Testimony of Frank Partnoy
Professor of Law, University of San Diego School of Law
Hearings before the United States Senate
Committee on Governmental Affairs, January 24, 2002
[posted January 29, 2002]
Introduction and Overview
Derivatives "Outside" Enron
Derivatives "Inside" Enron
Conclusion
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I am submitting testimony in response to this Committee's request that I address potential problems associated with the unregulated status of derivatives used by Enron Corporation.
I. Introduction and Overview
I am a law professor at the University of San Diego School of Law. I teach and research in the areas of financial market regulation, derivatives, and structured finance. During the mid-1990s, I worked on Wall Street structuring and selling financial instruments and investment vehicles similar to those used by Enron. As a lawyer, I have represented clients with problems similar to Enron's, but on a much smaller scale. I have never received any payment from Enron or from any Enron officer or employee.
Enron has been compared to Long-Term Capital Management, the Greenwich, Connecticut, hedge fund that lost $4.6 billion on more than $1 trillion of derivatives and was rescued in September 1998 in a private bailout engineered by the New York Federal Reserve. For the past several weeks, I have conducted my own investigation into Enron, and I believe the comparison is inapt. Yes, there are similarities in both firms' use and abuse of financial derivatives. But the scope of Enron's problems and their effects on its investors and employees are far more sweeping.
According to Enron's most recent annual report, the firm made more money trading derivatives in the year 2000 alone than Long-Term Capital Management made in its entire history. 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.
In short, Enron makes Long-Term Capital Management look like a lemonade stand. It will surprise many investors to learn that Enron was, at its core, a derivatives trading firm. Nothing made this more clear than the layout of Enron's extravagant new building - still not completed today, but mostly occupied - where the top executives' offices on the seventh floor were designed to overlook the crown jewel of Enron's empire: a cavernous derivatives trading pit on the sixth floor.
I believe there are two answers to the question of why Enron collapsed, and both involve derivatives. One relates to the use of derivatives "outside" Enron, in transactions with some now-infamous special purpose entities. The other - which has not been publicized at all - relates to the use of derivatives "inside" Enron. Derivatives are complex financial instruments whose value is based on one or more underlying variables, such as the price of a stock or the cost of natural gas. Derivatives can be traded in two ways: on regulated exchanges or in unregulated over-the-counter (OTC) markets. My testimony - and Enron's activities - involve the OTC derivatives markets.
Sometimes OTC derivatives can seem too esoteric to be relevant to average investors. Even the well-publicized OTC derivatives fiascos of a few years ago - Procter & Gamble or Orange County, for example - seem ages away. But the OTC derivatives markets are too important to ignore, and are critical to understanding Enron. The size of derivatives markets typically is measured in terms of the notional values of contracts. 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. And that estimate most likely is an understatement. |
