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THE ELEVATOR DOORS OPENED , and Jeff Skilling stepped into the broad hallway on the forty-ninth floor of the Enron building. He walked past a few inexpensive, nondescript paintings and turned left toward a solid-oak door. Fishing out his wallet, he rubbed it against a sensor in the wall and waited for the magnetic card inside to be read. The electronic lock clicked almost instantly.
Behind the door was a drab corridor with row upon row of empty offices and cubicles—space Enron had paid for but had little hope of filling anytime soon. Striding down the stark hallway, Skilling did not cut an impressive figure. At thirty-five, he was of medium height with a receding hairline and a few unnecessary pounds, the image of just another anonymous consultant working in the dreary surroundings of another besieged American corporation.
It was December 1988. For weeks Skilling and his team from McKinsey had been working here, struggling with Enron’s growing and maddeningly complex challenges. Deregulation had upended the game board for gas pipelines, but Enron had yet to devise a strategy to flourish in the new world. McKinsey was supposed to fix that, but after weeks of work Skilling’s team was no closer to an answer.
Skilling reached a large, open area lined with empty offices. His was the first on the right; a large conference table filled the room, piled high with stacks of paper—reports, memos, and other remnants of dozens of rejected strategies. He sat, reaching for a pad of quadrille paper. Something was tugging at the back of his mind—an idea, a thought, something Skilling had ruminated about for years. Maybe if he wrote it down, it would become clearer.
Pulling a pen out of his shirt pocket, Skilling sketched an axis, then drew a declining curve. He divided the curve into sections—at five years, ten years, twenty. He tore off the sheet and scribbled calculations on the next page. After about thirty minutes, he set down his pen and studied what he had written.
This is fucking brilliant .
Could it be this simple? Here, on a couple of pages, was the answer to Enron’s problems—hell, to the industry’s problems. Over the years, Skilling had often been electrified by his own ideas, but this one, this one was a gold mine. It was so elegant. It had to work.
Tearing the second sheet off the pad, Skilling scrambled out of the office in search of Rich Kinder, who was just moving up to the job of Enron’s vice chairman. As a consultant, Skilling couldn’t just take an idea and run with it; somebody at Enron needed to give the green light. He figured Kinder not only would understand his brainstorm but would have the guts to get it done.
On the other side of the building, Skilling rode a small executive elevator to fifty, then walked past the boardroom into Kinder’s office.
“Rich …”
“Jeff. What’s up?”
Skilling laid his quadrille paper on a small conference table. “Look at this.”
Kinder strode over to the table and skimmed the page. A bunch of numbers. He shrugged. So?
“Let’s say we go out and buy gas reserves,” Skilling said. “Give me a number, Rich. How much is it going to cost to buy gas reserves?”
“I don’t know, one dollar per mcf.”
A dollar for every thousand cubic feet of gas. Just as Skilling had figured. “Okay,” Skilling said. “So if we bought reserves at a dollar, we could take them and carve them up, send them to different term markets.”
Kinder didn’t know where this was going.
“Different contract terms,” Skilling continued. “Twenty years, ten years, five years, it doesn’t matter. And then we lock in their price with the contract.”
Skilling scribbled his graph again. Kinder recognized it as a standard gas-production curve. Gas wells are a lot like a shaken-up bottle of soda; when they are first tapped, built-up pressure pushes out fuel, but over time that force—and the volume of gas coming out—drop. That was reflected in the curve Skilling sketched, showing declining production over many years. But, he said, if Enron owned reserves with a production curve of two decades, it could calculate a fixed price for gas sales over periods of years. The longer the term of the contract—the further out on the production curve—the more expensive the price. The market movement for gas prices wouldn’t matter, since Enron would already have locked in its costs at one dollar.
Kinder understood the implications immediately. With deregulation, the old world of fixed gas rates was gone, and prices were now dictated by the open market—meaning a cold snap, a shortage, anything could drive them up rapidly. Suddenly industrial customers couldn’t anticipate fuel costs, pipelines couldn’t be sure they could guarantee delivery on a long-term contract, and producers were only as good as their last well. The uncertainty was already driving industry toward dirtier fuels—coal, oil—with more reliable pricing. This Skilling idea might change all that. Enron could transform cleaner natural gas into a dependable choice, buying it at fixed, rock-bottom prices, selling it for more, and pocketing the difference.
It would be like a bank, Skilling said, but instead of taking in and sending out money, Enron would traffic in gas. Producers would be depositors, gas customers would be borrowers, and Enron would be rich. To attract the business, he said, Enron would need a marketing division, but from there everything should come together.
“Rich,” Skilling said. “What if I told you that I can construct a twenty-year contract, right now, at $2.20.”
Kinder stood back. “You’re fucking kidding me.”
“No, I’m not fucking kidding you.”
It was one of those rare eureka moments. Industrial customers were having enough trouble obtaining twenty-year contracts, and finding one at less than four dollars per thousand cubic feet was thought to be impossible. A guaranteed fixed price from Enron of just over two dollars would bring every customer to the company’s doorstep.
“If that’s true,” Kinder said, “then we will own the power-generation market in North America.”
Skilling beamed. “Yep,” he said, nodding.
Word of some gangbuster new McKinsey idea crackled through Enron, and soon everyone wanted to hear the details. Within days, a group of about twenty Enron executives gathered in conference room 49C1 for their own briefing from Skilling. Most were ready to give up much of their afternoon; typically, McKinsey reports ran on for as long as a hundred pages and took hours to review.
Once everyone was seated, Skilling stepped forward and placed a single transparency on an overhead projector. It was a more professional version of his original scribbles.
“The concept is pretty simple,” Skilling began, launching into his analysis. After about twenty minutes, he stepped away from the projector.
The room was silent.
“That’s it?” Kinder asked. He had been expecting a beefed-up presentation this time.
“Yeah, that’s it.”
Kinder nodded. “Okay, let’s go around and see what everybody thinks.” To one side, Jim Rogers Jr., head of the interstate pipeline operation, waved a hand. Kinder nodded his way.
“Yeah,” Rogers said. “I’ve got to say, that’s the dumbest idea I’ve ever heard in my life.”
Skilling’s face fell.
“Who’s going to do this?” Rogers continued. “Why is somebody going to sell at those prices? Why will customers come to us? That’s not our business.”
Rogers’s scorn unleashed a torrent of doubts and criticism from other executives in the room. Skilling had failed to take a proper account of the take-or-pay contracts, they said; worse, it forced Enron to be responsible for maintaining a market for gas, making its pipelines almost beside the point. It just wouldn’t work.
The meeting ended, and Skilling, downcast, followed Kinder to the elevator for the fiftieth floor. Kinder pulled out an unlit cigar, chewing it as the doors opened. He pushed the button for fifty.
“Rich, I’m sorry,” Skilling said. “I thought it was a great idea, but I guess it came up short.”
Kinder pulled the cigar out of his mouth. “As soon as I heard Rogers say it was the dumbest idea he’s ever heard, I knew it’s exactly what we need to do.”
The elevator doors opened, and Kinder walked out into the hallway, again clenching the cigar in his teeth.
“Put a team on this,” he growled. “Make it happen.”
The Gas Bank was an instant success—and failure.
After months of pulling together the logistics, Enron set up its new gasmarketing division. Kinder and Skilling flew around the country, delivering sales pitches to big industrial customers. Many were wowed by the idea; obtaining a predictable price for a clean-burning fuel was a factory owner’s dream, even at above the current market. In less than two weeks Kinder and Skilling lined up multiyear contracts for more than a billion dollars of gas.
Then, problems. Despite the demand, gas producers weren’t eager to offer a supply. Gas was selling at low levels, and drillers had always survived on faith that prices would rise in the future. Why lock in low prices today, they argued, for gas being used tomorrow? But Enron executives didn’t want to abandon the customers they had rounded up, so they temporarily tossed some of the Gas Bank’s founding principles. Instead of locking up gas at a fixed cost, Enron purchased fuel on the open market—a gamble, since a price rise could force large losses. Enron won that initial roll of the dice; prices held steady.
The hot concept needed tinkering, and Skilling plunged into the task. A breakthrough came during a meeting with Kaiser Aluminum and Chemical Corporation. Kaiser wanted a five-year fixed-price gas contract for a Louisiana aluminum plant, but Enron had no gas in the state. The fuel, Skilling said, would have to come from Texas, adding thirty cents to the price. Kaiser nixed the idea as too expensive. Then, as everyone was leaving, Skilling had a thought. Why did Enron even need to deliver gas? “Wait a minute,” he said. “Sit down.”
Skilling asked the Kaiser executives some questions. They could already obtain gas in Louisiana, right? Yes, by purchasing it off of a Texaco pipeline.
“So let’s do this,” Skilling said. Kaiser would buy from Texaco. But Enron would guarantee that Kaiser would never pay more than $2.50 for every thousand cubic feet. If prices climbed, Enron would deliver gas to Kaiser in Texas at $2.50, which Kaiser could then sell at the higher price. If prices fell below $2.50, Kaiser would pay Enron the difference. Rather than agreeing to actually deliver fuel, Skilling was proposing that Enron be paid for assuming the price risk. Kaiser jumped at the proposal.
Over time, Skilling and his team were even able to solve their gas-supply problems. The recalcitrant wildcatters perked up when Enron came to the table with something they needed: loans. After years of turmoil in the energy markets, banks had tightened the purse strings on exploration and drilling. So, with Skilling’s urging, Enron offered the financing that the banks withheld in exchange for access to fixed-price gas. Yet another new division, Enron Finance Corporation, was set up to provide the credit.
By late 1989, the Gas Bank was carrying matched orders on its books between five customers and five suppliers. Now Skilling was ready to add the final tweak that would send his idea into the stratosphere. What Enron had created was, in truth, nothing more than a predictable future flow of cash, not much different from a mortgage or a bond. And for more than a decade, Wall Street had been pooling such cash flows together and trading them. Why, Skilling asked, couldn’t the cash flows from the Gas Bank be traded, too?
Almost imperceptibly, Skilling’s innovations were transforming Enron into a radically different beast. This company of pipelines and rigs, populated by rugged leathernecks with dirty fingernails, was grabbing on to intangible concepts of risk, attracting buttoned-down investment bankers with manicures. The changes were transforming the very nature of Enron, but few people inside or outside the company recognized it.
Late that year, Skilling figured his work was done and headed back to his office at McKinsey. Enron, he thought, was on the precipice of greatness. Then the Gas Bank began falling apart. Except with Kinder, the idea still generated little enthusiasm among Enron’s top ranks; it just seemed too foreign. Skilling watched with dismay as his program languished from indifference. Repeatedly, he visited Kinder, by then company president, and pounded his desk, saying Enron was squandering its one great opportunity.
“You guys have got to get going on this,” Skilling raged. “Somebody else is going to figure this out, and right now you’ve got a huge head start”
Kinder agreed, but also understood that Skilling was the only one with a personal stake in seeing the Gas Bank succeed. So in December 1989, he approached Skilling with a proposal: join Enron. Skilling dismissed the offer out of hand. The previous summer he had been elected a McKinsey director; he was on the track for great wealth. It seemed ridiculous now to take a flier on Enron.
But as the months wore on, Kinder—and then Lay—came to believe that the great idea was destined to fail without Skilling. Finally, in early 1990, Lay ran out of patience. He headed to Kinder’s office and announced that Skilling had to be persuaded to take charge of the effort.
The timing was perfect. By then, Skilling had glimpsed his future at McKinsey and didn’t like the view. He had recently joined the partner election committee and had grown frustrated with the meetings. Nothing ever changed; nothing was ever resolved. At one meeting, Skilling listened in dismay as the head of the German office mouthed the same arguments he had made months before.
Skilling scowled and crossed his arms. Ten years from now, I’m going to be sitting in this same room, listening to these same guys saying exactly the same things .
Despite the money he was making, despite the respect he commanded, Skilling was bored. He wanted a new challenge, a new vista, something to make his future more than just a repetition of his past.
At the peak of Skilling’s dissatisfaction, in April 1990, Kinder called. This time Skilling jumped at the chance. This was his challenge. He would be at the forefront of redefining American energy markets—maybe the international energy markets. That night he discussed the idea with his wife, Susan. With their third child on the way, he feared she would resist, but she said she would support whichever path he chose. The pay would be less—something Skilling glossed over—but Kinder had suggested Enron might give him a piece of the business. If his project worked, Skilling could become very rich; if not, joining Enron could turn out to be professional suicide.
On June 11, 1990, his wife went into labor, and he drove her to St. Luke’s Episcopal Hospital. After six hours his second son still had not arrived, and Skilling wandered into the hallway. He tracked down a pay phone and called Kinder. He was ready to finalize everything, Skilling said, and the two men haggled through the last details of the contract. Skilling would be chairman and chief executive of the division Enron Finance. His annual salary would be $275,000—a huge pay cut—but he would be granted his ownership stake in the division.
“Okay,” Skilling said. “That’s it. We’re done.”
The call ended, and Enron’s newest hire returned to his wife’s side.
Exactly one month later, on July 11, a line of black limousines eased out of the wooded campus of Rice University near downtown Houston. The cars moved northeast, passing tens of thousands of people on Main Street who were cheering, waving placards, and releasing hundreds of yellow balloons. It was one big celebration of Houston and of its special visitors, the leaders of the industrialized nations, there for the World Economic Summit.
In one limo, President George H. W. Bush watched through the passenger window. It was a glorious moment, a reward for the gamble he had taken pushing his adopted hometown as a summit site. At the time, Houston had still been struggling with the image of a weakened giant, knocked on its knees by the oil crash. It had failed in its bid for the national political conventions, large parts of the city were dirty, and its people were demoralized. But this week Houston sparkled. It had even parlayed a heat wave to its advantage with a new slogan for the summit: “Houston’s Hot.”
Bush could only smile. For months, planning had been at the brink of disaster. So in January, with seven months to go, Bush had phoned his friend Ken Lay and asked him to take charge, joining another Houston businessman, George Strake, as summit co-chair. But Bush had made it clear that the success or failure of the event rested with Lay.
In turning to Lay, Bush was reaching out to a man who had slowly become a friend over many years. Lay had been a Florida supporter during Bush’s first presidential run in 1980, but had really become part of the inner circle through his ties with other Bush associates. He had been longtime friends with Robert Mosbacher, a Texas oilman who was now Secretary of Commerce. Lay also had a close relationship with Jim Baker, the Houston lawyer who served as Bush’s most trusted adviser. Lay solidified his connections to Bush in 1988, when he hosted one of Bush’s first big fund-raisers for his successful presidential bid.
After Bush assumed the presidency, Lay had cultivated his relationship, often sending letters of support and playing roles large and small in the Administration. With the friendship blossoming, no one on the White House staff was surprised when Bush chastised them for failing to deliver a letter from Lay directly to the Oval Office. Lay was welcomed as a guest in the White House family quarters, where he had met with Bush, urging him to locate his presidential library in Houston; when Bush leaned toward another choice, Lay had traveled to the Dallas office of the President’s oldest son, George W, to lobby the family. Young George had greeted Lay warmly but cautioned that the decision would be made by his parents. Still, President Bush appreciated his friend’s effort and told him so during personal visits.
By the time of the summit, Bush had come to consider Lay a go-getter who could take charge of the big event. With little more than the force of will, Lay and his team had recruited some fifty-two hundred volunteers to clean up Houston, removing three million pounds of trash. Buildings were painted, flowers and trees planted, logos designed, traffic patterns altered. Now, with the meetings wrapping up, there was this —this seemingly impromptu celebration of the city and the summit. Bush could not have been prouder.
The procession of limousines pulled up to the George R. Brown Convention Center on the other side of town. One at a time, the world’s leaders emerged from their cars—Bush, Margaret Thatcher from England, Helmut Kohl from Germany, François Mitterrand from France, and on and on. Inside, the dignitaries congratulated Bush on what they had just witnessed. That warm outpouring on Houston’s streets, Bush was told, had been nothing short of miraculous.
Later that afternoon, the world leaders traveled to the “Thank You Houston Celebration,” held on the campus of the University of Houston. Thousands of people gathered in front of a sprawling stage that held bleachers for VIPs. Plenty of entertainers were on hand, including the singers Randy Travis and Marilyn McCoo and the actress Jaclyn Smith. But the stars of the evening were Bush and his powerful guests. Just after seven, the crowd broke into sustained applause as the procession of cars carrying the dignitaries pulled behind the stage.
A Secret Service agent popped open a limousine door, and George and Barbara Bush emerged, the President in a brown suit with a maroon tie, the First Lady in a dark blue dress with her trademark pearls. Ahead, they saw a large tent where everyone scheduled to be onstage—whether performing or watching from the bleachers—was supposed to gather. Waiting inside the doorway beside his wife, Linda, was Ken Lay, wearing a seersucker jacket with a red tie.
Bush beamed; this was his first chance that day to speak with Lay. The two men shook hands eagerly.
“Mr. President,” Lay said.
“Ken, I’m overwhelmed,” Bush said. “Our guests were incredibly impressed and were really left with a positive image of Houston. I can’t tell you how thankful I am.”
“Thank you, Mr. President,” Lay replied. “Everyone in the city worked very hard to make this happen.”
Barbara Bush approached Lay and spoke softly in his ear. “Ken, I really appreciate you taking all this on. You really bailed George out.”
The Lays escorted the Bushes around, introducing them to volunteers. Bush took a moment to speak with George Strake, Lay’s co-chair, and Fred Malek, the summit director. Finally, an aide announced it was time to head out on the stage. Everyone had been assigned a place on the bleachers, the aide announced, and they needed to line up in the order they would be seated. The aide approached Lay.
“Mr. Lay,” the aide said, “you’re between the President and the First Lady.”
Lay was astonished; the President’s gesture could not have been more generous. He walked to his spot behind Bush and struck up a conversation as they waited.
“Did you see anything we missed or should have done differently?” Lay asked. Bush smiled. “No, Ken. We keep looking for glitches, and we haven’t found any.”
With the line formed, everyone strode onto the stage. The crowd burst into renewed applause. At 7:13, as the cheers continued, Bush stepped up to a podium. Lay remained in his seat next to Barbara on the bleachers.
“Listen, Barbara and I really want to come over and say ‘thank you’ to all of you,” Bush said. “To Ken Lay and George Strake and Fred Malek and so many others. I am so very, very grateful—and so is Bar.”
It had been three historic days, Bush said, for Houston and the world. And it had all happened because of the town’s hard work. “So, in short, you’ve shown the world what Houston hospitality is all about,” he continued. “And you made this Houstonian very, very proud of his hometown tonight. Thank you all very, very much.”
Cheers again, louder than before—for Bush, for the summit, for Houston. It was as if the town were basking in the respect that had been so elusive for a decade. Bush headed back to the bleachers, shaking Lay’s hand again.
“Just wonderful, Ken,” Bush said. “Just wonderful”
It was a day that, years later, would be remembered as a turning point. The day Houston emerged from its years of desperation. The day a deep appreciation for Lay spread through the city. And the day the world realized that Enron and its chairman had acquired some very influential allies.
A little more than two weeks later, on August 1, Jeff Skilling started his new job at Enron—and hit the place like a hurricane. He arrived with fixed ideas on organizing and running his business, but a lot of those plans ran headlong into the company’s calcifying bureaucracy.
Out went the rows of offices on the edges of endless corridors. Instead, Skilling pushed to build a central work area modeled on a trading room. Any surviving offices would have glass walls so that everything in the division would be visible to everyone. The ideas appalled the people in charge of Enron’s office standards—the Building Nazis, Skilling took to calling them—but he got his way.
Same with the changes in personnel management. Enron employed a system where every job description was assigned a certain number of points, which could be used to “purchase” an office with a bigger window or a better chair. Not in Skilling’s group. There would be no job descriptions; he didn’t want anyone locked in to some predetermined list of duties.
With every step and every idea, Skilling won legions of enemies among Enron’s administrators. He reduced the company’s dozens of titles to just four in his division—associate, manager, director, and vice president. Seniority-based compensation was chucked out, too; instead, pay would be based solely on annual performance.
Skilling thought he was on his way to building a perfect meritocracy, where smart, gifted—and richly compensated—people would be pitted against one another in an endless battle for dominance, creating a free flow of ideas that could push the business past its competitors.
As his dream office space was being constructed on the thirty-ninth floor, Skilling started scouring around for talent. Gene Humphrey, Skilling’s first hire, was brought in from Citibank to head the effort providing financing to gas developers; Lou Pai, a former SEC economist, jumped from Enron’s marketing organization. George Posey, from the corporate division, was assigned to handle accounting and finance. Within a month, Skilling had filled almost every important position—except one.
The last piece Skilling needed on his game board was an expert in a form of finance known as securitization. In such deals an institution pools similar loans, and then sells interests in them to outside investors. That gives the institution new money, which can then be used to make new loans. Better still, loans sold in a securitization can be removed from the company’s balance sheet, since the risk of ownership has been shifted to the outside investors. With his plans to push loans into the gas market, Skilling knew a securitization expert could give his fledgling business access to an almost endless supply of capital.
The only question was, could he find somebody creative enough for the job?
The telephone rang in the Chicago office of Andrew Fastow, a young senior director with Continental Bank, on a morning in early October. On the line was Jonathan Crystal, a corporate recruiter from the Houston office of Spencer Stuart, one of the world’s largest executive search firms.
“There’s an opportunity available that I think you will find very interesting,” Crystal said.
Spencer Stuart had been hired by Skilling to track down his securitization expert, and Fastow, a twenty-eight-year-old banker, seemed to fit the bill. In the last few years, Fastow had specialized in such financings, working on some high-profile, complex deals. The second son of a buyer for drugstores and a homemaker, Fastow had grown up in New Providence, New Jersey. His family was comfortable, though hardly wealthy. But Fastow, who graduated summa cum laude in 1984 from Tufts University, soon came to be more familiar with the world of the well-heeled. He married his college sweetheart, Lea—an heiress to the Weingarten fortune, earned with grocery stores—and set off for Chicago to launch his business career. While working, he earned his MBA at the Kellogg School and eventually found his niche at Continental Bank.
Andy worked hard, but his personal style could be grating, even pompous. He was the type to take a stand in quicksand, making demands with shouts and temper tantrums, at times costing him more in reputation than he gained in deal points. Even a simple cab ride had once transformed into a fracas, with a hotheaded driver ultimately punching Fastow in the face in a dispute over seventy cents.
Still, the Fastows were restless. For months they had considered moving to Houston if the right jobs came along, but the idea seemed like a long shot. New York and Chicago were the hot spots for securitization; Houston wasn’t even on the industry’s map. But with this call from Crystal, suddenly it seemed like that might be changing.
Fastow listened as Crystal gave the rundown on the position. Enron needed someone who knew about securitization to join their new finance business; it sounded, Crystal said, like a great fit.
For a moment Fastow said nothing.
“Who,” he finally asked, “is Enron?”
On the morning of October 3, a Wednesday, Lou Rieger, head of Spencer Stuart’s Houston office, called Skilling. “We’ve found a good candidate,” Rieger said. “There’s a guy who wants to move to Houston. He’s been working at Continental Bank in Chicago.”
“You’re kidding me. He wants to move to Houston?” Skilling asked. “Send over his résumé. Let me look at it”
Minutes later, at 9:36, the fax machine near Skilling’s office hummed to life, and three pages of paper scrolled into a tray. His assistant, Sherri Reinartz, brought it in. Skilling flipped through the pages, reading quickly.
“Andrew S. Fastow.”
Education. “Kellogg, Tufts.”
Experience. “Continental Bank … Sold first security backed solely by senior LBO debt … named 1989 ‘Deal of the Year’ … directly responsible for pre-tax profit contribution of $12.8 million … structured and arranged leveraged buyouts … proficient in Chinese …”
“Holy shit,” Skilling said. The perfect guy .
He picked up the phone and dialed Rieger’s office.
“Lou, hey, home run,” Skilling said. “This guy is dead-on what we’re looking for.”
Fastow traveled to Houston later that month to visit a company that still made no sense to him. His world was one of esoteric deals, derivatives, wealthy bankers with business degrees. But from what he could tell, Enron worked in pipelines —expensive, dirty pipelines. It sounded like nothing more than a big step down.
Fastow arrived at the building early that morning and rode up to the thirty-ninth floor, where he asked for Skilling. A receptionist placed a call, and a minute later an energetic man in his late thirties—a little nerdy-looking, with steely eyes—came bounding toward him.
“Andy? Jeff Skilling”
“Good to meet you,” Fastow replied, shaking hands.
Skilling smiled as he glanced around the room. “Well, welcome to Enron. Follow me, we’ll go talk.”
Fastow trailed Skilling to a bullpen that housed most of the department’s professionals and support staff. The place bristled with energy, the staccato rhythms of computer keyboards punctuating a low hum of activity. Fastow had expected the place to be sleepy and dull. But here, no one dawdled or wandered about. There was work to be done, and Team Skilling seemed thrilled by the challenge.
The two men walked into Skilling’s glass-encased office and took seats at the table. Fastow didn’t smile and was a little standoffish; he still didn’t understand what role he could play in this corporation.
“So,” Fastow said, an edge of condescension in his voice, “what are you guys doing here?”
Skilling launched into his now-familiar speech about the irrationality of the natural-gas business and how his team was building a marketplace balanced between buyers and sellers. It was all about gathering risks and spreading them around, so that no one player got stuck if the music stopped. That’s where securitization came in; the division couldn’t be constrained by Enron’s capital or its balance sheet. New investors meant new money, new money meant more business, and more business was sure to mean more profit.
As Skilling spoke, Fastow’s eyes lit up. This wasn’t some company trying to hire a showcase executive it couldn’t use; for someone with his background, Enron’s new venture was right on the center of the fairway.
“Wait a minute,” Fastow interrupted. “Why is this going on at a pipeline company? What you’re talking about is finance and almost banking activities.”
“Having the pipelines gives us a jump, a place to start, and a knowledge of the business we can use.”
Made sense. Still, Fastow had trouble accepting that a corporation in such an old-line industry could harbor cutting-edge visions. Maybe this was all some fad.
“Is this company really going to stand behind this?” he asked. “Are they really committed?”
“Talk to Kinder,” Skilling replied. “He gets it. He knows this is the future, and he’s committed to it.”
Fastow sat back. This was all coming too fast, and this guy Skilling seemed to be at the center of it all. Fastow had already heard that Skilling abandoned a lucrative career at McKinsey to take on this new business. That stumped him more than anything.
“You walked away from McKinsey?”
“I did,” Skilling replied.
Fastow didn’t know how else to put it. “Why?”
Skilling smiled and turned up his hands. “Hey,” he said, “how often do you get a chance to change the world?”
The interview clinched it. The conversation transformed into a free-flowing exchange of ideas as Fastow brainstormed about how Enron could utilize securitizations. In about an hour, Fastow pushed the thinking further than anyone in the building had ever dreamed. Skilling was enthralled.
Afterward, Skilling telephoned Lou Rieger, telling him that Enron was very interested. Not long after, Fastow called the Spencer Stuart Houston office, too, equally enthusiastic. But there was a problem. If they were going to move, his wife also needed a job in Houston. Rieger phoned Skilling, telling him about the roadblock.
“Fine. Send me her résumé,” Skilling said. “I’ll see if we can find something for her here.”
The résumé arrived that same day by fax. Skilling read it through quickly; her background seemed perfect for Enron’s treasury department. In no time, both Fastows were offered jobs at Enron, with Andy’s paying a salary of seventy-five thousand dollars, a signing bonus of twenty thousand, and a guaranteed bonus for the following year of at least twenty-five thousand.
On December 3, 1990, Andy Fastow returned to Enron as a newly minted employee, one who would play a far greater role in its history than anyone could have possibly imagined.
The slime ball zipped across the room, splatting against a window before slowly oozing down the glass. Fastow grabbed another one of the green globs, going into a slow windup.
“Heads up!” he yelled, heaving the ball past his colleagues in the bullpen.
Skilling and his team kept talking, ignoring the mess from another typical late-night session at Enron Finance. No longer was Fastow the zipped-up banker he had been at his job interview; instead, he had emerged as a prankster, adept at lending the frequent after-hours discussions the feel of a college bull session. The bottom left-hand drawer of his desk had become known as the toy store; Skilling’s children always made a beeline there whenever they visited. Throughout the day—and into the night—the place descended into toy chaos; footballs flew, slime balls splatted, and Nerf-gun wars raged.
The mischievousness was all part of the division’s character, one that quickly made the thirty-ninth floor a central attraction for other employees. The executives there often spoke with messianic fervor about the new order they hoped to create: they were going to take power away from the monopolies, finance the dying gas industry, create markets that had never existed before.
The early years were a time of discovery, and Skilling’s division evolved into an idea factory. One of the earliest changes was a reorganization. The separation of Enron Finance, which worked with producers, from Enron Gas Marketing, which arranged long-term contracts, was simply illogical; both were different ends of the same business. So in January 1991, the two were melded into Enron Gas Services, with Skilling its top executive.
The business also evolved. Buying reserves outright made no sense; in order to get the gas it needed, Enron was paying for intangible things it didn’t want, like drilling opportunities and exploratory potential. But writing a contract to purchase the gas would limit securitization efforts; most producers were in lousy financial shape, and investors wouldn’t be eager to buy interests in contracts struck with businesses on the brink of bankruptcy.
The remedy was found in century-old laws, which created something called a production payment. In essence, the production payment was nothing more than the gas that a company could pump out of the ground; if a wildcatter sold production payments to Enron, then the company owned the fuel. It didn’t matter if the wildcatter went bankrupt, as several did; Enron’s ownership of the gas production would survive any challenge from the producer’s creditors.
With a solid asset available, Fastow went into action. The first securitization idea, named Cactus, was hatched in 1991, utilizing an accounting device called a special-purpose entity—the critical piece of such financings. Essentially, Enron could legally use special-purpose entities to transfer risks and debt off its books by selling interests in them to independent investors. The vehicle was like a sponge that soaked up the acquired gas before Enron tore it into bits for sale to investors.
But the rules governing what constituted an off-books special-purpose entity—and what instead would just be another part of the company itself—were detailed.
So in 1991, Fastow and his team met with lawyers from the Houston firm of Vinson & Elkins and accountants from Arthur Andersen. The rules, recited by a young Andersen accountant named Rick Causey, were fairly simple. First, loan sales to the special-purpose entity had to be real, with ownership transferring to outside investors. Enron couldn’t agree to compensate investors for losses; doing so meant the company retained the risk of ownership, and the loans would have to stay on its books. Plus, Enron could not control the entity; strategic decisions had to be made by third parties. The independent investors also had to invest at least three percent of the entity’s capital.
Eventually the accountants and lawyers left the room, and Fastow broke into laughter. The three percent rule struck him as hilarious.
“Who comes up with these ridiculous rules?” he laughed. “This is such bullshit! Your gardener could hold the three percent! I could get my brother to do it!”
Fastow set to putting Cactus together. With it, Enron pooled loan commitments to gas producers in exchange for a deal on their production payments, placed them in the Cactus special-purpose entity, and sold stakes to heavy-hitting institutional investors. Cactus investors would then resell the gas back to Enron, which in turn would use it to meet its obligations under the long-term supply contracts with customers. It was the Gas Bank in its final form; outsiders provided cash, producers received financing, customers obtained gas at a reliable price—all with Enron in the middle, profiting handsomely.
Or so it seemed. But a problem emerged. The accounting for the two sides of the transaction—buying production payments and selling fixed-price contracts—followed different rules. Enron could be forced to report a loss simply because it couldn’t count the two parts of the deal in the same way. Skilling thought the result absurd: how could things of the same value be worth different amounts?
The issue came to a head at a meeting between Skilling’s team, the accountants from Arthur Andersen, advisers from Bankers Trust, and lawyers from Vinson & Elkins. Steve Goddard, an Andersen partner, brought along a number of other accountants, including a young graduate from Texas A&M named David Duncan, who was working on the Cactus deals.
Skilling took the floor. He wanted his group’s accounting to shift from the old oil-and-gas rules to mark-to-market, a method commonly used by trading houses. It allowed a company to record the value of a transaction at the beginning; any changes over time—caused by anything from flawed assumptions to variations in market value—would be recorded as a profit or a loss. If a brokerage owned a stock that went up in price, it reported a profit—even if it didn’t sell the stock. If the value went down, it reported a loss. That was the beauty of mark-to-market, Skilling said. It reflected market reality.
“Wait,” Goddard said. “But this is an oil-and-gas transaction. You need to use oil-and-gas accounting.”
Around and around they went. The auditors with Andersen’s energy group were far more familiar with old-line oil-and-gas accounting; this new stuff was hard to get their heads around. Everyone became frustrated.
“You guys are just stupid,” Lou Pai finally railed in exasperation. “You’re fucking stupid!”
Skilling pushed Goddard to check with Andersen’s top accounting experts in Chicago; after that, he flew there to see them and to present his arguments in person. A few weeks later, Goddard dropped by Skilling’s office.
“Well, I talked to Chicago,” he said. “They agree mark-to-market is the appropriate treatment.”
Skilling clapped his hands. “Great!”
“Well, I still don’t feel up to speed on this. But they like it, and they think it’s the right way to go.”
“Okay,” Skilling said.
Goddard hesitated. “But they don’t think we can do this unilaterally.”
“What do you mean?”
“We’ve got to go to the SEC with this,” Goddard said. “This is a change in accounting methodology, so we’ve got to convince the SEC to approve it.”
Skilling flopped back in his chair. The SEC. The Securities and Exchange Commission. All we have to do is convince the government to reverse course .
Skilling was silent for a moment, then sat up.
“Okay,” he said. “Let’s go convince the SEC.”
“This is the stupidest accounting I’ve ever heard of. It’s just crazy.”
As he spoke, David Woytek stared across a conference table at Jack Tompkins, Enron’s chief financial officer. It was June 1991, and Woytek, the accountant who investigated the Valhalla oil-trading scandal, was attending a monthly meeting of Enron’s top financial executives. Now chief financial officer of Enron’s liquid-fuels division, Woytek had just heard George Posey, Skilling’s finance chief, explain the new accounting his team was pushing.
“Mark-to-market makes much more sense for what we’re doing,” Posey replied.
“Mark-to-market is all fine and good, but that’s not what you’re describing,” Woytek shot back.
“We’re describing mark-to-market.”
“No, you’re not. You’re saying you want to recognize revenues from twenty-year contracts in the first year. I don’t know what that is, but that’s not mark-to-market.”
Posey held up a hand. “We’re talking mark-to-market,” he said. “It’s the accounting the investment banks use.”
That wasn’t the same thing, Woytek argued. Those institutions were valuing their portfolios based on current, actively traded markets. If they owned stock in Exxon and Exxon’s share price rose two dollars, then the value of their investment went up. There was logic to it; the market was independently assessing the value. If an investment bank needed cash, the stock could be sold at the price recorded on its books. But this was different, he said. They were making estimates about the total revenues a contract would produce, and then reporting the whole thing right away. There was no independent judgment involved. It wasn’t mark-to-market; it was mark-to-guess.
“How can you book twenty years of revenue in the first year?” Woytek asked. “That goes against everything I was ever taught in accounting. You never recognize revenue in advance, only when title passes from one owner to the next. And title doesn’t pass on this until you deliver the gas, over the next twenty years.”
There were other problems, Woytek said. The strange accounting idea would make the profits from Skilling’s division unpredictable from one year to the next. If it sold fifty contracts in the first year—requiring gas deliveries over, say, five years—and recognized all future revenues up front, the next year it would start out at zero, with no revenues. In fact, it would start out at less than zero, since it would have already presumably done business with its stable of customers. So the second year, it would have to sell as many contracts as in the first year—and then more—just to beat its first year’s earnings. Year after year, it would be the same thing, forever. An investment bank using mark-to-market just needed market prices to rise to grow profits; but Skilling’s group was almost guaranteed to someday hit a wall.
Worse, the reported earnings would be huge, but the cash wouldn’t finish trickling in for years. Earnings without cash are anathema to investors; how would the company explain it?
“We’ve always sold long-term contracts, and we always took into earnings the amount of gas we delivered each month,” Woytek said. “Why should this be different?”
Posey didn’t back down. Woytek, he said, was looking at this from the old oil-and-gas method, which was affected by fluctuating energy prices. But Gas Services was matching its purchases and sales, and then marking to market the entire position. It made sense, Posey argued.
Woytek smiled. There were other reasons to use this accounting idea that nobody was mentioning. He had already heard that as part of his compensation, Skilling received an ownership stake in his division. When the division’s earnings went up, the value of that stake would, too. If that division started booking twenty years of contracts in a single year, its earnings would go through the roof.
And then—even if those profits came from fancy accounting—Jeff Skilling would be one very rich man.
The following month, on July 26, Jack Tompkins was sitting at his desk when a call came in from the SEC. It was Jack Albert from the agency’s office of the chief accountant, calling about the Skilling accounting proposal. Tompkins asked Albert to hold for a moment and patched in Posey from Skilling’s group.
“I’ve kept very close contact with this, but George has been the one carrying the ball,” Tompkins explained.
Albert acknowledged Posey, and then started. “The bottom line is that we don’t believe you can make a case with the preferability to change at this time,” he said. “I know this is not the best news to give you.”
The Enron executives spoke simultaneously for a second. What was the issue?
“The reasons vary,” Albert replied. “But at the present time we think accounting for oil and gas is locked into this historical cost model.”
Posey was almost speechless. Because Enron had an oil-and-gas business, it should use oil-and-gas accounting— even for its finance division? “Let me just maybe understand your point a little better,” he said. “This doesn’t include our oil-and-gas exploration company.”
“I understand that.”
“Okay,” Posey continued. So one division’s accounting should be dictated by another division’s business?
“This is a dramatic change for anyone in the oil-and-gas business,” Albert responded. “I don’t think you really have anyone analogous to Enron Gas Services out there.”
Tompkins jumped in, trying to play conciliator. “We certainly don’t want to be argumentative,” he said. “The more information we can get why and what we can do sometime down in the future as far as—”
Albert interrupted. “I think you’ve made an excellent point right there with ‘sometime down in the future.’ We think it is premature at this time.”
The call ended, and Posey rushed to Skilling’s office. He found him at his desk, engrossed in work.
“The SEC turned us down,” Posey announced.
Skilling sank in his chair. “What? That’s stupid.”
Furious, Skilling threw questions at Posey and learned the details of the call with the SEC. He phoned Tompkins, warning that he was coming up. Minutes later, in Tompkins’s office, Skilling could barely contain himself.
“What the hell happened?”
Tompkins shrugged. “They turned us down.”
“Did you give them the reasons that was the wrong thing to do?” Skilling barked. “Did you talk to them?”
“About how this compares with other companies, and I explained that other companies use it.”
“Did you explain why this is important?”
“I think our application was very clear about that.”
Skilling fumed in silence, then turned on his heel and stormed out. Back in his office, he called Steve Goddard from Andersen.
“Is this normal?” Skilling asked. “Mark-to-market makes all the sense in the world. Why wouldn’t they just automatically do this?”
“Well,” Goddard replied, “they are very conservative, and this is a big change.”
“It’s not a big change,” Skilling shot back. Lots of investment banks used the accounting, he said. It was ridiculous that competing companies would be forced to treat the same deals differently. The whole thing had been mishandled, Skilling said. Andersen needed to fix it.
“We can’t just send a letter and say, ‘Oh, we want to switch to mark-to-market,’ ” Skilling said. “We need a full-blown presentation about why it’s the right thing.”
Goddard agreed to call the SEC and set up a meeting. Skilling said he would make the presentation himself, but asked Andersen to be there ready to answer any questions on the technical accounting issues. Goddard said he would give the job to Rick Causey.
It was the assignment that set Causey on the path to becoming a power in his own right at Enron.
On September 17, 1991, SEC staffers gathered in a conference room at the agency’s Washington headquarters. Already the place was packed, with people standing along the walls or sitting on the carpet, eager to hear the presentation from Enron and Andersen. After all, it wasn’t every day a big company lobbied to fundamentally change the way it reported revenues and profits. This was as close to a financial wonk’s version of Woodstock as there could be.
With the place filled, Skilling and his team were escorted into the room. Goddard walked to the front of the assembled group, gave a few greetings, and introduced Skilling, who strode to an overhead projector.
“Thank you, Steve,” he said. “As Steve suggested, our business is changing radically. What has traditionally been a very fixed structure is now turning into a traded commodity. And with that, the accounting has to change.”
Skilling placed a series of transparencies on the projector, describing the history of his unit and the growth of the natural gas trading market. But it was the eighteenth transparency that captivated the room. It showed two gas portfolios—one with matched purchases and sales handled the way Enron did business, and another with a long-term supply contract satisfied by buying fuel in the open market. At first, since short-term prices were lower than long-term prices, such a deal might look good. But of course, Skilling said, the approach was reckless, since the company taking the position could be forced to sell gas at a loss if prices climbed. It was the kind of shortsighted strategy—lending long-term and buying short-term—that blew up the savings-and-loan industry, he said.
A new transparency appeared, showing how the two portfolios would be reported under the traditional, accrual accounting and the mark-to-market approach. With mark-to-market, the matched portfolio was worth the current value of all the cash it would generate over its life; the mismatched, dangerous portfolio was worth less. But with accrual accounting, the matched portfolio showed a loss while the dangerous portfolio showed big profits. Worse, traditional accounting provided benefits to companies that sold winning positions while holding on to losers.
Skilling glanced at the assembled faces. “Accrual accounting lets you pretty much create the outcome you want, by keeping the bad stuff and selling the good,” he said. “Mark-to-market doesn’t let you do this”
An SEC staffer sitting in front of Skilling stopped taking notes. He was from the financial-institutions group, and Skilling’s words had sounded a familiar chord.
“That’s gains trading,” the staffer said. “That’s what our banks do all the time.”
“Of course they do,” Skilling said. “Under accrual accounting, it’s a no-brainer. It’s a simple, easy way to report profits, but they don’t reflect reality.”
“Wait a minute,” the staffer continued. “Let me get this right. You’re asking to go to mark-to-market?”
“Yeah, we’re asking to go to mark-to-market.”
A pause. “Why?”
“Because,” Skilling said, “we think it’s a more accurate reflection of what is going on in the business.”
The staffer shook his head. “We’ve been trying to get the banks to go to mark-to-market accounting for years.”
“Well …,” Skilling began.
“I think this makes all the sense in the world,” the staffer interrupted, gathering his notes as he stood. “Sorry, I’ve gotta go.”
Skilling smiled as the staffer headed out of the room. “Well,” he said, “I think he gets it.”
The SEC ruminated over the idea for months, calling Enron periodically for more material—copies of Skilling’s presentation, information about other market participants. More meetings were held in Washington to review details.
Finally, on January 30, 1992, a call came to Skilling from Jack Tompkins. “Jeff, I just got a letter from the SEC, and they’ve agreed with our accounting change.”
“Really?”
“Yeah, they put some conditions in place, but they signed off on the idea.”
Skilling hurried upstairs to see the two-page letter. Posey was already there and handed Skilling a copy. Reading it, Skilling broke into a smile.
“Thank God,” he said. “There’s some logic in the world after all.”
After a round of congratulations, Skilling and Posey headed to their offices, now on the thirty-third floor. Skilling walked into the bullpen and called for everyone’s attention.
“We got mark-to-market!” he crowed.
The announcement elicited a burst of congratulatory chatter from the Enron executives. At last, their business was ready to take off. “Folks,” Posey announced, “I’m going out and getting us all some beer to celebrate.”
Still, there were loose ends. In its letter the SEC said it would allow Enron to use mark-to-market accounting beginning in January 1992. Days later, Tompkins wrote back, informing the SEC that Enron would be applying the new accounting treatment for 1991, although he said that the effect on earnings would not be material.
As far as the executives at Enron were concerned, they had no choice. They needed the profits they would gain from collapsing the estimated lifetime revenues of their gas contracts into a single year. Without them, under traditional accounting the company could miss the earnings targets Wall Street was projecting for the year just ended.
Accounting techniques—approved by the nation’s top securities regulator—now allowed Enron to report fast-growing profits. But the related cash would not finish flowing in for years. With high earnings and low cash, about the worst thing Enron could do at that moment was start throwing money into another risky business.
Rebecca Mark pushed open the door to a conference room for a group of dignitaries from India. The delegation, led by the country’s Power Secretary, Srinivas Rajgopal, had been in America almost a week and had flown to Houston on this day in May 1992 specifically to meet with her. The thirty-seven-year-old onetime Missouri farm girl had made a name for herself helping Enron build power plants in several countries—just what the Indian delegation wanted.
The meeting this day came at a time of transition for both India and Mark. After decades of shunning foreign investment, the Indian government had begun aggressively seeking overseas capital; in particular, it needed power plants to overcome chronic energy shortfalls that often paralyzed the country’s factories.
Enron had almost no track record in the developing world, but Mark wanted to change that. An attractive woman with a wave of blond hair that illuminated her face, Mark had just lost an internal political battle. Despite her work on a number of plant projects—including one constructed in Massachusetts while she attended Harvard Business School and a hugely successful plant in Teesside, England—she had drawn the short straw when the company split its power business into three units. The lucrative deals in Europe and the United States were divvied up to others. Mark and her team handled what was left—the riskier developing world. India was right in her bailiwick.
The Indian delegation took their seats and quickly got to the point. Rajgopal said that Enron had come to his attention because of its plant in Teesside. India needed such a project, he said. Mark listened, with reservations. She knew India mostly relied on high-polluting, coal-fired power plants, a business she wanted nothing to do with.
“I must tell you,” she said, “we don’t do coal, we do gas. We have some ethical issues about coal.”
“We understand that,” Rajgopal said. “That is why we’re here. We want you to bring gas into India.”
Ludicrous . India had no reserves, no infrastructure of a gas industry. Gas would have to be imported, but that seemed unlikely, she told her guests. A pipeline through Pakistan was too risky, and the only other alternative—shipped liquid natural gas, or LNG—was pricey. Plus, the investments required—gas field drilling, liquefaction technology, ports—meant that to justify the costs, an LNG plant would have to be huge, at least two thousand megawatts.
“The size would drive up the cost of electricity,” Mark said. “In my view, you can’t afford LNG.”
Rajgopal shook his head. “We think we can.”
Mark still was dubious. The cost of electricity would be almost double that from a coal plant, she said. How could India possibly handle that?
“We’re very power short,” Rajgopal responded. “Our industries need power. We want to look at LNG.”
The government was willing to make whatever commitments were necessary to ensure such a project worked, Rajgopal said. Mark sat back in her chair. These were determined people. Could this be the break her team needed?
It was almost a magical moment. After losing the internal battles, her group might well be stumbling into the lead role on one of the world’s biggest projects. It would cost billions. And it would shower cash on Mark and her team. Enron effectively paid the power-plant developers a percentage of their deals, based on estimates of the money they would bring in. The larger the project, the more electricity it produced, and—consequently—the bigger the bonuses, often running into millions. Enron would invest the cash, and the international team would get rich.
“Okay,” Mark said. “We’ll take a look at it.”
With that, the fuse was lit. Enron would soon be pursuing wildly contradictory strategies. One brought in huge earnings but little cash, and depended on Enron’s credit rating to survive. The other would devour cash while producing next to no earnings for years, potentially putting the credit rating at risk.
Enron was on a collision course with itself.