Enron's collapse has generated so many huge stories that it's been easy to miss one of the most ironic and self-revealing of all its myriad ventures. Enron, now famous for the largest corporate bankruptcy in American history, was also a big player in the relatively new market for buying and selling bankruptcy protection.
Enron's whiz kids dabbled in a wide variety of high-finance maneuvers. But its presence in the market for what are technically called "credit derivatives" was eye-opening -- or should have been, to anyone paying attention. The credit derivative game is dominated primarily by huge banks -- just seven institutions handle 96 percent of the multibillion-dollar business.
With good reason. Credit derivatives are designed to minimize risk. They are, in their simplest form, insurance policies on other assets. By buying a credit derivative, a bank, for instance, will pay another entity to assume the risk of a loan that it fears will not be paid back. If its hunch proves correct, the seller of protection will have to cover the loan. Since credit derivatives carry the potential for sudden, huge payouts, buyers rarely want to purchase credit derivatives from a risky provider. So sellers tend to be big and rich enough to handle large defaults without going bankrupt.
So what was a supposed energy trader from Texas doing in a market that epitomized Wall Street? According to derivatives experts, the Houston company bluffed and cajoled its way to the table, pretending to be bigger and more stable than it really was. At the same time, it used its formidable lobbying power in Washington to ensure that federal oversight over precisely this type of market was to all practical purposes nonexistent, and then proceeded to screw it up on a vast scale.
Operating without a net -- or a watchdog -- Enron trotted into one of the world's most complex financial arenas and made a colossal, billion dollar mess, inserting risk into a market designed specifically to avoid it. According to Standard & Poor's, the credit rating agency, Enron's collapse has thrown at least $3 billion worth of credit derivatives contracts into limbo. So far, Enron's bankruptcy hasn't set off a wider financial panic, but according to some experts, the credit derivatives fiasco nevertheless reveals larger systemic problems. The company's push into credit derivatives not only proves that it's possible to dupe some of the best financial minds in the world, but it also exposes potentially dangerous loopholes in the U.S.'s financial regulatory system. The SEC regulates the investment banks that typically dominate credit derivative trading. But Enron wasn't a bank -- so it escaped supervision.
Because derivatives markets are easy to enter and disclosure rules are weak, some experts believe that it's only a matter of time before another rogue derivatives player surfaces, fails and sends even greater shock waves through the system.
"There are other potential time bombs ticking," says Michael Greenberger, a law professor at the University of Maryland and the former director of trading and markets at the Commodity Futures Trading Commission (CFTC). "We don't know how many other companies like Enron are out there."
The term "derivatives" is used to describe a class of financial contracts that are derived from another asset and priced according to that asset's value. Also known as a form of "risk management," over the past 20 years derivatives trading has become increasingly popular on Wall Street as a way to "hedge" risk; to protect yourself from an investment bet that goes sour or from swings in interest rates or currency prices. Over the course of those 20 years, the debate on whether to regulate such trading has been one of the more abstruse battlegrounds between Washington and Wall Street -- and Enron has been a major player in that fight.
One of the first derivatives to gain popularity in the newly deregulated financial markets of the 1980s was the "interest-rate swap," which takes its value from underlying loans. Interest-rate swaps allow a bank that has, for example, a majority of variable rate loans to protect against the risk of falling interest rates -- which would decrease borrowers' payments and thus bank profits -- by "swapping" the loans for fixed rate debts held by another bank. The actual loans never change hands; the contract allows the banks to trade only the interest-rate risks, with the price of the deal being determined by the size of the loans and the probability of interest-rate fluctuations. If it looks like the Federal Reserve will raise rates, the fixed-rate bank will pay a higher premium. But if the Fed signals a cut, the bank with a high level of variable rate loans will pay a larger fee.
New kinds of derivatives are constantly being dreamed up by everyone from Nobel Prize laureates to MBAs fresh from the finest business schools. It is hardly an exaggeration to call derivatives the cutting edge of capitalism, the fanciest way humans have yet devised to gamble for big bucks. Credit derivatives, specifically, are one of the more recent products of this high-finance drive to innovate. For a company like Enron, which considered itself able and willing to trade anything, bankruptcy protection was just another commodity.
Dreamed up about 10 years ago in order to protect banks from risky borrowers, credit derivatives extended the concept of risk trading to all forms of credit risk, not just interest rates. They grew from a simple mix of reality and logic: "When you have a portfolio of loans, some are strong and some are weak," says Kathryn Dick, director of treasury and market risk for the Office of the Comptroller of the Currency, a division of the Federal Reserve. "Trying to keep a good balance, that's what started the thinking that became credit derivatives."
Large investment banks, led by J.P. Morgan, began to tout the idea in the early '90s. The first "products" focused specifically on bank loans. "Credit default swaps," for example, gave a bank in the Midwest that had mostly manufacturing loans -- which are especially sensitive to business cycles -- the ability to insure its debt by paying a New York bank to take on the risk of default. If the borrower couldn't pay, the New York bank ponied up the cash.
Each player in this equation has an incentive to make a deal. The mediator, or trader, bringing both sides together picks up a percentage of the price paid; the firm buying protection gains the ability to extend more credit without holding onto the risk, while the firm selling protection brings in extra cash by agreeing to cover for loans that it thinks it won't have to cover.
Banks also enjoy other advantages from the use of credit derivatives. If a bank sells a loan to another bank -- an older way to get rid of risk -- it then must inform the borrower that the loan has been picked up by another party. But because credit derivatives are not actual assets but rather meta-level contracts, lenders can keep the loans on their books without telling borrowers what's going on behind the scenes.
"One of the reasons that banks like credit derivatives is because of the way that the financial world has evolved," says Dick. "Banks now have very large corporate clients. They don't want to keep all of that exposure, but they want to maintain a relationship with the client. Credit derivatives let them do that."
Even with these incentives, many banks at first hesitated to buy or sell protection on their own loans, bonds or other securities. The pricing models were untested. The laws surrounding the new product remained murky. The Commodities Futures Trading Commission had exempted credit derivatives and other swaps from federal oversight in 1993, but because each contract was tailor-made to the deal at hand (instead of traded on a formal or over-the-counter exchange), the language of the contracts tended to vary too much for the bankers' tastes. It wasn't clear what would hold up in court in the case of a "credit event" like a bankruptcy.
"The problem with the market then [in the mid-'90s] was that the contracts were all different," says Mickey Mandelbaum, a spokesman for Morgan Stanley, which began researching credit derivatives in 1994. "There was a big joke that the busiest person on the derivatives desk was the lawyer."
Big investment banks eventually managed to standardize the contracts. J.P. Morgan and Credit Suisse launched credit derivatives products lines in 1997. Others followed, and in 1999 the International Swaps and Derivatives Association (ISDA), the industry's trade group, issued formal rules. The market began to quickly swell. In 1997, $55 billion in debt was covered by credit derivatives contracts; by the fourth quarter of 1999, that figure topped $287 billion.
The massive run-up spawned a recapitulation of age-old debates. Proponents of financial innovation argue that products like credit derivatives are nothing less than tools of progress -- market-oriented weapons that protect against instability and risk. But critics contend that new, untested markets always give con men and unscrupulous wheeler-dealers more room to hide.
Altogether, by the end of 1997, derivatives contracts represented more than $25 trillion in real assets. The question of whether the government should regulate the market or let it grow, untethered by red tape, began to heat up, fueled by some high-profile derivatives failures.
"Congress started saying that we need to regulate this stuff," recalls Greenberger, who was then the director of trading and markets at the CFTC. "Dingell [Rep. John Dingell, D-Mich., a ranking member of the House Commerce Committee] wanted to introduce legislation creating a derivatives exchange."
Enter Enron. The energy trader was fast leaving behind its commodity trading and delivery roots, and moving ever more aggressively into the world of pure finance. Enron, unsurprisingly, opposed the formalization of derivatives regulation. In April 1993, aggressive Enron lobbying had encouraged the CFTC to grant a broad exemption to the trading of energy derivatives, in which electricity dealers and wholesalers sign contracts that let both sides hedge against future price swings. But energy derivatives were just one front on which Enron's executives were advancing.
"They had an exciting agenda," said one East Coast finance professor who did some consulting for the company. Some of the brightest minds in finance and risk management wanted to work with Enron because, he said, "they were trying to move forward."
Wall Street also opposed derivatives legislation, but for slightly different reasons. The big banks argued that new laws would be too costly. Derivatives were not like the futures contracts used to lock in prices on grain and other commodities, they argued, so the CFTC should leave them alone. The SEC seemed willing to go along.
There was one dissenting voice. Brooksley Born, a Clinton appointee who became the head of the CFTC in 1996, refused to accept the industry's stance. "In late 1997 and early 1998, she said the emperor has no clothes," says Greenberger. "She said that derivatives are futures contracts and that the CFTC had jurisdiction."
On May 7, in a 62-page report, the CFTC announced that changes in the derivatives market "require the commission to review its regulations." Born called for public comment and hearings.
But Enron refused to buckle. Protests from Wall Street's major players drew more attention than Enron's opposition, but a July 4, 1998, Washington Post article revealed that Enron was forging ahead at that very moment in an attempt to create an entirely new market for "weather derivatives" -- in which contracts on energy supplies would be dependent on bets as to whether the weather was hot or cold. Such contracts would be exactly the kind of new product that CFTC regulators would likely examine.
A handful of legislators, including Sen. Phil Gramm, R-Texas, kept the forces of regulation at bay. For Gramm, derivatives deregulation was a family affair: His wife, Wendy Gramm, chairwoman of the CFTC from February 1988 to January 1993, had earlier shepherded through the exemption that (in April 1993) let Enron trade energy derivatives without federal oversight. (A few months after passage of the exemption, she quit the CFTC and took a seat on Enron's board of directors.) Enron also found a set of allies in the U.S. Treasury Department, the Federal Reserve and the SEC. All three agencies, though headed by Born's fellow Clinton appointees, scorned the new CFTC proposal. They even issued a rare joint statement declaring that "we have grave concerns about this action and its possible consequences. We seriously question the scope of the CFTC's jurisdiction in this area."
Congress, caught in the middle of a regulatory turf war that involved some of the country's most generous campaign donors, also declined to show interest in regulation. It maintained this stance even as, in September 1998, the huge hedge fund Long Term Capital Management warned the Fed that, in part because of its derivatives strategy, it was about to go under -- and threatened to drag several major banks down with it.
But despite the link between LTCM and derivatives, calls for regulation fell on deaf ears. After organizing a bailout of LTCM, Fed chairman Alan Greenspan -- along with SEC chairman Arthur Levitt; William J. Rainer, Born's replacement at the CFTC; and Lawrence Summers, secretary of the treasury -- penned a 42-page report that favored less, rather than more regulation.
Congress followed suit, passing the Commodity Futures Modernization Act in December 2000.
"The CFMA made it clear that this kind of trading would be exempted," Greenberger says. "Only a handful of congressmen and senators probably realized that they were enacting this deregulatory provision."
Brooksley Born "had it just right," and should be considered a hero, adds Martin Mayer, a finance expert and author of more than a dozen books on the U.S. banking system. "The whole political establishment, from Rubin and Greenspan and Levitt and Phil Gramm, turned on her."
And Enron forged on, stepping up its involvement in derivatives markets dramatically. The company's spokespeople failed to return calls for comment; Born also refused to comment because her law firm now represents several Enron creditors. But observers argue that the CFMA essentially let Enron move forward with its plan to aggressively court derivatives buyers and sellers.
By the end of 2000, a year after the launch of Enron's Web-based trading site EnronOnline, the company's derivatives business had more than quintupled in a single year. Assets increased from $2.2 billion to $12 billion; derivative-related liabilities increased from $1.8 billion to $10.5 billion.
It's not clear how much of this growth came from credit derivatives, although S&P's finding of $3.3 billion in exposure at Enron suggests that it played a major role. But regardless, Frank Partnoy, a law professor at the University of San Diego who cited Enron's derivative growth figures in testimony before Congress on Jan. 24, argues that Enron should never have been able to become such a powerful derivatives player. The financial and government institutions that protect the financial markets shouldn't have let the company gain so much as a foothold, he says.
"The collapse of Enron makes plain that the key gatekeeper institutions that support our system of market capitalism have failed," he told the Senate Committee on Governmental Affairs. "The institutions sharing the blame include auditors, law firms, banks, securities analysts, independent directors and credit rating agencies."
Specifically, Partnoy argues that the derivatives market is too easy to penetrate because all that's required is "credit worthiness and decent reputation." If one of the nation's three credit-rating agencies -- Moody's, Standard & Poor's or Fitch IBCA -- give a company an investment grade rating, it can essentially act like J.P. Morgan Chase or Citigroup, two of the world's biggest banks. But Enron was able to offer credit without being required to keep a set amount of capital in place, as banks are. And whereas traders dealing with securities or futures contracts must pass difficult licensing exams, companies that trade only in derivatives often can do as they please.
Enron managed to become a major player in the derivatives market not just by taking advantage of these loopholes. The company also built up its reputation through a mix of deceit, hobnobbing and bravado. Its high credit rating was maintained by hiding billions of dollars of debt in off-balance sheet partnerships. Its gravy train included prominent economists, politicians and journalists. By dint of ceaseless self-promotion, executives like Ken Lay and Jeffrey Skilling made Enron's name synonymous with successful financial innovation.
Investment bankers now speak with derision of Enron's arrogant attempt to invade the turf of the big boys. And many in the investment community are quick to separate themselves from Enron's taint. The fault for Enron's collapse lies with Enron, they argue -- not the lack of regulation. The company gamed the system and paid the price. New rules, they stress, would only punish the innocent companies with higher costs and more red tape. The lesson of Enron's collapse is not that government needs to save the markets from themselves, but rather that bad companies fail, says Nik Khakee, director of Standard & Poor's structured finance derivatives group.
"Some people would argue that it's good for there to be more players in the derivatives market, but you need to make sure that they're all operating under an accepted set of rules," he says. Enron, he implied, made up its own rules.
Proponents of credit derivatives, in particular, dismiss the idea that Enron's fall has any larger systemic importance. Enron's derivatives will simply be redistributed, they argue. In fact, Enron's involvement with credit derivatives should be seen as "a bright spot," according to William Harrison, CEO of J.P. Morgan Chase, who defended them on Jan. 16, according to a Financial Times report. Without credit derivatives, Harrison and others have argued, Enron's $33 billion debt default would have been more highly concentrated, forcing banks that had a direct relationship with Enron to lose massive amounts of money, or close.
In other words, credit derivatives make the system more stable, so as to prevent disruption when events as catastrophic as Enron's failure happen. But not everyone shares this view. Enron may not create a chain reaction of economic disruption by itself, but if dozens of companies engage in the same kind of practices, free from any kind of government oversight, a series of failures could threaten to undermine even the most stable banks and financial firms, Partnoy, Greenberger and others argue.
Clarifying disclosure rules may not even be enough to protect against another Enron, according to Greenberger. "You need to have some sort of regulatory structure," he says, noting that banks have federal examiners in-house. "You can debate what kind of structure to put in place, but you need stronger enforcement because financial statements are not going to protect the public from imprudent, unsound or fraudulent practices."
Ultimately, as Partnoy pointed out in his testimony, "Congress must decide whether, after 10 years of steady deregulation, the post-Enron derivatives markets should remain exempt from the regulation that covers all other investment contracts."
As Partnoy noted in his Senate testimony, the gatekeepers failed, and their continued failure may set the stage for even greater economic distress. Enron's derivatives adventures, ultimately, leave us with one major, and as yet unanswered, question. Who will guard the gatekeepers?