CEG's dose of tough love

August 15, 2008|By JAY HANCOCK

A few sentences on page 46 of a financial disclosure that did not change reported profits, sales or net worth caused Constellation Energy Group's prospects to go into brownout this week.

Its shares dropped 16 percent Tuesday. Analysts rushed to downgrade the stock, although one contrarian changed his recommendation from "underperform" to "hold" because the shares had fallen so far.

Standard & Poor's downgraded Constellation bonds to two steps above "junk" status.

A little jumpy, aren't we?

Not at all.

The punishment of Constellation is an encouraging sign that Wall Street is again skeptical of companies that depend on opaque accounting and complex financial bets for much of their profit. A little such skepticism for folks betting on subprime mortgages could have saved a lot of heartache.

Constellation, owner of Baltimore Gas and Electric, is wagering on energy and interest rates, not mortgages. There is no sign it is about to collapse in the manner of Bear Stearns, Countrywide and other subprime adventurers.

"The company's business profile is strong," Standard & Poor's hastened to note.

Still, the grown-ups are on alert. Think of Constellation as a kid in a bad neighborhood with worried parents. They hope he's OK, but he just broke curfew, and there were beer bottles in the car trunk. Tough love may yet save the day.

A few months ago, Constellation badly miscalculated how much collateral it would have to post with trading partners in the event its credit rating sank. In correcting the error this week, the company not only revealed sloppy bookkeeping but called new attention to the fact that much of its profit comes from bets on commodities, not producing and selling energy.

Under one scenario, Constellation might have to put up $4.6 billion in collateral - which gives a clue about how huge some of these wagers are. The company has agreed to supply five times as much electricity nationwide as it can generate itself, so it is constantly buying and selling contracts.

Correctly betting on rising coal, electricity and natural gas prices helped Constellation pad profits in the year's first half. But how has the company handled the reversal in energy prices that picked up in mid-July? It won't say, but investors are starting to remember that nobody wins every time he plays the ponies.

At the end of June, Constellation owned nearly $7 billion in complex assets called derivatives. It says they were worth $7 billion, anyway. It won't let outsiders look, and even financial analysts would have a hard time understanding them.

About a fourth of the company's profit so far this year came from open trading positions it said increased in market value, according to UBS analyst Shalini Mahajan. But the deals weren't done, so it is hard to be sure. And "market value," which not so long ago said certain toxic mortgage bonds were worth 100 cents on the dollar, is often fiction.

On Wednesday, Standard & Poor's warned that Constellation "could face a credit cliff" if its bonds ever got downgraded to junk status. This is a coded reference to Enron, the notorious Houston energy concern that quickly sank from blue chip to cow chip after trading partners refused to renew its borrowing privileges.

Constellation is no Enron, as CEO Mayo Shattuck took pains to point out two years ago after a shareholder at the annual meeting asked about similarities. Enron was rotten with fraud and administrative control problems.

But Constellation has taken over much of the business that Enron once did. Lots of former Enron employees work for Constellation. In the turbulence of the subprime blowup, Constellation's goof in disclosing collateral scenarios has people wondering if anything else is there.

"Under more optimistic market conditions, such an error might have been noted with [much deserved] reproach but minor market reaction," said bond analyst Philip C. Adams in a report yesterday for Gimme Credit. "But given the credit 'wreck' elsewhere in the markets these days ... CEG's gaffe pretty much caused folks to steer for the ditch."

A healthy response for everybody - even if Adams thinks it was an overreaction. Shareholders get reminded about risks. S&P, which gave poison mortgage bonds high ratings and waited months to warn investors about Enron, attempts a more nuanced approach to credit risk.

And Constellation and similar companies get put on notice to fix accounting problems and tone it down with the commodities bets. Constellation probably isn't feeling grateful, but Wall Street just did it a favor.

jay.hancock@baltsun.com

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