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AC948 Case Studies in Financial Environments Lecture 6: Enron Introduction

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Raptor issued securities based on the RNC stocks it had (but was not allowed to sell directly) ... The more Raptor's assets declined, the more of its own stock ... – PowerPoint PPT presentation

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Title: AC948 Case Studies in Financial Environments Lecture 6: Enron Introduction


1
AC948 Case Studies in Financial Environments
Lecture 6 Enron - Introduction
  • Yuval Millo, AFM, U. of Essex

2
Why is it important to study Enrons case?
  • Enrons shows the growing complexity in
    calculating firms earnings.
  • In LTCM case we saw how marking-to-market became
    an inherent part of the organisational trading
    strategies. However, the complex methods used to
    calculate value were abused in Enron to hide
    losses.
  • Enron illustrates the gradual convergence between
    financial markets and corporate governance. Enron
    established its place as a leading firm not only
    from its activity as energy company, but more
    through trading derivatives.

3
Derivatives and corporate governance
  • Enron used derivatives to manipulate its
    financial statements.
  • It hid speculator losses it suffered.
  • It hid huge debts incurred to finance
    unprofitable new businesses.
  • It inflated the value of other businesses.

4
Hiding losses using derivatives 1
  • Enron invested a relatively small amount of
    venture capital, (about 10 million), in Rhythms
    Net Connections.
  • RNC issued stock to the public in an initial
    public offering (IPO) on April 6, 1999, at a
    price of about 70 per share.
  • Enrons stake was suddenly worth hundreds of
    millions of dollars.
  • As is typical in IPOs, Enron was prohibited from
    selling its stock for six months.

5
Hiding losses using derivatives 2
  • So, Enron did not sell the stocks, but instead,
    it exchanged its shares in RNC for a loan from a
    limited partnership called Raptor.
  • Raptor issued securities based on the RNC stocks
    it had (but was not allowed to sell directly).
    These securities were supposedly reflecting the
    performance of RNC.
  • Raptors securities were backed by Enrons
    guarantee to give stocks to Raptor if Raptors
    assets declined. The more Raptors assets
    declined, the more of its own stock Enron was
    required to transfer.
  • This transaction was known as a price swap
    derivative.

6
Hiding losses using derivatives 3
  • Because the securities Raptor issued were backed
    by Enrons guarantee to deliver shares, the
    performance of RNC was irrelevant to Raptors
    securities.
  • In effect, Raptor sold securities that reflected
    Enrons performance.

7
Hiding losses using derivatives 4 What did Enron
gain?
  • The loan Enron received from Raptor was recorded
    in its reports as profit immediately Enron did
    not have to wait for 6 months to sell the RNC
    shares.
  • Since it did not hold the stocks, Enron was free
    of the risk of a drop in their price during that
    time.

8
Hiding losses using derivatives 5
  • Even as Enrons shares and Raptors assets
    declined in value, Enron did not reflect those
    declines in its financial statements.
  • The loan from Raptor, paid for with stocks, was
    covering the real value of Enrons assets.

9
The implications
  • Since Enron agreed to pay in its stocks for loans
    such as the Raptor one, its stock represented
    debt rather than assets.
  • As Enron entered The more such deals, its
    shareholders held relatively more debt than
    assets.

10
Hiding debts using derivatives 1
  • Enron set up a limited partnership called Joint
    Energy Development Investments (JEDI).
  • Enron owned only 50 of JEDI, and therefore
    under accounting rules did not have to include
    all of JEDIs financial results in its financial
    statements.
  • This fact allowed Enron to borrow in the name of
    JEDI).
  • So, in effect, Enron moved debt off its balance
    sheets and into the limited partnership, which it
    didnt have to report.

11
Hiding debts using derivatives 2
  • Enron entered a derivatives transaction with
    JEDI, effectively guaranteeing repayment to
    JEDIs outside investor (the other 50)
  • However, in its financial statements, Enron
    stated that the value of the guarantee cannot be
    calculated accurately.
  • Therefore, Enron did not consider it likely that
    it would have to repay the guarantee.
  • That position enabled Enron to avoid recording
    its guarantees.

12
Inflating value 1
  • A simple example. When trading starts, ABCs
    market price is 7. A person owns 1M ABC shares.
    At the end of the day, ABCs market price is 7.5
  • Does that mean that that person has now 500,000
    more than he did in the morning?

13
Inflating value 2
  • Yes, but only in paper profits.
  • What does that mean?
  • What will happen if he tries to realise ABCs
    value?
  • If he tries to sell too many shares, the market
    price would be reduced and the total value maybe
    much less then 500,000
  • Alternatively, if he sells gradually, then he
    takes the risk that the price will drop. Also,
    the cash stream would be spread over a longer
    period.

14
What do we learn from the example?
  • Paper profits and actual profits are very
    different.
  • So, if one sells a small part of an inventory of
    assets for a certain price and then values the
    whole inventory according to the price received
    the price is inflated paper prices are
    equated with real prices.
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