[A-List] JP Morgan and Enron

[Louis Proyect <lnp3@xxxxxxxxx>]

January 25, 2002
Energy-Trading Venture Could Result In an Enormous Loss for J.P. Morgan
By JATHON SAPSFORD and ANITA RAGHAVAN
Staff Reporters of THE WALL STREET JOURNAL

When J.P. Morgan & Co. set up an energy-trading business in the British
Channel Islands a decade ago, the tiny venture barely caused a ripple at
the giant bank.

The operation, called Mahonia Ltd., consisted of just a small office with
lots of phone lines. But the Jersey-based business grew over the years to
transact billions of dollars of natural-gas contracts with other energy
companies. Mahonia's trading followed a simple pattern: Many of its
transactions took place just before year-end. Often, the deliveries of
natural gas and oil were sold right back to those who delivered them
through complex derivative transactions. And about 60% of Mahonia's trades
were with just one company: Enron Corp.

The point of the choreographed trading? People familiar with Mahonia say
Enron used the transactions to manage tax liabilities by transferring
losses in one financial reporting period to another. As Enron's troubles
mounted, the Houston company eventually turned to Mahonia as a sort of
surrogate bank, these people say, using it to raise at least $2 billion in
financing over the years.

For J.P. Morgan, the arrangement was lucrative -- at least at first. The
bank received as much as $100 million in revenues. It also thought it had
insurance in place to cover any default by Enron.

But in the wake of Enron's collapse and bankruptcy-court filing, Mahonia
could cost the nation's second-largest bank as much as $1 billion. Several
insurers have alleged in a lawsuit in New York federal court that the
trading transactions were shams, thereby negating the insurance contracts.
The bank, now known as J.P. Morgan Chase & Co., disputes the court
allegation. Credit-rating concern Standard & Poor's cited J.P. Morgan's
overall exposure to Enron as one reason it is reviewing the bank's credit
rating for a possible downgrade. J.P. Morgan, which acted as a lender,
underwriter and merger adviser to Enron, says the energy concern owes it a
total of $2.6 billion.

Just a Sliver

The Mahonia arrangement -- which J.P. Morgan hadn't disclosed to investors
until last month's suit -- represents just a sliver of the many complicated
ventures Enron participated in. But unlike the hundreds of partnerships
Enron constructed on its own to keep debt off its books, this venture was
conceived, launched and operated by J.P. Morgan. Though many Wall Street
firms helped finance Enron -- acting as traditional lenders, underwriters
and advisers -- the fact that J.P. Morgan set up the partnership suggests
that Wall Street may have played a more active role in the Enron scandal.

J.P. Morgan won't comment on some key aspects of the dispute, citing
pending litigation. A spokesman says that "many companies routinely raise
funds using pre-paid commodity forward contracts. The benefits vary from
client to client, including pricing advantages and diversity of credit
sources."

Enron spokesman Mark Palmer says the trades were "perfectly legitimate and
proper transactions" made as part of the normal course of trading commodities.

Who Owns It?

Many things about the operation remain mysterious. It is unclear, for
instance, who owns Mahonia. According to records from the Jersey Financial
Services Commission, the company was incorporated on Dec. 16, 1992. It has
two nominee shareholders, Lively Ltd. and Juris Ltd., who represent
undisclosed owners.

"The question is: Was Mahonia a conduit on behalf of Enron or a conduit on
behalf of J.P. Morgan?" says Manfred Knoll, a managing director for
Germany's Westdeutsche Landesbank, which issued a $165 million letter of
credit to J.P. Morgan to guarantee against losses. He says Mahonia legally
was a conduit of J.P. Morgan. But in practice, "it was a conduit that was
set up to transact a variety of financial transactions for Enron."

On Tuesday, a New York bankruptcy-court judge ruled that Enron will have to
make available documents relating to Mahonia to the German bank, people
familiar with the matter say.

As part of its broad investigation into Enron, the Securities and Exchange
Commission is reviewing J.P. Morgan's multifaceted relationship with Enron,
people familiar with the matter say. Among other things, investigators are
examining whether the bank, through vehicles such as Mahonia, helped Enron
draw a misleading financial picture for investors.

People close to the matter say Enron told J.P. Morgan the trades were for
tax purposes. Tax experts say it is common for companies to manage tax
liabilities by, for instance, deferring certain losses from a bad year,
when the tax bill might be low, to a future period when they can be used to
offset high earnings. There's nothing inherently illegal about trying to
minimize corporate tax bills. Enron hasn't paid corporate income tax in
four of the past five years, a spokesman says.

The Mahonia maneuvers may draw additional scrutiny now, however, in light
of admissions by Enron that it used a series of outside partnerships to
hide losses.

Whatever the ultimate goal, the transactions worked like this: J.P. Morgan
would pay Enron between $150 million and $250 million for the future
delivery of natural gas or crude oil. This was constructed as a "trade,"
not a loan. So Enron would report this as earnings that would cancel out,
temporarily, losses on Enron books.

But Enron had to eventually deliver the oil or gas, usually in regular
installments with the value of $10 million to $20 million, the people
familiar with Mahonia say. With each delivery, the losses began again to
appear on Enron's ledger. These deliveries would begin the following year,
so the losses were carried from one year to the next, without showing up
clearly on Enron's books.

The result: Enron kept those losses in reserve in case Enron had any profit
windfall on which it might pay tax, the people familiar with the matter
say. If it did, it would use those losses to cancel out profits, and thus
lower its tax burden. Or if Enron didn't have big profits to hide, it would
just roll the losses over again to the next fiscal year -- by going back to
J.P. Morgan and selling it another gas contract. Two tax experts contacted
for this article described the technique as unusual but potentially very
effective. "It certainly makes sense as a tax strategy," says Doug
Carmichael, a professor of accounting at New York's Baruch College.

The whole process fed on itself. As one Wall Street banker put it, the
arrangements "practically guaranteed" Enron would come back to J.P. Morgan
for more.

What was in it for Morgan? The deals generated, over the decade, fees and
interest measuring as much as $100 million. In paying for future delivery
of gas to Mahonia, J.P. Morgan got the gas at a discount -- reflecting the
interest rate Enron would have paid were it getting a straightforward loan.
In the summer of 1999, this amounted to somewhere between 7% and 8%, or
roughly $7 million to $8 million for every $100 million J.P. Morgan
channeled to Enron under the Mahonia arrangement. (That revenue, of course,
was offset in part by the bank's funding costs.) The bank often got a small
fee for arranging the financing.

Source of Pride

The arrangements were for years a source of pride within the bank's small
commodities division, which directed the trades. Dinsa Mehta, one of J.P.
Morgan's senior commodity traders, praised the deals to colleagues, saying
that while Enron put out its other commodity financing needs for all of
Wall Street to bid on, Enron kept coming back to J.P. Morgan for trades
that would carry its losses forward. Mr. Mehta, contacted through a
spokeswoman, declined to comment.

In a basic way, the trading pact is a throwback. Prepaying for future
delivery of a commodity is known as a "gold trade," because it is the way
gold bullion has been trading for centuries. In recent years, trading
companies, whether from Houston or Wall Street, have been making more use
of this structure to buy and sell oil, natural gas and other commodities.
Some commercial banks, including Chase Manhattan, a predecessor of J.P.
Morgan, had to set up part of these trades overseas because their banking
charters wouldn't allow them to take delivery of commodities.

J.P. Morgan also bought commodities contracts from a number of other energy
companies. Yet by far Mahonia's biggest customer was Enron, accounting for
roughly 60% of its business, people familiar with the matter say.

Over the years, the size of the transactions grew and the repayment periods
stretched out further and further into the future.

Mahonia's business with Enron jumped sharply in 1999. Oil prices were weak,
causing concerns over the future profitability of the energy industry. The
stock and bond capital markets had become reluctant to finance energy
companies, leaving J.P. Morgan's offshore arrangements one of the few
places this industry could raise money.

In the summer of 1999, Enron officials contacted Morgan with requests to do
bigger and bigger trades, including a large arrangement of $650 million in
one trade. It was a far cry from earlier trades in the range of $150
million, and suggested to some people within the bank that Enron was no
longer merely interested in tax avoidance, but was actively using the
arrangement to meet its financing needs.

J.P. Morgan officials couldn't do the business without hedges. The firm
would be on the hook for a large chunk of cash if Enron defaulted before it
delivered the natural gas. These arrangements, after all, presented the
same default risk as any loan to Enron. J.P. Morgan effectively had been
paying a portion of its earnings to other banks in exchange for their
guaranteeing portions of the arrangement. This move shifted some of the
risk to other banks like ABN Amro Holding NV or West LB.

It wasn't enough. By this time, companies including Enron wanted to raise
more through Mahonia than the banking syndicate was willing to handle amid
the oil-price slump. So Enron, if it wanted more money, needed to find new
players to share the risk of financing the gas payments.

Enron turned to 11 insurance companies -- including National Fire Insurance
Co., Safeco Insurance Co., St. Paul Fire & Marine Insurance Co. and
Citigroup Inc.'s Travelers unit -- to issue "surety bonds." These are
financial guarantees insurance companies commonly issue to ensure a project
is completed, whether it's a bridge or Hollywood movie. Enron arranged
these contracts for J.P. Morgan -- and paid the insurance companies for it
-- so that the bank would feel more comfortable making increasingly large
trades with the energy company, according to a person familiar with the
arrangement.

As Enron's trades grew bigger and bigger, the bank was also financing other
energy companies, and the accounting on these trades became a source of
concern within the bank. On Aug. 5, 1999, Vice Chairman Marc Shapiro and
senior credit officer David Pflug convened a meeting in a glass room off
the bank's commodity trading floor.

As part of that briefing, the group went through a lengthy history of the
bank's trading with energy companies. The managers were told one reason
companies like Enron were entering the complex trades was to carry forward
losses and lower tax burdens, a person familiar with the briefing said.
This person said Mr. Shapiro reviewed the trades and said they were fine.
Mr. Shapiro declines to comment. Mr. Pflug, confirming the meeting, said it
was called to discuss another client and commodity derivative contracts in
general.

Two years later, the arrangement was still functioning as Enron's troubles
deepened. Both Enron and J.P. Morgan kept looking for other institutions to
share the risk as Enron kept running new trades through Mahonia.

That's when Enron and Morgan turned to the German bank for more comfort. On
Sept. 10, 2001, Enron and Morgan arranged to obtain a $165 million letter
of credit from West LB to guarantee derivatives trades between Mahonia and
Enron North America, according to Mr. Knoll, the bank managing director.

In an unusual move underscoring Morgan's keen interest in the letter of
credit, the legal documents were reviewed by Philip Levy, Morgan's
associate general counsel. Mr. Levy didn't return a call seeking comment.

Deepening Woes

Enron's woes deepened further. After a planned merger with rival Dynegy
Inc. fell through, Enron filed for Chapter 11 bankruptcy protection on Dec.
2. After the filing, Morgan requested to be paid under the letter of
credit, Mr. Knoll says. So far, West LB has refused to pay, depositing the
$165 million in an escrow account which it says it will make available when
the Mahonia transactions underlying the lending facility are proved proper.

It was only after the bankruptcy filing that investors first got a whiff of
Mahonia. Morgan's insurers, due to make a payment on the surety bonds by a
Dec. 21 deadline, refused to pay. Morgan sued in New York federal court.
The insurers filed a counterclaim, alleging that Mahonia was a fabrication
meant to disguise loans in the forms of commodity trades.

In court papers, the insurers say they were led to believe the arrangements
were meant to "actually supply natural gas and crude oil by Enron to
Mahonia." But the insurers refuse to pay the guarantees because the
arrangements "were not intended to be fulfilled," the insurers' complaint
alleges. It adds that Mahonia was a "mechanism to obtain surety bonds to
secure loans to be made to Enron in the guise" of trades.

J.P. Morgan says the insurers' claims are without merit, noting that the
surety contracts say the insurance liability is "absolute and unconditional."

The case is pending. But the spat already has dented Morgan's credibility.
Morgan Chief Executive Officer William Harrison called his board shortly
after the Enron bankruptcy filing and told them the bank had some $500
million in unsecured exposure and some other secured exposures, including
loans of $400 million backed by pipeline assets.

But after the insurers refused to honor their commitments on the surety
bonds, Mr. Harrison had to hit the phones again to directors, and raise the
number to $2.6 billion -- with roughly $1 billion of the additional
exposure directly related to Mahonia.

Morgan has been defending its position ever since. Last week, the bank
reported a fourth-quarter loss of $332 million, partly because of its
exposure to Enron.

Meanwhile, Mr. Shapiro, the vice chairman, asserts that Morgan has known
all along the extent of its Enron vulnerability. "It's not an issue of what
we knew," he said late last month "but what was appropriate to disclose."

-- Michael Schroeder contributed to this article.

Louis Proyect
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