JP Morgan says risk exposure in gold derivatives less than 10 mln usd

NEW YORK

JP Morgan Chase, answering charges by a pressure group that it may be facing excessive risks in the gold market but not disclosing them, said its exposure to gold including derivatives is less than 10 mln usd.
    JP Morgan was responding to allegations by the two-person Gold Anti-Trust Action Committee (GATA), a pressure group which alleges bullion banks and central banks are conspiring to rig prices in the gold market.
    The US Securities and Exchange Commission (SEC) is now being asked to arbitrate a long-running spat between JP Morgan and GATA which has generated a steady flow of conflicting claims, rumors, accusations and denials with few hard facts.
    Both sides are calling on the securities regulator to investigate their claims about the other party. GATA asked the SEC last week to investigate its suspicion that JP Morgan has a higher risk exposure to fluctuations in the price of gold than what it has acknowledged publicly.
    GATA's letter to the SEC spelling out its allegations followed JP Morgan's request to the regulator on Jan 3 that it investigate rumors the bank was trying to keep the price of gold down and covering up losses incurred from the recent rise in gold prices.
    JP Morgan Chase has registered 41 bln usd in gold derivative contracts as of the third quarter last year in its filings with the US Office of the Comptroller of the Currency. This is the notional value, or the sum of the value of different contracts of the bank's clients holding different positions, long or short, on the contracts.
    Derivatives are financial instruments that derive their value from another underlying asset, like gold. The most common derivatives are futures and options.
    "On any given day, JP Morgan's exposure to the gold market including derivatives is less than 10 million dollars," a bank spokesman told AFX Global Ethics Monitor.
    "The risk of contracts is held by our clients and we actually don't have any risk associated in the contracts."
    Analysts said that sorting out the conflicting claims comes down to finding out for sure which contracts JP Morgan holds on gold, and if it is betting the price of the precious metal will rise or fall -- two facts hard to pin down.
    Brock Vandervliet, vice president of equity research at Lehman Brothers said the amount in gold derivative contracts Morgan Chase has disclosed is not excessive for a large bank.
    However, Vandervliet said the amount is larger than what HSBC and Citibank reported in the third quarter of last year. HSBC had notional amounts of 14.2 billion dollars in gold derivative contracts while Citibank had 12.9 billion dollars.
    Vandervliet also said that gold is not a major part of JP Morgan's derivatives business and hence may not be that big a risk.
    But analysts agreed the information provided by JP Morgan is not enough to understand the actual risk involved.
    "There are two things that are absolutely critical to know which make it impossible to conclude anything really powerful," said Vandervliet.
    "First, is the net trading position long or short? We don't know. Second, how much of these contracts are held by JPM versus held for customers supporting a trading book and therefore not presenting JPM with a material risk. This is a weakness of the disclosure and makes firm conclusions very difficult."
    The dispute between JP Morgan and GATA, which gets funding from several small gold companies, goes back to late last year when GATA accused the bank of trying to run down the prices in the gold market.
    GATA has in the past also accused the US Federal Reserve Bank, the International Monetary Fund and other bullion banks like Goldman Sachs of price rigging.
    On Jan 6, GATA consultant James Turk wrote to the SEC asking for an inquiry.
    "It's about time that we learn the truth regarding JP Morgan Chase's activity in the gold market, the full extent of its gold exposure, and whether it used gold loans to fund the so-called 'disguised loans' that it arranged for Enron," Turk said in the letter to the SEC.
    A SEC spokesman said the organization does not comment on investigations, ongoing or otherwise.
    Some analysts are also skeptical of the risk exposure disclosed by JP Morgan.
    "They have to divulge only material risk that is a risk large enough to have impact on the company's assets," said Richard Bove, managing director, Hoefer and Arnett, a research group specializing in financial companies.
    "We accept the amount disclosed as a matter of faith."
    GATA disputed the 10 mln usd figure given the amount of gold derivative contracts booked by JP Morgan, citing the bank's alleged interest in keeping the price of gold down.
    Gold prices are currently at their highest levels in six years and GATA claims JP Morgan could be losing money at current prices.
    Some industry experts are questioning the veracity of GATA's claims.
    "I think they (GATA) could have had long positions in gold and are always complaining when prices go down never up," said Randall Dodd, director of the Derivatives Study Center, a non-profit group researching on financial markets, AFX-GEM.
    Investors who have a long position in gold derivatives profit when gold prices go up. GATA denies having a long position on gold.
    anupama.chandrasekaran@afxnews.com
    ac/mlo/gc

· Washington Post

October 17, 2002, Thursday, Final Edition, FINANCIAL; Pg. E01

Dynegy Ends Power-Trading Operations

Peter Behr, Washington Post Staff Writer

The energy-trading business, poisoned by scandals that followed the collapse of Enron Corp., suffered another casualty yesterday as Enron's former Houston rival, Dynegy Inc., announced it was closing its trading unit to preserve urgently needed cash reserves.

Dynegy, the nation's third-largest trader of electricity at the beginning of the year, also announced the resignation of Chief Operating Officer Stephen W. Bergstrom. And it said it will eliminate a "significant" number of jobs from its worldwide workforce of 5,500, hoping that cost cutting will help it meet heavy debt-repayment obligations.

While ending its speculative trading operations, Dynegy said it will continue to market power from its network of U.S. and foreign plants. Bergstrom's resignation was triggered by the decision to exit the trading business, the company said. He is the third senior official to resign this year, following founder and chairman Charles L. "Chuck" Watson and former chief financial officer Robert D. Doty Jr., who left when regulators began investigating the company.

Dynegy agreed last month to pay a $ 3 million fine to the Securities and Exchange Commission, without admitting or denying wrongdoing, to settle charges of trading and accounting abuses in a large, long-term energy-supply contract.

Two years ago, Enron and Dynegy were in the vanguard of a wide-open, burgeoning power market. Competitors rushed to open new generating plants and set up large, computer-driven power-trading desks in anticipation of the spread of electricity deregulation around the country. As power trading spread, blocks of electricity were traded dozens of times between the generating plant and the local electricity distributor.

After Enron's fall into bankruptcy and disclosures of sham energy transactions, "round-trip" sales and price manipulation, the power-trading market has collapsed. The nation's economic slowdown has sapped demand for electricity. And credit-rating agencies, caught off guard by the Enron bankruptcy, are forcing trading companies to post more cash collateral to back up their contracts -- a burden that Dynegy could not bear, it said.

Dynegy's shares have dropped by 96 percent this year, a market wipeout also experienced by its former power-trading rivals, Aquila Inc., Reliant Resources Inc., Williams Cos., El Paso Corp. and Mirant Corp.

"No one wants to trade with them," said Randall Dodd, director of the Derivatives Study Center in Washington. Customers "don't know if they can fulfill their contacts."

A Dynegy spokesman said it could not find a creditworthy buyer for its trading business and concluded it could not wait for the trading business to recover.

When that might happen is not clear, experts said.

Dodd said that power trading won't pick up until new regulations are in place to prevent the manipulations that blackened the industry's eye. Enron led a successful lobbying campaign to free speculative power trading from oversight by the Commodity Futures Trading Commission, he said. Attempts this year to impose new regulations were blocked in Congress. Now, the industry "has to convince people there is someone there who is guarding against fraud and manipulation," Dodd added.

Lawrence J. Makovich, senior director of Cambridge Energy Research Associates in Cambridge, Mass., said that the problems of the energy-trading industry are tied to the current glut in power plant capacity. Trading operations won't be profitable until after the generating industry has gone through a painful downsizing.

"The bubble has popped," he said. "We are overbuilt in the vast majority of the regional power markets. . . . There is a better-than-even chance of a couple of major bankruptcies" among the group of trading and competitive power generating companies, he said.

Peter H. Rodgers, a Washington lawyer who specializes in the commodity-trading industry, said there is a need for power trading, to help utilities and industries protect themselves against volatile power price changes. "When the dust settles, I think you'll see some renewal" of trading, he said.

But a recovery, he said, is likely to be led by Wall Street financial firms, private commodity companies such as giant agribusiness firm Cargill Inc., and foreign trading firms -- not the companies that jumped at the opportunity in the 1990s.

· Business Week

October 7, 2002

NEWS; Analysis & Commentary; Number 3802; Pg. 40

THE BREAKDOWN IN BANKING
Trust is eroding and profits may follow as business models falter

Emily Thornton, Peter Coy, and Heather Timmons in New York, with bureau reports

In the 1990s, the sky seemed the limit for financial institutions. Once restricted to taking deposits and making loans, banks broke into the business of selling securities. Wall Street investment houses began making loans to companies. The result was a flood of money to promising new companies, existing businesses, and consumers. That fueled the New Economy with its rapid productivity growth and made the American financial system the envy of the world. Moreover, the financial system seemingly sailed through the 2001 recession and the accompanying stock market decline in good shape. Commercial banks had record profits in the second quarter of this year, and their balance sheets were far stronger than in previous recessions.

But now, the ever-closer partnership between commercial banking and investment banking is showing signs of strain. Putnam Lovell Securities estimates that earnings at five of the largest firms -- Citigroup, J.P. Morgan Chase, Merrill Lynch, Goldman Sachs, and Morgan Stanley -- could stay stuck below 1998 levels this year. On Sept. 17, J.P. Morgan Chase & Co. warned that its third-quarter operating profits will be ''well below'' those of the second quarter as losses on corporate lending may more than quadruple, to $ 1.4 billion. One possible reason: Many of those loans were made to now-struggling or failed telecom companies in a bid to win investment banking. That's a small part of the unprecedented wave of bad debt flooding the financial system. A record $ 880 billion worth of corporate bonds and loans are distressed or in default, according to Edward I. Altman, a professor at New York University's Stern School of Business. As the losses mount, the biggest firms are facing the threat of legal action from investors who see themselves as the victims of a massive con game.

At issue is the economic recovery. Banks are indispensable links in the flow of money, and they must be perceived as honest players. Yet after a year of revelations about their questionable practices and conflicts of interest, investors have become increasingly skeptical of everything Wall Street sells.

That partially explains why the stock market is tanking even as the real economy shows signs of recovery. It also accounts for the higher rates that investors demand before they'll hold corporate bonds. Ford Motor Co., for example, is paying four percentage points more than the government on borrowing. With stock prices low, as well, the cost of capital for companies is rising, discouraging needed investment. And as long as investigations drag on, investors will steer clear of what they perceive to be a rigged game. ''Until we have some finality around recent regulatory and legislative reforms that make people feel it's safe to go back in the water, we're not going to get the confidence and credibility back in the marketplace,'' says Lehman Brothers Inc. Chief Financial Officer David Goldfarb.

How did we come to this? In the 1990s, market forces penetrated the once heavily policed U.S. financial system. The 1999 repeal of the Depression-era Glass-Steagall Act accelerated an existing trend of commercial and investment banks coming together -- or invading one another's turf -- by sweeping away barriers that were designed to protect corporations, borrowers, and investors from banks' conflicts of interest. The change sanctioned financial behemoths such as Citigroup and J.P. Morgan and allowed commercial banks such as Bank of America and FleetBoston Financial Corp. to jump on the investment-banking wagon. All were seeking to leverage low-margin lending into much more profitable fee businesses such as underwriting shares.

The result: Competition in investment banking became cutthroat. Research analysts became shills for stock offerings instead of investment advisers; investment bankers dangled allocations of initial public offerings to CEOs to get business. Loans were offered to entice lucrative investment-banking business. ''The whole financial system has become corrupt,'' says Felix G. Rohatyn, who runs financial advisory firm Rohatyn Associates LLC.

At the same time, market forces had begun to change the straitlaced culture of big commercial banks. They sold off pieces of their corporate loans to smaller banks, insurers, and mutual funds in a booming syndication market of more than $ 2 trillion. Then they moved on to repackaging consumer loans into securities, from mortgages to credit-card receivables, and sold them to institutions in what's now a $ 7 trillion securitization business. By selling off their loans, banks were able to lend to yet more borrowers because they could reuse their capital over and over. But it also meant that they made lending decisions based on what the market wanted rather than on their own credit judgments. The wholesale offloading of risk made the banking system less of a buffer and more of a highly streamlined transmitter of the whims of the market.

The more businesses that financial institutions assembled, the more conflicts of interest they faced. Heightened competition encouraged banks to use rosy stock recommendations, low-interest loans, and handouts of shares in hot IPOs to CEOs to win lucrative investment-banking business. It also led bankers to make unwise loans and underwrite securities that never should have come to market. The boom-time excesses of the banking system are ''a train wreck waiting to happen,'' says D.Quinn Mills, a finance professor at Harvard Business School.

Meanwhile, the resale of loans created moral hazard: a temptation for banks to scrutinize borrowers less carefully than when their own money was at stake. ''The banks abdicated credit judgment, and the people to whom they sold the paper had no credit judgment,'' says Martin Mayer, a guest scholar at the Brookings Institution and author of The Bankers.

Other problems may yet emerge. While the market for securitized consumer loans remains healthy, investors who took loans off banks' hands could get stung if the economy stumbles. Moreover, it's tougher for the Federal Reserve, which supervises banks, to fix systemic credit problems once the debt is in the market. Says Mayer: ''This is the first time that the banking system has ever predistributed losses.''

Many of the stocks and bonds floated during the 1990s boom probably never should have come to market. For example, 45% of junk bonds are distressed or in default, up from 5% in 1998, according to Stern's Altman. Now, investors balk at loading up on more junk bonds. And some are shying away from new issues of asset-backed securities from banks. ''There have been many deals we have turned away recently that have not passed our credit stress tests,'' says Dan Ivascyn, portfolio manager at Pacific Investment Management Co., which manages $ 274 billion of assets.

Compounding the stress on the economy is a loss of faith. Financial institutions are under siege from thousands of investor lawsuits. And some in Washington are starting to question if the one-stop financial shops allowed by the repeal of Glass-Steagall should continue to exist at all. To be explored, says a top Democratic Hill aide, is whether legislation ''pushed commercial and investment banks to take on greater risks than they otherwise would, and whether [the law] caused conflicts'' by placing bankers at odds with clients' interests.

Now, it's clear that in their race to become jacks-of-all-trades, many financial-services companies ended up mastering none. Many failed in their attempt to turn into one-stop financial shops selling everything from merger advice to credit cards. FleetBoston shut its investment-banking unit Robertson Stephens earlier this year largely because high-tech IPOs, its specialty, dried up and left big losses, says CEO Charles K. Gifford. Adds Wells Fargo & Co. CEO Richard M. Kovacevich: ''Almost 70% of banks buying investment banks fail.'' Wells Fargo itself has avoided the bidding. A growing share of profits at big banks comes from trading, which is inherently uncertain. ''Banks are playing the interest-rate market, and it is starting to explode,'' says David A. Hendler, an analyst with CreditSights, a bond research firm.

Things will get worse if more bad debts surface. J.P. Morgan wrote off $ 3.3 billion in bad loans in the nine months through June 30. And it's impossible to tell how exposed banks are to losses from derivatives, another market that boomed as banks sought profits from new trading opportunities, says Randall Dodd, director of the Derivatives Study Center in Washington. For example, J.P. Morgan has derivatives with a face value of $ 25 trillion. But investors don't know how vulnerable that enormous portfolio would be to, say, a sharp rise in rates or a fall in the dollar.

Wall Street also faces a potentially huge legal bill. Some pension funds and insurers are striking back. CalPERS has joined with several other pension funds to sue J.P. Morgan and Citigroup, the underwriters of WorldCom Inc.'s last bond issue, an $ 11 billion deal, for alleged lack of due diligence. Banks may have to pay up to $ 5 billion to settle over 300 class actions involving everything from hyping lousy IPOs to favoring their best banking clients, according to James Newman, executive director of research firm Securities Class Action Services. On top of that, there are 25 class actions pending against firms' research analysts.

Financial giants accelerated the growth of the New Economy in the 1990s. But they're looking shakier as the U.S. economy struggles to get out of the doldrums. ''You don't see a raft of companies trying to become the next Citigroup,'' says Brock Vanderfleet, a Lehman Brothers analyst. Putting the financial system on a solid foundation will be critical to putting the economy back on track.

· Power Markets Week

September 23, 2002 , MARKET REGULATION; Pg. 14

CHANGE SOUGHT IN FEINSTEIN BILL WOULD EXEMPT ICE FROM CAPITAL REQUIREMENTS

A draft amendment to Sen. Dianne Feinstein's bill (S 2724) that places over-the-counter energy and metals derivatives under federal regulation would remove bilateral dealers and online trading exchanges, such as the IntercontinentalExchange, from the legislation's capital requirements, industry sources said last week.

But the amendment proposed Sept. 6 by Senate Agriculture Committee Chairman Tom Harkin (D-Iowa) and ranking member Sen. Richard Lugar (R-Ind.) still attracted top-drawer complaints.

In a letter send Sept. 18, U.S. Federal Reserve Board Chairman Alan Greenspan and other federal officials say they have ''serious concerns'' about the Harkin-Lugar proposal. Joining Greenspan in signing the letter were Treasury Secretary Paul O'Neill, Securities and Exchange Commission Harvey Pitt and James Newsome, chairman of the Commodity Futures Trading Commission. ''The proposal would subject market participants to disclosure of proprietary trading information and new capital requirements,'' the administration officials wrote to senators including Harkin, Lugar, Feinstein, Senate Majority Leader Tom Daschle (D-SD). ''We do not believe a public policy case exists to justify this governmental intervention.''

Industry sources supporting the legislation said the amendment would bring more oversight to OTC energy derivatives, but acknowledged it leaves ''a few regulatory gaps.'' Foes of the bill, first introduced in July by Feinstein (D-Calif.), worry that the amendment would have unintended consequences and raise costs for trading these derivatives.

Harkin has yet to set a date for his committee to consider the legislation or the amendment and send it to the Senate floor for a vote. But committee staff and industry sources say the chairman wants to address the legislation before Congress recesses this fall.

Feinstein's bill would have the CFTC regulate OTC energy and metals derivatives and require traders to back their deals with capital. Under requirements specified by the CFTC, trading facilities would be required to report OTC transactions and keep books and records of these transactions for up to five years according to the legislation. Harkin and Lugar's amendment would limit the capital requirements but expand private regulatory organizations oversight that industry proponents fear will add new fees for trading OTC energy derivatives.

Administration officials were wary of these key components. ''The rationale for imposing capital requirements is unclear to us, the proposal's capital requirements also could duplicate or conflict with existing regulatory capital requirements,'' the administration officials wrote. ''It is also unclear who would benefit from the proposed disclosures and regulations other than whoever simply copied existing products and instruments or their own short-term advantage.''

The Feinstein bill would require electronic exchanges and OTC traders to have sufficient capital to back their operations. Feinstein introduced her bill to take aim at Enron and its online trading platform for its questionable trading practices during the Western power price crisis of 2000-2001. OTC energy and metals derivatives were exempt from CFTC oversight under the Commodity Futures Modernization Act of 2000.

Proponents last week noted that the Harkin-Lugar draft amendment would still require capital requirements for an entity such as the defunct EnronOnline where the energy company was the counterparty to each deal on its online trading platform.

''Who gets a free ride here are dealers like Apache, Williams, [and] El Paso,'' said Randall Dodd, director of the Derivatives Study Center. ''The market is in trouble because Enron didn't have sufficient capital so others did not have sufficient capital.''

Still, Dodd said overall it remains a good bill. The Harkin-Lugar language ''makes significant strides in addressing the importance of the derivatives markets, although it leaves a few regulatory gaps. It would still be a great step forward,'' said Dodd.

But the International Swaps and Derivatives Assn. disagreed. While the proposed amendment excludes the bilateral dealer market from its new regulations, ISDA noted it adds ''more troubling'' language that authorizing private regulatory bodies. It appears that the provisions could require each counterparty to register with an organization such as the National Futures Assn., and in turn be subject to new transactions fees for trading OTC energy and metals derivatives, said ISDA Policy Director Stacy Carey.

''This overreaction to Enron really undoes the innovation achieved through the CMFA and may have negative consequences in how these markets develop in the future,'' said Carey.

· Tax Management Financial Planning Journal

Senators to offer bipartisan amendments on Feinstein bill regulating certain swaps
Tax Management Financial Planning Journal; Washington; Sep 17, 2002; Anonymous;

Abstract:
Sen. Tom Harkin and Richard Lugar are collaborating on amendments to S. 2724, a derivatives oversight bill, and likely will offer them when the panel marks up the legislation. The amendments involve bolstering the financial penalty for fraud and manipulation and establishing a self-regulatory organization to oversee the off-exchange derivatives market.

Sen. Tom Harkin (D-Iowa), chairman of the Agriculture Committee, and committee ranking member Richard Lugar (R-Ind.) are collaborating on amendments to a derivatives oversight bill (S. 2724) introduced by Sen. Dianne Feinstein (D-Calif.) and likely will offer them when the panel marks up the legislation, a spokesman for the committee said Aug. 27.

"We're still working with the original draft. I don't think there will be any legislation introduced," said Seth Boffeli. "I think what will happen is we'll mark it up in committee, and that's where the Harkin-Lugar [language] will take form."

While Boffeli said he could not elaborate on possible changes, a source who said he has seen drafts of the amendments said they involve bolstering the financial penalty for fraud and manipulation and establishing a self-regulatory organization to oversee the off-- exchange derivatives market.

Boffeli said he expects the committee to mark up the bill, which both Harkin and Lugar co-sponsor, this session, but added that it will take a back seat to legislation to provide drought relief for farmers. Congress returned from its month-long recess Sept. 3 and has set Oct. 4 as its target date for adjournment.

Transparency. The Feinstein bill seeks to provide "transparency" to energy and metals swaps by subjecting them to registration, reporting, and disclosure requirements that would be set by the Commodity Futures Trading Commission, and it also would subject them to existing anti-fraud and anti-manipulation laws. Currently, such derivatives are exempt from CFTC oversight.

The legislation was introduced in February but failed to garner support at the committee level. It appeared to fade from consideration after a bid to offer it as an amendment to an energy bill in April failed, but renewed scrutiny of the conduct of corporations this summer led the Agriculture Committee to hold a hearing on the measure in July.

At that session, Lugar, a former chairman of the committee who was a key proponent of the swaps CFTC-exemption in 2000, indicated he had changed his mind and would support the Feinstein effort. He has since signed on as a co-sponsor of the legislation.

Most Changes Technical. The Harkin aide said most of the amendments will be "technical changes" to clean up language in the original bill. He said specifics have not been finalized but offered that some pointed changes will be directed at establishing punishments for those who violate new derivatives provisions.

"I don't know where they are going to end up, but I know they are talking about specific penalties," Boffeli said. "I don't think anything's set in stone."

The draft language of the amendments, according to the source, increases the fine for derivatives traders caught breaking fraud and manipulation laws from the current $500,000 to $1 million. The original Feinstein bill simply establishes that traders in energy and metals derivatives are subject to such laws.

SRO Would Oversee Trades. Also, another amendment, according to the source, would establish a selfregulatory organization to oversee derivatives trades. Boffeli said he could not confirm the SRO provision. A spokesman said Lugar "wanted to do some things to tighten up the markets" but would not elaborate other than to confirm that Lugar and Harkin are collaborating on changes.

Otherwise, the new language being circulated leaves the original "95 percent intact," the source said. "It is not substantially different. It's got a couple of new bells and whistles, but all the important provisions of the original remain." Those include the registration, reporting, and capital requirements, he said.

Randall Dodd, head of the Derivatives Study Center, who testified at the July 10 hearing on the Feinstein bill, said Aug. 28 that the Feinstein measure is needed. "It's really a pretty good bill, and it reflects a huge leap forward in thinking about how these markets should be regulated." The bill, he said, would make the derivatives markets, "more safe without threatening problems for the larger economy. ... It's not a regulatory burden and there's very little cost to anyone."

While the uncovering of corporate chicanery this year-including so-called wash trades by some energy companies-has fueled outrage in Washington against fraudulent derivatives trades, Dodd said Lugar's shift might be the key to getting the bill passed. "That's huge," he said. "If he says this needs to be changed, people will listen."

· Mergers & Acquisitions Litigation Reporter SPECIAL REPORT

September 3, 2002

SECTION: SECURITIES/CORPORATE GOVERNANCE/REGULATORY ISSUES; Vol. 13; No. 1; Pg. 10

LENGTH: 3022 words

HEADLINE: Regulation of Derivatives In a Post-Enron World

BYLINE: BY GEOFFREY ETHERINGTON AND BRIAN P. IAIA*; * Attorney Geoffrey Etherington III is a partner in the New York office of Edwards & Angell (www.ealaw.com) and Brian P. Iaia is an associate in the Hartford, Conn., office. Both are members of the firm's insurance and reinsurance practice group.

BODY:
Following the collapse of Enron late in 2001, journalists, regulators and legislators have criticized the over-the-counter derivatives trading and investing activities of Enron and other companies. Some have suggested that lack of regulation of the OTC derivatives market was a factor in the Enron debacle. 1 As Congress, the Securities and Exchange Commission, and the Justice Department continue their investigation of accounting irregularities, management fraud and self-dealing, and shortcomings or failures of independent directors, accountants and professionals, additional regulation of derivatives is being considered. 2

However, recent disclosures of improper accounting to inflate profits at companies like Enron and WorldCom do not appear to be related to derivatives activities. While Enron may have improperly accounted for derivatives transactions with its off-balance-sheet entities, before any effort is made to restrict, regulate or scale back the derivatives activities of financial market participants as a reaction to Enron, it is essential to recognize the crucial role of derivatives in ensuring the efficient and orderly functioning of global financial markets. 3

The last decade has witnessed dramatic growth in derivatives trading activities. In 2000 the notional value of exchanged-traded derivatives was $13 trillion to $14 trillion. OTC derivatives traded during the same period were at least $95.2 trillion (and probably much higher). 4 Derivatives are considered an essential arrow in any sophisticated corporate risk manager's quiver of tools to reduce business, portfolio, credit, interest-rate and currency risk. OTC derivatives in particular can be tailored to hedge risks and reduce volatility associated with both assets and liabilities, as well as operating results. Such risk management strategies benefit all constituencies by transferring exposures to other market participants, who are prepared to bear the consequences of a loss in return for the premium or fee earned to accept the risk.

Randall Dodd, director of the Derivatives Study Center in Washington, D.C., which conducts policy research with a grant from the Ford Foundation, stated in an April 2002 interview with Challenge magazine, " T here are four basic types of derivatives transactions: forwards, futures, swaps, and options. These instruments are sometimes combined to form more complicated transactions, but in the vast majority of cases, they are straightforward versions of the four types."

Many types of instruments are considered derivatives. Frank Partnoy, a professor at the University of San Diego School of Law who has studied Enron's derivatives transactions, told the Senate Committee on Government Affairs that derivatives are "complex financial instruments whose value is based on one or more underlying variables, such as the price of a stock or the cost of natural gas." 5

However, derivatives contracts can address a much broader range of risks such as those related to weather, bond defaults, exchange rates or interest rates to name a few.

A distinguishing characteristic of derivatives is that risk is transferred or hedged for a premium or fee. Thus, a pension fund with a large position in a telecommunications company may enter into an OTC derivative contract with an investment banker to "put" some or all of the stock for a specified price. The pension fund agrees to pay the investment banker a fee for the right to put and has effectively transferred the risk of a price decline below the notional value of the contract to the banker for a cost equal to the fee.

A firm that operates warehouses across the upper Midwest may hedge against increased heating costs in the event of a harsh winter by purchasing a weather derivative from a heating oil company which pays off if temperatures that winter are particularly cold. The oil company never pays off the derivative if the winter is warm. The oil company will increase its income in a warm winter (from the fee) because the warm weather would have resulted in decreased oil sales. While the oil company's profits are reduced during a cold winter by paying off the derivative, and the warehouse firm has higher expenses in a warm winter, both may be willing to enter into the OTC derivative transaction to reduce the volatility of their operating results.

The benefits to the company (and its owners) of transferring the risk in an OTC transaction are obvious. For the fee paid to its counterparty, it has effectively reduced the volatility of the related asset or liability or stabilized operating results, which will smooth out its fi nancial performance in the long term. The counterparty m ay in fact be hedging the risk accepted with another OTC derivative contract or an asset or liability position, simply diversifying a portfolio of risks or itself transferring a different risk. In addition, if the counterparty is never called upon to perform under the original OTC derivative, it will recognize income equal to the fee.

When any OTC derivative transaction is proposed, each party must analyze the ability of the other to perform its future obligations. While it is possible to secure those obligations, often parties rely upon rating agencies or financial data that is either publicly available or provided privately to determine counterparty credit risk. While Enron ultimately did not prove to be a credit-worthy participant in the derivatives markets, in fact most counterparties to OTC derivative transactions are large public corporations and financial institutions like commercial banks, investment banks, insurance companies and hedge funds.

More importantly, however, many counterparties were aware of Enron's precarious financial condition and the uncertain value of the assets it was leveraging and took steps to minimize credit risk, such as guarantees or other contingent commitments from Enron or credit enhancements such as insurance policies and letters of credit. While not all such efforts were successful, the market clearly reacted to Enron's condition and tried to address it. 6

The collapse of Enron to some appeared to be a warning bell of imminent financial collapse under the weight of unregulated OTC derivatives activities. However, there has been no collapse and there is nothing inherently unsafe or unsound about OTC derivatives trading or the risk transfers effected between market participants. The sheer scale of the OTC derivatives market and the sophistication of its participants evidence the impor tance of OTC derivatives to the financial system. Regulatory or legislative tinkering with the market could have far-reaching and unintended consequences.

It should be noted that other players were quick to take the place of Enron in trading energy derivatives and that the commodity markets for gas and power, in which OTC derivatives play a vital role, functioned normally. 7 Swiss investment bank UBS Warburg was confident enough in Enron's trading business to purchase its technology platform out of bankruptcy. The OTC derivatives markets continue to develop and mature and the prudent course of action may be as little governmental interference in their functioning as possible.

OTC derivatives are essentially private contracts between sophisticated parties, and have developed as highly flexible financial instruments. For this reason, they may be inherently unsuitable to regulation. Any effort to force derivative transactions into certain forms or procedures, or to require review, qualification or registration of derivatives with the SEC (or a new federal agency) is likely to make the process of completing an OTC derivative transaction so cumbersome and time-consuming that most, if not all, of their value to risk managers would be lost. While proposals to require disclosure of information specifically about derivatives activities may seem less problematic, the complex and varied nature and scope of OTC derivatives may make effective regulation of disclosures extremely difficult.

As subsequent investigation into Enron and the obstruction-of-justice trial of auditor Arthur Andersen LLP have revealed, Enron's collapse was the result of a combination of market reversals, fraudulent self-dealing and improper behavior by individual corporate officers and the failure of internal and external controls and monitors to identify deficiencies in accounting treatment and disclosure or, if discovered, to adequately and timely take corrective measures. Enron's derivatives trading activities may have been improperly booked and its internal risk management policies were probably not followed. Self-dealing by Enron employees at many levels appears to have been rampant. Enron leveraged its assets dramatically and used its stock as collateral, creating a potential death spiral for its stock price when its debt ratings or stock price fell. 8

However, Enron collapsed in large part because "Enron's managers, with a belief system biased toward winning, lost touch with hard economic constraints and the rules of the game." 9 In fact, management was so committed to the perceived efficacy of the Enron business model that it may have resorted to fraud to ensure Enron's unbroken string of successes would continue. 10 Arthur Andersen and other professionals, if not actively participating in "cooking the books" and "hiding the skeletons," certainly bear some responsibility for not requiring earlier disclosure or actions relating to the serious deficiencies in management, and financial and ethical standards and controls.

The derivatives trading business model pioneered by Enron, however, should not be blamed for the company's collapse. In fact, Enron made billions trading derivatives, but it lost billions on virtually everything else it did, including projects in fiber-optic bandwidth, retail gas and power, water systems, and even technology stocks. 11 Specifically, Enron reported gains from derivatives of $4.04 billion in 1998, $5.34 billion in 1999 and $7.23 billion in 2000, yet Enron's non-derivatives gross margin (the difference between non-derivatives revenues and non-derivatives expenses) shows in a general sense that Enron's non-derivatives business made some money in 1998, broke even in 1999 and actually lost money in 2000.

Accounting improprieties unrelated to derivatives trading have been uncovered at WorldCom, Xerox and elsewhere, and many experts believe these improprieties are more significant than those at Enron. In the case of WorldCom, it initially appears that management and outside advisers are largely to blame for a pattern of accounting irregularities that inflated profits and increased stock prices.

With each revelation about efforts by managers of public companies to artificially inflate earnings and hide expenses, sometimes with the tacit approval of boards of directors and outside professionals, it is evident that Enron's failure did not result from the inadequate regulation regarding disclosure of derivatives trading activities. Rather, a more basic problem existed at Enron -- a perception that technical compliance with accounting standards and disclosure requirements was enough, even when such technical compliance was misleading or, even worse, inaccurate.

While sophisticated analysts may have been aware that Enron was pursuing a strategy to convert itself from a conventional energy company to a trading firm that was hedging exposures through derivatives and leveraging its assets using its own stock as currency, because Enron did not clearly and prominently reveal this strategy and its extensive use of "off balance sheet" entities to inflate profits, the capital markets may not have had a clear picture of the nature of Enron's business. 12 However, most, if not all, of this was due to purposeful accounting obfuscation. If Enron had honored the intent of financial disclosure regulations or if its auditors had insisted that some of the questionable special purpose vehicles be accounted for as consolidated entities and that profits from derivatives transaction with related parties that did not effectively transfer risk be footnoted in a straightforward and succinct fashion, Enron might still be in business trading OTC derivatives today.

Under SEC or regulatory accounting rules or contractual requirements, sophisticated participants in the OTC derivatives markets currently provide significant amounts of information about their derivatives trading activities to regulators and/or their investors. Even Enron made disclosure about its OTC derivatives trades with related entities in its 2000 financial statements, although those disclosures were buried within a footnote and difficult for anyone except sophisticated analysts to decipher. 13

It may be necessary for the SEC to review how it applies disclosure and accounting rules to ensure that trading companies that follow Enron into the virtual trading floor that it is developing for derivative instruments and counterparties of those traders are including proper and complete disclosure of their derivatives activities. The SEC has the power to require such disclosure currently with only modest rule changes and without any significant new regulatory or legislative initiative.

Under current securities laws, disclosures that omit material facts necessary to make those disclosures not misleading are prohibited and may lead to private rights of actions. A recommitment to this standard may prevent future Enrons. Investors and regulators should insist that public companies and their professional advisers comply with the spirit of SEC regulations like its Rule 10b-5. Indeed, President Bush said in a July 9, 2002, speech, "The lure of heady profits of the late 1990s spawned (corporate) abuses and excesses. With strict enforcement and higher ethical standards, we must usher in a new era of integrity in corporate America."

Bush went on to say, "The American economy is the most creative, enterprising and productive system ever devised . High-profile acts of (corporate) deception have shaken people's trust. Too many corporations seem disconnected from the values of our country. These scandals have hurt the reputations of many good and honest companies . It is time to reaffirm the basic principles and rules that make capitalism work: truthful books and honest people and well-enforced laws against fraud and corruption."

Bush vowed to use the full weight of the law to expose and root out corruption and to propose tough new criminal penalties for corporate fraud. Management, boards of directors, accounting and legal professionals, analysts and others who currently play by the rules should strongly reaffirm the benefits of ethical and honest behavior and disinterested service to their stockholders. Resources can be made available to the SEC to aggressively enforce disclosure rules to ensure that new activities like OTC derivatives are clearly and forthrightly reported. Executives, accountants and attorneys who violate securities laws should be punished severely.

However, it would be a mistake to make OTC derivatives trading a scapegoat for Enron's fall. As noted above, Enron collapsed because of failures in corporate governance and the inability of those outsiders charged with overseeing Enron's activities to effectively monitor its activities. It is likely that similar problems existed at WorldCom, resulting in more substantial financial statement irregularities.

Based on their notional amounts, derivatives trading represent a larger market than equities in the United States. 14 Any direct interference with the functioning of this market, which has come to play an essential risk management role in the financial system, would be a mistake. Even indirect regulation, through burdensome disclosure requirements of derivatives activities, may negatively impact the ability of counterparties to structure creative flexible instruments to transfer specific risks.

Enron's high-profile failure has disrupted the lives of its employees and investors. Fallout from the collapse has lead to the demise of Arthur Andersen. However, inadequate regulation of derivatives was not to blame.

Footnotes
1 "Building the House of Enron: As Enron's Derivatives Trading Comes Into Focus, Gap in Oversight is Spotlighted", Michael Schroeder, Wall Street Journal, Jan. 28, 2002, p. C1. 2 Ibid. 3 While Greenwich, Conn., hedge fund Long Term Capital Management lost $4.6 billion on derivatives with a notional amount of more than $1 trillion and the bankruptcy of Orange County, Calif., resulted from ill-advised derivatives trading activities, in both cases extremely risky trading and hedging strategies were to blame, not derivatives themselves. While Enron has been compared by some to LTCM, it is important to note that Enron made more money trading derivatives in the year 2000 than LTCM made in its history. 4 "Enron and the Use of Derivatives", Frank Partnoy, Testimony before the Senate Committee on Governmental Affairs, Testimony 02-3, March 2002, p. 2. 5 Ibid. at p. 2 6 "Enron and the Dark Side of Shareholder Value", William W. Bratton, Public Law and Legal Theory Working Paper N. 035, George Washington University School of Law (2002), p. 43. 7 "Could Enron's Business Model Actually Work" Daniel Altman, New York Times, Jan. 28, 2002. 8 Bratton, pp 22-47. 9 Ibid. at p. 52. 10 Ibid. at p. 53. Now in bankruptcy, Enron was a mere 12 months ago regarded as one of the largest energy companies in the world, and ranked as one of the top 10 largest corporations in the United States. Enron was named by Fortune magazine as "America's Most Innovative Company," "Number One in Quality of Management" and "Number 2 in Employee Talent." Enron was once held up to the world as a model corporation, one that encompassed all of the wonders and genius of capitalism.

· Risk Transfer

2 Sep 200

Derivatives Study Center