EVERY SPOKEN WORD
15 min read · 3,382 words- 0:00 – 0:16
Intro
- DRDavid Rosenthal
They were funneling money to their own bank accounts.
- BGBen Gilbert
[laughing] Yeah. If the story were to stop there, this probably would be a great company.
- DRDavid Rosenthal
This shows how unbelievably savvy he is. He, he sort of realized he couldn't build a business.
- BGBen Gilbert
Well, he is effing smart, according to him.
- DRDavid Rosenthal
Yeah. Could not build the business that he wanted to without doing this.
- 0:16 – 3:49
Enron gets a name
- BGBen Gilbert
So Lay's now settled in, he's in charge, he's the chairman, he's the CEO, and he decides that he wants to get a new name for this company. You know, HNG, InterNorth, that, you know, it sounds too old, and, you know, it's reeking of his predecessor.
- DRDavid Rosenthal
And it is true that a- all these energy companies had, like, just the worst names. I mean, it's all these, like, completely meaningless prefixes and suffixes, like Co. and Corp. and Inter-, and it's like in Office Space, Intertek. They're all named something like that.
- BGBen Gilbert
Yes. Well, [chuckles] maybe this is the beginning of the modern era of that because they go and they hire very expensive naming and branding consultants. The logo would actually come a little later, but including, uh, a few years later, Paul Rand would design-
- DRDavid Rosenthal
Unbelievable
- BGBen Gilbert
... the Enron logo. This would be the last logo that the legendary-
- DRDavid Rosenthal
Oh, really?
- BGBen Gilbert
-Paul Rand designed before he died.
- DRDavid Rosenthal
He, of course, designed the IBM logo, the, uh-
- BGBen Gilbert
NeXT.
- DRDavid Rosenthal
NeXT logo, the UPS logo, maybe?
- BGBen Gilbert
And he very much has his style. Like, you think the IBM logo, or if you know the NeXT logo, you know, Steve Jobs' NeXT, like, uh, the Enron logo, like, they're all kind of in the same style.
- DRDavid Rosenthal
ABC, Yale Press, Westinghouse.
- BGBen Gilbert
Oh, Westinghouse.
- DRDavid Rosenthal
Yeah.
- BGBen Gilbert
My grandfather worked for Westinghouse.
- DRDavid Rosenthal
Really?
- BGBen Gilbert
Yeah. Ah, legendary. Enron would be the last logo he designed before he died. Oof, what a legacy.
- DRDavid Rosenthal
[chuckles]
- BGBen Gilbert
So the naming consultants, separate from Paul, they come up with a brilliant new idea for the company. They want to name it Enteron.
- DRDavid Rosenthal
Almost, almost.
- BGBen Gilbert
Lay loves it! The board loves it, Lay loves it, everybody's so excited. They announce the name. And the name comes from, it's a portmanteau, N-E-N for energy, T-E-R as a nod to InterNorth, get that, you know, legacy back in there, and then On at the end because it sounds cool and modern. Enteron. [laughing] So they announce it. Um, they didn't check, though, that, uh, in the dictionary, because enteron is actually a medical term. It is a word, it is a medical term, it comes from a Greek word, and it means the intestinal digestive tract of a living creature and is particularly used for embryos. So, like, the digestive tract of embryos is an enteron. So, uh, they kind of get pilloried in the press for this. Lay, you know, he's so concerned about appearances and, you know, political, like, he goes nuts. Like, L- Lay never loses his cool, as we'll see throughout this story. Like, he loses his cool here.
- DRDavid Rosenthal
[chuckles]
- BGBen Gilbert
He, like, goes completely ballistic, yelling at the naming consultants, everybody. Demands that they do another study, change it. And so they come back, and they're like, "Well, what if we just get rid of the ter, and we- [laughing]
- DRDavid Rosenthal
[laughing]
- BGBen Gilbert
... shorten it to Enron?" Which Lay probably loves because he's like, "Yeah, you know, I hate those guys. Those are the old guys. Get rid of them." So he ends up getting exactly what he wants. Headquarters moves to Houston. He's the CEO and chairman. Enron, future-looking, you know, it's his baby. It's a refounding, you know, new story, new era for the energy industry.
- DRDavid Rosenthal
Yep. So that's sort of the end of chapter one. You get this merger, they're real pipeline companies, they've got hard assets, they have sort of a new corporate culture with a new leader, and they're delivering real value to customers.
- BGBen Gilbert
Yep, and they're running the proto-trading playbook that Lay pioneered back in his early days, and pretty quickly after this, they
- 3:49 – 6:50
First trading scandal
- BGBen Gilbert
actually face their first trading scandal. Did you read about this?
- DRDavid Rosenthal
I did. It's such a predecessor, like, it's such an obvious personality flaw of Ken Lay is to look the other way, and it's, like, amazing that it happened, what, 10 years before the big scandal.
- BGBen Gilbert
So two traders at the new Enron, who are actually based in New York, they start embezzling money from the company. They're filing fake trades, they're filing fake tax returns, they're creating false bank accounts. They have a false bank account, famously, I think, in the name of a Mr. M. Gas, uh, which clearly, uh, this will give you a window into the-
- DRDavid Rosenthal
[laughing]
- BGBen Gilbert
... sophomoric nature of traders and trading cultures.
- DRDavid Rosenthal
Just write that out and figure it out for yourself.
- BGBen Gilbert
So the company picks up on this, it comes to Lay's attention, and, uh, you know, everybody recommends, the company's auditors at Arthur Andersen, you know, recommend to the board-
- DRDavid Rosenthal
The premier accounting firm of the day.
- BGBen Gilbert
Premier Big Five accounting firm at the time. They recommend that Lay and the company should fire these guys. Obviously, they're stealing from the company, they're falsifying trades. And Lay's like, "Well, [sighs] you know, these guys, it's really bad. It's bad what they did. We should censor them for sure. You know, we should set up some controls, make sure this doesn't happen again, but they're really good traders, you know? They've really made a lot of money for the firm. I don't think we should fire them. You know, that, that feels like a big step." And everybody's like, "Uh, okay?"
- DRDavid Rosenthal
They were funneling money to their own bank accounts.
- BGBen Gilbert
Yeah. [laughing]
- DRDavid Rosenthal
Um. [laughing]
- BGBen Gilbert
Uh, but Lay lets it slide, and, um, he is immediately rewarded for his faith in them and his, uh, decision here. Almost immediately, they do what any sophomoric people in a situation like that would do who just got away with one, they go way risk-on. So they go on tilt, and they rack up, within the next few months, almost a billion dollars, one B, that's a B, a billion dollars, this is in the late '80s, of trading losses, uh, which that would be enough to, like, bring down the whole firm at the get-go.
- DRDavid Rosenthal
Well, and you gotta think, the enterprise value of the combined company, I don't have it in front of me, but you had a, I don't know, five-ish billion dollar company buy a two-and-a-half-ish billion dollar company, and so, you know, whole enterprise value of the firm can't be more than $10 billion.
- BGBen Gilbert
And these two bozos just racked up a billion dollars in trading losses.... This time Lay does fire them, and fortunately for young Enron and for Lay, but unfortunately for the rest of the world, this happens early enough in the quarter that the trading floor is able to dig out enough of these losses that they don't have to report the whole billion-dollar loss come earnings time, and only end up reporting, I think, less than one hundred million dollars of losses. So the company miraculously survives. So you would think that Lay would learn his lesson here, but no, this is Kenneth Lay we're dealing with.
- DRDavid Rosenthal
And let's, for a moment, say, why
- 6:50 – 8:19
Traders at Enron
- DRDavid Rosenthal
are there traders? That's sort of an interesting thing that's happening here. I thought this was a pipeline company. I thought this was a logistics company that moved natural gas from one place to another and charged customers for the services associated with that. Well, the traders originally are there, to your point, to sort of help match supply to demand. You know, it's not like everybody's just got a computer in front of them where they can automatically be buying the right products to fit their needs at the right price at this moment in time. You sort of need to interface with people, and those people can quote spreads wherever they want. They can say, "Uh, I got a seller for this price, and you're the buyer, and I'm sort of sensing that you'll buy for that price. Okay, I'll matchmake supply to demand. I'll quote a spread where I think I can make the most possible money on this trade, and we'll go with that." And so this is the beginning of them being both a logistics, energy transportation company and also a financial organization of sorts, a trading desk.
- BGBen Gilbert
Yes, a trading desk, a proto-financial institution for the energy industry.
- DRDavid Rosenthal
Yep.
- BGBen Gilbert
So speaking of, back to Houston and the promised McKinsey strategic engagement, it's happening. Jeff Skilling is lead hotshot partner to develop a strategic plan for this very thing, the new finance and trading operations of Enron. And one day, Skilling has a
- 8:19 – 12:45
Enron’s idea on becoming an investment bank
- BGBen Gilbert
absolutely brilliant idea, brilliant by his own estimation, and he proclaims it to everybody how brilliant it is. What if Enron goes one step further from Lay's kind of original innovation of creating a spot market for energy, and rather than just being sort of the facilitator of the market, being the pipeline in the middle, what if Enron started acting even more like an investment bank in this industry? And the phrase that he uses for this idea is Enron becoming a, quote, "bank for gas." And the idea is that they can go to oil and gas producers, to drillers, and they can buy up a lot of the future production that's gonna come out of their wells, kind of almost like the old companies used to do. But rather than Enron then being the customer for what's gonna come out of those wells, they repackage everything here. This is the securitization that you were talking about a minute ago, Ben. They repackage all of these future energy commodities, they slice it and dice it, and then they resell it to buyers, to consumers of energy, on kind of whatever timeline and term length they wanted. So we've gone now the industry from the pipelines, buy the assets from the producers, buy the energy commodities from the producers, and then sell them to customers. Lay's innovation is, like, create a market where you let the producers and the customers trade directly today.
- DRDavid Rosenthal
In real time, spot markets where everyone is subject to, "I don't know what tomorrow's price is gonna be. I'll quote it to you tomorrow." So you, you have inherent risk that tomorrow's price could be higher, so sorry, but that is what it is.
- BGBen Gilbert
Yep. So Skilling's innovation here is let's turn this into a full-fledged kind of financial derivatives market and let buyers and sellers write contracts and buy contracts for any amount of this commodity in the future at a set price, so true futures contracts.
- DRDavid Rosenthal
And the most sort of early legitimate use case for this is imagine you are a local utility who's trying to provide natural gas to your town, and, you know, you've been using this great spot market that Enron stood up to figure out, you know, what's the price gonna be tomorrow? You're pretty worried about it skyrocketing in the event of some unknown black swan event or something like that. So wouldn't it be nice if you could hedge your exposure to that risk by also negotiating a futures contract where you say, "Well, let me lock in a certain rate, and, yeah, I know it's gonna be more expensive than it is now, but at least nothing bad can happen, and then I can sort of be predictable in the way that I'm thinking about what my spend's gonna be over the next three months"? So that's, like, a super legitimate use case of one of these futures contracts that they could, you know, trade using Enron.
- BGBen Gilbert
You can imagine all sorts of utility here.
- DRDavid Rosenthal
Yep.
- BGBen Gilbert
So Enron does it. They pioneer this market that would come to be known, and is, uh, I think it assumes still a very, very large part of the energy market today, called energy derivatives. Uh, Skilling and Enron invent it and pioneer it.
- DRDavid Rosenthal
And at this point, the energy is the underlying asset. The derivative itself is not particularly interesting other than its own utility for if you are actually buying or selling the underlying asset. That's, like, an important thing to note. Everyone will lose their heads later and get excited about the derivative on its own. Like, they don't care what it's a derivative of. It's a tradable thing that numbers go up, numbers go down. It reminds me a lot of some of crypto over the last year. It's like trading Dogecoin.
- BGBen Gilbert
Right. Does anybody even know what this coin is or is supposed to do? Does anybody care?
- DRDavid Rosenthal
No, but I can speculate on it. And so there is a very interesting, almost innocent, early beginning of why you would offer energy derivatives that completely falls apart over time as everyone loses their head.... And Skilling's still outside, right? When he pitches this idea.
- BGBen Gilbert
He's still at McKinsey at this point. Yes, for, for the moment, and, and still in this next thing, they realize, you know, this is a, a new concept they need to bring to the market. How are they gonna bootstrap up this new derivatives market? Well, they kinda need the producers to get on board. They need to get the supply, the raw supply that they can then financialize, securitize, turn into these derivatives,
- 12:45 – 14:00
Enron becomes investment bank
- BGBen Gilbert
and the way that they can really convince producers to wanna do this is if they fund them. So [chuckles] just like an investment bank, they now start going out and doing these development deals and co-development deals with drillers, saying, "Hey, we'll fund you. We will finance your exploration, your drilling, and as part of financing that, Enron is gonna lock up the rights to then securitize the future production out of your assets."
- DRDavid Rosenthal
Which again, on its own, not a malicious strategy. Think about our Qualcomm episode. "Hey, Sony, will you spin up a new venture that we'll co-invest in to make flip phones that use CDMA so we can prove to everyone else in the market that CDMA is a viable technology? We'll invest in it. You just have to provide these strategic assets. You can own half of it," blah, blah, blah. It is a common way to bootstrap an ecosystem, to use your dollars to incentivize other participants to bring a thing into your ecosystem.
- BGBen Gilbert
And, you know, honestly, like, if the story were to stop there, this probably would be a great company, bringing huge innovation to a commodity market. Yeah, probably this market should work this way. It should be financialized and securitized. Energy assets are commodities.
- DRDavid Rosenthal
Yep.
- BGBen Gilbert
Unfortunately, that is not where
- 14:00 – 16:28
Convincing Skilling to leave Mckinsey and join Enron
- BGBen Gilbert
the story ends. Far, far, far from it. So 1990, now we're a couple of years into the Lay-Enron era, and Lay and the vice chairman of the company, a guy named Rich Kinder, who later would leave Enron before all the dirt hits the fan, and start Kinder Morgan-
- DRDavid Rosenthal
You can think of Rich Kinder, for now, as the hard assets guy. He's the guy that really understands the intrinsic value of delivering hydrocarbons through a pipe to customers and trying to build a company that is just executing really well on doing that.
- BGBen Gilbert
Yes. So the two of them, they work on convincing Skilling. They think this is a big idea, and this is the future of Enron. They work on convincing Skilling to leave McKinsey and come over and join Enron as the full-time CEO of this new gas bank that they're gonna call the Enron Finance division. And in a very telling move, tells you a lot about what you need to know about Jeff Skilling as a person, they're talking about this, and they're negotiating. He decides he wants to take them up on the offer. He's gonna leave McKinsey. He calls them up to do the final negotiations of the terms of his offer. He calls them up from the hospital, where he is with his wife while his wife is in labor with their, I think, second child. That tells you where his priorities lie. Uh, obviously, that marriage does not last too much longer. [chuckles]
- DRDavid Rosenthal
I love he said, "Obviously," there.
- BGBen Gilbert
Yeah, obviously. [chuckles] Obviously. Um, so Skilling comes in, he takes over Enron Finance, starts this new division.
- DRDavid Rosenthal
It is worth pointing out the thing that he made a necessary condition in order for him to join and do this. Do you know what that thing is?
- BGBen Gilbert
Ooh, I don't.
- DRDavid Rosenthal
It was that Jeff Skilling insisted that in order to join Enron and start this new division, Ken Lay and the board had to agree to use mark-to-market accounting.
- BGBen Gilbert
I did not realize that Skilling was looking that far ahead and made it a condition of his joining.
- DRDavid Rosenthal
This shows how unbelievably savvy he is. He, he sort of realized he couldn't build a business-
- BGBen Gilbert
Well, he is effing smart, according to him.
- DRDavid Rosenthal
Yeah. [chuckles] He could not build the business that he wanted to without doing this. He literally called it, and this is in The Smartest Guys in the Room, "a lay my body across the tracks issue-
- BGBen Gilbert
Wow!
- DRDavid Rosenthal
... about joining the company."
- BGBen Gilbert
I wonder if he talked about it from the, from the delivery room.
- DRDavid Rosenthal
[laughing] Awful. So what
- 16:28 – 19:06
Mark to market account
- DRDavid Rosenthal
is mark-to-market accounting? 'Cause we'll get into this a bunch, but let's understand it conceptually.
- BGBen Gilbert
Yeah. It ends up taking a while for Enron to be able to implement this, that we'll get into, but go for it.
- DRDavid Rosenthal
So normally, if you're in the business of delivering gas to customers who will pay for it, you account for the cost that it takes to physically move the gas when you deliver it, at the time you're delivering it, and the cash that your customers pay you, that's your revenue, and you recognize that when they pay you. But imagine you're in a different business, like trading stocks. You probably should be accounting for the market value of everything you buy and sell, whether or not you have actually sold it. Like, if you bought Tesla at $20 a share, and it's now worth $200 a share, you should reflect that you have a gain, albeit an unrealized one. This is mark-to-market accounting.
- BGBen Gilbert
And famously, all VCs do this, right? You talk about marks, you know, of your portfolio.
- DRDavid Rosenthal
Right. Company raises an upround from a third party who's setting a new price. That is what the market is saying this asset is worth, and you get to account for that value, even though you haven't actually received the cash. You know, just because you haven't sold your Tesla shares, it doesn't mean that you don't have an unrealized gain, or just 'cause the VC hasn't realized the liquidity event from that company, it doesn't mean that the company's not worth more. So Skilling obviously really wanted this mark-to-market treatment, and while you can imagine that it's probably easy to abuse mark-to-market accounting rules, it is probably okay if you can avoid the temptation. But it is [chuckles] worth pointing out that Enron, when they did adopt this, became the very first non-financial company to use this method.
- BGBen Gilbert
Let's just say the potential for a litany of abuse is high, very, very high, especially for what is an operating company, not actually a financial firm.
- DRDavid Rosenthal
Yeah. Mark-to-market accounting, to me, is the epitome of "With great power comes great responsibility," because it really does open up this question of, like, okay, well, what is the market price, and how do you discover the true market price of something? When someone's not paying you for it and giving you the cash, doesn't it seem a little squishy to say what the thing is actually worth?
- BGBen Gilbert
Oh, put a pin in that. We're gonna- [chuckles]
- DRDavid Rosenthal
All right.
- BGBen Gilbert
We're gonna come back to that.
- SPSpeaker
[singing] Who got the truth? Hmm. Is it you? Is it you? Is it you? Sit me down. Say it straight. Another story on the way. Who got the truth? Who got the truth now? Hmm.
Episode duration: 19:07
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