Title: AC948 Case Studies in Financial Environments Lecture 6: Enron Introduction
1AC948 Case Studies in Financial Environments
Lecture 6 Enron - Introduction
- Yuval Millo, AFM, U. of Essex
2Why 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.
3Derivatives 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.
4Hiding 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.
5Hiding 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.
6Hiding 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.
7Hiding 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.
8Hiding 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.
9The 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.
10Hiding 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.
11Hiding 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.
12Inflating 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? -
13Inflating 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.
14What 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.