In other words, OTC derivatives markets, which for the most part did not exist twenty (or, in some cases, even ten) years ago, now comprise about 90 percent of the aggregate derivatives market, with trillions of dollars at risk every day. By those measures, OTC derivatives markets are bigger than the markets for U.S. stocks. Enron may have been just an energy company when it was created in 1985, but by the end it had become a full-blown OTC derivatives trading firm. Its OTC derivatives-related assets and liabilities increased more than five-fold during 2000 alone.
And, let me repeat, the OTC derivatives markets are largely unregulated. Enron's trading operations were not regulated, or even recently audited, by U.S. securities regulators, and the OTC derivatives it traded are not 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.
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. But its proposals were rejected, and in December 2000 Congress made the deregulated status of derivatives clear when it 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.
Many parties are to blame for Enron's collapse. But as this Committee and others take a hard look at Enron and its officers, directors, accountants, lawyers, bankers, and analysts, Congress also should take a hard look at the current state of OTC derivatives regulation. (In the remainder of this testimony, when I refer generally to "derivatives," I am referring to these OTC derivatives markets.)
II. Derivatives "Outside" Enron
The first answer to the question of why Enron collapsed relates to derivatives deals between Enron and several of its 3,000-plus off-balance sheet subsidiaries and partnerships. The names of these byzantine financial entities - such as JEDI, Raptor, and LJM - have been widely reported.
Such special purpose entities might seem odd to someone who has not seen them used before, but they actually are very common in modern financial markets. Structured finance is a significant part of the U.S. economy, and special purpose entities are involved in most investors' lives, even if they do not realize it. For example, most credit card and mortgage payments flow through special purpose entities, and financial services firms typically use such entities as well. Some special purpose entities generate great economic benefits; others - as I will describe below - are used to manipulate company's financial reports to inflate assets, to understate liabilities, to create false profits, and to hide losses. In this way, special purpose entities are a lot like fire: they can be used for good or ill. Special purpose entities, like derivatives, are unregulated.
The key problem at Enron involved the confluence of derivatives and special purpose entities. Enron entered into derivatives transactions with these entities to shield volatile assets from quarterly financial reporting and to inflate artificially the value of certain Enron assets. These derivatives included price swap derivatives (described below), as well as call and put options.
Specifically, Enron used derivatives and special purpose vehicles to manipulate its financial statements in three ways. First, it hid speculator losses it suffered on technology stocks. Second, it hid huge debts incurred to finance unprofitable new businesses, including retail energy services for new customers. Third, it inflated the value of other troubled businesses, including its new ventures in fiber-optic bandwidth. Although Enron was founded as an energy company, many of these derivatives transactions did not involve energy at all. |
