Conspiracy of Fools (41 page)

And the arrogance of the place
. Shelby didn’t understand the swagger. Enron executives clearly considered themselves brilliant because of their success in energy. But why did they think that made them tops in high tech? It was like arguing that a skilled brain surgeon would, by extension, be a brilliant rocket scientist.

They were all so puffed up that they hadn’t noticed how badly managed the broadband unit was. It was having trouble hiring people because it wasn’t competitive on software. At the same time, it was still growing too fast as executives pursued every idea that popped into their heads. Now, Shelby heard, some trading guy was coming to co-head the division with Hirko, himself a technology neophyte.

Maybe I ought to resign
, he thought. Go back to the techie world. There were plenty of jobs; the high-tech and Internet industries were booming. There was no reason to hang around Enron.

Shelby went to see Hirko to talk about it. But Hirko told him to bide his time. Things were getting better, he said. The pieces were coming together. Just wait and see.

Robert Jeffe, a banker with Credit Suisse First Boston, couldn’t help but feel suspicious.

It was June 8, and Enron’s chief financial officer had just come to him with a bizarre proposal: Enron was forming an equity fund and wanted Fastow to run it. And now he was hitting up CSFB to make an eight-million-dollar investment in it.

Jeffe didn’t like the idea. Why would Enron’s board, its lawyers, its accountants ever consider such a thing? The conflicts were overwhelming; Enron’s CFO would be selling assets to himself. What was everyone thinking?

“You know, Andy, you really need to be careful here,” Jeffe said. “If this transaction ever comes to light, you will look very, very bad.”

Fastow pushed the idea, proclaiming the fund as a wonderful opportunity. It didn’t take long for Jeffe to understand Fastow’s enthusiasm. If the deal went through the way Fastow envisioned, Jeffe realized, Enron’s CFO stood to rake in north of twenty million dollars.

On June 10, three pairs of fifty-five-foot legs, decked out with giant shoes, dangled down the front of the New York Stock Exchange. Inside, mannequins draped with custom-made clothes jammed a balcony overlooking the trading floor.

As 9:30 approached, nine men and women—salespeople from Nordstrom, the department-store chain whose stock was beginning to trade on the exchange that morning—appeared on the balcony alongside the mannequins. At the half hour, they pressed a button, sounding the opening bell.

While Nordstrom grabbed the limelight, another company was quietly making its Big Board debut—Azurix. And in history’s hottest market for new stock issues, investors greeted it with indifference. Azurix executives had hoped to issue shares for twenty-two dollars each; investor demand only supported nineteen dollars. There was no massive price run-up; Azurix shares just drifted, closing the first day up thirty-seven cents.

The outcome didn’t ruffle Rebecca Mark. Azurix had raised almost $700 million, enough to launch some big deals. She seemed to forget the fact that Azurix had some debts to pay.

Jeff McMahon, Enron’s corporate treasurer, was at his desk when he heard that Rebecca Mark was holding for him. He picked up the phone. “Morning, Jeff. How are you?”

As always, McMahon found Mark unerringly pleasant.

“I’m fine, Rebecca. Congratulations on the offering.”

“Thanks. But that’s why I’m calling. Our proceeds have been swept into the corporate account. I want my money.”

McMahon paused. “I don’t understand it to be your money, Rebecca,” he said.

“No, no. The IPO funds are mine. They’re supposed to go to the Azurix accounts.”

“That wasn’t my understanding. My understanding is that money from the IPO issuance came back to satisfy Marlin obligations and other debts.”

Marlin—the water trust set up by Fastow to finance the original acquisition of Wessex, the British water company—had sold certificates to investors, who were now owed money. Some of the IPO funds were meant for them.

“That wasn’t the deal,” Mark objected.

“Rebecca, read the Marlin certificates. The funds are pretty much earmarked.”

“That’s not the deal I had with Ken.”

“You need to talk to Skilling,” McMahon said. “Because Skilling told me that was the deal.”

“You misunderstand the deal.”

“Rebecca, the deal wasn’t with
me,”
McMahon said, an edge to his voice. “I’m just telling you what I’m being told. So if you have an issue, you have to talk to Jeff.”

The call ended, and McMahon dialed Fastow.

“Hey, Andy, I just had a call from Rebecca Mark,” he began. He recounted the conversation.

“Let me talk to Skilling about it,” Fastow said.

A minute later, McMahon’s phone rang. The caller ID displayed Skilling’s name. McMahon grabbed the receiver. Skilling skipped the pleasantries.

“You are absolutely right,” he said. “We’re getting our money back. I’ve told them this a lot of times. That is not her money, and under no circumstances are you to release funds to Azurix without my okay.”

McMahon agreed and hung up. He never heard back from Rebecca Mark about the issue.

That same day, the phone rang in the twenty-ninth-floor office of Vince Kaminski, Enron’s top risk analyst.
^*
It was Rick Buy, calling from his office one floor down.

“Hey, Vince, Jeff Skilling and I have been down here talking,” Buy began. “He wants you and the guys to start working on a put option on Rhythms stock.”

Skilling had just gone through his final briefing on this fund idea of Fastow’s with Causey. Skilling considered the idea a godsend; with it, Enron could use the Rhythms profits to repurchase employee stakes in Enron Communications, without worrying about future price falls.

“This has to be a top priority,” Buy continued. “It’s really urgent. Skilling wants your best guys on it.”

“Okay,” Kaminski said. “We’ll get on it.”

Kaminski dialed his top options-pricing expert, Stinson Gibner, and asked him to come by. As Kaminski hung up, Skilling dashed in. The man had just bounded up the staircase from the twenty-eighth floor. Kaminski thought he looked like somebody who had partied too hard the night before.

“I want to talk to you about this Rhythms put option,” Skilling said as he walked in.

Gibner arrived, glancing at Kaminski with a look of surprise. What was

Skilling doing here?

Kaminski stood. “Okay. Let’s go to the conference room and talk about it.” The three men traipsed out the door, turning right toward the nearby conference room. Skilling started jabbering about … 
something
. Neither
Kaminski nor Gibner could make heads or tails of it. The words all seemed to run together. Hedging Rhythms. Some outside fund. Transferring a couple of hundred million dollars in stock.

Kaminski held up a hand. “Umm, Jeff, I’m not sure we’re getting all of this.”

“Okay,” Skilling said.

He walked to the conference room whiteboard, picked up a marker, and began drawing boxes and arrows. He hesitated. It looked like a mess. “I’m not gonna draw it,” he said. “Hold on, just hear me out.”

Back to the monologue. This was going no place fast.

“Jeff, I think we have enough information,” Kaminski interrupted. “Who can we call if we have other questions?”

Skilling set down the marker.

“Call Rick Causey,” he said.

Skilling thanked the men for their time and traipsed out of the room. Kaminski and Gibner stayed behind for a moment, then glanced at each other. “You know what he was talking about?” Kaminski asked. Gibner shook his head. “No.”

Kaminski shrugged, standing to head back to his office. “Well,” he said, “let’s call Causey.”

A minute later, he had Causey on the line.

“We were just talking to Jeff about Rhythms,” Kaminski began on his speakerphone. With his thick Polish accent, the company name came out sounding like “RITH-Ma.”

“Oh yes, yes,” Causey said excitedly. The two should make sure the option was as expensive as possible, he said.

What?
The more expensive the option, the more Enron would have to pay. Why would Causey want that? Kaminski asked a few questions, but Causey didn’t seem to know much of the deal’s intricacies either.

“Just in case,” Kaminski said. “Who has all the details of the transaction? Who do I call if I have questions?”

“Bob Butts.” The company controller.

Kaminski thanked Causey and hung up. Maybe the third time would be the charm.

It was.

Butts laid out the deal structure, explaining how Enron would contribute its own stock—now with a value of about $250 million—to some outside fund, which would then sell a put option on Rhythms stock to Enron.

Kaminski still struggled with the idea. “One problem. Who’s writing the option? Because I don’t understand how they’re going to protect themselves from a price decline.”

Butts’s response was matter-of-fact. “The option’s being written by a partnership set up by the finance group.”

The finance group?
Fastow’s
finance group? A thought shot into Kaminski’s head—a few years back, Fastow running retail, asking him to come up with a way to hedge against operating losses. The man was
an idiot!
He didn’t understand hedging. People in Kaminski’s group were always laughing about the silliness coming out of Fastow’s group. One analyst, Rick Murphy, even suggested Fastow would destroy Enron with his ridiculous financial ideas.

Those guys
, Kaminski thought,
have no idea what they’re doing
.

Kaminski went back to his office, deeply distressed. This deal was nonsense, gibberish, the product of foolish minds. It couldn’t work, and no one seemed to know that.

The evidence was there for anyone to see. Ordinarily, if Enron needed a put option on a stock, it could just buy one from some investment bank. But in this case, no institution would ever offer to sell one because of the enormous risk involved.

Ah, but here the hicks of the financial world think they’re smarter than Wall Street
.

If the market won’t provide something, Kaminski thought, there’s usually a darned good reason. And there was. No one
—no one
—would sell a put option on a volatile stock without taking precautions against a possible price fall. Essentially, that would mean setting up
another
hedge by establishing a short position—borrowing shares and selling them in a bet that the share price would go down. But for the stock to be shorted, it had to be heavily traded. There would have to be plenty of shares available for borrowing, and with Rhythms there weren’t.

That wasn’t the worst of it. The very stock sales required to create the short position could drive down the price, triggering the financial obligations of the option writer. And Rhythms was so thinly traded, Kaminski was fairly sure that was exactly what would happen.

Plus, the economics of the deal were laughable. Enron was taking $250 million in stock out of its own pocket and putting it into the fund’s pocket. Then the fund would give the money back if Rhythms’ price went down.
But the fund owed the money either way!
Enron would receive nothing that the fund wasn’t already obligated to surrender.

Suddenly it hit him. A moment of clarity.

Fastow put this together assuming Enron’s stock price would go up, no matter what
. Such an increase would give this fund the ability to pay Enron for any losses in Rhythms and ultimately pay back the $250 million.

Kaminski shook his head. This was just a massive bet on Enron’s stock price. The company’s top managers might as well have gone to Las Vegas and placed a few hundred million dollars on black.

Minutes later, Kaminski stuck his head into one of the analysts’ offices. “We need to have a meeting,” he said. “Could you come down to the conference room.”

He wasn’t going to fight this until he and his team worked it through. He still needed to give his bosses the pricing answers—no matter how foolish the idea. But he had already decided to do his best to kill this thing.

After gathering a few more people, Kaminski walked with them down to the conference room. “Listen,” he said. “We have to price a put option on Rhythms NetConnections.”

No purpose in sugarcoating this.

“We have to price an option on a large number of shares. But this is a stock with a small trading volume, so it’s basically impossible to hedge.”

He paused. “The option will be written by a partnership formed by our finance group.”

Silence for a second as his words sank in. Then the room exploded in laughter. Loud, sidesplitting laughter.

Kaminski brought a hand to his eye, until he, too, began chortling. “Okay, I know. But first things first. Let’s figure out a fair value for this option.”

At eight the next morning, June 11, Causey put down the phone and looked toward his doorway. Vince Kaminski and Stinson Gibner were there waiting.

“Rick, hello,” Kaminski said. “We’ve put together the pricing model you wanted for Rhythms.”

“Wonderful,” Causey said. “Come in. Take a seat.”

The two sat down at the conference table. Kaminski handed over a copy of a PowerPoint presentation he had written up. Causey quickly riffled through the pages.

“As I’m sure you know, this is a very difficult option to price,” Kaminski began.

There was no way to make it affordable without incorporating some mechanism for the fund to hedge its position by shorting Rhythms stock, Kaminski said. That could only be done by building up a position slowly, so that the short sales didn’t bring down the stock price. He and his team had calculated it
would take about a year until a fully protected position could be set up. During that time, the fund would be exposed to a collapse in the value of Rhythms’ stock. That risk left the cost of the option very high, Kaminski said. Causey seemed unpersuaded.

“Okay, thanks, Vince. We might try some other ideas.”

Kaminski headed to the twenty-eighth floor, where he wandered over to the office of Rick Buy, Enron’s chief risk officer.