The Benefit of the Doubt?
Factor 3: Broadband and Model Risk
In the hearing before the Senate’s Subcommittee for Consumer Affairs, when asked by Missouri Democratic Senator Jean Carnahan to explain why
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Enron’s stock price had plummeted, former CEO Skilling cited several causes, including the foreign investments just mentioned. The firstcause he pointed to, however, was broadband: “The first one,” he told the senators,
“was that the collapse in optical-fiber stock started in February and March of the year 2001. We were viewed as a player in that optical-fiber business, and that immediately hit our stock.”
Enron set out to create a bandwidth market on its own. It would launch a product and—to draw on the terms introduced in the last chapter—trade that product over the counter, as well as be that product’s market maker. In other words, it would be prepared to sell bandwidth to whomever wanted to buy it and purchase it from whomever wanted to sell it. On both sales and purchases, Enron would make a small profit. And because the transac- tions would be over the counter—in other words, not regulated by a stock exchange—and because of the structure of the energy industry, where play- ers are either buyers or sellers, the spread between Enron’s buying and sell- ing would remain a private matter.
Enron did not lack ambition. As in the energy field, Enron aimed to be
“the market” in broadband. And based on its track record, it had cause for optimism. At one point, as noted earlier, Enron managed to trade 25 per- centof the U.S. domestic electricity consumption—an astounding accom- plishment for a once-obscure pipeline company in Houston.
It is worth noting that in its conquest of the electricity market, Enron had some good friends who wielded a lot of influence. For example, for Enron’s strategy to succeed, the company had to remain the main player in the market. A switch to an organized market, open to independent traders, would have been death to this strategy. In 1992, Wendy L. Gramm—chair- woman of the Commodity Futures Trading Commission—played an instru- mental role in ensuring that the trading of energy derivatives (such as the forward contracts that were Enron’s bread and butter) would remain unreg- ulated. A year later she joined Enron’s board of directors and also became a member of the board’s audit committee.
On the broadband side of the shop, Enron was trading with its coun- terparts over the counter, defining the terms of the trades, and trying to meet expectations that it would do as well as a bona fide exchange. A large piece of this, of course, was coming up with standardized products to trade. Give the devil his due: In this realm, Enron pioneered, coming up with the first standardized bandwidth product.
This deserves some explanation. In order for a commodity to qualify for standardization, two conditions must be met: The good needs to be con-
sumableand fungible. The second criterion means that there needs to be a true and reliable unit of measure that makes trades strictly comparable.
Thus, for instance, if bandwidth between New York and Los Angeles is cho- sen as the fundamental unit for bandwidth consumption, then it becomes possible to state that bandwidth between New York and London represents so many of those New York–to–Los Angeles units. And this is precisely what Enron managed to achieve.
On an organized market set on an exchange such as the New York Stock Exchange, the role of the market makers is clear. When they are asked where they will place their bid and ask, they cast their eyes on the electronic tote board where quotes are displayed—ask, bid, last settle, and so on—and make their decision based on what they see other traders doing.
However, when, like Enron, you try to do it all on your own, over the counter, there is no reliable place to cast your eyes. In order for the market you have set up to have any chance of surviving, you need to know with some assurance where to locate your bid and your ask. In other words, you need to make good guesses about the level where buy orders and sell orders are likely to meet in somewhat similar quantities. The risk involved here if you are wrong is called model risk,which simply means the risk that grows out of an inaccurate representation of the fundamentals of the market—a bad model that leads to locating the bid and ask quoted to your over-the- counter counterparties at the wrong level.
Kenneth Lay, Enron’s last CEO, understood this well. He emphasized in an interview that Enron did not really need to care about how high or how low the prices were as long as it knew wherethey were: “Whether the price is high or low is not that important to us; it’s mainly a matter of matching up transactions.”8Again, at what level would a near-equivalent number of buy and sell orders meet?
In previous chapters I have compared debt instruments (for example, bonds) with equities mainly to cast light on how equities work. In order to calculate accurately the present value of a bond, you need to be able to dis- count accurately the different interest cash flows associated with that bond.
In order to do this, you need to derive a zero-coupon yield curve from the market yield curve; simple multiplication and division then permit you to calculate all needed forward rates, such as 3 months in 6 years.
This is a relatively easy task. But how do you calculate a forward 3 months in 6 years for electricity?
Some risks can be managed using new financial instruments. For exam- ple, default risk of counterparties can be hedged with credit swaps,which
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act as insurance against insolvency. Risk linked to spikes in energy demand can be managed with weather swaps,which act as insurance against unex- pectedly good or unexpectedly bad weather upsetting time-in-the-year con- sumption patterns. Pollution risks can be managed through emissions swaps, which act as insurance against pollution exceeding regulatory thresholds.
And these were the paths that Enron took.
In contrast, in order to protect itself against the uncertainties of its mod- eling of energy yield curves, Enron and other players in the energy-trading business decided to manage the inherent risk in the most traditional man- ner: through insurance and reinsurance.
In April 2002, Michael Brick reported in the New York Times that
“because Enron was dealing in commodities where there was no established public market to set prices, a trader had to decide on a price curve—the expected direction of prices in the future—on which to value each deal in the present.”
However, there is a trap and a temptation in this, as Brick reported:
“‘The further out you go on a forward curve, the values are less known,’
one trader said. ‘The further out you go, there’s some potential that there’s a less objective value.’ Some traders took advantage of this subjectivity to set unreasonably high curves, and later to change those curves to establish even higher values, which they could report as profits immediately, a for- mer manager on the trading desk said. ‘The curve moved constantly,’ this manager added, ‘especially toward the end of the quarter, to generate reported income.’”9
Calculating a forwardfor energy products—and certainly for novelties such as bandwidth—proved to be very, very difficult. This became painfully clear during the energy crisis in California in 2000–2001. If the forward turns out at some point to have been way off the mark, then the irate cus- tomer is likely to demand contract renegotiations. And this is exactly what happened in April 2002 when California renegotiated the energy forwards it had purchased at the high point of the crisis in 2000. Why? Because by April 2002, the electricity forwards that had been bought in 2000 were priced at three timesthe spot price for electricity.
Did Enron fall victim to model risk? The answer is “yes.” And worse than that, Enron’s bad guesses may have been influenced by their growing need to show profits. As utility industry analyst Robert F. McCullough phrased it, “Their [Enron’s] financial problems might have been interven- ing in their day-to-day trading activities.”