Up In Smoke

Enron used political ties to rid itself of regulators. But in the end, its supposed free-market trailblazing only burned investors.

Two years later, Gramm led the push to open the door for Enron even wider by heading the effort to exempt over-the-counter derivatives from commission control. That allowed Enron to break free of the spot market for natural gas. It also enabled the company to customize derivative contracts for customers looking for long-term price stability in the market.

Gramm had previously announced she would be leaving the commission. A week after delivering the rule change for congressional approval, she departed.

Five weeks later, Gramm had a new position: Lay appointed her to Enron's board of directors. The position paid about $30,000 a year, plus stock options. One CFTC member called the timing "horrible." Lay told The Washington Post that it was "convoluted" to suggest Gramm was brought on board for any reason other than her brilliance.

"Her knowledge of the derivatives market is a big plus for Enron," Lay said. "There aren't that many people who really understand that business."

However, the corporation itself would soon be wondering how well it understood business in the vastly broadened markets delivered through deregulation.


Enron's extended leg room in the over-the-counter market brought it trouble almost immediately. In 1993, TGT, an Enron subsidiary in Great Britain, entered into a "take or pay" contract with companies pumping natural gas from the J-Block field in the North Sea. Enron agreed to take 260 million cubic feet of gas per day for ten years to supply one of its own power plants and to sell to others.

But when the contract matured and Enron had to take delivery, demand for natural gas was down and the price had dropped by half. Enron tried to litigate its way out of the mess, but a British court ruled that the meaning of "take or pay" was pretty clear.

The failed deal cost Enron $537 million in 1997. Bob Young, a derivatives consultant with New York-based ERisk, says the massive loss should have raised concerns inside the company.

Young believes that trading in the "short end," meaning locking in prices for three to five years, is a safe bet because everyone has the same idea what the commodity will cost in that time frame. But he explains that there are no markets for pegging prices in the more distant future, such as 15 years out.

"No one knows what the price is going to be," he says, "so you have to base it on expectations, which can change."

In retrospect, the J-Block debacle appears to be just one of many problems Enron faced in 1997. After all, that's when it formed the first of its subsidiaries to shield transactions from the balance sheet. One of the more infamous was called LJM, for the initials of CFO Andrew Fastow's three children.

The J-Block contract suggested to Young that Enron wasn't managing its trading books closely enough. Traders are supposed to adjust the value daily on long-term contracts, a practice called mark-to-market accounting. A responsible trader will watch for price decreases that reduce the long-term value of contracts. If that happens, the trader will try to hedge the lost value by making another trade that promises a better outcome.

The flaw in such accounting of unregulated derivatives was the potential for a harried or unscrupulous trader to inflate long-term contract values, knowing no one outside the company would have access to the information. Traders for any company might decide to impress their bosses or increase their bonuses by setting unrealistic future prices, then simply ignoring any subsequent changes in the commodity's price.

"It's a real conflict of interest," Young says. "A trader can set the market almost however he wants, then manipulate the market value to his own benefit. He just tells his boss the trade has been booked and he wants to be paid for that value now."

Whatever problems were escalating within the walls of Enron's far-flung enterprises, the exterior looked sleeker than ever. The corporation concentrated more and more resources into the heady stuff of derivatives trading. It invested in broadband, coal, water, pulp, paper and more. World market analysts were wowed by the new and novel initiatives into expanding economic markets.

Executive Jeff Skilling showed the brash style with personalized license plates -- WLEC -- for "world's largest energy company."

As that target came within Enron's sights, there were a few pesky chores to be taken care of first. Creative bookkeeping had spawned more and more sleight-of-hand subsidiaries to mask accurate numbers from corporate balance sheets. And government was trying to get in the way again, this time with the audacity of proposals to require proper accounting and oversight to the wide-open field of derivatives.

Lay would soon be returning to the front to break more regulatory leashes. This time, he was better armed than ever with political largesse.


The Enron chairman had invested his massive campaign contributions wisely. While he'd made it clear that one of his goals was a GOP majority in Congress, he would put his money on Democrats when there were no viable alternatives.

Lay is conservative, but "he is not some right-wing nut," says Enron fund-raiser Sue Walden, a loyalist who stays in regular contact with Lay. "He is pragmatic in 'What do I need to do on the PR end to achieve my goals?' "

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