Enron, 2001

At a glance

What happened

Enron grew from a pipeline company into a dominant trader of gas, power and other commodities, and booked the estimated lifetime profit of long contracts on the day they were signed. To protect its earnings it hedged its investments with partnerships whose main asset was Enron stock, and it raised billions through prepaid commodity deals. In late 2001 it reported a large loss, restated four years of results and saw its credit rating cut to junk. Its trading business, which depended on its credit, stopped, and it filed for bankruptcy in December.

Why it went wrong

The hedges only worked if Enron's share price held up, and its shares were most likely to fall exactly when its investments did, so the risk never left the company. The prepays were loans in disguise: a circle of swaps left Enron with cash today and fixed payments later, but recorded as trading they looked like operating cash flow rather than debt. Mark-to-model accounting let earnings be written from assumptions about the future.

What it teaches

A hedge is only as good as the counterparty's ability to pay in the scenario it covers, and a hedge with yourself is no hedge at all. A derivative whose legs net away to a cash flow is financing and should be treated as debt. The case led to the Sarbanes–Oxley Act in 2002 and the collapse of Enron's auditor, Arthur Andersen.

Key terms

Special purpose entity

A separate legal vehicle set up for a narrow purpose, often to hold assets or risk off a sponsor’s balance sheet.

Prepay

Payment today for a commodity delivered later; when hedged back to the seller it becomes a loan in substance.

Mark-to-market accounting

Valuing contracts at current market or model value, so expected lifetime profit can be booked at signing.

Self-referencing hedge

A hedge whose payout depends on the hedger’s own share price or credit, which fails when it is needed.

Substance over form

The accounting principle that a transaction is recorded by its economic effect, not its legal shape.

Rating trigger

A clause that adds collateral or accelerates debt when a company’s credit rating falls.

Where it sits in the course

Case studies like this one are used throughout risk management teaching, including FRM® preparation, as worked examples of accounting, counterparty and wrong-way risk. In OTC Learn the lesson runs in five steps: what happened, the position, why it broke, what it cost and what it teaches, followed by a worked example with the numbers. See the lesson outline.

Related case studies

• AIG, 2008Protection that could not pay its collateral calls

The instruments behind it

OTC Learn lessons on the products this case turns on:

• Commodity SwapFixed price for floating market price
• Commodity ForwardAgree a price today for delivery later