Why Enron Went Bankrupt

This article in the Harvard Business Review is the most lucid explanation of Enron’s bankruptcy to date. The most stunning paragraph is this:

As the value of the assets in the SPEs became impaired, Enron faced an unpleasant choice: issue new equity as promised, thereby diluting current shareholders and causing a drop in stock price, or risk a loss of Enron’s investment-grade rating and potentially destroy the firm.

Enron’s CEO at the time, Ken Lay, decided against issuing the stock (and against living up to the financial structure created by Fastow), apparently believing that (a) dilution would cause an even greater loss of confidence than would the impairment of Enron’s balance sheet from including the SPEs and (b) the rating agencies would back down. Instead, the rating agencies downgraded Enron, the trading operations were forced out of business, $4 billion of debt was accelerated, and Enron was forced to file for bankruptcy.

Nobody’s ever said it quite like that. Quite so clearly and simply and powerfully.

What is staggering about this is that it is the exact opposite of what was publicized by pundits, newspapers and naysayers. In his analysis published in HBR, Professor Weiss explains that the “oft-maligned” SPEs actually would have saved Enron, had it not been for Lay unwinding them. Let that sink in a moment: unwinding Raptor actually caused the bankruptcy.

Quite simply, a number of Enron assets (such as the Azurix, International, and Merchant Investments HAD declined in value. Even if these assets were on-balance sheet, Enron would have had to issue a ginormous amount of equity in order to maintain the investment-grade rating. When Lay backed out of his pledge to do so, it was game over with the agencies.

The argument to date has been a total non-sequitor: Enron went bankrupt because it was being forced to issue equity. That’s like saying a sick patient died because he was being forced to take life-saving medicine. The issuance of new equity was the life-saving medicine. It pains me to say that Ken Lay and Greg Whalley took the medicine away.

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