The fall of the house of Enron

Ironically, the events that led directly to Enron's collapse had little directly to do with its energy trading business. The beginning of the end was the discovery in October 2001 by Wall Street Journal reporters of some strange partnerships Enron's chief financial officer, Andrew Fastow, had created, apparently with his board's approval, in order to move debt off its public books and boost its publicly reported profits. These special-purpose entities, which happened to be hugely profitable to Fastow personally, turned out to be the financial termites that ate away Enron's foundation.

At a stroke, Enron's shocking downfall tore the blinders off regulators and watchdogs, causing sudden sharp scrutiny of the entire energy trading industry. First to be affected were the energy traders themselves, the firms that buy and sell contracts for electricity and gas in over-the-counter (off-exchange) markets. These contracts are purely financial instruments, derivatives that reflect the price of something else, such as electricity, and are used to hedge against future losses as prices change. It soon came to light that some of the biggest-name firms in the business—Reliant Energy, CMS Energy, Dynegy—had engaged in the fake transactions known variously as round-trip or "wash" trades.

The financial markets now decided that energy and electricity trading was risky business. The leading credit raters, Moody's, Standard and Poor's, and Fitch, coming under criticism for not having been skeptical enough in the salad days of trading, responded harshly, downgrading not only the traders but also merchant generators—companies that own generating plants and sell the electricity into the competitive wholesale market.

Soon, only the distribution utilities still had investment-grade bond ratings. But by fall 2002, even some of those came under heavy attack, as the taint of Enron spread to almost every company involved in making, selling, and distributing electricity. Initially, only California's PG and E and Southern California Edison had been in trouble, caught in regulatory pincers not particularly of their making. Now, partly because electricity trading was beginning to work better in many other parts of the country and internationally, utility distributors and merchant generators were seeing profits fall because prices were coming down sharply.