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Derivatives at root of Enron collapse, expert says

Enron Corp's extensive use of derivatives, not just its accounting practices, lie at the root of the fallen energy giant's slide into the largest bankruptcy in US history, an expert in the complex financial instruments told Congress on Thursday.

University of San Diego law professor Frank Partnoy said Enron had used profits from its derivatives trading operation -- the full scale of which was little appreciated by investors -- to mask losses in its more visible businesses even as some of its employees were fraudulently manipulating those profits.

"It will surprise many investors to learn that Enron was, at its core, a derivatives trading firm," he said in testimony delivered at a Senate Governmental Affairs Committee hearing.

A former Wall Street derivatives trader and white-collar crime specialist, Partnoy has been researching Enron's business practices for a book he is writing about its collapse.

"I have not seen the professor's testimony, and was surprised to learn about the book that he'll be marketing soon," Enron spokesman Vance Meyer said. "Out of respect to the process, we are not planning to launch a counterargument to every testimony in Washington."

In his testimony, Partnoy said Enron reaped huge profits from derivatives.

"It made billions trading derivatives, but it lost billions on virtually everything else it did, including projects in fiber-optic bandwidth, retail gas and power, water systems and even technology stocks," he said. "Enron used its expertise in derivatives to hide these losses."

Derivatives are complex financial contracts whose values are linked to underlying variables such as the prices of commodities, stocks or bonds. They are typically used by sophisticated investors to manage risk.

Partnoy said Enron's use of derivatives both outside and inside the company could be directly linked to its collapse.

On the outside, he said, they were used to create the company's web of off-balance sheet deals with complex financial partnerships known as special-purpose vehicles. After some of those deals went sour, Enron in October took a $1 billion charge against earnings and a $1.2 billion write-down in shareholder equity, triggering its nosedive into bankruptcy.

"Specifically, Enron used derivatives and special purpose vehicles in three ways," Partnoy said.

"First, it hid speculator losses it suffered on technology stocks," he said. "Second, it hid huge debts incurred to finance unprofitable new businesses, including retail energy service. Third, it inflated the value of other troubled businesses, including new ventures in fiber-optic bandwidth."

MANIPULATION ALLEGED

But Enron's derivatives problems ran far deeper than the outside special purpose vehicles, Partnoy said, adding he had also gathered information indicating widespread manipulation of the company's derivatives trading revenues.

"In a nutshell, it appears that some Enron employees used dummy accounts and rigged valuation methodologies to create false profit and loss entries for the derivatives Enron traded," he said. "Simply put, Enron's reported earnings from derivatives seem to be more imagined than real."

Enron reported more than $16 billion in gains from derivatives over the three years to 2000, Partnoy said. He said the alleged false entries "were systematic and occurred over several years, beginning as early as 1997."

Partnoy said some Enron traders had misused so-called "prudency reserves," meant to reflect the inherent uncertainty about future profits from derivatives deals, as rainy-day funds to smooth out their profits and losses over time.

Some had also apparently deliberately misvalued the forward rate curves used to determine the current value of their derivatives portfolios in order to hide losses, he said.

"I cannot offer fact testimony as to any of these matters," Partnoy told the committee. "Nonetheless, I strongly believe the information I have gathered is credible. It is from many sources, including written information, e-mail correspondence and telephone interviews."

At least eight congressional committees, as well as the Securities and Exchange Commission and the Department of Justice, are probing Enron's fall from grace and Partnoy said the episode should raise major questions about the regulation of derivatives as well as capital markets in general.

"The collapse of Enron makes it plain that the key gatekeeper institutions that support our system of market capitalism have failed," he said. "The institutions sharing the blame include auditors, law firms, banks, securities analysts, independent directors and credit rating agencies."

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