Trading and the Risks of Derivatives Exposure

In testimony before the Senate Committee on Governmental Affairs, on January 24, 2002, Frank Partnoy of the University of San Diego and formerly of Morgan Stanley, described Enron as, “at its core, a derivatives trading firm,” whose activity “makes Long-Term Capital Management look like a lemonade stand.” At its zenith, LTCM was not “a lemonade stand” but the Rolls-Royce of hedge funds. What Enron, LTCM, Bank of New England, and so many other financial institutions have in common is that they have been ill-fated derivatives’ speculators. As a former investment banker, Partnoy detailed how Enron had used derivatives dealings with its 3,000-plus off-balance sheet subsidiaries and partnerships to shield volatile assets from quarterly financial reporting and artificially inflate the value of many of its assets. As the preceding chapters have documented, Enron used these manipulations to: Hide repeated speculative losses Hide huge debts incurred in financing unprofitable new ventures, and Inflate the value of its stock in spite of economic downturn and of nonperforming business units. According to Frank Partnoy’s Congressional testimony, most of what Enron represented as its core business divisions were not making money and it also appears that the same was true of the profits and losses of Enron’s derivatives operations, as we saw in Chapter 9. More cases of losses concerning derivative financial instruments are presented in this chapter.