Enron Trading Risks

PAUL SOLMAN:

Enron. Its reputation has gotten so bad, people now routinely call it the crooked "E." But before it was known for its financial finagling, Enron had become famous as a business pioneer, blazing new trails in the market for trading risk.

FRANK PARTNOY:

They ended up as a derivatives trading firm, something very different from what they had started with, which was essentially a traditional energy firm where they could buy and operate pipelines, and ship natural gas to customers.

PAUL SOLMAN:

Law Professor Frank Partnoy is writing a book on Enron and derivatives.

PAUL SOLMAN:

Explain derivatives markets.

FRANK PARTNOY:

Derivatives are financial instruments whose value is linked to something else. They're basically fancy instruments that have evolved over the last ten years that enable investors and institutions to bet on virtually anything, from interest rates or exchange rates to commodities.

PAUL SOLMAN:

Now, to make things a little clearer, let's go down on the farm to give you one of our typically oversimplified, but we hope helpful, demonstrations.

Old MacDonald here has a problem. He's fattening his hogs today, but they won't be ready to sell for six months. A hog like Wilbur will cost, say, $100 to keep and feed till slaughter time, when, if there's a God in hog heaven, Mac will get $150 for Wilbur– a fat profit.

But now suppose the worst: A bumper crop of pigs comes to market just when Wilbur does, or people suddenly lose their taste for pork. At any rate, Wilbur and kin fetch only $50 apiece when they have to be sold. Big Mac here could go broke. But not if he hedged his bets on the commodities market.

SPOKESMAN:

11 on five! 11 on five!

PAUL SOLMAN:

Yes, those human pens that provide the backdrop for movies like "Trading Places," the stock footage for stories like this one. They're marketplaces where farmers can sell their pigs, corn, wheat, what-have-you, at a date in the future, at a locked- in price.

So in Mac's case, if Wilburs are going for $150 today, he can enter into a contract that promises him, say, $150 per pig six months from now. It's really a bet on the future price of pigs, but for Mac, it's kind of like insurance against the risk that the future market price will go down.

FRANK PARTNOY:

So Old MacDonald can enter into one of these contracts to lock in a future price. He no longer has to worry about whether the price goes down.

PAUL SOLMAN:

Now contracts in this market don't just protect producers of pork, or any other commodity. Think about someone who needs to buy pork, like Kevin Bacon here, for his hot dog business. The risk to him is that the price will rise. So he could take the other side of a contract like Mac's, and lock in a price of no more than $150.

In effect, the parties would be swapping risks at a minimal cost– basically the commission the market takes for brokering deals like these.

FRANK PARTNOY:

Both sides love this agreement. It's great because it eliminates risk for the farmer. It eliminates risk for Kevin Bacon.

PAUL SOLMAN:

And the market thrives because it charges something for doing this.

FRANK PARTNOY:

There's always an intermediary putting these two together, and that intermediary, whether it's the market or an exchange, makes a few pennies off of both people so that everybody is happy.

PAUL SOLMAN:

These contracts are essentially bets on the price of something in the future. You can use them to lower the price risk of something you make or buy, or anyone can just gamble with them– speculate.

So there's another set of players, speculators, whose incarnation for us is specs, who thinks he can see the future, and wants to bet on his vision. In his mind's eye, perhaps, he sees Mad Cow Disease sweeping the land, killing the cattle industry, and thus forcing desperate meat eaters to switch to pork, driving the price way up. So he can take the other side of the Big Mac contract, just like Kevin Bacon did, promising to pay $150 six months from now, and rooting for the price to rise. That's speculation. But whether it was producers and consumers hedging their risks, or speculators taking risks, the commodity markets evolved to enable such trades, making a commission on each.

FRANK PARTNOY:

And that's what makes markets efficient.

PAUL SOLMAN:

What do you mean, "efficient"?

FRANK PARTNOY:

Because the price will reflect all information that's available in the market. The speculator has certain information that the farmer and Kevin Bacon might not have. As long as you allow speculators to come in and participate in the market, all the information that the speculators have will be reflected in market prices.

PAUL SOLMAN:

"Okay," you may be asking, "what's this have to do with Enron?" Well, since commodity markets proved so useful for transferring risk and for predicting prices, they began to expand, trading more kinds of commodities: Metals like gold and silver, and energy products like crude oil, home heating oil, to name just a few.

And in the 1980s, when natural gas, long subject to strict price controls, was deregulated, Enron, a natural gas company, decided to transform itself by pioneering new trails in the commodities business. Deregulated, the price of natural gas could now go down and up, which meant producers and consumers were suddenly at risk.

FRANK PARTNOY:

So customers are exposed to changes in the price of natural gas, and they like to hedge those risks. But they're very limited in terms of where they can go. The New York Mercantile Exchange offers them a hedge, but it's a limited hedge.

PAUL SOLMAN:

Why would you want to hedge against different prices of natural gas?

FRANK PARTNOY:

Well, as people probably know, prices of commodities can vary by region. So for example, the price of a gallon of gas in San Diego is a lot higher than the price of a gallon of gas in the Midwest. And so Enron said, "we'll enter this market and we'll supply custom-tailored contracts for these customers' needs. We'll deliver natural gas, or agree to deliver natural gas, to any location in the U.S. at any time."

PAUL SOLMAN:

Of all the new kinds of contracts Enron began trading, none seemed more obscure or complex than weather derivatives, where there's no tangible commodity like hogs or gas at all. But weather derivatives are simply bets on the weather.

So we're going to try to keep the basic idea grade-school simple. Say the children's author Roald Dahl had a daughter, Barbara, who owns a ski resort in the Rockies. Barbara Dahl's worried about global warming. Suppose it keeps up for the next decade or two: No snow, no customers– a total meltdown in her business.

Meanwhile, her twin sister, Barbara Dahl II, owns a golf resort in Colorado. For her, global warming might mean more business– just what the weatherman ordered. A weather derivative would be a long-term contract Barbara I could enter into with anyone– a speculator, Enron, or another businessperson. They would pay her money in the event of warmer weather– above normal years for, say, 15 years.

But according to the contract, she'd have to pay if the weather was below normal. She would be then be protected against global warming, and if there were global cooling, she could afford to pay, since she'd be making money on all those extra skiers the snows would bring.

And you might be able to see why Barbara II would want to take the other side of such a contract: Getting paid in the event of global cooling, paying if the weather warmed up, since she'd be making lots of money from the flood of warm-weather duffers.

Finally, as always, specs the speculator could simply bet by entering into a contract with either of the Barbaras.

FRANK PARTNOY:

A few years ago, you couldn't bet on the weather, and Enron came in and did what economists call "completing the market." If you were worried about changes in the weather, you could go to Enron and hedge those risks. They supplied a series of bets on the weather in the same way they had supplied a series of bets on natural gas.

PAUL SOLMAN:

So what went wrong?

Well, for one thing, Enron's position in the trading business may have been highly profitable, but not for long. Think about it. If you're the only market in town, you can charge sizable commissions. Plus, you know more than everyone else, so you get to see price discrepancies– essentially bargains in the market– before others do, others like Enron's Houston neighbor and rival, El Paso, whose trading floor this is. But where there are profits, there's soon competition. Wall Street firms like Goldman Sachs and Morgan Stanley started competing with Enron, charging less for commissions, learning as much about price discrepancies as Enron did. Inevitably Enron's trading operation became less profitable. And experts now suspect it was losing money in nearly every other part of its business.

FRANK PARTNOY:

Where Enron went wrong is it abandoned its core business. It made money every year, trading derivatives on natural gas and power. But as it expanded to other investments– water, a power plant in India, telecommunications, Internet stocks, broadband– it started losing billions of dollars on each of those investments. And the further it moved from its core business of trading, the more money it lost.

PAUL SOLMAN:

But if Enron appeared to be in trouble, who would trade with it anymore? Would any of these folks use a market, or buy insurance from a company that made promises a decade or more away, but might not be able to keep them? Would you?

FRANK PARTNOY:

As Enron continued to lose money in these other businesses, it had to hide those losses, and it started entering into all sorts of bizarre financial contracts in order to hide those losses.

And in the end, when people saw that, in fact, Enron was essentially a shell game– that it had lost these huge amounts of money– they withdrew their credit. They said, "We're not lending you any more money." And at that point, Enron went into a death spiral, and bankruptcy was inevitable.

PAUL SOLMAN:

Of course, in the wake of disasters like the California energy crisis, some people draw a different moral from the Enron debacle: That when markets are deregulated, the price swings they're suddenly subject to can be a business opportunity for some, and a catastrophe for others, like California, which found itself at the mercy of price volatility that threatened the state's economy and quality of life.

Did companies like Enron, El Paso, and others manipulate the market to drive prices up? The jury's still out on those charges.

But one thing's for sure: They don't call it market risk for nothing.