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Non-Tech : The ENRON Scandal -- Ignore unavailable to you. Want to Upgrade?

To: Baldur Fjvlnisson who wrote (3794)	4/2/2002 5:56:08 AM
From: Baldur Fjvlnisson	Read Replies (1) \| Respond to of 5185

B. Mismarking Forward Curves Not all of the misreporting of derivatives positions at Enron was as brazen as "prudency." Another way derivatives frequently are used to misstate profits and losses is by mismarking "forward curves." It appears that Enron traders did this, too. 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. Traders are compensated based on their profits, so if a trader can hide losses by mismarking forward curves, he or she is likely to receive a larger bonus. These losses apparently ranged in the tens of millions of dollars for certain markets. At times, a trader would manually input a forward curve that was different from the market. For more complex deals, a trader would use a spreadsheet model of the trade for valuation purposes, and tweak the assumptions in the model to make a transaction appear more or less valuable. Spreadsheet models are especially susceptible to mismarking. Certain derivatives contracts were more susceptible to mismarking than others. A trader would be unlikely to mismark contracts that were publicly traded - such as the natural gas contracts traded on NYMEX - because quotations of the values of those contracts are publicly available. However, the NYMEX forward curve has a maturity of only six years; accordingly, a trader would be more likely to mismark a ten-year natural gas forward rate. At Enron, forward curves apparently remained mismarked for as long as three years. In more esoteric areas, where markets were not as liquid, traders apparently were even more aggressive. One trader who already had recorded a substantial profit for the year, and believed any additional profit would not increase his bonus much, reportedly reduced his recorded profits for one year, so he could push them forward into the next year, which he wasn't yet certain would be as profitable. This strategy would have resembled the "prudency" accounts described earlier. C. Warning Signs Why didn't any of the "gatekeepers" tell investors that Enron was so risky? There were numerous warning signs related to Enron's derivatives trading. Yet the gatekeepers either failed utterly to spot those signs, or spotted those signs and decided not to warn investors about them. Either way, the gatekeepers failed to do their job. This was so even though there have been several recent and high-profile cases involving internal misreporting of derivatives. Enron disclosed that it used "value at risk" (VAR) methodologies that captured a 95 percent confidence interval for a one-day holding period, and therefore did not disclose worst-case scenarios for Enron's trading operations. Enron said it relied on "the professional judgment of experienced business and risk managers" to assess these worst-case scenarios (which, apparently, Enron ultimately encountered). Enron reported only high and low month-end values for its trading, and therefore had incentives to smooth its profits and losses at month-end. Because Enron did not report its maximum VAR during the year, investors had no way of knowing just how much risk Enron was taking. Even the reported VAR figures are remarkable. Enron reported VAR for what it called its "commodity price" risk - including natural gas derivatives trading - of $66 million, more than triple the 1999 value. Enron reported VAR for its equity trading of $59 million, more than double the 1999 value. A VAR of $66 million meant that Enron could expect based on historical averages that on five percent of all trading days (on average, twelve business days during the year) its "commodity" derivatives trading operations alone would gain or lose $66 million, a not trivial sum. Moreover, because Enron's derivatives frequently had long maturities - maximum terms ranged from 6 to 29 years - there often were not prices from liquid markets to use as benchmarks. For those long-dated derivatives, professional judgment was especially important. For a simple instrument, Enron might calculate the discounted present value of cash flows using Enron's borrowing rates. But more complex instruments required more complex methodologies. For example, Enron completed over 5,000 weather derivatives deals, with a notional value of more than $4.5 billion, and many of those deals could not be valued without a healthy dose of professional judgment. The same was true of Enron's trading of fiber-optic bandwidth. And finally there was the following flashing red light in Enron's most recent annual report: "In 2000, the value at risk model utilized for equity trading market risk was refined to more closely correlate with the valuation methodologies used for merchant activities." Enron's financial statements do not describe these refinements, and their effects, but given the failure of the risk and valuation models even at a sophisticated hedge fund such as Long-Term Capital Management - which employed "rocket scientists" and Nobel laureates to design various sophisticated computer models - there should have been reason for concern when Enron spoke of "refining" its own models.