant? Baird & Picker - Enron Seminar 2002