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Published by: Foreclosure Fraud on Feb 20, 2013
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What was so scandalous about these swaps? Bistro holds out a
comparative tool that helps us appreciate the insidious nature of Enron’s
structure. Where the Bistro SPE relied on outside lenders for its funding,
Enron’s SPEs followed the lead of First Executive and did their
borrowing from Enron itself, which also happened to be the party whose
balance sheet risk was being covered by the borrowed money. The risk
accordingly was never really externalized—if the SPE lost heavily on the
swaps but without exhausting the value of the Enron stock with which it
was funded, it still would have had no capital left to repay the loan from
Enron. Thus Enron, having covered $1.1 billion of losses under the
swaps in the short run, would in the long the run have to write off $1.1
billion of SPE notes payable (or a portion thereof). The only scenario
that would avoid the write-off is if the value of the Enron stock in the
SPE increased by $1 for every $1 of loss covered by the swaps.

The transaction structure would have been subject to question
even if the Enron stock had gone up. Stock goes up because earnings
increases are projected. Earnings projections depend in turn on recent
earnings results. In this case, Enron was stoking its earnings with a swap
contract that derived its economic substance from Enron stock, which in
turn derived its economic substance from positive earnings reports,
reports that would not be forthcoming absent the swap contract. This
causal chain of stock to earnings to stock to earnings to stock made the
transaction and accounting result intrinsically unsound.

The substance came down to this: Enron issued its own common
stock to cover a loss on its own income statement. This one may not do
under the most basic rules of accounting, indeed, under the most basic
rules of capitalism. Corporations issue stock to raise capital. They then
use the capital to do business and generate income. They are not
permitted to skip the step and enter the proceeds of the sale of stock
directly into income. The value of a firm stems from its ability to take
the capital and earn money over time; its stock market capitalization
reflects projections of its ability so to do. Enron used SPEs and swaps to
subvert the system, using its market capitalization—the value of its
common—to support the value of its common.

The surprising thing about the Enron scandal is that for the
outrage and fulmination little attention was paid to the transaction
structure’s substantive implications. Everybody got the point that
Enron’s earnings were fake. Almost no one worked through the smoke
and mirrors to see how Enron had faked it and how fine the line was that



© 2012 William W. Bratton & Adam J. Levitin

separated Enron’s fraud from transaction structures that were moving
billions daily.

Significantly, Enron never concealed the LJM structures. Its
financials provided the financial community an adequate basis to do the
analysis above and start asking questions about the soundness of Enron’s

Apparently, it lay beyond the system’s ability to comprehend.
Transaction engineers were inventing structures that only other engineers
could understand. The engineers worked with their eye on the asset light
prize but without working through the implications of downside
scenarios, whether for the promoter or the economy at large.

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