Enron's agressive use of mark-to-market (or mark-to-model) accounting allowed it to manufacture earnings. Manufacturing operating cash flows to support these earnings was the goal of several of its structured finance deals.
Enron was agressive in revaluing investments in its portfolio. Even more agressive was the process whereby Enron would book profits on ten year or more natural gas delivery contracts in the year the deal was signed, even though delivery and payments therefore would only be made and received over the term of the contract, as the gas was delivered.
Any analyst worth his salt, such as those at the ratings agencies, would keep an eye on the cash flow from operations line in the statement of cash flows, to try to get an idea of the 'quality' of the accounting earnings. Strong operating cash flows to match high revenues and earnings are usually a good indicator of quality earnings, whereas weak or negative operating cash flows in periods of high revenue would have raised serious questions.
Knowing this, Enron looked for techniques that would allow it to show the analysts and ratings agencies these highly-desired operating cash flows, even in times where the genuine underlying business was not performing. A structure previously used as tax deferral mechanism, involving a Channel Islands entity known as Mahonia, affiliated to Chase, was reused with the primary purpose of manufacturing these operating cash flows.
The structure worked as follows:
Enron entered into a prepaid commodity sale with Mahonia, in terms of which it would receive a single upfront payment from Mahonia in exchange for delivering specified amounts of natural gas over the ensuing period. Viewed in isolation, Mahonia could be considered either to be fixing its input costs or alternatively taking a view that future natural gas prices were increasing, while Enron was entering into a long-term, fixed price, physical delivery contract in the ordinary course of its operations.
However, the chain did not end there. Mahonia entered into an agreement with the bank Chase, with almost identical terms. Chase would now be expected to receive natural gas, which it would then sell either into the market or back to Enron. At this point in time, Chase appeared to be exposed to commodity price risk. To hedge out its risk and achieve the final goal, Chase entered into a pay-floating/receive-fixed swap with Enron, in terms of which it would pay Enron an index-referenced amount calculated with reference to the current market price of the natural gas and receive instead a series of fixed payments, which were chosen and designed to match the cash flows of a loan amortisation based on the prepay amount on the first leg of the
transaction.
Chase would prepay Mahonia, which would then prepay Enron. Enron treated this cash receipt as an operating cash flow arising from normal trading operations. While the debit went to bank, the credit side of the entry was processed to "Liaibilities from price-risk management activities", classified under current liabilities.
Over time, Enron would deliver natural gas to Mahonia, who would deliver the same natural gas to Chase, who in turn would sell this gas into the market or to Enron at current market prices. Chase would then use the proceeds of this sale to settle the variable payment leg of the swap agreement with Enron, who would then pay Chase the previously agreed 'fixed' payments, thus amortising the original loan amount.
All in all, the variable rate payments were paid by Mahonia to Enron, Enron to Chase and then by Chase to Mahonia, completing the circle. The fixed rate payments were made in time 0 by Chase to Mahonia and then Mahonia to Enron. In future periods, the fixed rate payments were made by Enron to Chase. This constituted the financing aspect.
In effect, by using this structure Enron borrowed money and treated this loan finance as an operating cash flow.
As an aside, Arthur Andersen were suspicious of certain legs of these transactions which were identified under audit. As auditors of Enron without access to either Chase or Mahonia's internal documentation, they asked for specific representations from both Enron and Chase, including that Mahonia was an independent entity and acting for its own account, which they duly received. They were actively mislead into signing off on accounting that was improper.
