Enron, 2001

Hedges against itself, and loans dressed as trades

Enron turned itself from a pipeline company into the largest trader of energy derivatives in the US, booking long-dated contracts at model values up front. To manage its earnings it hedged its investments with partnerships capitalised by its own shares, and raised billions through prepaid commodity trades that were, in substance, loans. When the share price fell the hedges failed, the loans came into view, its credit rating was cut, and the trading business that depended on its credit stopped. It filed for bankruptcy on 2 December 2001, then the largest in US history.

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What the lesson covers

1. What happened
2. The hedges
3. The prepays
4. What it cost
5. What it teaches

Key terms

• Special purpose entity — A separate legal vehicle set up for a narrow purpose, often to hold assets or risk off a sponsor’s balance sheet.
• Prepay — Payment today for a commodity delivered later; when hedged back to the seller it becomes a loan in substance.
• Mark-to-market accounting — Valuing contracts at current market or model value, so expected lifetime profit can be booked at signing.
• Self-referencing hedge — A hedge whose payout depends on the hedger’s own share price or credit, which fails when it is needed.
• Substance over form — The accounting principle that a transaction is recorded by its economic effect, not its legal shape.
• Rating trigger — A clause that adds collateral or accelerates debt when a company’s credit rating falls.

Every key term, A to Z

In practice

Auditors and regulators now look through chains of offsetting trades to the net cash flow and treat circular commodity financings as debt; derivatives users must show a hedge counterparty can pay in the stressed scenario; and consolidation rules bring most sponsor-controlled entities back onto the balance sheet.

Read next

• Commodity Swap — Fixed price for floating market price
• Commodity Forward — Agree a price today for delivery later
• AIG, 2008 — Protection that could not pay its collateral calls

In the app, Enron, 2001 carries a five-step lesson, a worked example and a bank of twelve questions drawn differently every sitting.

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