Derivatives Study Center


1660 L Street, NW, Suite 1200


Washington, D.C.    20036





In The News




·          CNN FN, December 16, 2003

·          San Diego Union-Tribune, December 7, 2003

(also Copley News Service, December 15, 2003)

·          The Street.com, November, 26, 2003

·          The Institutional Risk Analyst, November 17, 2003

·          Washington Post, November 6, 2003

·          Fort Worth Star-Telegram, November 1, 2003

·          Florida Times, September 23, 2003

·          Yahoo News, August 25, 2003

·          Bloomberg Magazine, August 2003

·          Reuters Magazine, July-August 2003

·          Dow Jones Newswire, July 22, 2003

·          Dow Jones Newswire, July 21, 2003

·          Dow Jones Newswire, July 15, 2003

·          CNN FN, July 15, 2003

·          Agence France Press (AFP), July 13, 2003

(also in Taipei Times, Business Report–Africa, Independence Online S. Africa, IT MATTERS, New Age Business)

·          Goldseek.com – The Daily Reckoning

·          Palm Beach Daily, June 30, 2003

·          Miami Daily Business Review, June 30, 2003

·          Marketplace Radio, June 23, 2003

·          USA Today, June 20, 2003

·          CNN FN, June 19, 2003

·          Marketplace, NPR Radio, June 19, 2003

·          Reuters, June 16, 2003

·          Reuters, June 13, 2003

·          Investment Dealers Digest, June 9, 2003

·          CNNfn TV, May 12, 2003

·          Newsweek International, May 12, 2003

·          Reuters, May 5, 2003

·          San Diego Union Tribune, April 29, 2003

·          CNNfn TV, April 17, 2003

·          Foster Natural Gas Report, April 10, 2003

·          U.P.I., April 9, 2003

·          Spanish Newswire Services, April 4, 2003

·          Kiplinger Business Forecast, March 28, 2003

·          Small Business Advocate – Texas, March-April 2003

·          ABC Radio, March 21, 2003

·          CNBC TV, March 11, 2003

·          Washington Post, March 12, 2003

(also in La Prensa, Panama)

·          Calgary Herald, March 9, 2003

·          Washington Post, March 6, 2003

(also appeared in Seattle Times, Kansas City Star, Calgary Herald)

·          Reuters, March 4, 2003

·          Forbes, March 4, 2003

·          E-RISK, March 2003

·          Reuters TV, January 21, 2003

·          AFX News, European Focus, January 15, 2003

·          Power Markets Week, January 13, 2003

·          Megawatt Daily, January 7, 2003

(also appeared in Platts-Electric Power Daily)


* not included below




·         CNN fn

December 16, 2003


Perspective On Mutual Funds and Your Money, CNNfn

BYLINE: David Haffenreffer

GUESTS: Randall Dodd



HAFFENREFFER: Alliance Capital will reportedly lower its mutual fund fees by as much as 20 percent. That is focusing attention now on the hidden costs that many investors pay to stay invested in the market. If Alliance does lower its fees then others may follow, and investors could end up saving big bucks.

But what about the even bigger question of investor losses due to improper mutual fund trading? Joining us from Washington, D.C. with his thoughts on mutual funds and your money, Randall Dodd, director of the Financial Policy Forum.



HAFFENREFFER: When you heard this news that Alliance was voluntarily offering to lower their fees, your first impression was what?

DODD: It wasn't so voluntary. Spitzer negotiated and talked to them of reducing the fees as part of the penalty for the fraud they committed on their customers.

HAFFENREFFER: Is this necessarily to pay customers back on the part of larger customers, or this is something permanent?

DODD: I don't believe it is permanent. The $250 million fee that they're paying will also go to repay some of the losses that their customers have experienced over the past few years. And the fee reduction, as I understand it, will be temporary. And it will be about 20 percent over what they have been charging in the past.

HAFFENREFFER: Is this a proper type of settlement in your opinion?

DODD: I do. I think it's a pretty good idea. Spitzer has been somewhat thinking outside the box. It's a creative response to the situation. Alliance has had very high fees in an industry where fees are already, by most people's standards, too high. Theirs have been on average about 1.85 percent in an industry where fees are running around 1.5 percent. In that regards, it seems to be a kind of creative response.

HAFFENREFFER: This is an industry that, for the most part, does a pretty good job about detailing the fees that it charges its customers -- for the most part. Yet, you would be hard pressed to find a mutual fund customer today that knows exactly what they're paying in fees to mutual funds. Tell me about the transparency you see on that side of the business and how this may or may not affect customers in the future.

DODD: David, I think in many regards the mutual fund industry is lacking in transparency regarding fees. One proposal also on the table that the SEC, as well as Spitzer, as well as the mutual fund industry is talking about, are these bundled or soft dollar commissions.

What they do is they move a lot of their expenses out of the managing corporation and into each customer's account by paying the brokerage firm to buy and sell the securities for the mutual fund a higher than market commission on those securities trades.

And what that does is reduce transparency because people have a hard time figuring out how much they're really paying for research, for product placement by the brokerage, and other so-called, you know, supermarkets of mutual funds. And that has actually reduced transparency and made it hard for customers to, if you will, compete these overcharges out of the industry.

HAFFENREFFER: Most of the settlements that we heard about coming out of Wall Street in the past few years have led critics to say this is simply a slap on the wrist and will not necessarily prevent future types of fraud from taking place.

What are your thoughts as you look at the mutual fund industry at this point? Are any of the settlements you heard to date enough to keep people from being greedy?

DODD: Well, I think this is -- $250 million for one firm, I think that's a pretty substantial penalty. I think this reduction in fees will be an ongoing reminder to them that what they have done is very profoundly wrong.

I think also what we need is a legislative remedy to this. Clearly, we've been for decades now talking about deregulation and about impugning the quality of the government. And now we realized we made the wrong mistake and the government hasn't been allowed to keep up with the needs of these financial markets.

There are a couple legislative proposals that will be introduced in the coming Congress, and hopefully they will address not only these late trading and market timing problems but also address the rather high fee and management fee and brokerage fee, and other nontransparent costs to mutual fund customers.

I know that they're aware of them and I think we just have to really keep some pressure on them in hopes that that will be incorporated into new legislation.

HAFFENREFFER: Thank you, Randall.


·         San Diego Union-Tribune

December 7, 2003


Tricks of the trade:  The SEC is cracking down on two mutual fund scams, but some fear the reforms will be ineffective


By Craig D. Rose


Like a night guard awakened from a sound snooze, the Securities and Exchange Commission took its first shot last week at ending one of the scams that has quietly stolen money from the vast majority of mutual fund investors for years.


But this first action may be a shot in the dark, as some fear it will be unfair and ineffective. And that's the optimistic scenario.


While many in the investment industry have been quick to assert that typical investor losses from the unfolding mutual fund scams amount to only small change, investigations continue and the scope of the damage cannot yet be determined.


Just last week, for example, New York State Attorney General Eliot Spitzer filed a complaint against Invesco Funds for allegedly allowing rapid-fire trading, called market timing, by large investors in a fund it pitched through Young Americans Bank, which caters to customers under 22, as a place to invest for the long haul.


Those large, market-timing investors are hedge funds, unregulated investment vehicles for wealthy individuals and institutions seeking a high return through complex transactions.


In the Invesco case, the hedge funds' high trading volume added large transaction costs to the fund – costs shared by all shareholders. But the profits skimmed by flipping the shares in quick sales went only to the hedge funds.


Even worse, funds allowing market timing are often forced to sell shares at disadvantageous times. Managers may also find a need for more cash on hand than they would otherwise need.


The SEC action last week sought to slam the door on the simplest of the mutual fund scams, namely late trading. This practice allows some investors to place mutual fund trade orders after the 4 p.m. EST time deadline – when investors have had the chance to take in late-breaking news – and still get the 4 p.m. closing price.


Late trading is illegal and apparently widespread. Professor John Coffee Jr. of Columbia University, who specializes in the study of white-collar crime, said an SEC survey found that 25 percent of brokers allowed the practice.


SEC enforcement? Nil, according to a commission spokesman who said staff could not recall a single late-trading enforcement action.


New York's Spitzer, who has played the lead role in busting the scams, likened late trading to betting on a horse race after it's been run.


The SEC-proposed change would cut off trading at 4 p.m. While the so-called hard and fast rule is easiest to enforce, some say it will disadvantage smaller investors whose orders may take time to process.


An investor in San Diego with funds in a 401(k) plan, for example, might find that a trade he or she placed at noon PST time might not be completed until the next day because of processing delays. At the same time, an individual investing directly in a mutual fund might be able to get the same transaction processed the same day.


Groups including the American Benefits Council instead proposed using fool-proof electronic stamps on trade orders, which would provide auditable proof that trades were placed before the 4 p.m. market close, although they might be processed after the deadline.


The SEC also voted last week to require funds to have a compliance officer report to the board of directors and improve disclosure requirements.


Tens of millions of investors have a stake in the ability of the SEC to halt abuses. Although ownership fell slightly last year, 53 million households – about 48 percent of all homes in the United States – had mutual fund investments during 2002. More than half of those investments were retirement savings.


Randall Dodd, director of the Financial Policy Forum in Washington, D.C., noted that middle-class investors typically have about $80,000 invested in mutuals. At that level, even scams of a small percentage quickly compound into big bucks.


Using academic studies of losses from the two key mutual fund scams, Dodd said he believes that the average middle-class investor may have lost more than $3,500 over the past five years.


The calculation factors in what Dodd and others call mutual fund expense or commission overcharges, a whole other area of abuse, according to fund critics.


These charges take the form of management companies charging mutual fund shareholders more for advisory services, failing to provide discounts that funds claim to provide and padding expenses in other ways, Spitzer said.


In congressional testimony last month, the New York attorney general said a fund shareholder with $100,000 could have lost $6,000 over the past decade because of excess fees.


Spitzer said there's a connection between fees that are too high and the recently exposed scams. In exchange for their special privileges, he noted, hedge funds often agree to park money in other mutual fund investments, allowing managers to collect fees on those investments.


The attorney general further noted that although mutual fund investment grew 60-fold between 1980 and 2000, the industry's fees increased 90-fold. There have been no economies of scale, he said.


"The fees paid by mutual fund investors seem to defy the laws of economics," Spitzer said.


But investors have been largely oblivious to these fees, said Max Rottersman, president of fundexpenses.com, which tracks the cost of mutual investments.


"In California, people complained about the hundreds of dollars they paid for auto registration fees and ignored the hundreds of dollars they paid in mutual fund fees," Rottersman said.


University of San Diego law professor Frank Partnoy noted that the SEC was repeatedly warned about the scams that skimmed profits from mutual funds but did nothing. He believes that rule changes and high profile prosecutions may fail to eliminate the problems unless key incentives for scamming are eliminated.


"The authorities are not going to be able to round up everybody," said Partnoy, author of "Infectious Greed: Deceit and Risk Corrupted Financial Markets."


The key incentive, he said, is the failure of mutual funds to update their share prices continuously during the day. By setting prices just once daily, he said, fund prices are often stale in market terms and allow hedge funds to make money on the difference between the outdated price and the price that they can predict that shares will soon reach.


Add the damage from these arbitraging schemes to what Partnoy also said are excessive fees and he concludes, "Investing in mutual funds is a mistake for most investors."


Investors with a computer and Internet access can create balanced portfolios of perhaps two dozen stocks and beat the performance of most mutual funds, Partnoy said.


To be sure, that remains a minority view among investment experts. Nearly all experts, though, believe investors should be much more active in shopping for investments.


Mercer Bullard, a University of Mississippi law professor and founder of Fund Democracy, a mutual fund investor advocate, said activism should start with a careful reading of the fund's prospectus.


"If reading it gives you a headache, it's been written to discourage understanding," Bullard said. In that case, he said, move on to another fund.


Bullard and other investment advisers recommend that investors seek funds with below average expense fees. Most suggest paying no more than 50 basis points – equivalent to 0.5 percent – for passively managed funds, or funds that seek to mimic established indexes.


For specialty funds, investors should be wary of paying more than 1 percent for expenses, unless there are compelling reasons to do so.


"It is very difficult to overcome high fees," said Dale Stephens of Grasswood Partners, a Malibu consulting firm for wealthy individuals and pension funds. "You're going to have a hard time making up for that fee in terms of performance."


But he and others say properly managed and reasonably priced mutual funds are still a good deal for most investors.


"The majority of people cannot beat a mutual fund," said Charles Foster, a principal of Blankinship & Foster, a financial planning firm in Del Mar.


"It takes more than a little bit of study. And it takes gumption to buy when others are selling and to sell when others are buying."


Foster said he prefer mutuals even for relatively affluent investors, including those with more than $500,000 to invest.


"I'd rather have somebody with gray hair – or no hair – who has been at it for 30 or 40 years and who has the interest of investors at heart but does not overcharge for it," he said.


One point on which a sampling of investment advisers agreed was that investors should penalize those funds found to have allowed scamming by withdrawing their investments.


"Do not support a fund that is (allowing) market timing or late trading," said Neil Hokanson of Hokanson Capital Management, a Solana Beach investment adviser to pensions, nonprofits and wealthy individuals. "Pull money out of any fund that has violated the rules."


The SEC has yet to deal with the problem of market timing, which most experts believe has been more costly to average investors than late trading.


Market timing involves large investors who perceive discrepancies between how a fund prices its shares and its actual market value. This often arises in international funds, where a 4 p.m. closing price might be based upon the share prices in markets that closed more than 12 hours earlier.


Events since the close of the Asian market might strongly suggest that the price of the shares will rise sharply, so the large investors buy shares at the stale daily price of the U.S. mutual fund set at 4 p.m. and sell them the next day for tidy profit.


Funds bar most investors from this strategy by limiting the number of trades. But Spitzer is finding a growing number of funds that made special arrangements with larger investors allowing unlimited trading.


The SEC is considering slapping a redemption fee on short-term trades of perhaps 2 percent, reducing the profit incentive for market timers.



·         The Street.com

The CFTC, Reluctant Regulator


By Will Swarts

Whatever the Commodity Futures Trading Commission finds out about disputed asset pricing at the Clinton Group of hedge funds, the most surprising thing about the investigation is that it happened at all.

The federal agency that was once poised to become the most active regulator of the diffuse and opaque hedge fund industry spent the last three years backing away from its oversight role, to the point where some former CFTC officials worry that derivatives trading, a critical sector of U.S. financial markets, is dangerously unsupervised.

Under chairman James Newsome, a former lobbyist for the Mississippi cattle industry, the CFTC has reduced the criteria that once forced many hedge funds to submit annual reports as registered commodity pool operators and commodity trading advisers. In August, the agency passed a set of rules relaxing reporting requirements for hedge funds, many of which were overseen by the agency because they trade futures contracts.

The nearest thing the hedge fund industry has to a lobbying group is the Managed Futures Association. Since 2000, the MFA has stepped up its lobbying efforts with regulators, asking the Securities and Exchange Commission to let hedge funds advertise and pressing for minimal disclosure and registration requirements for fund managers.

While the Clinton Group is not a member of the Managed Funds Association, founder George Hall was a featured speaker at an MFA conference in June. Richard Clarida, Clinton's chief economic strategist, is scheduled to address another MFA conference in February.

Clinton's problems came to light in October, when senior trader Anthony Barkan resigned and issued a public statement about his concerns over possible mispricing in asset-backed securities portfolios in the firm's $4 billion hedge fund business. The firm quickly hired PricewaterhouseCoopers to check its valuations, but with hedge funds under the microscope, Clinton was soon visited by both the SEC and CFTC.

It was an unusual move for the latter.

"This is a very strange time for the CFTC to be investigating anybody," says one person who knows the agency well. The agency, this person says, has been stepping away from its regulatory duties since 2000 and gets involved in big investigations only when it can't avoid them.

"The CFTC took a deregulatory course, even though the SEC was moving in the other direction. They probably gave up regulatory jurisdiction over half the funds they regulated."

A CFTC spokesman says the agency doesn't comment on whether it is investigating particular firms, but says it is "very active with enforcement and investor protection." The agency's Web site lists 109 enforcement actions taken this year, many against foreign currency traders and energy derivatives traders.

But hedge funds are less of a priority. While the SEC now appears to be leaning in the direction of increased regulation for hedge funds, the MFA has succeeded in easing CFTC oversight. Part of the reason is the extensive contacts between the MFA and the agency it lobbies. MFA president Jack Gaine has a history of working well with Newsome, and last year the CFTC hired former MFA general counsel Patrick McCarty as its own general counsel.

While he lauds the deregulatory direction of the CFTC over the last several years, Gaine points out that the agency's antifraud provisions remain unchanged, and that funds could face criminal and civil penalties for misrepresenting or misvaluing their assets or performance.

Gaine has high praise for Newsome. "I share his views, particularly on market development," Gaine says. "I think he's the best, or one of the best, chairmen they've had over there."

"In this situation, you basically have the CFTC very much influenced by a lot of the industry groups it represents," says Michael Greenberger, a law professor at the University of Maryland and the former director of trading and markets at the CFTC.

"Chairman Newsome is as deregulatory as any chairman the CFTC has had," says one agency veteran. "Once McCarty was brought in as general counsel, well, it certainly sent a signal."

The CFTC also delegates much of its investigative work to the National Futures Association, a self-regulatory organization that handles initial complaints and concerns about futures traders, similar to the way the NASD sometimes works in conjunction with the SEC.

But the CFTC does spend money and put resources into its own investigations; it sent $22.8 million of its tiny $82.8 million fiscal 2003 budget to its enforcement division, which is well regarded, though much smaller than the SEC's operation.

Randall Dodd, a former CFTC economist who now runs the Derivatives Study Center, a Washington think tank, says the agency has long been underfunded and understaffed, long before its recent deregulatory bent.

"You can't send David in against Goliath every day and expect him to win," he says. "The derivatives industry has grown so much faster than banking or equities or insurance, and regulation has not kept pace."

Dodd and Greenberger both say the agency's value was most apparent in 1998, when the CFTC was the only federal body that had any information on Long Term Capital Management, a heavily leveraged hedge fund that was on the verge of blowing up while holding derivatives with a notional value of $1.25 trillion.

After the Treasury Department, the Federal Reserve Board, and the Federal Reserve Bank of New York convened to organize major investment banks in a hasty and expensive buyout of the bankrupt fund, the CFTC was the agency that called out for regulation of over-the-counter derivatives activity, says Greenberger.

"They recommended at the time that there be a rigorous reporting of hedge fund activities to the federal government, but the question about how it would be done was left open," he says. "But after [then chairman] Brooksley Born retired in 1999, each new chair became more devoted to moving from regulation to deregulation."

At the same time, he says, the Securities and Exchange Commission was starting to look more seriously at regulating hedge funds.

"Even Harvey Pitt saw that hedge funds were having an impact on the economy," Greenberger says. "Now the SEC is in the driver's seat, but it doesn't have the most direct regulatory tools that the CFTC had. And they've given up every meaningful regulatory peg they had."

Greenberger says the agency's enforcement actions now are directed at small-time operators, "and there are a lot of them and they can be very bad," but that it won't go after pillars of the futures industry.

"Look at the MFA -- they can't say enough good things about how good a regulatory agency the CFTC is, and that is because it is basically a toothless regulator. Anything they're doing with Clinton, they've basically been dragged into."



·         Washington Post

November 7, 2003


Fund Scandal in New Territory

Definition of 'Insider Trading' Broadens


By Brooke A. Masters

Washington Post Staff Writer

Friday, November 7, 2003; Page E01


NEW YORK, Nov. 6 -- The exploding mutual fund scandal makes some regulators

and prosecutors wonder if they've uncovered a new kind of insider trading.


There is growing evidence that some fund company executives who had access

to inside information made short-term personal trades that may have hurt

their investors, and nearly a third of large fund families have admitted to

the Securities and Exchange Commission that they shared private portfolio

information with hedge funds, which are largely unregulated investment

pools for the wealthy.


"The fundamentally unethical nature of this conduct is obvious," said

Massachusetts Secretary of the Commonwealth William F. Galvin, who brought

a complaint alleging that two Putnam Investments portfolio managers

improperly made short-term trades in their own funds. "Clearly the fund

managers [who were] trading their own funds had knowledge that is not

shared with other investors . . . and they were making huge amounts of

money on this."


New York state Attorney General Eliot L. Spitzer, who on Sept. 3 became the

first to move against mutual fund abuses, and federal authorities said they

too are looking at whether any of the alleged conduct merits bringing an

insider-trading case.


"The issue of fund managers sharing portfolio information is . . . the

equivalent of receiving a tip from an insider about securities," said SEC

enforcement director Stephen M. Cutler. "We would consider the full array

of enforcement tools, including, where warranted, insider trading."


SEC Chairman William H. Donaldson, in a speech Thursday, said the scandals

"involving . . . insider trading at mutual funds have revealed wrongdoing

in the part of the securities industry where individual investors are most

exposed and must be protected. The wrongdoing must stop; past and present

malefactors must be brought to account through both civil and criminal



The SEC brings only civil insider-trading cases, which can lead to large

fines, but the agency also works with prosecutors to develop criminal cases

for the most serious offenses. In the case of the mutual fund

investigation, federal prosecutors in both Boston and Manhattan are deeply



No one has been charged with insider trading in the mutual fund scandal,

but the hedge funds and managers who have been cited in the investigations

used what authorities say may be insider information to engage in

"market-timing," making short-term investments that try to exploit the fact

that mutual fund prices, which change only once a day, can lag behind the

value of their holdings. While the strategy is legal, most funds say they

try to prevent it because market-timing increases fund costs and allows

short-term investors to make profits that cut into returns for longer-term



Legal experts cautioned that building an insider-trading case could be



Classic insider trading involves a trader who has improperly gotten or been

given important nonpublic information about a particular stock and profited

from that information.


In the fund scandal, the timers had no special information about what was

going on with the underlying stocks owned by the mutual funds. But they

allegedly knew exactly what a particular fund was holding and therefore

might have been in a better position to judge which fund prices were out of



For instance, if a fund was heavily invested in a particular European

computer company, its share price, which is set when markets close in New

York at 4 p.m., would have reflected what happened to that stock before the

close of European markets at noon the same day. If, between the close of

the European markets and the setting of the fund price, there was a

development that was likely to cause the computer company's stock price to

go higher the next day, the market timer would buy shares in the fund

anticipating a quick profit.


Regulators and investigators agree that the big challenge would be to show

that the insiders who traded had particular nonpublic information about the

funds that made their market-timing trades more successful.


For example, they are trying to determine if those who were market-timing

shares in a mutual fund sat on the fund's valuation committee and therefore

had direct, nonpublic information about how funds were going to change in

value on any given day, one regulatory source said. They're also looking at

situations where the timers -- but not other people -- knew that a fund had

a large position in a particular stock whose price was about to move

significantly, a second source said.


If such abuses are found, the first source said, "it's a new species of

insider trading."


"It's really a law professor's dream and a prosecutor's nightmare," said

University of Mississippi law professor Mercer Bullard. An alleged

perpetrator "can argue, 'I was buying on the same public information as

everyone else,' " Bullard said.


The example of Richard S. Strong, who resigned this week as chairman of the

Strong funds during the furor about his personal trading, may be crucial.


Spitzer has said he intends to bring an action against Strong for making

short-term trades in specific Strong funds while he chaired the board of

directors, which is supposed to look out for the funds' investors.

Investigators say that the company made an effort to stop timing in some of

its funds but that Richard Strong made a point of trading other areas.


"Strong is probably the poster boy for market-timing abuse, and he would be

a good candidate for criminal action," said Columbia University law

professor John C. Coffee.


But Strong's lawyer, Stanley S. Arkin, denied that his client ever misused

nonpublic information about the funds he oversaw. "It is incorrect as a

matter of fact and law to suggest that anything my client did could ever

amount to insider trading. That's just dead wrong," Arkin said.


Building a case against fund managers may be complicated by the fact that

many fund companies encourage their executives to invest in their funds

rather than trading stocks in their personal accounts. That rule was in

turn a reaction to earlier problems. In the late 1990s, the SEC discovered

situations where some portfolio managers were "front running" their own

funds by buying or selling particular stocks that the fund was going to buy

or sell.


Lawyers for the former Putnam portfolio managers who have been charged with

timing their own funds either declined to comment or did not return phone



The SEC and Spitzer's staff are also looking at whether mutual fund

executives violated insider-trading laws by sharing portfolio information

with hedge funds.


In Spitzer's settled civil complaint against Canary Capital Management LLP,

he alleged that several fund companies, including Strong and Bank of

America, shared information about their holdings with the New Jersey hedge

fund. That enabled Canary's manager, Edward J. Stern, to not only make

money in a rising market by timing but also to profit in a falling market.

Stern did that by buying financial instruments known as derivatives that

gained value when the price of stocks in the funds went down.


As a result, Stern, unlike less informed investors, was in a position to

make money no matter what happened. "People who can only buy the fund, can

only profit on a good day. But if you have a derivative, you can profit

either way," said Randall Dodd, director of the Financial Policy Forum.

"That's identical to insider trading because [the hedge fund] had knowledge

of the composition of the funds that others didn't."


Stern's lawyer, Gary Naftalis, did not return a message left with his

office. Outside lawyers said that some funds may have protected themselves

against insider-trading allegations by saying in their prospectuses that

they occasionally shared portfolio information with outsiders.


"You can't have insider trading unless you have a breach of a fiduciary

duty to keep quiet," said New York Law School professor Jeffrey J. Haas.


Given the murkiness of the law, the SEC, state enforcers and federal

prosecutors are looking for alternate punishments for conduct they find

egregious, officials and other sources said.


"We are looking at a whole range of criminal theories, larceny . . .

embezzlement. There are going to be more felony charges brought," Spitzer



Staff writer Kathleen Day contributed to this report.


·         Fort Worth Star-Telegram

November 1, 2003


Reliant takes $1 billion charge on plants

By Dan Piller

Star-Telegram Staff Writer


Reliant Resources of Houston said Friday that it will take a $1 billion

charge against third-quarter earnings to cover lost asset value of

electrical generating plants it bought less than two years ago.


"We're saying that the value of the wholesale energy business has

declined," Reliant spokeswoman Sandy Fruhman said. Reliant will report

third-quarter operating results Nov. 10.


The write-down won't cover operations but instead will reflect lowered

value on Reliant's $5.4 billion purchase of 22 generating plants in

Pennsylvania, New Jersey and New York from Orion Energy in February 2002.


Reliant is subtracting $1 billion from the goodwill item in its equity

accounts because of an equal amount of losses during the past two years.

The write-down will follow a reduction of equity from $6.3 billion in March

2002 to $5.2 billion at the end of last year.


Goodwill is defined as the difference between the brick-and-mortar value of

a property and its ability to generate revenues and profits. Such

charge-offs are most common in capital-intensive industries that see

financial reverses, such as railroads, energy companies and utilities.


"The entire merchant generation industry has been a disaster," said Randall

Dodd, director of the Financial Policy Forum, an energy consulting group in

Washington, D.C. "The generators have high fixed costs, and when demand is

down, the losses can be huge."


Reliant is the former Houston Lighting & Power Co. and has 1.6 million

residential customers in Harris County. It also has more than 100,000

customers in the Dallas-Fort Worth area that it has won from TXU Corp. of

Dallas in the 22 months since the state's residential electricity market

was deregulated. Fruhman said Reliant's North Texas retail operations are

not affected by the charge-off.


The announcement Friday wasn't a surprise. Joel Staff, who replaced Steven

Letbetter as Reliant's chief executive in April after the company was

forced to renegotiate bank debt, had indicated last summer that a

charge-off was likely. Reliant's stock closed down 2 cents Friday at $5.03.

The stock has traded as high as $37 per share in the past three years.


Reliant, like several other traditional investor-owned utilities, responded

to electricity deregulation by buying generating facilities outside of its

home territory. By the end of 2002, Reliant owned 129 generators from the

East Coast to California.


The strategy backfired loudly, first in California, where Reliant was

entangled in the electricity crisis of 2000-01. Several Reliant traders

were implicated in electricity-market manipulating schemes. Reliant has

paid a $13.8 million fine to regulators and faces more government and legal

action in California.


Despite the California setback, Reliant went ahead with the Orion purchase

early last year. The acquisitions added substantially to Reliant's debt,

forcing a showdown with lenders in March that ended with Letbetter's



Fruhman said Reliant went into the merchant generating business earlier

this decade, "at a time when many assumptions about the industry were

different from today." She said Reliant assumed there would be growing

demand for electricity, as well as lower costs, when it made the Orion



Reliant's situation is similar to that of Mirant of Atlanta, a nationwide

merchant generator that filed for Chapter 11 bankruptcy protection in U.S.

Bankruptcy Court in Fort Worth in July. Last week, Mirant reported a loss

of $2 billion for the third quarter.


TXU avoided getting into the merchant generating business, but it suffered

a $4.2 billion loss in 2002 when its British subsidiary went bankrupt.


Reliant said that absent the charge-off, it expects to earn 10 cents per

share from continuing operations for 2003. Reliant lost $458 million in the

first six months of this year and $560 million in 2002.




·         Florida Today

Sep 23, 9:58 PM

Financial advisers see investors coming back

Firms hope stock market turnaround continues to grow

By Brian Monroe

It's not the deluge some hoped for, but that could be coming. Now, it's more of a building trickle. A good earnings report here, a higher stock price there.

Taken together, many investors are starting to notice Wall Street's building momentum and are "putting their toes back in the market." That's good news for local investment firms, which have noticed a significant increase in business compared with last year.

Industry experts say the growth of financial advising firms is not limited to Brevard County, but instead is part of an overall trend of investors regaining more confidence.

Two reasons seen as encouragement: Both the Dow Jones industrial average and the tech-heavy Nasdaq composite index have trudged steadily upward this year.

Since floundering in the 7,000s in March, the Dow has risen more than 24 percent, ending Tuesday at 9,576.04.

Similarly, the Nasdaq -- below 1,300 in early February -- surged more than 45 percent to above 1,900 in recent weeks and ended Tuesday at 1,901.72.

"Investors are realizing some of the best opportunities exist today," said Steven Wilmarth, associate vice president of investments for Raymond James & Associates in Melbourne, adding that while bargains abound, it is better to chart a course with a financial expert than go it alone.

Wilmarth said his business is up more than 66 percent, comparing the last six months to the same period a year ago. He attributes that increase to different factors:

With war now turned to rebuilding, "the geopolitical backdrop for the market has improved dramatically," he said.

·  Stronger corporate earnings are luring potential investors as companies do more with less, and there's "a significant increase in employee productivity," Wilmarth said.

·  Historically low interest rates -- which have fueled home-buying -- have reduced fixed-income investment rates, such as on a money-market account, coaxing investors back into stocks and mutual funds.

·  The government is cracking down on those involved in the corporate fraud -- like the WorldCom and Enron scandals -- heartening investors that not every corporation will mislead.

"Over longer periods of time, the equity markets have delivered very impressive results for investors," Wilmarth said.

Exactly, said Kenneth Janke, chairman of the National Association of Investors Corp., a nonprofit organization of more than 400,000 members devoted to investor education.

"I have been in the investment business for 43 years, and I have never seen a bear market that didn't end," he said. "You need to have confidence in the long term. Everyone wants progress, and we have seen that in recent quarters. It is not as robust a turnaround, but very positive."

After being spoiled on huge gains in technology and Internet stocks, investors now are "going back to the basics and looking at the business fundamentals of a company," Janke said.

"They are finding there are a number of stocks selling favorably, compared to what they will earn this year and the next year."

"I have seen a general trend of clients sticking their toes back into the market," said Kevin Smith, vice president of investments and portfolio program manager at the Melbourne branch of UBS Financial Services Inc., formerly PaineWebber. "People's tastes have changed. They realize that risk exists, and some of the more-aggressive clients have come back into the market, but are looking for more-conservative investments."

UBS recently made a move to give potential investors a simpler name to turn to for financial services, by dropping the PaineWebber part of its name in June. Three years ago, Swiss banking group UBS AG bought PaineWebber for $10.8 billion in cash and stock, the largest acquisition by a European company of a U.S. brokerage firm.

By acquiring New York-based PaineWebber -- the fourth-biggest brokerage firm in the United States with 8,500 brokers at the time -- UBS gained a stronger foothold in the United States with a company known for its affluent clients.

And for the company's Melbourne operation, "business is up versus this time last year, there's no question," Smith said. In the last two years, "investors thought the market will go down and never come up. Now, investors are more willing to try more options . . . take a more-balanced approach."

At least they are approaching.

"We have noticed our clients having more confidence about stock prospects," said Jorge Hoffmann, an investment representative for Edward Jones in Rockledge.

He said business, is up more than 10 percent so far this year, compared with the same period last year.

Still, what is high one day could crumble the next, Hoffmann said.

That is why he believes clients should "always maintain a well-balance and diversified account regardless of market performance. It is time in the market, not the timing of the market that is important."

One investor said he is considering changing his "conservative" investment tactics to a more "moderately aggressive" approach because the market is getting healthier, said Indialantic resident Mike Spragins.

"Things seem to be turning around," he said. "I am not going full-speed aggressive like I was five or six years ago, but I am still not afraid to invest. I just choose now to invest in rock-solid blue-chip stocks that will stand the test of time."

Many investors, however, are still "sitting on the sidelines" because they have been hurt by the market and are worried about corporate fraud, said Randall Dodd, director of the Financial Policy Forum, a Washington-based nonprofit research institute.


But when those on the sideline finally decide the time is right, there would be a "tipping point -- a deluge. When investors feel confident again, there is a lot of money that will come back in."



·         Yahoo News

Monday August 25, 10:03 PM


Fitch cuts freddie mac amid more management woes


Freddie Mac (NYSE: FRE - news) came under fire again Monday, as rating agency Fitch slashed its rating on the firm's subordinated debt and preferred stock. The move came after the housing finance firm ousted its new chief executive late Friday.


Freddie Mac's board of directors said Chief Executive Greg Parseghian would step down less than three months into the job, at a time when the company is beset by questions about its accounting. "The current management problems come at a critical time," said Randall Dodd of the Financial Policy Forum.


Parseghian had taken the helm in June when Freddie Mac's board replaced top management over accounting irregularities. At the time, Freddie Mac said it would restate profits upward by between $1.5 billion and $4.5 billion.


In a statement, the company's chairman said, "the restatement remains unaffected by this change, and is still on track to be completed during the third quarter."


In July, Wall Street digested an independent report commissioned by the board that said executives massaged earnings to create the aura of a "steady Freddie" that could generate consistent, predictable financial results. The same report raised questions about Parseghian's role at a time when the firm's was chief investment officer.


The stock tells part of the story, starting off the year above $64 a share, but falling to a low of 47.35 on the midyear management shuffle, before closing Monday above $51 a share.


Congress is weighing what should be done -- the most likely move would be to allow the Treasury Department to take over the independent auditor that watches over Freddie Mac and Fannie Mae (NYSE: FNM - news) .


Late Monday, there was some relief for Freddie Mac, when rating agencies Standard & Poor's and Moody's affirmed their ratings, although Moody's said it may cut the firm's financial strength rating.



·         CNN FN


July 15, 2003 Tuesday


J.P. Morgan May Settle Out of Court In Enron Collapse, CNNfn

GUESTS: Randall Dodd

BYLINE: David Haffenreffer

DAVID HAFFENREFFER, CNNfn ANCHOR, MONEY & MARKETS: On the pension front, J.P. Morgan Chase (Company: J.P. Morgan Chase & Co. ; Ticker: JPM ; URL: tttp://www.chase.com/) may settle out of court for its role in the Enron collapse. According to the "The Wall Street Journal," the investment bank could pay $175 million to the New York District attorney's office and to the Securities and Exchange Commission.

Such a deal could protect J.P. Morgan from criminal charges but has too much damage been done to the bank's reputation? Randall Dodd is the director of the Financial Policy Forum; he joins us now from Washington with his expertise on this front.

Randall, nice to see you again.


HAFFENREFFER: Let's pick this apart. The headline here is that there could quite possibly not be criminal charges. That would deliver quite a blow to the company.

DODD: Well, the lack of criminal charges would be quite a gift to the company. I think they're afraid with criminal charges that would bar them from certain lines of business, and that would be a substantial hit to their earnings and bottom line.

HAFFENREFFER: But without criminal charges, does any type of settlement have any real teeth?

DODD: I don't think it does in this case. Not only are there no criminal charges, from what we know so far, but also even the fines seem extraordinarily small. If you look at it as a percentage of how much they made in trading derivatives in the first quarter of this year, it's about 13 percent. It's not even a large fraction of one quarter's derivatives trading profit.

HAFFENREFFER: This could be about $175 million, at least according to "The Journal's" write on this one.

DODD: That's a high-end estimate, yes. It could be as little at $1.25.

HAFFENREFFER: Let's break it down according to -- what office is doing discussions with them at the moment. The Manhattan District Attorney Robert Morganthal (ph) is working on what angle on this front? He's using some tactics that Eliot Spitzer used along the way as well.

DODD: That's correct. It's a 1921 law designed to prevent people from manipulating or misrepresenting transactions to the market. That doesn't require the prosecutor to prove intent, which of course, is very hard to do. And they're going --


DODD: And they're going --

HAFFENREFFER: Yes, go ahead.

DODD: I was going to say, one of the things they're going after is some of these really nefarious activities we saw associated with Enron, where series of derivatives transactions were used to basically create a financing or debt transaction and yet to be reported on the books as though they were just a series of derivatives transactions.

Then just to add a little bit of injury to this insult to investors, they snookered some insurance companies into guaranteeing these derivatives transactions. Insurance companies ended up being on the hook for some of the costs.

HAFFENREFFER: They were doing this through these things called "gas prepaid contracts". The idea here is that J.P. Morgan helped them coordinate all this?

DODD: They were very involved in the coordination. J.P. Morgan Chase set up special purpose entity in the Cayman Islands, called Mahonia (ph). And they acted as a mask for these multiple transactions between Enron, Mahonia (ph) and J.P. Morgan Chase. Some of those transactions were then presented to insurance companies, as arms-length transactions, that they were convinced to guarantee through assurity bonds.

HAFFENREFFER: We talked about reputation on the way into the segment; does anybody care about this? Is it going to hurt the potential client base that the company is hoping to attract to do business with them on a corporate level?

DODD: If I were a client of there's, I would certainly be very, very cautious. Not just with J.P. Morgan but most of the derivatives dealers on Wall Street. Because this is -- they're not the only ones that have, if you will, ripped the face off their customers or clients.

I think the other concern for J.P. Morgan is that what it means, though, for their stock price and earnings going out. In that regard, this is a very small fine. In some sense, it's not a fine at all but merely an inoculation. Because what the settlement will do will help protect them from shareholder suits and other legal liabilities coming down the pike.

This is probably a very good thing for them in and of itself. Their reputational problems are larger and different from this settlement per se.

HAFFENREFFER: Sounds like we're going to lump this settlement in with the rest of the Wall Street related settlements that we've seen over the last couple of years, as more slap on the wrist type settlements and they won't lead to any meaningful reform, you think?

DODD: That's what I'm afraid. We just don't see in Congress a movement by either House or Senate leadership to move to any substantial reforms of our financial markets. Meanwhile, these transactions that we're seeing motivating these charges have really wreaked a lot of damage on our equity markets and especially on our energy derivatives markets, where trading volume is still, at best, 80 percent of what it was pre-Enron.


DODD: I'm sorry, David?


DODD: I was just listing some of the damages that have been caused by this activity. It's been no apparent leadership in the House or Senate to repair these damages. And so in these fines, themselves, I don't think are substantial magnitude to convince these firms that this was wrong, and that they would have to change their ways.

These fines to me in a settlement, this seems much more like an inoculation against future damages. I'm afraid they're not going to be taken seriously.

HAFFENREFFER: All right, Randall Dodd, we appreciate your insights.

DODD: OK, David. Thank you.

HAFFENREFFER: Thanks for being with us from the Financial Policy Forum, joining from us our D.C. bureau.



·         Agence France Presse

July 13, 2003 Sunday

SECTION: Financial Pages

HEADLINE: Microsoft's rejection of stock options fans revolt against corporate "greed"


Corporate America's struggle to win back investors jaded by financial scandal got a jolt last week when Microsoft Corp. said it would jettison stock options, once the golden egg of the Internet age but now a tarnished symbol of fat-cat greed.

Starting in September, Microsoft will abandon the practice of awarding stock options to executives and workers, giving them the chance to earn actual shares instead, the company said July 8.

Microsoft added that it would account for stock-based compensation as an expense on its balance sheet for fiscal 2004, which began July 1.

The company took the decision after employees expressed "angst" about the options plan, chief executive Steve Ballmer told reporters. Stock options give bearers the right to buy shares at a fixed price over a specified period, essentially gambling that the price will have risen by the time they convert the options into actual shares, which they then keep or sell.

In recent years, however, Microsoft shares have fallen.

The announcement also came amid pressure from investors and regulators alarmed by a plague of US corporate scandals involving management chicanery and revelations that bosses had enriched themselves even as they laid off workers and misled shareholders savaged by the markets.

"All firms are now looked at with suspicion, so what might be considered the smarter ones are trying to get out ahead of that," said Randall Dodd, director of the Washington-based research group Financial Policy Forum.

Last month, the US Securities and Exchange Commission ordered companies listed on the New York Stock Exchange and Nasdaq stock market to get approval from shareholders before granting stock options to executives and directors.

The Financial Accounting Standards Board, the setter of corporate accountants' rules, also is moving to force companies to expense stock options.

Big business, however, has successfully lobbied US lawmakers to introduce bills that would block enforcement of any such rule for three years.

Dodd, who opposes expensing, said firms are loath to give up options because, while they do not book them as expenses, companies do claim options as tax deductions when employees convert or cash them.

Thus, in 2000, Microsoft and five other top US tech firms paid no federal tax because they deducted some 10 billion dollars in exercised options.

The US labor movement, which is leading a shareholder assault on what it sees as executive excess, seized on Microsoft's announcement to turn up the heat on other firms.

"Microsoft's announcement establishes an important executive compensation precedent," Richard Trumka, secretary-treasurer of the 13-million-member AFL-CIO federation of labor unions, wrote to the chief executives of a dozen leading firms on July 9.

Labor-affiliated pension funds with 400 billion dollars in combined assets have filed some 200 out of a record 300 shareholder proposals on executive pay-related issues, according to the Washington-based advisory group Investor Responsibility Research Center.

Fanning workers' and investors' ire, the center said in April that chief executives of the top 100 US firms earned an average of 1,017 dollars per hour in 2002, compared with 16.23 dollars for the average worker.

Stock options were excluded from the comparison but would further widen the boss-worker pay gulf, already the largest in the industrialised world, it said.

Union-sponsored proposals specifically asking management to expense stock options have received majority votes at this year's annual shareholder meetings of 26 US companies, according to the AFL-CIO.

Most shareholder proposals are not legally binding, but investors say strong support puts pressure on companies to change their ways.

The threat of a vote moved 11 firms, including telecommunications providers Verizon and Sprint, to offer to expense options if unions withdrew their proposals.

Supporters of expensing say firms have used stock options to muddy their books and inflate their earnings but would stop showering them upon employees if they were forced to count options as a cost, like salaries.

Opponents of expensing counter that options have enabled startups with little cash to attract workers and executives by supplementing modest salaries with incentives they can cash in later.

Such was the case with Microsoft, which gave options to all of its 50,000-plus employees, making millionaires of thousands of them -- at least before the dot-com bubble began to burst in the late 1990s.


·         Goldseek.com – The Daily Reckoning


The Big Truth Revealed

By: Richard Daughty, The Mogambo Guru - The Daily Reckoning

The Mogambo Guru

July 02, 2003 -

A newsy item on Dow Jones reports, "Global bond issuance reached record levels in the first half of this year as borrowers locked in low interest rates and investors flocked to fixed-income assets."   How come when we talk about the borrowers, we mention the low interest rates, but when we are talking about the investors investing their money at these ridiculously-low yields, we refer to them as moving into "fixed-income assets"?Some of these borrowers are apparently the states themselves, as Stateline.org, the guys who report on the spendthrift weenies in state governments, reports that "States borrowed $224 billion in the 12 months ending Monday, double the amount two years ago." The state jackasses are not content to constantly increase spending faster than inflation, not content to increase taxes, but have been heroically able to constrain themselves enough to only borrow the equivalent of more than $2,000 for every American who has a job in the private sector.  In one year.   No wonder they make the big money, huh? 

And why is America doomed to bankruptcy and ruination? Because we so desperately deserve it, as we are obviously a nation of imbeciles and morons who elect imbeciles and morons to spend us into hell.

And how did we get to be such morons and imbeciles?  Well, you don't get kicked out of your house because you did not know about Byzantine art.  You don't get bill collectors calling you at 2 am. with their snotty scripts and disrespectful attitudes and their vague threats and one of these days I'm going to call their bluff and see what happens because I don't think they really know people named Vito and Scarface, all just because you can't quote a poem about some damn fog coming in on little cat's feet.  Sandburg, as I recall.  And you don't get your damn car repossessed because you didn't know that the capital of  Tanzania is, oh, I don't know either, and notice that I did NOT get my car repossessed as a result, which proves my whole point.  

But all the teachers in all the schools are all Democrats, and all Democrats think that your money is so unimportant that it is immaterial to them whether or not you know even the most meager basics about money, finance or economics.  The one damn thing that you really need to know about, because it will literally determine whether your whole society lives or dies, not to mention whether or not you will personally be wiped out financially and ruined completely due to your financial ignorance, they don't teach at all! 

Teachers and the education establishment.  Hah!  I laugh with a disrespectful and condescending tone, but in a manly way, and not with the typical girlish giggle, so that is a nice change of pace.  The surprising thing, to me, is that they think they deserve any respect at all. 

-          A note from Randall Dodd, director of the International Swaps and Derivatives Association,  gives us the good news that the entire derivatives market, including transactions based on stocks, bonds, loans, commodities, currencies, mortgages, tacos, and cases of Twinkies snack cakes, which has a notional value of more than $100 trillion, is completely unregulated   Mr. Dodd recounts how the derivatives market has "No reporting requirements, no collateral requirements, no licensing of traders. There's no supervision of this activity.   Even if you're a regulator and you want to see what's happening, you can't."

[NOTE!  The author of this story incorrectly associates Randall Dodd with ISDA – the International Swap and Derivatives Association.  The remark within quotation marks is correct]

Fabulous.  I am sure that you can show how every other example of unregulated markets in history, especially ones that have government-guaranteed access to huge piles of secret, unregulated money of such staggering size that they total more than 300% of the GDP of the entire globe, always leads to prosperity, happiness and success.  

-      When it comes to money, the latest reading is that government salaries and transfer payments were up more than any other income category.  Fabulous.  It is always a good sign when government employees make more money than us peasant trash out here, and when government employees get salaries hikes but us proletariat losers get our wages and positions cut.   And I am always delighted to hear how the recipients of transfer payments are getting more and more money, because I imagine it is so tiring to be a parasite and then have to suffer the added indignity of not being able to have a higher standard of living next year.

-            Addison Wiggin at the DR writes, "The Mortgage Bankers Association released their data last week showing that nearly all the profits being banked through mortgages are now coming from cash-out refinancings (the practice of refinancing your home for more than it's worth, so you can afford to make payments on your SUV and meet the minimum monthly requirement on your 8 credit cards!). The Federal Reserve's own numbers reveal that cash from refinancing accounted for nearly $700 billion of consumer spending last year." 

That $700 billion certainly seems like a large amount of money, until you realize it is just the average, two-day hospital bill.  It is also about 9% of disposable personal income.

In a similar vein, Marc Faber, in an essay on the Daily Reckoning site, wrote, "Fannie Mae is the perfect example of today's reckless excess of credit. The GSE mortgage lender just raised its projection of mortgage originations for 2003 to a record $3.7 trillion - this in a $10 trillion U.S. economy and compared to an increase of total mortgage borrowing of just $1 trillion between 1990 and 1996!" 

Perfect.  Just freaking perfect.  The jackasses known as the American electorate have, in one damn year, saddled themselves with more huge mortgages, to the tune of 40% of everything that this country produces in a whole year. In one year!



·         Miami Daily Business Review

(also appeared in Palm Beach Daily Business Review the same day)
June 30, 2003


HEADLINE: Is fast-growing credit derivatives market putting banks at risk?
With so few dealers, trouble with one could spread quickly to all

P. Morgan Chase & Co. recently held a conference in Manhattan, drawing about a thousand people to discuss one of the fastest-growing and least understandable financial markets in the world: credit derivatives.

"We outgrew the Waldorf and had to go to the Sheraton Towers," said Andy Brindle, global head of credit derivatives at J.P. Morgan. "Next year, we'll have to go to Madison Square Garden, I think."

That arena, as large as it is, could not begin to capture the immensity, complexity and potential risks of credit derivatives.

"The range of derivatives contracts is limited only by the imagination of man, or sometimes, so it seems, madmen," Warren Buffett, chairman of Berkshire Hathaway, said in his annual letter to shareholders in February.

A credit derivative is an investment contract between two parties - usually banks and insurance companies or hedge funds - that's derived from the anticipated future value of a bond or loan.

The most common form of a credit derivative is the credit default swap, in which a bank contracts with an insurance company to hedge against the risk of default on a loan. A credit swap is like an insurance policy tied to the creditworthiness of a borrower.

The buyer of the policy, usually a bank, swaps its risk to an insurer, to which it pays an annual premium in the form of a specified percentage of the principal being insured. If the borrower defaults on the loan, the insurance company has to reimburse the bank - much the way an insurer would pay a homeowner after a fire.

The global credit derivatives market, which wasn't even tracked until 1997, has ballooned to $2 trillion based on the so-called notional value of the debts that underlie the contracts, according to Fitch Ratings Service. That market, Fitch predicts, will grow to $4.8 trillion by next year.

The entire derivatives market - including transactions based on stocks, bonds, loans, commodities, currencies and mortgages - has a notional value of about $100 trillion, according to the International Swaps and Derivatives Association.

Those numbers are only guesses. Nobody knows how much money is actually at risk. Banks don't have to report the details of their exposure, which leaves regulators in the dark.

"This market is completely unregulated," said Randall Dodd, director of the Derivatives Study Center, a nonprofit research organization in Washington, D.C., and a former economist at the Commodity Futures Trading Commission.

"No reporting requirements, no collateral requirements, no licensing of traders," Dodd said. "There's no supervision of this activity. Even if you're a regulator and you want to see what's happening, you can't."

The Financial Services Authority, the United Kingdom's financial watchdog, wrote in a May 2002 report on derivatives, "The concern is that we do not know enough about where the risks ultimately reside, and whether adequate capital is being held against them."

Big banks, led by J.P. Morgan, dominate the trading of credit derivatives, and some investors worry these institutions have too much power. If something goes wrong at one of these banks, they warn, the havoc could spread quickly to the others.

Last year, J.P. Morgan handled 26 percent of all of the world's credit derivative trades by banks, with a notional value of $364 billion, according to a study released in April by Fox-Pitt Kelton, the investment banking arm of Swiss Re.

The business is "very profitable" for J.P. Morgan, said Brindle, who declined to provide numbers. J.P. Morgan -along with No. 2 Citigroup, which had a 10 percent share; and No. 3 UBS Warburg LLC, with 9 percent -controlled 45 percent of trading by banks in the swaps market, according to Fox-Pitt Kelton.

The two next-largest credit derivative dealers were Bank of America Corp. and Deutsche Bank AG, with 7 percent each.

"Large amounts of risk, particularly credit risk, have been concentrated in the hands of relatively few derivatives dealers, who in addition trade extensively with one another," Buffett, the world's second-richest person, told his shareholders in February. "The trouble of one could quickly infect the others."

U.S. Federal Reserve Chairman Alan Greenspan said credit default swaps can help banks reduce risk.

"Banks appear to have effectively used such instruments to shift a significant portion of the risk from their corporate loan portfolios to other organizations," he told the Conference on Bank Structure and Competition in Chicago in May.

At the same conference, Greenspan cautioned about the danger of concentrating so much risk at only a half dozen banks. "Concentration of market making has the potential to create concentration of credit risks," he said.



·         NPR Radio, MARKET PLACE

SHOW: Marketplace (6:30 PM ET) - SYND

June 23, 2003 Monday

HEADLINE: New York Times investigates Fannie Mae's financial health




The spotlight on the accounting at Freddie Mac has widened to include its competitor in the mortgage finance business, Fannie Mae. Two weeks ago Freddie Mac announced it had fired three executives and would recalculate three years' worth of profits. Now The New York Times has taken a closer look at Fannie Mae's books and hasn't found wrongdoing. What it did find were two very different pictures of the company's financial health. MARKETPLACE's Amy Scott reports.

AMY SCOTT reporting:

The summer of 2002 was a heyday for homeownership, but it wasn't so good for the company that takes a lot of the credit for that, Fannie Mae. That's because the government-sponsored mortgage backer sells bonds to pay for the mortgages it buys. Randall Dodd at the Financial Policy Forum says the trouble accelerated when mortgage interest rates fell to 40-year lows.

Mr. RANDALL DODD (Financial Policy Forum): When interest rates come down, people refinance those mortgages, and hence the owner of them gets a lower interest income from holding those mortgages while they're still stuck having to service the bonds they'd issued over the past one to 10 years.

SCOTT: So why then did Fannie Mae report profits of $6.4 billion last year? That figure depends on how the numbers added up. As The New York Times reported today, that $6.4 billion was a non-standard number businesses call core earnings. The company's profit under Generally Accepted Accounting Principles was a smaller $4.6 billion. But a third statement called the fair-value balance sheet presents a much starker picture. Based on the market value of all its assets and liabilities, Fannie Mae barely would have made a profit. Charles Mulford directs the Dupree Financial Analysis Lab at Georgia Tech. He says, in reality, Fannie Mae would pay those losses over many years, not all at once.

Mr. CHARLES MULFORD (Director, Dupree Financial Analysis Lab, Georgia Tech): This does provide a good leading indicator of where their earnings are going in the future, but that assumes they don't take any steps to--to offset these affects, which they can, in fact, do.

SCOTT: Observers say Fannie Mae didn't hedge enough of its interest rate risk to weather last year's mortgage rate collapse. The very thing that could have shielded Fannie Mae from greater losses, a heavier reliance on derivatives contracts to hedge risk, is what got competitor Freddie Mac in trouble. In Washington, I'm Amy Scott for MARKETPLACE.

BRANCACCIO: Fannie Mae, it should be noted, is an underwriter of this program. Fannie Mae's shares fell 2.7 percent today.

The Dow Jones industrial average lost 127 points, 1.4 percent. The Nasdaq fell 33 points, 2.1 percent. The Federal Reserve is set to cut interest rates this week.



·         CNN FN

MONEY & MARKETS 04:00 PM Eastern Standard Time

June 19, 2003 Thursday

Wall Street Retaliation?

BYLINE: David Haffenreffer

 DAVID HAFFENREFFER, CNNfn ANCHOR, MONEY & MARKETS: U.S. firms have never taken kindly to analysts who write nasty things about their stock. And the fear is that the potential for retaliation could even get worse now that the Wall Street global settlement is in place.

The Securities and Exchange Commission wants to make sure that companies don't punish analysts that speak their mind under these new tough standards. And it's asking the major stock exchanges to take action. But should the SEC be taking on the job itself? Joining us now from Washington with his thoughts on the matter, is Randall Dodd, of the Financial Policy Forum.

Randall, nice to see you.


HAFFENREFFER: I would imagine that maybe under the settlement recently between the SEC and Eliot Spitzer, up here in New York, might have taken care of this type of thing. But, no?

DODD: No, I don't think so. And I'm not sure the rush of the current direction of the SEC is going to fix it, either. I don't think the exchanges are the best way to handle this problem. The exchanges don't have a very subtle form of enforcement of the rules. All they pretty much have is the ability to embarrass firms or to de-list them. The SEC has a much more wide and subtle form of enforcement mechanisms.

HAFFENREFFER: Throughout the proceedings leading up to that big Wall Street settlement, we were hearing so much about the wall being erected between research and the investment banking division. So, all of a sudden, I guess, my impression here is that if an analyst comes out and writes some negative comments about a particular company, and the company does business with the investment banking side of that research house, what? They just lose the business? What are they worried about?

DODD: I think they're not only worried about losing the business, but other forms of conflicts of interest here. One is that there may be other associations between the boss of the analysts and the companies.

And then, also, there's a broader economic concern, David. And that is what this problem represents is that there's not perfect transparency in our securities markets. Not everyone has access to the same level of information. And these analysts provide a very key role in getting to a deeper level of information, digesting it, and then making it available to the public.

If companies decide they don't like an analyst, they won't allow them to participate in conference calls, will exclude them from one-on-one conversations with the company's management. And will, therefore, deny the analysts access to, if you will, that sort of deeper, otherwise nonpublic level of information. And that's, I think a very important concern for market efficiency.

HAFFENREFFER: So, with no access to the company, then, does the research firm drop coverage of that particular company?

DODD: That would be the implication of what they would have to do. Otherwise their coverage would be incomplete. They would be competing with other analysts who had access to deeper information, that they'd have to worry about getting scooped or otherwise missing some critical information.

HAFFENREFFER: OK. So, in a perfect world, how could the SEC best take this type of enforcement on itself, rather than bringing the exchanges in?

DODD: I think one thing they do is it is a prohibit. The companies contacting the analysts and the analysts' employers, and threatening them. The same way you might want to outlaw, if you will, a gangster going around to businesses, selling protection insurance. It's a form of kind of - thuggery, on a level.

HAFFENREFFER: Yes, it was my sense, though, that when companies make announcements, even just to analysts, it was to be done at once. And this was supposed to sort of open up the lines of communication between corporate heads and all of the analysts that follow such companies.

DODD: That would be the right way to do it. If everyone was invited to the party and everyone who wanted to could attend, that would help solve some of these problems. It would give all the analysts equal access to the information. But unfortunately, in the actually world there's also a lot of informal contact in which a lot of information flows.

Even at the level of credit rating agencies, which I've written a little bit about. People who subscribe to their services have direct access to their analysts that outsiders don't see by just observing their credit ratings.

Similarly, here, in addition to the conference calls and the more pooled form of reporting on the company, there are also individual contacts with management, in which they can get additional information.

HAFFENREFFER: All right, Randal, thank you for coming on the program. We appreciate your insights.

DODD: Thank you, David.

HAFFENREFFER: Randall Dodd from the Financial Policy Forum.



·         NPR Radio, Market Place

June 19, 2003

SHOW: Marketplace


TYPE: National Radio
Freddie Mac.; Word from the Wall Street Journal is that the government-backed mortgage financer will restate its earnings for the past three years upwards which could push future earnings down.

Interview - Randall Dodd, director of the Financial Policy Forum, says use those derivatives to shift earnings, profit, cost, whatever you want, across time, across national boundaries.


Amy Scott reporting.

·         Investment Dealers Digest

June 9, 2003

Behind the Mask: The booming credit derivatives market harbors unseen risks.

BYLINE: Bill Shepherd

Credit derivatives, one of Wall Street's hottest revenue generators the past two years, have become the controversy du jour. The nearly $3 trillion market, described by some as "the Wild West of finance," is supposed to be the greatest mechanism ever invented to protect lenders by dispersing the credit risks inherent in bank loans and bond issues. But a growing minority of analysts is beginning to wonder if these instruments-which can be dizzyingly complex-are actually doing their job, or whether they might, in fact, be adding unseen risk to the financial system.

The main argument in favor of credit derivatives is that they have helped banks weather an onslaught of corporate defaults. During the most recent recession, U.S. and European corporate bond defaults were six times higher than in the 1990-1991 downturn-$215 billion compared with $36 billion, according to Robert Grossman, chief credit officer at Fitch Ratings. Yet the U.S. banking system has remained remarkably strong.

Indeed, last month Federal Reserve Chairman Alan Greenspan lauded derivatives in general for making financial institutions "less vulnerable to shocks from underlying risk factors" and "the financial system as a whole...more resilient."

But there's a growing body of evidence that derivatives aren't always successful at protecting creditors. What's more, despite increased disclosure from institutions dealing in credit derivatives, there are worrying signs of concentration of risk. J.P. Morgan Chase, which is widely believed to be the biggest player in credit derivatives, is rumored to be involved in as much as 65% of the business. Other big U.S. bank players include Citigroup and Bank of America, and investment banks and European banks are in the market. Unregulated hedge funds and barely regulated insurance companies are also big players, adding to the unease about what is really going on.

Assuming the credit risk of these derivatives, as well as trading them, is proving lucrative to market participants or else it would not be such a booming business. And they are being used as a hedge, too. But the lack of disclosure makes it impossible for outsiders to determine how much money is being made.

The biggest irony, though, is that these instruments might not be protecting lenders as much as has been trumpeted. Tanya Azarchs, a banking analyst at Standard & Poor's Corp. who has made credit derivatives a specialty, thinks that's the case. "They haven't helped banks dodge a lot of bullets," she says. "We can't think of more than about $1 billion in losses that the banks have managed to escape" by using credit derivatives.

Still less than a decade old, this market is still feeling its way. As much as a third to a half of credit derivatives (depending on who's doing the counting) originate in Europe, where conventions on triggers and settlement vary. Much must still be done to standardize terms across borders, as today's credit derivatives are a patchwork of standardized and customized products.

Most important are single-name credit default swaps, written on the debt of such big borrowers as the auto companies' and General Electric Co.'s financing arms, Household Finance International, the biggest international telecom companies, AOL Time Warner Inc., Walt Disney Co., Dow Chemical Co., IBM, a slew of major banks themselves and even a smattering of foreign governments, including Greece, Italy, Colombia and Japan. Single-name CDSs account for somewhere between 47% and 90% of the field.

In a credit default swap, the protection seller (or risk buyer) receives an annual premium from the protection buyer (or risk seller) that typically ranges from 10 to 50 basis points, but that can soar to 2,000 basis points (20 full percentage points) if the debt looks likely to default. If the debt does default, the protection seller must cover the risk seller's loss.

Protected or no?

If credit derivatives aren't providing much protection to banks or bondholders, one reason is that the derivatives are written chiefly on investment-grade debt-that is, debt that carries the least risk. A derivatives market for sub-investment-grade debt has yet to develop. And few investment-grade borrowers (Enron Corp. being the leading exception) go directly into bankruptcy without first suffering ratings downgrades.

Then too, loopholes in the fine print can keep credit derivatives from working the way they're supposed to. In what some argue is an unusual case, the Royal Bank of Canada and the Netherlands' Cooperatieve Centrale Raiffeisen-Boerenleenbank, or Rabobank for short, have been locked in a legal tiff for the past year over a total-return swap, one type of credit derivative, that RBC thought was going to cover $517 million in losses on Enron debt. But Rabobank refuses to pay.

The case does point to the fact that many settlement issues have yet to be resolved. Robert Pickel, executive director of the International Swaps and Derivatives Association, the industry's standard-setting group, explains that ISDA is pressing to answer such questions as what types of loans-convertibles? exchangeable debt?-can be substituted for settlement; who's responsible for defaulted debt when the company in question disappears in a demerger; and what exactly should or shouldn't trigger default payments when a company restructures its debt. The restructuring issue has proved so nettlesome that some issuers-most notably J.P. Morgan-have begun to leave restructuring out of their CDS contracts.

Yet another reason credit derivatives haven't helped lenders much is a peculiarity of one type of financially engineered deal, what's called a synthetic collateralized debt obligation. After credit default swaps, the fastest-growing credit derivatives are basket or portfolio securitizations, like synthetic CDOs (sometimes called synthetic CLOs, for collateralized loan obligations, or portfolio default swaps). Synthetic CDOs work like any asset securitization: a special-purpose vehicle issues a series of tranches against a pool of assets. The tranches represent different levels of risk, from senior to mezzanine to junior notes, for different investors.

The lowest level, known as the "first loss piece," is unrated and bears the brunt of most losses. Lenders that do synthetic CDOs retain the first loss piece themselves, which is anyway difficult to sell. So most of the credit risk is not, after all, transferred to others. (Often, however, the lenders will buy credit default swaps from the special-purpose vehicle in an effort to "immunize" their risk-which raises the fascinating question, where does the risk go?)

Meantime, the rated tranches bought by others don't represent much risk. "The rated, and therefore sold, subordinated tranches in these CDOs that have actually defaulted," says Azarchs, "add up to nine series of securities with a sum total of losses of $163 million." Not, please note, billion, but million.

That's a paltry sum compared with the amount of credit derivatives outstanding. According to ISDA's semi-annual surveys of its members, credit derivatives grew 98% last year, to around $2.2 trillion in notional value (the par value of the debt against which the derivatives were written). As huge as that sounds, it's barely 2% of the $100 trillion market for interest rate and currency derivatives, which grew about 43% last year.

In fact, enthusiasm for credit derivatives may ease this year, as credit conditions improve and fears of default subside. Bids for derivatives to hedge the latest convertible bond underwritings, for instance, have declined sharply. If growth slows, forecasts by the British Bankers Association, which expects the global market for credit derivatives to hit $4.8 trillion by 2004, may prove too rosy.

Other worries

Portfolio-type derivatives raise other concerns. For instance, under some structures, the lender can periodically change the companies represented by the derivative tranches. "Some of these structured credit derivatives are extremely complicated," complains Randall Dodd, director of the Derivatives Study Center at the Financial Policy Forum in Washington, D.C. "Some are an index of synthetic credit derivatives with an embedded option that enables the issuer to substitute the credit risk of firms within the index-whatever seems opportune for the issuer."

Dodd compares that to a three-card monte game. "They could swap into and out of all kinds of credit risk. You don't know what they hold anymore, and they're not telling. The ability to price that doesn't exist." And, he adds, "the ability to infer much about the credit risk portfolio of any financial institution now has been drastically changed."

Also much rumored on Wall Street is that credit information sometimes leaks from banks' lending side to their traders, a breach of banking's so-called Chinese wall. Credit information may also leak to hedge funds, which are rapidly becoming powers in the credit derivatives market. "Credit derivatives have now spawned a class of hedge funds that use arbitrage strategies to exploit valuation anomalies among the convertible, straight bonds, equities and credit default swaps of the same issuer," according to a report by capital markets senior analyst Peter Keppler and associate Deborah Williams of Financial Insights in Framingham, Mass., a unit of International Data Corp.

Those hedge funds have been criticized for exploiting the illiquidity and price sensitivity of the market for credit default swaps. The CDS market is an over-the-counter affair made by a small number of broker/dealers, and the price, or premium, can move more quickly than bond prices. Moreover, credit default swaps are written not for baskets of debt but for loans or bonds of a specific issuer, so smart traders watch CDS premiums for advance warning on what's happening to a company.

Some bond investors have complained that hedge funds exploit this by intentionally creating demand for CDSs that push up the premium, scaring other players into wondering, "What do they know that I don't know?" If the funds "move the market" when a company is trying to negotiate a credit line to forestall a ratings downgrade, they might be able to quash

the credit line and hasten

the downgrade-and make a killing when the CDS premium then soars.

Since hedge funds are unregulated, it's impossible to know if they are deploying such strategies. But one former hedge fund manager, who insists on anonymity, thinks it's a natural strategy for hedgies, pointing out that "It isn't so different from selling stock short, and they've been driving companies nuts for decades with short-selling."

Clearly, trading in credit derivatives is influencing prices in other markets-for bonds, stocks, loans and convertible securities-in ways that aren't fully understood yet.

The concentration risk

By far the biggest problem hampering credit derivatives is insufficient disclosure. A veiled market invites abuses, and the question "Where do the risks go?" is a valid one. "No one's really come up with a way of seeing who's loading up on risks," says David Hendler, who covers financial services at CreditSights, a New York research firm.

Compounding worries is the small number of players responsible for most of the business. "Right now, the top three banks account for roughly 90% of the market," says Brock Vandervliet, a banking analyst at Lehman Brothers, which also acts as a broker/dealer of credit derivatives. He believes that credit derivatives are too expensive for small banks, and even superregionals, to use them.

To get a better fix on where the risks are going, Fitch Ratings is finishing up a survey this month that it hopes will provide some answers.

In a preliminary March report on the survey of 200 banks, insurers, reinsurers, financial guarantors and broker/dealers, Fitch noted that several insurers that were buyers of credit risk have been burned by defaults. Chubb Insurance Co., Centre Re, Pacific Life and Swiss Re have all pulled back a bit from the market, a trend, Fitch says, that could "act as a constraint on the growth of the credit derivatives market in the future."

The study also noted high levels of risk mounting at European regional banks, particularly Germany's landesbanks, which have become avid investors and traders in credit derivatives, not just hedgers of loans. Those high levels of risk may, in Fitch's final report, turn out to be due to glitches in data gathering. But an executive at Landesbank Baden-Wurttemberg, based in Stuttgart, Germany, admits that exposure at the landesbanks "is not insignificant."

Long expert at trading Deutschemark bonds, the landesbanks have discovered-as have hedge funds and some U.S. banks-that it's more profitable to buy credit risk than to make corporate loans, which are chronically underpriced to nurture client "relationships" in hopes of winning other, more profitable business, such as M&A deals. And buying derivatives doesn't entail actually having to lend money or set aside much to meet capital rules.

One of the Fitch study's most interesting concerns, however, is the enormous concentration of counterparty risk at the few broker/dealers who dominate market making. J.P. Morgan Chase, the dominant player in most derivatives, heads the list, followed by Merrill Lynch & Co., Deutsche Bank, Morgan Stanley, Credit Suisse First Boston, Goldman Sachs, UBS and Citigroup.

Fitch doesn't break out market share for the broker/dealers, but some experts guess that those top eight banks account for 60%-and perhaps 90%-of all credit derivatives trading, while rumors abound that J.P. Morgan alone accounts for as much as 65% of the market. A study by Lehman that draws on bank filings at the Office of Comptroller of the Currency shows J.P. Morgan with 56.5% and states that together, J.P. Morgan, Citigroup and Bank of America account for 92.7% of the market. But the study largely neglects non-U.S. banks, and it entirely omits investment banks (such as Lehman itself), which don't disclose derivatives activities.

It's something of a wry joke in the market that credit default swaps substitue credit risk for counterparty risk. As Fitch points out, a big loss, a contractual dispute or a credit downgrade at one of the major market makers could create stress across wide swathes of the financial system. "Will the liquidity be there when you have to get out?" wonders one banker who is long credit derivative risk. J.P. Morgan, it should be noted, suffered a small credit downgrade last year and continues to warrant a "negative rating outlook." It has taken huge hits on loans to Enron and Argentina, and last month it admitted that its credit risk management is flawed. J.P. Morgan would not make executives available for interviews for this article.

So much of the business is hidden from view, in fact, that some prestigious voices have begun to sound alarms. Early this year, Warren Buffett, the multibillionaire who invests through Berkshire Hathaway, warned that derivatives are supposed to disperse risks but may actually be concentrating them in major banks that dominate derivatives trading, a potential threat to the banking system.

Even Alan Greenspan, an outspoken champion of derivatives, last month revealed his own concerns about concentrations of counterparty risk building up at the broker/dealers. He also chastised major banks for confusing disclosure with transparency-a clear swipe at J.P. Morgan, which is notorious for disclosing reams of derivative data that shroud its risk exposures instead of clarifying them.

What else could go wrong? Various ways that credit derivatives don't match up with the loans they're supposed to represent-what's called basis risk-might create trouble at some point, too. For instance, loans go on the balance sheet; credit derivatives are off-balance sheet items. Derivatives are marked to market; loans aren't. Credit default swaps typically run five years, while the loans or bonds underlying them can run longer-creating a gap in the hedge. "No hedge is perfect" is a mantra of the business.

The most realistic fear in credit derivatives is the classic one that brought down the prestigious British firm of Baring Brothers a decade ago: that a trader somewhere is hiding credit exposure, from his senior management as well as from investors and counterparties. "OK, these things transfer risk-but where does the risk go?" says S&P's Azarchs. "Somebody has to be left holding the bag. If somebody out there is loading up on this, and it's out of sight...."

"Don't blame derivatives for the flaws in risk management systems," counsels a banker in London. But the two biggest flaws in risk management systems are that somebody has to put the data in, and somebody has to pay attention to what the system is telling him.


·         CNN FN

May 12, 2003 Monday


Bear Stearns Apologizes for Analyst Promoting IPO, CNNfn

BYLINE: David Haffenreffer

 DAVID HAFFENREFFER, CNNfn ANCHOR, MONEY & MARKETS: iPayment (Company: iPayment Inc.; Ticker: IPMT; URL: http://www.ipaymentinc.com/) shares began trading on the Nasdaq today under the ticker symbol IPMT. The electronic payment company's IPO rose more than 30 percent. It's a noteworthy achievement given the weak state of the IPO market. But iPayment has drawn attention for another less flattering reason, Bear Stearns (Company: The Bear Stearns Companies Inc.: Ticker: BSC; URL: http://www.bearstearns.com/), the underwriter of the iPayment deal, is apologizing after finding out that one of its stock analysts appeared in a video promoting the IPO. Obviously that's a violation of the recently completely global financial settlement. Bear Stearns said in a statement: "We fully support both the letter, and more importantly, the spirit of the recent settlement agreement. Once the problem was identified, we took immediate action and are taking precautions to ensure that it will not occur again." This issue is raising questions about how much financial firms have learned from the Wall Street research scandal. Joining us now from Washington with his thoughts is Randall Todd, director of the Financial Policy Forum.

Welcome to the program.


HAFFENREFFER: What do you think about this little Bear Stearns slip-up?

DODD: Well, it may just that, a slip-up, but it raises some various, serious concerns. Have these firms really taken the settlement as a sanction about some of their misconduct in the past or whether they view it as a slap on the wrist. It is a very small percentage of their annual revenues. And whether they realize that this is something that needs to help them change their behavior.

HAFFENREFFER: In this day and age, with compliance offices and what-not going on, how easy is it for an analyst to pop up in a video promoting an IPO without anybody in senior management knowing about it?

DODD: Exactly. I think if these firms were taking it as seriously as they should, their compliance offices would already be functioning at a tip-top level to be alert for just these kinds of problems. This is not - it may have just been a simple slip-up, but it does indicate that they don't have a serious application of their compliance offices to treat this as important as it is.

HAFFENREFFER: Are you among the critics of the settlement deal reached between the SEC and our New York Attorney General Eliot Spitzer here and the Wall Street firms, saying that it maybe didn't go far enough?

DODD: Well, I believe that, as they say, money is the only language they understand. It may not have been a large enough penalty to get them to appreciate the seriousness of the offenses that have occurred. Sometimes people show a lot more respect when there's a lot more money on the table.

HAFFENREFFER: This is not the first time we have seen this since the settlement was reached, we had the CEO, I think, of J.P. Morgan (Company: J.P. Morgan Chase & Co. ; Ticker: JPM ; URL: http://www.chase.com/) last week, making some comments that sort of.

DODD: Merrill (Company: Merrill Lynch & Co. Inc.; Ticker: MER; URL: http://www.ml.com/) and Morgan Stanley (Company: Morgan Stanley Dean Witter & Company ; Ticker: MWD ; URL: http://www.msdw.com/).

HAFFENREFFER: Morgan Stanley, pardon me, pardon me, Philip Purcell. And obviously - this seems to be a problem. They are not looking at this all that seriously. What could be done materially to change their behavior?

DODD: Well, I would like to see a stronger role played by watchdog organizations, not only the government, not only the press such as yourself, but also groups like my own who are sort of nonprofit, independent entities that out there studying financial markets, and trying to come up with ideas on how to make them work better. I think that's one good line of defense. I think the other one is just to get these guys to realize what they've done is wrong. I don't think it's sufficient, as Chairman Greenspan mentioned last week, to kind of rely on their concerns for their own reputation. We can sort of think back about an image of a golden yesteryear where people behave so as to protect their reputations, but I doubt that that was ever really that much the case. And it's hard to think that that is sufficiently the case today. I think we need to look at how people actually behave and get some sanctions in there to encourage them to do the right thing.

HAFFENREFFER: Where has this all left the small investor, where we in the financial media are not covering the daily upgrades and downgrades as we used to, so that information isn't necessarily getting out there as much as - it's not as present in the daily broadcast anymore, because I guess we are not really sure it matters to anybody anymore. Where is the small investor's head right now?

DODD: Well, there are two things. The small investor I think has lost a lot of trust in the market. I think it's not just a matter of this company or that company, a few bad apples, I think they sense some systematic problems. And even when I was on your show last time talking about accusations of front-running in the New York Stock Exchange, I think the most fundamental crime that can occur on that exchange, I think that the New York Stock Exchange has not addressed that very readily. It's not been very transparent. It has made it hard for watchdog organizations, except for the SEC who has got the subpoena power, to try to figure out really what happened and what steps they are going to take in the future to prevent it. In that context, I think the small investor is reasonable to sit on the side and to wait until they feel they can, again, be on a level playing field.

HAFFENREFFER: Yes. All of this exacerbated, of course, by the multi-year bear market as well. Randall Dodd, thanks for being with us.

DODD: You're welcome.

HAFFENREFFER: From the Financial Policy Forum joining us from Washington.



·         NEWSWEEK

May 12, 2003, Atlantic Edition


HEADLINE: The Alarmist of Omaha

BYLINE: By Rana Foroohar

Are 'financial weapons of mass destruction' for real?

Do you know what feline pride means to a money manager? (Flexible equity-linked exchangeable security.) A Synthetic CDO? If the acronyms sound exotic, the truth is that these are garden-variety derivatives, a fast-growing form of investment now used by nearly every major bank and corporation in the world. If you've got a retirement fund, your future is probably tied up one way or another in derivatives, which is why this story may alarm you. For derivatives have been making news lately both for dramatic growth--and for widening concern that they are the tangled tripwire for the next major global financial meltdown. As Berkshire Hathaway chair Warren Buffett put it recently, derivatives threaten to become "financial weapons of mass destruction."

This is not how it was supposed to work out. Derivatives are as old as civilization: Aristotle referred to an option on the use of olive-oil presses in his "Politics" some 2,500 years ago. The idea behind derivatives is to reduce risk by offering investors a chance to hedge against future movements of anything from interest rates, to commodity prices, even weather. Say you've got a lot of money in oranges--derivatives let you hedge against the risk of a cold snap. The problem: the derivatives market is now so big and so complex, the world is wagering stunning sums on bets it can't possibly understand. The market for OTC (over the counter) derivatives rose from $2.9 trillion in 1990 to $128 trillion in 2002. And while companies in the 1980s traded "plain vanilla" interest-rate swaps, since then Enron, WorldCom, Global Crossing and others have unraveled in part due to convoluted derivatives deals the forensic accountants are still trying to figure out.

Buffett is not the first to raise the alarm. As former derivatives trader and law professor Frank Partnoy outlines in a new book, "Infectious Greed: How Deceit and Risk Corrupted the Financial Markets," others tried over the past decade. In the mid-1990s, a rise in the use of OTC derivatives helped contribute to disasters like the bankruptcy of California's Orange County. According to Partnoy, calls for new market legislation were beaten back by powerful industry lobbyists. Even after the infamous hedge fund Long Term Capital Management nearly brought down world markets in 1998 thanks to complex derivatives trades concocted by Nobel Prize winners, regulators still failed to act, in part because the deals had gotten too complicated. Government accountants simply couldn't keep up.

Throughout it all, free-market advocates, including Fed Chairman Alan Greenspan, have argued that derivatives are, in fact, crucial to managing risk in a globalized world. They point to the fact that major banks have been able to maintain high levels of lending, in part because they've successfully used derivatives to move risk away from themselves. This much is true. But if the rest of the free-market thesis holds, derivative risk should end up in the hands of those who are both best able to handle it, and to quantify it.

In fact, neither seems to be the case. Consider the credit-derivatives market, which grew 37 percent in the second half of 2002 alone. Credit derivatives are basically insurance policies that allow lenders to hedge the risk of lending to a particular company. Major banks have been able to use these derivatives to offload a lot of risk, but a recent survey done by the Fitch credit-ratings agency suggests that much of the risk has been passed to the beleaguered insurance industry, which may not be able to cope with it as well as banks. Andrew Large, the new deputy governor of the Bank of England, recently expressed concern about an imminent liquidity crisis, as risk-heavy insurers are dumping equities bought in better times onto an unwilling market.

Smaller European regional banks, much less savvy than their global counterparts, have also emerged as net buyers of risk. And notoriously secretive hedge funds appear to be getting in the game, too, which may make the risks even harder to spot. In either case, the derivatives traded need not be complicated to create confusion. "Even common-vanilla derivatives can be used to hide information," says economist Randall Dodd, head of the Derivatives Study Center in Washington, D.C.

With so much hidden risk, another nasty shock seems almost inevitable. In the United States and Europe, authorities are trying to tighten regulation of derivatives markets and accounting. But fine print may not be enough--after all, Enron exploited the voluminous derivatives laws to confuse investors. It got caught--but only after the meltdown. Dan Curry, a managing director at Moody's ratings service, says, "There is no great solution on the horizon." Nor is it likely inspectors will find the explosives hidden on big-company balance sheets. Even Buffett, "the sage of Omaha," says all he learns from the fine print on these deals is how much he doesn't understand. In ignorance, he says, lies huge risk for investors and the economic system.




·         CNNfn

April 17, 2003 Thursday


Will Front-Running Scandals Rock Wall Street?

BYLINE: David Haffenreffer

 DAVID HAFFENREFFER, CNNfn ANCHOR, MONEY & MARKETS: If the trading firms are found guilty of front-running, how damaging will that be to a marketplace already plagued by accounting scandals from the likes of Enron and WorldCom and so many others. Here to talk about that situation is Randall Dodd, director at the Financial Policy Forum.

Welcome to the program.


HAFFENREFFER: Did it surprise you to hear this news?

DODD: It did. I was really excited to hear it as well. I think there's been a whole host of problems that have been affecting the markets for a while now. I think trust and confidence is at quite a low for a long time. And so this is just potentially devastating.

HAFFENREFFER: But as Chris just told us, the Exchange had to deal with this just not too long ago. Why do you think it was still able to be done?

DODD: Well, I think because it's partially the role of allowing specialists who are the market-makers in this instance in the stock exchange to trade both as specialists and for their own account. There is a precedent for this. On the future exchanges in Chicago and New York, they have to deal with a similar problem known as dual trading, whether some of the brokers there are also allowed to trade for their own accounts as well as filling the orders of their customers.

HAFFENREFFER: How can you prevent it from happening as long as you have a public outcry system?

DODD: Well, there are two ways. One, you can prevent this sort of dual trading, you can prevent the specialists from trading both for their own account and running the book for GE (Company: General Electric Company; Ticker: GE ; URL: http://www.ge.com/) or whatever company they're responsible for by simply not allowing them to trade for their own account - would curtail that. There also is another method. What you could do is what they have done on future exchanges in that you've gone to a higher level of supervision by requiring very close time-stamping or time identification of when the trade's occurring. And that way you can see that the customer orders are coming in and that the specialist is buying on their own account moments before the customer orders are being filled. And this careful timed supervision of the order flow and filling will allow the exchanges and the SEC to detect this kind of activity. And that will hopefully deter people from doing it.

HAFFENREFFER: Now this comes at an inopportune time for the New York Stock Exchange which has been busy in the headlines dealing with other issues. For example, the proposed members of their own board down there. Tell me a little bit about the backdrop against which this news event is coming.

DODD: Well, I think the bigger backdrop is the macroeconomic consequence of this. The markets have suffered from a loss of confidence and normally the firms that are being traded. Now we've got a situation that questions the confidence in the mechanism itself, the microstructure of the market where we trade securities for the many firms. And I think this is particularly important because it threatens both the question of efficiency and fraud in the market. I mean, it's important for our economy that everyone face the same prices so that everyone can make decisions on buying and selling a stock, on buying and selling alternative stocks based on looking at the same prices. This kind of activity means that there's not a common set of prices in the market. It also affects basic trust. If you're going to manage your retirement account, if you're managing a large account, as a pension fund manage in an insurance fund, you want to know that you're getting honest value for your dollar. If you're buying a stock for $100, you think it should be worth $100. If you're paying too much for it, that's a severe problem. And even though these are small crumb-like changes, if you will, in the price, we're talking about 1 1/4 billion transactions a day. You can make yourself a nice birthday cake with this number of crumbs.

HAFFENREFFER: We've only got about 15 seconds left. Tell me, with all this money that we hear about so often on the sidelines of the stock market at the moment, what percentage of that money remains on the sidelines due to lack of trust in the system versus an investor who is simply beaten up by the downward performance in the market?

DODD: Well, I think it's a matter of trust because people know better than to try to perfectly time the market, in terms of peaks and troughs. But what they're seeing is there has been a deterioration in the integrity of these markets and very little yet has been done about it.

HAFFENREFFER: All right. Randall Dodd, thanks for being with us.

DODD: You're welcome.

HAFFENREFFER: From the Financial Policy Forum, joining us from our Washington, D.C., bureau.



·         Foster Natural Gas Report

April 10, 2003

SECTION: Report No. 2433; Pg. 8

LENGTH: 410 words


FERC has issued the agenda for the technical conference scheduled on April 24, 2003 at FERC headquarters, 888 First Street, NW, Washington, DC, in the Commission Meeting Room (Room 2C), for the purpose of discussing the adequacy of natural gas price information and discovery (AD03-7). The Commission and parties will examine ways to fix deficiencies in the manner price data are currently collected; how to increase reliability; and what alternative models might produce reliable natural gas price discovery.

According to its notice, FERC plans to hear from those who currently report transactions, receive and publish price information, use the published data reports, and anyone with "constructive suggestions for overcoming impediments and inconsistencies." Parties with specific alternative models for achieving the goals are invited.

PANEL 1 - Private Sector Price Reporting Systems Larry Foster, Platt's News Service Ellen Beswick or Mark Curran, Intelligence Press Andrew Ware, Energy Intelligence Group Michael Smith, Executive Director, Committee of Chief Risk Officers (CCRO) Chuck Vice, Senior Vice President and Chief Operating Officer, Inter-Continental Exchange (ICE) Robert Levin, Senior Vice President, New York Mercantile Exchange (NYMEX)

PANEL 2 - Governmental or Third Party Models

Craig Pirrong, Bauer College of Business, University of Houston Obie O'Brien, Director of Government & Regulatory Affairs, Apache Corp. Representative from Energy Information Administration (EIA) Representative from National Association of Securities Dealers (NASD)

PANEL 3 - Industry Responses to Morning Discussion Gerald Ballinger, President, Public Energy Authority of Kentucky (representing APGA) Arthur Corbin, President, Coalition for Energy Market Integrity and Transparency (EMIT) and President & General Manager of the Municipal Gas Authority of Georgia Al Musur, Director, Energy and Utility Programs for Abott Labs (also, Chair of the Industrial Energy Consumers of America (IECA) Thomas Skains, Chair of American Gas Association's (AGA) Board Task Force on Gas Price Index Reform (President & CEO, Piedmont Natural Gas) Representative from Natural Gas Supply Association (NGSA) Representative from INGAA

PANEL 4 - Financial Houses' and Other's Responses Laurie Ferber, Managing Director, U.S. Power Trading, Goldman Sachs Randall Dodd, Derivatives Study Center Representative from Fitch Ratings Representative from SILCAP, LLC



·         United Press International

April 9, 2003 Wednesday


Analysis: Rating agencies and development



 A Financial Policy Forum study has examined the credit rating agencies and their effect on capital flows to emerging markets. Its conclusion: the agencies are somewhat pro-cyclical; they encourage emerging market investment when it is popular, and capital flight when it isn't.

The study was carried out by Gautum Setty of the FPF and introduced by the FPF's director Randall Dodd. It looked at the rise of the rating agencies in relation to emerging markets' bond investments, their ability to forecast financial difficulty, and possible reforms in their structure that could improve their performance.

Traditionally, emerging market bond issues weren't rated, because the rating agencies, which had existed since the 19th century in relation to corporate debt, were not felt to have any special ability in rating sovereign credits. Their faux-pas in rating Venezuela AAA in the late 1970s, because of its oil revenues, was often used by non-U.S. bankers as an example of their relative naivete outside the United States.

Bond issues were marketed through a syndicate by the lead banker, and the banker's reputation was believed to be at stake in the event too many of its issues failed.

This system worked well before 1914, when in practice emerging markets such as those in Latin America were taken under the wing of one of the London or New York merchant bankers, and their economic policies were monitored in return for access to the international capital markets. In the stable pre-1914 economy, crises were manageable, and the emerging markets that cooperated with the merchant banks enjoyed relatively rapid economic growth, without excessive debt burdens.

In the 1920s, things went wrong. The London merchant banks, now short of capital and with an impoverished European investor base, were considerably less aggressive in their dealings with the emerging markets, and were consequently outbid for business by New York houses, not just JP Morgan, which was a traditional participant in the business, but other houses such as the National City Bank that were inexperienced in underwriting.

Consequently, when the 1929 crash hit, the level of defaults on emerging market debt was far higher than had ever been seen before 1914, and investors were appropriately deterred from further investment in this asset class. The problem was exacerbated by the Glass-Steagall Act, which separated commercial and investment banks, thus depriving potential emerging market bond underwriters of capital.

This was the background to Harry Dexter White and Maynard Keynes' 1944 creation, at Bretton Woods, of the World Bank and the International Monetary Fund. To them, in the international capital market as in so many other things, the private sector had failed and a monopoly public sector solution was necessary.

Rather than attempting to return to the stable and effective model of the pre-1914 world, Keynes and White created an autarkic financial model, that effectively prevented international bond financing to the developing world for 30 years.

A modest market remained in New York, but Securities and Exchange Commission regulations and the Interest Equalization Tax of 1964-74 meant that it was never a major source of money for developing countries or of revenue for the New York houses. Instead, the principal sources of development finance became the World Bank (and later the IMF), the national export credit banks, and the major international commercial banks through the syndicated loan market.

In the 1960s, with the emergence of the Euromarkets, the possibility opened again of a market for developing country debt. Nevertheless, it did not quickly re-emerge. The London merchant banks had lost most of their capability for advising and monitoring developing country credits, while the major international commercial banks, that had such a capability, were not heavily involved in underwriting.

It thus took the banking crisis of the 1980s and its aftermath for the international bond markets to reopen fully to emerging market credits.

At this point, a new mechanism was needed by which investors could assess the credit quality of the bonds they bought. The London merchant banks by now were a much smaller factor in international finance, were being bought out by large commercial banks, and in any case had oriented themselves primarily toward the equity markets, which they saw as most profitable.

The bond market had been commoditized, with issue spreads sharply reduced and the role of the lead manager reduced to a mere producer of legal documentation and launcher of the issue onto the world's trading desks. Into this vacuum stepped the rating agencies, selling their services to developing country borrowers at a suitably remunerative fee. Nobody thought the rating agencies particularly capable in rating emerging market credits, but they were the only game in town.

The FPF study demonstrated that the rating agencies have tended to lag reality in assessing developing country credit ratings, rating them above the level that would be indicated by purely statistical considerations in good times, and marking them down sharply, often by three or four rating levels, when things went wrong.

Rating agency down-gradings, in turn, are watched very closely by the market, and tend to be a signal for a tsunami of selling when they happen, thus exacerbating the problem that caused the downgrade and causing a liquidity crisis in the country's obligations just when it is most dangerous.

Indeed, there is a particular "insider trading problem" in the rating agencies' sale of some information to subscription-paying clients, and their frequent contact with Wall Street traders, both of which can provide indications of rating agency intentions to insiders before the investing public as a whole are aware of them.

The FPF study was also critical of the oligopolistic nature of the credit rating agencies -- only four are granted by the SEC the status of a Nationally Recognized Statistical Rating Organization, of which one, Dominion Bond Ratings, is primarily a Canadian national agency and another, Fitch, is considerably smaller than the two major agencies, Moody's and Standard and Poors.

The study suggested that if further agencies were granted NRSRO status, competition would be increased, rating agency fees reduced and the quality of debt ratings improved.

It is on this last point that I differ. Since rating agencies are paid by issuers, there would be a natural tendency for smaller agencies seeking business to shave their quality standards and grant higher ratings, thus reducing the information content of a debt rating to investors. Moreover, there seems no reason to suppose that the pro-cyclical nature of the ratings process would be improved by these means.

This may well indeed be a problem without a solution, so long as the present world financial architecture remains in place, with development finance dominated by a public sector monopoly cartel, and bond issuance being carried out through rapid-response trading desks.

It is however likely that, following the Argentina default, and possible further international bond defaults in Turkey and Brazil, the international bond market will effectively close to new borrowers for several years. At that point, if the hugely pro-cyclical nature of the international bond markets needs to be removed, it could be done -? by closing down the operations of the World Bank and IMF and allowing development finance to be returned to the competitive private sector, where it belongs.

If this were done, it would be likely that issuing banks, and not artificially established rating agencies, would once more govern investors' credit assessment process, to the great benefit of the developing world's economy.




·         Spanish Newswire Services

April 4, 2003

EEUU-DEUDA Tesoro de EEUU hace maniobra contable para no ser un moroso

Washington, 4 abr (EFE).- El Departamento del Tesoro de EEUU anuncio hoy una maniobra contable que liberara unos 12.000 millones de dolares e impedira que el Gobierno supere el limite de endeudamiento impuesto por el Congreso.

Segun la Oficina de Deuda Publica del Departamento del Tesoro, la deuda nacional de EEUU asciende hoy a 6,46 billones de dolares y esta al borde del maximo fijado por el Congreso que, el ano pasado, aumento el anterior limite en 450.000 millones de dolares.

Pero la deuda nacional ha ido aumentando en los ultimos dos anos a un ritmo creciente, mientras el Gobierno del presidente George W. Bush lleva adelante una politica de reduccion de impuestos y aumento de los gastos, especialmente militares.

El secretario del Tesoro, John Snow, en un mensaje enviado hoy a la Camara de Representantes y al Senado, notifico que su ministerio suspende las nuevas inversiones en bonos del Tesoro que se hubieran acreditado al Fondo para Jubilacion y Pagos por Incapacidad para los Funcionarios publicos.

Snow indico que la accion podria comenzar hoy mismo, y con toda seguridad se aplicara antes del viernes proximo, y la suspension de inversiones continuara hasta el 11 de junio.

Esto liberara unos 12.000 millones de dolares que, junto con otras maniobras contables anteriores permitira que el gobierno siga pagando sus cuentas.

La maniobra "a largo plazo, es un problema muy grave porque amenaza el valor mas preciado de Estados Unidos: nuestro credito", dijo a EFE, Randall Dodd, director del grupo de estudios Financial Policy Forum, en Washington.

Dodd explico que "a corto plazo, esto no tiene consecuencias economicas graves y es, mas bien, un juego del Tesoro con fondos entre cuentas".

Sin embargo, considero que "politicamente, es un asunto muy grave", pues cree que se estan jugando "con el valor mas preciado de Estados Unidos, la calificacion de nuestro credito... No deberia hacerse algo que ponga en riesgo esa calificacion".

Los presupuestos del Gobierno y las reducciones de impuestos propuestos por Bush incluyen crecientes deficit.

En opinion de muchos analistas, el retorno del Gobierno federal como competidor por fondos en los mercados financieros causara un incremento de las tasas de interes, que estan en su nivel mas bajo desde 1961 y estan siendo un elemento clave para mantener el estimulo economico a la renqueante economia. EFE


Kiplinger Business Forecasts

March 28, 2003 Friday

Rising Debt Loads Will Push Up Rates

BYLINE: Jerome Idaszak

 Every leg of the U.S. debt tripod household, corporate and government is rising. That doesn't mean we're headed for a financial crisis, but it will mean higher borrowing costs for many years to come. More debt will boost demand for credit and prompt lenders to hike interest rates.

Pinpointing the impact of rising debt on borrowing rates is a bit tricky because the equation comprises several elements, notably economic growth rates, inflation expectations and the ability of many businesses to increase profit margins by raising prices. The U.S. debt overhang will probably add a roughly 1% premium to interest rates across the board over the next decade unless we can find ways to reduce liabilities, especially on the government side.

Federal debt totaled $3.6 trillion in early 2003. It actually shrank for four years starting in 1998 but rose nearly 8% last year and will rise about the same this year. In fact, debt is on course to continue rising in the future as President Bush's tax cuts and the war with Iraq all but guarantee budget deficits for the rest of this decade. The Congressional Budget Office estimates that deficits over the next decade will total at least $1.8 trillion, not including combat and aid costs in Iraq.

The federal budget deficit as a percentage of gross domestic product (GDP) is a bit less than 3% not so bad in relation to the 5% reached in previous economic downturns. But the current rising trend, after four years of surpluses starting in the late 1990s, is disturbing. Federal Reserve Chairman Alan Greenspan told Congress last month that a sustained increase in the deficit beyond about 3% of GDP would result in a rise in long-term interest rates.

The question is whether GDP can grow faster than the debt. If so, it's similar to households seeing their incomes rise or businesses seeing profits go up. The debt burden of repayment would be manageable. For the federal government, however, the growth path of Medicare, combined with more money for defense, homeland security and other programs, raises serious doubts that the economy can grow fast enough.

The level of corporate borrowing is less worrisome, though there's still cause for concern about the financial stability of companies in the telecommunications, auto and air travel sectors. Growth in total U.S. corporate debt actually slowed last year to 1.3% after gains of between 5% and 12% in the previous five years. This year, the increase will be in mid-single digits.

The stock of credit market borrowing by corporations is currently around $5 trillion, up from only $2.5 trillion in 1992 and $1 trillion in 1982. Until recently, companies were able to secure a lot of their funding in the short-term commercial paper market, helping to keep their bond-based debt burden under control. But the paper market has dried up in response to the wave of corporate financial scandals and recent economic weakness, so firms have piled into bond issuance.

As long as business income rises steadily enough to meet interest payments, things will be OK. Indeed, companies are counting on a strong economic recovery to kick in fairly soon and help boost their profits. If that doesn't happen, some companies may be caught short. Average profits have only lately been on the mend after falling on average in 2000 and 2001.

Corporations defaulted on 3.2% of bonds outstanding last year, surpassing the level reached during the 1991 recession. But much of the recent distress has been concentrated in telecom companies, airlines, energy traders and scattered high-profile cases such as Kmart. What's more, interest payments as a percentage of total cash flow were about 18% coming into this year, well below the peak of 27% in 1991. Therefore, as Ben Bernanke, a governor of the Federal Reserve Board, comments, balance sheets are healthier "for many firms."

Perhaps the bigger worry with corporate debt involves the rapidly growing use of derivatives swaps, futures, options and other financial products aimed at managing the risk of firms' bond issues. Although these instruments help companies spread risks to other parties, derivatives can also spread default damage through the economy. That's why investor Warren Buffett calls them "financial weapons of mass destruction."

Randall Dodd, director of the Derivatives Study Center in Washington, D.C., says that more federal regulation and supervision are needed because of the continuing growth and potential risks of derivatives. He cites the rescue arranged by the Federal Reserve in 1998 when Long-Term Capital Management (LTCM), a private investment fund, nearly went bankrupt. Fed officials worried about the effect on the U.S. banking system as well as on credit markets. The problem was contained, but, Dodd says, "to say that LTCM wasn't a problem is like saying Chernobyl wasn't a problem because the nuclear fallout didn't spread through the rest of the world."

On the household side, mortgage debt has been up 8% or more each year since 1998. Although that's above the 5% to 7% growth rate of the previous seven years, it's below the annual double-digit increases seen from 1983 through 1989. Meanwhile, the growth of credit cards and other short-term consumer debt has slowed during the past two years.

What's equally important is the growth rate of consumer incomes and assets, which determines the ability to pay off loans. Income after inflation rose a strong 4.5% last year. Regarding assets, although the stock market is struggling after three years of declines, home prices were up 7% last year and are on course to increase about 5% on average this year. That puts the ratio of assets to debt at a historically comfortable level.



·         CNBC Closing Bell

March 11, 2003, Tuesday 15:00-16:00 ET

Teased Segment - Economy; In recent days 2 respected financial leaders, Warren Buffett and William Poole, Pres., St. Louis Federal Reserve Bank, have warned about potential market meltdown from separate by related financial areas. One of the warnings was that investors should be concerned about possible market problems from the derivatives market and the mortgage portfolio of Fannie Mae.

Interview - William Poole, St. Louis Fed. Reserve Pres., says that the threat is substantial because of their scale. The potential threat is from government sponsored enterprises like Fannie Mae and Freddie Mac.

Visual - Exterior Freddie Mac.
Visual - Fannie Mae sign. Poole worries about the impact on Fannie's portfolio from a quick decline in housing prices or a rapid rise in interest rates.
Visual - Warren Buffett. Buffett cautioned about possible dangers from the derivatives market.
Graphic - Warren Buffet on Derivatives; Source: Letter to Berkshire Hathaway shareholders. Buffett said that derivatives are financial weapons of mass destruction.

Interview - Randall Dodd, Derivatives Study Center, says that there is inadequate collateral in those markets just as Buffett has pointed out and there are interlinking credit risks between the major financial institutions.
Visual - Exterior Enron. Dodd points to the meltdown of Enron and its energy derivatives portfolio as an example of how an unregulated market can spin out of control.
Interview - Robert Pickel, International Swaps & Derivatives Association, says that the structure works. He says that when an organization the size of Enron goes under it can be absorbed within the system and move smoothly.
Interview - Franklin Raines, Chairman, CEO, Fannie Mae, says that they put in place a liquidity plan as requested by the Treasury that allows Fannie Mae to continue operating for 90 days or more without access to the market. In and upcoming paper Dodd will argue that Fannie Mae is a model for how the entire derivatives market should be regulated. Dodd says that Poole's remarks were inappropriate. He says that Poole's views were far too alarming and it caused disruptions in the financial markets. He says that he thinks that Fannie Mae and Freddie Mac use derivatives to manage the risks well.

 Steve Liesman reporting.



March 12, 2003, Wednesday, Final Edition


 A Financial 'Time Bomb'?

BYLINE: Robert J. Samuelson

Since the 19th century, governments have tried to prevent financial panics, which led to economic slumps and depressions. In 1873 Walter Bagehot, editor of the Economist, published his landmark book "Lombard Street: A Description of the Money Market," which advised the Bank of England about how to stop bank runs. When the Federal Reserve disregarded his advice in the 1930s, the Great Depression ensued. Congress later enacted deposit insurance as another protection against panics. To the list of financial threats can now be added "derivatives" -- sophisticated securities that are used mostly by big investors (banks, insurance companies, corporations).

Just last week, legendary investor Warren Buffett denounced derivatives as "financial weapons of mass destruction" that could cause economic havoc. By contrast, Federal Reserve Chairman Alan Greenspan says derivatives have improved economic stability. Who's right? This is an important debate, because derivatives have exploded and are implicated in two recent financial scandals -- Enron's bankruptcy and the near-bankruptcy in 1998 of Long-Term Capital Management (LTCM), a private investment fund.

About derivatives' growth, there's no debate. From 1990 to 2002, their face value rose from $ 2.9 trillion to $ 127.6 trillion, says Randall Dodd of the Derivatives Study Center, an advocacy group. These figures, based on data from the Bank for International Settlements, can be misleading. The amounts at risk are much smaller than the face value -- probably less than 10 percent. Still, the numbers are huge and reflect two realities: (1) Derivatives are one way to make a fast buck; and (2) they allow companies and others to hedge against unfavorable economic developments -- changes in interest rates, for instance.

Derivatives are so named because they "derive" their value from the future price movements of some commodity or financial asset: oil, wheat or stocks. Small swings in prices can mean huge profits and losses, because investors have to commit only tiny amounts of cash compared with the contracts' face value. Buffett's fears start with this explosive arithmetic. In an extreme case, LTCM used about $ 5 billion of investment capital to control more than $ 1 trillion of derivatives, according to Dodd.

But trading isn't just gambling by speculators. In economics texts, farmers provide the classic illustration of the advantages of hedging. Suppose you raise wheat. When you plant in the spring, the price is $ 3 a bushel. You can make a profit at that. The trouble is that you sell in the fall, after the harvest, and if the price drops to $ 2.50, you can't cover your costs. To reduce that risk, you invest in wheat futures contracts. If wheat prices decline, you offset losses on your crop with profits from your futures contracts. Thus reassured, you plant in the spring.

Hedging has spread far beyond the farm. Four-fifths of derivatives now involve interest rates; another 10 percent or so involve currency exchange rates. These provide protection for companies whose businesses involve lots of debt or foreign trade. One benefit, Greenspan has argued, has been the mortgage-refinancing boom. Investors in mortgage-backed securities face the risk that, if interest rates fall, homeowners will refinance. Investors lose. To minimize that risk, they can hedge against lower interest rates. If they couldn't, they might impose larger prepayment penalties or charge higher interest rates.

Similarly, Greenspan has noted that despite $ 1 trillion in worldwide lending to telecommunications companies from 1998 to 2001, the subsequent telecom bankruptcies have not caused any major bank failures. One reason, he contends, is that banks spread their lending risks to other investors (say, insurance companies) through "credit derivatives." Dispersing risk has made the financial system sturdier, he argues.

Buffett doesn't deny derivatives' theoretical benefits. Indeed, he's not worried by standard futures contracts such as wheat (traded on exchanges, such as the Chicago Mercantile Exchange). What frightens him is the possibility that newer derivatives (traded "over the counter" -- between one customer and another) could trigger a panic. Financial markets require trust. Without it, people won't deal with each other. Credit and confidence shrivel. To Buffett, derivatives are "time bombs" that could shatter confidence in three ways.

First, a few big banks dominate the market. Among U.S. banks, seven (led by JPMorgan Chase, Citibank and Bank of America) account for 96 percent of derivatives holdings. "The troubles of one could quickly infect the others," he writes.

Second, weakness could feed on itself. A company whose credit rating is lowered -- for whatever reason -- typically has to put up more collateral against its derivatives contracts. A "corporate meltdown" and defaults could ensue because the company needs more cash just when cash is least available.

Third, complex accounting rules for derivatives can lead to overstatements of profits (this was true of Enron) and confusion. All the "long footnotes" on derivatives convince Buffett "that we don't understand how much risk" is involved.

Although Buffett could be wrong, his record in spotting financial excesses -- in tech stocks and executive options -- commands respect. What can be done? He doesn't say. One thing that can't be done is to outlaw "speculators" (customers trading for profit) and allow only "hedgers" (customers trying to protect themselves). The markets need speculators to counterbalance hedgers. But as Dodd suggests, some steps might improve financial safety. Capital requirements could be imposed on all dealers (banks have them, but non-banks -- such as Enron -- typically don't). Reporting requirements could be increased.

Even Greenspan concedes "the remote possibility of a chain reaction, a cascading sequence of defaults" that would impel the Fed, heeding Bagehot, to try to rescue the financial system -- an outcome that no one should want.



·         Calgary Herald (Alberta, Canada)

March 9, 2003 Sunday Final Edition


Derivatives are risky, unregulated -- and essential

John M. Berry

When billionaire investor Warren Buffett warned bluntly this week that the growing use of the esoteric financial instruments known as derivatives poses a threat to the stability of world markets, he put himself directly at odds with another financial sage, Federal Reserve chairman Alan Greenspan.

"Derivatives are financial weapons of mass destruction," Buffett said in his annual letter to shareholders of Berkshire Hathaway Inc., of which he is chairman. "The dangers are now latent -- but they could be lethal."

Greenspan, on the other hand, believes the spread of derivatives has reduced rather than increased the risk that a wave of losses in some markets could trigger a financial crisis.

"These increasingly complex financial instruments have especially contributed, particularly over the past couple of stressful years, to the development of a far more flexible, efficient and resilient financial system than existed just a quarter-century ago," Greenspan said late last year.

Derivatives, essentially contracts whose value depends on an underlying asset, such as the value of a currency or a bushel of corn, have been controversial for years, especially as they have exploded in popularity. That's because they are basically unregulated and have played a role in several financial scandals, from the fall of Barings Bank in Britain in 1995 and the collapse in 1998 of the huge New England-based hedge fund Long-Term Capital Management to the more recent demise of Enron Corp.

The use of derivatives has grown exponentially in recent years. The total value of all unregulated derivatives is estimated to be $127 trillion -- up from $3 trillion in 1990. J.P. Morgan Chase & Co. is the world's largest derivatives trader, with contracts on its books totalling more than $27 trillion. Most of those contracts are designed to offset each other, so the actual amount of bank capital at risk is supposed to be a small fraction of that amount.

Previous efforts to increase federal oversight of the derivatives market have failed, including one during the Clinton administration when the industry, with support from Greenspan and other regulators, beat back an effort by Brooksley Born, the chief futures contracts regulator. Sen. Dianne Feinstein, D-Calif., has introduced a bill to regulate energy derivatives because of her belief that Enron used them to manipulate prices during the California energy crisis, but no immediate congressional action is expected.

Randall Dodd, director of the Derivatives Study Center, a Washington think-tank, said both Buffett and Greenspan are right -- unregulated derivatives are essential tools, but also very risky. Dodd believes more oversight is needed to reduce that inherent risk.

"It's a double-edged sword," he said. "Derivatives are extremely useful for risk management, but they also create a host of new risks that expose the entire economy to potential financial market disruptions."

Buffett has no problem with simpler derivatives, such as futures contracts in commodities that are traded on organized exchanges, which are regulated. For instance, a farmer growing corn can protect himself against a drop in prices before he sells his crop by buying a futures contract that would pay off if the price fell. In essence, derivatives are used to spread the risk of loss to someone else who is willing to take it on -- at a price.

Buffett's concern about more complex derivatives has increased since Berkshire Hathaway purchased General Re Corp., a reinsurance company, with a subsidiary that is a derivatives dealer. Buffett and his partner, Charles T. Munger, judged that business "to be too dangerous."

Because many of the subsidiary's derivatives involve long-term commitments, "it will be a great many years before we are totally out of this operation," Buffett wrote in the letter, which was excerpted on the Fortune magazine Web site. The full text of the letter was to be made available on Berkshire Hathaway's Web site on Saturday. "In fact, the reinsurance and derivatives businesses are similar: Like hell, both are easy to enter and almost impossible to exit."

Susan M. Phillips, dean of the George Washington University School of Business and Public Management and a former member of both the Federal Reserve Board and the Commodity Futures Trading Commission, said she believes Buffett "overstated the danger" of the use of derivatives to financial markets.

"In many ways, derivatives provide stability to our markets, but they are instruments only for people who want to be in that business and have the expertise to do the valuations," Phillips said. "We have seen a lot of volatility in markets recently and, if this had happened 15 or 20 years ago, we would have seen a lot of bank failures and failures of brokerages. The use of derivatives has helped shore up the financial system."

At least at banks, Phillips said, losses on derivatives have been very small. "That's not where they lose money. It's the old-fashioned way: bad loans," she said.

John M. Berry covers economics for the Washington Post

GRAPHIC: Photo: Warren Buffett; Photo: Calgary Herald Archive; Derivatives have played a role in several financial scandals, from the fall of Barings Bank in Britain in 1995 to the more recent demise of Enron Corp.




March 06, 2003, Thursday, Final Edition


Divided on Derivatives; Greenspan, Buffett at Odds on Risks of the Financial Instruments

John M. Berry, Washington Post Staff Writer

 When billionaire investor Warren Buffett warned bluntly this week that the growing use of the esoteric financial instruments known as derivatives poses a threat to the stability of world markets, he put himself directly at odds with another financial sage, Federal Reserve Chairman Alan Greenspan.

"Derivatives are financial weapons of mass destruction," Buffett said in his annual letter to shareholders of Berkshire Hathaway Inc., of which he is chairman. "The dangers are now latent -- but they could be lethal."

Greenspan, on the other hand, believes the spread of derivatives has reduced rather than increased the risk that a wave of losses in some markets could trigger a financial crisis.

"These increasingly complex financial instruments have especially contributed, particularly over the past couple of stressful years, to the development of a far more flexible, efficient and resilient financial system than existed just a quarter-century ago," Greenspan said late last year.

Derivatives, essentially contracts whose value depends on an underlying asset, such as the value of a currency or a bushel of corn, have been controversial for years, especially as they have exploded in popularity. That's because they are basically unregulated and have played a role in several financial scandals, from the fall of Barings Bank in Britain in 1995 and the collapse in 1998 of the huge New England-based hedge fund Long-Term Capital Management to the more recent demise of Enron Corp.

The use of derivatives has grown exponentially in recent years. The total value of all unregulated derivatives is estimated to be $ 127 trillion -- up from $ 3 trillion 1990. J.P. Morgan Chase & Co. is the world's largest derivatives trader, with contracts on its books totaling more than $ 27 trillion. Most of those contracts are designed to offset each other, so the actual amount of bank capital at risk is supposed to be a small fraction of that amount.

Previous efforts to increase federal oversight of the derivatives market have failed, including one during the Clinton administration when the industry, with support from Greenspan and other regulators, beat back an effort by Brooksley Born, the chief futures contracts' regulator. Sen. Dianne Feinstein (D-Calif.) has introduced a bill to regulate energy derivatives because of her belief that Enron used them to manipulate prices during the California energy crisis, but no immediate congressional action is expected.

Randall Dodd, director of the Derivatives Study Center, a Washington think tank, said both Buffett and Greenspan are right -- unregulated derivatives are essential tools, but also potentially very risky. Dodd believes more oversight is needed to reduce that inherent risk.

"It's a double-edged sword," he said. "Derivatives are extremely useful for risk management, but they also create a host of new risks that expose the entire economy to potential financial market disruptions."

Buffett has no problem with simpler derivatives, such as futures contracts in commodities that are traded on organized exchanges, which are regulated. For instance, a farmer growing corn can protect himself against a drop in prices before he sells his crop by buying a futures contract that would pay off if the price fell. In essence, derivatives are used to spread the risk of loss to someone else who is willing to take it on -- at a price.

Buffett's concern about more complex derivatives has increased since Berkshire Hathaway purchased General Re Corp., a reinsurance company, with a subsidiary that is a derivatives dealer. Buffett and his partner, Charles T. Munger, judged that business "to be too dangerous."

Because many of the subsidiary's derivatives involve long-term commitments, "it will be a great many years before we are totally out of this operation," Buffett wrote in the letter, which was excerpted on the Fortune magazine Web site. The full text of the letter will be available on Berkshire Hathaway's Web site on Saturday. "In fact, the reinsurance and derivatives businesses are similar: Like Hell, both are easy to enter and almost impossible to exit."

One derivatives expert said several of General Re's contracts probably involved credit risk swaps with lenders in which General Re had agreed to pay off a loan if a borrower -- perhaps a telecommunications company -- were to default. In testimony last year, Greenspan singled out the case of telecom companies, which had defaulted on a significant portion of about $ 1 trillion in loans. The defaults, the Fed chairman said, had strained financial markets, but because much of the risk had been "swapped" to others -- such as insurance companies, hedge funds and pension funds -- the defaults did not cause a wave of financial-institution bankruptcies.

"Many people argue that derivatives reduce systemic problems, in that participants who can't bear certain risks are able to transfer them to stronger hands," Buffett acknowledged. "These people believe that derivatives act to stabilize the economy, facilitate trade and eliminate bumps for individual participants. And, on a micro level, what they say is often true. Indeed, at Berkshire, I sometimes engage in large-scale derivatives transactions in order to facilitate certain investment strategies."

But then Buffett added: "The macro picture is dangerous and getting more so. Large amounts of risk, particularly credit risk, have become concentrated in the hands of relatively few derivatives dealers, who in addition trade extensively with one another. The troubles of one could quickly infect the others. On top of that, these dealers are owed huge amounts by nondealer counterparties," some of whom are linked in such a way that many of them could run into problems simultaneously and set off a cascade of defaults.

Susan M. Phillips, dean of the George Washington University School of Business and Public Management, who is a former member of both the Federal Reserve Board and the Commodity Futures Trading Commission, said she believes Buffett "overstated the danger" of the use of derivatives to financial markets.

"In many ways, derivatives provide stability to our markets, but they are instruments only for people who want to be in that business and have the expertise to do the valuations," Phillips said. "We have seen a lot of volatility in markets recently, and if this had happened 15 or 20 years ago, we would have seen a lot of bank failures and failures of brokerages. The use of derivatives has helped shore up the financial system."

At least at banks, Phillips said, losses on derivatives have been very small. "That's not where they lose money. It's the old-fashioned way: bad loans," she said.

E. Gerald Corrigan of Goldman Sachs Group Inc., who had extensive experience dealing with derivatives issues when he was president of the New York Federal Reserve Bank, said he believes the risk of a financial market crisis has been reduced by the widespread use of derivatives. In addition, he said, "risk management is better, supervision is better and the capital position of major financial institutions is better" than it was 10 years ago.

"What is not so clear, on the other side of the ledger, is, has the complexity [of derivatives and other new financial instruments] left the potential damage quotient higher?" Corrigan asked. The issue, he said, is whether "the use of credit derivatives left risk in the hands of people who may not understand the risk, and has the sheer growth of derivatives" increased the potential damage from a crisis should one occur.

Corrigan said he is not sure of the answer, and added, "I really do think that all of us should go back and take a look at some of these questions again."

Staff writer Kathleen Day contributed to this report.




·         ERisk News, Weekly Review

01 - 07 March 2003


There aren’t many things, on the face of it, that unite the US, the UK and China except, perhaps, for this week’s news that all three are at risk of a property crash – which could prove particularly painful given the global economic climate.


In China, what looks like a rapidly inflating real-estate bubble has been prompted by Beijing’s decision in 1998 to eliminate free and subsidized housing, which has made construction a far more lucrative and competitive industry.


The resulting real estate investment boom has been “no less intense” that the one sparked by dotcom mania in the US, according to one report this week – and the latter boom's excesses have since been cruelly exposed. The value of office space in Silicon Valley has crashed during the last three years – Palm paid $220 million for its new campus-style HQ in 1999, but falling prices forced the company to write down the value of the property to just $60m this week. Commercial vacancies hit 27% in Silicon Valley at the end of last year. In San Francisco, vacancies hover around 22%, while rents have fallen from $100 per square foot to $28.


Could a similar crash affect residential property? Alan Greenspan this week argued that it wouldn’t, but noted that with mortgage interest rates bottoming out, there was a danger that house prices – which are already showing slower growth – would fall. Data out this week underlined a need for caution. Average property prices in the US rose by 0.83% during the fourth quarter of last year – the slowest rate of growth for five years.


The UK has been on edge about the state of its housing market for some time now. The double-digit price increases of recent years have far outstripped wage growth, and fears were heightened this week by an IMF report that singled out the housing market as a source of “appreciable” risk for the UK economy. At the same time, a new survey by one lender found that house price growth had dropped to 0.4% during February – its slowest pace for two years. But economists are divided on the outlook for the UK market, with some forecasting continued strong growth, while others see it running out of steam.


The week began with a spasm of anxiety about the impact of oil prices, which had reached 12-year highs. Some analysts worried about the short-term impact on stock markets, others focused on the medium-term threat to the global economy. Reports noted that every US downturn for the last 40 years has been preceded by a big rise in oil prices that has hit energy consumers hard. Worries of this nature were being cited by some as a likely prompt for the European Central Bank to cut rates when it met on Thursday. When the ECB announced its decision to cut, though, markets were disappointed that it chose to lop only a quarter-point off rates, rather than the half-point many had been hoping for.


Meanwhile, oil markets showed little sign of settling down. Crude prices fell on Monday as traders reacted to sentiment that Iraq might be complying with UN demands. “The pendulum of market sentiment appears to be focused on a delay to a military strike, which will erode the war premium,” said one Sydney-based trader.


A day later, that pendulum was swinging back the other way. The US benchmark rose 3% as military build-up continued in the Gulf. On Wednesday, prices zigzagged within a $1.50 range – volatility on a scale that traders are rapidly becoming accustomed to. After George Bush’s prime-time address to the US on Thursday, in which he talked of a decision on war “within days,” oil prices began rising again, although they remained below last week’s peak of $39.


Among the obvious beneficiaries of a higher oil price are the companies who sell it, but Exxon’s chairman and chief executive was at pains to point out that it isn’t an unambiguous benefit. In fact, he told analysts in New York on Tuesday, high oil prices exact a long-term cost on the energy industry, because peaks tend to be followed by troughs, and investors are scared away by the volatility.


One answer, of course, is to hedge, which is done not just to protect companies from weak prices, but to ensure price consistency. Sadly, investors don’t always thank companies for this stability, as one of the world’s biggest gold mining companies, Barrick, is currently finding out. With gold prices near recent highs after surging last year, the environment should be good for Barrick, but investors have sent the company’s stock down 11% over the last year, fearing that the Barrick’s well-documented hedging program is preventing it from reaping the rewards of gold’s rise.


“By far the biggest imputed liability to the stock price we estimate is related to concerns about the hedge book,” said one Canadian mining analyst. Barrick has responded by trimming the size of its positions – 20% of its reserves are currently committed to hedges, compared with 26% last June, one report claims. Selling its hedging strategy to investors isn’t Barrick’s only worry at the moment – along with JP Morgan Chase, the company is also named in a lawsuit alleging that it manipulated gold prices.


The appointment of new US treasury secretary John Snow has been touted in many quarters as an antidote to the nervousness in world financial markets prompted whenever his predecessor, Paul O’Neill, got near a microphone, but Snow this week seemed determined to continue in the same mould. With the dollar falling at the start of the week, Snow was asked for his response and claimed to be “not particularly concerned.” Soon after, the dollar hit a four-year low of $1.103 to the euro.


Right now, everyone is itching for a reason to sell the dollar and Snow provided one, said Lara Rhame, foreign exchange strategist at Brown Brothers Harriman in New York. Accordingly, Snow took the opportunity provided by a ceremonial engagement the following day to squeeze in a remark restating his commitment to a strong dollar. It made little difference as the week wore on.


Marmite – a quintessentially British spread made from yeast extract – is famous for provoking vastly differing reactions among its consumers. You either love it or hate it, according to its advertising. The same might be said for derivatives, which seem to be loved and loathed in equal parts.


Federal Reserve chairman Alan Greenspan put the case for derivatives in a speech in Washington last November. Derivatives, he said, had protected the US economy and financial system from the worst impact of the market downturn by spreading risk across different kinds of investors, making them “far more flexible, efficient and resilient.”


This week, investment guru Warren Buffet put the case against derivatives in his annual letter to shareholders of Berkshire Hathaway – the company he chairs. If all specific references to derivatives had been excised from Buffett’s letter, you’d never have known that he and Greenspan were talking about the same things. Buffett, who appears to have turned to White House speech-writers for advice on phrasing, described derivatives as “time bombs” and “financial weapons of mass destruction,” carrying the latent but “potentially lethal” threat of a “mega-catastrophe.”


Of course, there’s no reason why derivatives can’t, in one instance, be a force for good and, in another, give rise to the financial Armageddon which Buffett fears – and there was no shortage of people willing to interpret the “Sage of Omaha’s” fire and brimstone warnings as a call for greater regulation and disclosure on derivatives.   


Frank Partnoy, a derivatives trader-turned-critic who’s now a professor at the University of San Diego School of Law, said of Buffet’s letter: “He's right on target, and is in a perfect position to know and comment on these things. There needs to be more disclosure here, so investors can know about the derivatives positions of companies they invest in.” Randall Dodd, a former economist at the Commodity Futures Trading Commission, agreed: “These derivatives do pose a danger to our financial markets and the economy as a whole. They need special attention.”


Will they get it? Not if the derivatives industry has its way. Derivatives were subjected to severe criticism following the collapse of Enron (see this ERisk analysis) but no substantive regulatory changes followed. Buffett’s fears are focused primarily on the risk of a chain-effect catastrophe sweeping through the relatively few companies who are heavily involved in the derivatives market. Fears of just this kind of catastrophe prompted the Federal Reserve to organise a banking industry bail-out of Long Term Capital Management in 1998.


But derivatives aren’t the only financial products that are tricky to value, as US regional bank Provident demonstrated this week when it fell prey to the infrequent but oh-so-embarrassing problem of model risk. Provident was forced to announce that it would restate financials for the last five years after overstating revenues from its auto-leasing business by $70 million, news which caused the stock’s biggest single-day drop in 14 years. Provident said that testing of a new model revealed that the bank had overstated earnings from transactions originated between 1997 and 1999.


Enron was back in the news this week as creditors continue in their attempts to recover money from the bankrupt energy giant. Neal Batson, Enron’s court-appointed “examiner”, suggested in a report this week that as much as $5bn could be recovered from the off-balance sheet deals set up by Enron and its advisers in the banking industry. A later report will consider whether Enron’s bankers should share the blame for the fraud that those deals were used to perpetuate – but the banking industry is certainly not off the hook at this point.


Separately, Batson this week filed a request to the bankruptcy court requesting an order for seven CSFB staff to provide testimony in his ongoing investigations. CSFB was quick to point out that it was not under any kind of particular suspicion: “The examiner has informed us that he intends to take testimony from eight investment banks including CSFB and we have and will continue to cooperate with his investigation,” a spokesman said.   


Meanwhile, banks are still struggling with another consequence of Enron’s collapse: the subsequent meltdown in energy trading – a business which they had extended large amounts of credit to finance. However, with many creditors in a precarious financial state, banks are apparently unwilling to push too hard for repayment in case they are left holding cumbersome and expensive power plants.


Europe’s largest bank, HSBC, reported a 21% increase in profits for last year, to $9.65bn – at the lower end of analyst's expectations – and said that its priority for 2003 would be to complete the acquisition and integration of Household. One of the bank’s key risks seems to have been dealt with well during 2002 – loan loss costs fell by $716m – but there’s still the possibility of legal risk derailing the bank’s purchase of Household.


Some shareholders are still pursuing lawsuits that allege that HSBC’s bid undervalues Household. Another lawsuit wants the deal blocked on grounds that HSBC discriminates against Hispanic customers, but the bank is confident that the acquisition will be completed without a hitch.


CSFB’s high-tech investment banking rainmaker, Frank Quattrone has appeared to be in an unenviable position for months, but after it emerged that he had urged the destruction of documents relating to the bank’s IPO practices, things have got rapidly worse for the former star banker. This week, reports suggested that CSFB, which had suspended Quattrone last month, was ready to fire him. Then, on Tuesday, he was gone – after what the bank said was an agreement that it was in both sides best interests for him to leave.


But Quattrone isn’t going quietly. As the National Association of Securities Dealers filed civil complaints that could lead to millions of dollars in fines and a lifetime ban from the industry, Quattrone’s lawyer said that, “The NASD charges are completely without merit and represent an unprecedented attempt to take punitive action against an individual for conduct that was legal at the time and widespread throughout the industry.”


The implication that CSFB was well-aware of Quattrones behaviour and saw nothing wrong with it became clearer as the lawyer went on to note that some of the specific charges relate to practices approved by the firms lawyers. A spokesman for Quattrone also signalled that CSFBs former employee isnt prepared to meekly accept responsibility for the destruction of documents, arguing that, Frank worked in a structure where it was the responsibility of other people in legal to enforce the document retention policy.


The week started quietly for the insurance industry, but there was a sudden flurry of news towards its end. Unsurprisingly, most of that news was bad.


Swiss Life, which seemed to spend much of last year restating its accounts and fighting off allegations of executive sleaze, found a new way to traumatize investors on Thursday. In a sneak preview of its 2002 results, which aren’t officially due out until April, Switzerland’s largest life assurer warned it would take a record SFr1.7 billion loss for 2002 – more than twice the figure being touted by insurance analysts.


Where did it all go wrong? The company’s explanation reads like a laundry list of the European insurance industry’s woes. First up are the equity losses; then there’s the decline of its core domestic business, aided and abetted by rising disability claims and historically low interest rates. Next, disappointing performance at its banking arm, and finally the inevitable restructuring costs involved in its new mission to strip its business back to basics.


Nonetheless, Swiss Life expressed cautious optimism for 2003; it says that its capital base of some $4bn, minimal exposure to equities and newfound strategic clarity mean that it’s hoping for a return to the “profit zone” this year. Investors didn’t seem to buy it: the company’s shares fell 9% on the announcement.


Aegon, too, suffered shareholders’ wrath, even though it actually matched its 2002 profit forecast. Unfortunately, what it had forecast was a drop of more than a third compared with 2001, which duly came to pass. The second-largest Dutch insurer said it suffered from much the same ailments as its peers, but added a couple of its own, in the form of losses from bond defaults and acquisition write-downs on deferred acquisition costs.


Aegon said it would pay a dividend of E0.74 per share for 2002, and expects to cut its 2003 dividend to just E0.40 per share – a move that suggests it’s expecting a tough year. What’s more, the final dividend for 2002 will be paid entirely in stock, a move that will save it half a billion euros in cash and boost its share capital by about four per cent.


That may in turn help to boost its capital and prop up its credit rating, although the company says it already holds twice the minimum capital required by European regulators and more than three times that required by their US counterparts.


In an apparent change of strategic direction, it also said that from 2004 it will account for capital gains as earnings when realized, rather than smoothing them out over time. It’s an interesting move for a company whose reputation for stable growth made it an investors’ darling; now its performance will be much more closely tied to market trends – and potentially, to greater volatility.


The last of Thursday’s earnings announcements came from Royal & Sun Alliance, which became the latest UK insurer to cut its dividend. Like some of other assurers who’ve taken the axe to payouts in recent weeks, the R&SA said it had increased operating profits in 2002 – posting full-year profits of £226mn – and saw a mild rise in its stock price as a result. But it also disclosed a £406mn hole in its own pension fund, one that would need to be met by an infusion of an extra £30mn per year for the next ten years – but that was better than £1bn figure the market had been anticipating.




·         AFX European Focus

January 15, 2003 Wednesday

JP Morgan says risk exposure in gold derivatives less than $10 million

  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.


·         Power Markets Week

January 13, 2003


 The litigation wars between the IntercontinentalExchange and the New York Mercantile Exchange heated up last week as ICE last Monday filed a counter-suit against NYMEX, claiming that its proposal to bar ICE from its energy settlement prices violates free trade.

NYMEX sued ICE, an over-the-counter platform, Nov. 20 for copyright infringement, alleging that ICE ''has been copying, reproducing, distributing and preparing derivatives works'' based on settlement prices for gas and light sweet crude oil contracts. As a result, NYMEX said it has lost and ''will continue to lose substantial revenues and profits.''

But in its counter-suit, ICE said that NYMEX's action is an attempt to keep its ''existing monopoly into the OTC arena,'' ICE Chairman and CEO Jeffrey Sprecher said last week. ''This self-serving practice, along with other abusive practices, including the tying of trade execution and clearing, enables NYMEX to extend its market power and extract monopoly fees on clearing.''

ICE also charged that NYMEX attempted to ''undermine'' it by releasing ''false'' or ''misleading'' information about its clearing services and energy products. In its suit, filed with the U.S. District Court for the Southern District of New York, ICE said NYMEX operates a regulated monopoly for trading North American energy futures and that federal regulations require NYMEX to make its settlement prices available to the public.

''In order to participate in the market for trading North American energy OTC contracts, Intercontinental must be able to refer to and consider NYMEX's settlement prices in settling OTC transactions executed on Intercontinental,'' ICE said. ''Intercontinental cannot duplicate NYMEX's settlement prices without access to NYMEX market data.''

An attorney for ICE, Dan Webb, said NYMEX's claim that its market prices merit copyright protection ''as original works of authorship'' cannot be supported. ''We believe that NYMEX is engaged in the very type of conduct that the antitrust laws are designed to protect against,'' Webb said.

NYMEX fired back last Thursday, though, claiming that the counter-suit was ''baseless'' and noted that it has not received any other complaints about its competitive practices.

NYMEX asserted that it has ''applied considerable expertise and invested a great deal of effort to develop its contracts and contract marketplace,'' including a price-settlement process ''that has earned the respect of the energy industry for its reliability and integrity.'' NYMEX also called itself ''a neutral forum for trading that provides a level playing field for all participants, large and small, from all segments of the energy industry.''

NYMEX noted that most of ICE's shareholders are long-time NYMEX customers and shareholders and that ''none have previously complained to us'' about its practices. ''Copycat marketplaces seeking commercial gain should not be permitted to misuse or misappropriate the hard won credibility and goodwill of'' NYMEX, the statement said.

A market researcher said the suit and counter-suit would not affect the energy prices or market liquidity. ''No one thinks NYMEX will got away. The market is used to suits; it's not a terrible surprise,'' said Randall Dodd, director of the Derivatives Study Center, a nonprofit market-research organization in Washington.

NYMEX is preparing to go head-to-head with ICE when it introduces a trading platform for OTC energy traders sometime this month. The exchange said contracts to be made available on new platform would replicate the ''most commonly traded OTC products.''  
URL: http://www.platts.com




January 7, 2003

SECTION: Vol. 8, No. 4; Pg. 1

ICE strikes back, sues NYMEX over settlements

 The IntercontinentalExchange Monday filed a counter-suit against the New York Mercantile Exchange, which sued the over-the-counter online platform in November, claiming that NYMEX's proposal to bar ICE from using its energy settlement prices violates free trade.

''By seeking to prevent its principal competitor, Intercontinental, from using published settlement prices, NYMEX is attempting to maintain its existing monopoly into the OTC arena,'' said ICE Chairman and CEO Jeffrey Sprecher. ''This self-serving practice, along with other abusive practices, including the tying of trade execution and clearing, enables NYMEX to extend its market power and extract monopoly fees on clearing.''

NYMEX yesterday declined to comment on the ICE suit.

ICE also charged that NYMEX attempted to ''undermine'' it by releasing ''false'' or ''misleading'' information about its clearing services and energy products. In its suit, filed with the U.S. District Court for the Southern District of New York, ICE said NYMEX operates a regulated monopoly for trading North American energy futures and that federal regulations require NYMEX to make its settlement prices available to the public.

''In order to participate in the market for trading North American energy OTC contracts, Intercontinental must be able to refer to and consider NYMEX's settlement prices in settling OTC transactions executed on Intercontinental,'' ICE said. ''Intercontinental cannot duplicate NYMEX's settlement prices without access to NYMEX market data.''

NYMEX sued ICE Nov. 20 for copyright infringement, claiming ICE ''has been copying, reproducing, distributing and preparing derivatives works'' based on settlement prices for gas and light sweet crude oil contracts. As a result, NYMEX said it has lost and ''will continue to lose substantial revenues and profits.''

But an attorney for ICE, Dan Webb, said NYMEX's claim that its market prices merit copyright protection ''as original works of authorship'' cannot be supported. ''We believe that NYMEX is engaged in the very type of conduct that the antitrust laws are designed to protect against,'' Webb said.

A market researcher said the suit and counter-suit would not affect the energy prices or market liquidity. ''No one thinks NYMEX will go away. The market is used to suits; it's not a terrible surprise,'' said Randall Dodd, director of the Derivatives Study Center, a nonprofit market-research organization in Washington.

NYMEX is preparing to go head-to-head with ICE when it introduces a trading platform for OTC energy traders sometime this month. The exchange said contracts to be made available on new platform would replicate the ''most commonly traded OTC products.''  
URL: http://www.platts.com