Among skeptics of this kind of financial engineering is Stephen Wright, a finance professor at the University of London and co-author of Valuing Wall Street, a 2000 book devoted to the then-unfashionable notion of Tobin's Q, which holds that a company's market value ultimately equals the replacement cost of its tangible assets. Says Wright: "Not everybody can shift assets off their balance sheet, and when everybody is claiming that they should, clearly there are grounds for suspicion of that claim."
Having assets on the balance sheet is a much bigger issue now than it was just a year ago, and not just for energy companies. Consider the rise in asset-based lending, which requires assets to be used as collateral. While such lending has long been a source of capital for troubled companies, even investment-grade borrowers are going this route. "Demand is extremely robust," says an investment banker whose firm specializes in such lending and has had dealings with Enron.
Bank Run
Now, in fact, the rating agencies promise to take a much harder look at off-balance-sheet arrangements. And the additional scrutiny won't stop there, as Enron's meltdown is beginning to spark intensive congressional scrutiny of the regulation of the financial and commodity markets (not to mention the adequacy of federal protection of 401(k) plan assets). At a minimum, new standards for disclosure of off-balance-sheet liabilities seem in order. FASB seems to recognize this, as a spokeswoman reports that the accounting body has placed its long-waylaid Consolidations Project back near the top of its agenda. Its key proposal would tighten FASB's definition of control, and with it the conditions under which the results of a company's subsidiaries and other affiliates needn't be consolidated in its own financial statements.
For its part, the SEC says it plans to close certain loopholes in its disclosure requirements. The most relevant one may involve the definition of what constitutes material information, since Enron's auditor, Arthur Andersen LLP, accepted the company's claims that much of its off-balance-sheet activities needn't be disclosed, because the amounts at stake were sufficiently small to be considered immaterial. What more the commission should do here is open to question, however, since it issued guidelines some three years ago that made it clear that size alone wasn't an appropriate measure of materiality. Indeed, many suggest that a more effective move would be to ban accounting firms from providing consulting services to clients they audit. (Andersen billed Enron $27 million for consulting services in 2000, versus $25 million for auditing work.) Such a ban was proposed by former SEC chairman Arthur Levitt, but was abandoned in the face of industry opposition.
In the end, Enron was a victim of its own success. Just as it billed itself, it was more of an asset-light investment bank than an industrial company weighed down by tangibles. But exactly as can happen with a bank, once a critical mass of customers stopped trusting Enron's very name — effectively deeming its once-considerable knowledge capital to be worthless — it was only a matter of days before a sufficient number of others, including Dynegy, followed suit, leaving Enron a nearly empty shell.
The salvage job for what remains promises to take a little longer. Whether or not investors continue to punish off-balance-sheet gimmickry, regulators will doubtless start taking it more seriously. At press time, the Justice Department announced that it had formed a task force to coordinate the various federal investigations into Enron. While that may streamline the process, helping Enron emerge from bankruptcy more quickly, it will also expand the potential scope of prosecution of those responsible — to the level of criminality.
That alone should be a red flag for financial engineers everywhere, even if they haven't plied their trade as fast and loose as Andy Fastow did.
Hide and Seek
Although credit analysts and the company's auditor insist that Enron's true condition caught them by surprise, hints of trouble might have been detected earlier than last October, when the company announced its shocking Q3 2001 results.
Fastow himself told this magazine some two and a half years ago how Enron jumped through hoops to hide the debt associated with the acquisition of three New Jersey power plants from Cogen Technologies in 1999. Said Fastow: "We accessed $1.5 billion in capital but expanded the Enron balance sheet by only $65 million." Enron, like the overall market, was flying high back then, and as Fastow was the first to admit, "that's a significant amount of leverage you wouldn't want on the balance sheet." (Fastow declined to be interviewed for this article.)
A report last September by investment manager David Tice's firm cited those remarks. At the time Fastow made them, however, the then-37-year-old graduate of Northwestern University's Kellogg School of Management also insisted that "we've completely segregated these assets, so if something were to happen here, given the high leverage, it would not be able to come back at Enron." As it turns out, much of this purportedly nonrecourse financing has done just that, and belonged on Enron's balance sheet from the start.
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