Raptor Hedging Strategy Analysis

Raptor Hedging Strategy Analysis

Today In Enron History

When Andy Fastow pleaded guilty, he stated as an example of how the Raptors were improperly used involved a hedge of an investment called Avici. He stated:

I and others, including Enron’s Chief Accounting Officer, agreed to date the AVICI hedge August 3, 2000 in order to locking in the value of AVICI (a volatile stock) at its all-time high and not incur the known and quantifiable loss from the AVICI stock having declined after August 3, 2000.

An intriguing contradiction: it is legal to back-date stock options as part as compensation, yet apparently backdating documents which result in basically the same outcome is illegal.

In any case, the Avici stock on that date was $162.50. If they’d used September 30 as the reporting date, Enron would have reported a loss of $65,500,000.

Three Percent

One of the repeated complaints I hear about LJM and other special-purpose vehicles is that only three percent of liquidity came from other investors for the investment to conform to GAAP and be legitimately separate from Enron. This always amazes me for two reasons. The first is, that’s the law. Enron didn’t create the law. Enron was only doing what the law demanded. The second is the more salient point.

Three percent is what a buyer must put down for a Fannie Mae or Freddy Mac mortgage. Sometimes you don’t even need three percent. So if you’re in a home or car or any other asset in which you paid only three percent down, you are automatically disqualified from complaining.

When the rule was changed in 2002, the SEC, in its infinite wisdom, increased the amount at risk to be at least ten percent.

I marvel at the literal-minded robots who work at the SEC. Enron cobbled together the three percent outside equity – as the law required – but is there any doubt that Enron could have also found ten percent, or twenty, or fifty?

The Raptors absolutely conformed to the rules. The fact that the company collapsed gave investigators an opportunity to accuse not just people who worked there, but even the business structures that were in place to benefit all complex companies.

Today In Enron History

September 28, 2001.

After the meeting with Greg Whalley, Andy Fastow, Ken Lay, Rick Causey and a few others, Ken Lay had made the executive decision to unwind Raptors. Today in Enron history, Enron did so.

According to the Powers report, Enron calculated the Raptors’ combined assets were approximately $2.5 billion and their liabilities $3.2 billion. This would result, in the next month, of a write-off of $544 million.

Meanwhile, at the Arthur Andersen office in Chicago, a young attorney named Nancy Temple was invited to a conference call to deal with Enron’s third-quarter accounting issues. The reasons given in the literature on the subject indicate that AA’s Enron team on the ground was in conflict with the Professional Standards Group, what Jeff Skilling called at his trial the “rocket scientists of accountants.” It was time to involve the lawyers.

After the meeting, another attorney asked Nancy Temple what documents should be kept from all this. Andersen had a policy on document retention, Temple replied, and explained that the policy was to keep the original and final drafts of memos from David Duncan (head of the Enron account). Everything else, including emails, should be destroyed. It was Andersen’s policy.

Today In Enron History

After Sherron Watkins had written a memo to Ken Lay, he took her advice and launched an investigation into the accounting treatment of the Raptors. About a month later – the same week of 9/11/01 – Rick Causey reported to new President Greg Whalley it would cost about $800 million to close out the structure. Whalley then reported this to Lay, and Lay decided to hold a meeting on the subject.

On the morning of September 19, 2001, a handful of Enron executives gathered in Ken Lay’s office to discuss the Raptors. Some wanted to find a way to postpone shutting down the vehicles, hesitant to spend the $800 million. Others wanted to close them once and for all. Ken Lay decided that the Raptors would be shut down.

Today In Enron History

On this day in 2000,  Ben Glisan and Rick Causey presented Raptor I to the Finance Committee of the Board. According to the minutes, Glisan described Raptor as “a risk management program to enable the Company to hedge the profit and loss volatility of the Company’s investments.”

Rebecca Carter, the Secretary of the Board, was responsible for recording the minutes of the meeting.  During the presentation, on the “Structural Highlights” page, which showed how the Talon hedge would work, Ms. Carter jotted down a note: “Does not transfer economic risk but transfers P&L volitility.”

Ms. Carter was never called as a witness during her husband’s trial, and thus was never questioned about this comment, so we can not know exactly what she meant when she jotted those words. Nevertheless Mr. Skilling was grilled about them three seperate times: at the SEC, in front of the Senate, and during his trial. At trial, Mr. Skilling repeated the same things he had said before: LJM was most definitely at risk, therefore everything they did – including the Raptors which included Talon – was a true economic hedge. Of course, at trial Mr. Fastow said something different – that the Raptors were expected to decrease in value, and thus the company needed a hedge -ie, Talon – to disguise the loss.

Despite the contentious back and forth, it was one of the many times Jeff Skilling’s intellect shined against Sean Berkowitz:

Q. Mr. Fastow in response to Mr. Petrocelli’s question, “Enron anticipated a number of its assets in the future were likely to decline?” That’s not your understanding?

A. No.I think that’s exactly why you do a hedge. I mean, it —

Q. Because you anticipated that these assets were going to decline?

A. That there was a chance that the assets would decline. It’s like —

Q. And the —

A. I don’t buy life insurance because I think I’m going to die.I buy life insurance because I might have some chance of dying. You want to try to protect your kids. So go back to the last page. If you read through that, the question was, “Was there some chance that these could go down?” Yes.There absolutely was a chance.

I don’t know what Rebecca Carter meant when she wrote down those words. I do know that the issues surrounding them – ie, Talon and the Raptors in general – were absolutely legitimate and suited legitimate business requirements.