In Conversation with Former Enron CFO Andy Fastow Part One

Richard Kramer:

Welcome back to Bubble Trouble, conversations between our real life double act of the independent analyst, Richard Kramer, that's me, and the economist and author, Will Page, that's him. And this is what we do. If there's a bubble that burst, we pricked it first.

We have reached our 100th episode of laying out inconvenient truths about how business and financial markets really work, from exposing sycophants and stenographers of Wall Street who just praise, not appraise, companies they're covering. We've smacked the SPACs and we were early in calling out NFTs. They were not for me.

And taking inspiration from The Who's Won't Get Fooled Again, we ask why do we find ourselves constantly getting back into bubble trouble? Don't markets ever learn? So today we take you back with one of the biggest bubbles bursting in living memory, Enron, which went from America's seventh-largest company to bankrupt within a year at the turn of the millennium.

How many booms, busts, frauds, and financial irregularities have we witnessed since then? We lost count. A hundred episodes in, we get to sit down and learn from Andy Fastow, the former CFO of Enron, who we've wanted as a guest on this pod since, well, before the podcast began.

Buckle up for a conversation about what happened that fateful year, why it's continued to happen since, and honestly, where and how, not if, the same is going to happen again.

Today the first part of a two episode conversation with Andy Fastow. More in a moment.

Will Page:

Andy, to welcome you to the podcast, to say this is a dream come true, would not be an exaggeration. The purpose of Bubble Trouble wasn't just to get you on the show. I think the purpose of Bubble Trouble was inspired by you, in particular, a talk that you gave in London in 2015. A sweltering heat wave of a summer, a Financial Times event, Financial Times being a huge friend and supporter of this show.

I had done some panel about Spotify, lost a lot of body fluid on stage it was that hot. I walked into a big tent and I saw you on stage. And I'll just preface this by saying Bethany McLean and Peter Elkind's, Smartest Guys in the Room, is one of my favorite books and documentaries of all time.

And I'll never forget the scene where you held aloft two items. On one hand, you had the CFO of the Year award. On the other hand, you had a prison card. And you asked the audience how is it possible that one person can be given these two things within 12 months of each other? And I'm sitting in the front row in that marquee and I just felt I had to put my seatbelt on because nobody else could tell this story.

So I'm grateful that you're here today.

Andy Fastow:

Well, thanks, Will. Thanks, Richard. Happy to be here. I guess I have to ask the first question, if I was the inspiration for this podcast, how come I don't have a piece of it?

Will Page:

So I've worked in copyright for many years. So you have a performing right. You've registered with ASCAP, you'll get royalties.

Andy Fastow:

Okay. But I guess I'd start out by saying when I held those two items up, Will, back at the Alphaville Conference in London, I didn't just say, "How is it possible that I got both of these within such a short period of time?"

I said, "How is it possible that I got both of these for doing the same deals within the same amount of time?"

And that was really the essence of the talk, is that it's possible to do deals that technically follow the rules, but at the same time are misleading or ultimately fraudulent, which is what I did. And let me make one thing clear if I can.

Will Page:

Sure.

Andy Fastow:

Before I talk about Enron, before I talk about my own actions, and if your audience were to remember just one thing about my comments today, I hope this is what they remember. I believe that what I did was wrong. I believe that what I did was unethical and I believe that what I did was illegal. I take full responsibility for my actions.

And in fact, I consider myself one of the people most responsible for Enron's failure. So I own that. So please, for those who are listening, when you hear me talk about what happened at Enron and try to provide some insight into what happened at Enron and how that might be relevant today, and I think it is relevant today, in no way is that me making an excuse for my actions or minimizing what I did or trying to blame other people for what I did.

Absolutely not. I own it and I'm responsible for it.

Will Page:

Heartfelt. Thanks for those words. And maybe a quick correction to Richard's introduction because on stage at the Financial Times event, you changed your job title. You called yourself the Chief Loophole Officer. Is that correct?

Andy Fastow:

Well, that's what I should have been called when I was at Enron. I had the title Chief Financial Officer for several years, but I should have been called Chief Loophole Officer. And again, that gets to the essence of what I think the true Enron story is.

Now look, I mean people have read a lot about Enron. They've watched movies. Bethany McLean and Peter Elkind wrote a long book about Enron. And I understand what most people probably think, which was that Enron was a case of a few sinister guys sitting in a dimly lit conference room trying to commit fraud.

I would argue that's not the case. And instead I think it's better described as a big group of peoples, accountants, attorneys, finance people, bankers, all sitting in a brightly lit conference room thinking they were doing the right thing in many cases, but committing fraud. And the question is, how is that possible?

And an oversimplification, but I think a good word to use to describe what happened at Enron, is the word loophole. Enron was not necessarily a case of people trying to break rules. It was a case of people trying to exploit rules, finding the loopholes in the rules to get to the answers they want.

And that's a common thing, and I'm not suggesting there's anything wrong with that. But when people find these loopholes, when people go into the gray area of accounting, it involves a lot of risk. And when people's brains hear the phrase, it's been approved or you're allowed to do this, they stop thinking about risk.

And Enron is really, more than anything else, a case of not seeing the risk. And even when we saw it, mis-pricing the risk, which led to the downfall of the company,

Richard Kramer:

First of all, I think that's a brilliant summary because... And one of the pieces I saw in preparing for this, was to watch the videos of the movie Smartest Guys in the Room. And someone made the point that the accountants, the lawyers, there were so many enablers that should have been saying no or should have been raising questions throughout that, but they had a massive conflict of interest.

And Will and I were just running down, since we started the podcast... And we'll ask you for a couple suggestions as well. But since we started the podcast, we've had SPACs, NFTs, crypto, Wirecard, Evergrande, Credit Suisse went bust.

Will Page:

Credit Suisse.

Richard Kramer:

Silicon Valley Bank went bust, FTX went bust. You had the COVID stocks blow up. And so, is what you're describing, what you just described for us, something that is just such a widespread phenomenon that we are seeing it everywhere, and Enron was just maybe a very high profile example when you think about all these other August institutions and paragons of the economy that are now no longer with us?

And that was just since we started this podcast two and a half, three years ago.

Andy Fastow:

That's a great question, Richard. But let me start out by, if I can, offering that I think two of the premises in your question, I disagree with. You called the accountants and the attorneys enablers and you said that they should have been pointing out the problems with these deals. And I disagree with that.

And this is an important fact and one that many executives and most directors I talk to don't really appreciate. The gatekeepers, what we think of as gatekeepers, auditors and attorneys, are there for only one reason. To tell us whether we are following the rules. They are not there to tell us whether what we are doing involves too much risk or whether it's in the best interests of our shareholders a long time or whether it would be considered ethical or whether it would be to reputational risk and demise.

That's not their job and they don't want that job. There's too much risk associated with that job. They're only there to answer one very specific question. Are you following the rules? Now, people tend to think of rules as black and white, especially with accounting. If you're an accounting student, you've got debits and credits and if it balances at the end you get an A. But accounting-

Will Page:

Andy, I always like to differentiate accountants from economists by saying accountants count the beans. Economists measures gaps between the beans.

Andy Fastow:

... Now there's a huge amount of gray area in accounting and obviously people know there's a great amount of gray area in the law. That's how you can have opinions from attorneys that directly contradict each other.

On an extreme example is how is it possible that top attorneys in the US said it's acceptable to torture people after 911? But you can always get an opinion, you can make a case, and that's why we have courts and judges and juries to determine which opinion makes sense. But there's a gray area and that's the key.

The Enron story is best described as people, myself especially, who sought to exploit the gray area to get to the answers we wanted. Loopholes is a simple word for that. Now, it's interesting because if I were to ask you, or when I ask audiences when I talk to them or groups or directors, I'll ask them, is the word loophole a pejorative? A bad word?

And very few people will say it's a bad word. But what's the definition of loophole? It means that you are technically following the rules, but that you're intentionally getting around the principles of those rules.

Now, let me ask the question a different way. Let's say you go home tonight and you're sitting at the dinner table with your children. And your clever child asks, "Hey Mom, hey Dad. You've given me some rules I have to live by in this house. I just want to make sure that so long as I technically follow the rules, if I were to find a way to comply with the rules but get around the reason for those rules, I want to make sure you won't punish me."

 I suspect that would lead to a rather lengthy discussion about the meaning of your life and risk and reputation and what kind of person you want to be. Why is it that our brains would give such different answers to that question when we're in business versus when we're talking to our children? It's because we're trained to be in a rules-based society and to think in terms of complying with the rules.

And in fact, generally when we talk to our children, we say, get permission, follow the rules because we believe that so long as you're getting permission and following the rules that by definition your behavior will be considered acceptable. I'm the poster boy to show that isn't the case. People assume in business you are following the rules. That's why we have auditors and attorneys and other risk management features in our company. That's a precondition.

What most companies fail at and what we later tend to call fraud is when companies aren't necessarily breaking the rules. And make no mistake, there are companies and there are people that intentionally break the rules. But they're few and far between and they're usually caught. Where companies get into trouble is when they are following the rules but doing something that injects too much risk into their system. And that risk eventually catches up with them.

And then everyone comes back and they don't ask where you're following the rules. They ask a fundamentally different question. Was this action the action of a reasonable person under normal circumstances? And if you can't answer that question affirmatively, you're in trouble.

Will Page:

I hear it.

Richard Kramer:

I think what you're describing, if I can summarize, it's the spirit of the law versus the letter of the law. And equally it's, I think in business versus our children, it's the principal agent problem.

Andy Fastow:

Here's the problem, Richard. You have to go into the gray area, okay? That's life. That's business. You have to be in the gray area, and if you don't, you're going to be at too big of a disadvantage.

So in no way am I suggesting that companies have to only adhere to the spirit of the law What I'm suggesting is that's not practical. You're going to have to find the advantages in the gray area. But when you do, there's greater risk than your brain is seeing. And that risk is the danger.

Will Page:

We need to switch lanes because how on earth do you unpack this story in a one-hour podcast? It's mission impossible, but we're going to try. And I thought the best thing that we could try and do is to go back in time, way back in time, and just hear from you, Andy.

If I can just cut to the chase here, that job interview you had with Enron, walk us through what made you apply to work for Enron, how the interview went, what you thought you were walking into when you joined the company? I think for our audience, that's part of your story that hasn't been told is sitting there in a job interview, sending your resume. Take us back to that point in history.

Andy Fastow:

Okay, so my background. Very quickly, my background, the most important thing about me is I'm married, miraculously still, after 38 years, given everything my wife has had to endured as part of this whole process. I was in Economics and Chinese majors as an undergrad student. I got my MBA at the Northwestern University in Chicago. And then I worked for a bank, Continental Bank, which at the time was a major money center bank in the US. It's now part of, through the consolidations, part of Bank of America.

And at Continental Bank I was focused on securitization and was the junior member on a team of people that developed the first collateralized loan obligations.

Will Page:

Oh, wow.

Andy Fastow:

So that was packaging up commercial bank loans, in our case what were LBO loans basically to an asset backed vehicle and selling them. And it was a way for the bank to, in large measure, syndicate their loan portfolio very efficiently and profitably. But then we also began to do it for other banks as well.

So that was the beginning of what's now, I think, about a $1.3 trillion market in CLOs. Because of that background, I was found by a headhunter in Houston who had just been hired by Enron to find someone with exactly this background.

Now, I had never heard of Enron in 1990.

Will Page:

Wow.

Andy Fastow:

And even most people in Houston had never heard of Enron back in 1990.

Will Page:

There was no tower back then, right? There's no tower. The famous Enron tower. That hadn't been built?

Andy Fastow:

That's right. But I agreed to meet with the headhunter because my wife's family's from Houston, and so why not make the contact? But I really didn't think much of it. But I sat down with the headhunter and after 10 minutes he said, "Okay, let's walk across the street to Enron."

And my response was, "I've never heard of Enron."

He said, "Come on, let's go over and talk to them."

And I find myself sitting across the table from Jeff Skilling who had been hired recently from McKinsey to set up what essentially was described then as a trading operation, like a bank's trading operation. But instead of trading currencies or interest rates, they would be trading natural gas.

And before the interview started, I said to Jeff, I said, "Look, Jeff, you need to understand. Before this morning I've never heard of Enron. I know nothing about natural gas. I know nothing about pipelines. I know almost nothing about energy. I'm not sure why I'm here."

And he looked at me, he said, "Because that's exactly what we're looking for."

They wanted to find a guy who would be able to... He was a good salesman, right? They wanted to find a guy who'd be able to finance the acquisitions of large amounts of natural gas reserves, but it would have to be done off balance sheet. And in this case, through a securitization. And what we were doing at Continental Bank was the closest analogy to what he wanted to do at Enron.

I moved down two weeks later.

Will Page:

And it wasn't the weather?

Andy Fastow:

No. I've lived in Chicago and Houston, I'm not sure which has worse weather.

Richard Kramer:

And basically it could have been natural gas, it could have been anything. You were using that process of securitization and taking a commodity asset and figuring out a way to manage risk around it.

Andy Fastow:

Well, this new subsidiary was. My job was really very specific. Enron wanted to build a market, if you will, in natural gas. But their problem was that there were a lot of buyers, potential buyers, for long-term fixed price or what you'd call derivative contracts in natural gas. But there weren't a lot of sellers. The sellers had the natural gas, but they didn't want to enter into long-term fixed price contracts.

And that makes sense if you think about it, because companies that explore for commodities tend to be very bullish, and so they don't want to lock in the price necessarily. So Enron, in order to get the supply side of the market, they needed to acquire the natural gas.

But here was Enron's problem. It was balance sheet constrained. It was barely a Triple B company that needed to acquire billions of dollars of natural gas so they'd have both the sell side and the buy side of the market. But they couldn't do it on balance sheet. So they needed to finance it in a way that is different than the way oil and gas had been financed for a hundred years.

To me, that seemed very exciting. Oil and gas was the largest commodity market in the world. Largest asset market that had never been securitized, and I was going to be given the first shot at it.

Will Page:

So Andy, one more historical scene setting question before we get into the deeper details here. And I feel very old when I say this, a lot of our audience weren't born when Enron collapsed, which is quite a sad thing to say. In fact, there'll be students graduating from economics today who were born after the collapse of Enron. Let's feel really old. Let's get the zoomer frames out.

Can you describe for that audience just what the office floor was like back then? No cameras on phones, no social media, perhaps no mobile in the early days of your Enron career.

Can you, for that younger demographic, just tell us what it was like working in that company?

Andy Fastow:

Well, I think that you're referring to the trading floor more than anything else. And that looked very much like a bank trading floor, when in fact Enron built it from scratch. And from what I understand, by taking the best components of the trading systems and risk management systems from the major banks.

Enron worked with banks, and I remember Skilling was working with Bankers Trust at the beginning. It was a joint venture. And I think that Enron adopted or incorporated a lot of BT technology, at least from what I understand.

Richard Kramer:

One of our most popular podcasts, if you can believe this, was we had a guy named Steven Clapham who runs a business called Behind the Balance Sheet. And he helps investors understand and do forensic accounting and to try to figure out when there are strange anomalies in accounts.

But you mentioned a moment ago how a lot of what was happening at Enron was put off balance sheet. Can you explain in relatively simple jargon-free language to our generalist audience, how you can take liabilities and/or aspects in a company's books, in their balance sheet, and put them over to the side so that no one sees them? How did that work?

Andy Fastow:

Well, I'm not sure that no one sees them, but they assume a different legal form, if you will. And according to the accounting rules, which are, in some cases, very arbitrary. And remember, accounting rules don't necessarily reflect reality. They're just a set of rules.

A good example of this is operating leases. And so I apologize, I'm going to use a little jargon, but operating leases... Now, the rules changed in the last, what is it? About three years ago the rules changed?

But prior to that point in time, operating leases were off balance sheet, which meant that they didn't show up as debt on the balance sheet. They showed up in a footnote instead, as a liability or potential, a contingent liability, if you will.

Now, for all intents and purposes, operating leases were debt. But because of a legal form, they didn't show up as debt. They showed up as leases in the footnote. Now, that rule changed about three years ago. Now they show up on the balance sheet. Has reality changed? No, the rule has changed. So the financial statements look different.

And people need to keep in mind that when an auditor signs off on financial statements and they say it's a fair representation, what they are saying is that it's a fair representation. According to the rules, they are not saying it's a fair representation of reality.

And now we accept that because we have all of these debt and equity analysts who are supposed to then reverse engineer and make adjustments to the financial statements so that we get a true picture of the financial condition of the company.

So which is it? Which is reality?

Richard Kramer:

Well, so I think so another podcast we had, which was one of our most popular, again, we had Dan McCrum, the FT journalist who followed the trail of Wirecard. And what he found was the auditors there were presented these bank accounts in the Philippines and they saw the statements and they never questioned them.

Now, those accounts were falsified, but the auditors for doing their job said, well, we checked the bank account and it had this number in it, and that's fine. So I think that's another great example. Now, one other thing I'd love you to explain, because I think it was central to Enron's profit story, was the notion of mark-to-market and how you could do a transaction that would generate profit over a long period of time, but you'd recognize all the profit immediately, not over that long period of time. Can you help people understand how that came to be and is it still good in the rules today?

Andy Fastow:

Yeah. But Richard, I will answer the question about mark-to-market, but let me come back to your prior statement about Wirecard and I'd throw WorldCom and several other companies in this. And there's an important distinction to make. And again, this in no way is an excuse for what I did at Enron. What I did was wrong.

But there are two types of fraud, if you will, and we focus only on one type. And by ignoring the other type, that is where the problems arise. In the case of Wirecard, in the case of WorldCom, they just made up numbers. Made up statements. At WorldCom, I think they erased numbers and just wrote new numbers in. That's pretty black and white.

Richard Kramer:

When our kids do that, we know. When the report card comes back and your son has erased it and put something else in, you kind of know.

Andy Fastow:

In the case of Enron, I don't think anyone ever suggested anything like that was done. And it begs the question. In fact, I was asked this question in one of the depositions I gave in the lawsuits following Enron.

"Andy, you spent hundreds of millions of dollars devising these complex financial transactions, paying fees to the bankers and the attorneys and the auditors and consultants. If you wanted to commit fraud, why didn't you just do what WorldCom did? Just erase a number and put a new number in and you could have saved all that money and booked it as profit."

Will Page:

Opportunity cost right there.

Andy Fastow:

It's in that area where the danger really is. And the way the system works now is we leave it to the analysts to detect all of those things and report on that. The conflict occurs very often in the banks with the analysts.

As you probably know, almost every company has a buy rating on it. Those same analysts understand that their banks are involved in transactions to change the appearance of the financial statements of those companies. Yet you very rarely see analysts outline those maneuvers, those structured finance transactions, those accounting maneuvers by companies until it's too late. Why is that the case?

Richard Kramer:

Conflict of interest.

Andy Fastow:

But differentiate between the outright fraud, black and white fraud I should call it, where you're just faking making up numbers, creating fake bank statements versus the fraud where the company, which is a fraud still, where the company is maybe thinking that what they're doing is allowed like that loophole that your child may want to find.

Will Page:

We are going to take a quick break, then back for more with Andy Fastow. Stay tuned.

Today we continue our two-part conversation with Andy Fastow, former CFO, or Chief Loophole Officer, of Enron.

I have to share a story with you. One way that myself and Richard have prepared for the 99 podcast up until now is we go running. And Richard runs a lot faster than me, but when I can keep pace with them, I ask him, "How do I understand this crazy market that you work in?"

He's a 30-year, three straight veteran of analytical work. I'm not. And he said to me, "If you go to the back of an analyst note, you'll find an important sentence which says, this bank currently or intends to do business with the company that we're analyzing."

And he said, "You showing me that footnote and I'll tell you whether it's a buyer or sell on the front page."

Andy Fastow:

That's right. Now maybe it would be worthwhile because I used the example of operating leases before, to give you an example of a gray area transaction using an operating lease. Okay? Now, operating leases are perfectly legal if you followed the rules. And prior to a few years ago, if you followed the rules and did it correctly, all of that debt would instead show up in a footnote as a contingent liability, which is companies typically value at zero. The contingent liability.

So all of a sudden the debt just disappears. Why would companies do that in the first place? By having leverage, it allows them to lower their weighted average cost of capital, which makes them more profitable. It also allows them to access new pools of capital to expand their business. So there are a lot of good business reasons for getting that leverage and doing it off balance sheet.

So in the case of Enron, I'll give you an example from before I was CFO. Enron was acquiring a smaller pipeline for about $1 billion. Now, if Enron were to have financed that acquisition on balance sheet, it would've had to issue or borrow about $500 million of debt, but also it would've had to issue about $500 million of stock, which is dilutive. Shareholders don't like that. That would've been, in essence too expensive because of course equity is more expensive than debt.

So instead, Enron decided to use an operating lease. And again, in case people are unfamiliar with operating leases this was, until they changed the rule a few years ago, the most ubiquitous form of structured financing in the world. Just in the US alone, there is over a trillion dollars of assets, finance, in the form of an operating lease. Okay?

And again, that makes sense and is perfectly legal if you follow the rules. So in the case of Enron, it could not finance it on balance sheet. So we didn't operating lease, and these again were so common, it was literally the attorneys would press a button, the documents would pop out. It was that simple.

And to give you an idea of the economic impact of this, by doing it off balance sheet in the form of an operating lease, instead of getting 50% leverage on balance sheet, we would get 97% leverage off balance sheet.

Roughly speaking, if you put that in economic terms, that was equivalent to $50 million a year in earnings. Okay? Which flows right to EPS. Rural earnings. You're saving the money for your shareholders. And think of it as a 10-year deal. So this is a half billion dollars of real economic impact by doing the operating lease.

And we're moving ahead, we're about to close. And two days before closing, one of the attorneys who was doing due diligence found a problem. He called a meeting. He said, "We've got a big problem."

It turns out that Enron owns indirectly a tiny bit of that pipeline. Enron had invested in another company or private equity fund that had bought a participation in a little spur of the pipe. Now, under the lease operating rules, you cannot do an operating lease if you own any part of the asset. Now, having read all there is to read about Enron, you would think that we would just say, "Okay, do it anyway. Don't tell anyone."

That's not how we operated. That's what I mean by the fact that when I say we always tried to stay within the rules. But instead of that, what we did is we all got together in a room. And when I say all, what I mean is the accountants, Enron accountants, the outside auditors, Enron finance people, the lawyers, the bankers. And we started trying to figure out how do you structure around this? How do you find that loophole?

And we kept going around, but we were having a lot of trouble. And someone would make a suggestion, but the auditor would say, "No, that's a problem with FASB," whatever.

And someone else would come up with an idea and the attorney would say, "No, then I can't give you the true sale opinion."

And we were stuck. This was a disaster. I was literally getting out of my chair to go tell Skilling and Lay about this disaster. And someone in the room says, "Wait, Andy. Before you leave, I've got one more idea, but it's so crazy, I've been afraid to say it. But since we're stuck, I'll throw it out there."

He said-

Will Page:

[inaudible 00:34:30].

Andy Fastow:

... "Yeah, we've been trying to do an operating lease of the physical pipeline, but we can't do that according to the lease operating rules. How about instead of leasing the physical asset, we lease the name of the holding company that owns the asset. And in the lease agreement, we assign all the rights to use the assets of the company? If the bankers are willing to be one more step removed from the physical collateral, maybe it works."

And we all looked around the room and we're like, "Can you do that?"

Will Page:

That's part and parcel, Russian performance enhancing drugs.

Andy Fastow:

Right. Return to the Arthur Anderson partner. He said, "I don't know, I have to call headquarters."

And we turned to the lawyer, says, "I don't know, I have to do research."

Turned to the banker, he said, "I don't know. I'll talk to credit committee."

We all got back together the next morning. We turned to the Anderson partner and he said, "I talked to the guys in The Ivory Tower," that's what they called headquarter. "And they said, they can find no rule that says you cannot do this."

And we turned to the attorney, he says, "I can find no law that says you cannot do this."

And we turned to the banker. He said, "Are you kidding? This is a whole new product line for us. We're in."

So we did, what I believe was, the first operating lease of an intangible asset. So let me put it to you, Richard and Will, is that evil or genius?

Richard Kramer:

Well, it shows in the US economy, which has been financialized to the point where something like 40, 45% of the US economy is financial assets trading all the time. It's innovation.

And to, in under the letter of the law, not necessarily the spirit of the law, like you said, maybe because it's such innovation, no one thought of it yet. It's not illegal.

Andy Fastow:

That's exactly right. So you sort of said innovation, which is another word... I asked the question, evil or genius. That's a little bit of genius. But it was also a little bit of evil at the same time. It was right in that gray area.

Now, where companies get into trouble, to finish this anecdote, is that when we walked out of that room, we didn't say, "Don't tell anyone. Be quiet."

We were high-fiving, thinking we were just geniuses. No one stopped to think, is there risk associated with doing this deal? Is there a risk that someone from the outside will look in and say, "Wait a minute, we really don't think that qualifies as an operating lease," and we're going to add a billion dollars of debt back to your balance sheet, which would've caused us to lose our investment grade credit rating.

No one stopped to think about that risk because we heard the phrase, it's allowed. You're following the rules. It's legal. That's again, that's the danger area. This gray area is where the most risk is, but it's where the least amount of training for executives and directors occurs.

Richard Kramer:

And on that mark-to-market point, which I think is so important, the notion that if you do a 10-year deal and it's going to generate $50 million of profit over the 10 years, that under the accounting rules, you can book that $50 million of profit in year one on day one, and assume that it-

Andy Fastow:

It's worse than that.

Richard Kramer:

... You can get a deduction for it.

Andy Fastow:

It's worse than that, Richard. Yes, mark-to-market accounting, in my opinion, may have been a rule that was put in place for all the right reasons, but had such bad unintended consequences that it's caused a lot of corporate disasters.

I remember when I was at Enron, I had never even heard of mark-to-market accounting. I'm not an accountant by training. And I remember the day that Enron was approved to do mark-to-market accounting for natural gas contracts.

Will Page:

It's captured as a documentary.

Andy Fastow:

Yeah. And I remember it vividly because late one afternoon in a conference room, there were a bunch of people opening bottles of champagne. And so I went in and I was a little put off that I hadn't been invited. But after I got over that, I asked what's going on? And they said, "The SEC approved mark-to-market accounting."

And I went back to my office and I looked in my old accounting textbooks to try to find mark-to-market accounting, and I couldn't really find it and understand it. So I called an old friend at the bank and he explained it to me. But then I went back later on after the party had ended, and I asked Jeff Skilling. I said, "Jeff, why is this such a big deal for us?"

And his response was, "Well, yesterday I was worth $5 million. Today I'm worth $50 million," because his compensation was based off of reported earnings. And mark-to-market accounting allows you to report future earnings in the present day, whether or not those future earnings actually materialize or not.

Now, here's the problem with mark-to-market accounting, though. Mark-to-market accounting makes some intuitive sense. A lot of your listeners probably own stocks for mutual funds, right? And at the end of every day, the mutual fund will look at the price on the screen and it'll adjust the value of your portfolio. So you'll see the gain or the loss that day. That's mark-to-market accountant. They're looking at the market, finding the price, and recording a gain or a loss that day. Straightforward.

That works if there's a screen price for your commodity. It works very well. But what if there's no screen price for your commodity? So in the case of, for example, natural gas, the NYMEX only traded contracts out 18 months. So for the first 18 months, it was very easy to mark-to-market your contract. But what if you had a 10-year contract for natural gas? What do the accounting rules say?

The accounting rules say the company gets to assume what the price of natural gas will be over that entire 10 years, and then they mark their contract against that assumed curve. Who gets to come up with a curve? The company. And that leads to a lot of abuse. So anytime you see companies... People often ask me, how can we spot problems? If companies are marking to market assets in illiquid markets or in markets that don't exist, you should be looking at those earnings with a high degree of skepticism.

Will Page:

If I can just quickly jump in, Andy, I'm fond of describing tech companies as bicycles in that if they don't move forward, they fall over. And if we go from the finance of mark-to-market accounting to the economics, the incentives, surely let put Enron into becoming a bicycle.

That is, if the stock price doesn't move up, the company falls over it. It's all hinging on the stock price to cover the ground that hasn't actually been booked yet.

Andy Fastow:

Well, you used the key word there, Will. Incentive.

Will Page:

You show me the incentives now, I'll show you the outcome, is that famous expression.

Andy Fastow:

Most public companies trade as a multiple of reported earnings, okay? And people tend to mistake or assume that reported in earnings is synonymous with true economic value. And what I'm suggesting is because there's so much gray area and flexibility for companies to make up the future value of contracts, that they should not assume that reported earnings are the same as true economic value.

For example, you don't see this problem with mark-to-market accounting in privately held companies, because they're not trying necessarily to report higher earnings. Their concern with true economic value over the long term. Now, when these private companies start to go public or when they're bought by a private equity fund, often the accounting changes. Private equity funds getting ready to IPO them or flip them. So they start using aggressive mark-to-market accounting to juice earnings.

Richard Kramer:

This reminds me very much of... I've spent years looking at companies like Google and Meta and people will say about their advertising businesses, they're marking their own homework. They're telling you whether the ads were effective, but they do it in a closed system that you don't get the data from.

So I think what you're describing is a process whereby companies mark their own homework as well. Now, let me just give you one final anecdote that a billionaire investor told me about one company that you'll know very well in the naughties, which was IBM. Where the CFO would go in to see this billionaire investor who would short the stock. And the CFO would tell him, "I've already told you what the EPS will be. You don't need to know anything else."

And I think it's exactly the point you were describing, which is we'll come up with the numbers to meet the narrative. You don't need to ask the questions about how we're doing it under the hood. And of course, IBM, an icon of American business, famously had a decade of terrible under-performance and ended up getting dismembered because it was so dependent on that flawed accounting.

Andy Fastow:

Right. I think I agree with that. And I think another great example of this in the United States is General Electric. I think they've lost something close to $700 billion of market cap. Now, they were, among the non-banks, they were considered the best at financial engineering. And Jack Welch made a career out of always beating EPS by one penny. And he had the longest streak because GE had so many levers, if you will, to pull to create what I would say weren't earnings, but the appearance of earnings.

And let me give you one example that I've read about, I don't know personally, is in their turbine business, which was one of their biggest businesses and apparently one of their most profitable businesses. When the new CEO took over after Immelt, his name escapes me at the moment, he made a public statement that, "Every turbine we deliver loses money."

Now, how is that possible in one of their most profitable businesses? And it was because of the way GE was using mark-to-market accounting. They would package together a turbine with a long-term service contract. And then what they would do is they would mark-to-market the service contract. But in order to market, you have to make assumptions about what services are going to be provided over time and what the profitability of those services will be.

And what it turns out that it appears they were doing was selling the turbines at a loss, but marking these long-term services contract to market using assumptions that were unrealistic when you package them together, it looked profitable. The problem was that those assumptions in the long-term service contract didn't come true.

And so it was really showing up as an NPV positive economic activity, but it was really losing money over time. And they've had to work their way out of it.

Richard Kramer:

And you have to wonder how many bubbles we're going to see burst when companies didn't assume 18 months ago that interest rates wouldn't stay at zero forever, and we would never see wage inflation.

Andy Fastow:

Well, let's talk about Silicon Valley Bank then. Okay? Silicon Valley Bank is, believe it or not, one of the best analogies to Enron, if you're thinking of Enron like I do, which is that we may have technically followed accounting rules. But what we were presenting, the result of the transactions we were doing was massively misleading. That's fraud. I wasn't thinking of it as fraud. I should have been. That's why I say I'm responsible for Enron's demise.

Silicon Valley Bank. Look, it was one accounting decision they made. They didn't think about the risk appropriately with that accounting decision that destroyed that bank. And it all came down to this. During the period up until about a year ago when there was too much cash floating around the system, especially in Silicon Valley, Silicon Valley Bank received about $40 billion of deposits.

Basically, a bank like Silicon Valley Bank could do one of two things with those deposits, make new loans or invest it temporarily. In the case of Silicon Valley Bank, they couldn't make any more loans, so they had to invest it. I'm oversimplifying this story, but they essentially bought $40 billion of US Treasury Securities.

Now, on the surface, that sounds very conservative. Risk averse, right? It's US Treasury Securities. Putting us politics aside, those can't default, right? So it's a safe bet, right? And for the guys at Silicon Valley Bank, this was a great situation because if you were to say, just assume a 2% spread on US Treasury Securities, back then, that would've been $800 million of profit dropping to the bottom line every day.

But here's the problem. These were temporary investments. They weren't going to be held 10 years to maturity, which meant that there was interest rate risk associated with them. Obviously, interest rates in the price of a bond are inversely related. So if interest rates fall, the value of your bond rises and vice versa. If interest rates rise, your bonds will be worth less.

Now, they had to make an accounting decision. Where do you technically put these bonds for accounting purposes? The only decision that makes sense for a bank like Silicon Valley Bank is to put it in your trading portfolio, which is liquid. It's meant to be, do you need to make a new loan or depositor withdraws their money, you sell the bond, you give them the money, right? The problem is trading portfolios are subject to mark-to-market accounting, which meant that every day as interest rates fluctuated, they'd have to book gains or losses.

Now, if there's one thing public companies don't like, or I should say that Wall Street doesn't like, is earnings volatility. Unpredictable earnings volatility, okay? So there is a problem for the bank. Now, you could solve that problem very easily. You can buy an interest rate hedge. The problem is the cost of the interest rate hedge would wipe out most of that $800 million of excess profit. And they didn't want that. They wanted the 800 million of excess profit.

So instead, they followed the accounting rules, which allowed them to put these bonds in their long-term investment portfolio or hold to maturity portfolio. That portfolio is accounted for using accrual accounting, which meant that on a daily basis, you would not have to recognize gains or losses.

Now, that solves one problem. It solves the financial reporting problem. And the accountants, I'm sure, said, "That is allowed. The rules allow you to do that."

Now, the question though, the rhetorical question, is the interest rate risk really gone? No, it's not gone.

Will Page:

And it's asymmetric. It can't go down. It can only go up.

Andy Fastow:

But yeah, but the key thing here is how the brains are working of the senior people at the bank. They're thinking, if interest rates rise and the value of the bonds go down, we don't have to report it. It's an unrealized loss. No problem. If interest rates drop and the value of the bonds rise, we could sell them and book it as earnings. It's like a free option.

Here is a problem. And so they followed the rules, but they did something that made no sense. This is the Enron story. Following the rules and did something that made no sense. Now, it just took some analysts to do the math and calculate that the amount of unrealized loss in that bond portfolio was probably greater than the entire equity of the bank.

Richard Kramer:

It was.

Andy Fastow:

And as soon as people saw that, they said, "It doesn't matter what the financial statements say, we want to look at true economic reality."

And people started pulling their money out. And when they pulled their money out, you had to sell the bonds and recognize the losses. Game over. That happened faster than Enron. But it was analogous at Enron because in October of 2001, people started looking at one of the deals I had done in great detail. It had been reported and disclosed in the footnotes for years, but they focused on it and said this might be technically correct. And the postmortem showed that you can argue it was technically correct. It was in the gray area. You could have argued both ways, probably. It was technically correct, but it made no sense.

Enron, why would you do this? Why did you need to do something like this? And kind of like Warren Buffet, he has many great quotes, but one of my favorite quotes is, "There's never just one cockroach in the kitchen."

And if you find that one dead cockroach, it means there are hundreds you're not seeing behind the wall. And if a company would assess risk in that manner, take that type of risk like Silicon Valley Bank did, like Enron did, like GE did, eventually people will either see the cockroaches or assume they're there. And they'll price it in, eventually.

Will Page:

The analysts had buy notices on the analyst notes on the months, weeks, and days leading up to the collapse. All had buys. Goldman Sachs had a buy seven days before the collapse.

Andy Fastow:

And what's amazing is that, remember, these were financial transactions we were doing to change the appearance of Enron's financial conditions. Who are the counterparties in those financial transactions?

The banks. Yeah, they knew about it. No one suggests they didn't know about it, as far as I know.

Richard Kramer:

Well, for the analysts, our phrase to explain all this comes from Mark Twain, which is, "Never expect a man to understand something when his job depends on not understanding it."

So for the analyst looking at those footnotes, they are not paid to point that out. And our podcast on SVB Bank was called Damned by Duration. They simply got a massive duration mismatch and never imagined that all of their loyal clients would come to them and say, "Could we actually have our money back at some point?"

And that damned-

Andy Fastow:

No. There's an old Amish phrase that's similar that I often use is, "Much of what we see is dependent upon what we're looking for."

Will Page:

Let's take it back. We're going to turn this podcast into a two-parter. And it's been solid gold. Solid gold from the get-go. I'm keen to ask about the difference between tax evasion and tax avoidance in Part Two, because that's what you're training me to think about is the rules.

You're allowed to put your money into a tax wrapper for savings and investments, but you're not allowed to avoid paying tax. And this black, white, gray is just a fascinating theme to pick up in Part Two.

But thank you, Andy Fastow, for your time. We'll be back next week with our 101st episode to continue this conversation. Part Two of our time with Andy Fastow.

See you there.

Richard Kramer:

... If you're new to Bubble Trouble, we hope you'll follow the show wherever you listen to your podcast.

Bubble Trouble is produced by Eric Nuzum, Jesse Baker, and Julia Natt at Magnificent Noise.

You can learn more at bubbletroublepodcast.com.

Until next time, for my co-host, Will Page, I'm Richard Kramer.