[This is a re-post from 2004.]
In this section we’re going to clarify exactly what hedging is and how Enron used hedging in its financial strategy. But first, let’s clarify the very basic terms of securities.
Security positions are referred to as long, short, or flat.
* If you own stock are you are said to be in a “long” position. A long position is positive.
* If you owe stock, you are “short” the stock. A short position is negative.
* If you neither own nor owe the stock, you are said to be “flat”. A flat position is neutral.
A person or company can hedge a trade by taking a small position on the opposite end of the transaction. An example: an airline. You believe the airline industry is going to do well (*snort*, sorry, that cracks me up) so you go long on airline stocks. At the same time, you can go long on fuel stocks or commodities, because if the airlines do well you make money but at the same time, a factor that could cause a depreciation of the value of stock prices (rising fuel costs), could also cause an increase in the other stock (the fuel stocks). As long as you’re long on the fuel, you make money.
This is a rudimentary hedge position. The hedges can become much more complex when you add short stocks. One way to hedge is to use an option.
* Call options give their owners the right to buy stock at a set price.
* Put options give their owners the right to sell stock.
A call option can be bought as a form of insurance that can protect a short term position against a catastrophic loss or protect an already-established profit on a short position. On a short sale, there is, theoretically, no limit to how much an investor can lose: he has borrowed the stock to deliver against his short sale and some day must buy back shares to cover the transaction so that he can return the borrowed shares. There is no way in telling how much what price he will have to pay because, at least in theory, there is no telling how high a price will go. The short seller is facing a huge potential loss. He can protect himself with a call.
Enron had bought a small Portland internet company, Rhythms, for $10 million dollars. A year later it went public and shot past $400 million. With mark-to-market accounting, every one of those dollars would be counted as profit, even though, as standard with IPOs, the stock could not be sold by executives for at least six months. Jeffrey Skilling, CEO of Enron, wanted to find a way to protect these enormous gains with “hedges” – related investments that would go up in value (fuel stocks, so to speak) if Enron’s holdings went down (the airline stocks, so to speak.) If the stock collapsed while Enron was required to hold the shares, the incredible gains in the first quarter would be a huge, unexpected loss in the third.
Enron’s idea was to pay a third party to assume the risk that Rhythms’ price would fall. If Enron could find an investment firm to sell it a put option, then its profits would be locked in. Unfortunately, that was impossible. No investment bank would sell a put option on a volatile, new, thinly traded stock like Rhythms. And more worrisome, such a put option would violate Enron’s agreement with Rhythms.
Andrew Fastow, the CFO of Enron, thought and thought and thought about the problem. And then he solved it.
LJM (named by Fastow after his wife, Lea and his two sons, Jeffrey and Matthew) would act as an off-balance-sheet fund (in other words, completely separate from Enron; it would be a partner to Enron, not an asset of Enron). Enron would contribute its own stock (about $250 million) to some outside fund, which would then sell a put option on Rhythms stock to Enron.
That outside fund, of course, was LJM.
