What the Dog Saw

It was a plea for leniency. Skilling wasn’t a murderer or a rapist. He was a pillar of the Houston community, and a small adjustment in his sentence would keep him from spending the rest of his life among hardened criminals.

“No,” Judge Lake said.

2.

The national security expert Gregory Treverton has famously made a distinction between puzzles and mysteries. Osama bin Laden’s whereabouts are a puzzle. We can’t find him because we don’t have enough information. The key to the puzzle will probably come from someone close to bin Laden, and until we can find that source, bin Laden will remain at large.

The problem of what would happen in Iraq after the toppling of Saddam Hussein was, by contrast, a mystery. It wasn’t a question that had a simple, factual answer. Mysteries require judgments and the assessment of uncertainty, and the hard part is not that we have too little information but that we have too much. The CIA had a position on what a post-invasion Iraq would look like, and so did the Pentagon and the State Department and Colin Powell and Dick Cheney and any number of political scientists and journalists and think tank fellows. For that matter, so did every cabdriver in Baghdad.

The distinction is not trivial. If you consider the motivation and methods behind the attacks of September 11 to be mainly a puzzle, for instance, then the logical response is to increase the collection of intelligence, recruit more spies, add to the volume of information we have about Al Qaeda. If you consider September 11 a mystery, though, you’d have to wonder whether adding to the volume of information will only make things worse. You’d want to improve the analysis within the intelligence community; you’d want more thoughtful and skeptical people with the skills to look more closely at what we already know about Al Qaeda. You’d want to send the counterterrorism team from the CIA on a golfing trip twice a month with the counterterrorism teams from the FBI and the NSA and the Defense Department, so they could get to know one another and compare notes.

If things go wrong with a puzzle, identifying the culprit is easy: it’s the person who withheld information. Mysteries, though, are a lot murkier: sometimes the information we’ve been given is inadequate, and sometimes we aren’t very smart about making sense of what we’ve been given, and sometimes the question itself cannot be answered. Puzzles come to satisfying conclusions. Mysteries often don’t.

If you sat through the trial of Jeffrey Skilling, you’d think that the Enron scandal was a puzzle. The company, the prosecution said, conducted shady side deals that no one quite understood. Senior executives withheld critical information from investors. Skilling, the architect of the firm’s strategy, was a liar, a thief, and a drunk. We were not told enough—the classic puzzle premise—was the central assumption of the Enron prosecution.

“This is a simple case, ladies and gentlemen,” the lead prosecutor for the Department of Justice said in his closing arguments to the jury:

Because it’s so simple, I’m probably going to end before my allotted time. It’s black-and-white. Truth and lies. The shareholders, ladies and gentlemen… buy a share of stock, and for that they’re not entitled to much but they’re entitled to the truth. They’re entitled for the officers and employees of the company to put their interests ahead of their own. They’re entitled to be told what the financial condition of the company is. They are entitled to honesty, ladies and gentlemen.

But the prosecutor was wrong. Enron wasn’t really a puzzle. It was a mystery.

3.

In late July of 2000, Jonathan Weil, a reporter at the Dallas bureau of the Wall Street Journal, got a call from someone he knew in the investment-management business. Weil wrote the stock column called “Heard in Texas” for the paper’s regional edition, and he had been closely following the big energy firms based in Houston— Dynegy, El Paso, and Enron. His caller had a suggestion. “He said, ‘You really ought to check out Enron and Dynegy and see where their earnings come from,’” Weil recalled. “So I did.”

Weil was interested in Enron’s use of what is called mark-to-market accounting, which is a technique used by companies that engage in complicated financial trading. Suppose, for instance, that you are an energy company and you enter into a $100 million contract with the state of California to deliver a billion kilowatt hours of electricity in 2016. How much is that contract worth? You aren’t going to get paid for another ten years, and you aren’t going to know until then whether you’ll show a profit on the deal or a loss. Nonetheless, that $100 million promise clearly matters to your bottom line. If electricity steadily drops in price over the next several years, the contract is going to become a hugely valuable asset. But if electricity starts to get more expensive as 2016 approaches, you could be out tens of millions of dollars. With mark-to-market accounting, you estimate how much revenue the deal is going to bring in and put that number in your books at the moment you sign the contract. If, down the line, the estimate changes, you adjust the balance sheet accordingly.

When a company using mark-to-market accounting says it has made a profit of $10 million on revenues of $100 million, then, it could mean one of two things. The company may actually have $100 million in its bank accounts, of which $10 million will remain after it has paid its bills. Or it may be guessing that it will make $10 million on a deal where money may not actually change hands for years. Weil’s source wanted him to see how much of the money Enron said it was making was “real.”

Weil got copies of the firm’s annual reports and quarterly filings and began comparing the income statements and the cash-flow statements. “It took me a while to figure out everything I needed to,” Weil said. “It probably took a good month or so. There was a lot of noise in the financial statements, and to zero in on this particular issue you needed to cut through a lot of that.” Weil spoke to Thomas Linsmeier, then an accounting professor at Michigan State, and they talked about how some finance companies in the 1990s had used mark-to- market accounting on subprime loans—that is, loans made to higher-credit-risk consumers—and when the economy declined and consumers defaulted or paid off their loans more quickly than expected, the lenders suddenly realized that their estimates of how much money they were going to make were far too generous. Weil spoke to someone at the Financial Accounting Standards Board, to an analyst at the Moody’s investment-rating agency, and to a dozen or so others. Then he went back to Enron’s financial statements. His conclusions were sobering. In the second quarter of 2000, $747 million of the money Enron said it had made was unrealized—that is, it was money that executives thought they were going to make at some point in the future. If you took that imaginary money away, Enron had shown a significant loss in the second quarter. This was one of the most admired companies in the United States, a firm that was then valued by the stock market as the seventh-largest corporation in the country, and there was practically no cash coming into its coffers.

Weil’s story ran in the Journal on September 20, 2000. A few days later, it was read by a Wall Street financier named James Chanos. Chanos is a short-seller—an investor who tries to make money by betting that a company’s stock will fall. “It pricked up my ears,” Chanos said. “I read the 10-K and the 10 -Q that first weekend,” he went on, referring to the financial statements that public companies are required to file with federal regulators. “I went through it pretty quickly. I flagged right away the stuff that was questionable. I circled it. That was the first run-through. Then I flagged the pages and read the stuff I didn’t understand, and reread it two or three times. I remember I spent a couple hours on it.” Enron’s profit margins and its return on equity were plunging, Chanos saw. Cash flow—the lifeblood of any business—had slowed to a trickle, and the company’s rate of return was less than its cost of capital: it was as if you had borrowed money from the bank at 9 percent interest and invested it in a savings bond that paid you 7 percent interest. “They were basically liquidating themselves,” Chanos said.

In November of that year, Chanos began shorting Enron stock. Over the next few months, he spread the word that he thought the company was in trouble. He tipped off a reporter for Fortune, Bethany McLean. She read the same reports that Chanos and Weil had, and came to the same conclusion. Her