Bear Stearns' Subprime IPO

Everquest Financial is going public with risky mortgage bets purchased from its underwriter’s hedge funds

by Matthew Goldstein

Never underestimate the ability of a Wall Street investment firm to find a new way to pawn off risky assets onto retail investors. The latest example? The initial public offering for Everquest Financial.

Everquest is a fledgling financial-services company that has been buying up equity interests in risky bonds backed by subprime mortgages from hedge funds managed by Bear Stearns (BSC)—one of Wall Street's biggest underwriters of mortgage-backed securities and other exotic mortgage-related bonds. The deal appears to be an unprecedented attempt by a Wall Street house to dump its mortgage bets.

The sales pitch for the IPO, which Bear Stearns is also underwriting, is that Everquest will "provide attractive risk-adjusted returns" to shareholders by investing in collateralized debt obligations (CDOs)—a sophisticated bond that's made up of pieces of lots of other asset-backed bonds. The nine-month-old company expects to produce reliable earnings from the quarterly cash flows generated by the underlying "financial assets" in the 19 CDOs it either owns outright or has a majority equity interest in. Everquest's portfolio of CDOs is valued at about $720 million, of which nearly two-thirds were purchased last fall from hedge funds managed by Bear Stearns Asset Management, a subsidiary of the Wall Street firm.

But Everquest's portfolio could be a time bomb. A "substantial majority" of the CDOs are backed by mortgages to home buyers with risky credit histories, according to its filing with the Securities & Exchange Commission.

Trouble is, the subprime market has imploded this year with scores of home lenders going out of business and home foreclosures on the rise. There's fear on Wall Street that pain in the subprime housing market will undermine some of the bonds and CDOs backed by these mortgages—especially as the level of home loan defaults rises.

The Everquest filing notes this possibility, saying: "Subprime mortgages have experienced increased default rates in recent periods. A deterioration in the assets collateralizing the asset-backed securities held by our CDOs could negatively affect the cash flows."

No Arm's Length Transaction

The prospectus for every IPO contains a lengthy section entitled "risk factors." The purpose of this section is to make it difficult for investors to sue a company. It alerts them to all the things that could go wrong with a company's business model. Often much of what appears in the "risk factors" section is boilerplate stuff about the perils of operating in a competitive market, or a company's slim operating history.

But the risk factors section of the Everquest IPO—spread out over 21 pages—would give even the most high-stakes gambler reason to pause. That's especially so in light of the close relationship between Everquest and Bear Stearns.

The filing notes that most of the CDOs were bought from hedge funds managed by Bear Stearns and based on valuations established, in part, by Bear Stearns. The filing concedes that the transaction, in which Bear Stearns hedge funds received 16 million shares in the soon-to-be public company and $149 million in cash, was "not negotiated at arm's length."

That's not to say Everquest got a raw deal in buying up these CDOs from Bear Stearns. But the lack of a give-and-take negotiating process in assembling Everquest's investment portfolio is an indication of just how beholden the company is to the interests of Bear Stearns.

In fact, Everquest, which is based in New York but incorporated in the Cayman Islands, intends to operate with a minimum of employees. Other than an independently hired chief financial officer, Everquest mainly will rely on employees from Bear Stearns Asset Management to oversee the business.

Some Proceeds Will Pay Down Debt

Also running the show will be employees from Stone Tower Capital, a partner in the venture. Ralph Cioffi, a Bear Stearns senior managing director, will serve as co-chief executive, along with Michael Levitt, chairman of Stone Tower, a New York hedge fund. In fact, Everquest and Stone Tower have the same mailing address on West 57th Street in Manhattan.

Everquest also has a $200 million line of credit from Citigroup (C), from which it borrowed to pay for some of the CDO purchases. Some of the proceeds from the IPO will be used to pay down the line of credit.

The company isn't saying how many shares will be sold in the offering or who will do the selling. Presumably, some of the 16 million shares obtained by the Bear Stearns hedge fund will be included in the deal. Additionally, Bear Stearns itself purchased 1 million shares. The stock has yet to price.

Janet Tavakoli, a Chicago financial consultant who specializes in advising clients on asset-backed investments, isn't impressed with the Everquest offering. "There is a huge moral hazard with Bear providing the assumptions for valuing the CDO equity," says Tavakoli. "Bear Stearns Asset Management is very good at surveillance, so if it is trying to get CDO equity off of its balance sheet, incur the costs of securitization, and sell the risk without arm's length valuation, why would a customer want to buy it on that basis?" Bear Stearns declined to comment for this story.

The Everquest filing could be just the start of things to come for the CDO market, which has grown exponentially in recent years, largely because of the demand for bonds backed by mortgages. Last year about $158 billion in CDOs were sold, up from just $14 billion in 1996. In April, Highland Financial Partners, a CDO manager, filed for an IPO. If Bear Stearns can find buyers for Everquest shares, it's likely that other Wall Street banks with big exposure to the subprime market may follow its lead.

Matthew Goldstein is an associate editor at BusinessWeek, covering hedge funds and finance.

SocGen Sinks on Stock Issue, Writedown

The bank's Feb. 11 announcement reveals another drop thanks to the rogue trading scandal and subprime-related losses

by Carol Matlack

Société Générale's already-battered shares fell more than 4% in Paris trading on Feb. 11, to €74.59 ($108.22) a share, after the bank announced a heavily discounted $8 billion capital increase to help offset losses from a rogue trading scandal and bad U.S. real estate investments. SocGen (SOGN) shares have fallen nearly 50% over the past year but had risen slightly since the scandal was disclosed Jan. 24 on speculation the bank could be a takeover target.

"We offered attractive terms in a volatile market," SocGen Chief Financial Officer Frédéric Oudea said in a conference call, explaining why existing stockholders will be able to buy additional shares for €47.50 ($68.91), a 39% discount on the Feb 8 closing price. Outside investors will have to buy additional dividend rights that would raise the cost to €71 ($103) per share, the bank said.

Also on Feb. 11, SocGen disclosed it suffered an additional $871 million in losses related to the U.S. real estate market, on top of $2.9 billion in subprime-related losses disclosed earlier this year. Among European banks, SocGen now ranks second in its subprime exposure, behind UBS (UBS)—though the Swiss bank's losses of $18 billion are much higher (BusinessWeek.com, 1/30/08).

SocGen won't release official 2007 results until Feb. 21, but it is forecasting net earnings of $1.3 billion, down from nearly $7.8 billion in 2006.

Tightening Oversight of Traders

During the conference call, Oudea and Jean-Pierre Mustier, head of SocGen's investment banking unit, declined to discuss the latest twist in the investigation of rogue trader Jérôme Kerviel, focusing on the possible involvement (BusinessWeek.com, 2/8/08) of an employee of SocGen's futures brokerage Newedge, known until recently as Fimat. Police questioned the employee, Moussa Bakir, over the weekend, but released him from custody.

However, Mustier outlined steps SocGen has taken to tighten oversight of its trading operations, including daily reconciliation of traders' positions and an ironclad requirement that all traders must take at least 15 days' annual vacation. The 15-day rule was already in effect, but "an exception was made" for Kerviel, who told investigators he took only four days off during 2007.

Matlack is BusinessWeek's Paris bureau chi

SocGen Pounded on Losses and Revelations

The bank's record fourth-quarter loss and fresh questions about its internal controls increase pressure for a management shakeup

by Carol Matlack

Société Générale's (SOGN.PA) share price took another hammering on Feb. 21, falling nearly 9% in Paris trading as it reported a record $4.9 billion fourth-quarter loss from rogue trading and U.S. subprime write-offs. Even as the big French bank launched an $8 billion capital increase to regain its financial footing, a new investigation report raised fresh questions about its failure to act on warnings about Jérôme Kerviel, whose unauthorized trades cost the bank more than $7.1 billion.

Late on Feb. 20 a committee appointed by SocGen's board released the most-detailed—and the most damning—accounting so far of the rogue trading scandal. According to its preliminary report, the bank's internal control system generated 75 alerts about questionable trades by Kerviel, starting in 2006.

Bank controllers responded to each of the alerts, but rather than making detailed inquiries they accepted false documents and explanations that Kerviel provided, "even when these lacked plausibility," the report said. Nor did the controllers notify their superiors, even when they received alerts about transactions that greatly exceeded the sums that Kerviel was authorized to trade.

Systemic Flaw

The report also noted a key flaw in SocGen's control system that allowed Kerviel to cover his unauthorized trades by creating fictitious offsetting trades: Rather than tracking each trade individually, the system merely recorded the balance shown on Kerviel's books.

That weakness, and the lack of "initiative" by bank staff, allowed Kerviel to carry out rogue trades for nearly three years, starting in 2005, the report said. While the sums involved in the early trades were relatively modest, by mid-2007 he was betting tens of billions of euros.

Confirming Kerviel's earlier statements to prosecutors, the preliminary report found that he acted alone, and that he did not make any personal financial gain on the trades. Those findings confirm "the principal characteristics of the fraud as we reported it," SocGen CEO Daniel Bouton said in a conference call with reporters on Feb. 21, as the bank announced 2007 earnings.

$8 Billion Share Sale

Reporting that 2007 profits plunged to $1.39 billion from $7.67 billion the previous year, SocGen said it would slash its dividend from $7.64 to $1.32. The numbers were in line with forecasts that the bank provided earlier in February. Without the Kerviel losses, SocGen said it would have earned $6.13 billion for the full year.

The latest disclosures on SocGen's lax internal controls are likely to increase pressure for a management shakeup. Several executives in the division where Kerviel worked have been removed from their jobs, and Bouton offered his resignation when Kerviel's trading losses came to light in late January. But the board asked him to remain as the bank prepared its $8 billion share sale.

From Feb. 21-29, SocGen investors will be able to purchase additional shares at €47.50 ($69.83), about 27% below the current price of €65. Outside investors would have to buy additional rights that would push their cost above $100 per share—a provision intended to defend against a possible hostile takeover. But if SocGen shares keep sliding, it could still fall prey to, most likely, a French rival such as BNP Paribas (BNPP.PA).

Matlack is BusinessWeek's Paris bureau chief .

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Five Lessons of the WorldCom Debacle

The moral of Bernie Ebbers' rise and fall is simple and sobering: If something seems too good to be true, it probably is

The rise and fall of WorldCom founder Bernard Ebbers likely will be studied for years to come. Certainly, Ebbers' Mar. 15 conviction on nine counts of fraud, conspiracy, and filing false documents marked a major victory in the government's war on white-collar corruption (see BW Online 3/16/05, "Ebbers: Giant Fraud, Simple Conclusion").

Ebbers' "I-knew-nothing-about-the-books" defense failed to persuade the jury. "This is absolutely going to raise the level of expectation that CEOs should know everything that's going on inside their companies, because they will be held responsible for it," says Dan Reingold, a former telecom analyst with Credit Suisse First Boston.

WorldCom's collapse already has had a profound impact on the business climate in the U.S. It was one of the major reasons lawmakers passed the Sarbanes-Oxley Act, which requires companies to share more information with investors, says Reingold, who witnessed the trial and plans to publish a book on it later this year.

But WorldCom was more than just a tale of lax accounting principles or substandard reporting requirements. Some important lessons can be gleaned from the testimony in the trial for investors, B-school students, and aspiring execs alike. Here are five:

Beware of companies with cult-like corporate cultures.
From the start, telecom upstart WorldCom functioned more like a tribe than a business. Its operations centered around a charismatic leader, the imposing former basketball coach Ebbers. If Ebbers was the oracle, Chief Financial Officer Scott Sullivan was his high priest. Together, they exercised unquestioned authority and demanded unquestioned loyalty from employees.

Both men imbued WorldCom shares with enormous symbolism. Each employee received a grant of stock, a form of initiation into the tribe. But the culture created by Ebbers and Sullivan prevented them from selling the stock, lest the employees be ostracized from the group, according to testimony at the trial.

This closed culture turned out to be dangerous. The jury found that Ebbers and Sullivan compelled their subordinates to cook the financial books to protect their sacrosanct stock. Subordinates said they simply concluded that the accounting manipulations must be legitimate, because their infallible leadership had approved them. And the penalty for challenging their authority was excommunication. That allowed the blatant fraud to go on for seven quarters, with the participation of at least a half-dozen key executives.

In truth, WorldCom wasn't solely to blame for this situation. Investors, analysts, and the media also bought into its corporate mindset. Some viewed it as heroic. Everyone lost sight of a simple, mundane reality: It was a publicly traded company, just like any other.

Beware of too much corporate reliance on Washington.
WorldCom, like many telecom companies, spent an enormous amount of time and energy lobbying regulators and elected officials. The telecom boom led by WorldCom was driven mostly by the government-ordered breakup of AT&T (T ) in 1984 and the Telecom Act of 1996. As an upstart, WorldCom benefited from rules that helped it compete. But when the rules unexpectedly changed, it found itself in trouble, ultimately pulling out of the consumer market.

Investors should be very wary of industries that have high exposure to government policy, which can shift as quickly as the political winds. The climate becomes even more treacherous when the government tries to pick winners and losers. As an industry, telecom has long favored big companies that can distribute fixed costs over a huge base of customers. But with telecom reform, federal policymakers tried to nurture a vision of open competition that ultimately didn't make economic sense. Too many poorly funded rivals were encouraged to enter the market. That led to overcapacity -- and financial disaster for some.

Beware of companies that rely too heavily on mergers and acquisitions.
There's no question that M&A is a legitimate means of growth for many companies. But when a corporation like WorldCom, which did nearly 70 deals in less than five years, bases its business plan on acquiring even more companies, that's a flashing yellow light. It's a strong signal that the other engines of growth, such as product development, sales, and marketing, aren't very strong.

If the M&A machine stallS, as WorldCom's did, the company could wind up in real trouble. And the accounting surrounding M&A activity raises other risks, because it's very hard to compare the performance of ongoing operations from one quarter to the next -- the surest metric of corporate health. Plus, the constant write-offs of good will, which reflects the premium that an acquiring company pays on a purchase, distorts quarterly earnings and can lead to confusion.

The hares need as much watching as the tortoises. Everyone loves an amazing success story. But just as investors are usually wary of the worst-performing company in a group, they ought to approach the biggest winners with caution, too. Certainly, examples are plentiful of companies that dramatically raced ahead of their rivals thanks to legitimate means, such as introducing new products or exercising more astute management. But investors must remember that companies in a specific sector -- in this case, telecom -- are generally subject to the same rules and market conditions.

When a company like WorldCom, which promised inordinate revenue growth and enjoyed some of the best stock returns of any company, comes along, investors, analysts, and journalists must demand a rigorous explanation of the exceptional results. Sometimes they turn out to rest on a shaky foundation. Enron boasted of outperforming its rivals in dramatic ways, too.

Beware of close personal ties between management and the board.
Most of WorldCom's directors had been with the company for years. Many of them invested in the company at the founding, or led companies that WorldCom acquired. All of them received significant amounts of stock and in some cases enjoyed perks like the use of corporate jets.

Yes, their share values dropped, too, like everyone else's, when WorldCom hit the skids, and there's no suggestion that any were aware of fraud. Still, close ties didn't help the board when it came to asking tough questions about the company's accounting, or probing the wisdom of Ebbers' strategy, or offering hundreds of millions of dollars in loans to Ebbers, their benefactor and CEO.

The biggest lesson.
The most haunting of them all, it's the image of Ebbers sitting in that old Manhattan courtroom, stoically contemplating his fate before the jury returned its verdict. It's no place any CEO would ever want to be.

The Fall of Enron

How ex-CEO Jeff Skilling's strategy grew so complex that even his boss couldn't get a handle on it

To former Enron (ENE ) CEO Jeffrey K. Skilling, there were two kinds of people in the world: those who got it and those who didn't. "It" was Enron's complex strategy for minting rich profits and returns from a trading and risk-management business built essentially on assets owned by others. Vertically integrated behemoths like ExxonMobil Corp. (XOM ), whose balance sheet was rich with oil reserves, gas stations, and other assets, were dinosaurs to a contemptuous Skilling. "In the old days, people worked for the assets," Skilling mused in an interview last January. "We've turned it around--what we've said is the assets work for the people."

But who looks like Tyrannosaurus Rex now? As Enron Corp. struggles to salvage something from the nation's largest bankruptcy case, filed on Dec. 2, it's clear that the real Enron was a far cry from the nimble "asset light" market maker that Skilling proclaimed. And the financial maneuvering and off-balance-sheet partnerships that he and ex-Chief Financial Officer Andrew S. Fastow perfected to remove everything from telecom fiber to water companies from Enron's debt-heavy balance sheet helped spark the company's implosion. "Jeff's theory was assets were bad, intellectual capital was good," says one former senior executive. Employees readily embraced the rhetoric, the executive says, but they "didn't understand how it was funded."

Neither did many others. Bankers, stock analysts, auditors, and Enron's own board failed to comprehend the risks in this heavily leveraged trading giant. Enron's bankruptcy filings show $13.1 billion in debt for the parent company and an additional $18.1 billion for affiliates. But that doesn't include at least $20 billion more estimated to exist off the balance sheet. Kenneth L. Lay, 59, who had nurtured Skilling, 48, as his successor, sparked the first wave of panic when he revealed in an Oct. 16 conference call with analysts that deals involving partnerships run by his CFO would knock $1.2 billion off shareholder equity. Lay, who had been out of day-to-day management for years, was never able to clearly explain how the partnerships worked or why anyone shouldn't assume the worst--that they were set up to hide Enron's problems, inflate earnings, and personally benefit the executives who managed some of them.

That uncertainty ultimately scuttled Enron's best hope for a rescue: its deal to be acquired by its smaller but healthier rival, Dynegy Inc. (DYN ) Now Enron is frantically seeking a rock-solid banking partner to help maintain some shred of its once-mighty trading empire. Already, 4,000 Enron workers in Houston have lost their jobs. And hundreds of creditors, from banks to telecoms to construction companies, are trying to recover part of the billions they're owed.

From the beginning, Lay had a vision for Enron that went far beyond that of a traditional energy company. When Lay formed Enron from the merger of two pipeline companies in 1985, he understood that deregulation of the business would offer vast new opportunities. To exploit them, he turned to Skilling, then a McKinsey & Co. consultant. Skilling was the chief nuts-and-bolts-operator from 1997 until his departure last summer, and the architect of an increasingly byzantine financial structure. After he abruptly quit in August, citing personal reasons, and his right-hand financier Fastow was ousted Oct. 24, there was no one left to explain it.

Much of the blame for Enron's collapse has focused on the partnerships, but the seeds of its destruction were planted well before the October surprises. According to former insiders and other sources close to Enron, it was already on shaky financial ground from a slew of bad investments, including overseas projects ranging from a water business in England to a power distributor in Brazil. "You make enough billion-dollar mistakes, and they add up," says one source close to Enron's top executives. In June, Standard & Poor's analysts put the company on notice that its underperforming international assets were of growing concern. But S&P, which like BusinessWeek is a unit of The McGraw-Hill companies, ultimately reaffirmed the credit ratings, based on Enron's apparent willingness to sell assets and take other steps.

Behind all the analyses of Enron was the assumption that the core energy business was thriving. It was still growing rapidly, but margins were inevitably coming down as the market matured. "Once that growth slowed, any weakness would start becoming more apparent," says Standard & Poor's Corp. director Todd A. Shipman. "They were not the best at watching their cost." Indeed, the tight risk controls that seemed to work well in the trading business apparently didn't apply to other parts of the company.

Skilling's answer to growing competition in energy trading was to push Enron's innovative techniques into new arenas, everything from broadband to metals, steel, and even advertising time and space. Skilling knew he had to find a way to finance his big growth plans and manage the international problems without killing the company's critical investment-grade credit rating. Without a clever solution, trading partners would flee, or the cost of doing deals would become insurmountable.

"HE'S HEARTBROKEN." No one ever disputed that Skilling was clever. The Pittsburgh-born son of a sales manager for an Illinois valve company, he took over as production director at a startup Aurora (Ill.) TV station at age 13 when an older staffer quit and he was the only one who knew how to operate the equipment. Skilling landed a full-tuition scholarship to Southern Methodist University in Dallas to study engineering, but quickly changed to business. After graduation, he went to work for a Houston bank. The bank later went bust while Skilling was at Harvard Business School. Skilling said that fiasco made him determined to keep strict risk controls on Enron's trading business. He once told BusinessWeek that "I've never not been successful in business or work, ever." Skilling now declines to comment, but his brother Tom, a Chicago TV weatherman, says of him: "He's heartbroken over what's going on there.... We were not raised to look on these kinds of things absent emotion."

Enron's "intellectual capital" was Skilling's pride and joy. He recruited more than 250 newly minted MBAs each year from the nation's top business schools. Meteorologists and PhDs in math and economics helped analyze and model the vast amounts of data that Enron used in its trading operations. A forced ranking system weeded out the poor performers. "It was as competitive internally as it was externally," says one former executive.

It was no surprise then that Skilling would turn to a bright young finance wizard, Fastow, to help him find capital for his rapidly expanding empire. Boasting an MBA from Northwestern University, Fastow was recruited to Enron in 1990 from Continental Bank, where he worked on leveraged buyouts. Articulate, handsome, and mature beyond his years, he became Enron's CFO at age 36. In October, 1999, he earned CFO Magazine's CFO Excellence Award for Capital Structure Management. An effusive Skilling crowed to the magazine: "We didn't want someone stuck in the past, since the industry of yesterday is no longer. Andy has the intelligence and the youthful exuberance to think in new ways."

But Skilling's fondness for the buttoned-down Fastow was not widely shared. Many colleagues considered him a prickly, even vindictive man, prone to attacking those he didn't like in Enron's group performance reviews. Fastow, through his attorney, declined to comment for this story. When he formed and took a personal stake in the LJM partnerships that blew up in October, the conflict of interest inherent in those deals only added to his colleagues' distaste for him. Enron admits Fastow earned more than $30 million from the partnerships. The Enron CFO wasn't any more popular on Wall Street, where investment bankers bristled at the finance group's "we're smarter than you guys" attitude. Indeed, that came back to haunt Enron when it needed capital commitments to stem the liquidity crisis. "It's the sort of organization about which people said, `Screw them. We don't really owe them anything,"' says one investment banker.

While LJM--and Fastow's direct personal involvement and enrichment--shocked many, the deal was just the latest version of a financing strategy that Skilling and Fastow had used to good effect many times since the mid-'90s to fund investments with private equity while keeping assets and debt off the balance sheet. Keeping the debt off Enron's books depended on a steady or rising stock price and an investment- grade credit rating. "They were put together with good intentions to offset some risk," says S&P analyst Ron M. Barone. "It's conceivable that it got away from them."

Did it ever. The off-balance-sheet structures grew increasingly complex and risky, according to insiders and others who have studied the deals. Some, with names like Osprey, Whitewing, and Marlin, were revealed in Enron's financial filings and even rated by the big credit-rating agencies. But almost no one seemed to have a clear picture of Enron's total debt, what triggers might hasten repayment, or how some of the deals could dilute shareholder equity. "No one ever sat down and added up how many liabilities would come due if this company got downgraded," says one lender involved with Enron. Many investors were unaware of provisions in some deals that could essentially dump the debts back on Enron. In some cases, if Enron's stock fell below a certain price and the credit rating dropped below investment grade--once unimaginable--nearly $4 billion in partnership debt would have to be covered by Enron. At the same time, the value of the assets in many of these partnerships was dropping, making it even harder for Enron to cover the debt.

HIGH HOPES. Skilling tried to accelerate the sale of international assets after becoming chief operating officer in 1997, but the efforts were arduous and time-consuming. Even as tech stocks melted down, Skilling was determined not to scale back his grandiose broadband trading dreams or the resulting price-to-earnings multiple of almost 60 that they helped create for Enron's stock. At its peak in August, 2000, about a third of the stock's $90 price was attributable to expectations for growth of broadband trading, executives estimate.

That rapidly rising stock price--up 55% in '99 and 87% in 2000--gave Skilling and Fastow a hot currency for luring investors into their off-balance-sheet deals. They quickly became dependent on such deals to finance their expansion efforts. "It was like crack," says a company insider. Trouble is, Enron's stock came tumbling back to earth when market valuations fell this year. By April, its price had fallen to about 55. And its far-flung operational troubles were taking their own toll. In its much-hyped broadband business, for instance, a capacity glut and financial meltdown made it hard to find creditworthy counterparties for trading. And after spending some $1.2 billion to build and operate a fiber-optic network, Enron found itself with an asset whose value was rapidly deteriorating. Even last year, company executives could see the need to cut back an operation that had 1,700 employees and a cash burn rate of $700 million a year.

"SOMETHING TO PROVE." And the international problems weren't going away. Enron's 65% stake in the $3 billion Dabhol power plant in India was mired in a dispute with its largest customer, which refused to pay for electricity. Some Indian politicians have despised the deal for years, claiming that cunning and even corrupt Enron executives cut a deal that charged India too much for its power.

Enron's ill-fated 1998 investment in the water-services business was another drag on earnings. Many saw the purchase of Wessex Water in England as a "consolation prize" for Rebecca P. Mark, the hard-charging Enron executive who had negotiated the Dabhol deal and other investments around the world. With Skilling having won out as Lay's clear heir apparent, top executives wanted to move her out of the way, say former insiders. A narrowly split board approved the Wessex deal, which formed the core of Azurix Corp., to be run by Mark. But Enron was blindsided by British regulators who slashed the rates the utility could charge. Meanwhile, Mark piled on more high-priced water assets. "Once [Skilling] put her there, he let her go wild," says a former executive. "And she's going to go wild because she has something to prove." Mark spent too much on a water concession in Brazil and ran into political obstacles. She declined to comment for this story.

But if Azurix was a prime example of Enron's sketchy investment strategy, it also demonstrated how the company tried to disguise its problems with financial alchemy. To set up the company, Enron formed a partnership called the Atlantic Water Trust, in which it held a 50% stake. That kept Wessex off Enron's balance sheet. Enron's partner in the joint venture was Marlin Water Trust, which consisted of institutional investors. To help attract them, Enron promised to back up the debt with its own stock if necessary. But if Enron's credit rating fell below investment grade and the stock fell below a certain point, Enron could be on the hook for the partnership's $915 million in debt.

The end for Enron came when its murky finances and less-than-forthright disclosures spooked investors and Dynegy. The clincher came when Dynegy's bankers spent hours sifting through a supposedly final draft of Enron's about-to-be-released 10Q--only to discover two pages of damning new numbers when the quarterly statement was made publicly available. Debt coming due in the fourth quarter had leapt from under $1 billion to $2.8 billion. Even worse, cash on hand--to which Dynegy had recently contributed $1.5 billion--shrunk from $3 billion to $1.2 billion. Dynegy "had a two-hour meeting with the new treasurer of Enron, who had been in that seat for two weeks," said a source close to the deal. "He had no clue where the numbers came from."

RESPECT FOR ASSETS. Skilling and Fastow face most of the wrath of reeling employees. "Someone told me yesterday if they see Jeff Skilling on the street, they would scratch out his eyes," says a former executive. One of Fastow's lawyers, David B. Gerger, says his client has been the subject of death threats and anti-Semitic tirades in Internet chat rooms. "Naturally people look for scapegoats, but it would be wrong to scapegoat Mr. Fastow," says Gerger.

He confirms that Fastow has hired a big gun to handle his civil litigation: David Boies's firm, which represented the Justice Dept. in its suit against Microsoft Corp. On Dec. 5, Milberg Weiss Bershad Hynes & Lerach filed a suit against Fastow, Skilling, and 27 other Enron executives, saying they illegally made more than $1 billion off stock sales before Enron tanked. And a source at the Securities & Exchange Commission says four U.S. Attorney Offices are considering whether to pursue criminal charges against Enron and its officers.

Would the cash squeeze have caught up to Enron, even without Skilling's and Fastow's fancy financing? Credit analysts still argue that the debt would have been manageable, absent the crisis of confidence that dried up Enron's trading business and access to the capital markets. But even they have a new respect for old-fashioned, high-quality assets. "When things get really tough, hard assets are the kind you can depend upon," says S&P's Shipman. That's something Enron's whiz-kid financiers failed to appreciate.

By Wendy Zellner and Stephanie Anderson Forest in Dallas with Emily Thornton, Peter Coy, Heather Timmons, Louis Lavelle, and David Henry in New York, and bureau reports

Enron and Information Age Disclosure

In the New Economy, more companies are being built on soft assets, and that makes trustworthy financial reporting all the more critical

The downfall of Enron Corp. has occasioned a chorus of "we-told-you-so" from the self-proclaimed fuddy-duddies of the business world. They say Enron tumbled so quickly because it lacked enough hard assets, and that its $60 billion-plus market value was built in the clouds -- on brands, intellectual capital, transactional networks, and other tricky-to-measure stuff that will be difficult for creditors to get a piece of in bankruptcy court. In their view, real assets are the Industrial Era things that remain useful and valuable even if the company that owns them goes belly-up -- airplanes, coal deposits, steel-rolling machines, and the like.

This nostalgic view is understandably popular in the aftermath of the biggest bankruptcy in U.S. history. But it misunderstands the problems of Enron as well as the ongoing transformation of Corporate America. Like it or not, the era of hard assets' supremacy is over -- for good. Instead of fighting the transition to an economy of ideas and information, we need to figure out how to build in safeguards against more New Economy flameouts like Enron's. And the key to preventing such disasters is detailed, understandable information about how a company works, instead of razzle-dazzle press releases masquerading as disclosure (see BW Cover Story, 12/17/01, "The Fall of Enron").

OLD-FASHIONED TROUBLE. Start by taking another look at what went wrong at Enron. Ironically, it wasn't its New Economy side that triggered the downward spiral. The soft assets at Enron, especially the energy-trading business, were doing just fine, even if most of us couldn't begin to understand the derivatives transactions they specialized in. The trouble at Enron started the old-fashioned way, with dumb investments in hard assets like power plants and a fiber-optic network.

Enron's financial wizards appear to have used accounting sleight-of-hand to hide their mistakes. When those errors came to light, Enron's credit rating tumbled. That proved fatal to the trading operation, which can't survive unless people doing business with it are confident they'll be able to collect their money. In short, the Old Economy part of Enron infected the New Economy part, not vice versa.

Critics of the New Economy do have one thing right, though: Soft assets are far more vulnerable to destruction than hard assets. Take the Enron name, which the company proudly plastered on its business units and Houston's baseball stadium. Whatever marquee value the Enron name once had is gone. Or take the trading operation itself. Because of a crisis of confidence, it went from being the nation's dominant energy-trading platform to virtually nothing in a matter of weeks.

CONFIDENCE IS KEY. That's what used to happen to banks on a regular basis before federal deposit insurance: Even if Depositor A was confident of a bank's soundness, she might still pull out her money if she thought Depositors B and C were about to yank their money. No bank in the world keeps enough cash on hand to pay off its depositors if they all want their money at once. Ditto for Enron's trading operation, where counterparties' fears about its creditworthiness rapidly became a self-fulfilling prophecy.

What can be done to protect employees, investors, and the economy from a repeat of the Enron disaster? It's a crucial question for the New Economy, in which more and more companies are built on perishable intellectual assets. Government insurance isn't really the answer. Companies would be tempted to take all manner of foolish risks, knowing that the government would bail them out -- and the costs would be enormous.

Actually, investors themselves can help prevent another Enron, as can regulators and Wall Street. For far too long, investors, research analysts, and credit-rating agencies took Enron at its word, pushing the stock higher and higher without much information on what was behind the company's spectacular performance, which in hindsight was not so spectacular at all. When a New Economy company is wowing everyone with its results, it can be easy to forget that no one except management knows exactly how those results are being produced.

A few harder questions early on in the Enron debacle might have provided a warning that the company was jeopardizing key assets. With more prodding, Enron might have been forced to disclose its accounting gimmickry much earlier, preventing billions of dollars in losses.

LATE CRUSADE. It's all too easy now to see now that at Enron, problems festered until it was too late. Joe Berardino, the managing partner of Arthur Andersen, wrote a long piece in The Wall Street Journal on Dec. 4 calling for accounting reforms in the wake of the Enron debacle. It so happens that Andersen got paid $52 million last year as Enron's accountant and adviser, and gave it a clean bill of health. So his crusade seems to come a bit after the fact. But Berardino's message is correct: If companies' books can't be trusted, many more will blow up.

That would be unfortunate, because Information Age companies like Enron are worth far more intact than in salvage. To keep them from blowing up, let's strengthen our disclosure rules so that these companies don't get overinflated in the first place.

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