Were Ken Lay and Jeff Skilling "Innocent"?

Megan McArdle thinks that Ken Lay and Jeff Skilling and Richard Causey (who in the end pled guilty just before the trial, thus playing havoc with Skilling's and Lay's planned defenses) were factually innocent. Or maybe she doesn't:

Asymmetrical Information: the only solid evidence that Messrs Skilling and Lay were "just as guilty" as Mr Fastow comes from... Mr Fastow, who got a drastically reduced sentence for telling the prosecutors this. Mr Fastow is the fellow we know stole from the company; the conviction of the others is based largely on his testimony. I haven't followed the case all that closely....

There is a small (but I believe growing) school of thought on Enron which argues that Enron was a fairly healthy business--done in not by deteriorating financials, papered over by accounting fraud, but rather by a collapse in trust in the market place, helped along by appallingly bad financial journalism, which basically caused a bank run. Since Enron was a trading operation, which requires liquidity to stay in business, profitability was irrelevant; they were killed by a credit crunch.

I don't assert that this is the case, mind you, though I find it at least plausible given my knowlege of the case.... Mr Fastow is the only higher-level executive against whom the government possessed a smoking gun. So this isn't a case of Fastow getting the ride on the lifeboat because he was the first conspirator to break, which is the general excuse for such plea bargains. In this case, the most obviously, incontravertibly guilty person in the case got a much, much lighter sentence because he testified against others whose guilt was more arguable....

According to Enron, it had stockholders' equity of $11 billion at the end of 2000. It gained an extra $2 billion from the California energy crisis in the winter of 2001. Yet by the fall of 2001 all of that was gone--Enron was bankrupt.

A bank that runs into confidence problems--that has a "run on the bank"--can go bankrupt. A bank has lots of short-term liquid liabilities, and lots of long-term illiquid assets that it can turn into cash only at heavy discounts.

But Enron was not a bank. Enron was--or was supposed to be--an asset-light trading operation. Its assets and liabilities were (a) securities and (b) promises to buy or sell energy and other commodities in quantity at various times in the future. These are not the kinds of assets that should lose much value even in a fire sale--even if it is accompanied by "appallingly bad financial journalism."

When Enron lost credibility--if it were a trading company--it should have been able to unwind its operations coherently, sacrificing some but not all of its $13 billion in equity to grease the deals. It was--or was supposed to be--a properly-hedged trading company with liquid assets, not a highly-leveraged bank with illiquid assets. But Enron went belly-up. Its unsecured creditors got 30 cents on the dollar. They are now (with Andy Fastow's help) hunting for the heads of the banks that did the paperwork for Enron's financial frauds.

It seems overwhelmingly likely that the $13 billion in stockholders' equity never existed. Enron marked its positions to market--which means that when it signed a contract with, say, a midwestern city to provide it with power for the next 20 years, it claimed the whole value of that contract as income in that quarter. And how did it calculate the long-run present value of the contract? It let the person who negotiated the contract say what it was worth.

Enron had--before Skilling--had a somewhat more sophisticated risk-control system. They had people in charge of reviewing and monitoring the contracts made--experts in figuring out what the contract would be worth if it were a liquid security. People like Vince Kaminski, who one day, Kurt Eichenwald reports, got a call from Enron President Jeff Skilling:

"There have been some complaints, Vince, that you're not helping people do transactions," Skilling said. "Instead, you are spending all your time acting like cops." A pause. "We don't need cops, Vince."

When you remove the "cops," you create the mother of all principal-agent problems. Each time a contract was completed, the contract was valued as if it were a liquid security by the negotiator who closed the deal. This meant that a negotiator desperate to reach a deal could (a) give away the store to the counterparty, (b) still make assumptions in his "mark to market" valuation that made the deal look really profitable, and so (c) help Skilling and Lay report another banner quarter for earnings. But you are reporting profits that do not really exist--and claiming stockholders' equity that is not really there.

For example:

http://www.thunderbird.edu/wwwfiles/pdf/about_thunderbird/case_series/a15040016.pdf#search=%22arthur%20anderson%20enron%20restatement%20of%20assets%22: The Dabhol, India, project was a microcosm of Enron’s business model. In December 1993, after roughly 18 months of negotiations, Enron Development signed a long-term power sales contract with the electricity board of Maharashtra, India (MSEB). Enron would build a 2000-megawatt natural gas- fueled power plant at an estimated cost of $2.8 billion. The Maharashtra energy board agreed to buy 90% of the power produced by the plant at a U.S. dollar-denominated price for a minimum of 20 years.

From the very beginning, problems mounted. It took Mark more than two years and millions of dollars in negotiations, court cases, and contract restructurings to get the financing in place. Within months, a change in the Maharashtra government resulted in an outpouring of project opposition. Once again, Mark went into overdrive for months of negotiations and renegotiations. Finally, on February 23, 1996, a new contract was signed between Enron and the MSEB. By December, financing was in place and the project’s construction resumed. But opposition continued, and it became clear that the MSEB would never be willing or able to pay for the power (estimated at over $30 billion for the project life).

The project was dead. In the words of one Wall Street Analyst on Enron’s India activities, “I’ve never been to another country where every single person hates one company.” Phase I of the project was operational for only a short period of time, and Phase II, as of December 2003, was still only 80% complete. The Dabhol power plant today is considered a failure for everyone involved but Rebecca Mark. Mark earned bonuses for both the original deal [in 1993] and the successful renegotiation [in 1996]. In 1996, Enron International generated 15% of Enron’s total earnings, and was expected to grow at double-digit rates for years to come. Rebecca Mark was named CEO of Enron International. Many people believed that Rebecca Mark would be Enron’s next CEO...

And:

[I]n July 2000 Enron signed a 20-year agreement with Blockbuster Video to introduce entertainment on demand.... Pilot projects in Portland, Seattle, and Salt Lake City were created to stream movies to a few dozen apartments.... Based on these pilot projects, Enron... recognized... profits of more than $110 million from the Blockbuster deal...

And:

Enron entered into a $1.3 billion, 15-year contract to supply electricity to the Indianapolis company Eli Lilly... [booked] the present value of the contract... more than half a billion dollars, as [current] revenues. Enron then had to report the present value of the costs of servicing the contract as an expense. However, Indiana had not yet deregulated electricity, requiring Enron to predict when Indiana would deregulate and how much impact this would have on the costs of servicing the contract...

And we haven't even gotten to Andy Fastow and his special purpose entities yet...