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Enron's Web of Complex Hedges, Bets

Finances: Massive trading of derivatives may have clouded the firm's books, experts say.


As accountants and investigators begin poring over Enron Corp.'s books, they are likely to collide head-on with a factor that makes its finances particularly impenetrable--the extent to which the company relied on financial instruments known as commodity derivatives to inflate income, hide losses and misrepresent the true nature of its business.

Although to this day Enron is generally known as an energy trading company, a close review of financial records and interviews with accounting experts show that at its heart it had become a massive trading operation in derivatives, which are financial contracts that can entail significant risks.

Missteps in such trading have cost highly sophisticated investors billions in past years. Among other cases, derivatives trading was behind Orange County's bankruptcy filing in 1994 and the failure of Barings Bank in 1995.

Derivatives, which come in many forms, allow investors to bet with other investors on changes in an underlying asset or index, such as stocks, interest rates, weather or electricity prices. Properly used, derivatives are effective at hedging against an almost infinite variety of business risks ranging from crop failures to changes in interest rates and oil prices. But they can sharply exaggerate market gains or losses.

There are signs that, in the company's hands, derivatives evolved into more than risk-hedging devices. They became tools of fiscal concealment and manipulation, some experts say.

Among other things, derivatives allowed Enron to inflate the value of its assets and transactions while understating their risks and obscuring their real nature, they say.

"Enron used derivatives to manipulate accounting standards and tax reporting," said Randall Dodd, head of the Derivatives Study Group, an economics watchdog. "They used them to fabricate income. It was a bit of a shell game."

Enron spokesman Mark Palmer on Wednesday declined to discuss the company's accounting. He said the issue "is being investigated by a special committee of our board, the Securities and Exchange Commission and the Department of Justice. They may reveal facts that may lead us to take further action."

It is still unclear to investors and government investigators how big a role losses on these contracts played in Enron's collapse. Nor is the full extent of the damage yet known. Some analysts believe the company still may be losing money on some contracts.

Much Derivatives Trading Unregulated

Enron could engage in its complex trading strategy without fear of regulatory intervention because the government explicitly exempted much derivatives trading from oversight. That's at least in small part because of a ruling by the Commodity Futures Trading Commission's former chairwoman, Wendy L. Gramm, just five weeks before she joined the Enron board in 1993. Gramm is the wife of Sen. Phil Gramm (R-Texas).

The trading market for the contracts has blossomed in the last decade, with nearly $100 trillion traded worldwide as of last June, according to the Bank for International Settlements.

Most of these were so-called over-the-counter or OTC derivatives--those not traded on a registered futures or options exchange, but rather contracts between big investors.

Enron did not entirely conceal that aspect of its business. As early as October 1999, its then-chief financial officer, Andrew S. Fastow, told CFO Magazine that the company's finance business would "buy and sell risk positions."

"Enron may have been just an energy company when it was created in 1985," said Frank Partnoy, a law professor at the University of San Diego who testified before the Senate last week. "But by the end it had become a full-blown OTC derivatives trading firm."

The world of derivatives was almost tailor-made for the aggressively secretive Enron. Accountants still have not settled on a consistent way to represent their value and risk on a company's books. The relevant standard set by the Financial Accounting Standards Board, an independent agency that sets guidelines for corporate auditors, is Rule 133--a behemoth that stands at more than 800 pages.

Enron's derivatives-related assets soared to $21 billion in 2000 from $3.1 billion the year before, according to the company's 2000 annual report. This enormous growth, apparently related to its Internet trading system, Enron Online, made it the fifth-largest commodity derivatives dealer in the U.S., according to figures compiled by Swaps Monitor, a market research firm.

Nevertheless, the company also reported last year that its net financial exposure to derivatives was only $66 million. Although that figure tripled from the year before, analysts contend that it is absurdly low, considering that a large portion of the contracts covered long-term energy deals subject to dramatic price fluctuations.

"Clearly these values are no longer credible," said Robert McCullough, a Portland, Ore., energy consultant.

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