That human nature example is why we should also spend a little time on trading controls.

To manage emotion, I do touch on these as they are important and thankfully, for my human nature sake, when I traded we had implemented a strong mark-to-market program that was completely void of my input, or others including our President. As I have mentioned, I traded in nearly every energy product in our portfolio to manage correlation risk and to trade long-term economic spreads.

Some of these markets were illiquid – i.e. there were no forward physical Polyethylene forward curves save Enron-Online, and that lasted about two years before they went bankrupt. And, there were many industry pundits who had projects to bring liquidity to chemicals who also failed. Even today, in 2016, the liquidity to trade chemical physical and paper is still limited, not as liquid as when Enron, et al, were trading chemicals.

We had multi-year positions, and how were we going to mark-to-market those?

We decided my first year to craft an approach. It had three tiers to it:

• Exchange – The most liquid
• OTC – Discernable through Platt’s, OPIS, Brokers, et al….
• Industry Pundit Forecasters – Small and large companies

 

We crafted and got approved an EWMA (Exponential Weighted Moving Average) process that was blessed all throughout the company to the executive and board level, and we never changed for the six years I was there.

Yes, it was rather interesting that subsequently FASB 157 mirrored that approach. Whether it was the trading experience and/or a combination of being a CPA that we crafted this mirroring approach was completely coincidental. No, we didn’t submit our program like Enron did to get FASB to bless it – LOL.

I was very glad we had it, too, as it removed the human emotion, the pressure I felt to deliver profits. Being on the trading side, I can attest to it bringing a different perspective. A perspective that you will want to test. And, there were two occasions it was tested beyond the Fashion Guru I mentioned earlier.

One idea my first year that was being pushed was that we engage in off-balance sheet financing deals just like Enron was doing. Everyone was following Enron, and if you were around then, one of the major magazines said Enron was the most visionary company on the planet for four straight years. It’s like Apple today, for a comparison, but Apple is loaded to gills with cash unlike Enron ever was, including when I was there in 1994.

Therefore, everyone wanted to do Enron-like things, not knowing what Enron was up to. Since I was at Enron, I knew it wasn’t good. Nevertheless, our group got onto this thought that we should do some off-balance sheet financing. At the time, you only had to put up 3% equity to get the off-balance sheet treatment. Forget we were a mega big oil company with a great credit rating. Our group was an experiment of sorts early on and we wanted to show our stuff from every angle, which 90% of the time was great stuff.

But, we couldn’t stop discussing this off-balance sheet financing. I finally, one day, pulled the President aside, still in my first year trying to feel my way around this behemoth, old-school system. And, I said that I should tell you this won’t end well.

I should tell you about my story at Enron working on these. I rarely, if ever, shared prior company issues or opportunities. Using that approach with a new company or new client, that we did this or that at another company, never goes well. But, this time I had to play the card to simmer this down.

I said that I have witnessed these deals and they are not what they seem. I said, we can do this, but it will cost us double digit percentage points, even with our stellar credit rating. I confessed to knowing of Enron’s early tranches of these for reasons that were obviously not public nor well understood, even after Enron succumb to its greed.

The 2^nd annual tranche Enron did, in 1994, when I was there, was interesting and I feel compelled to share. Enron still owned EOG, which is thankfully still around today, doing well. They were spun off and finally eluded the rest of Enron when Mr. Skilling unloaded EOG, i.e. he monetized his asset positions to keep the game going.

Before spinning off EOG, in 1994 Enron needed cash desperately. I knew that as I had been on the trading floor and knew the director of treasury, unfortunately, well.  I also had done a twenty-year cash flow statement, and knew Enron was in trouble. In December of 1994 we received $175 million and $200 million, respectively from two New York Banks, both still in existence today. After you hear the terms of this deal, you know why the banks still exist.

Enron did a pre-pay of oil from EOG with the NYC banks for seven subsequent years of oil delivery. When the deal was done, we put the sales into the crude oil book and did a mark-to-market at flat, no profit, a perfectly hedged deal. And, just recorded the cash in-flow for the prepay. All off-balance sheet accounts as Enron constructed it. The very few who knew, we just LOL with our heads down and kept on going.  I started looking for another job, and a few just kept on plugging away at Enron, even in the know.

After about two weeks from booking that deal, the treasury director called me and said I should run an NPV on the deal and disclose the effective rate of interest. So, I took the deal from its day of inception and did an NPV against the Nymex, which at that time one did have to interpolate between June and December in the forward periods beyond three years, as I recall. Nevertheless, when I did the calculation I was thinking I missed something. There was another finance guru, as there were many on the Enron Trading floor, but these deals were not for the rest of trading to know about.

So, it was another person who I trusted. He ran the calculation separately, and he got within one percentage point of my result. He interpolated the oil curve slightly differently than I did. After showing him how the differences were mute, we both agreed that the effective interest rate on that deal was 25%!

Yes, ouch, that hurts.  It’s like a credit card for someone with bad credit.  Oh, yes, the NY banks obviously knew this, too.

Now you can understand when Enron went from a few hundred million in off-balance sheet deals in 1994 to ~$25 billion in 2001, and when those deals went bad, it completely took the company under.

I do want to make a public note, too, that if Mr. Rich Kinder had stayed with Enron he wouldn’t have become a billionaire, and Enron would have never got to a billion, much less $25 billion in off-balance sheet financing, because he was the one who was the number two guy, and he would not allow any more than what was done as he knew it was risky. Mr. Kinder left Enron around the same time I did, in 1996. A coincidence, but I do believe we must have aligned in our thinking about Enron’s future, and both went our own successful ways.

I shared this story with my boss in 1999 and the idea of off-balance sheet financing faded away. If you are under 40 you may not have lived that era where money was flowing crazily for anything Dot-Com, and getting money was easier than walking into a bank and loading it into a truck. It was easier to just put up a website called www.givememoney.com and people would send you millions. Note: that website is still for sale.

The moral is that judgment is an important control. Yes, judgment is an important control. One you cannot craft into a program. Colleagues surrounding you have that sense of control, or the company culture is so far over to where Enron was, you know things won’t end well.

I too will share how to short the Enron mentality when you see it for personal gain later in the book.

The key is that human nature and perceptions change constantly and we will manage through them with you.

After having installed that FASB 157-like MTM process, while trading, I had my own emotional reaction that was removed by our process, thank God, on December 31^st one year. In my trading portfolio, we had a lot of product in storage and the official monthly publication to establish the price determined the mark-to-market value, which was the official spot price posting many contracts settled.

Intra-month December, the signals did not look good. Rumors of spot trades were in the middle teens and after Christmas, I recall my right-hand man, a very funny, very level-headed, one who thought everything through before reacting, a matter-of-fact person when not quietly making great jokes, a very educated PhD, who said all of us PhDs are just “poor, helpless dummies”, and I were fretting our bonus was going down with the spot market. If you are smart, well-published, methodical and you can make light, or be humble, it’s a good thing, we will discern why shortly.

December 31^st came and the publication, to our astonishment, printed 19.75. That was over 10% better than we had expected – yippee. I wasn’t going to complain or question it. I knew we had yet to fully realize this book, or said another way collect the cash. In my role, I wasn’t going to question it, and we had a process that didn’t question it. We accepted that it was our fate.  We went past “Go,” and collected our $200.  Seriously, it wasn’t that good compared to other trading houses.  Satisfaction, was and is as important than money.

For utmost transparency, I did not leave that trading role until I liquidated the entire book, and until every counterparty was settled, deliberately.  I did not trade my last year as I was just watching it settle month after month, and collecting cash all 12 months.  Then, on December 31, I handed in my resignation, collected my last bonus and moved to Colorado.

Since that trading role, I have never had the inkling to trade again. After working both sides of the trading roles, where you either trade or were on the other side of the wall, which I was on both sides, I could clearly see an incredible opportunity to make a difference for others beyond just trading a book.

Money doesn’t drive everyone – ask Mr. Charles Koch. It doesn’t drive him. He is proving there is a better way, an economic way to make an impact on society to keep the American Dream moving forward. I find consulting to be much more challenging than trading as I deal with different human nature, different cultures at every client, and I enjoy meeting so many new people I wouldn’t have enjoyed this path if I had stayed in one place.

Overall, therefore the trading controls should have:

• Why discipline and full disclosure are more important than the hedging programs.

• Formal trading and hedging strategies are documented and approved.
• Formal monitoring, on a daily basis, is in place and working effectively.

• Continuous formal reporting to senior leaders and the board.