Here is another good article on Enron and the necessity of regulation, from Clark Worswick on the Derivatives thread. The last paragraph summarizes his general point concerning regulation. Not that it is anything new, but it bears repeating over and over again, especially in the face of a putative laissez faire administration. I didn't realize how OTC derivatives allowed traders and companies their own discretion in how they determined the fair market value of their derivatives (see bolded section below).
This is a long article, but worth reading.
Sam
From the Prudent Bear. For Private Use Only
PARTNOY’S COMPLAINT: THE MALIGN NEGLECT OF OTC DERIVATIVES
February 5, 2002
Much ink has been spilled over Enron. Its demise has engendered an analysis about the general decline in the
standards of financial reporting for publicly owned corporations, the virtual non-existence of proper conflict of
interest rules governing the accountancy profession, and the manner in which Enron itself appeared to buy reams of
influence in Washington so as to forestall legislative developments detrimental to the company’s interests. These are
all important issues, but it seems that most commentators have neglected the most germane issue in this whole
debacle: the lack of regulatory oversight for the OTC derivatives market.
Given the complicity of powerful figures such as Federal Reserve Chairman Alan Greenspan and former Treasury
Secretary Robert Rubin (along with various leading members of Congress) in persistently hindering efforts to
regulate these instruments, we are not surprised that leading figures in the political and economic establishment have
been loath to tackle this issue. Far easier to be critic and search for the next Whitewater than face the difficult task
of self-assessment which might highlight one’s own delinquency in this fiasco. But things are beginning to change,
and eloquent critics of the OTC derivatives market are finally beginning to speak out more vociferously.
One such individual is Frank Partnoy, a University of San Diego Law Professor. In recent testimony before the
United States Senate Committee on Governmental Affairs, Professor Partnoy, a specialist in the areas of financial
market regulation, derivatives, and structured finance, has presented a very powerful analysis on the root cause of
Enron’s demise – the unregulated status of OTC derivatives used by the company for the past several years.
Partnoy documents the company’s transition from a straightforward energy utility into a huge financial conglomerate
which, at its core, was nothing but a derivatives trading firm: “It made billions trading derivatives, but it lost billions
on virtually everything else it did, including projects in fibre-optic bandwidth, retail gas and power, water systems,
and even technology stocks. Enron used its expertise in derivatives to hide these losses. For most people, the fact
that Enron had transformed itself from an energy company into a derivatives trading firm is a surprise.”
A surprise indeed, but perhaps even more surprising is that this transition took place in a manner perfectly consonant
with existing laws and regulations. Not even the best conflict of interest provisions in the world pertaining to its
auditor, Arthur Andersen, could have prevented Enron from developing its business in the manner in which it did in
the absence of proper regulation, especially in the area of OTC derivatives. There were no regulatory sanctions
attached to Enron’s activities because the company very cleverly focused on areas that legislators had scrupulously
exempted from legislative and regulatory oversight (exemptions, of course, for which the company did much
lobbying to secure in the first place). It used the resultant gap in the system’s regulatory apparatus to manipulate its
earnings, artificially boost its profits, whilst simultaneously masking poorly performing assets through complex
financial derivatives. The increasingly parlous state of its balance sheet was concealed by shifting debts into
offshore entities that the company created and in effect controlled, even though these were classified as
non-controlled items by the auditors. In short, Enron was a virtual company with virtual profits that employed all of
the leeway granted it by our leading New Economy practitioners – all without a shred of regulatory oversight.
Indeed, after reading his testimony, it is clear that Partnoy implicitly regards these instruments as the Achilles heel of
the entire American financial system. He poses the question to Congress as to whether, after ten years of steady
deregulation, the post-Enron derivatives markets should remain exempt from the regulation that covers virtually all
other investment contracts and instruments. His own analysis provides a robust “No” to that question. OTC
derivatives were both a proximate cause of Enron’s demise, whilst simultaneously providing the means to mask the
underlying fragilities created by the aggressive use of such instruments in the first place:
"In a nutshell, it appears that some Enron employees used dummy accounts and rigged valuation methodologies to
create false profit and loss entries for the derivatives Enron traded. These false entries were systematic and
occurred over several years, beginning as early as 1997. They included not only the more esoteric financial
instruments Enron began trading recently – such as fiber-optic bandwidth and weather derivatives – but also
Enron’s very profitable trading operations in natural gas derivatives.
Enron derivatives traders faced intense pressure to meet quarterly earnings targets imposed directly by management
and indirectly by securities analysts who covered Enron. To ensure that Enron met these estimates, some traders
apparently hid losses and understated profits. Traders apparently manipulated the reporting of their “real” economic
profits and losses in an attempt to fit the “imagined” accounting profits and losses that drove Enron management."
Issues relating to conflicts of interest, campaign finance reform, the unlawful shredding of documents, the horrific
suicide of a leading Enron executive, all these make for great front page stories, so it is understandable why these
matters have tended to preoccupy the press, rather than the highly technical, esoteric, and complex world of
financial derivatives. But as Partnoy himself recognises, OTC derivatives markets are far too large and therefore
far too important to ignore any longer. They are critical to understanding the fate of Enron, others that have recently
fallen in its wake, such as K-Mart, and perhaps most significantly, the Russian roulette activities of leading financial
institutions, such as PNC Financial or JP Morgan Chase. After all, recent estimates of the size of the
exchange-traded derivatives market, which includes all contracts traded on the major options and futures exchanges,
are in the range of $13 to $14 trillion in notional amount. By contrast, the estimated notional amount of outstanding
OTC derivatives as of year-end 2000 was $95.2 trillion, according to Partnoy. And he acknowledges in his
testimony that this estimate will most likely prove conservative.
When viewed in this context, accounting issues per se, and the discussions of conflicts of interests that might
compromise the independence of the audit itself, become irrelevant. Indeed, even some who have been highly
critical of the role of auditor Arthur Andersen concede that they conceivably acted within the rules. Douglas
Carmichael, a professor of accountancy at Baruch College has argued: “Absent a smoking-gun e-mail or something
similar, it is an issue of trying to attack the reasonableness of the assumptions [Andersen] made”. This implies that
even if Andersen had operated under strict conflict of interest laws, it does not necessarily follow that the fate of
Enron could have been avoided. Far more important a challenge is to get a grip on the OTC derivatives market so as
to preclude further eruptions of financial instability in the future.
It is only when our financial and monetary authorities stop living in a state of denial and move to regulate the
derivatives market, (and possibly restrict its range of activities) that we will get to the nub of the problem. Enron’s
derivative trading operations were not regulated, nor were they audited by any relevant regulatory bodies, because,
as Partnoy notes, OTC derivatives themselves are not legally deemed securities: “OTC derivatives trading is beyond
the purview of organized, regulated exchanges. Thus, Enron – like many firms that trade OTC derivatives – fell into
a regulatory black hole”. Deliberately so, we might add, but the door was held wide open to them by the
gatekeepers of our financial system.
Derivatives were not always the ticking time bomb of finance they appear to be today. The problem is that much of
America's regulatory regime was devised at a time when derivatives trading consisted mainly of standardised
futures contracts transacted through third-party exchanges like the Chicago Board of Trade, and involving traditional
commodity products such as corn, wheat or soybeans.
But during the 1980s and 1990s, a good deal of risk-management action had shifted to the over-the-counter market,
where banks and trading firms negotiated bilateral contracts (often called "swaps") on an individual basis. There had
also been phenomenal growth in financial contracts - hedging interest rate or currency exposures, for example.
These became tremendously profitable activities for Wall Street’s institutions coming into the 1990s.
Yet despite this phenomenal growth in the OTC market, there has remained a curious reluctance to amend the
regulatory framework which, if anything, has become even more benign as a result of the last batch of legislation
that was passed in December 2000, despite increasing evidence of the destructive power of these instruments.
George Soros, who ought to know, has repeatedly called attention to the destabilising risks posed by derivatives, and
argued that they serve no purpose other than to facilitate speculation - in particular to enable fund managers and
banks to circumvent prudential restrictions on their investments. Alfred Steinherr, the author of "Derivatives: The
Wild Beast of Finance", has described derivatives as "the dynamite for financial crises and the fuse-wire for
international transmission at the same time. Unfortunately, the ignition trigger does not seem to be under control."
These warnings have been amply vindicated by events in recent years. The bankruptcy of Orange County in 1994,
Mexico’s “tequila crisis” in 1995, the melt-down in Asia during 1997/98, the destruction of the Russian Treasury
market in 1998, the end of Long Term Capital Management, all provide vivid illustrations of the global havoc
wrought in part through the widespread use of derivatives. An IMF study from 1998, for example, suggests that
most of the initial losses sustained during the initial impact of the Asian crisis were related to derivative-based credit
swap contracts. Furthermore, the Bank of Korea reported in March 1998 that trading in financial derivatives by
South Korean banks increased by 60.1% in 1997 to $556.5 billion and largely contributed to the virtual nationalization
of the entire Korean banking system as these positions blew up.
After 360 customers lost $11.4 billion on derivatives during the decade ending in March 1997, the Commodity
Futures Trading Commission began considering whether to regulate OTC derivatives. Perhaps not coincidentally,
this is just about the time that Enron began its embrace of exotic financial engineering, which might explain why they
increased their lobbying activities to ensure continued exemptions from regulatory oversight. But moves to regulate
the market at this stage could have presumably nipped incipient problems in the bud.
No such luck. And given the prevailing regulatory climate of the late 1990s, and a Treasury Secretary who seemed
to operate under the credo, “What’s good for Goldman Sachs is good for America”, nothing was done in time to
prevent the problems that arose at Long Term Capital Management. And this was a failure that supposedly risked
placing the entire global financial system at risk to meltdown, (if we are to believe those who constructed the bailout
to rescue the fund).
One would have envisaged legislative moves at this stage to respond to the problem, particularly if LTCM truly
placed us as close to systemic collapse as has been implied (we simply don’t know; gag orders have reportedly been
placed on all of the relevant players involved in the bailout). Yet still nothing followed. The former head of the
CFTC, Brooksley Borne, was reportedly axed for actively opposing the laissez-faire approach to OTC derivatives
advocated by Messrs. Rubin and Greenspan, whose lead was ultimately embraced by Congress in December 2000.
At that stage, the House and Senate made the deregulated status of derivatives clear when they passed the
Commodity Futures Modernization Act. As a result, the OTC derivatives markets have become a ticking time bomb,
which Congress thus far has chosen not to defuse.
And what has been the cost in the specific case of Enron? According to Partnoy, Enron makes Long Term
Capital’s problems appear “like a lemonade stand” in comparison:
“Long-Term Capital Management generated losses of a few billion dollars; by contrast, Enron not only wiped out
$70 billion of shareholder value, but also defaulted on tens of billions of dollars of debts. Long-Term Capital
Management employed only 200 people worldwide, many of whom simply started a new hedge fund after the
bailout, while Enron employed 20,000 people, more than 4,000 of whom have been fired, and many more of whom
lost their life savings as Enron’s stock plummeted last fall.”
The very fact of non-regulation helped Enron to systematically misstate earnings in a way that would not have been
possible had the derivatives on a recognised, regulated exchange been employed. Consider a simple example that
Partnoy cites of “forward curves”:
“A forward curve is a list of “forward rates” for a range of maturities. In simple terms, a forward rate is the rate at
which a person can buy something in the future. For example, natural gas forward contracts trade on the New York
Mercantile Exchange (NYMEX). A trader can commit to buy a particular type of natural gas to be delivered in a
few weeks, months, or even years. The rate at which a trader can buy natural gas in one year is the one-year
forward rate. The rate at which a trader can buy natural gas in ten years is the ten-year forward rate. The forward
curve for a particular natural gas contract is simply the list of forward rates for all maturities. Forward curves are
crucial to any derivatives trading operation because they determine the value of a derivatives contract today. Like
any firm involved in trading derivatives, Enron had risk management and valuation systems that used forward curves
to generate profit and loss statements. It appears that Enron traders selectively mismarked their forward curves,
typically in order to hide losses.”
For most assets trading on recognised exchanges, there is little or no discretion in determining a “fair market” price.
By definition, trading items on a recognised exchange achieves this objective independent of the company issuing the
security; the market determines the price, not the issuer or the owner of the security. The crucial point to bear in
mind here is that the discretion to mis-mark forward curves was left at the hands of Enron’s traders; it would be
virtually impossible to do so on a recognised, well-regulated exchange like the NYMEX. Nor was there any
independent check of the values of long-term energy contracts; Enron was left to estimate fair market value on its
own. Clearly, there was method to Ms. Borne’s apparent desire to bring these instruments under regulatory control.
But Partnoy brings out another crucial aspect of the problem in his testimony: the moral hazard element implicit
within a self-regulated structure in which annual bonuses are predicated on profits and revenues regardless of how
sound the underlying practices that generate these profits turn out to be. It also explains why Wall Street is so loath
to have such a bonus cash cow placed under the oversight of a regulatory body. If traders are generally to be
compensated based on their profits generation, no matter how these earnings are achieved, it behoves the employee
to trade as aggressively as possible and, when things start to go wrong, to hide losses by mis-marking forward
curves, or engage in other forms of financial engineering, so that a nice fat bonus is still paid out at year end.
Millions of dollars rest at the discretion of a trader in an OTC market. The trader becomes judge, jury and
executioner all at once. The temptations associated with derivatives have proved too great for many companies, and
Enron is no exception. That at least is understandable. But it is extraordinary to contemplate that the risks of
acceding to these temptations have been virtually ignored or dismissed by Congress and the Chairman of the Federal
Reserve over the past several years.
Not only did OTC derivatives create a financially unstable structure that ultimately forced Enron into bankruptcy, but
they were also used to facilitate accounting subterfuge, according to Partnoy. As it began to lose billions in
fibre-optic bandwidth projects, retail gas and power, water systems, and even technology stocks, Enron then began
to use its expertise in derivatives to hide these losses. Untangling a series of highly complex structures backed by
highly questionable accounting, Partnoy illustrates how Enron was using derivatives to hide losses it took on high
technology stocks. It also used derivatives to inflate the value of troubled business effectively by selling a small
portion of those assets to a special purpose entity (which it either owned or for whom it underwrote any associated
losses) at an inflated price, and then revaluing the lion’s share of those assets it still held at that higher price. Via the
OTC derivatives market, Enron also employed two special purpose entities to mask huge debts incurred to finance
unprofitable new businesses. As the special investigation committee appointed by the newly configured Enron board
concludes in a recent report, the company’s demise was ensured by the adoption of one flawed idea after another,
self-enrichment by employees, inadequately designed internal controls, lax oversight, aggressive accounting coupled
with basic accounting mistakes, and “overreaching in a culture that appears to have encouraged pushing the limits”.
In the latter regard, Enron is truly representative of its era.
Above and beyond Partnoy’s testimony it is also becoming increasingly apparent that investors in Enron’s
off-balance sheet special purpose entities knew that the energy group was using the vehicles to enhance its earnings
and maintain its credit rating. Why not? They were all in this together and if Enron was able to pull it off, so much
the better for the rest of them in terms of future bonuses, investment banking fees, etc. But this simply demonstrates
Partnoy’s contention that the key gatekeeper institutions that support our system of market capitalism have
comprehensively failed. The institutions sharing the blame include auditors, law firms, banks, securities analysts,
independent directors, and credit rating agencies. It is also why we cannot view Enron as a simple “slip through the
cracks” of an otherwise healthy system.
We like to think of our culture as a “risk-taking” one with all of the benefits and drawbacks implied by that term.
Inherent within a free market system is the possibility of huge success or bankruptcy. The rewards brought about
through the assumption of risk are important elements of the system and it would clearly be inappropriate to seek to
eliminate them. But equally crucial is the threat of bankruptcy; it tends to circumscribe risk and hopefully force us to
calibrate it in a more rational manner as we seek the rewards of the market economy. Crucial to this “risk/reward”
assessment, however, is a sensible regulatory framework that neither unduly punishes risk-takers, nor underwrites
the recklessness of a leveraged speculator through moral hazard and an unremitting hostility to sensible regulatory
oversight. In the absence of the latter, markets become dysfunctional and market participants are implicitly
encouraged to leave their brains on the doorstep. There is no longer critical scrutiny of the fundamentals or any
pursuit of real prospective returns over the long run. The risk/reward spectrum effectively becomes inverted, since
prudent risk taking means smaller rewards, whilst huge, leveraged bets mean bigger bonuses and no corresponding
penalties in the event of failure due to our persistent resort to bailouts, which eliminate the ultimate sanction against
such recklessness. In such an environment, swindlers and frauds are possible and their perpetrators thrive. This is a
lesson that we are learning to our cost yet again with Enron as Frank Partnoy eloquently has outlined in his recent
Senate testimony. Will Congress, the Bush administration, and Alan Greenspan finally take note? |
