——— FINANCIAL POLICY FORUM ———
|
www.financialpolicy.org |
rdodd@financialpolicy.org
|
|
|
|
Enron: Derivatives and the
Damage Done
Randall Dodd
March 12, 2002
Executive Summary:
·
The collapse of
Enron caused substantial damage to the overall
·
Loss of
confidence and the rise of doubts about the integrity of information about
·
The energy sector
took a beating in the wake of Enron’s failure.
The sector has lost a large amount of market capitalization since
Enron’s problems hit the front page on October 16th. This will impair their ability to raise
capital to finance new investment in energy production for the foreseeable
future. A sample of 18 large gas and
electric companies lost $64.4 billion in market capitalization in the past
year, and most of it -- $38 billion – since October 16th.
·
Although the
damages to the economy as a whole are greater than the sum of the particular
losses by creditors, employees and trading partners to Enron, the list of
itemized losses from the largest bankruptcy in
·
Derivatives
played an important and two-fold role in the collapse of Enron. Regulatory changes will be needed to make OTC
derivatives markets more safe and sound and make trading more transparent. Capital requirements on derivatives dealers
and collateral requirements on transactions will make this market more stable
and less vulnerable to collapse.
Registration and reporting requirements will make the market more
transparent and less susceptible to fraud.
Introduction
The sensational rise of Enron was the story of a rapidly expanding energy supply business through debt financed mergers and acquisitions. It was also the story of bringing new levels of financial sophistication into commodity markets, especially the newly deregulated markets for gas and electricity, and forming new derivatives markets for commodities where none previously existed. The wealth it generated enriched dozens of individuals, the largess it doled out helped fund the fine arts and the campaign contributions it put to use made it one of the most politically influential.
The meteoric fall of Enron was also
many stories. One was the colossal size
of Enron – once one of the largest
In the wake of this enormous
failure, Congress has convened a series of hearing in order to better
understand what went wrong and why. The
media has scrutinized Enron’s investment strategies and political maneuverings,
and is investigating some of its suspicious financial transactions. Now the policy discussion is shifting towards
the less exciting, but more important task of analyzing how the
This Special Policy Brief is designed to clarify two important points that are emerging in this public policy debate. The first point is that Enron’s failure and its impact on the economy and thus people well beyond those immediately involved with Enron is of sufficient magnitude that it be considered of national public interest. The second point is that unregulated OTC derivatives played an important role in the collapse of Enron.
Lobbyists for Wall Street firms are already making their rounds on Capitol Hill and to the Bush Administration, and meanwhile their public relations counterparts are making their pitches to the media. They are claiming that the Enron bankruptcy is not a national problem, and that it does not justify a more prudential regulatory approach towards financial markets. They are saying that the Enron collapse was not a problem of national importance because, after all, “the lights did not go out.”[1]
That is not a serious standard or threshold for what constitute the national public interest. At the same, it is worth identifying the irony in the fact that the failure of the Enron Online electronic trading platform was described in similar terms when the screens went blank as Enron Online went offline in November.[2]
The following section of this Special Policy Brief, entitled “The Damage Done,” provides ample evidence to show that the actual and potential harm to the economy is substantial, and that the damage impacts firms and individuals far beyond those who were immediately involved with Enron.
The section of this policy brief following that, entitled “The Role of Derivatives in Enron’s Collapse,” addresses the second point in the public policy debate. It seeks to answer to question, what was the role of derivatives, and the lack of a regulation of the derivatives markets, in the collapse of Enron?
The Damage Done
The failure of the unregulated derivatives dealer Enron has led to the largest bankruptcy in U.S. history. The damages from the collapse of this large financial institution are wide and deep. It has harmed the reputation of U.S. financial markets, it has caused collateral damage to the value of corporations in the energy sector and it has directly lead to loses by a long list of creditors.
Some of the unsound and non-transparent practices and structures of derivatives markets have been exposed by the demise of its derivatives trading operation. The disclosure of the corporation’s machinations to hide debt and losses through a veil of partnerships and derivatives transactions offended even the most cynical and cast a pale of distrust on U.S. financial markets by even the most trusting. The result has been to impugn the reputation of the U.S. financial system, otherwise regarded at the best in the world, and thereby threaten to raise to cost of capital to this great capital importing economy.
This concern was well expressed by former Federal Reserve Chair Paul Volcker before the Senate Banking Committee.
"Enron is not the only symptom." "We have had too many restatements of earnings, too many doubts about pro forma earnings, too many sudden charges of billions of dollars to good will (and) too many perceived auditing failures accompanying bankruptcies to feel comfortable."
Portents of the ongoing effects of this are well expressed by Milton Ezrati of Lord Abbett & Co.l which has $42 billion under management.
"This accounting cloud is going to hang over the
market for a while."
It is hard to measure this impact of the fall of the 50th largest corporation because the economy has experienced the effects of the recent recession, the terrorist attacks on September 11th, the subsequent commencement of war and the fact that Enron did not fall all at once. However, one broad measure is the rise in Baa investment grade corporate bond yields above that on Treasury notes. That credit spread has risen 30 basis points since October 16th when Enron reported a large charge-off against shareholder equity – thus bringing some of the hidden losses from its 3000 partnerships back onto the balance sheet.[3] The corporate bond market is key source of funding for new capital investment in the economy, and so higher capital costs – in so far that it can be attributed to an Enron-effect on investor confidence – surely represents damage to the overall economy.
The importance of the reputation of U.S. financial markets should not be underestimated. Former U.S. Ambassador to France and a voice of enlightened self-interest from Wall Street, investment banker Felix Rohatyn recently wrote[4] that “integrity must be maintained… to maintain the flow of foreign investment.” He went on to point out that 15% or $2 trillion of shares traded on the NYSE and NASDAQ were foreign owned, and then concluded, “The last thing we should tolerate is a loss of confidence in our capital markets.”
In 2000, the U.S. ran a deficit in its current account on trade in goods and services and payments of income on capital that reached $444 billion. That deficit was financed with an equally large net inflow of capital from foreign investors. That net inflow of foreign capital, amounting to 4.5% of the GDP of the U.S., underestimates the actual inflow of foreign investment into U.S. markets. The gross inflow was $1,024 billion, or 10.4% of GDP, and it functioned to offset an outflow of investment from the U.S. of $581 billion. Not only will foreign investors be discouraged by a loss of confidence in the integrity of U.S. financial reporting and corporate investment practices, but so will U.S. investors. Thus, the ability to successfully finance the U.S. current account deficit with net capital inflows will be harmed by both the willingness of foreigners to invest in U.S. capital markets as well as the interest of U.S. investors in increasing their investments abroad. For example, a reduction of foreign investment inflows by 15% and a similar 15% in U.S. investment abroad would reduce the net inflow by $240.75 billion or by more than 54%!
The costs of Enron’s collapse on investor confidence in market integrity focused especially on the volatility of stock prices in the energy sector. Along with Enron’s failure came lower share prices for stocks in the energy sector. Energy analyst Fadel Gheit, of Fahnestock & Co. in New York, put it dramatically, "Enron is the third World Trade Center. This is the collateral damage."
The fall in stock prices following the break of the first major news of Enron’s reporting problems on October 16th wiped out tens of billions of dollars of market capitalization in the energy sector. Gas corporations suffered along with electricity corporations. The result was that the stock prices and market capitalization were reduced by more than half over the preceding year, and most of that loss occurred in the recent months following the Enron “event.”
The consequent of this hit to the energy will likely be a reduction in investment in additional energy supply capacity for years to come. Energy production is very capital intensive, and the higher capital costs associated with such a decline in market valuation will discourage a great of potential new investment.
Moreover, the damage to the whole economy is larger than the sum of these particular losses. One reason for this is due to the Enron-effect on the stock market. This effect can be shown by the decline in market value of share prices for other major energy firms. The Derivatives Study Center collected information on the market capitalization[5] of Enron and 15 other major energy companies in the U.S. and looked at how it has changed over the past year, after the terrorist attacks on September 11 and then after the initial disclosure of Enron’s problems on October 16.
The three gas companies comprise 28.8% of the market capitalization in their sector while the 12 electricity companies make up 26% of the market capitalization in theirs. Thus these large firms represent a considerable share of their total sectors.
Starting from February 26, 2001 (a year from the date when we began collecting this information), these 15 corporations lost $36.3 billion in market value in the six and one-half months prior to September 11th. They lost another $7 billion following the terrorist attacks and before October 16th. In the four months from October 16th until February 25, 2002, those firms lost another $42.5 billion in market capitalization. Enron itself lost $24.8 billion in market capitalization during that fateful period. Those 16 firms together lost $93.3 billion in market value. (The figures are shown below in a table in Appendix I.)
Note that not all firms lost value over the entire year or in each time segment. For example, five of the electricity companies and one of the gas companies actually gained in market value in the month immediately following September 11th. All the gas companies lost money following October 16th while three electricity companies gained (one was First Energy which managed to increase market capitalization during each of the time periods).
These losses are not just symbolic, but rather have the very real effect of determining the cost of capital to these enterprises. When share prices decline and the cost of capital rises, then the energy firms find it more difficult if not infeasible to raise new capital in order to invest in additional energy supplies. Thus these figures suggest that the U.S. economy will suffer from a shortfall in investment in energy into the near future.
The widespread impact of Enron’s collapse on the macroeconomy and the energy industry should not distract from identifying the large losses to particular firms and individuals.
By collecting various reports from the media, the Derivatives Study Center has compiled a partial list of the reported losses. Of these, pension funds lost $1,147,000,000 – that of the Florida Pension Plans alone lost $325 million. Insurance companies lost $1,571,412,000 with John Hancock and Aegon topping the list in their sector. The bank system was the biggest loser with $5,434,800,000 reported, and the U.S. share of bank losses was $3.3 billion. The largest bank losses by far were from J.P. Morgan Chase with $2.6 billion. (All these figures are shown below in a table in Appendix II.)
Note that the figure for banks would be considerably larger but for Citigroup’s reported success in shifting most of their exposure onto unidentified investors through a special purpose off-shore entity that sold securities whose yield was enhanced by a short-option position on Enron’s creditworthiness. When Enron filed for bankruptcy, Citigroup exercised its option and the credit exposure was transferred to the investors.
Other energy companies reported losses of $535,000,000, while Enron’s employees are reported to have lost $1 billion.
Together these losses total to $9.7 billion. This is less than most estimates of the total losses, but by listing these details on a firm by firm basis it serves to highlight how widely the damages were distributed.
The failure of Enron was not apocalyptic and it did not bring down the entire system. That’s a good thing. Had its impact reached that level of destruction, then the national public interest in seeking regulatory remedy for these financial activities would be apparent to all but the most extreme free market advocates.
The failure of Enron did inflict large damages on individuals, firms and the overall economy in the U.S. and even abroad. The following section details some of the reported losses to pension funds, insurance companies, banks, other energy companies, even waste management companies and of course Enron employees. The damage however was greater than the sum of the losses to the employees and the various businesses that engaged in transactions with Enron. Enron’s collapse, and especially the way in which it failed, as cast a depressing pale over U.S. capital markets because of the devastating effect it has had on investment trust and confidence in the integrity of information about the capital markets.
The
Role of Derivatives in the Failure of Enron
Derivatives played two roles in Enron’s failure: first as farce, and then as tragedy.
The catalyst for Enron’s collapse starts from the heavy losses it suffered on real, physical investment in such assets as an electrical power plant in India, a water treatment plant in England, a steel mill in Arkansas, stock in a hi-tech startup telecommunications corporation and ownership of fiber optic broadband capacity across the U.S. It also lost money by investing in ventures designed to create new centralized markets in commodity trading that would dovetail with its wholesale and derivatives trading activities. For example, it tried to create such markets in steel, coal, wood pulp and broadband capacity. When these investments turned bad, Enron turned to creative accounting. It hid debt and moved losses off the books of the parent corporation and into a web of partnerships. It then used these partnerships to fabricate income that was reported by the parent Enron.
Enron used derivatives extensively in the creation of these partnerships and then again in its effort to hide debt and losses while fabricating income.[6] Derivatives were used to capitalize the partnerships and to guarantee them a positive rate of profit. Derivatives were also used to generate income from the partnerships for the parent Enron Corporation.
Eventually the farce ended, although not in humor but in tragedy. The losses became so large that they had to be reported publicly as a $1.2 billion charge against equity. This shocking news attracted greater scrutiny to Enron and its practices. Two top executives left, the SEC announced it was looking into Enron’s reporting practices and the company restated income for four prior years to show a $600 million reduction in previously reported earnings. Then the news got really bad. Other energy companies and derivatives traders began to lose confidence in Enron as a derivatives counterparty. Enron’s trading partners announced that they would either no longer trade with Enron or they would enter into only short-term transactions while they kept a close watch on the situation.
Enron the derivatives dealer was not regulated as financial institution, and so unlike financial institutions such as banks, securities brokers or futures brokers, it was not separately capitalized and did not maintain adequate capital reserves. What is more, unlike securities transactions and exchange-traded derivatives transactions, the OTC derivatives that Enron dealt in were not subject to collateral or margin requirements. This lack of safety provisions proved a fatal flaw.
The next blow fell when Enron’s credit rating was downgraded. This required Enron to post “super margin,”[7] which is a collateral or performance bond on derivatives positions, with their trading counterparties. The implication was Enron had to come up with a substantial amount of fresh capital at a time that it was already in trouble for having inadequate capital. This practice of requiring additional margin (or collateral) once a firm gets into trouble has the structural design flaw that it creates a requirement for additional capital just at the time that it is most expensive if not impossible to obtain. The likely result is to hasten, not dampen, a bankruptcy. For this reason such margin requirements should be considered crisis accelerators.
Thus the lack of adequate capital together with the structurally unsound collateral provisions[8] laid the foundation
The need to increase the amount of collateral pledged against positions that had negative asset value (i.e. were losing positions)
The loss of both trust and investment grade credit rating caused Enron’s trading volume to evaporate. Without trading volume, Enron could not earn their bid-ask spread as dealer for Enron Online and other derivatives markets, and without the bid-ask times volume there were no longer the enormous trading profits earned in the previous years.
The OTC derivatives markets are very large. At $100 trillion outstanding volume worldwide, and $59.2 trillion[9] outstanding amounts at U.S. banks and securities broker-dealers they are every bit as large that those for stocks, bond, mortgages and other loans. However unlike those markets, OTC derivatives markets are completely unregulated. Securities transactions in stock and bonds are regulated through the Securities and Securities Exchange Act to require securities brokers and dealers to register, report their activities, maintain adequate capital and to follow collateral or margin requirements on their securities transactions. Similar rules apply for futures and options brokers. Banks too must register, report, and maintain adequate capital requirements.
OTC derivatives markets are different. Following the December 2000 passage of the Commodity Futures Modernization Act, those transactions are excluded from federal financial regulation. What is more, dealers and derivatives participants in the market need not register, report or maintain adequate capital. Only if an institution is already subject to federal financial regulation for some other line of business such as securities broker or banking does the financial institution come under regulatory authority. Nonetheless, the transactions themselves still remain outside the authority of any federal regulator.
The
following set of prudential financial market
regulations would make OTC derivatives markets more safe, sound and
transparent. They are similar to
regulations that apply to other sectors of the financial system, such as
banking, securities and futures trading, and they should be applied to all OTC
derivatives dealers and derivatives transactions in order to improve safety and
soundness and to maintain regulatory parity.
In order to
establish extend to same prudential regulation to derivatives market and
establish a more level regulatory playing field for all sectors of the
financial system, the OTC derivatives markets
First, establish capital requirements and margin
(collateral) requirements. Capital requirements are critical to
prevent the problems at one firm from becoming problems at another firm;
and they prevent short-term problems at a dealer from causing the market
to freeze-up or meltdown. Margin (collateral) requirements do the same
for each transaction. The current market practice, in so far there is
one, is dangerous. It requires a firm to become
"super-margined" if its credit rating drops, and thus initiates a
large increase in the need for margin (collateral) just at the time the firm is
experiencing problems with inadequate capital. This amounts to a crisis
accelerator.
Second,
establish registration and reporting requirements. All brokers, dealers
and other non-end-users of OTC derivatives should be licensed and
registered. This is the approach used for securities markets, banking,
insurance and exchange-traded derivatives, and it should apply to OTC
derivatives markets as well. Reporting requirements will make the markets
transparent for the first time, and will give regulators the capability to
observe markets to detect problems before they become a crisis.
Third,
establish obligations for OTC derivatives dealers to act as market
makers. They capture the advantages of their position in the market, and
like dealers in U.S. government securities (the most efficient and highly
regarded OTC market in the world) they should be obliged to act as market
makers throughout the trading day. This will ensure market liquidity was
they must maintain bid-ask prices continuously through trading hours.
Market Capitalization |
||||
|
|
|
|
|
|
|
|
Pre-Sept 11. |
Sept. 11th
Related |
Enron Related |
Annual |
|
|
3/1/01 - 9/10/01 |
9/10/01 -
10/16/01 |
10/16/01 -
3/1/02 |
3/1/01 - 3/01/02 |
|
|
|
|
|
|
|
Natural Gas Utilities |
|
|
|
|
|
El Paso |
(10,746,918,000) |
1,275,750,000 |
(6,286,896,000) |
(15,758,064,000) |
|
Sempra |
977,984,000 |
(406,112,000) |
(470,344,000) |
101,528,000 |
|
Williams |
(4,818,855,000) |
(757,050,000) |
(7,204,850,000) |
(12,780,755,000) |
|
Total Natural Gas Utilities |
(14,587,789,000) |
112,588,000 |
(13,962,090,000) |
(28,437,291,000) |
|
|
|
|
|
|
|
Electical Companies |
|
|
|
|
|
AEP |
(283,536,000) |
(715,284,000) |
(106,326,000) |
(1,105,146,000) |
|
Alliant |
(159,000,000) |
105,735,000 |
(193,980,000) |
(247,245,000) |
|
Calpine |
(4,730,600,000) |
(448,644,000) |
(6,192,508,000) |
(11,371,752,000) |
|
Dominion |
(1,213,209,000) |
171,189,000 |
(449,061,000) |
(1,491,081,000) |
|
Duke |
(1,451,120,000) |
85,360,000 |
(2,646,160,000) |
(4,011,920,000) |
|
Dynegy |
(2,463,160,000) |
1,821,442,000 |
(6,002,332,000) |
(6,644,050,000) |
|
Excelon Corp. |
(3,305,270,000) |
(3,273,180,000) |
1,748,905,000 |
(4,829,545,000) |
|
First Energy |
1,084,160,000 |
631,680,000 |
306,880,000 |
2,022,720,000 |
|
Mirant |
68,100,000 |
1,014,690,000 |
(6,602,295,000) |
(5,519,505,000) |
|
NRG |
(2,086,235,000) |
690,780,000 |
(1,705,115,000) |
(3,100,570,000) |
|
Reliant |
(3,469,884,000) |
(321,948,000) |
(2,319,218,000) |
(6,111,050,000) |
|
Southern Co. |
3,096,826,200 |
1,194,024,000 |
138,840,000 |
4,429,690,200 |
|
Total Electric Utilities |
(14,912,927,800) |
955,844,000 |
(24,022,370,000) |
(37,979,453,800) |
|
|
|
|
|
|
|
Grand Total: |
(29,500,716,800) |
1,068,432,000 |
(37,984,460,000) |
(66,416,744,800) |
|
|
|
|
|
|
|
Enron |
(27,080,088,000) |
814,212,000 |
(25,304,653,500) |
(51,570,529,500) |
|
|
|
|
|
|
|
Total (Including Enron) |
(56,580,804,800) |
1,882,644,000 |
(63,289,113,500) |
(117,987,274,300) |
|
Total Exposure
to Enron |
||||
|
|
|
|
|
|
|
Sector/Company |
Amount |
Date Reported |
Notes |
|
|
Insurance:
Domestic |
|
|
|
|
|
ACE Ltd. |
0 |
12/18/01 |
minimal |
|
|
American International Group Inc. |
69,000,000 |
2/8/02 |
|
|
|
American National Insurance Co. |
10,000,000 |
12/18/01 |
|
|
|
AmerUS Group Co. |
0 |
12/18/01 |
|
|
|
Chubb |
143,000,000 |
2/8/02 |
after-tax |
|
|
CNA Financial Corporation |
50,000,000 |
12/5/01 |
|
|
|
CNA Surety Corp |
5,000,000 |
12/20/01 |
|
|
|
Erie Family Life Insurance Co. |
46,000,000 |
2/27/02 |
|
|
|
Erie Indemnity Co. |
4,500,000 |
2/27/02 |
|
|
|
Everest Re Group Ltd |
25,000,000 |
12/20/01 |
|
|
|
FBL Financial Group Inc. |
7,500,000 |
12/18/01 |
pre-tax loss on bonds |
|
|
Hartford Financial Services Group Inc |
12,000,000 |
1/29/02 |
|
|
|
MetLife Inc. |
63,000,000 |
2/7/02 |
|
|
|
Odyssey RE Holdings Corp |
23,000,000 |
2/9/02 |
|
|
|
PartnerRe Ltd |
49,000,000 |
12/20/01 |
|
|