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In The News

2006

· CNBC TV interview, December, 29, 2006

· Investor Business Daily, November 8, 2006

· Human Resources, November, 2006

· The Advocate, October 27, 2006

· Kevin McKern, October 19, 2006

· Forbes, October 16, 2006

· BNA – Bureau of National Affairs, October 4, 2006

· Oil Daily, October 3, 2006

· Power Markets Weekly, October, 2006

· Market Regulation, October 2, 2006

· Hedge Funds, September 22, 2006

· BNA – Bureau of National Affairs, September 21, 2006

· Business Week, September 20, 2006

· Gas Daily, September 20, 2006

· Gas Daily, July 20, 2006

(also in Energy Trader and Coal Trader)

· Energy Trader, May 8, 2006

· Times-Picayune (of New Orleans), May 6, 2006

· Inside FERC, May 5, 2006

· The Plain Dealer (Cleveland), May 5, 2006

(also in Standard (Syracuse, NY), Star-Ledger, and Newhouse News Service)

· Seattle Times, April 22, 2006

· Wall Street Journal, April 7, 2006

· New York Times, March 15, 2006

· CA Magazine, March, 2006

· Catholic News Service, February 16, 2006

· Bloomberg Market Magazine, February 2006

· Greenwire, January, 16, 2006

· New York Times, January 15, 2006

· Investor’s Business Daily

November 8, 2006

Sarbanes-Oxley Likely To Stand With Democrats

BY DANIEL DEL'RE AND BEN STEVERMAN

INVESTOR'S BUSINESS DAILY

Posted 11/8/2006

U.S. Rep. Barney Frank, D-Mass., could barely get proposals considered, let alone passed into law, when he pushed Congress to look into executive pay levels and scrutinize hedge funds earlier this year.

That will probably change when Democrats take charge of Congress in January.

Frank is assumed to become chairman of the House Financial Services Committee, giving him considerable power over a range of financial regulations and corporate governance issues important to investors.

Regulatory changes, however, are unlikely to be sweeping or surprising, observers said, as legislators have already tipped their hand by introducing policies to regulate hedge funds and expose excessive executive compensation.

"My assessment is that it's not going to create a major shift," said Lucian Bebchuk, director of the Harvard University Program on Corporate Governance. However, Democrats will be able to slow the momentum for rolling back previous reforms, he said.

Calls to revamp the Sarbanes-Oxley Act, for example, will probably stall in a Democrat-led Congress. The legislation was enacted in the wake of the Enron scandal to reform financial reporting. Much of corporate America has assailed the act as costly and time consuming, especially for smaller companies. But studies show most financial fraud is committed by smaller public firms. If anything, Congress may clarify Section 404 pertaining to internal accounting controls, said Randall Dodd, director of the Financial Policy Forum.

What's more, legislators seem content to let the Public Company Accounting Oversight Board, created by the act, determine how the law should be applied.

"I don't think that there's a general sense that it's worthwhile or necessary to change Sarbanes-Oxley, said Nell Minow, chief executive of the Corporate Library, a governance think tank. "My sense is that any effort to water it down is dead for the moment."

Interest in regulating hedge funds could resurface, especially if Frank decides to hold hearings on the issue. Some policymakers are concerned with the amount of pension money flowing into these largely unregulated investment pools. That concern has heightened since Amaranth Advisors lost about $6 billion on energy trades this year.

Many expect the new Congress to strengthen the SEC's ability to oversee the hedge fund industry, which manages $1.5 trillion, according to most estimates.

Earlier this year, a federal court struck down SEC rules that forced hedge funds to register, saying the commission had overstepped its congressional mandate.

This ruling effectively put the ball in Congress' court to strengthen the SEC's regulatory purview, said Marie DeFalco, attorney with Lowenstein Sandler.

"I think it's more likely than before that we will see reformulation of the hedge fund rules," she said.

Congress could take what DeFalco termed a "minimalist" approach by requiring hedge funds to register. This would let the SEC audit hedge funds and require them to keep records of their investments.

Stricter regulations would require them to file public financial reports, disclose large bond or stock holdings, and put up collateral for large trades.

Frank has also been a vocal critic of "sky-high executive pay." The SEC has already enacted policies to enforce clearer disclosure of compensation so that perquisites cannot be obscured in footnotes or left out altogether. Most observers say Frank can add teeth to this by reintroducing legislation that would let shareholders approve executive compensation packages.

"Disclosure is nice, but it doesn't do much good unless investors have the authority to act on the information," said Minow.

Frank may be a sponsor of other investor-friendly resolutions, said Minow. For example, he may support legislation to give shareholders a greater say over approving board directors.

The congressman issued a statement Wednesday acknowledging "the great amount of interest in the agenda of the committee."

His statement added, "Right now it is too premature to discuss any agenda items that the committee will or will not consider next year."

· Human Resources

November, 2006

Practitioners Seek Clarification of Auto Enrollment Rule

401(k) practitioners who were interviewed about the proposed automatic enrollment default investment alternatives regulation said the proposal is timely, but expressed some concerns with the proposed rule and asked for clarifications.

All noted that their comments were subject to further review and study of the proposed rule. They will be filing more extensive written comments with the Department of Labor. Written comments are due by November 13.

"The department has moved swiftly to provide clarity," said Dallas Salisbury, president of the Employee Benefit Research Institute (EBRI; Washington, D.C. www.ebri.org), which conducts public policy research and education on economic security and employee benefits. However, he expressed concern over the exclusion of money market and stable value funds from the proposed rule's protected class of investments.

While commending the department for promptly issuing its proposed regulation, Nell Hennessy, president and chief executive officer of investment adviser Fiduciary Counselors Inc. (Washington, D.C.; www.fiduciarycounselors.com), said "the proposed regulation does not include any capital preservation alternatives."

"I was disappointed with the requirement that the qualified default investment alternatives had to be managed by an investment manager or a registered investment company," C. Frederick Reish of the employee benefits law firm Reish, Luftman, Reicher, and Cohen (Los Angeles; www.reish.com) noted. "It is very common for plans to use asset allocation models, where the underlying funds in the plan are used to populate the models," he said.

Default investment funds should not be automatically redirected immediately, and the two conditions for automatically directed funds are "inadequately addressed," added Randall Dodd, director of Financial Policy Forum (Washington, D.C.; www.financialpolicy.org), a research institute that studies financial markets, the regulation of financial markets, and their impact on the economy.

Larry H. Goldbrum, general counsel for the Society of Professional Administrators and Recordkeepers' Institute (SPARK; Simsbury, Conn.; www.rgwuelfing.com/spark1.shtml), which provides research, education, testimony, and comments on behalf of the retirement services industry, said the institute would like clarification or slight modification of the 30-day notice requirement, among other provisions of the proposed rule.

Praise for Timeliness

"The department did a good job in issuing a timely proposed regulation under the Pension Protection Act," said Jon Breyfogle, a principal in the Groom Law Group (Washington, D.C.; www.groom.com), an employee benefits specialty law firm. "It suggests that they will get a final regulation out in time for people to rely on it in early 2007. The department deserves some credit for this," he said.

"The department should be commended for developing this thoughtful proposal so quickly," according to Chris Wloszczyna, spokesman for the Washington, D.C.-based Investment Company Institute, a trade organization for the U.S. fund industry. "The department proposal will help encourage more plans to use automatic enrollment. In addition, the default investment provision will improve the ability of workers to prepare for their retirement needs," he said.

"Overall, there is no doubt that this is very good news for the retirement of American workers," according to Ed Ferrigno, vice president of Washington Affairs for the Profit Sharing/401(k) Council of America (PSCA: Chicago, www.psca.org), which represents its members' interests to federal policymakers and offers assistance with profit-sharing and 401(k) plan design.

"We welcome the department's quick action on this vital area and look forward to commenting on the regulations and working rapidly toward final guidance," said Mark Ugoretz, president of the ERISA Industry Committee, which represents the employee benefits and compensation interests of America's major employers.

"The American Benefits Council is very pleased with the department's proposed default investment regulation," Jan Jacobson, director of retirement policy for the American Benefits Council, added. However, Jacobson explained that the Council plans to file written comments in response to the proposed rule to address a few technical issues, such as fiduciary relief.

Relief Beyond 404(c) Plans

"The proposed regulation is written to extend relief beyond just 404(c) plans," Groom's Breyfogle said, adding that "this creative and flexible approach is a favorable development."

According to Breyfogle, the proposed regulation is not just limited to default investments in connection with an automatic enrollment program but would, for example, be available when a plan transitions from one recordkeeper to a new one or from one investment option to another.

"I think plan sponsors will find this to be a very valuable option when they change record keepers or investment options," Breyfogle pointed out.

Automatic Redirection

Rather than automatically redirecting funds immediately, "they should be held in a low risk, fixed income account, something akin to a money market mutual fund account, for six weeks before being transferred," Financial Policy Forum's Dodd noted.

"This solves several problems," Dodd said. One is it avoids temptation by an investment manager to cheat or a pensioner to feel cheated when funds are transferred during times when price movements are substantial. Large price changes make the timing of such transfers critical, and the recent back dating and spring loading of stock options demonstrate the importance of these concerns, Dodd added.

The six-week period also would allow the participant time to make an informed decision, Dodd said. After six weeks, the transfer date becomes automatic and thus "less susceptible to shenanigans."

One of the conditions of the fiduciary relief is that the participant or beneficiary must have had the opportunity to direct the investment but fails to do so, ABC's Jacobsen said.

"Depending on how this requirement is interpreted, it could have a detrimental effect on plan sponsors attempting to change the default investment from something like a money market fund to one of the investment options described in the proposed regulation," she said. "Plan sponsors may not know which money market fund investors chose to invest in the fund versus participants who were simply defaulted into the fund," Jacobsen concluded.

Funds and Models

"Plans with automatic enrollment will have participants withdrawing their money within a shorter time horizon, either because they unwind the automatic election or they leave within months or a couple of years," Fiduciary Counselor's Hennessy said. The department "needs to provide a safe default alternative [for capital preservation alternatives] as well as the long-term blend."

An employer with mainly young workers and high turnover might do better for these workers with money market and stable value fund options, given the propensity to cash out small accounts, according to EBRI's Salisbury. The proposed rule is limited to equity weighted options only and will cause some employers to avoid automatic plan features resulting in many workers having no savings instead of some savings, he added.

Notice Requirement

The 30-day notice to participants should be modified to accommodate those plans that have immediate eligibility, SPARK's Goldbrum said. Under such circumstances it may not be feasible to provide the required 30-day notice. Goldbrum suggested a clarification in the regulations. For plans with immediate eligibility, the notice requirement may be satisfied when participants are provided with enrollment materials.

The proposed regulation calls for the participant to be provided with any material provided to the plan, according to Goldbrum. The language "any material provided to the plan" could require plan sponsors to provide affected participants with information that is not typically made available to participants on a regular basis or is supplied only upon request by the participant, such as fund prospectuses and amendments, fund annual reports, and proxies, he said.

The effect would be that plan sponsors will be required to provide passive participants with more information than they typically offer to participants who actively manage their assets, Goldbrum said. This requirement should be modified or clarified to specify that those participating in qualified default investment alternatives need only be provided the same information that is made available to participants who make affirmative investment elections.

The participant must be able to transfer out of the default investment fund without incurring a penalty, Goldbrum added. This requirement should be clarified or modified to address situations where the qualified default investment alternatives may impose a redemption fee on shares that are redeemed after a short holding period. It should be clarified as to whether these fees that are imposed on all investors in a fund would constitute a penalty, he said.

· The Advocate

October 27, 2006

Summit hits on energy attitudes

GARY PERILLOUX

John Felmy was working a tough crowd Thursday at LSU's Energy Summit 2006.

On a day when Exxon Mobil Corp. announced the second-highest quarterly earnings on record in the U.S. - $10.5 billion worth - Felmy speaks as perhaps the nation's leading apologist for the oil and gas industry, serving as chief economist for the American Petroleum Institute.

And what a year 2006 has been: $3-a-gallon gasoline, multibillion-dollar investments culminating in ultra-low sulfur diesel, congressional strife over drilling in the Arctic National Wildlife Refuge and those record oil profits.

"Unscrupulous politicians" and others have been taking shots at the industry all year, Felmy said, first blaming oil companies for soaring crude prices and expensive refined products. Then, when gasoline prices tumbled in the fall, nearly half the respondents in a USA Today poll thought the industry intentionally trimmed prices to get Republicans elected in November, he said.

"That's how bad off we are," said Felmy, referring to the poll.

While Felmy spoke on the final day of LSU's energy conference, U.S. Rep. Ed Markey, D-Mass., was telling constituents, "Coming just a few days before Halloween, Exxon Mobil's latest earnings reports may be a treat for their shareholders, but they're a dirty trick for American consumers."

Said Felmy, "My goal in life is to build a refinery (in Markey's district)."

Demagoguery aside, the oil economist said $60-a-barrel oil equates to a $1.43 base gasoline cost. Toss in 47 cents in average national taxes (38.4 cents in Louisiana) and the price of a gallon of gas nearly reaches pump prices before distribution, marketing and profits are figured in.

Similarly, while global oil companies are reaping 10 percent profit margins on an admittedly huge scale, refineries produced 6 percent profits in the most recent quarter, he said.

The media have made much of no new U.S. refineries being built since 1976, but expansions of existing refineries are simply more efficient, Felmy said. He said the equivalent of 12 new refineries, doing 200,000 barrels a day, has been added via expansions in the past decade.

That still leaves the nation 3.3 million barrels a day short of its 20.6 million-barrel demand for gasoline. Imports bridge the gap, and companies have reason to be cautious, Felmy said.

By 2030, Exxon Mobil projects demand for on-road fuel will be lower than it is today, he said.

Projections of oil and gas demand - and the infrastructure needed to deliver it - formed the heart of the two-day LSU conference. And where money and power are discussed, so, too, are politics.

On Wednesday, a Washington, D.C., attorney who's the executive director of the Center for Liquefied Natural Gas grimaced after U.S. Sen. Diane Feinstein, D-Calif., was praised for introducing unsuccessful legislation to regulate energy trading.

"I haven't gotten over my hyperventilation attack when I heard Sen. Feinstein's name mentioned in a positive light," said Bill Cooper, the liquefied natural gas proponent.

Of 45 LNG facilities proposed along U.S. coastlines - many of them on the shores of Louisiana and Texas - experts see only seven to nine coming to fruition, he said. The facilities take super-cooled natural gas from special ships, revaporize the gas and deliver it to consumers via pipelines.

Ship contents aren't under pressure, but "the biggest misconception we face is people think this is a moving time bomb," he said. Instead, "it's a big Thermos bottle."

While Cooper cited environmental studies predicting an LNG open-loop system would kill just eight adult redfish a year, environmentalists counter that potentially far more fish would be killed because the systems would destroy fish eggs by circulating cooled-down water into the Gulf of Mexico.

For that reason, Gov. Kathleen Blanco has opposed LNG terminals that don't use a closed system of recirculated water.

Randall Dodd, the fan of the Feinstein legislation, does think government could do more to stop energy spikes.

Dodd bristled at the school of thought espoused by the conference's opening speaker, Heritage Foundation analyst Ben Lieberman.

It was Lieberman who blamed Washington for complacent energy attitudes in the 1990s that enabled today's high-cost energy environment.

Specifically, Lieberman said, had President Clinton not refused to sign a bill allowing drilling in the Arctic National Wildlife Refuge, another million barrels of oil a day would be available now, easing hurricane disruptions and tight global markets.

Now, there would be a 10-year lead time to produce in the refuge if environmental objections were overcome. In the 1990s, both presidents Bush and Clinton erred on the side of restricting offshore drilling, Lieberman said.

Environmental issues aside, Dodd said other energy price culprits exist that "free market fundamentalism" won't fix.

Hedge funds and over-the-counter energy derivatives aren't sufficiently regulated, creating an energy trading market that's like the Wild, Wild West, Dodd said.

In the summer 2006, consumption and production were substantially changed but crude oil prices soared to $77 a barrel and gasoline to $3 a gallon.

True, Middle East tensions rattled markets, Dodd said, but industrial consumers keep leaner oil and gas inventories these days. Volatile markets cause them to increase orders as a hedge against rising prices.

Meanwhile, unregulated hedge funds outside the petrochemical industry take bigger positions to exploit profits. Producers who have more incentive to sell at tomorrow's expected higher prices, require higher prices today.

And the cycle continues.

"There's your theory; there's your partial explanation," said Dodd, who advocates a real-world government crude oil reserve that could be cushion volatile markets and ease price spikes that deaden the economy.

The Strategic Petroleum Reserve, tapped only once in the past two decades, doesn't do much good, Dodd said.

Others disagreed about the source of oil spikes.

"We still import a lot of oil and probably will continue to do so forever," said Michael Curole, a senior Shell staff engineer, later adding that high prices stem from that equation. "The price of oil is dictated by the government of Saudi Arabia ... by putting additional oil on the market or taking it off the market."

Hundreds of millions of barrels a day can have the effect, Curole said.

And demand won't dry up any time soon.

By 2030, the U.S. will be producing an estimated 10 billion barrels of oil per day and consuming 28 billion barrels, said Michael Schaal, director of the federal Energy Information Administration's oil and gas division.

While the administration forecasts $57 a barrel oil in 2030, that price could vary from $34 to $96.

And it's that price volatility that keeps developers of the import-driven LNG technology walking the floors at night.

If the oil price is $34, an estimated 7.4 trillion cubic feet of liquefied natural gas would be imported in 2030, Schaal said. At $96, LNG imports shrink to 1.9 trillion cubic feet.

The cost of shipping would become prohibitive at the higher prices, and domestic exploration - like today - would become decidedly more robust.

· Kevin McKern

October 19, 2006

Hedge Funds and Credit Derivatives

Hedge funds have gotten rich from credit derivatives. Will they blow up?

The downfall of Amaranth Advisors, the hedge fund that lost $6 billion in a
single week by betting on natural gas, was a special case. There was no
domino effect taking down energy traders generally, no meltdown of an
industry. But if you want to fret over the next financial catastrophes, turn
your gaze away from energy futures and focus on something far more obscure:
credit default swaps. Hedge funds are neck-deep in these derivatives, and if
something goes wrong, the pain will be widespread.

A credit swap is an insurance policy on a bond, often a junk bond. The
fellow selling the swap--writing the policy, that is--collects a premium. If
nothing goes wrong, he pockets the premium and looks like a financial
genius. But if the bond defaults, the swap seller has to make good. The
notional amount--the aggregate of bonds, loans and other debt covered by
credit default swaps--is now $26 trillion. This is a staggering sum, twice
the annual economic output of the U.S.

Hedge funds account for 58% of the trading in these derivatives, says
Greenwich Associates, a financial research firm. Selling protection has been
a big moneymaker for funds like $23 billion (assets) D.E. Shaw and $12
billion Citadel, say market participants, and for specialized outfits like
Primus Guaranty (nyse: PRS - news - people ) in Bermuda, which took in $57
million in the first half of 2006 selling protection on $1.6 billion in
debt.

With corporate debt defaults low these days, the temptation is high to write
insurance policies on bonds. A hedge fund can make $60,000 to $1 million a
year selling protection on $10 million in bonds. It's like finding money in
the street. Unless, of course, the economy suddenly enters a recession. If
that happens, hedge funds addicted to the credit market will be in deep
trouble. "A lot of [hedge funds] have sold insurance, are sitting on the
premiums--and are bare-ass," says Charles Gradante, cofounder of Hennessee
Group, which tracks hedge fund performance. "If there is a Long Term
Capital-type systemic risk potential out there, it's in the [credit swap]
market."

There must be a lot of investors--or credit speculators--who are cavalier
about corporate defaults because junk bonds are trading at yields only
modestly higher than the yields on safe U.S. Treasury bonds. The chart
displays the yield spread, as calculated by Moody's Investors Service,
between junk bonds rated speculative and seven-year Treasurys. Saks bonds
with a 97TK8 coupon due October 2011, for example, are now yielding 7.6%, or
287 basis points (2.9 percentage points) over seven-year Treasurys, compared
with a 700-basis-point spread to Treasurys four years ago. Today's tight
spreads don't leave much of a cushion to cover defaults.

There is a close correlation between yield spreads and credit default swap
prices. That's because selling a credit swap is equivalent to buying the
corporate bond on margin. If you buy a junk bond with borrowed funds, you
collect the high coupon on the bond while paying out a lower amount,
presumably not too much more than what the U.S. government pays to borrow
money. Either way--with a swap or a margined bond trade--you pocket the
spread, unless and until the corporate bond gets into trouble, at which
point you're sitting on a painful capital loss.

The credit-derivatives business is dominated by 14 dealers. Among them:
jpmorgan Chase, Citigroup (nyse: C - news - people ), Bank of America (nyse:
BAC - news - people ), Goldman Sachs (nyse: GS - news - people ) and Morgan
Stanley (nyse: MS - news - people ). All have staggering amounts of
derivatives on their books: JPMorgan's notional exposure was $3.6 trillion
as of June 30, according to the Federal Deposit Insurance Corp., which is
almost three times assets and 30 times capital. Credit derivatives at
Wachovia Corp. (nyse: WB - news - people ) have jumped sevenfold since 2003
to $170 billion, more than three times capital. Banks love derivatives
because they provide multiple ways to make money. Revenue from all types of
derivatives will hit $34 billion or so this year at U.S. banks and
securities firms, says Tower Group (nasdaq: TWGP - news - people ), a
financial-research outfit, with hedge funds generating much of the money.

Hedge funds also buy the potentially toxic waste that banks create when they
bundle credit derivatives into so-called synthetic deals. By separating a
portfolio of derivatives into different tranches, banks can create virtually
default-proof securities for conservative investors--if somebody else is
willing to buy riskier "equity" tranches whose value vaporizes when as few
as one or two of the underlying bonds default. Banks once kept such tranches
on their books as a cost of doing business. Now, says Fitch Ratings, hedge
funds are buying them to goose returns.

Regulators say there's no reason to worry--yet. All big banks require hedge
funds to back up their swaps with cash collateral that is adjusted daily,
says Kathryn Dick, deputy comptroller for credit and market risk at the
Office of the Comptroller of the Currency.

But banks can make only rough guesses at the value of swaps and thus how
much collateral their counterparties need to ante up. Even the smartest guys
can come up shorthanded. Ask Charlie T. Munger, vice chairman of Warren
Buffett's Berkshire Hathaway (nyse: BRKA - news - people ), which lost $404
million unwinding credit, interest-rate and foreign-exchange derivatives
positions in its General Re unit. "When we ran it off, it didn't run off at
anything like book value," Munger says. "I would bet a lot of money there
are some terrible valuations on the books of corporate America."

JPMorgan, the most forthcoming of the big derivatives dealers, figures it
could lose $65 billion over several years if everybody on the other side of
a derivatives trade went broke. A scary number when compared with the bank's
$110 billion in capital. Implausible, too, because most of its
counterparties are big financial institutions.

Hedge funds and other smaller players are much more exposed. Like swaps on
interest rates and foreign currency, credit swaps outstanding dwarf the
underlying bonds in circulation. That can be a problem when a creditor
defaults, as with Delphi (nyse: DPH - news - people ) and other auto parts
makers earlier this year. With most swaps, the buyer of protection has to
hand over defaulted bonds to get its money, tough to do if, as with Delphi,
$20 billion in protection has been written on just $2 billion in bonds.
Calamity was averted by the International Swaps & Derivatives Association,
which held an auction to determine the amount of cash protection buyers
would get.

The derivatives market weathered its last near-death experience in early
2005, when credit agencies downgraded the debt of General Motors (nyse: GM -
news - people ) and Ford (nyse: F - news - people ), devastating the value
of the most risky synthetic derivatives. Hedge funds thought they'd been
smart by locking in a three-to-four-percentage-point spread by selling
protection on those tranches and buying it on less risky ones. Suddenly,
though, they had to close out their moneylosing positions. So many funds had
made the same bet that it "magnified the deleveraging process," in the dry
words of the Bank for International Settlements. Translation: "Banks refused
to buy or sell," says Randall Dodd, a former Commodity Futures Trading
Commission economist who now runs the Financial Policy Forum, a Washington
think tank. "These guys couldn't trade out of their positions."

Bottom-fishing investment banks eventually bailed hedge funds out of their
problems. But Dodd and other critics wonder if banks have extracted enough
collateral from their hedge fund clients to protect themselves in a wider
crisis. "No one has good facts on these things," says David Hsieh, professor
at Fuqua School of Business at Duke University, "because hedge funds are
private investments."

· Forbes

October 16, 2006

Daniel Fisher

OutFront - A Dangerous Game

Hedge funds have gotten rich from credit derivatives. Will they blow up?

The downfall of Amaranth Advisors, the hedge fund that lost $6 billion in a single week by betting on natural gas, was a special case. There was no domino effect taking down energy traders generally, no meltdown of an industry. But if you want to fret over the next financial catastrophes, turn your gaze away from energy futures and focus on something far more obscure: credit default swaps. Hedge funds are neck-deep in these derivatives, and if something goes wrong, the pain will be widespread.

A credit swap is an insurance policy on a bond, often a junk bond. The fellow selling the swap--writing the policy, that is--collects a premium. If nothing goes wrong, he pockets the premium and looks like a financial genius. But if the bond defaults, the swap seller has to make good. The notional amount--the aggregate of bonds, loans and other debt covered by credit default swaps--is now $26 trillion. This is a staggering sum, twice the annual economic output of the U.S.

Hedge funds account for 58% of the trading in these derivatives, says Greenwich Associates, a financial research firm. Selling protection has been a big moneymaker for funds like $23 billion (assets) D.E. Shaw and $12 billion Citadel, say market participants, and for specialized outfits like Primus Guaranty in Bermuda, which took in $57 million in the first half of 2006 selling protection on $1.6 billion in debt.

With corporate debt defaults low these days, the temptation is high to write insurance policies on bonds. A hedge fund can make $60,000 to $1 million a year selling protection on $10 million in bonds. It's like finding money in the street. Unless, of course, the economy suddenly enters a recession. If that happens, hedge funds addicted to the credit market will be in deep trouble. "A lot of [hedge funds] have sold insurance, are sitting on the premiums--and are bare-ass," says Charles Gradante, cofounder of Hennessee Group, which tracks hedge fund performance. "If there is a Long Term Capital-type systemic risk potential out there, it's in the [credit swap] market."

There must be a lot of investors--or credit speculators--who are cavalier about corporate defaults because junk bonds are trading at yields only modestly higher than the yields on safe U.S. Treasury bonds. The chart displays the yield spread, as calculated by Moody's Investors Service, between junk bonds rated speculative and seven-year Treasurys. Saks bonds with a 97TK8 coupon due October 2011, for example, are now yielding 7.6%, or 287 basis points (2.9 percentage points) over seven-year Treasurys, compared with a 700-basis-point spread to Treasurys four years ago. Today's tight spreads don't leave much of a cushion to cover defaults.

There is a close correlation between yield spreads and credit default swap prices. That's because selling a credit swap is equivalent to buying the corporate bond on margin. If you buy a junk bond with borrowed funds, you collect the high coupon on the bond while paying out a lower amount, presumably not too much more than what the U.S. government pays to borrow money. Either way--with a swap or a margined bond trade--you pocket the spread, unless and until the corporate bond gets into trouble, at which point you're sitting on a painful capital loss.

The credit-derivatives business is dominated by 14 dealers. Among them: jpmorgan Chase, Citigroup, Bank of America, Goldman Sachs and Morgan Stanley. All have staggering amounts of derivatives on their books: JPMorgan's notional exposure was $3.6 trillion as of June 30, according to the Federal Deposit Insurance Corp., which is almost three times assets and 30 times capital. Credit derivatives at Wachovia Corp. have jumped sevenfold since 2003 to $170 billion, more than three times capital. Banks love derivatives because they provide multiple ways to make money. Revenue from all types of derivatives will hit $34 billion or so this year at U.S. banks and securities firms, says Tower Group, a financial-research outfit, with hedge funds generating much of the money.

Hedge funds also buy the potentially toxic waste that banks create when they bundle credit derivatives into so-called synthetic deals. By separating a portfolio of derivatives into different tranches, banks can create virtually default-proof securities for conservative investors--if somebody else is willing to buy riskier "equity" tranches whose value vaporizes when as few as one or two of the underlying bonds default. Banks once kept such tranches on their books as a cost of doing business. Now, says Fitch Ratings, hedge funds are buying them to goose returns.

Regulators say there's no reason to worry--yet. All big banks require hedge funds to back up their swaps with cash collateral that is adjusted daily, says Kathryn Dick, deputy comptroller for credit and market risk at the Office of the Comptroller of the Currency.

But banks can make only rough guesses at the value of swaps and thus how much collateral their counterparties need to ante up. Even the smartest guys can come up shorthanded. Ask Charlie T. Munger, vice chairman of Warren Buffett's Berkshire Hathaway, which lost $404 million unwinding credit, interest-rate and foreign-exchange derivatives positions in its General Re unit. "When we ran it off, it didn't run off at anything like book value," Munger says. "I would bet a lot of money there are some terrible valuations on the books of corporate America."

JPMorgan, the most forthcoming of the big derivatives dealers, figures it could lose $65 billion over several years if everybody on the other side of a derivatives trade went broke. A scary number when compared with the bank's $110 billion in capital. Implausible, too, because most of its counterparties are big financial institutions.

Hedge funds and other smaller players are much more exposed. Like swaps on interest rates and foreign currency, credit swaps outstanding dwarf the underlying bonds in circulation. That can be a problem when a creditor defaults, as with Delphi and other auto parts makers earlier this year. With most swaps, the buyer of protection has to hand over defaulted bonds to get its money, tough to do if, as with Delphi, $20 billion in protection has been written on just $2 billion in bonds. Calamity was averted by the International Swaps & Derivatives Association, which held an auction to determine the amount of cash protection buyers would get.

The derivatives market weathered its last near-death experience in early 2005, when credit agencies downgraded the debt of General Motors and Ford, devastating the value of the most risky synthetic derivatives. Hedge funds thought they'd been smart by locking in a three-to-four-percentage-point spread by selling protection on those tranches and buying it on less risky ones. Suddenly, though, they had to close out their moneylosing positions. So many funds had made the same bet that it "magnified the deleveraging process," in the dry words of the Bank for International Settlements. Translation: "Banks refused to buy or sell," says Randall Dodd, a former Commodity Futures Trading Commission economist who now runs the Financial Policy Forum, a Washington think tank. "These guys couldn't trade out of their positions."

Bottom-fishing investment banks eventually bailed hedge funds out of their problems. But Dodd and other critics wonder if banks have extracted enough collateral from their hedge fund clients to protect themselves in a wider crisis. "No one has good facts on these things," says David Hsieh, professor at Fuqua School of Business at Duke University, "because hedge funds are private investments."

· BNA

October 04, 2006

Michael W. Wyand

Practitioners Seek Clarifications of Automatic Enrollment Proposal

Practitioners told BNA Sept. 28 that the Labor Department's automatic enrollment and default investment proposal is timely but expressed some concerns with the proposed rule and asked for clarifications.

All the practitioners interviewed by BNA said their comments were subject to further review and study of the proposed rule. They will be filing more extensive written comments with the department. Written comments are due by Nov. 13.

“The department has moved swiftly to provide clarity,” said Dallas Salisbury, president of the Washington, D.C.-based Employee Benefit Research Institute, which conducts public policy research and education on economic security and employee benefits. However, he expressed concern over the exclusion of money market and stable value funds from the proposed rule's protected class of investments.

While commending the department for promptly issuing its proposed regulation, Nell Hennessy, president and chief executive officer of Washington, D.C.-based Fiduciary Counselors Inc., told BNA “the proposed regulation does not include any capital preservation alternatives.” Fiduciary Counselors is an investment adviser registered with the Securities and Exchange Commission under the Investment Advisers Act.

“I was disappointed with the requirement that the qualified default investment alternatives had to be managed by an investment manager or a registered investment company,” C. Frederick Reish of the Los Angeles-based employee benefits law firm Reish, Luftman, Reicher, and Cohen, told BNA. “It is very common for plans to use asset allocation models, where the underlying funds in the plan are used to populate the models,” he said.

Default investment funds should not be automatically redirected immediately, and the two conditions for automatically directed funds are “inadequately addressed,” said Randall Dodd, director of the Washington, D.C.-based Financial Policy Forum, a research institute that studies financial markets, the regulation of financial markets, and their impact on the economy.

Larry H. Goldbrum, general counsel for the Simsbury, Conn.-based SPARK Institute, which provides research, education, testimony, and comments on behalf of the retirement services industry, said the institute would like clarification or slight modification of the 30-day notice requirement, among other provisions of the proposed rule.

Praise for Timeliness.

“The department did a good job in issuing a timely proposed regulation under the Pension Protection Act,” said Jon Breyfogle, a principal in the Washington, D.C.-based Groom Law Group, an employee benefits specialty law firm. “It suggests that they will get a final regulation out in time for people to rely on it in early 2007. The department deserves some credit for this,” he said.

“The department should be commended for developing this thoughtful proposal so quickly,” Chris Wloszczyna, spokesman for the Washington, D.C.-based Investment Company Institute, a trade organization for the U.S. fund industry, told BNA. “The department proposal will help encourage more plans to use automatic enrollment. In addition, the default investment provision will improve the ability of workers to prepare for their retirement needs,” he said.

“Overall, there is no doubt that this is very good news for the retirement of American workers,” said Ed Ferrigno, vice president of Washington Affairs for the Chicago-based Profit Sharing/401(k) Council of America, which represents its members' interests to federal policymakers and offers assistance with profit-sharing and tax code Section 401(k) plan design.

“We welcome the department's quick action on this vital area and look forward to commenting on the regulations and working rapidly toward final guidance,” said Mark Ugoretz, president of the ERISA Industry Committee, which represents the employee benefits and compensation interests of America's major employers.

“The American Benefits Council is very pleased with the department's proposed default investment regulation,” Jan Jacobson, director of retirement policy for ABC, told BNA. However, Jacobson said that ABC plans to file written comments in response to the proposed rule to address a few technical issues, such as fiduciary relief.

The Proposed Rule.

The department published Sept. 27 the first major proposed regulation to implement provisions of the PPA by making it easier for fiduciaries of Section 401(k) plans and other participant-directed defined contribution plans to adopt automatic enrollment and default investment plan design features (186 PBD, 9/27/06; 71 Fed. Reg. 56,806, 9/27/06).

The PPA Section 624(a) amended Employee Retirement Income Security Act Section 404(c), by adding a new ERISA Section 404(c)(5) to provide relief accorded by Section 404(c)(1) to fiduciaries that invest participant assets in certain types of default investment alternatives in the absence of participant investment direction.

Under the proposed regulation, a fiduciary would not be liable for any loss as a result of automatically investing a participant's account in a qualified default investment alternative (QDIA), provided certain conditions are met. However, the fiduciary would remain liable for the selection and monitoring of a qualified default investment alternative.

The department said the proposed rule, by providing relief from fiduciary liability, is expected to tilt plan sponsors' default investment preferences away from near risk-free fixed income instruments toward QDIAs.

Relief Beyond Section 404(c) Plans.

“The proposed regulation is written to extend relief beyond just Section 404(c) plans,” Groom's Breyfogle said, adding that “this creative and flexible approach is a favorable development.”

According to Breyfogle, the proposed regulation is not just limited to default investments in connection with an automatic enrollment program but would, for example, be available when a plan transitions from one recordkeeper to a new recordkeeper or from one investment option to another investment option.

“I think plan sponsors will find this to be a very valuable option when they change record keepers or investment options,” Breyfogle said.

PSCA's Ferrigno said his organization are currently studying “some of the finer points” of the proposed regulation such as relief beyond Section 404(c), he said.

Automatic Redirection.

Rather than automatically redirecting funds immediately, “they should be held in a low risk, fixed income account, something akin to a money market mutual fund account, for six weeks before being transferred,” Financial Policy Forum's Dodd said.

“This solves several problems,” Dodd said. One is it avoids temptation by an investment manager to cheat or a pensioner to feel cheated when funds are transferred during times when price movements are substantial. Large price changes make the timing of such transfers critical, and the recent back dating and spring loading of stock options demonstrates the importance of these concerns, Dodd said.

The six-week period also would allow the participant time to make an informed decision, Dodd said. After six weeks, the transfer date becomes automatic and thus “less susceptible to schenanigans,” he said.

“Any automatic directed fund should meet the two conditions, which are inadequately addressed in the current version of the rule, Dodd said. The fund should have low management fees; the benchmark for what is low should be the electronic transfer fund and should never exceed 1 percent, he said.

The alternative investment also should be a broad index of securities such as the S&P 500, Nasdaq composite, or Lehman Brothers bond index, Dodd said. “The 'investment service' alternative is questionable without more clear and strict guidelines on management fees,” he said.

One of the conditions of the fiduciary relief is that the participant or beneficiary must have had the opportunity to direct the investment but fails to do so, ABC's Jacobsen said.

“Depending on how this requirement is interpreted, it could have a detrimental effect on plan sponsors attempting to change the default investment from something like a money market fund to one of the investment options described in the proposed regulations,” she said. “Plan sponsors may not know which money market fund investors chose to invest in the fund versus participants who were simply defaulted into the fund,” Jacobsen said.

Funds and Models.

“Plans with automatic enrollment will have participants withdrawing their money within a shorter time horizon, either because they unwind the automatic election or they leave within months or a couple of years,” Fiduciary Counselor's Hennessy said. The department “needs to provide a safe default alternative [for capital preservation alternatives] as well as the long-term blend,” she said.

An employer with mainly young workers and high turnover might do better for these workers with money market and stable value fund options, given the propensity to cash out small accounts, EBRI's Salisbury said. The proposed rule is limited to equity weighted options only, and will cause some employers to avoid automatic plan features resulting in many workers having no savings instead of some savings, he said.

“While I would like all workers to think of the Section 401(k) plan as a long-term retirement plan, the facts say otherwise,” Salisbury said. “The EBRI Section 401(k) plan has neither loans or hardship withdrawals because I view it as a retirement plan, but many plans with auto enrollment have these short term features. Since the law allows such nonretirement provisions, it makes no sense for them to issue a regulation that ignores these realities,” he said.

“Workers will be the losers of this particular paternalistic strait jacket,” Salisbury said. Stable value funds, for example, have produced higher returns than the interest credit in many cash balance plans for the last several years, he said.

“It is very common for plans to use asset allocation models where the underlying funds in the plan are used to populate the models,” Reish said, expressing disappointment that qualified default investment alternatives had to be managed by an investment manager or a registered investment company.

“While generally accepted investment principles are utilized in constructing the models, they are not 'managed' by either a mutual fund or an investment manager,” Reish said. “In my opinion, that needs to be corrected before the regulation is finalized.”

Notice Requirement.

The 30-day notice to participants should be modified to accommodate those plans that have immediate eligibility, SPARK's Goldbrum said. Under such circumstances it may not be feasible to provide the required 30-day notice. Goldbrum suggested a clarification in the regulations that for plans with immediate eligibility, the notice requirement may be satisfied when participants are provided with enrollment materials.

The proposed regulation calls for the participant to be provided with any material provided to the plan, Goldbrum said. The language “any material provided to the plan” could require plan sponsors to provide affected participants with information that is not typically provided to participants on a regular basis or is provided only upon request by the participant, such as fund prospectuses and amendments, fund annual reports, and proxies, he said.

The effect would be that plan sponsors will be required to provide passive participants with more information than they typically provide to participants who actively manage their assets, Goldbrum said. This requirement should be modified or clarified to specify that participants invested in QDIAs need only be provided or offered the same information that is otherwise provided or made available to participants who make affirmative investment elections.

The participant must be able to transfer out of the default investment fund without incurring a penalty to do so, Goldbrum said. This requirement should be clarified or modified to address situations where the QDIA may impose a redemption fee on shares that are redeemed after a short holding period. This should be clarified as to whether redemption fees that are imposed on all investors in a fund would constitute a penalty, he said.

· BNA

September 21, 2006

Michael W. Wyand

Advisory Council - Speakers Discuss Issues on Investment

Of Plan Assets in Cross Trades, Hedge Funds

Speakers Sept. 20 expressed a variety of

views about pension plan participation in

cross trades and investment in hedge funds

in statements before a working group of

the Department of Labor's ERISA Advisory

Council.

The council's Working Group on Plan Asset

Rules, Exemptions, and Cross Trading is

reviewing whether the department should

clarify or modify the existing plan asset

regulation regarding hedge funds and if

the department should issue broader

exemption relief for cross trading.

According to the speakers, a cross trade

is a purchase and sale of securities

between two client accounts of the same

investment manager. A hedge fund is an

investment company that raises funds from

institutional investors and high income

individuals and pursues investment

strategies with high degrees of leverage

and/or complexity.

"There is room for a thoughtful expansion

of the ability of investment professionals

dealing with plan assets to use cross

trading to benefit plans, but generally

speaking, only for large plans that have

the resources and sophistication to

protect their interests," said Norman

Stein, a University of Alabama School of

Law professor who specializes in employee

benefits and tax law.

"Cross trading, subject to appropriate

regulatory constraints, can still save

some plans money," Stein said. However,

"any liberalization of cross trading

should create two regulatory regimes, one

for larger plans, and one for smaller

plans," he added.

"Large plans are equipped to protect

themselves from illegal costs and to

minimize legal costs of cross trading,"