JP Morgan says risk exposure in gold derivatives less than 10 mln usd

NEW YORK

JP Morgan Chase, answering charges by a pressure group that it may be facing excessive risks in the gold market but not disclosing them, said its exposure to gold including derivatives is less than 10 mln usd.
    JP Morgan was responding to allegations by the two-person Gold Anti-Trust Action Committee (GATA), a pressure group which alleges bullion banks and central banks are conspiring to rig prices in the gold market.
    The US Securities and Exchange Commission (SEC) is now being asked to arbitrate a long-running spat between JP Morgan and GATA which has generated a steady flow of conflicting claims, rumors, accusations and denials with few hard facts.
    Both sides are calling on the securities regulator to investigate their claims about the other party. GATA asked the SEC last week to investigate its suspicion that JP Morgan has a higher risk exposure to fluctuations in the price of gold than what it has acknowledged publicly.
    GATA's letter to the SEC spelling out its allegations followed JP Morgan's request to the regulator on Jan 3 that it investigate rumors the bank was trying to keep the price of gold down and covering up losses incurred from the recent rise in gold prices.
    JP Morgan Chase has registered 41 bln usd in gold derivative contracts as of the third quarter last year in its filings with the US Office of the Comptroller of the Currency. This is the notional value, or the sum of the value of different contracts of the bank's clients holding different positions, long or short, on the contracts.
    Derivatives are financial instruments that derive their value from another underlying asset, like gold. The most common derivatives are futures and options.
    "On any given day, JP Morgan's exposure to the gold market including derivatives is less than 10 million dollars," a bank spokesman told AFX Global Ethics Monitor.
    "The risk of contracts is held by our clients and we actually don't have any risk associated in the contracts."
    Analysts said that sorting out the conflicting claims comes down to finding out for sure which contracts JP Morgan holds on gold, and if it is betting the price of the precious metal will rise or fall -- two facts hard to pin down.
    Brock Vandervliet, vice president of equity research at Lehman Brothers said the amount in gold derivative contracts Morgan Chase has disclosed is not excessive for a large bank.
    However, Vandervliet said the amount is larger than what HSBC and Citibank reported in the third quarter of last year. HSBC had notional amounts of 14.2 billion dollars in gold derivative contracts while Citibank had 12.9 billion dollars.
    Vandervliet also said that gold is not a major part of JP Morgan's derivatives business and hence may not be that big a risk.
    But analysts agreed the information provided by JP Morgan is not enough to understand the actual risk involved.
    "There are two things that are absolutely critical to know which make it impossible to conclude anything really powerful," said Vandervliet.
    "First, is the net trading position long or short? We don't know. Second, how much of these contracts are held by JPM versus held for customers supporting a trading book and therefore not presenting JPM with a material risk. This is a weakness of the disclosure and makes firm conclusions very difficult."
    The dispute between JP Morgan and GATA, which gets funding from several small gold companies, goes back to late last year when GATA accused the bank of trying to run down the prices in the gold market.
    GATA has in the past also accused the US Federal Reserve Bank, the International Monetary Fund and other bullion banks like Goldman Sachs of price rigging.
    On Jan 6, GATA consultant James Turk wrote to the SEC asking for an inquiry.
    "It's about time that we learn the truth regarding JP Morgan Chase's activity in the gold market, the full extent of its gold exposure, and whether it used gold loans to fund the so-called 'disguised loans' that it arranged for Enron," Turk said in the letter to the SEC.
    A SEC spokesman said the organization does not comment on investigations, ongoing or otherwise.
    Some analysts are also skeptical of the risk exposure disclosed by JP Morgan.
    "They have to divulge only material risk that is a risk large enough to have impact on the company's assets," said Richard Bove, managing director, Hoefer and Arnett, a research group specializing in financial companies.
    "We accept the amount disclosed as a matter of faith."
    GATA disputed the 10 mln usd figure given the amount of gold derivative contracts booked by JP Morgan, citing the bank's alleged interest in keeping the price of gold down.
    Gold prices are currently at their highest levels in six years and GATA claims JP Morgan could be losing money at current prices.
    Some industry experts are questioning the veracity of GATA's claims.
    "I think they (GATA) could have had long positions in gold and are always complaining when prices go down never up," said Randall Dodd, director of the Derivatives Study Center, a non-profit group researching on financial markets, AFX-GEM.
    Investors who have a long position in gold derivatives profit when gold prices go up. GATA denies having a long position on gold.
    anupama.chandrasekaran@afxnews.com
    ac/mlo/gc

· Washington Post

October 17, 2002, Thursday, Final Edition, FINANCIAL; Pg. E01

Dynegy Ends Power-Trading Operations

Peter Behr, Washington Post Staff Writer

The energy-trading business, poisoned by scandals that followed the collapse of Enron Corp., suffered another casualty yesterday as Enron's former Houston rival, Dynegy Inc., announced it was closing its trading unit to preserve urgently needed cash reserves.

Dynegy, the nation's third-largest trader of electricity at the beginning of the year, also announced the resignation of Chief Operating Officer Stephen W. Bergstrom. And it said it will eliminate a "significant" number of jobs from its worldwide workforce of 5,500, hoping that cost cutting will help it meet heavy debt-repayment obligations.

While ending its speculative trading operations, Dynegy said it will continue to market power from its network of U.S. and foreign plants. Bergstrom's resignation was triggered by the decision to exit the trading business, the company said. He is the third senior official to resign this year, following founder and chairman Charles L. "Chuck" Watson and former chief financial officer Robert D. Doty Jr., who left when regulators began investigating the company.

Dynegy agreed last month to pay a $ 3 million fine to the Securities and Exchange Commission, without admitting or denying wrongdoing, to settle charges of trading and accounting abuses in a large, long-term energy-supply contract.

Two years ago, Enron and Dynegy were in the vanguard of a wide-open, burgeoning power market. Competitors rushed to open new generating plants and set up large, computer-driven power-trading desks in anticipation of the spread of electricity deregulation around the country. As power trading spread, blocks of electricity were traded dozens of times between the generating plant and the local electricity distributor.

After Enron's fall into bankruptcy and disclosures of sham energy transactions, "round-trip" sales and price manipulation, the power-trading market has collapsed. The nation's economic slowdown has sapped demand for electricity. And credit-rating agencies, caught off guard by the Enron bankruptcy, are forcing trading companies to post more cash collateral to back up their contracts -- a burden that Dynegy could not bear, it said.

Dynegy's shares have dropped by 96 percent this year, a market wipeout also experienced by its former power-trading rivals, Aquila Inc., Reliant Resources Inc., Williams Cos., El Paso Corp. and Mirant Corp.

"No one wants to trade with them," said Randall Dodd, director of the Derivatives Study Center in Washington. Customers "don't know if they can fulfill their contacts."

A Dynegy spokesman said it could not find a creditworthy buyer for its trading business and concluded it could not wait for the trading business to recover.

When that might happen is not clear, experts said.

Dodd said that power trading won't pick up until new regulations are in place to prevent the manipulations that blackened the industry's eye. Enron led a successful lobbying campaign to free speculative power trading from oversight by the Commodity Futures Trading Commission, he said. Attempts this year to impose new regulations were blocked in Congress. Now, the industry "has to convince people there is someone there who is guarding against fraud and manipulation," Dodd added.

Lawrence J. Makovich, senior director of Cambridge Energy Research Associates in Cambridge, Mass., said that the problems of the energy-trading industry are tied to the current glut in power plant capacity. Trading operations won't be profitable until after the generating industry has gone through a painful downsizing.

"The bubble has popped," he said. "We are overbuilt in the vast majority of the regional power markets. . . . There is a better-than-even chance of a couple of major bankruptcies" among the group of trading and competitive power generating companies, he said.

Peter H. Rodgers, a Washington lawyer who specializes in the commodity-trading industry, said there is a need for power trading, to help utilities and industries protect themselves against volatile power price changes. "When the dust settles, I think you'll see some renewal" of trading, he said.

But a recovery, he said, is likely to be led by Wall Street financial firms, private commodity companies such as giant agribusiness firm Cargill Inc., and foreign trading firms -- not the companies that jumped at the opportunity in the 1990s.

· Business Week

October 7, 2002

NEWS; Analysis & Commentary; Number 3802; Pg. 40

THE BREAKDOWN IN BANKING
Trust is eroding and profits may follow as business models falter

Emily Thornton, Peter Coy, and Heather Timmons in New York, with bureau reports

In the 1990s, the sky seemed the limit for financial institutions. Once restricted to taking deposits and making loans, banks broke into the business of selling securities. Wall Street investment houses began making loans to companies. The result was a flood of money to promising new companies, existing businesses, and consumers. That fueled the New Economy with its rapid productivity growth and made the American financial system the envy of the world. Moreover, the financial system seemingly sailed through the 2001 recession and the accompanying stock market decline in good shape. Commercial banks had record profits in the second quarter of this year, and their balance sheets were far stronger than in previous recessions.

But now, the ever-closer partnership between commercial banking and investment banking is showing signs of strain. Putnam Lovell Securities estimates that earnings at five of the largest firms -- Citigroup, J.P. Morgan Chase, Merrill Lynch, Goldman Sachs, and Morgan Stanley -- could stay stuck below 1998 levels this year. On Sept. 17, J.P. Morgan Chase & Co. warned that its third-quarter operating profits will be ''well below'' those of the second quarter as losses on corporate lending may more than quadruple, to $ 1.4 billion. One possible reason: Many of those loans were made to now-struggling or failed telecom companies in a bid to win investment banking. That's a small part of the unprecedented wave of bad debt flooding the financial system. A record $ 880 billion worth of corporate bonds and loans are distressed or in default, according to Edward I. Altman, a professor at New York University's Stern School of Business. As the losses mount, the biggest firms are facing the threat of legal action from investors who see themselves as the victims of a massive con game.

At issue is the economic recovery. Banks are indispensable links in the flow of money, and they must be perceived as honest players. Yet after a year of revelations about their questionable practices and conflicts of interest, investors have become increasingly skeptical of everything Wall Street sells.

That partially explains why the stock market is tanking even as the real economy shows signs of recovery. It also accounts for the higher rates that investors demand before they'll hold corporate bonds. Ford Motor Co., for example, is paying four percentage points more than the government on borrowing. With stock prices low, as well, the cost of capital for companies is rising, discouraging needed investment. And as long as investigations drag on, investors will steer clear of what they perceive to be a rigged game. ''Until we have some finality around recent regulatory and legislative reforms that make people feel it's safe to go back in the water, we're not going to get the confidence and credibility back in the marketplace,'' says Lehman Brothers Inc. Chief Financial Officer David Goldfarb.

How did we come to this? In the 1990s, market forces penetrated the once heavily policed U.S. financial system. The 1999 repeal of the Depression-era Glass-Steagall Act accelerated an existing trend of commercial and investment banks coming together -- or invading one another's turf -- by sweeping away barriers that were designed to protect corporations, borrowers, and investors from banks' conflicts of interest. The change sanctioned financial behemoths such as Citigroup and J.P. Morgan and allowed commercial banks such as Bank of America and FleetBoston Financial Corp. to jump on the investment-banking wagon. All were seeking to leverage low-margin lending into much more profitable fee businesses such as underwriting shares.

The result: Competition in investment banking became cutthroat. Research analysts became shills for stock offerings instead of investment advisers; investment bankers dangled allocations of initial public offerings to CEOs to get business. Loans were offered to entice lucrative investment-banking business. ''The whole financial system has become corrupt,'' says Felix G. Rohatyn, who runs financial advisory firm Rohatyn Associates LLC.

At the same time, market forces had begun to change the straitlaced culture of big commercial banks. They sold off pieces of their corporate loans to smaller banks, insurers, and mutual funds in a booming syndication market of more than $ 2 trillion. Then they moved on to repackaging consumer loans into securities, from mortgages to credit-card receivables, and sold them to institutions in what's now a $ 7 trillion securitization business. By selling off their loans, banks were able to lend to yet more borrowers because they could reuse their capital over and over. But it also meant that they made lending decisions based on what the market wanted rather than on their own credit judgments. The wholesale offloading of risk made the banking system less of a buffer and more of a highly streamlined transmitter of the whims of the market.

The more businesses that financial institutions assembled, the more conflicts of interest they faced. Heightened competition encouraged banks to use rosy stock recommendations, low-interest loans, and handouts of shares in hot IPOs to CEOs to win lucrative investment-banking business. It also led bankers to make unwise loans and underwrite securities that never should have come to market. The boom-time excesses of the banking system are ''a train wreck waiting to happen,'' says D.Quinn Mills, a finance professor at Harvard Business School.

Meanwhile, the resale of loans created moral hazard: a temptation for banks to scrutinize borrowers less carefully than when their own money was at stake. ''The banks abdicated credit judgment, and the people to whom they sold the paper had no credit judgment,'' says Martin Mayer, a guest scholar at the Brookings Institution and author of The Bankers.

Other problems may yet emerge. While the market for securitized consumer loans remains healthy, investors who took loans off banks' hands could get stung if the economy stumbles. Moreover, it's tougher for the Federal Reserve, which supervises banks, to fix systemic credit problems once the debt is in the market. Says Mayer: ''This is the first time that the banking system has ever predistributed losses.''

Many of the stocks and bonds floated during the 1990s boom probably never should have come to market. For example, 45% of junk bonds are distressed or in default, up from 5% in 1998, according to Stern's Altman. Now, investors balk at loading up on more junk bonds. And some are shying away from new issues of asset-backed securities from banks. ''There have been many deals we have turned away recently that have not passed our credit stress tests,'' says Dan Ivascyn, portfolio manager at Pacific Investment Management Co., which manages $ 274 billion of assets.

Compounding the stress on the economy is a loss of faith. Financial institutions are under siege from thousands of investor lawsuits. And some in Washington are starting to question if the one-stop financial shops allowed by the repeal of Glass-Steagall should continue to exist at all. To be explored, says a top Democratic Hill aide, is whether legislation ''pushed commercial and investment banks to take on greater risks than they otherwise would, and whether [the law] caused conflicts'' by placing bankers at odds with clients' interests.

Now, it's clear that in their race to become jacks-of-all-trades, many financial-services companies ended up mastering none. Many failed in their attempt to turn into one-stop financial shops selling everything from merger advice to credit cards. FleetBoston shut its investment-banking unit Robertson Stephens earlier this year largely because high-tech IPOs, its specialty, dried up and left big losses, says CEO Charles K. Gifford. Adds Wells Fargo & Co. CEO Richard M. Kovacevich: ''Almost 70% of banks buying investment banks fail.'' Wells Fargo itself has avoided the bidding. A growing share of profits at big banks comes from trading, which is inherently uncertain. ''Banks are playing the interest-rate market, and it is starting to explode,'' says David A. Hendler, an analyst with CreditSights, a bond research firm.

Things will get worse if more bad debts surface. J.P. Morgan wrote off $ 3.3 billion in bad loans in the nine months through June 30. And it's impossible to tell how exposed banks are to losses from derivatives, another market that boomed as banks sought profits from new trading opportunities, says Randall Dodd, director of the Derivatives Study Center in Washington. For example, J.P. Morgan has derivatives with a face value of $ 25 trillion. But investors don't know how vulnerable that enormous portfolio would be to, say, a sharp rise in rates or a fall in the dollar.

Wall Street also faces a potentially huge legal bill. Some pension funds and insurers are striking back. CalPERS has joined with several other pension funds to sue J.P. Morgan and Citigroup, the underwriters of WorldCom Inc.'s last bond issue, an $ 11 billion deal, for alleged lack of due diligence. Banks may have to pay up to $ 5 billion to settle over 300 class actions involving everything from hyping lousy IPOs to favoring their best banking clients, according to James Newman, executive director of research firm Securities Class Action Services. On top of that, there are 25 class actions pending against firms' research analysts.

Financial giants accelerated the growth of the New Economy in the 1990s. But they're looking shakier as the U.S. economy struggles to get out of the doldrums. ''You don't see a raft of companies trying to become the next Citigroup,'' says Brock Vanderfleet, a Lehman Brothers analyst. Putting the financial system on a solid foundation will be critical to putting the economy back on track.

· Power Markets Week

September 23, 2002 , MARKET REGULATION; Pg. 14

CHANGE SOUGHT IN FEINSTEIN BILL WOULD EXEMPT ICE FROM CAPITAL REQUIREMENTS

A draft amendment to Sen. Dianne Feinstein's bill (S 2724) that places over-the-counter energy and metals derivatives under federal regulation would remove bilateral dealers and online trading exchanges, such as the IntercontinentalExchange, from the legislation's capital requirements, industry sources said last week.

But the amendment proposed Sept. 6 by Senate Agriculture Committee Chairman Tom Harkin (D-Iowa) and ranking member Sen. Richard Lugar (R-Ind.) still attracted top-drawer complaints.

In a letter send Sept. 18, U.S. Federal Reserve Board Chairman Alan Greenspan and other federal officials say they have ''serious concerns'' about the Harkin-Lugar proposal. Joining Greenspan in signing the letter were Treasury Secretary Paul O'Neill, Securities and Exchange Commission Harvey Pitt and James Newsome, chairman of the Commodity Futures Trading Commission. ''The proposal would subject market participants to disclosure of proprietary trading information and new capital requirements,'' the administration officials wrote to senators including Harkin, Lugar, Feinstein, Senate Majority Leader Tom Daschle (D-SD). ''We do not believe a public policy case exists to justify this governmental intervention.''

Industry sources supporting the legislation said the amendment would bring more oversight to OTC energy derivatives, but acknowledged it leaves ''a few regulatory gaps.'' Foes of the bill, first introduced in July by Feinstein (D-Calif.), worry that the amendment would have unintended consequences and raise costs for trading these derivatives.

Harkin has yet to set a date for his committee to consider the legislation or the amendment and send it to the Senate floor for a vote. But committee staff and industry sources say the chairman wants to address the legislation before Congress recesses this fall.

Feinstein's bill would have the CFTC regulate OTC energy and metals derivatives and require traders to back their deals with capital. Under requirements specified by the CFTC, trading facilities would be required to report OTC transactions and keep books and records of these transactions for up to five years according to the legislation. Harkin and Lugar's amendment would limit the capital requirements but expand private regulatory organizations oversight that industry proponents fear will add new fees for trading OTC energy derivatives.

Administration officials were wary of these key components. ''The rationale for imposing capital requirements is unclear to us, the proposal's capital requirements also could duplicate or conflict with existing regulatory capital requirements,'' the administration officials wrote. ''It is also unclear who would benefit from the proposed disclosures and regulations other than whoever simply copied existing products and instruments or their own short-term advantage.''

The Feinstein bill would require electronic exchanges and OTC traders to have sufficient capital to back their operations. Feinstein introduced her bill to take aim at Enron and its online trading platform for its questionable trading practices during the Western power price crisis of 2000-2001. OTC energy and metals derivatives were exempt from CFTC oversight under the Commodity Futures Modernization Act of 2000.

Proponents last week noted that the Harkin-Lugar draft amendment would still require capital requirements for an entity such as the defunct EnronOnline where the energy company was the counterparty to each deal on its online trading platform.

''Who gets a free ride here are dealers like Apache, Williams, [and] El Paso,'' said Randall Dodd, director of the Derivatives Study Center. ''The market is in trouble because Enron didn't have sufficient capital so others did not have sufficient capital.''

Still, Dodd said overall it remains a good bill. The Harkin-Lugar language ''makes significant strides in addressing the importance of the derivatives markets, although it leaves a few regulatory gaps. It would still be a great step forward,'' said Dodd.

But the International Swaps and Derivatives Assn. disagreed. While the proposed amendment excludes the bilateral dealer market from its new regulations, ISDA noted it adds ''more troubling'' language that authorizing private regulatory bodies. It appears that the provisions could require each counterparty to register with an organization such as the National Futures Assn., and in turn be subject to new transactions fees for trading OTC energy and metals derivatives, said ISDA Policy Director Stacy Carey.

''This overreaction to Enron really undoes the innovation achieved through the CMFA and may have negative consequences in how these markets develop in the future,'' said Carey.

· Tax Management Financial Planning Journal

Senators to offer bipartisan amendments on Feinstein bill regulating certain swaps
Tax Management Financial Planning Journal; Washington; Sep 17, 2002; Anonymous;

Abstract:
Sen. Tom Harkin and Richard Lugar are collaborating on amendments to S. 2724, a derivatives oversight bill, and likely will offer them when the panel marks up the legislation. The amendments involve bolstering the financial penalty for fraud and manipulation and establishing a self-regulatory organization to oversee the off-exchange derivatives market.

Sen. Tom Harkin (D-Iowa), chairman of the Agriculture Committee, and committee ranking member Richard Lugar (R-Ind.) are collaborating on amendments to a derivatives oversight bill (S. 2724) introduced by Sen. Dianne Feinstein (D-Calif.) and likely will offer them when the panel marks up the legislation, a spokesman for the committee said Aug. 27.

"We're still working with the original draft. I don't think there will be any legislation introduced," said Seth Boffeli. "I think what will happen is we'll mark it up in committee, and that's where the Harkin-Lugar [language] will take form."

While Boffeli said he could not elaborate on possible changes, a source who said he has seen drafts of the amendments said they involve bolstering the financial penalty for fraud and manipulation and establishing a self-regulatory organization to oversee the off-- exchange derivatives market.

Boffeli said he expects the committee to mark up the bill, which both Harkin and Lugar co-sponsor, this session, but added that it will take a back seat to legislation to provide drought relief for farmers. Congress returned from its month-long recess Sept. 3 and has set Oct. 4 as its target date for adjournment.

Transparency. The Feinstein bill seeks to provide "transparency" to energy and metals swaps by subjecting them to registration, reporting, and disclosure requirements that would be set by the Commodity Futures Trading Commission, and it also would subject them to existing anti-fraud and anti-manipulation laws. Currently, such derivatives are exempt from CFTC oversight.

The legislation was introduced in February but failed to garner support at the committee level. It appeared to fade from consideration after a bid to offer it as an amendment to an energy bill in April failed, but renewed scrutiny of the conduct of corporations this summer led the Agriculture Committee to hold a hearing on the measure in July.

At that session, Lugar, a former chairman of the committee who was a key proponent of the swaps CFTC-exemption in 2000, indicated he had changed his mind and would support the Feinstein effort. He has since signed on as a co-sponsor of the legislation.

Most Changes Technical. The Harkin aide said most of the amendments will be "technical changes" to clean up language in the original bill. He said specifics have not been finalized but offered that some pointed changes will be directed at establishing punishments for those who violate new derivatives provisions.

"I don't know where they are going to end up, but I know they are talking about specific penalties," Boffeli said. "I don't think anything's set in stone."

The draft language of the amendments, according to the source, increases the fine for derivatives traders caught breaking fraud and manipulation laws from the current $500,000 to $1 million. The original Feinstein bill simply establishes that traders in energy and metals derivatives are subject to such laws.

SRO Would Oversee Trades. Also, another amendment, according to the source, would establish a selfregulatory organization to oversee derivatives trades. Boffeli said he could not confirm the SRO provision. A spokesman said Lugar "wanted to do some things to tighten up the markets" but would not elaborate other than to confirm that Lugar and Harkin are collaborating on changes.

Otherwise, the new language being circulated leaves the original "95 percent intact," the source said. "It is not substantially different. It's got a couple of new bells and whistles, but all the important provisions of the original remain." Those include the registration, reporting, and capital requirements, he said.

Randall Dodd, head of the Derivatives Study Center, who testified at the July 10 hearing on the Feinstein bill, said Aug. 28 that the Feinstein measure is needed. "It's really a pretty good bill, and it reflects a huge leap forward in thinking about how these markets should be regulated." The bill, he said, would make the derivatives markets, "more safe without threatening problems for the larger economy. ... It's not a regulatory burden and there's very little cost to anyone."

While the uncovering of corporate chicanery this year-including so-called wash trades by some energy companies-has fueled outrage in Washington against fraudulent derivatives trades, Dodd said Lugar's shift might be the key to getting the bill passed. "That's huge," he said. "If he says this needs to be changed, people will listen."

· Mergers & Acquisitions Litigation Reporter SPECIAL REPORT

September 3, 2002

SECTION: SECURITIES/CORPORATE GOVERNANCE/REGULATORY ISSUES; Vol. 13; No. 1; Pg. 10

LENGTH: 3022 words

HEADLINE: Regulation of Derivatives In a Post-Enron World

BYLINE: BY GEOFFREY ETHERINGTON AND BRIAN P. IAIA*; * Attorney Geoffrey Etherington III is a partner in the New York office of Edwards & Angell (www.ealaw.com) and Brian P. Iaia is an associate in the Hartford, Conn., office. Both are members of the firm's insurance and reinsurance practice group.

BODY:
Following the collapse of Enron late in 2001, journalists, regulators and legislators have criticized the over-the-counter derivatives trading and investing activities of Enron and other companies. Some have suggested that lack of regulation of the OTC derivatives market was a factor in the Enron debacle. 1 As Congress, the Securities and Exchange Commission, and the Justice Department continue their investigation of accounting irregularities, management fraud and self-dealing, and shortcomings or failures of independent directors, accountants and professionals, additional regulation of derivatives is being considered. 2

However, recent disclosures of improper accounting to inflate profits at companies like Enron and WorldCom do not appear to be related to derivatives activities. While Enron may have improperly accounted for derivatives transactions with its off-balance-sheet entities, before any effort is made to restrict, regulate or scale back the derivatives activities of financial market participants as a reaction to Enron, it is essential to recognize the crucial role of derivatives in ensuring the efficient and orderly functioning of global financial markets. 3

The last decade has witnessed dramatic growth in derivatives trading activities. In 2000 the notional value of exchanged-traded derivatives was $13 trillion to $14 trillion. OTC derivatives traded during the same period were at least $95.2 trillion (and probably much higher). 4 Derivatives are considered an essential arrow in any sophisticated corporate risk manager's quiver of tools to reduce business, portfolio, credit, interest-rate and currency risk. OTC derivatives in particular can be tailored to hedge risks and reduce volatility associated with both assets and liabilities, as well as operating results. Such risk management strategies benefit all constituencies by transferring exposures to other market participants, who are prepared to bear the consequences of a loss in return for the premium or fee earned to accept the risk.

Randall Dodd, director of the Derivatives Study Center in Washington, D.C., which conducts policy research with a grant from the Ford Foundation, stated in an April 2002 interview with Challenge magazine, " T here are four basic types of derivatives transactions: forwards, futures, swaps, and options. These instruments are sometimes combined to form more complicated transactions, but in the vast majority of cases, they are straightforward versions of the four types."

Many types of instruments are considered derivatives. Frank Partnoy, a professor at the University of San Diego School of Law who has studied Enron's derivatives transactions, told the Senate Committee on Government Affairs that 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." 5

However, derivatives contracts can address a much broader range of risks such as those related to weather, bond defaults, exchange rates or interest rates to name a few.

A distinguishing characteristic of derivatives is that risk is transferred or hedged for a premium or fee. Thus, a pension fund with a large position in a telecommunications company may enter into an OTC derivative contract with an investment banker to "put" some or all of the stock for a specified price. The pension fund agrees to pay the investment banker a fee for the right to put and has effectively transferred the risk of a price decline below the notional value of the contract to the banker for a cost equal to the fee.

A firm that operates warehouses across the upper Midwest may hedge against increased heating costs in the event of a harsh winter by purchasing a weather derivative from a heating oil company which pays off if temperatures that winter are particularly cold. The oil company never pays off the derivative if the winter is warm. The oil company will increase its income in a warm winter (from the fee) because the warm weather would have resulted in decreased oil sales. While the oil company's profits are reduced during a cold winter by paying off the derivative, and the warehouse firm has higher expenses in a warm winter, both may be willing to enter into the OTC derivative transaction to reduce the volatility of their operating results.

The benefits to the company (and its owners) of transferring the risk in an OTC transaction are obvious. For the fee paid to its counterparty, it has effectively reduced the volatility of the related asset or liability or stabilized operating results, which will smooth out its fi nancial performance in the long term. The counterparty m ay in fact be hedging the risk accepted with another OTC derivative contract or an asset or liability position, simply diversifying a portfolio of risks or itself transferring a different risk. In addition, if the counterparty is never called upon to perform under the original OTC derivative, it will recognize income equal to the fee.

When any OTC derivative transaction is proposed, each party must analyze the ability of the other to perform its future obligations. While it is possible to secure those obligations, often parties rely upon rating agencies or financial data that is either publicly available or provided privately to determine counterparty credit risk. While Enron ultimately did not prove to be a credit-worthy participant in the derivatives markets, in fact most counterparties to OTC derivative transactions are large public corporations and financial institutions like commercial banks, investment banks, insurance companies and hedge funds.

More importantly, however, many counterparties were aware of Enron's precarious financial condition and the uncertain value of the assets it was leveraging and took steps to minimize credit risk, such as guarantees or other contingent commitments from Enron or credit enhancements such as insurance policies and letters of credit. While not all such efforts were successful, the market clearly reacted to Enron's condition and tried to address it. 6

The collapse of Enron to some appeared to be a warning bell of imminent financial collapse under the weight of unregulated OTC derivatives activities. However, there has been no collapse and there is nothing inherently unsafe or unsound about OTC derivatives trading or the risk transfers effected between market participants. The sheer scale of the OTC derivatives market and the sophistication of its participants evidence the impor tance of OTC derivatives to the financial system. Regulatory or legislative tinkering with the market could have far-reaching and unintended consequences.

It should be noted that other players were quick to take the place of Enron in trading energy derivatives and that the commodity markets for gas and power, in which OTC derivatives play a vital role, functioned normally. 7 Swiss investment bank UBS Warburg was confident enough in Enron's trading business to purchase its technology platform out of bankruptcy. The OTC derivatives markets continue to develop and mature and the prudent course of action may be as little governmental interference in their functioning as possible.

OTC derivatives are essentially private contracts between sophisticated parties, and have developed as highly flexible financial instruments. For this reason, they may be inherently unsuitable to regulation. Any effort to force derivative transactions into certain forms or procedures, or to require review, qualification or registration of derivatives with the SEC (or a new federal agency) is likely to make the process of completing an OTC derivative transaction so cumbersome and time-consuming that most, if not all, of their value to risk managers would be lost. While proposals to require disclosure of information specifically about derivatives activities may seem less problematic, the complex and varied nature and scope of OTC derivatives may make effective regulation of disclosures extremely difficult.

As subsequent investigation into Enron and the obstruction-of-justice trial of auditor Arthur Andersen LLP have revealed, Enron's collapse was the result of a combination of market reversals, fraudulent self-dealing and improper behavior by individual corporate officers and the failure of internal and external controls and monitors to identify deficiencies in accounting treatment and disclosure or, if discovered, to adequately and timely take corrective measures. Enron's derivatives trading activities may have been improperly booked and its internal risk management policies were probably not followed. Self-dealing by Enron employees at many levels appears to have been rampant. Enron leveraged its assets dramatically and used its stock as collateral, creating a potential death spiral for its stock price when its debt ratings or stock price fell. 8

However, Enron collapsed in large part because "Enron's managers, with a belief system biased toward winning, lost touch with hard economic constraints and the rules of the game." 9 In fact, management was so committed to the perceived efficacy of the Enron business model that it may have resorted to fraud to ensure Enron's unbroken string of successes would continue. 10 Arthur Andersen and other professionals, if not actively participating in "cooking the books" and "hiding the skeletons," certainly bear some responsibility for not requiring earlier disclosure or actions relating to the serious deficiencies in management, and financial and ethical standards and controls.

The derivatives trading business model pioneered by Enron, however, should not be blamed for the company's collapse. In fact, Enron made billions trading derivatives, but it lost billions on virtually everything else it did, including projects in fiber-optic bandwidth, retail gas and power, water systems, and even technology stocks. 11 Specifically, Enron reported gains from derivatives of $4.04 billion in 1998, $5.34 billion in 1999 and $7.23 billion in 2000, yet Enron's non-derivatives gross margin (the difference between non-derivatives revenues and non-derivatives expenses) shows in a general sense that Enron's non-derivatives business made some money in 1998, broke even in 1999 and actually lost money in 2000.

Accounting improprieties unrelated to derivatives trading have been uncovered at WorldCom, Xerox and elsewhere, and many experts believe these improprieties are more significant than those at Enron. In the case of WorldCom, it initially appears that management and outside advisers are largely to blame for a pattern of accounting irregularities that inflated profits and increased stock prices.

With each revelation about efforts by managers of public companies to artificially inflate earnings and hide expenses, sometimes with the tacit approval of boards of directors and outside professionals, it is evident that Enron's failure did not result from the inadequate regulation regarding disclosure of derivatives trading activities. Rather, a more basic problem existed at Enron -- a perception that technical compliance with accounting standards and disclosure requirements was enough, even when such technical compliance was misleading or, even worse, inaccurate.

While sophisticated analysts may have been aware that Enron was pursuing a strategy to convert itself from a conventional energy company to a trading firm that was hedging exposures through derivatives and leveraging its assets using its own stock as currency, because Enron did not clearly and prominently reveal this strategy and its extensive use of "off balance sheet" entities to inflate profits, the capital markets may not have had a clear picture of the nature of Enron's business. 12 However, most, if not all, of this was due to purposeful accounting obfuscation. If Enron had honored the intent of financial disclosure regulations or if its auditors had insisted that some of the questionable special purpose vehicles be accounted for as consolidated entities and that profits from derivatives transaction with related parties that did not effectively transfer risk be footnoted in a straightforward and succinct fashion, Enron might still be in business trading OTC derivatives today.

Under SEC or regulatory accounting rules or contractual requirements, sophisticated participants in the OTC derivatives markets currently provide significant amounts of information about their derivatives trading activities to regulators and/or their investors. Even Enron made disclosure about its OTC derivatives trades with related entities in its 2000 financial statements, although those disclosures were buried within a footnote and difficult for anyone except sophisticated analysts to decipher. 13

It may be necessary for the SEC to review how it applies disclosure and accounting rules to ensure that trading companies that follow Enron into the virtual trading floor that it is developing for derivative instruments and counterparties of those traders are including proper and complete disclosure of their derivatives activities. The SEC has the power to require such disclosure currently with only modest rule changes and without any significant new regulatory or legislative initiative.

Under current securities laws, disclosures that omit material facts necessary to make those disclosures not misleading are prohibited and may lead to private rights of actions. A recommitment to this standard may prevent future Enrons. Investors and regulators should insist that public companies and their professional advisers comply with the spirit of SEC regulations like its Rule 10b-5. Indeed, President Bush said in a July 9, 2002, speech, "The lure of heady profits of the late 1990s spawned (corporate) abuses and excesses. With strict enforcement and higher ethical standards, we must usher in a new era of integrity in corporate America."

Bush went on to say, "The American economy is the most creative, enterprising and productive system ever devised . High-profile acts of (corporate) deception have shaken people's trust. Too many corporations seem disconnected from the values of our country. These scandals have hurt the reputations of many good and honest companies . It is time to reaffirm the basic principles and rules that make capitalism work: truthful books and honest people and well-enforced laws against fraud and corruption."

Bush vowed to use the full weight of the law to expose and root out corruption and to propose tough new criminal penalties for corporate fraud. Management, boards of directors, accounting and legal professionals, analysts and others who currently play by the rules should strongly reaffirm the benefits of ethical and honest behavior and disinterested service to their stockholders. Resources can be made available to the SEC to aggressively enforce disclosure rules to ensure that new activities like OTC derivatives are clearly and forthrightly reported. Executives, accountants and attorneys who violate securities laws should be punished severely.

However, it would be a mistake to make OTC derivatives trading a scapegoat for Enron's fall. As noted above, Enron collapsed because of failures in corporate governance and the inability of those outsiders charged with overseeing Enron's activities to effectively monitor its activities. It is likely that similar problems existed at WorldCom, resulting in more substantial financial statement irregularities.

Based on their notional amounts, derivatives trading represent a larger market than equities in the United States. 14 Any direct interference with the functioning of this market, which has come to play an essential risk management role in the financial system, would be a mistake. Even indirect regulation, through burdensome disclosure requirements of derivatives activities, may negatively impact the ability of counterparties to structure creative flexible instruments to transfer specific risks.

Enron's high-profile failure has disrupted the lives of its employees and investors. Fallout from the collapse has lead to the demise of Arthur Andersen. However, inadequate regulation of derivatives was not to blame.

Footnotes
1 "Building the House of Enron: As Enron's Derivatives Trading Comes Into Focus, Gap in Oversight is Spotlighted", Michael Schroeder, Wall Street Journal, Jan. 28, 2002, p. C1. 2 Ibid. 3 While Greenwich, Conn., hedge fund Long Term Capital Management lost $4.6 billion on derivatives with a notional amount of more than $1 trillion and the bankruptcy of Orange County, Calif., resulted from ill-advised derivatives trading activities, in both cases extremely risky trading and hedging strategies were to blame, not derivatives themselves. While Enron has been compared by some to LTCM, it is important to note that Enron made more money trading derivatives in the year 2000 than LTCM made in its history. 4 "Enron and the Use of Derivatives", Frank Partnoy, Testimony before the Senate Committee on Governmental Affairs, Testimony 02-3, March 2002, p. 2. 5 Ibid. at p. 2 6 "Enron and the Dark Side of Shareholder Value", William W. Bratton, Public Law and Legal Theory Working Paper N. 035, George Washington University School of Law (2002), p. 43. 7 "Could Enron's Business Model Actually Work" Daniel Altman, New York Times, Jan. 28, 2002. 8 Bratton, pp 22-47. 9 Ibid. at p. 52. 10 Ibid. at p. 53. Now in bankruptcy, Enron was a mere 12 months ago regarded as one of the largest energy companies in the world, and ranked as one of the top 10 largest corporations in the United States. Enron was named by Fortune magazine as "America's Most Innovative Company," "Number One in Quality of Management" and "Number 2 in Employee Talent." Enron was once held up to the world as a model corporation, one that encompassed all of the wonders and genius of capitalism.

· Risk Transfer

2 Sep 2002 in Volume 1 Issue 1

Keeping an eye on the weather: the use of derivatives

The US Department of Commerce estimates that 80 per cent of US companies are affected by the weather, and the Department of the Treasury asserts that weather has a direct impact on 20 per cent of the economy. For many businesses, just the wrong kind of weather can cause a painful uncertainty in earnings or cash flow, and for some businesses, weather is the single largest source of financial uncertainty. Stephen Velotti outlines the benefits of weather derivatives and sums up the current market.

While insuring against the weather has been around for a long time, only now are businesses starting to see the advantages of hedging weather risk. There are an ever-increasing variety of products available to businesses to protect against weather risk, and a more sophisticated market for delivering those services.Unlike the sophisticated operations of energy companies, the solution to weather risk does not have to be as elaborate as an in-house weather derivative trading desk, as many energy companies are now adopting. For example, Corney and Barrow, owner of a chain of wine bars and restaurants in London, does a good deal more business on sunny days.

To stabilise its revenues against the vagaries of London’s weather, Corney and Barrow’s owner purchased a simple weather contract in summer 2000 that paid out L15,000 for each Thursday and Friday from June to September on which the temperature in London fell below 24ºC (75ºF), with a maximum payout of L100,000.

While the number of companies outside the energy sector hedging their weather risk remains relatively small, weather hedging has taken off like a rocket in the past four years, and continues to expand. Randall Dodd, director of the Derivatives Study Center in Washington DC, notes that the market for weather-based derivatives is one of the fastest-growing sectors of the derivatives market.
But Dodd also points out that there are factors that can limit the growth of weather hedging. One is the perennial problem of new markets: liquidity. There are still relatively few dealers in the market for weather options, and in a potential vicious circle, others could stay away for this reason, keeping markets problematically illiquid. Another potential hazard for dealers in weather risk is their own hedging. With weather there is no underlying commodity. The dealer in other kinds of derivatives can manage their risk by hedging in other sectors of the market. A long position on one security can be hedged by a short position in another. The only option is to use cross-commodity hedging principles that can lead to basis risk exposures. However, the potential size of the market continues to attract new entrants. According to a study by PricewaterhouseCoopers for the Weather Risk Management Association, hedging weather risk is now a $4.3bn industry, and the number of weather contracts grew by 43 per cent in 2002 from April.

Europe’s share of the market grew from 6 per cent in 2000 to 20 per cent last year, and Japan has seen some big recent contracts. New exchanges, weather indices and types of contracts also play a role in the industry’s growth. In Britain, the London International Financial Futures and Options Exchange announced its launch of weather future contracts in November 2001. In France, Euronext, an international European stock exchange, and Météo France, the French national weather information service, rolled out six weather-related indices providing high-quality data in January 2002. This autumn, a new US-based Weather Board of Trade has been given regulatory approval by the Commodities Futures Trading Commission to begin operations. The advantages of an independent index. The weather hedging structures in question differ from traditional insurance in important ways:

· Payouts are based on objective data, not assessed loss. Most insurance coverage pays off when the customer suffers a measurable financial loss. But ‘measurable’ is, of course, a matter of perspective, and differences between insurer and insured on the nature and amount of a given loss are not uncommon. The process of determining what is owed after a loss can be long and cumbersome;

· If the policy pays out, the company can still profit;

· There is no ‘moral hazard’. Insurance against risk can have a perverse effect on the behaviour of the insured: assuming a risk on behalf of a company may make that company more inclined to ignore that risk.

Measuring accumulated temperature: heating degree-days and cooling degree-days.

Weather contracts are structured around several quantifiable weather phenomena: precipitation, humidity, wind speed and temperature. Of these, temperature is the most common. Though average temperature seems a useful way to describe a season, most weather insurance contracts employ a unit that, while not as immediately intuitive, is a great deal more flexible: the degree-day.

Degree-days are used to measure the deviation of one day's average temperature from 65ºF. Most people feel ‘comfortable’ at this benchmark.

A heating degree-day (HDD), counter-intuitively, is a measure of cold weather. On a given day, the number of heating degree-days (HDD) is the higher of 0 or (65 minus the day's average temperature).

A cooling degree-day (CDD), then, is a measure of warm weather. On any given day, the number of CDDs is the higher of 0 or (the day's average temperature minus 65).

Definitions

Much of the language of weather insurance is borrowed from options contracts:

· A strike is a pre-determined index level at which a contract pays out. If the index is snowfall, the contract may strike at an accumulation of three feet.

· A binary strike triggers full coverage, as with the example of the three consecutive freezing days. There are no gradations of payout for a binary strike: the policy either pays out in full or not at all.

· A put pays off if an index is below the strike at the end of the time period specified in a contract. A CDD put would pay off if there were fewer than 3,000 CDDs total for a summer season.

· A call pays off if an index is above the strike at the end of the contract period.

· A tick is the amount paid per predetermined increment of the index. A tick may pay US$500,000 for every inch of snowfall above the strike.

Conclusion

The market for weather risk insurance is expanding in both size and geographical spread. The quality of data and the understanding of weather risk are continually improving. The products available are becoming ever more sophisticated and flexible, in line with the widely varying needs of end users. All of these developments point to a world not long off in which analysts and rating agencies expect all companies to hedge against even the most unpredictable factor in their business, the weather.

Stephen A. Velotti is vice president at Converium Reinsurance. He can be contacted at Stephen.velotti@converium.com

· CBS News Transcripts

SHOW: CBS Morning News (6:30 AM ET) - CBS

August 27, 2002 Tuesday

CBS Morning News, August 27, 2002
LENGTH: 345 words

HEADLINE: Real estate sales picking up around the nation

ANCHORS: JULIE CHEN

REPORTERS: BOB ORR

BODY:
JULIE CHEN, anchor:

Some investors, disillusioned with the stock market, are keeping their money closer to home. And for many, that's been a winning strategy. Bob Orr reports.

BOB ORR reporting:

In a stagnant economy, marred by accounting scandals, bankruptcies and layoffs, there is one shining star: Real estate is soaring. Homeowners are trading up, and renters are buying in. Sales of existing homes shot up 4 1/2 percent in July. And new construction sales were even hotter, up a staggering 6.7 percent. Buyers, attracted by the lowest mortgage interest rates in 40 years, also see home values rising at a time when other investments are flat or even falling.

Mr. DAVID SEIDERS (National Association of Home Builders): In the context of a flagging stock market and low interest rates on fixed-income investments, housing as an investment has really come to the forefront. So people--it's cheap to buy housing, in terms of the interest rates at least, and people are really thinking they're getting a good investment at the same time.

ORR: The housing boom is biggest in the Midwest, where July sales jumped 16 percent. New home sales rose 10 percent in the South, dipped slightly in the West and actually fell 9 percent in the Northeast. Prices overall are up 6 percent to 7 percent this year, and analysts expect more gains next year. Economists say they're not worried about an overheated housing market imploding, but home buyers should temper their expectations.

Mr. RANDALL DODD (Economic Strategy Institute): People getting into the market now and expecting a killing may be disappointed, but I don't think people are going to be losing their shirts, and they're not going to be suffering from the kind of reporting and accounting problems that we've had in the stock market.

ORR: Builders are already having a tough time meeting the demand for new homes, but with inventories being depleted and interest rates still at rock-bottom lows, that demand--in the short term, at least--is expected to grow. Bob Orr, CBS News, Washington.

· Corporate Officers and Directors Liability Litigation Reporter SPECIAL REPORT

August 19, 2002

SECTION: SECURITIES/CORPORATE GOVERNANCE/REGULATORY ISSUES; Vol. 18; No. 2; Pg. 10

LENGTH: 3022 words

HEADLINE: Regulation of Derivatives In a Post-Enron World

BYLINE: BY GEOFFREY ETHERINGTON AND BRIAN P. IAIA*; * Attorney Geoffrey Etherington III is a partner in the New York office of Edwards & Angell (www.ealaw.com) and Brian P. Iaia is an associate in the Hartford, Conn., office. Both are members of the firm's insurance and reinsurance practice group.

BODY:
Following the collapse of Enron late in 2001, journalists, regulators and legislators have criticized the over-the-counter derivatives trading and investing activities of Enron and other companies. Some have suggested that lack of regulation of the OTC derivatives market was a factor in the Enron debacle. 1 As Congress, the Securities and Exchange Commission, and the Justice Department continue their investigation of accounting irregularities, management fraud and self-dealing, and shortcomings or failures of independent directors, accountants and professionals, additional regulation of derivatives is being considered. 2

However, recent disclosures of improper accounting to inflate profits at companies like Enron and WorldCom do not appear to be related to derivatives activities. While Enron may have improperly accounted for derivatives transactions with its off-balance-sheet entities, before any effort is made to restrict, regulate or scale back the derivatives activities of financial market participants as a reaction to Enron, it is essential to recognize the crucial role of derivatives in ensuring the efficient and orderly functioning of global financial markets. 3

The last decade has witnessed dramatic growth in derivatives trading activities. In 2000 the notional value of exchanged-traded derivatives was $13 trillion to $14 trillion. OTC derivatives traded during the same period were at least $95.2 trillion (and probably much higher). 4 Derivatives are considered an essential arrow in any sophisticated corporate risk manager's quiver of tools to reduce business, portfolio, credit, interest-rate and currency risk. OTC derivatives in particular can be tailored to hedge risks and reduce volatility associated with both assets and liabilities, as well as operating results. Such risk management strategies benefit all constituencies by transferring exposures to other market participants, who are prepared to bear the consequences of a loss in return for the premium or fee earned to accept the risk.

Randall Dodd, director of the Derivatives Study Center in Washington, D.C., which conducts policy research with a grant from the Ford Foundation, stated in an April 2002 interview with Challenge magazine, " T here are four basic types of derivatives transactions: forwards, futures, swaps, and options. These instruments are sometimes combined to form more complicated transactions, but in the vast majority of cases, they are straightforward versions of the four types."

Many types of instruments are considered derivatives. Frank Partnoy, a professor at the University of San Diego School of Law who has studied Enron's derivatives transactions, told the Senate Committee on Government Affairs that 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." 5

However, derivatives contracts can address a much broader range of risks such as those related to weather, bond defaults, exchange rates or interest rates to name a few.

A distinguishing characteristic of derivatives is that risk is transferred or hedged for a premium or fee. Thus, a pension fund with a large position in a telecommunications company may enter into an OTC derivative contract with an investment banker to "put" some or all of the stock for a specified price. The pension fund agrees to pay the investment banker a fee for the right to put and has effectively transferred the risk of a price decline below the notional value of the contract to the banker for a cost equal to the fee.

A firm that operates warehouses across the upper Midwest may hedge against increased heating costs in the event of a harsh winter by purchasing a weather derivative from a heating oil company which pays off if temperatures that winter are particularly cold. The oil company never pays off the derivative if the winter is warm. The oil company will increase its income in a warm winter (from the fee) because the warm weather would have resulted in decreased oil sales. While the oil company's profits are reduced during a cold winter by paying off the derivative, and the warehouse firm has higher expenses in a warm winter, both may be willing to enter into the OTC derivative transaction to reduce the volatility of their operating results.

The benefits to the company (and its owners) of transferring the risk in an OTC transaction are obvious. For the fee paid to its counterparty, it has effectively reduced the volatility of the related asset or liability or stabilized operating results, which will smooth out its fi nancial performance in the long term. The counterparty m ay in fact be hedging the risk accepted with another OTC derivative contract or an asset or liability position, simply diversifying a portfolio of risks or itself transferring a different risk. In addition, if the counterparty is never called upon to perform under the original OTC derivative, it will recognize income equal to the fee.

When any OTC derivative transaction is proposed, each party must analyze the ability of the other to perform its future obligations. While it is possible to secure those obligations, often parties rely upon rating agencies or financial data that is either publicly available or provided privately to determine counterparty credit risk. While Enron ultimately did not prove to be a credit-worthy participant in the derivatives markets, in fact most counterparties to OTC derivative transactions are large public corporations and financial institutions like commercial banks, investment banks, insurance companies and hedge funds.

More importantly, however, many counterparties were aware of Enron's precarious financial condition and the uncertain value of the assets it was leveraging and took steps to minimize credit risk, such as guarantees or other contingent commitments from Enron or credit enhancements such as insurance policies and letters of credit. While not all such efforts were successful, the market clearly reacted to Enron's condition and tried to address it. 6

The collapse of Enron to some appeared to be a warning bell of imminent financial collapse under the weight of unregulated OTC derivatives activities. However, there has been no collapse and there is nothing inherently unsafe or unsound about OTC derivatives trading or the risk transfers effected between market participants. The sheer scale of the OTC derivatives market and the sophistication of its participants evidence the impor tance of OTC derivatives to the financial system. Regulatory or legislative tinkering with the market could have far-reaching and unintended consequences.

It should be noted that other players were quick to take the place of Enron in trading energy derivatives and that the commodity markets for gas and power, in which OTC derivatives play a vital role, functioned normally. 7 Swiss investment bank UBS Warburg was confident enough in Enron's trading business to purchase its technology platform out of bankruptcy. The OTC derivatives markets continue to develop and mature and the prudent course of action may be as little governmental interference in their functioning as possible.

OTC derivatives are essentially private contracts between sophisticated parties, and have developed as highly flexible financial instruments. For this reason, they may be inherently unsuitable to regulation. Any effort to force derivative transactions into certain forms or procedures, or to require review, qualification or registration of derivatives with the SEC (or a new federal agency) is likely to make the process of completing an OTC derivative transaction so cumbersome and time-consuming that most, if not all, of their value to risk managers would be lost. While proposals to require disclosure of information specifically about derivatives activities may seem less problematic, the complex and varied nature and scope of OTC derivatives may make effective regulation of disclosures extremely difficult.

As subsequent investigation into Enron and the obstruction-of-justice trial of auditor Arthur Andersen LLP have revealed, Enron's collapse was the result of a combination of market reversals, fraudulent self-dealing and improper behavior by individual corporate officers and the failure of internal and external controls and monitors to identify deficiencies in accounting treatment and disclosure or, if discovered, to adequately and timely take corrective measures. Enron's derivatives trading activities may have been improperly booked and its internal risk management policies were probably not followed. Self-dealing by Enron employees at many levels appears to have been rampant. Enron leveraged its assets dramatically and used its stock as collateral, creating a potential death spiral for its stock price when its debt ratings or stock price fell. 8

However, Enron collapsed in large part because "Enron's managers, with a belief system biased toward winning, lost touch with hard economic constraints and the rules of the game." 9 In fact, management was so committed to the perceived efficacy of the Enron business model that it may have resorted to fraud to ensure Enron's unbroken string of successes would continue. 10 Arthur Andersen and other professionals, if not actively participating in "cooking the books" and "hiding the skeletons," certainly bear some responsibility for not requiring earlier disclosure or actions relating to the serious deficiencies in management, and financial and ethical standards and controls.

The derivatives trading business model pioneered by Enron, however, should not be blamed for the company's collapse. In fact, Enron made billions trading derivatives, but it lost billions on virtually everything else it did, including projects in fiber-optic bandwidth, retail gas and power, water systems, and even technology stocks. 11 Specifically, Enron reported gains from derivatives of $4.04 billion in 1998, $5.34 billion in 1999 and $7.23 billion in 2000, yet Enron's non-derivatives gross margin (the difference between non-derivatives revenues and non-derivatives expenses) shows in a general sense that Enron's non-derivatives business made some money in 1998, broke even in 1999 and actually lost money in 2000.

Accounting improprieties unrelated to derivatives trading have been uncovered at WorldCom, Xerox and elsewhere, and many experts believe these improprieties are more significant than those at Enron. In the case of WorldCom, it initially appears that management and outside advisers are largely to blame for a pattern of accounting irregularities that inflated profits and increased stock prices.

With each revelation about efforts by managers of public companies to artificially inflate earnings and hide expenses, sometimes with the tacit approval of boards of directors and outside professionals, it is evident that Enron's failure did not result from the inadequate regulation regarding disclosure of derivatives trading activities. Rather, a more basic problem existed at Enron -- a perception that technical compliance with accounting standards and disclosure requirements was enough, even when such technical compliance was misleading or, even worse, inaccurate.

While sophisticated analysts may have been aware that Enron was pursuing a strategy to convert itself from a conventional energy company to a trading firm that was hedging exposures through derivatives and leveraging its assets using its own stock as currency, because Enron did not clearly and prominently reveal this strategy and its extensive use of "off balance sheet" entities to inflate profits, the capital markets may not have had a clear picture of the nature of Enron's business. 12 However, most, if not all, of this was due to purposeful accounting obfuscation. If Enron had honored the intent of financial disclosure regulations or if its auditors had insisted that some of the questionable special purpose vehicles be accounted for as consolidated entities and that profits from derivatives transaction with related parties that did not effectively transfer risk be footnoted in a straightforward and succinct fashion, Enron might still be in business trading OTC derivatives today.

Under SEC or regulatory accounting rules or contractual requirements, sophisticated participants in the OTC derivatives markets currently provide significant amounts of information about their derivatives trading activities to regulators and/or their investors. Even Enron made disclosure about its OTC derivatives trades with related entities in its 2000 financial statements, although those disclosures were buried within a footnote and difficult for anyone except sophisticated analysts to decipher. 13

It may be necessary for the SEC to review how it applies disclosure and accounting rules to ensure that trading companies that follow Enron into the virtual trading floor that it is developing for derivative instruments and counterparties of those traders are including proper and complete disclosure of their derivatives activities. The SEC has the power to require such disclosure currently with only modest rule changes and without any significant new regulatory or legislative initiative.

Under current securities laws, disclosures that omit material facts necessary to make those disclosures not misleading are prohibited and may lead to private rights of actions. A recommitment to this standard may prevent future Enrons. Investors and regulators should insist that public companies and their professional advisers comply with the spirit of SEC regulations like its Rule 10b-5. Indeed, President Bush said in a July 9, 2002, speech, "The lure of heady profits of the late 1990s spawned (corporate) abuses and excesses. With strict enforcement and higher ethical standards, we must usher in a new era of integrity in corporate America."

Bush went on to say, "The American economy is the most creative, enterprising and productive system ever devised . High-profile acts of (corporate) deception have shaken people's trust. Too many corporations seem disconnected from the values of our country. These scandals have hurt the reputations of many good and honest companies . It is time to reaffirm the basic principles and rules that make capitalism work: truthful books and honest people and well-enforced laws against fraud and corruption."

Bush vowed to use the full weight of the law to expose and root out corruption and to propose tough new criminal penalties for corporate fraud. Management, boards of directors, accounting and legal professionals, analysts and others who currently play by the rules should strongly reaffirm the benefits of ethical and honest behavior and disinterested service to their stockholders. Resources can be made available to the SEC to aggressively enforce disclosure rules to ensure that new activities like OTC derivatives are clearly and forthrightly reported. Executives, accountants and attorneys who violate securities laws should be punished severely.

However, it would be a mistake to make OTC derivatives trading a scapegoat for Enron's fall. As noted above, Enron collapsed because of failures in corporate governance and the inability of those outsiders charged with overseeing Enron's activities to effectively monitor its activities. It is likely that similar problems existed at WorldCom, resulting in more substantial financial statement irregularities.

Based on their notional amounts, derivatives trading represent a larger market than equities in the United States. 14 Any direct interference with the functioning of this market, which has come to play an essential risk management role in the financial system, would be a mistake. Even indirect regulation, through burdensome disclosure requirements of derivatives activities, may negatively impact the ability of counterparties to structure creative flexible instruments to transfer specific risks.

Enron's high-profile failure has disrupted the lives of its employees and investors. Fallout from the collapse has lead to the demise of Arthur Andersen. However, inadequate regulation of derivatives was not to blame.

Footnotes
"Building the House of Enron: As Enron's Derivatives Trading Comes Into Focus, Gap in Oversight is Spotlighted", Michael Schroeder, Wall Street Journal, Jan. 28, 2002, p. C1. 2 Ibid. 3 While Greenwich, Conn., hedge fund Long Term Capital Management lost $4.6 billion on derivatives with a notional amount of more than $1 trillion and the bankruptcy of Orange County, Calif., resulted from ill-advised derivatives trading activities, in both cases extremely risky trading and hedging strategies were to blame, not derivatives themselves. While Enron has been compared by some to LTCM, it is important to note that Enron made more money trading derivatives in the year 2000 than LTCM made in its history. 4 "Enron and the Use of Derivatives", Frank Partnoy, Testimony before the Senate Committee on Governmental Affairs, Testimony 02-3, March 2002, p. 2. 5 Ibid. at p. 2 6 "Enron and the Dark Side of Shareholder Value", William W. Bratton, Public Law and Legal Theory Working Paper N. 035, George Washington University School of Law (2002), p. 43. 7 "Could Enron's Business Model Actually Work" Daniel Altman, New York Times, Jan. 28, 2002. 8 Bratton, pp 22-47. 9 Ibid. at p. 52. 10 Ibid. at p. 53. Now in bankruptcy, Enron was a mere 12 months ago regarded as one of the largest energy companies in the world, and ranked as one of the top 10 largest corporations in the United States. Enron was named by Fortune magazine as "America's Most Innovative Company," "Number One in Quality of Management" and "Number 2 in Employee Talent." Enron was once held up to the world as a model corporation, one that encompassed all of the wonders and genius of capitalism.

11 Partnoy at pp. 20-21. 12 Ibid. at p. 53. 13 Partnoy at p. 8. 14 Ibid. at p. 2.

· The McGraw-Hill Companies, Inc. www.mcgraw-hill.com
Gas Daily

August 12, 2002

SECTION: Vol. 19, No. 153; Pg. 3

LENGTH: 576 words

HEADLINE: Sen. Harkin floats tougher derivatives bill

BYLINE: CC

BODY:
An industry group would enforce trading rules for over-the-counter energy derivatives and increase penalties for market players guilty of manipulating prices under draft legislation proposed by Senate Agriculture Committee Chairman Tom Harkin, D-Iowa.

The proposal, which would amend legislation introduced by Sen. Dianne Feinstein, D-Calif., and co-sponsored by Harkin and ranking committee minority member Richard Lugar, R-Ind., appears to contain tougher enforcement over OTC energy trading than did the original bill introduced July 11. Feinstein's bill would eliminate the current exemption from federal oversight that energy and metals derivatives enjoy under the Commodity Futures Modernization Act of 2000. The draft amendment, which was obtained by Platts last week, would allow the Commodity Futures Trading Commission to appoint a futures association to establish and enforce rules for the OTC energy market. The CFTC also would be able to enforce regulations to deter market abuses.

In addition, Harkin's draft would impose civil penalties of up to $ 1 million for each violation or triple the monetary gain to the party for each violation in cases of price manipulation or attempted manipulation. The proposal would make it a felony punishable by a fine of up to $ 1 million and/or 10 years in prison for market manipulation.

The committee could take up the draft when Congress returns from its month-long summer recess next month.

Feinstein's bill, which was blocked earlier this year and then revived last month, calls for the CFTC to investigate allegations of fraud and manipulation, while subjecting electronic trading platforms to registration and disclosure requirements. So-called ''many-to-many'' exchanges would have to have enough capital to carry out their operations, while bilateral dealers would have to adopt a ''value-at-risk model'' approved by the CFTC to meet their financial obligations.

Opponents of the Feinstein bill last week expressed concern over Harkin's alternative. For instance, the International Swaps and Derivatives Association noted that the Harkin proposal ''goes beyond the scope'' of Feinstein's original bill with its provision for a futures association to enforce rules for OTC market participants.

But Feinstein bill proponent Randall Dodd, of the Derivatives Study Center, said the political and business climates are likely to be more receptive to added regulation of OTC energy trading following the revelations of the Enron debacle and disclosures of how large financial institutions may have propped up the energy trader.

''Knee-jerk defenders of the free market are now embarrassed,'' Dodd said. ''People are just realizing that supervision is a good thing.''

But the Feinstein bill's primary opponent in Congress -- Texas Republican Sen. Phil Gramm -- is almost certain to resume his fight against the measure should it clear the committee this fall, sources said. Gramm earlier this summer beat back an effort by Feinstein to include her measure in the Senate's version of a broad energy bill. ''The majority of the Senate already spoke against it,'' an aide to Gramm said.

Supporters of derivatives reform might find it difficult to bring either derivatives bill to the floor. Much of the Senate's time is expected to be taken up this fall by appropriations bills and legislation to establish a Homeland Security Department.

· The McGraw-Hill Companies, Inc. www.mcgraw-hill.com

Metals Week

August 12, 2002

SECTION: GOVERNMENT; Vol. 73, No. 32; Pg. 7

LENGTH: 484 words

HEADLINE: New version of US derivatives legislation even tougher

DATELINE: Washington

BODY:
An industry group would enforce trading rules for over-the-counter metals derivatives and increase penalties for market players guilty of manipulating prices under draft legislation proposed by US Senate Agriculture Committee Chairman Tom Harkin (Democrat-Iowa). The proposal, which would amend legislation introduced by Sen Dianne Feinstein (D-California), and co-sponsored by Harkin and ranking committee member Richard Lugar (Republican-Indiana), appears to contain tougher enforcement over OTC trading than the original bill introduced on Jul 11.

Feinstein's bill would eliminate the exemption from federal oversight that energy and metals derivatives enjoy under the Commodity Futures Modernization Act of 2000. The draft amendment, obtained by Platts on Aug 8, would allow the Commodity Futures Trading Commission to appoint a futures association to establish and enforce rules for the OTC market. The CFTC also would be able to enforce regulations to deter market abuses. In addition, Harkin's draft would impose civil penalties of up to $ 1-mil for each violation, or triple the monetary gain to the party for each violation in cases of price manipulation or attempted manipulation. The proposal would make it a felony punishable by a fine of up to $ 1-mil and/or ten years in prison for price manipulation.

The committee could take up the draft when Congress returns in September from its month-long summer recess.

Feinstein's bill calls for the CFTC to investigate allegations of fraud and manipulation while subjecting electronic trading platforms to registration and disclosure requirements. "Many-to-many" exchanges would have to have enough capital to carry out their operations while bilateral dealers would have to adopt a "value-at-risk model" approved by the CFTC to meet their financial obligations.

Opponents of the Feinstein bill expressed concern over Harkin's version, with the International Swaps and Derivatives Assn saying it "goes beyond the scope" of Feinstein's bill with its provision for a rule-enforcing association.

But Feinstein bill proponent Randall Dodd of the Derivatives Study Center said more regulation of OTC energy and metals trading is likely in the current environment. "Knee-jerk defenders of the free market are now embarrassed," said Dodd. "People are just realizing that supervision is a good thing."

The bill's primary opponent in Congress is Texas Republican Sen Phil Gramm, seen as certain to resume his fight against the measure should it clear the committee this fall. Gramm earlier this summer beat back an effort by Feinstein to include her measure in the Senate's version of a broad energy bill.

"The majority of the Senate already spoke against it," an aide to the senator said. Bill supporters will also likely find it difficult to find time to bring the bill to the floor, due to other priorities on the Senate's agenda.

· Electric Utility Week (formerly Electrical Week)

The McGraw-Hill Companies, Inc.

August 12, 2002

SECTION: RATES & REGULATIONS; Pg. 14

LENGTH: 553 words

HEADLINE: SENATE AG CHAIR OFFERS TOUGHER BILL TO REGULATE OTC DERIVATIVES

BODY:
An industry group would enforce trading rules for over-the-counter energy derivatives and increase penalties for market players guilty of manipulating prices under draft legislation proposed by Senate Agriculture Committee Chairman Tom Harkin (D-Iowa).

The proposal, which would amend legislation introduced by Sen. Dianne Feinstein (D-Calif.), and cosponsored by Harkin and ranking committee member Richard Lugar (R-Ind.), appears to contain tougher enforcement over OTC energy trading than did the original bill introduced July 11. Feinstein's bill would eliminate the current exemption from federal oversight that energy and metals derivatives enjoy under the Commodity Futures Modernization Act of 2000. The draft amendment, which was obtained by Platts Thursday, would allow the Commodity Futures Trading Commission to appoint a futures association to establish and enforce rules for the OTC energy market. The CFTC also would be able to enforce regulations to deter market abuses.

In addition, Harkin's draft would impose civil penalties of up to $ 1-million for each violation or triple the monetary gain to the party for each violation in cases of price manipulation or attempted manipulation. The proposal would make it a felony punishable by a fine of up to $ 1-million and/or 10 years in prison for price manipulation. The committee could take up the draft when Congress returns from its month-long summer recess next month.

Feinstein's bill calls for the CFTC to investigate allegations of fraud and manipulation, while subjecting electronic trading platforms to registration and disclosure requirements. Many-to-many exchanges would have to have enough capital to carry out their operations while bilateral dealers would have to adopt a ''value-at-risk model'' approved by the CFTC to meet their financial obligations.

Opponents of the Feinstein bill yesterday expressed concern over the Harkin's alternative. The International Swaps and Derivatives Assn. noted that the chairman's proposal ''goes beyond the scope'' of Feinstein's original bill with its provision for a futures association to enforce rules for OTC market participants.

But Feinstein bill proponent Randall Dodd of the Derivatives Study Center said the political and business climates are likely to be more receptive to more regulation of OTC energy trading following the revelations of the Enron debacle and disclosures of how large financial institutions may have propped up the energy trader. ''Knee-jerk defenders of the free market are now embarrassed,'' said Dodd. ''People are just realizing that supervision is a good thing.'' But the bill's primary opponent in Congress -- Texas Republican Sen. Phil Gramm -- is considered certain to resume his fight against the measure should it clear the committee this fall. Gramm earlier this summer beat back an effort by Feinstein to include her measure in the Senate's version of a broad energy bill. ''The majority of the Senate already spoke against it,'' an aide to the senator said.

Bill supporters will also likely find it difficult to find time to bring the bill to the floor. Much of the Senate's time is expected to be taken up this fall by appropriations bills and legislation to establish a Homeland Security Dept.
URL: http://www.platts.com

· Platt's Oilgram News

August 12, 2002

SECTION: Vol. 80, No. 153; Pg. 5

LENGTH: 595 words

HEADLINE: HARKIN DRAFTS TOUGHER ENERGY TRADING BILL

BYLINE: Catherine Cash

DATELINE: Washington

HIGHLIGHT:
Oversight of derivatives trade in US at issue

BODY:
An industry group would enforce trading rules for over-the-counter energy derivatives and market players guilty of manipulating prices would be hit hard in the wallet under draft legislation proposed by Senate Agriculture Committee chairman Tom Harkin (Democrat-Iowa).

The proposal, which would amend legislation introduced by Sen. Dianne Feinstein (Democrat-California), and cosponsored by Harkin and ranking committee member Richard Lugar (Republican-Indiana), appears to contain tougher enforcement over OTC energy trading than the original bill (S. 2724) introduced July 11.

Feinstein's bill would eliminate the current exemption from federal oversight that energy and metals derivatives enjoy under the Commodity Futures Modernization Act of 2000. Harkin's draft amendment, obtained by Platts, would allow the Commodity Futures Trading Commission to appoint a futures association to establish and enforce rules for traders or trading platforms with contracts or transactions in the OTC energy market. The CFTC also would be able to enforce regulations to deter market abuses. In addition, the draft would impose civil penalties of up to $ 1-mil or triple the monetary gain for each violation in cases of price manipulation or attempted manipulation. The proposal also would make such price manipulation a felony punishable by a fine of up to $ 1-mil and/or up to 10 years in prison.

A Harkin aide Aug 9 described the draft as "very, very preliminary" and said it had not yet been circulated to all staff. The committee could take up the draft when Congress returns from its summer recess next month, but the aide said scheduling would be tight because the committee must address drought-relief legislation.

Feinstein's bill calls for the CFTC to investigate allegations of fraud and manipulation, while subjecting electronic trading platforms to registration and disclosure requirements. Many-to-many exchanges would have to have enough capital to carry out their operations while bilateral dealers would have to adopt a "value-at-risk model" approved by the CFTC to meet their financial obligations.

Opponents of the Feinstein bill expressed concern over the Harkin alternative. The International Swaps and Derivatives Association noted the proposal "goes beyond the scope" of Feinstein's bill with its provision for a futures association to enforce rules for OTC market participants.

But Feinstein bill proponent Randall Dodd of the Derivatives Study Center said there is a more receptive climate to increased regulation of OTC energy trading following the Enron debacle and revelations of bogus "wash" trading. "Knee-jerk defenders of the free market are now embarrassed," said Dodd. "People are just realizing that supervision is a good thing."

The primary opponent in Congress of such increased regulation, Texas Republican Sen. Phil Gramm, is considered certain to resume his fight should the Harkin draft clear the committee this fall. Gramm earlier this summer beat back an effort by Feinstein to include her measure in the Senate's version of a broad energy bill. "The majority of the Senate already spoke against it," an aide to the senator said.

Bill supporters will also likely find it difficult to find time to bring the bill to the floor. Much of the Senate's time is expected to be taken up this fall by appropriations bills and legislation to establish a Homeland Security Department

· Megawatt Daily

August 9, 2002

SECTION: Vol. 7, No. 151; Pg. 8

LENGTH: 553 words

HEADLINE: Senate Ag chairman toughens Feinstein's OTC derivatives bill

BODY:
An industry group would enforce trading rules for over-the-counter energy derivatives and increase penalties for market players guilty of manipulating prices under draft legislation proposed by Senate Agriculture Committee Chairman Tom Harkin (D-Iowa).

The proposal, which would amend legislation introduced by Sen. Dianne Feinstein (D-Calif.), and cosponsored by Harkin and ranking committee member Richard Lugar (R-Ind.), appears to contain tougher enforcement over OTC energy trading than did the original bill introduced July 11. Feinstein's bill would eliminate the current exemption from federal oversight that energy and metals derivatives enjoy under the Commodity Futures Modernization Act of 2000. The draft amendment, which was obtained by Platts Thursday, would allow the Commodity Futures Trading Commission to appoint a futures association to establish and enforce rules for the OTC energy market. The CFTC also would be able to enforce regulations to deter market abuses.

In addition, Harkin's draft would impose civil penalties of up to $ 1-million for each violation or triple the monetary gain to the party for each violation in cases of price manipulation or attempted manipulation. The proposal would make it a felony punishable by a fine of up to $ 1-million and/or 10 years in prison for price manipulation. The committee could take up the draft when Congress returns from its month-long summer recess next month.

Feinstein's bill calls for the CFTC to investigate allegations of fraud and manipulation, while subjecting electronic trading platforms to registration and disclosure requirements. Many-to-many exchanges would have to have enough capital to carry out their operations while bilateral dealers would have to adopt a ''value-at-risk model'' approved by the CFTC to meet their financial obligations.

Opponents of the Feinstein bill yesterday expressed concern over the Harkin's alternative. The International Swaps and Derivatives Assn. noted that the chairman's proposal ''goes beyond the scope'' of Feinstein's original bill with its provision for a futures association to enforce rules for OTC market participants.

But Feinstein bill proponent Randall Dodd of the Derivatives Study Center said the political and business climates are likely to be more receptive to more regulation of OTC energy trading following the revelations of the Enron debacle and disclosures of how large financial institutions may have propped up the energy trader. ''Knee-jerk defenders of the free market are now embarrassed,'' said Dodd. ''People are just realizing that supervision is a good thing.''

But the bill's primary opponent in Congress -- Texas Republican Sen. Phil Gramm -- is considered certain to resume his fight against the measure should it clear the committee this fall. Gramm earlier this summer beat back an effort by Feinstein to include her measure in the Senate's version of a broad energy bill. ''The majority of the Senate already spoke against it,'' an aide to the senator said.

Bill supporters will also likely find it difficult to find time to bring the bill to the floor. Much of the Senate's time is expected to be taken up this fall by appropriations bills and legislation to establish a Homeland Security Dept.
URL: http://www.platts.com

· The Washington Daybook

July 10, 2002

ORGANIZATION: Senate Agriculture, Nutrition and Forestry Committee

COMMITTEE: Senate Agriculture, Nutrition and Forestry Committee

EVENT: Full committee hearing on Commodity Futures Trading Commission regulation and oversight of derivatives.

TIME: 9:30 a.m.

LOCATION: 106 Dirksen Senate Office Building

CONTACT: 202-224-6901 http://agriculture.senate.gov

PARTICIPANTS: Sen. Dianne Feinstein, D-CA; James Newsom, chairman, CTFC; Tom Erickson, commission, CFTC; Randall Dodd, director, Derivatives Study Center; John Coffee, law professor, Columbia; Richard Green, chairman, Aquila; Neil Wolkoff, COO, New York Mercantile Exchange; Don Moorehouse, International Swaps and Derivatives Association

TYPE: Hearing (Revised)

PERSON: DIANNE FEINSTEIN (91%); RICHARD C GREEN JR (91%);

LN-ORG: COMMODITY FUTURES TRADING COMMISSION (92%); NEW YORK MERCANTILE EXCHANGE (81%);

COMPANY: COMMODITY FUTURES TRADING COMMISSION (92%); NEW YORK MERCANTILE EXCHANGE (81%); COMMODITY FUTURES TRADING COMMISSION (76%);

· The Arkansas Democrat-Gazette

June 27, 2002, Thursday

SECTION: BUSINESS; Pg. D1

LENGTH: 1229 words

HEADLINE: Prices provoked Des Arc farmer

BYLINE: DAVID MERCER, ARKANSAS DEMOCRAT-GAZETTE

BODY:
After almost 13 years of delays, a suit filed by farmers accusing 26 Chicago Board of Trade officials of driving down the price of soybeans for their own gain will go to trial in September.
The class-action suit was filed by Des Arc farmer and longtime agricultural activist Harvey Joe Sanner and a few other soybean growers, who say they and thousands like them lost millions of dollars in the summer of 1989 as prices unexpectedly fell.
The suit claims that an order that summer by the Board of Trade forced anyone with large soybean futures contracts to sell them, enriching some board officials or grain-trading and processing firms they worked for or owned.
"There was a 40-cent [per bushel] drop in the futures price immediately following the emergency order, and the cash price drop closely followed that," said Terrance Reed, a Washington, D.C., attorney representing the farmers. "It's a pretty significant drop."
The exchange has denied the allegations, saying the order was intended to protect the market from an Italian company that it believed was trying to corner the soybean market.
Neither the Board of Trade nor its attorneys returned calls this week seeking comment on the suit. Earlier this month, U.S. District Court Judge Wayne Andersen set the trial for Sept. 9 in Chicago.
Attorneys for the Board of Trade have filed at least seven motions over the years to have parts or all of the farmers' case dismissed or pared, arguing at times that the farmers lacked standing to sue the commodities exchange, that there was no evidence of a conspiracy to depress prices and that the farmers couldn't prove they had been harmed by falling prices. Twice the suit was dismissed, only to be reinstated on appeal.
The suit names the Board of Trade and the 26 individuals, all members at the time of its board of directors -- which issued the order -- or its business conduct committee. Many of them also were employees or owners of grain-processing and trading firms that, the suit claims, stood to lose money if soybean prices remained high.
The class represented by the suit, Reed said, includes anyone who sold soybeans into the cash market between July 11, 1989, and the end of that month, potentially tens of thousands of farmers. They seek the money they believe they lost to price declines, a figure Sanner puts at around $ 150 million. Reed says the figure is much lower, "more than $ 10 million."
A witness for the farmers, University of California professor Jeffrey Williams, estimated the traders and grain companies who stood to lose if prices remained high made $ 5 million or more when prices dropped.
'JUST LIKE ENRON'
While the dollar amounts aren't necessarily huge, the case is significant because the Board of Trade officials with links to companies that might benefit from the order to sell soybean contracts took part in the decision to issue it, said Randall Dodd, director of the Derivatives Study Center, a Washington, D.C., think tank.
"Just like we're seeing with Enron and Dynegy," he said, "we're starting to identify that there are a lot of conflicts of interest within the business community that the market doesn't solve. The markets can't police themselves."
Much of the evidence farmers will rely on to make their case has been sealed until trial at the request of attorneys for the Board of Trade.
The passage of time has also blurred the memories of some involved, further obscuring some details.
"The novelty has worn off, let's just say," Williams said. "It's become just a test of memory."
Since the suit was filed, at least one of the named defendants has died, while most no longer hold leadership positions at the commodities exchange.
The 59-year-old Sanner has since stopped farming, leaving the operation of his farm to his two sons to become a full-time farm activist.
The Board of Trade is a 154-year-old exchange where futures -- contracts to buy or sell commodities at a future date at a set price -- are traded at a rate of more than 233 million contracts a year.
Farmers -- who generally sell the soybeans they grow into the cash market, where payment and delivery are immediate -- have long distrusted the Board of Trade, Dodd said.
"They've often felt the derivatives market drives down the prices of what they're trying to sell," Dodd said. "The Board of Trade is often naturally a target."
The term derivative refers to a financial contract, like the futures contracts, whose value is dependent on the commodity, bond, equity or currency it obligates its holder to either buy or sell.

To most farmers, Sanner included, much of the workings of the Board of Trade are a mystery, he said.
By 1989, though, soybean prices were rising to the benefit of growers.
The drought of 1988 had whittled American soybean stocks to less than 1 billion bushels for the first time since the early 1970s.
"All the signs were pointing to soybeans probably going to nine and a half [dollars per bushel] that year," Sanner said.
STRATEGY SUSPECTED
But the Board of Trade and the U.S. Commodity Futures Trading Commission, according to court documents, were concerned that Ferruzzi Finanziaria S.p.A., an Italian agribusiness and financial firm, had amassed an "unusually large soybean futures position" and was trying to corner the market.
Ferruzzi held more than 4,000 contracts to receive about 20 million bushels of soybeans, according to the Derivatives Study Center.
On July 11, 1989, the commission and the Board of Trade acted.
The commission sent a private letter to a Ferruzzi subsidiary ordering it to sell most of its futures contracts.
The Board of Trade took a broader step, publicly issuing what it called an emergency resolution ordering any trader who owned contracts for more than 3 million bushels of soybeans to reduce their holdings to 1 million bushels within 10 days, according to court documents.
Prices immediately tumbled, from $ 7.26 a bushel on July 11 to $ 6.80 by the end of the next day.
The plaintiffs believe about 25 cents of that loss is attributable to the action by the Board of Trade, Reed said.
Rather than being concerned over the actions of Ferruzzi, the suit claims the board was saving millions of dollars for large traders who held what are known as shorts -- contracts, in this case, to deliver soybeans to buyers that July, soybeans they didn't have. Traders with short positions sell something they don't yet have for delivery at a later date, betting prices will decline and they will be able to meet their obligations for less than what they were paid.
"They were going to have to come into the market and buy and they didn't want to do that," Sanner said. "Prices had been trending upward."
Those large traders included grain processors such as the Cargill Corp., commodities brokerage Stotler & Co., and others whose employees or owners were members of the Board of Trade's board of directors -- which issued the emergency resolution -- or on its business conduct committee.
Enron, the now-bankrupt energy trader, had only existed for a few years when the suit was filed, but may be on the minds of jurors, probably with a little prodding from the farmers' attorneys, Dodd said.
"I'm not the only one who is going to connect those dots," he said, "and that will be in the back of people's minds as the trial progresses."

· Salon

Foxes guarding the chicken coop
President Bush's nominees to the agency that should have regulated Enron instead helped write the rules that let the company do whatever it wanted in the first place.

- - - - - - - - - - - -
By Damien Cave

June 26, 2002 | Does anyone in the current administration even remember Enron? Judging by President Bush's two nominees to the Commodity Futures Trading Commission (CFTC), who appeared at Senate hearings on Tuesday, the answer is no.

If there was one thing that could legitimately be hoped for after the biggest corporate bankruptcy of all time, it was that accounting rules would be tightened, and the rush to dismantle regulatory oversight over the kind of complicated financial games that Enron specialized in would be reversed. But instead, the people most responsible for loosening the rules are being put in charge.

The CFTC is the government agency that is supposed to be the watchdog over such advanced "financial instruments" as derivatives trading. But Bush's nominees boast what critics call a laughable regulatory record. Walter Lukken is the drafter of a law passed in 2000 that gave Enron's online trading arm the right to act without a shred of oversight. Sharon Brown-Hruska is a free-market economist and protégé of Wendy Gramm, the former CFTC commissioner who, after shepherding through a regulatory exemption for Enron, resigned from the commission and joined the company's board of directors.

Enron's implosion last fall and winter was declared at the time to be a watershed event, a Teapot Dome-like scandal that would lead to new legislation, increased oversight and greater degrees of financial transparency. Enron, the argument went, would be the spark that set ablaze a fire of reform.

If anything, the wave of corporate accounting scandals that dominated the business headlines all spring might have been expected to give even more fuel to the forces of reform. On June 23, Treasury Secretary Paul O'Neill declared that he and the Bush administration were "outraged" at the current rash of corporate malfeasance.

But little has actually changed, and the backgrounds of the new nominees to the CFTC -- along with Congress' rejection, earlier this spring, of a bill aiming to give the CFTC more responsibility for regulating energy traders -- put the lie to O'Neill's rhetoric. More than six months after Enron declared bankruptcy, the regulatory landscape is largely the same as it was before Enron's problems became public. In fact, says Michael Greenberger, a law professor at the University of Maryland and the former director of trading and markets at the CFTC, "It's not changed at all."

"The mantra for not regulating is that these are isolated events," says Greenberger. "But when you look across the spectrum, how can it be an isolated event with Enron, with Tyco, Arthur Andersen, Global Crossing, Adelphia, ImClone and all the others? What's needed is a very dramatic reversal, almost to the kind Bush made with the Office of Homeland Security. And except for an accounting measure getting out of the Senate banking committee [which would create an independent board to oversee the industry], everything strong has failed."

Enron proved, among other things, that lobbying and large donations are an excellent way to rewrite the corporate rulebook. The list of the company's political victories is long and diverse. Electricity deregulation, the power to essentially veto appointments at the Federal Energy Regulatory Commission, passage of a law that exempted EnronOnline from all oversight -- these are just a few of the perks that Enron claimed on its way up the Fortune 500 ladder.

But perhaps no single instance demonstrates Enron's success better than its influence over the CFTC. The commission could have and should have been Enron's key regulator. The CFTC is the agency most closely aligned what turned out to be one of Enron's primary profit centers: derivatives trading.

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. Enron, although once primarily a trader in actual physical commodities such as gas and electricity, rapidly developed in the late '90s into a serious trader of derivatives based on a vast array of commodities.

The question of how to regulate derivatives has been at the heart of a vigorous, if abstruse, debate for the past 20 years between Wall Street and Washington. Enron has been in the middle of the battle, and until its demise, won every skirmish.

The first victory came in 1993. At that time, Enron's primary business was selling actual energy but the Houston company wanted to get involved in selling energy derivatives. But rather than put up with the oversight requirements of the CFTC, Enron lobbied for an exemption -- the right to trade energy derivatives without being subject to CFTC jurisdiction.

Wendy Gramm, chairwoman of the CFTC from February 1988 to January 1993, agreed. She shepherded the exemption through, and in April of 1993 -- after Gramm quit the CFTC and took a seat on Enron's board of directors -- the CFTC approved the policy Enron favored.

Enron took its exemption to the bank. Its derivatives business grew enormously over the next few years. Eventually, however, the exemption came up once again for debate. By the end of 1997, derivatives contracts of all kinds represented more than $25 trillion in real assets, and many in Congress -- and at the CFTC -- wanted to know more about their effects. Brooksley Born, a Clinton appointee who became the head of the CFTC in 1996, called for oversight.

"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."

But once again, Enron carried the day. A handful of legislators, including Sen. Phil Gramm, R-Texas (husband of Wendy Gramm), defeated the forces of regulation, with no small help from the U.S. Treasury Department, the Federal Reserve and the Securities and Exchange Commission. All three government agencies, though headed by Born's fellow Clinton appointees, scorned her new CFTC proposal. They even issued a rare joint statement declaring, "We have grave concerns about this action and its possible consequences. We seriously question the scope of the CFTC's jurisdiction in this area."

After a report favoring less regulation rather than more reached both houses, Congress acted. In December 2000, the Commodities Futures Modernization Act (CFMA) became law. The CFMA essentially established derivatives as a new, unregulated form of finance.

"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."

For those working under the law, however, the CFMA has proven hard to ignore. Thomas Erickson, a Clinton-appointed commissioner, says that the law has severely undermined the agency's ability to keep track of the economy. Not only does the law let companies deal in derivatives without maintaining established levels of capital (to protect against overextended investing), as banks are required to do; the law also protects companies from having to disclose information about their derivatives business.

"It's a black hole of information," says Erickson. "It's off our radar completely."

Ultimately, he adds, the law makes it much harder for the CFTC to do its job -- to hold companies accountable.

"It's a real challenge," Erickson says. "We've got so many built-in hurdles to an investigation that you have the possibility of having your jurisdiction questioned at every stage. Where we are today, I believe that we would be hard pressed to be able to reach the same kinds of settlements as we did before the CFMA, like with Sumitomo, a case where the commission earned a $150 million settlement for the manipulation of copper prices."

Immediately after Enron's bankruptcy, Sen. Dianne Feinstein, D-Calif., drafted legislation that aimed to close the loophole in the CFMA that allows energy trading to be exempt from regulatory oversight. The law would have put electronic energy exchanges like Enron's EnronOnline under CFTC jurisdiction: Companies would have to disclose information on trading volumes, players, profits and losses while also keeping capital reserves.

There is no guarantee that CFTC oversight could have prevented Enron's collapse. But experts argue that it would have made Enron's troubles more visible. Regulators have learned only recently that Enron controlled about 25 percent of all U.S. wholesale energy trades during its peak, and that during the California energy crisis, the company -- according to its own internal documents -- used its market power to manipulate the market. Feinstein maintains that her proposal, which would have put energy and metal trades under CFTC jurisdiction, would prevent a similar scenario from occurring elsewhere.

"In terms of energy derivatives, there seems to have been real gaming of the market, so it's clear that there needs to be some basic oversight," says Howard Gantman, a Feinstein spokesman. "It existed in the past -- until the CFMA -- and we'd like it to be returned."

But in order to achieve this goal, Feinstein has been forced to go up against many of the same forces that kept the CFTC impotent for much of the '90s. So far, she's lost. Her attempt to tie the legislation to the Senate energy bill failed in April by two votes.

"At present, there is no constituency for reform in the derivatives world, and there won't be until a major financial institution collapses -- which will happen," says Mayer, author of "The Fed" and more than a dozen other finance books. "Until then, the Fed, the SEC, the CFTC, the Treasury, Congress and the White House will all accept the industry's lunatic claim that the tightening of links between markets, the elimination of friction and the loss of redundancy improves the reported profits of derivatives transactions and stabilizes the system."

Bush's nominations to the CFTC add insult to injury for critics looking for real reform.

Brown-Hruska started her career as an economist whose Ph.D. thesis argued that markets self-correct against price manipulation -- no regulation or disclosure required. In 2001 she co-wrote an article for Barron's that argued against an SEC proposal that would force brokers to reveal how much they paid for exclusive market information.

She also served as chief economist at the CFTC from 1990 to 1995 under then-chairwoman Wendy Gramm. She now works as an assistant professor of finance at George Mason University's Mercatus Center -- a free-market think tank headed by Gramm, and which has received $50,000 from Enron since 1996.

Given the degree of outrage over Enron, says Greenberger, "the idea that a protégé of Wendy Gramm could be placed on the commission that will investigate this issue is mind boggling."

Lukken's record is similarly tainted. A former legislative assistant to Sen. Richard Lugar, R-Ind., Lukken has one major piece of legislation associated with him: the CFMA, a law which current CFTC commissioner Erickson describes as "Swiss cheese," meaning "there are so many holes that let you get out of the block."

"[Lukken and Brown-Hruska] don't represent any new thinking that will provide a remedy," says Randall Dodd, director of the Derivatives Study Center. "What needs to be done is broad rethinking of where the system has failed, and how to come up with new solutions. These people have never supported a government regulation in their life. And at this juncture, that's not the type of narrow-minded thinking that's needed."

Brown-Hruska declined to comment on her appropriateness for appointment to the CFTC.

Seth Boffelli, a spokesman for Sen. Tom Harkin, D-Iowa, who is chairing the hearings on the pair of Bush nominees, said only that "I'm sure there will be some tough questions asked and depending on what they say, we'll go from there."

To critics, Bush's nomination of two people who are the epitome of the deregulatory thinking that allowed Enron to get away with financial murder is a clear indication that no substantive changes can be expected from the current administration. But some potential critics are holding fire.

"I haven't seen significant change yet, but I think the jury is still out," says Brooksley Born, now in private practice. "Congress is still working on a number of things, and the administration itself is also in the process of working out some issues. So we have to wait and see."

But some critics argue that we are waiting and seeing our way into a continued financial meltdown. The signs are obvious, they say: The energy industry has been battered in the stock market; the NASDAQ is at lows not seen since Sept. 11.

"There's a crisis of confidence in the market, in energy in particular," says Erickson. "The participants no longer trust each other or have confidence in each other. I'm as interested as anyone else in seeing the markets grow and I think there are a few simple things that you can attach that instill confidence -- transparency, disclosure requirements. Those are the kinds of things that are the cornerstones of markets."

Robert Shiller, author of "Irrational Exuberance," agrees. "In the long run, business people are better off if we have good strong regulations in place to prevent shenanigans from happening," he says. "If people are getting upset, we need to take measures that have some teeth. The mood is souring; we need to do something."

· The Nightly Business Report

SHOW: NIGHTLY BUSINESS REPORT (NBR 6:30 pm ET)

June 18, 2002 Tuesday

Transcript # 061800cb.118

SECTION: BUSINESS

LENGTH: 4170 words

HEADLINE: Nightly Business Report
GUESTS: Laura Unger
BYLINE: Paul Kangas, Susie Gharib

THIS IS A RUSH TRANSCRIPT. THIS COPY MAY NOT BE IN ITS FINAL FORM AND MAY BE UPDATED.

SUSIE GHARIB, NIGHTLY BUSINESS REPORT ANCHOR: The housing industry is still booming. We'll tell you about the latest report on housing starts and what it could mean for the economy. Good evening, everyone. I'm Susie Gharib at the New York Stock Exchange.

PAUL KANGAS, NIGHTLY BUSINESS REPORT ANCHOR: And I'm Paul Kangas in Miami. Wall Street took a breather from yesterday's stunning rally. The Dow ended the day up 18 points while the NASDAQ Index fell 10 points. Then, Oracle (ORCL) posts better-than-expected earnings after the bell. We'll run down the numbers.

KANGAS: Three tech titans have news after the closing bell today that could have a major impact on trading tomorrow. First chip-maker Advanced Micro Devices (AMD) warned of second quarter losses, saying the weak PC market would take a bite out of sales. Second, Apple Computer (AAPL) also warned for much the same reason, weak sales to consumers. But Oracle bucked the trend. And the nation's second-largest software market posted earnings that beat the Street by $0.02. Oracle earned $0.14 a share, excluding a charge for its investment in Liberate Technologies (LBRT). Analysts were closely watching software license revenues. They came in at almost $1.2 billion. Down from last year, but higher than revised Street targets of $950 million.

DAVID HILAL, SR. ANALYST. FRIEDMAN BILLINGS RAMSEY: This was a good quarter. This was also their fiscal fourth quarter which is very seasonally strong. So what we need to decipher is how much of it was seasonality driven versus maybe a general turn around in the economy. We probably think it's more of the former, given that we've seen some continued difficulties with other software vendors.

KANGAS: While analysts say today's earnings report may show signs of a bottom in technology spending, Oracle says it doesn't see tech spending picking up significantly until 2003.

GHARIB: But a big surprise from the housing industry today: Construction starts for new homes surged almost 12 percent; that's the biggest gain in seven years. Angela Terrell Heath takes a look at what's driving those housing numbers.

ANGELA TERRELL HEATH, NIGHTLY BUSINESS REPORT CORRESPONDENT: Even housing industry economists were surprised by the sharp jump in May housing starts. They say one of the primary reasons for that jump is that consumers see housing as an attractive investment.

DAVID SEIDERS, CHIEF ECONOMIST, NATIONAL ASSOC. OF HOME BUILDERS: All the stars have aligned, great, great investment demand for housing. And then once you have the house and you start accumulating the capital gains, then you can get at them. You can tap them through refinancings or home equity loans. HEATH: The strong May number recovered some of the losses seen in March and April. Starts fell 6.3 percent in March and 7.3 percent in April. May's number reflects building that didn't take place in the two prior months because of poor weather. Most of May's gains were in multifamily units up 20 percent. But those orders were already in the pipeline. Economists say housing has been strong for many reasons. They point to low mortgage rates, averaging about 6.8 percent last month, home price appreciation and immigration that's creating greater household formation. Economists also note that a slumping stock market and poor performance in the bond market makes housing an attractive investment. But economist Randall Dodd says that doesn't work for everyone.

RANDALL DODD, ECONOMIST, ECONOMIC STRATEGY INSTITUTE: I think if you've lost a third or two-thirds of your financial wealth, that doesn't encourage you to go out and put additional new money or even borrow to put a new investment into housing.

HEATH: Dodd says wealthier consumers are making that choice.

DODD: They are now considering moving their money into housing as an area where they might hope to get a higher rate of return than in this Enron- depressed stock market.

HEATH: So far this year, home sales are 6 percent above where they were for the first four months of last year, and Fannie Mae chief economist David Berson sees record housing growth again this year.

DAVID BERSON, CHIEF ECONOMIST, FANNIE MAE: On top of that, the leading indicators of housing, for example, the weekly Mortgage Bankers Association survey of applications for mortgages to buy homes were at record levels in May and are still very strong in early June, telling us the home sales numbers for May, June, July are going to be exceptionally strong. So for more than the first half of the year, we'll be running ahead of last year.

HEATH: Economists say unless the economy sinks or mortgage rates skyrocket, neither of which they expect to happen, we are going to continue to see strong housing numbers for the rest of the year. Angela Terrell Heath, NIGHTLY BUSINESS REPORT, Washington.

KANGAS: Wall Street had a mixed opening as bullish enthusiasm over that impressive jump in May new housing starts was largely offset by news of another deadly suicide bombing in Jerusalem. Some negative assessments about IBM's (IBM) revenue outlook also hurt the blue chips at the outset. At 10:00 a.m., the Dow Industrial Average posted an 18-point loss, but the NASDAQ Index managed a 1-point gain. The market showed moderate signs of strength as morning trading progressed, as some investors were impressed at the very mild nature of the early weakness in the wake of yesterday's sizable advance, while others were encouraged by the report that the May Consumer Price Index showed no change. At noontime, the Dow moved to a 25- point gain and the NASDAQ was up 8 points. Afternoon trading brought some minor weakness, but the sellers were not aggressive. As a result, prices moved narrowly and finally ended on a mixed note with the Dow Industrial Average closing with a gain of 18.70 at 9706.12. The NASDAQ Index, however, came in with a loss of 10.33 at 1542.96.

· The Daily Deal

June 5, 2002 Wednesday

BYLINE: by Katherine Goncharoff

HIGHLIGHT:
GFI has now raised $61 million in institutional funding and has attained a post-round valuation "substantially in excess of $100 million."

BODY:
Showing a renewed appetite for the financial services sector, Advent International Inc. is expected to announce Wednesday, June 5, a $34 million growth equity investment in New York's GFI Group Inc., an online brokerage and software firm.

Other participants in the round include prior investors 3i Group plc, CMS Group, a division of investment fund CMS Co., and Venturion Capital. Salomon Smith Barney Inc. served as placement agent.

With the Series C round, 15-year-old GFI has now raised $61 million in institutional funding and has attained a post-round valuation "substantially in excess of $100 million," GFI's chief executive and founder Michael Gooch said. He said some of the money will be used for acquisitions. Advent, a hybrid venture capital and buyout firm, received a "significant minority stake" in GFI in this deal, said Bob Taylor, an Advent partner.

GFI has created about 60 independent online markets with a focus on the fast-growing credit derivatives sector. It functions as a financial intermediary for a wide range of customers including commercial banks, broker-dealers, trading houses, insurance companies, energy companies and utilities.

The firm also provides software and data services to the derivatives, commodities, currencies and securities markets. Last year it acquired Fenics Ltd., a London-based provider of foreign exchange and option pricing software.

"What we like about this deal is that Micky Gooch has built a profitable business from scratch, has grown the firm rapidly over the past 14 years and early on took a leadership position in the credit derivatives market, one of the fastest growing markets in the financial services arena," Taylor said.

"We also like the fact that this is a high-margin business where the company itself is not putting their own capital at risk and where the trading desks have extremely high margins," Taylor said.

GFI, he added, is the leading intermediary in a majority of the credit derivative markets. "We probably talked to about 35 of their customers, and we consistently heard that these guys have either the No. 1 or No. 2 positions," he said.

Gooch said the financing took about seven months to complete and his original goal was to raise $25 million. Interest from the prior investors drove up the round's size, he said.

He said that new funding would be used to improve delivery of technology products and for acquisitions. "We are interested in smaller, boutique-type operations that have newer derivatives products, and we are strongly interested in new analytical and data components for our business," he said.

For Advent, the deal also presented possible synergies with other Advent portfolio companies, in particular Island ECN, an electronic communications network reportedly in talks for Instinet Group to acquire it.

Advent has also invested in online brokerage Datek Online Holding Corp., which Ameritrade acquired for $1.3 billion in April.

Randall Dodd, director of the Derivatives Study Center in Washington, a nonprofit center backed by the Ford Foundation, said that he was not surprised to learn of the GFI deal.

"The world has become a far more volatile place, and consequently, people have been using the derivatives more and more to help manage their exposure to this volatility," Dodd said.

Yet he said that GFI will have to continue to face some formidable competition. "If I want to buy a weather derivative, why should I go to a broker like GFI when I can go directly to the source?" he asked.

He also noted that GFI's competition, including Volbroker of New York; eSpeed Inc. of New York, a unit of Cantor Fitzgerald; and Fleet & Tokyo Liberty plc of London, are well funded.

Simon Hewitt of Salomon Smith Barney was placement agent on the deal, and John O'Connor of Milbank, Tweed, Hadley & McCloy LLP of New York handled legal matters for GFI. Pepper, Hamilton & Scheetz LLP of Philadelphia represented Advent.

Taylor and another Advent partner, Chris Pike, will serve on GFI's board.

· WHAT W. DIDN'T LEARN FROM ENRON

The New Republic
Option Play
by John B. Judis

Post date: 04.30.02 Issue date: 05.06.02

Not long ago, the Enron scandal seemed destined to become the Bush administration's Whitewater. One reason it hasn't is that the Democrats and the media haven't turned up a smoking gun showing that the Bushies tried to bail out Enron. Another is that the Bush Justice Department has come down on Enron's auditor, Arthur Andersen, like a ton of bricks. But third, and perhaps most important, the administration quickly endorsed reforms aimed at discouraging the practices that allowed Enron--and many other companies fueling the late 1990s bubble--to deceive investors about their financial health. "This much is clear," the president declared soon after the scandal broke, "To properly inform shareholders and the investing public, we must adopt better standards of disclosure and accounting practices for all of corporate America."

If only he'd meant it. Several months later, with Enron off the front page, the Bush administration has not only neglected the accounting reforms needed to prevent Enron from happening again, but it is actively working with the business lobbies trying to block them. A perfect example is the debate over stock options and how companies list them on their financial statements and tax returns.

During the '90s companies increasingly resorted to stock options to pay their top executives and managers. The practice spread from tiny start-ups to the Fortune 500, where stock options today account for almost 60 percent of executive pay. Now, there's nothing intrinsically wrong with stock options; they can motivate employees by granting them a stake in their company's success. What is problematic is the way companies count them on their financial records and tax returns. As the law now stands, companies don't have to deduct stock options from the profit totals on their financial statements even though, like wages, the options are a form of compensation. This omission played a key role in creating the wildly inflated profits and consequent euphoria that fueled the '90s stock market bubble. According to the Federal Reserve, if stock options had been counted from 1995 to 2000, Fortune 500 companies would have seen their annual profit margins drop from 12 percent to 9.4 percent. Among some high flyers the deflation would have been larger still: Counting stock options, Cisco Systems' profits in 2000 would have been 40 percent lower and Lucent Technologies' 32 percent lower.

But it gets worse. The same firms that have not deducted the cost of options from their profit statements have deducted the cost on their tax returns. And as a result, many of America's most prosperous firms enjoyed a lucrative tax loophole. In 2000, for instance, Microsoft saved $2.06 billion in taxes and Cisco $1.4 billion by deducting stock-option costs. According to Citizens for Tax Justice, Enron turned what would have been a $112 million tax bill into a $278 million refund. This cycle of inflated profits and deflated tax payments helped push America's high-tech sector in the late '90s from fast, sustained growth into manic overdrive and then--when reality finally intruded--into the slump and disillusionment from which it has still not fully recovered.

Federal Reserve Chairman Alan Greenspan, former Fed Chairman Paul Volcker, superinvestor Warren Buffett, and former Securities and Exchange Commission head Arthur Levitt--the cream of America's financial establishment--all want to require companies to deduct the costs of stock options on their financial balance sheets. So do the Council of Institutional Investors (the country's main shareholding organization) and Standard & Poor's (the main credit-rating agency). Senators Carl Levin and John McCain have introduced legislation that would go part of the way toward doing this: The Levin-McCain bill says that if companies want a tax deduction on their stock options, they have to make the same deduction on their financial statement. If they decide not to deduct options on their financial statement, they can't deduct them from their taxes. (California Representative Pete Stark has introduced parallel legislation in the House.)

But the business lobbies that pack K Street are determined to block any change in accounting and tax rules, as they did in 1994 and again in 1997 when Levin and McCain introduced similar legislation. The Business Roundtable, the American Electronics Associations, the US Chamber of Commerce, and the National Association of Manufacturers--acting through the newly formed Coalition to Preserve and Protect Stock Options--have lined up squarely against Levin-McCain. And in spite of George W. Bush's avowed commitment to reform, they've found an ally in the president. On April 8 Bush told The Wall Street Journal, "Alan Greenspan is very smart. I'd hate to get into a debate with him." He then proceeded to do exactly that, explaining that he opposed any change in the way businesses counted stock options.

Here, in brief, is how stock options work. Employees who get stock options from their employer as payment acquire the right to buy the company's stock after a fixed period at the price at which it was initially selling. If the stock's price has risen in the meantime, the employee can make money by buying the stock from the company at its original price and then reselling it on the market at its current price.

Companies claim stock options should not count as costs because they are not cash payments from the firm to the employee. But Greenspan and Buffett call them noncash costs, like depreciation, which ultimately come out of a company's earnings. After all, when employees exercise their stock options, the company has to forego selling its stock at the higher market price in order to sell it at the original price to the employee. The Internal Revenue Service (IRS) also considers stock options a cost, which is why it allows companies to deduct the difference in what they could have received from selling their stock on the open market from their earnings for tax purposes.

Companies that provide stock options also pay a cost in what is called the "dilution" of their stock values. When employees exercise their stock options, companies have to put new stock on the market, thus diluting the earnings per share of the old stock. To avoid this, companies frequently buy back and retire their own stock, so there is no net increase in the number of shares on the market. These repurchases, which became extremely common in the late '90s, are another cost on the firms' earnings from issuing stock options.

The Coalition to Preserve and Protect Stock Options has marshaled three basic arguments in favor of retaining the status quo. First, as it argued in one press release, reforms like Levin-McCain would "discourage broad-based, rank-and-file access to stock options." But it's hard to see how. Perhaps if the only benefit companies received from issuing stock options was inflating their profit margins, then Levin-McCain would persuade them it wasn't worth it. But companies have long claimed that they benefit in many ways from issuing stock options, including by fostering employee identification with the company and deferring compensation costs.

Second, the Coalition claims the reform will "lead to investor confusion and less accurate financial statements." But it's hard to imagine that any new disclosure requirements would be more confusing than the current system, which dates back to 1994, when business successfully beat back an effort by the Financial Accounting Standards Board (FASB)--the private, independent body that sets accounting policy--to require companies to deduct stock-option costs from their profits. The FASB ultimately settled for merely requiring companies to include a footnote about stock options in their financial reports--a footnote it often takes a trained stock analyst to find and interpret. In Cisco Systems' annual report for 1997, for instance, it took me a half-hour to locate the relevant footnote: It was the second item of the ninth heading of the seventh section of the report's seventh (and last) chapter.

Finally, the Coalition argues that the legislation will "raise taxes on companies issuing employee stock options." And to be sure, some liberal critics of stock options, like Randall Dodd of the Derivatives Study Center, want to do exactly that--by simply ending the tax deduction for stock options. But the Levin-McCain bill would do nothing of the sort. It would end the deduction on stock options only for companies that excluded stock options from their profit-and-loss statements. The business groups worry that the FASB's formulas for calculating the cost of stock options could produce a number less than the IRS's formula for calculating a tax deduction, thus limiting the deductions and, in effect, raising taxes on companies. But that could be easily solved by adjusting the formula for determining stock options' impact on profits so that it equaled the calculated tax deduction, as FASB contemplated doing in 1993. (At the time companies weren't interested because they feared equalizing the two numbers would take too big a bite out of their published profit figures.)

But the really depressing thing about the stock-options battle isn't that the administration--and most Republicans--are backing the K Street lobbies. It's that key Democrats are too. Senator Joe Lieberman, who helped block reform in 1994, sent a letter to Commerce Secretary Donald L. Evans and Treasury Secretary Paul H. O'Neill last month charging that the Levin-McCain bill would "deprive investors of information about stock options and reduce the availability of broad based stock option plans." According to Michael Siegel, spokesman for the Senate Finance Committee, Chair Max Baucus "is inclined not to support the legislation, but he does believe the issue should be addressed in a thoughtful way." Thanks a lot. Senate Majority Leader Tom Daschle backed an earlier Levin bill on the topic but has now turned publicly noncommittal; Lieberman's staff say Daschle is against it. And if he and Baucus are opposed, Levin-McCain might not even make it to a Senate vote.

That's not just stupid policy; it's stupid politics. After all, Enron drove a truck through the stock-options loophole. From 1996 to 2000 the company failed to figure $600 million in stock-option deductions into the $1.8 billion in earnings it claimed on itsfinancial statements. And thanks to stock options, it didn't pay taxes for four out of these five years. The real Enron scandal, as this magazine has said from the beginning, is the policies that allowed the company to perpetrate its fraud. And on stock options at least, the Democrats aren't merely neglecting to hold the Bush administration accountable for that scandal; they've become part of it themselves.

· MARKETPLACE MORNING REPORT

Minnesota Public Radio.

SHOW: Marketplace Morning Report (5:50 AM ET) - SYND

May 1, 2002 Wednesday

LENGTH: 260 words

HEADLINE: SEC tentatively approves new reporting standards for corporations, but critics are skeptical

ANCHORS: KAI RYSSDAL

REPORTERS: SAM EATON

BODY:
KAI RYSSDAL, anchor:

The Securities and Exchange Commission has tentatively approved new reporting standards that would shed some more light on corporate balance sheets, but as MARKETPLACE's Sam Eaton reports, not everyone's convinced the new rules will do enough.

SAM EATON reporting:

Before its financial collapse, Enron used complex partnerships to inflate its profits, disclosing some of them only in the form of jargon-filled footnotes in its financial reports. Under the new SEC plan, businesses would be required to report this kind of accounting information with greater clarity. Randall Dodd with the non-partisan research group Economic Strategy Institute says the new SEC guidelines are important, but only if they're followed up with more binding laws.

Mr. RANDALL DODD (Economic Strategy Institute): On one hand, these are proposals that are good in themselves, but I think they're very small steps, and they seem to be being used as a distraction from what they're not doing, which is making the big changes.

EATON: Dodd says one of those big changes would involve cracking down on the use of business partnerships in countries where companies can hide debt and avoid US taxes. Only then, he says, will the SEC begin to rein in the true accounting abusers. In New York, I'm Sam Eaton for MARKETPLACE.

RYSSDAL: One quick SEC addendum here: Federal investigators have begun mailing requests for documents to major Wall Street brokerage houses. They're looking for any possible conflicts of interest stock analysts may have.

· BILL TO PLACE ENRON-LIKE TRADING UNDER REGULATION FAILS IN SENATE

April 11, 2002

Portland Oregonian

By TOM DETZEL

Summary: A procedural vote blocks the effort on derivatives that was backed by Sen. Ron Wyden

The Senate on Wednesday defeated an effort led by Sen. Ron Wyden of Oregon and two other West Coast Democrats to regulate trading in the kind of complex energy and financial transactions that Enron pioneered.

Critics of the proposal, which included banks and energy suppliers and marketers, won a procedural vote that forced Sen. Dianne Feinstein, D-Calif., to withdraw the amendment, which was backed by major consumer groups.

The proposal would have put trading in financial derivatives based on energy and metals back under the oversight of the Commodity Futures Trading Commission. Congress had exempted such trading only two years ago.

Feinstein, Wyden and Sen. Maria Cantwell, D-Wash., originated the amendment, calling it an anti-fraud measure to plug a legal loophole that allowed Enron and other energy traders to conduct their business in secret.

"This loophole was created for Enron by Enron, and I think it is tragic that the Enron experience was not enough to enable its passage at this time," Feinstein said after her side fell 12 votes short of the 60 needed to block a filibuster.

Sen. Phil Gramm, R-Texas, who led the opposition, said the amendment threatened the broader market in over-the-counter derivatives, which are widely used by business to hedge financial risk and help stabilize commodity markets.

Although they can take many forms, derivatives essentially are financial contracts in which the parties promise to exchange payments based on the price of some underlying security, market index or commodity.

The global market for derivatives is estimated at $100 trillion; about two-thirds of it is in the United States. Despite the large number -- called the "notional" value of the contracts -- experts say much less cash is actually at risk in the deals.

Critics seized on Enron's free fall into bankruptcy last year as a prime example of the need for more oversight.

The company's online arm traded derivatives based on electricity, natural gas, broadband capacity and the weather. Financial derivatives propped up the web of off-the-books partnerships that figured in the company's bankruptcy.

Randall Dodd, director of the Derivatives Study Center, said that Enron had $758 billion in derivatives on its books and that Enron's crash came once investors realized the firm didn't have enough capital to back up the deals.

In a debate last month, Wyden said the amendment's disclosure requirements would have made it easier to tell whether Enron or other traders were able to manipulate wholesale power markets last year on the West Coast. The power crisis left a legacy of rate increases that consumers are still paying off.

Although manipulation hasn't been proved, Wyden and Feinstein have cited anecdotal evidence that Enron controlled natural gas and power prices.

"It seems to me if energy is going to be bought and sold as a commodity, the public should at least have the same protections that exist for trading any other commodity," Wyden said last month, comparing power to pork bellies.

Opponents of the measure included Federal Reserve Board Chairman Alan Greenspan, who had argued that oversight by the Commodity Futures Trading Commission was unnecessary and that Enron's problems were rooted in fraud, not trading in derivatives per se.

Feinstein won the endorsement of Pat Wood, chairman of the Federal Energy Regulatory Commission, and utility industry groups such as the American Public Power Association and the American Public Gas Association.

In February, FERC opened an investigation into possible market manipulation by Enron after one analyst reported a 30 percent price drop at one Oregon wholesale power exchange following the company's Dec. 2 bankruptcy.

The amendment would have repealed a special regulatory exemption for online energy and metals trading in the Commodity Futures Modernization Act of 2000. Dealers would have been subject to registration and reporting of transactions not already reviewed by FERC, and the CFTC would have set collateral requirements.

Sen. Gordon Smith, R-Ore., voted with opponents to the amendment Wednesday. His spokesman, Chris Matthews, said Smith agreed with Greenspan's assessment that the problem at Enron was fraudulent accounting.

The amendment would have been attached to a broad energy bill working its way through the Senate. Feinstein said she might reintroduce the amendment as a separate bill later.

· Senate Energy Bill Enters Crucial Stage.

April 08, 2002

The Oil Daily

By Manimoli Dinesh.

The game plan for a comprehensive energy bill is being crafted by Democrats and Republicans as the Senate returns this week from its Easter recess to debate some hotly contested issues, including opening the Arctic National Wildlife Refuge (ANWR) to oil and gas drilling.

After nearly three weeks of choppy action on the comprehensive bill that addresses key oil and gas, electricity, nuclear, and renewable energy issues, some oil companies are applauding certain aspects of the legislation, but are lukewarm to the package as a whole.

Support from environmental groups is also waning. But the Bush administration's desire to brandish new energy legislation as one of its key achievements since taking office is expected to provide momentum, sources say.

The current rally, which has sent crude and gasoline prices to their highest levels in months - sparked mainly by tension in the Middle East - will also go far in convincing legislators to get things moving if the US is to push ahead with its goal of lessening foreign oil dependency.

Senate Majority Leader Tom Daschle (D-S.D.) wants to wrap up action by the end of this week, but before senators left for the two-week recess they could not agree on a draft list of finite amendments because of objections raised by Sen. Phil Gramm (R-Texas), a Senate aide said.

Democrats have filed as many as 100 amendments and the Republicans 40, according to a Republican aide. Not all of these amendments will be offered for inclusion. Aides say the leadership has the option of limiting the number of amendments and expediting a vote on the bill by filing for cloture, a procedural maneuver.

A much-talked-about amendment from Sen. Frank Murkowski (R-Alaska) to allow drilling in ANWR is still elusive and aides could not give a clear time line on when it would be offered.

However, opponents and proponents are arming themselves for the big battle. Democrats are brandishing a new US Geological Survey (USGS) report on the risk to wildlife if drilling is allowed in ANWR (OD Apr.1,p1). The Bush administration, for which ANWR drilling is a priority issue, is likely to release a supplement to the USGS report today.

Interior Secretary Gale Norton and Energy Secretary Spencer Abraham have been appearing at events in major cities with union leaders drumming up support for ANWR drilling and the energy bill as envisioned by the White House.

The energy bill debate is also expected to focus on the regulation of online energy derivatives trading, increased use of renewable fuels like ethanol, climate change, and oil and gas tax incentives.

Sen. Dianne Feinstein's (D-Calif.) fiercely debated amendment to regulate online energy derivatives trading will probably come to a vote this week. Sources on and off Capitol Hill expect the final outcome to be close, even though it appeared at one time that the amendment would be a shoo-in before influential Federal Reserve Chairman Alan Greenspan weighed in against it.

Randall Dodd with the Derivatives Study Center, a supporter of the amendment, said this would be the first vote relating to the Enron financial scandal that will put members on the record, indicating that it could be tough to vote against it. Feinstein, who has accused Enron of manipulating the market, offered the amendment contending that it would deter fraud and manipulation.

Feinstein and California colleague Barbara Boxer (D) are also locked in a fight with Midwest senators over a negotiated proposal for increasing the use of corn-based ethanol and other renewable fuels and phasing out the use of methyl tertiary butyl ether (MTBE) by 2006. An aide in the Daschle's office said that since the two sides lack the votes they may not even offer the amendments.

Some oil companies are increasingly unhappy with the proposal. They believe the mandate to use 5 billion gallons of ethanol annually by 2012 is much too high. A source said Citgo and ChevronTexaco were working with Feinstein to change the proposal, but Chevron did not return calls to confirm this.

If the proposal survives in the Senate, oil firms are vowing to fight it during a Senate-US House of Representatives conference to coalesce the different versions of the legislation. The House bill that passed in August of last year does not contain the renewable fuels proposal.

On the climate change issue, there could be an attempt to change the current provision of mandatory registry of greenhouse gas emissions by corporations to a voluntary registry. The tax incentives of $4 billion for oil and gas have solid support among domestic producers and it should pass without much ado. But the item to watch out for is whether senators will agree to a financial incentive for a natural gas pipeline from Alaska to the lower 48 states.

To some in the oil industry, the legislation doesn't benefit them much. For others, like Phillips, which is counting on the Alaska natural gas pipeline permitting provisions and tax incentives, only parts of the bill excite them, industry sources say. Companies are also disappointed that the liability relief for contamination by fuel additives is not broad enough to include MTBE contamination of groundwater. At present, major oil companies have been sued for million of dollars for MTBE contamination.

For environmental groups, any enthusiasm for the legislation plummeted with passage of an amendment that would block a substantial increase in fuel economy standards of vehicles. While some have already condemned the bill, others are in a wait-and-watch mode.

· OTC energy market eyes regulation proposal warily.

April 07, 2002

Reuters English News Service

By Christina Ling

WASHINGTON, April 7 (Reuters) - A proposed amendment to the energy bill scheduled for debate in the U.S. Senate on Monday could mean even less transparency in the secretive energy derivatives market, which some blame for the collapse of its biggest player Enron , market players say.

Several analysts welcomed California Democrat Sen. Dianne Feinstein's push for price disclosure and capitalization requirements for participants in over-the-counter (OTC) markets, which are traded outside regulated exchanges.

But other traders, exchanges and members of the market - estimated at some $3 trillion in notional value - saw dire results if the amendment were passed into law.

"Frankly, it would probably make the players obfuscate more," said Peter Fusaro, head of energy risk management consultancy Global Change Associates, adding it could drive the market offshore. "It would have the reverse impact of what she wants, which is more financial disclosure."

The legislators and some analysts allege manipulation of the highly secret over-the-counter market led to power price spikes and rolling blackouts last year as well as contributed to Enron's collapse.

Enron built up huge OTC positions on its Internet trading platform EnronOnline, in which the now-humbled energy giant was counterparty to every trade.

Feinstein's bill, which is co-sponsored by other lawmakers from Western states hit by an electricity crisis last year, would give the U.S. Commodity Futures Trading Commission oversight of all OTC-traded energy and metals derivatives.

Legislators say the bill would allow regulators to better track trades and to respond faster to any illegal activity in the market.

KEEP RECORDS FOR YEARS

While leaving much of the detail up to the CFTC, the bill would require firms to keep books and records of transactions for five years and to publish data daily on volume, settlement price, open interest and opening and closing ranges.

"I think it would be useful ... because transparency's good," said independent analyst Philip Verleger. "It's hard to oppose it."

Those who favor greater transparency say it can only serve to bolster faith in the market and thus draw in greater participation. They reject claims that increased regulation was a burden that dragged on business.

"Almost all the information is available, it's all electronic these days," Verleger added. "(The traders) know what all the transactions were, they know what all the settlements are, they know the bids and the asks. It's a question of reporting it."

But Fusaro and Dynegy spokesman David Byford both said the very availability of data to regulators who cared to ask for it was a case against new legislation. Saying the bill would create legal uncertainties, Byford echoed Fusaro's concern that passage would drive the market abroad.

Former Enron rival, the IntercontinentalExchange (ICE), a booming Atlanta-based online exchange owned by over 100 energy and metals traders, brokers and bankers, also rejects the proposal as unnecessary.

"It's like fighting the last war," a source who did not want to be identified said, noting that unlike Enron, ICE is not counterparty to every trade and thus did not need the same capitalization requirements.

"It's the wrong business model they're looking at," he added.

But Randall Dodd, a former CFTC economist who heads the independent Derivatives Study Center in Washington, notes the bill would give the CFTC flexibility to set appropriate requirements for the greater safety of the market.

"If Enron (Online) had been properly capitalized and collateralized I think Enron as a derivatives dealer would have survived - and that was the most profitable part of their business, after all," Dodd said.

· Enron, California Energy Woes Fail to Move Lawmakers

April 6, 2002

Congressional Quarterly

By Keith Perine, CQ Staff

The Senate was deep into its debate of a major energy bill March 19 when Dianne Feinstein, D-Calif., offered an amendment that would have imposed new regulations on the electronic trading of energy futures.

Feinstein was convinced that her state’s energy crisis in 2000 had been made worse because of a lack of transparency in the prices on those trades, known as derivatives, because they derive their value from an underlying asset such as the price of electricity or natural gas. (CQ Weekly, p. 825)

But the argument over Feinstein’s proposal was not about the merits of announcing prices, it was a brief, intense clash over the federal regulation of financial markets. Her amendment was set aside after Republican objections made it clear a filibuster might be brought against it.

Despite the cautionary tale that some say should be read into the spectacular bankruptcy of Enron Corp., which used a mix of derivatives trading and off-the-books partnerships to conceal a ruinous debt, Congress remains in the throes of a deregulatory spirit that began in the 1970s with the airline and energy sectors and has run through the financial industry in recent years.

The debate over Feinstein’s amendment shows that the climate in Congress has not been changed by Enron, making it a near certainty that any upcoming effort to broadly revamp federal regulation of the financial services sector is unlikely to get off the ground.

“I don’t think that’s warranted,” said Richard H. Baker, R-La., chairman of the House Financial Services subcommittee on Capital Markets. “I think the system has been abused by creative individuals. I don’t think the circumstances today warrant” a broader inquiry.

Easing Financial Regulations

Instead, Congress will continue to focus on rifle-shot proposals, such as an update of pension laws and some new rules for the accounting industry, and leave unanswered the question of whether Enron was an aberration or a symptom of systemic failure. For some voices, inside and outside Congress, that will not be enough.

“We need to start re-evaluating this big push that occurred in the 1990s to remove government oversight,” said Tom Schlesinger, executive director of the Financial Markets Center, a nonprofit research group. “Congress really doesn’t get it. It’s incredible to me that they are still trying to call this an isolated problem.”

When Feinstein offered her amendment, just the idea of tampering with federal rules regarding a complex financial market worth tens of trillions of dollars to the United States drew the withering reproach of Phil Gramm, R-Texas. “I say, let’s put a little sign up that says: ‘Danger, high voltage,’ ” Gramm said on the floor. “Do not be fooling around in here if you do not know what you are doing.”

He was followed by Minority Leader Trent Lott, R-Miss., who read a dictionary definition of “derivative,” before informing his colleagues “we do not know what we are doing here.”

Feinstein was not proposing wholesale regulation of the derivatives market. She had been in private negotiations with Gramm seeking to narrow the scope of her amendment, but those talks failed to produce a deal.

Immediately after leaving the Senate floor she said she could not even imagine taking a broader look at derivatives. “I’m not going to get into that now,” she said wearily. “I’ve got enough problems.”

Bipartisan Deregulation

A series of laws, passed after Republicans took control of the House and Senate in 1995 for the first time in 40 years, removed regulatory barriers and government oversight from complex financial contracts and banking, and raised the bar for shareholder lawsuits.

In the late 1990s, a battle over how to regulate complex financial contracts known as over-the-counter derivatives — those involving contracts directly between private interests rather than trades on a public exchange such as the Chicago Board of Trade — resulted in a law (PL 106-554) that virtually excluded the contracts from federal regulation. (2000 Almanac, p. 5-14)

Legislation (PL 106-102) sweeping away the last vestiges of Depression-era barriers between investment banking and commercial banking was enacted in 1999, capping years of steady regulatory erosion. (1999 Almanac, p. 5-3)

And it was not just Republicans who were easing the rules. One of the most successful items in the 1995 Republican “Contract With America,” a law raising the bar for shareholder lawsuits for securities fraud (PL 104-67), also was one of the most bipartisan. Congress voted overwhelmingly to pass the law, which also partially shielded outside accountants from some legal liability, over President Bill Clinton’s veto. (1995 Almanac, p. 2-90)

Taken together, critics now say each of these laws either contributed directly to or fostered a freewheeling atmosphere that played some part in the Enron case. The Houston-based energy trading giant used derivatives as a tool to construct its off-the-books partnerships and hide debt from shareholders, and the company also benefited from financing and investment services from big financial conglomerates eager to keep Enron’s business. Now that Enron has collapsed, shareholder lawsuits filed in recent months face longer odds of success.

Many important members of Congress have shown little interest in exploring new regulation. Senate Banking Chairman Paul S. Sarbanes, D-Md., has held 10 hearings on accounting rules and corporate governance but has not yet decided whether to seek a rewrite of financial sector regulations.

Faced with the pressures of a short legislative calendar and a raft of major pending legislation on agriculture, trade and welfare, lawmakers appear to be accepting the argument made by financial services lobbyists that the Enron debacle is the work of creative liars and thieves, rather than a sign of deeper regulatory problems.

They also are deferring to senior administration officials such as Treasury Secretary Paul H. O’Neill, Federal Reserve Chairman Alan Greenspan, and Securities and Exchange Commission Chairman Harvey L. Pitt, who have urged Congress not to act hastily in imposing new rules on financial markets.

‘Dropping the Ball’

To be sure, the congressional mood on Enron is not monolithic. Several lawmakers have introduced bills that would overhaul the regulation of derivatives or roll back the 1995 securities litigation law. And some lawmakers are voicing support for tackling some of the larger issues.

“I think Congress has dropped the ball over the years in conducting effective oversight,” said Rep. Bob Barr, R-Ga., a member of the House Financial Services Committee. “I think that it is much more important than rushing out and passing some remedial legislation.”

The House Financial Services Committee’s ranking Democrat, John J. LaFalce of New York, who complains that the committee’s Enron hearings have not been comprehensive, has pushed committee Chairman Michael G. Oxley, R-Ohio, to schedule another hearing, planned for April 9, which could include some discussion of the marriage of commercial and investment banking, before marking up legislation April 11.

But the prevailing cautionary sentiment was captured by Sen. John McCain, R-Ariz.

“Whenever something like Enron happens, clearly you’ve got to go back and review,” McCain said. “I think there need to be changes made, but we need to have a methodical process for doing so.”

The House and Senate leaderships already have drawn specific road maps for Enron-related legislation that do not include any broad review of deregulation. In the House, the committees on Education and the Workforce and Ways and Means have been charged with writing a single pension bill. (Pension, p. 910)

Senate Majority Leader Tom Daschle, D-S.D., has prescribed a reform agenda involving accounting regulation, tax shelters, securities fraud penalties and pension law changes, along with an examination by Governmental Affairs Committee Chairman Joseph I. Lieberman, D-Conn., of Enron’s dealings with the White House and a slew of government agencies.

“It’s our intention to pass whatever new laws are needed before the end of this Congress,” Daschle said Feb. 14. “We can’t afford to wait.”

Derivatives Trading

The thorniest policy question related to the Enron collapse is regulation — or the lack of it — of the complex financial instruments known as over-the-counter derivatives.

Traditional derivatives — commodity futures based on the prices of tangible products such as corn and soybeans — are traded through long-established public exchanges, such as the Chicago Board of Trade and the New York Mercantile Exchange, and regulated by the Commodity Futures Trading Commission. Members of the exchanges are required to register and report on the details of their transactions, and prices are publicly listed. Traders are required to maintain both capital reserves and a certain amount of collateral pegged to each transaction.

Congress purposely exempted over-the-counter derivatives from those requirements, essentially codifying the system as it had existed for an instrument that accounts for trillions of dollars in global financial markets. The financial sector pushed for the law to give “legal certainty” to over-the-counter derivatives trading, much of which had been occurring outside defined regulations.

Critics say the statutory curtain Congress draped across over-the-counter derivatives enabled Enron to use them as linchpins in constructing myriad business partnerships the company used to hide its debt from investors and the public.

“If [over-the-counter derivatives] markets were transparent, government could have said [whether] Enron was working well and given it a clean bill of health,” said Randall Dodd, executive director of the Derivatives Study Center. “Enron wouldn’t have used derivatives to hide losses, hide debt and inflate income.”

Consumer advocates have been pushing Congress to amend a 1995 law that raised the bar for civil lawsuits related to securities fraud. Accounting firms sought and won a provision that made them liable for only a share of damages.

Consumer groups argue that the law so weakened the threat of securities fraud lawsuits that it effectively reduced public oversight of Enron and its former outside auditor, Arthur Andersen LLP.

The law “set up so many hurdles for the swindled investor that every step along the way there’s almost an impossible barrier to get over,” said Sally Greenberg, senior product safety counsel for the Consumer Federation of America, a citizens group.

Richard C. Shelby, R-Ala., a high-ranking minority member of the Senate Banking Committee, has introduced a bill (S 1933) that would restore so-called joint and several liability, to make all defendants liable for all damages.

But Sarbanes, who opposed the 1995 law, has not scheduled a hearing on Shelby’s bill. Furthermore, Sen. Christopher J. Dodd, D-Conn., a senior majority member of the Banking Committee, was a main proponent of the 1995 law, as was Oxley in the House. A Senate aide predicted that Dodd has the votes to keep the Shelby bill bottled up for the rest of the year.

Pitt has argued before congressional committees that the law has had little effect on either the number of lawsuits filed or the amount of damages awarded.

Banking Regulation

House Energy and Commerce Committee Chairman Billy Tauzin, R-La., who has conducted the most publicized congressional Enron inquiry, sent letters to more than a dozen major Wall Street investment and credit-rating firms on March 6, probing their relationships to Enron. Tauzin referred to testimony from an Enron executive that the company pressured big financial conglomerates, such as Merrill Lynch & Co., Inc. and Citigroup, to fund some of the partnerships, which were key to maintaining Enron’s illusion of profitability, as a condition of obtaining lucrative investment banking services. The firms collectively could lose billions of dollars in the Enron collapse.

Under the 1933 Glass-Steagall Act, federal regulation prohibited just such transactions in which commercial lending institutions provided services as an investment bank to a single client. That law was enacted after revelations that large banks had speculated with deposits and had sold off, through investment banking subsidiaries, bad loans they had made to Cuba.

Those barriers between commercial and investment banking were removed in 1999, but Tauzin says he does not intend to examine the effects of those changes because his committee does not have jurisdiction.

That law “clearly deserves more scrutiny,” said Ed Mierzwinski, consumer program director for U.S. PIRG. “I haven’t seen any committees investigating whether they went too far.”

The House Financial Services Committee, which has jurisdiction over the 1999 law, so far is showing no signs of re-examining it in light of the Enron collapse. Oxley said he is concentrating on moving a bill (HR 3763) that would, among other provisions, change the regulation of accounting firms. Oxley added he would “assess where we are” after shepherding the bill through the House. One of the other items already on Oxley’s post-recess agenda: a bill (HR 3951) that would grant a laundry list of minor “regulatory relief” measures to the financial sector.

“I don’t think anyone in 80 percent of the mainstream would propose to use Enron as a reason to do anything about [the 1999 law],” said Steve Bartlett, president of the Financial Services Roundtable, an association of large financial services companies.

Gramm adamantly rejected the notion that there was any connection between the 1999 law and the Enron bankruptcy.

“How can more competitive financial institutions be linked” to the company’s collapse, Gramm asked rhetorically.

In the end, the high-water mark of the congressional response to Enron could come when and if the Senate votes on the Feinstein derivatives amendment, which is still pending on the energy bill despite an objection by the Republicans.

A Feinstein spokesman said April 4 that the pro-amendment forces were “very close” to rounding up the 60 votes needed to end debate on the amendment.

· DESPITE ENRON SPOTLIGHT, MtM CHANGES SEEN YEARS AWAY; MANY IDEAS FLOATED

April 01, 2002

Power Markets Week

By Rick Stouffer

Despite the spotlight Enron Corp.'s supernova-like flameout has put on potential abuses of mark-to-market (MtM) accounting, and the ensuing outcry for tightening up the rules to limit misuse of deal and asset valuation, industry observers and experts agree substantive changes to MtM practices probably are years away.

``I see no comprehensive rule changes for the next couple years concerning company financial statements,'' said Thomas R. Weirich, an accounting professor at Central Michigan University. ``I think it will take two to three years to work through all of this.''

At the same time, the industry is pushing for a go-slow approach to any changes, and worries that quick action could do more harm than good.

Securities and Exchange Commission Chairman Harvey L. Pitt, in testimony March 21 before the Senate Banking, Housing and Urban Affairs Committee, said that generally, he does not believe new legislation or regulation are key to solving problems.

``I do, however, believe that we must respond to a unique crisis of confidence created in our capital markets,'' Pitt said. ``I want very much to assist this committee in developing a sound legislative proposal and to work with you to tailor our concepts of necessary regulations.''

Many industry watchers feel the market--meaning investors--with some urging from the SEC, already are flexing their investment muscles, forcing companies to disclose much more information or risk an investment blacklist.

The SEC currently is, in its chairman's words, ``contemplating'' reform to its rules for the management discussion and analysis of financial condition and result of operations section of disclosure documents.

Referenced in the SEC's early December ``urgings'' on public companies to make their disclosures more transparent and worthwhile, the SEC now is looking to codify actual rules, requiring companies to identify their most critical accounting policies.

In addition, according to Pitt in his March 21 testimony, the commission also is ``contemplating'' making companies produce clear and concise financial statements.

``This would not be an initiative to `dumb down' financial statements,'' Pitt said in his testimony, ``but an effort to give companies the flexibility to produce and disclose financial information in `layers.''' However, no mention was made in Pitt's testimony regarding a timetable for the above changes and others referenced in his remarks.

Why not just banish MtM to the financial scrap heap? The consensus among many experts is that MtM shouldn't be discarded just because Enron abused the system. Tweaking may be required, not wholesale rejection.

``Mark-to-market is designed to show the full extent of a company's liabilities over a period of time so that there are no hidden landmines for investors,'' said Andre Meade, an energy analyst in New York for Commerzbank Securities.

``Unfortunately, mark-to-market also can help distort a view of a company's earnings, and it makes modeling a company more difficult.''

Simply put, mark-to-market accounting means financial assets, such as marketable securities, derivatives and financial contracts, are reported on a company's balance sheet at their current market value at a specific point in time, although the actual realization of cash may not occur for years.

While earnings distortion is possible using mark-to-market accounting, given investors' need to know just what an asset is worth today--not when it was purchased or acquired years ago--means mark-to-market is here to stay.

``If you bought an asset five years ago for $1,000 and today it's worth $5,000, does an investor want to know what you paid for it, or what it's now worth?'' asked Lynn Turner, former chief accountant at the Securities and Exchange Commission, and now director of the Center for Quality Financial Reporting at Colorado State University. ``Mark-to-market on the balance sheet shows fair value--and that's very good.''

Mark-to-market accounting is not new. It was implemented by the Financial Accounting Standards Board, the private entity charged with establishing accounting and reporting standards, nearly a decade ago for financial assets with readily determined asset values, such as stocks, futures and options.

In 1996, the FASB extended MtM to all financial derivatives, even those without a traded market value.

That last phrase is key, because one of the criticisms of the use of MtM is that without a market, without benchmarks, companies using derivatives trading may have to rely on complex models to determine asset values based on dozens of assumptions, giving them huge leeway to distort financial results.

``People who build models may make-up market data, to make it what they think the market should be,'' according to John E. Parsons, a financial economist with Charles Rivers Associates, Boston.

``MtM accounting represents the classic accounting struggle of weighing the trade-off between relevance and reliability--in this case the relevance of market data against the reliability of the data,'' said Bala Dharan, the J. Howard Creekmore Professor of Management at Rice University, Houston, in prepared testimony recently presented before the House Energy and Commerce Committee.

According to Dharan, accounting standard-setters took the position that the increased benefit from reporting market value information on the balance sheet justified the cost of decreased reliability of income statement and earnings numbers.

A number of proposals concerning the accounting profession in general and mark-to-market accounting in particular, are being floated. Some involve using common sense, and count on a fair amount of skepticism on the part of analysts, investors and the press. Others are more far reaching, and call for legislation and new rules and regulatory bodies.

Models based on economic reality. If there is no market for what's being traded, no benchmarks to base future prices on, companies should be more careful to establish their models on economic reality--not on fairy tale-like hypotheses, Charles River's Parsons believes.

``A lot of company boards, treasury offices and risk management offices need to determine how reliable is the model being used for mark-to-market, how widely accepted the model is,'' Parsons said. ``Companies also need to test their models against market data, to ask how often they get the answer that the marketplace gets.''

The staff of FASB's Emerging Issues Task Force has proposed that company financial statements include which contracts are accounted for as trading contracts, and a description of how their so-called fair value was reached. Included within the description would be methods and assumptions used if no quoted market prices existed, such as estimated forward prices, discount rate, contract length and estimated volatility.

EITF staff's proposals would clarify requirements the Task Force put in place some four years ago, when it mandated trading contracts be marked to market. At that time, the EITF determined that a decision should be made at the time an energy contract was signed concerning whether it would be considered a trading agreement.

While mandating that gains and losses from marking contracts to fair market value be included in earnings and included in notes to financial statements, EITF did not require the disclosure of assumptions and forecasts used to determine fair market value, nor did it require the use of any particular method to determine fair value.

The EITF was expected to take up expanded disclosure requirements as part of discussion of ``Issue 02-3, Accounting for Contracts Involved in Energy Trading and Risk Management Activities'' at its bi-monthly meeting on Jan. 24. However, discussion was postponed at that meeting, the issue was not brought up at the March 20-21 meeting and currently is not slated for debate anytime in the future.

Transparency. Analysts, academics and the SEC are telling all companies to be more transparent when it comes to revealing numbers--and just as important--where those numbers came from. The idea is that gobble-dy-gook-like explanations Enron no longer will be tolerated.

Proper numbers placement. Closely aligned with transparency is the call by many numbers experts to ``tell it like it is.'' In other words, if, for example, 30% of a company's profits won't be realized for two years, put it in plain English on the balance sheet--not the income statement. The amount should not hit the income statement until the company can meet some high confidence level concerning future cash flows.

``Or companies should place an asterisk on their income statement, and footnote what percentage of that income hasn't yet been realized,'' said Randall Dodd, director of the Derivatives Study Center, Washington, D.C.

New rules mandated. Who mandates and pushes required changes in the use of mark-to-market accounting? Right now, Congress continues to be immersed in the Enron meltdown and thus is wont to do a lot of saber-rattling concerning new legislation.

Frank Partnoy, a law professor at the University of San Diego law school and former Wall Street derivatives trader, likes the idea of federal legislation pertaining to gatekeepers, including law firms, auditors, banks, securities analysts, independent company directors and credit rating agencies.

Starting from the assumption that gatekeepers failed to do their job with respect to Enron, Partnoy said one answer to the question of what to do about gatekeepers is to eliminate the legal requirements that companies use particular entities, especially credit rating agencies, while expanding the scope of securities fraud liability and enforcement.

``[The idea is] to make it clear that all gatekeepers will be liable for assisting companies in transactions designed to distort the economic reality of financial statements,'' Partnoy said in testimony in late January before the Senate Government Affairs Committee.

But many question the possibility of meaningful legislation from Congress in 2002. ``It's hard to imagine Congress taking some forward steps in an election year,'' said Robert P. Strauss, professor of economics and public policy in the H.J. Heinz School of Public Policy, Carnegie Mellon University, Pittsburgh, Pa.

If not Congress, who? The accounting profession largely regulates itself and for years has steadfastly resisted change.

FASB, founded nearly 30 years ago, merely sets industry guidelines and advises the SEC, and does so at less than the proverbial snail's pace. According to Colorado State's Turner, the SEC asked FASB to address the issue of whether certain transactions result in a liability or equity. That request was made in the 1970s--no answer yet.

Also in the 70s, it was recommended to FASB that it adopt a standard that would mandate a footnote describing and discussing financial statement items that affect the ability to compare statements from one reporting period to another. Investors still are waiting for guidance.

``We have let our monitoring institutions atrophy,'' said Carnegie Mellon's Strauss. ``Voluntary organizations have no incentive to do anything.''

Turner believes the trade group American Institute of Certified Public Accountants needs to put together a task force overseen by the SEC to make mark-to-market work.

Central Michigan accounting professor Weirich sees a united front from the SEC and the FASB teaming to make MtM changes. But again, not in the immediate future.

New self-regulatory organization. SEC Chairman Pitt wants to transfer both auditor regulation and discipline to a new self-regulatory organization, the Public Accountability Board. It would be staffed and overseen primarily by outsiders--not practicing accountants--who would assume control of the review process.

But setting-up such an independent organization would take a move by Congress; again, unlikely in an election year.

Fewer, broader rules. Partnoy believes that regardless of which body makes a move, enacting more and more precise rules is not the answer to the current accounting mess. Rather, broad general standards should be enacted.

``The industry will oppose broad standards because they could be sued,'' Partnoy said in an interview. ``Over the last 10 years, more and more rules have been enacted and the industry has been able to say `we followed the rules,' and was able to hide its malfeasance,'' Partnoy said.

To get away from hiding behind the rules, Partnoy suggests passage of a general law, much like the general anti-abuse rule in the nation's tax system. Such a general law would allow the SEC to bring enforcement against the perpetrators and allow litigation to be brought by the private sector.

``Broad general standards would make it more difficult for companies to engage in accounting shenanigans,'' Partnoy said.

As more and more companies inundate investors and analysts with more and detailed information concerning where their numbers originate from, this ``upfrontness,'' while perhaps trimming some former and future reported earnings, only can help companies in the long run, many say.

Jeremy Siegel, a finance professor at the University of Pennsylvania's Wharton School, believes the spotlight on accounting is causing many companies to follow a conservative approach concerning earnings, revenue or debt that fall into gray areas.

As a result, reported earnings could be lower this year than expected, even as business rebounds from the current downturn. Earnings affect stock prices, according to Siegel, and lower earnings mean lower stock prices.

The claim that increased scrutiny and forthrightness concerning a company's financial picture causes volatility overlooks the more important fact that such detail provides greater clarity, according to Charles River's Parsons.

``In some cases, by reducing discretion and the sometime arbitrariness used in calculating values, you actually will reduce volatility,'' Parsons said.

Ultimately, with Congress snarled in election-year politics, and the accounting industry at least for the present remaining guarded and overseen by its own, the investment community may have to do more to make sure mark-to-market accounting is used in a more responsible way.

``The problems with mark-to-market are partially resolving themselves,'' according to Commerzbank's Meade, ``as investors and analysts get comfortable with MtM and demand to know more.

``It's hard to go back backwards with disclosure; we are likely to see even more disclosure in the future,'' Meade said.

· THE IDEAS INDUSTRY. Overtaxed Underwear and the Toll of Tariffs

March 26, 2002

The Washington Post

By Richard Morin and Claudia Deane

To understand what's wrong with U.S. tariff policy, think about women's silk panties. So says Edward Gresser, director of the project on trade and global markets at the Progressive Policy Institute.

The tariff imposed on these upscale undergarments is 2.4 percent.

Now consider nylon and other "artificial fiber" panties. The tariff on these working-class unmentionables is more than 16 percent, or seven times the tariff on the luxury underwear.

And what's true for underwear is true for sneakers, spoons, men's shirts, drinking glasses, baby clothes and dozens of other household items, Gresser writes in a paper to be released by PPI today.

Within these categories, tariffs on inexpensive goods are considerably higher than those on luxury items.

"A look at today's U.S. tariff system reveals a surprising and uncomfortable fact: It has become steeply tilted against the poor," Gresser says.

Years of trade talks have brought tariffs, on average, to less than 2 percent. But they remain high on all sorts of consumer goods -- particularly clothes and shoes, where "tariffs are almost eight times the overall average," according to Gresser's paper.

"Thus the poor -- above all single mothers, who spend more on average on clothing than other families -- lose far more of their income to tariffs than wealthy or middle-income consumers," argues Gresser, policy adviser to the U.S. trade representative during the last two years of the Clinton administration.

DIG THOSE DERIVATIVES: Enron's smashup has brought infamy to some of the country's corporate citizens, but it also has delivered a dollop of fame to some members of Washington's thinking class.

A case in point is Randall Dodd, who persuaded the Ford Foundation to fund a new Derivatives Study Center at the Economic Strategy Institute in June 2000.

"A year and a half ago, I couldn't get people to even focus on the subject" of derivatives, said Dodd, recently returned from a New York press junket. "Now I've got every journalist in town calling me up every day for hours, asking me to explain what derivatives are like. I've got people from the Hill, government agencies, calling me up."

"I have to write at night, because I'm spending the day briefing people," he added.

For those of you nodding and smiling and having no clue what we're talking about, Dodd explains that a derivative is "a futures contract. We agree today on the price at which you are going to buy and I am going to sell something, like corn, at a future date." Enron's disastrous foray into the derivatives market has made the subject hot hot hot.

One lesser-known fact: You can sign a futures contract on just about anything in the world, with the exception of . . . onions, according to Dodd.

"It's a famous case," often joked about at derivative conferences, he said (as in: "Don't cry over onion contracts . . . ha ha.")

The Columbia University-trained economist admits that being a derivatives specialist can occasionally be a turnoff at cocktail parties.

"It does have sort of a geekish aura about it, that's true," Dodd said. "But sort of like the way the high-tech boom made quants and code geeks cool, somehow, Enron is raising the curiousity about derivatives, even if it's in a sort of sinister way."

RANK THE TANKS: Speaking of silver linings, last year's economic downturn boosted the National Bureau of Economic Research into the top five category of 2001's most-cited think tanks, according to a new report.

Last November, the Massachusetts-based tank sounded the recession's official starting gun, and then watched its media citations skyrocket, according to data collected by Montana State University sociologist Michael Dolny for the left-leaning Fairness & Accuracy in Reporting.

NBER came in No. 4. Rounding out the top five were four repeats from last year's list: the Brookings Institution (1), the Cato Institute (2), the Heritage Foundation (3) and the American Enterprise Institute (5).

Dolny also finds that conservative tanks continue to dominate the limelight, snagging 48 percent of the citations, compared to 16 percent for left-leaners and 36 percent for the middle-of-the-roaders. Check out the report at www.fair.org.

PEOPLE: The American Enterprise Institute has hired Senate Foreign Relations Committee senior staffer Danielle Pletka as vice president for foreign and defense policy. For the past 10 years, the Australian-born Pletka (now a U.S. citizen) has served as an adviser on the Near East and South Asia to Sen. Jesse Helms (R-N.C.).

Known on the Hill as a staunch conservative with a caustic manner, Pletka is also a partner in a true Washington-style marriage. Her husband, Stephen Rademaker, is the deputy staff director of the House Committee on International Relations, and is awaiting Senate confirmation to become assistant secretary of state for arms control.

The Henry L. Stimson Center has hired Ellen Laipson as its new president and chief executive. Laipson, who has worked for the National Security Council and the State Department, is currently the vice chairman of the National Intelligence Council.

David Scheffer, a former Clinton administration ambassador at large for war crimes issues, is joining the United Nations Association of the USA as senior vice president. Scheffer most recently served as a senior fellow at the U.S. Institute of Peace.

· Congress Again Tries to Tighten Derivatives Rules a Bit

March 13, 2002

The New York Times

By RIVA D. ATLAS

Congress is making another modest attempt to tighten regulation of the derivatives markets after the bankruptcy of the Enron Corporation, which used derivatives in part to keep debt off its balance sheet.

Derivatives are financial contracts that promise payments from one party to another and that have a value derived from changes in the price of an underlying security, index or commodity. The value of outstanding derivatives contracts is estimated at $100 trillion by the Bank for International Settlements, an organization based in Basel, Switzerland, that works with central banks.

The business is a big one for banks, which are working to defeat efforts to regulate these contracts.

''This is the sacred cash cow for banks,'' said Prof. Frank Partnoy of the University of San Diego's law school and a former derivatives salesman at Morgan Stanley. ''Derivatives contribute more to the profits of commercial and investment banks than any other business line.''

As part of its consideration of a broad energy bill, the Senate today temporarily set aside an amendment sponsored by Senator Dianne Feinstein, Democrat of California, that would allow the government to regulate certain energy and commodity derivatives. (The bill does not address agricultural or financial commodities.) Senator Feinstein and Senator Phil Gramm, Republican of Texas, were working on a mutually satisfactory way to bring the amendment to a vote.

The energy and commodity derivatives that are the focus of Senator Feinstein's bill are traded over the counter and not on any exchange. Approximately 90 percent of all derivatives are traded over the counter, but less than 4 percent of O.T.C. derivatives are energy contracts, said Randall Dodd, director of the Derivatives Study Center, a nonprofit research institute. These derivatives include contracts tied to the price of fuel oil or electricity.

Though it would affect a relatively small portion of the market, the Feinstein amendment is being watched by the banking industry, because its passage could signal that Washington is open to broader regulation of derivatives trading.

If the amendment passes, ''it will shift the nature of the debate from whether derivatives will be regulated and establish that the O.T.C. derivatives market does need some oversight,'' Mr. Dodd said.

This is at least the fourth time that Congress has looked at regulating derivatives this decade, each time after a scandal over losses on trades by large institutions.

In 1994, derivatives were in the spotlight after Procter & Gamble sued Bankers Trust, citing more than $100 million in derivatives losses. Later that year, Orange County, Calif., reported a $1.5 billion loss, largely because of investments in derivatives. Then in 1998, Long-Term Capital Management, a hedge fund, nearly failed, thanks to approximately $4 billion in losses that included soured derivatives bets.

After each event, Congress held hearings but failed to pass legislation, Mr. Partnoy said. ''The financial services lobby is much too powerful,'' he said. ''Scandals aren't enough to get Congress moving.''

After heavy lobbying by the banking industry -- and Enron -- derivatives regulation was instead loosened in December 2000 when Congress passed the Commodity Futures Modernization Act. The bill exempted or excluded O.T.C. derivatives from regulation by the Commodity Futures Trading Commission.

Now, just over a year later, banks worry that the Feinstein amendment could be the first step at reversing that legislation. While individual banks are keeping a low profile in lobbying Congress, groups representing the industry are aggressively fighting the Feinstein amendment.

''What's amazing is how much the derivatives lobby cares about this,'' said Mr. Partnoy, considering the small size of the energy derivatives market. ''Maybe dealers are worried that this will open the floodgates.''

On March 5 eight trade associations, including the American Bankers Association, the Financial Services Roundtable and the Chamber of Commerce, sent a letter about the amendment to Senator Tom Daschle, the Democratic majority leader, and Senator Trent Lott, the Republican leader. The letter said the Feinstein amendment would ''impose new regulatory burdens on the parties to and dealers in these transactions and on the trading facilities they use.''

Stacy Carey, policy director for the International Swaps and Derivatives Association, which also signed the letter to the senators, said the industry did not believe that derivatives were a cause of Enron's collapse. ''We don't feel efforts like the Feinstein legislation will prevent another Enron from happening,'' she said. ''It may make people feel good. But a regulatory review should focus on areas that really were a problem.''

On Monday, Harvey L. Pitt, chairman of the Securities and Exchange Commission, sent a letter to Senator Michael B. Enzi, Republican of Wyoming and a member of the Banking Committee, indicating his opposition to the Feinstein amendment.

''The Securities and Exchange Commission believes this legislative change is premature,'' Mr. Pitt stated, citing ''the absence of a determination about what role (if any) over- the-counter derivatives played in the collapse of Enron.''

Mr. Dodd, though, is hoping the Feinstein bill is just the beginning of further regulation. He said he was in contact with half a dozen House and Senate committees, as well as several federal agencies. In a report to be released today, Mr. Dodd outlines broader recommendations to tighten oversight of derivatives, including establishing capital and margin requirements and establishing registration and reporting requirements.

The bank with the most to lose if derivatives regulation is tightened is J. P. Morgan Chase, the largest dealer in the contracts, according to Swaps Monitor, which tracks the industry. J. P. Morgan had $24 trillion worth of such contracts outstanding in November, although the firm says it has only $50 billion at risk, after taking into account collateral and hedges. Morgan's derivatives business is more than twice the amount of the second-largest bank in the market, Deutsche Bank. Derivatives accounted for an estimated 15 percent to 20 percent of Morgan's profit last year, according to Ruchi Madan, an analyst at Salomon Smith Barney.

A spokesman for Morgan, Michael Dorfsman, declined to comment on the pending legislation, referring calls to the trade associations.

Mr. Partnoy said he was pessimistic that Congress would finally overcome the banking industry's opposition and get any significant legislation passed this year that would increase the regulation of derivatives.

''The problem is, this is not something the public will get excited about, so nothing will happen,'' he said. ''Any serious reform does not have a chance.''

· Enron And The Betrayal Of Capitalism

March 08, 2002

Felix G Rohatyn

Australian Financial Review 4

Felix G Rohatyn urges strong measures to bring accountants to book

During my nearly four years as US ambassador to France I frequently gave a speech I called ``Popular Capitalism in America'' to audiences throughout France. This is a subject of intense interest to the French and to most other Europeans, who envy us our high rates of growth and low unemployment but who often believe that the price we pay for these benefits is an inadequate social safety net, a tolerance for speculation and unacceptable inequality in wealth and income. They also see the American system as one that inflicts high levels of poverty and unemployment on developing countries by the harsh stabilisation measures required by the IMF and other Western-directed financial institutions. I made this speech to dispel some of these notions and to encourage reforms in European countries in matters such as taxes, investment and employment. These, I argued, would, to our mutual benefit, align our systems more closely.

In doing so, I defended our economic model as one that could deliver more jobs, and more wealth, to a higher proportion of citizens than any other system so far invented. A major component of this system is its ability to include increasing numbers of working Americans in the ownership of US companies through IRAs, pension funds, broad-based stock options and other vehicles for investment and savings. I agreed with, and cited, Federal Reserve chairman Alan Greenspan's statement that ``modern market forces must be coupled with advanced financial regulatory systems, a sophisticated legal architecture and a culture supportive of the rule of law''. After 40 years on Wall Street I had no doubt that, despite occasional glitches, our economy met Greenspan's requirements.

However, as I regularly travelled back to America between 1997 and 2001 there were developments in our financial system that deeply troubled me. The increase in speculative behaviour in the stockmarkets was astonishing. In 1998, as a result of reckless speculation by its managers, the giant hedge fund Long Term Capital Management went bankrupt and, in doing so, threatened the financial system itself. The New York Federal Reserve organised a group of banks and investment houses to rescue the company at a cost of several billion dollars. The sharp rise in dotcom stocks came soon after, together with relentless publicity campaigns to push the markets higher and higher. TV ads of online brokers urged everybody to buy stocks and trade them day by day. So-called independent analysts made fantastic claims about their favourite stocks in hopes of generating investment-banking business for their firms. These claims were often supported by creative accounting concepts such as ``pro forma earnings'' a management-created fiction intended to show strong results by excluding a variety of charges and losses and one that was implicitly approved by supposedly independent auditors. A large part of the stockmarket was becoming a branch of show business, and was driving the economy instead of vice versa.

The financial regulators whether in the Treasury Department, the Federal Reserve, the Securities and Exchange Commission or other agencies were either unwilling or unable to check this behaviour. The then chairman of the SEC, Arthur Levitt, tried to adopt rules that would prevent the more obvious of the conflicts of interest that were widespread among auditors. He was blocked from doing so when the accounting industry lobbied members of Congress to oppose his initiative. The Federal Reserve could have raised the margin requirements for stocks listed on the NASDAQ, which would have sent a powerful signal to the rampant speculation on that market and somewhat limited the damage caused by it. The Federal Reserve chose not to do so.

When the inevitable happened and the bubble burst, $US4 trillion of market value evaporated, much of it in high-tech stocks. Half of all American families own listed stocks, and as more and more middle-income Americans saw their savings disappear, and company after company went bankrupt and thousands were laid off, I began asking myself whether I could make that speech again. Was our popular capitalism in fact providing both for the creation of wealth and for regulation that would protect the public and encourage high standards of corporate governance? Greenspan's belief in the effectiveness of responsibly regulated market forces clearly was not being matched by reality.

The events surrounding the bankruptcy of Enron go beyond the sordid situation of Enron itself and raise the larger question of the integrity of our financial markets. That integrity must be maintained to protect our own investors, to finance economic growth, and to maintain the flow of foreign investment. As of the end of 2001 about 15 per cent of all shares listed on the New York Stock Exchange and the NASDAQ were foreign-owned. They had a value of about $US2 trillion. We must keep in mind that the US requires about $US1 billion a day in capital inflows to finance our trade deficit. A decrease in foreign investment would have seriously damaging effects on the securities markets, the stability of the dollar and the economy generally. The last thing we should tolerate is a loss of confidence in our capital markets.

While it is too early to make definitive judgements, recent events suggest that our regulatory system is failing. Enron, one of America's Fortune 50 public companies, reporting over $US100 billion in sales and almost $US1 billion in earnings, melted into bankruptcy in a period of six months, with a loss of $US90 billion in market value. As many did not realise, Enron was not only a supplier of energy but a major financier of dealings in energy, and eventually in other commodities as well. In carrying out its trading operations, the company organised more than a thousand financial partnerships and other entities, some involving Enron executives, whose losses were not fully disclosed to the public, and these losses ultimately caused huge write-downs in earnings and assets. Parts of the company's record in its dealings in the commodity futures called derivatives and in other risky financial operations appear to have been deliberately concealed and the company's overall financial position was misrepresented. Enron's management and auditors knew about these matters but did not make them public.

Nor in many cases, apparently, were they obliged to. The US derivatives market had been deregulated in December 2000 by the Commodity Futures Modernisation Act. Although Enron was in effect a financial institution, it had, for a considerable period, no legal obligation to submit some of its important financial operations to regulators for scrutiny; and no state or federal agency was responsible for regulating some of its most important transactions.1 The company's accounting firm, for its part, has now admitted destroying documents. Most troubling of all, Enron's senior executives and board members sold over $US1 billion of Enron stock while many of the company's 25,000 employees lost much of their savings, which, trusting the company's assurances, they had invested in Enron-managed 401(k) retirement plans.

In a single six-month period one of America's leading companies became the symbol of the defects in American capitalism claimed by its critics. And Enron's failure is only the latest in a series of events that have cast a shadow on the integrity of our markets and the efficacy of the regulators over the past few years. If we allow continued abuse of our securities markets, one of the basic functions of our system will be destroyed. As Congress examines the fate of Enron's stockholders, creditors and employees, it should bear in mind the other abuses of the system that, over the past few years, have caused immense harm.

In 1932, the congressional hearings conducted by Ferdinand Pecora of New York started a major process of reform of our financial system. As a result a regulatory structure was created which, until recently, has served us well, although such episodes as the savings-and-loan debacle required strong government action. Serious reforms again are needed, particularly to ensure that accounting firms will henceforth act honestly and responsibly. The securities laws require full disclosure; the accounting firms must ensure that their clients' profits, losses and assets are disclosed accurately and coherently. The self-regulation of the accounting industry should be closely scrutinised, and, if necessary, abolished and replaced by a new system of controls. At present, five accounting firms have a virtual monopoly on the audits of most of the US companies listed on the stock markets, a highly unusual level of concentration for any industry.

These firms had enough political power to prevent former SEC chairman Arthur Levitt from adopting rules that would prohibit the conflicts of interest inherent in the present system, in which accounting firms often audit the accounts of a company while also acting as its paid financial consultant. For the accounting industry to rely on a system of ``peer review'', by which the major accounting firms are responsible for reviewing one another's work, is evidently unsatisfactory. During the 40 years or so that I have served on the boards of directors, and often on the audit committees, of a variety of companies, I do not recall a single instance when a negative peer review was brought to the attention of an audit committee. In this period, the technology of finance and the creation of innumerable derivatives and other new financial instruments (and the problems that resulted) certainly warranted a different approach. Just who should regulate the auditors is an important question for Congress to debate, but there is no question that a new system of regulation is necessary.

Harvey Pitt, the new chairman of the SEC, believes in creating a new agency that will establish more stringent accounting standards but would address neither of the two central issues: the need for a governmental review mechanism that is independent of leading accounting firms, and the need to eliminate the conflict of interest between auditing a firm's accounts and acting as its financial consultant. Arthur Levitt strongly dissents from Pitt's view, and considers the issue of independence to be fundamental. They are both right: accounting standards have to be dealt with more effectively but so do conflicts of interest. (Increased fees for basic audit services would help to offset the loss of income from consulting.) The SEC has considerable powers in these matters, and if more extensive powers are needed, the Congress can provide them, as well as the budgets to enable the SEC staff to deal with them.

One possibility worth considering for any new regulatory system would be a requirement that companies periodically change their accounting firms, for example every five years. This would be expensive and somewhat cumbersome, but in addition to keeping auditors on their toes, since their work will be subject to scrutiny, it might also generate greater competition in the industry by encouraging new accounting firms to enter it. We should bear in mind that the crucial accounting functions for any companies must be carried out by its own internal auditing and will depend on the strength of its internal controls. (Internal auditors should be company employees with no recent affiliation with the company's outside auditors.) In a new system the continuity of these internal functions would be maintained while outside auditors would come and go.

Potential conflicts of interest, of course, are not limited to the work of auditors; there is a lot of blame to be shared. To cite only a few other examples, questions have also been raised about the objectivity of securities analysts who are pursuing investment banking business; about the way investment banks allocate underwritings of hot new issues among their clients; and about the activities of banks in the US, following the repeal of the Glass-Steagall Act, in acting simultaneously as lenders, underwriters, financial advisers and principal investors in some transactions.

American popular capitalism is a highly sophisticated system that needs sophisticated regulation whether in finance or in other fields. The government itself does not seem to have acted illegally in the Enron case; it is the government's failure to anticipate and prevent what happened that is the problem. Unless we take the regulatory and legislative steps required to prevent a recurrence of these events, American market capitalism will run increasing risks and be seen as defective here and abroad. That could have deeply serious consequences not only for our domestic economy but for the world economy as well. Enron's failure was a failure of particular people and institutions but it was above all, part of a general failure to maintain the ethical standards that are, in my view, fundamental to the American economic system. Without respect for those standards, popular capitalism cannot survive.

NOTE

1 Information on these and other operations of Enron, on which I draw here, has been compiled by Randall Dodd and Jeff Madrick.

· Going private

March 01, 2002

Institutional Investor

Lucy Conger

LATIN AMERICA DEVELOPMENT

The IDB plans to promote the private sector to tap its entrepreneurial energy to revive growth. Critics call it trickle-down economics.

Although a number of Latin American leaders and not a few U.S. economists are inclined to believe otherwise, "free" markets don't come without a cost. After more than a decade of reducing trade barriers, privatizing state enterprises, imposing fiscal discipline and carrying out other classic neoliberal free-market reforms, Latin America appears to be worse off than before by several key economic measures.

Alarmed at the lack of progress, Inter-American Development Bank president Enrique Iglesias last year commissioned a study of IDB member countries' global competitiveness that amply confirmed his fears. Released in October, the analysis found that over the past decade, most of the 26 nations in the bank's Latin American and Caribbean domain had backtracked in productivity; seen slower gains in education; made no headway against the poverty that afflicts one out three of the region's residents, even as the gap between rich and poor widened; and managed as a group to grow at a lackluster 3.3 percent a year, compared with 5.2 percent for Asian developing nations. Only Africa ranks behind Latin America and the Caribbean in competitiveness, the report said. Its unflinching conclusion: "Most countries in Latin America and the Caribbean lack the foundation to substantially improve growth in productivity and incomes." Latin America's infrastructure needs are put at $500 billion over the next decade.

What's the solution? The cure for the deficiencies of capitalism may be more capitalism, the IDB has been told. In recommendations to be presented at the bank's annual meeting this month in Fortaleza, Brazil, a blue-ribbon panel appointed by Iglesias and headed by former Mexican Finance minister Angel Gurria will lay out the case for creating an IDB affiliate comparable to the World Bank's International Finance Corp. to promote the private sector by making loans directly to companies.

This new entity would use partial loan guarantees and other forms of insurance and reinsurance products in a bid to lure wary investors back to Latin America and the Caribbean. The affiliate would be "more creative and modern, design new products and projects and use capital to a greater extent to deal with the private sector," says Gurria.

"The scenario in which Latin America carried out the reforms in the 1990s no longer holds," Iglesias told Institutional Investor. "We have to rethink things. The fronts where we must work to be more competitive include credit, institutions, technology and information systems. And our actions must go in tandem with a comprehensive social program."

The panel has urged the bank to engage member governments in a dialogue to identify the "next big thing" that would allow their countries to prosper in the global economy. Each country would draft a national competitiveness program revolving around legal and bureaucratic reforms; easier access to capital; and educational, infrastructure and trade improvements.

At issue are so-called second-generation structural reforms that are more complex and often more prickly than first-generation measures such as taming inflation, trimming public spending and privatizing state enterprises. Countries need to provide fuller disclosure and establish accountability at major institutions, upgrade administration, combat corruption, enforce the law and ensure continuity in regulation. This is in addition to maintaining fiscal discipline and pushing through difficult labor and tax reforms.

Under the Gurria panel's proposals, the IDB would press for and help underwrite establishment of reasonable and predictable rules, solid enforcement mechanisms and greater transparency. Poor creditor rights and slipshod corporate governance are "big issues preventing greater capital flows" to emerging markets, points out Abigail McKenna, managing director of Morgan Stanley Asset Management.

The panel's recommendations, which must be vetted by the IDB's full membership, are bound to be contentious because they involve a significant shift in the bank's resources from the public sector to the private. In January the IDB doubled its existing cap on private sector lending to 10 percent of its portfolio. The panel has not proposed a funding level for the affiliate.

Its recommendations would appear to derive from a certain logic. "It's a simple equation," explains Gurria. "The savings irate in Latin America is insufficient to fund the necessary investment for economies in the region to grow at their cruising speed, to absorb new labor entrants and pick up the lag. You have to give people education, health and jobs to cover the lag, and the only way to do this is to increase investment and growth." Another panel member, Marcilio Marques Moreira, a former Brazilian minister of Economics, Finance and Planning and now senior international adviser to Merrill Lynch & Co. in Rio de Janeiro, says of the proposed private sector arm: "You need to have a more dynamic unit at the IDB to deal with the private sector and capital markets. It's a very different story from sovereign governments and the public sector."

Still, the IDB's prospective free-market thrust comes at a time of growing doubts in Latin America and elsewhere about the extent of the benefits of capital markets liberalization and export-led growth (see related story, page 89). The development bank is already under fire for supposedly neglecting the plight of the poor. "It is difficult to have sustainable economic growth without more equitable sharing in the wealth it has generated," contends Peter Bell, president of Care. "There has been a growing appreciation at the bank for issues of poverty and the social side of development, including the building of civil society. But the capacity to follow through on that, and turn it into effective policies, programs and loans, lags."

The panel's development experts, in championing private enterprise rather than the state as the engine of growth, argue that only such an emphasis can significantly raise productivity and output, which ultimately improves living standards for the poor as well as the middle class.

But to some skeptics this harks back to the discredited "trickle down" economics of the 1980s. "They should consider that a rising tide doesn't lift all boats," says Randall Dodd, director of the Derivatives Studies Center, a Washington, D.C., research and policy group specializing in financial market regulation. "It has done so with full employment in developed countries, but developing countries that are far from full employment need policies that address income distribution and create demand." Nora Lustig, an economist on leave from the IDB to serve as rector of the Universidad de las Americas in Puebla, Mexico, observes that "things that can imply investing in the poor are also good for growth: Human capital investments in education, health and nutrition improve the living conditions of the poor and make them more productive."

But as Nancy Birdsall, president of the Center for Global Development and a former executive vice president of the IDB, points out: "It would be a false hope to think the Bank's projects, which represent 2 to 5 percent of public spending, will be in and of themselves a big factor in reducing poverty, so you can't get away from the overall policy framework."

Others fault the panel's loan guarantees and kindred proposals on technical grounds. "There should not be a blanket application of credit enhancements and guarantees,"says Mohamed EI-Erian, emerging-markets director at Pacific Investment Management Co. in Newport Beach, California. "They obfuscate market signals, subordinate unsecured creditors and do not result in a net addition of resources." Gurria, however, counters: "Markets don't have complete information and tend to move in procyclical swings. So the IDB - with its knowledge of the region - can mitigate risk with partial guarantees, reinsurance and risk-sharing."

The Gurria panel is more than familiar with the many permutations of the development debate. A powerhouse team combining expertise in regional issues with savvy about the capital markets, the 15-strong External Advisory Group is laden with former finance ministers and central bankers as well as academics and prominent commercial and investment bankers. Roughly half the members are former Finance or Economy ministers from Latin America and the Caribbean: Argentina's Jose Luis Machinea, Brazil's Marques Moreira, Chile's Manuel Marfan, Colombia's Jose Antonio Ocampo, El Salvador's Manuel Hinds, Mexico's Gurria and Wendell Mottley of Trinidad and Tobago. The other eight represent the IDB's nonborrowing member countries: Canada's Sylvia Ostry, a University of Toronto economics professor and a former deputy Trade minister; Germany's Albrecht Raedecke, an advisory board member of Deutsch-Sudamerikanische Bank; Israel's Jacob Frenkel, chairman of Merrill Lynch Sovereign Advisory Group and a former Bank of Israel governor; Japan's Makoto Utsumi, a former vice minister of Finance and now a business professor at Keio University; Spain's Guillermo de la Dehesa, president of Plus Ultra Insurance and a former Finance minister; the U.K.'s Nicholas Baring, a member of the Baring Foundation's management council; Darby Overseas Investments chairman and former U.S. Treasury secretary Nicholas Brady; and David Hale, global chief economist of the Zurich Group, also of the U.S.

The panel's stress on private sector solutions stems as much from practical considerations as ideology. Great shifts have occurred in Latin American and Caribbean economies over the past decade. Privatization campaigns have transformed once state-run utilities, telecommunications companies and highways. Governments have restrained their hitherto dominant economic role and cut back spending and borrowing accordingly, while encouraging private investment.

Foreign investors have responded enthusiastically, albeit with intermittent panic attacks; private capital flows into the major Latin economies now eclipse lending by the IDB.

Yet, as has so often been seen in Latin America - in the 1995 "tequila" panic, the 1997 Asia crisis, Russia's 1998 default and again with Argentina's collapse in recent months -- private capital flows can dry up suddenly. "The lesson of Argentina is that, with the private sector, it's feast or famine," says Pimco's El-Erian.

What can the IDB do to help tie down this foreign money? Possessed of $101 billion in capital, the bank is well positioned to play a greater role alongside private investors in supporting infrastructure and other growth-generating projects. The bank's private sector affiliate might, the panel suggests, develop and invest in regional, subregional, national and sector funds to promote private investment through private equity and mezzanine funds. The private sector arm might also enter into partnerships with investors and regional development banks to underwrite private sector ventures.

It would also develop innovative financial products to make investing in the region more alluring. The panel envisions credit-enhancement and risk-mitigation tools, partial guarantees, the leadership of syndications for national and regional projects, credit guarantees and insurance. The affiliate should also embrace a completely new financial mechanism, says Gurria: partial guarantees on contracts. Backed by the affiliate, these would cover arbitrary changes in regulations or in the legal climate. Another recommendation is to make greater use of insurance to entice Latin America's growing pension funds to make direct investments that they'd otherwise deem too risky.

"What is often lacking in development is private sector financiers willing to invest in infrastructure projects because they are concerned the government will back away from its undertaking," says a close associate of the panel, Robert Graffam, managing director of Darby Overseas Investments in Washington, D.C., and former head of risk management for the IFC.

The idea of the various guarantees, says Gurria, "is to seek structures in which every peso or dollar that the IDB lends can mobilize six or seven." Graffam illustrates the concept this way: If the IDB lent $1 to Colombia to build a power plant, it wouldn't get nearly as much bang for the buck as if it instead backed a partial guarantee covering 20 percent of the risk in the plant on behalf of private investors.

Funding for the private sector arm would come either from a direct equity investment by the IDB or from a capital increase by shareholders. But the key is that the affiliate would be launched as a financially distinct entity so that it could leverage its capital by borrowing. Although the IDB would retain a controlling interest, the affiliate would have a separate balance sheet to protect the bank's cherished triple-A rating, explains Gurria. As for the affiliate, it would be expected to achieve and maintain an investment-grade rating.

Some market players are skeptical about the panel's rough sketches for products (the blueprint stage is still a ways off). Political-risk guarantees tend to be hard to understand because of all the qualifiers and exclusions, they say, suggesting that the contractual-risk notion would require elaborate explanations that might intimidate investors. Some market analysts argue that it's not efficient to use the IDB's triple-A balance sheet in the guise of a partial guarantee to back a private investor's double-B risk and come up with something in between. Darby Overseas' Graffam, however, points out that the panel emphasizes partial guarantees and risk reducers precisely because these would allow the affiliate to use up as little of the IDB's own risk as possible backing other credits. In addition, panel members say, the use of such sophisticated instruments would accelerate the transfer of financial technology to Latin America.

Others critics, like Pimco's EI-Erian, question cushions for credits because they can distort the market. Instead, he proposes that the IDB affiliate apply enhancements and guarantees only to companies that have no access to the markets. "Certainly, there is a market failure in financing small, medium and local enterprises in Latin America," he says. "The way to do it is through equity participation and allowing entrepreneurs to graduate" by being bought out or going public.

In a sensitive proposal that does not involve the private sector affiliate, the panel urges the IDB to launch a pilot program of direct lending to provincial and municipal governments and regional utilities without the usual sovereign guarantees. The rationale is that decentralization over the past decade has left provincial governments in charge of many health and education programs and some antipoverty initiatives, making them much more critical players in development. "If you want to reform education and health, you have to work at the level of provinces because that's where the decisions are made," says panel member Machinea, former Argentinean Economy minister.

This form of lending nevertheless demands strict supervision to prevent provincial and city governments from taking on too much debt. Claudio Loser, director of the Western Hemisphere department of the International Monetary Fund, sounds a note of caution: "Our position has always been one of concern about the foreign indebtedness of subnational governments. We have always asked for great prudence and strict coordination with subnational governments."

Perhaps the most controversial of all the panel's proposals, though, is that the IDB consider calling for a ninth capital replenishment. The last time that the bank was recapitalized by its members, with an injection of $40 billion in 1994, its lending capacity grew substantially. But a "zero growth" constraint was imposed that mandated that the bank's lending be "sustainable"; in practice, this meant it had to cap new loans at the amount of loan repayments.

That cap now feels snug. The panel also recommends that other means be explored to expand the IDB's capital, such as increasing leverage. But now that the subject of a major new capital infusion has been broached, it is sure to be debated animatedly at the IDB meeting. The U.S., for instance, is understood to back funding for the private sector initiative.

Machinea says of the IDB's need for fresh funds, "Emergency situations arise in the countries, and the bank has to be prepared to lend in them." And, as an Argentinean, he can say that with particular conviction.

· Sound Off!

March 01, 2002

Futures

Misplaced pride? Joseph Graham's pride in being part of the trading staff of Enron is admirable and possibly deserved (see "Don't Blame the Traders," Sound Off! Futures, February 2002).

However, in one of the many investigations of the disgusting collapse of Enron, San Diego University law professor Frank Partnoy discovered that some Enron traders "hid losses and understated profits, which had the effect of making derivative trades appear less volatile than they were. Further, Randall Dodd of the Derivatives Study Center said that he had reached a similar conclusion. Thus, the traders' alleged cheating added further fuel to the fire that was burning Enron alive.

[Some former Enron traders] may suffer from "Stockholm Syndrome," a psychological condition where hostages identify with and support their captors after a period of time has passed. Perhaps it should be referred to...as "Enron Syndrome." Jeff Skilling would be proud.

A lot of qualified former Enron traders are looking for work. Of course, they will tell you they were profitable. Apparently, some Enron traders "cheated" to become profitable. Will we ever know who they were?

Randy Brown

RBrown5658@aol.com

End of the road I thoroughly enjoyed your article about the "end-run" of Enron. You pointed out some things I have not heard elsewhere yet.

It looks like the regular employee got taken to the "gas chamber" on that one. I hope our leaders, regulators and investigators can revamp the 401k system and produce meaningful regulations to protect the retirements of the average employee.

E. W. "Bill" McGary

Commodity Dept. Manager/VP TD Waterhouse Commodities

Thanks for the note. However, instead of increasing the rules governing 401k accounts, authorities should crack down on the accounting practices with which Enron built its house of straw.

· DERIVATIVES LEGISLATION ALARMS SOME; NEW FORM OF OVERSIGHT SEEN LIKELY

March 01, 2002

Inside F.E.R.C.'s Gas Market Report

Many in the energy industry have resigned themselves to tighter regulatory oversight of energy markets following the collapse of Enron Corp. But a proposed bill to give federal agencies more control over energy derivatives trading is seen by some industry players as going too far.

``There clearly will be some legislation in this area, just given the political pressure for Congress to respond to recent events and to respond to its own failure to address these issues several years ago,'' said one industry source.

Nevertheless, industry insiders are calling S. 1951, a bill sponsored by Sen. Dianne Feinstein, D-Calif., a ``knee-jerk reaction'' aimed at the wrong culprits in the nation's largest bankruptcy. But an independent derivatives market watcher said the measure was ``a good beginning'' to protect the market and rein in companies' ability to abuse derivatives to the detriment of the industry.

Feinstein plans to offer the legislation as an amendment to the broad Senate energy bill, S. 517, during floor debate, which began this week. Her measure, aimed specifically at EnronOnline, would repeal exemptions and exclusions for bilateral derivatives and electronic energy markets from oversight by the Commodity Futures Trading Commission.

Dealers in energy derivatives would face registration and transparency, disclosure and reporting requirements. The bill expands FERC jurisdiction over derivative trades, allowing the commission to determine ``just and reasonable'' prices for derivatives. Firms running online trading platforms also would have to maintain enough capital to back their deals and keep their books open for possible investigation and regulatory enforcement.

The Enron bankruptcy ``has uncovered many gaping holes in our regulatory structure, everything from accounting and investment practices to online energy transactions,'' Feinstein said. Greater transparency would give consumers more protection, she added.

Support for the measure as an amendment on the floor remains unclear, but Feinstein, a member of the Senate Energy and Natural Resources Committee and the Senate Judiciary Committee, could pursue her bill, introduced Feb. 14, as a stand-alone measure later this year.

At least one CFTC commissioner agrees that trading operations such as EOL deserve regulatory oversight. Thomas Erickson, a Clinton nominee serving through 2003, told the Senate Energy and Natural Resources Committee that because of the ``gaping holes'' in the current law ``none of our federal regulators can give you any assurance that there was no manipulative or fraudulent activity in energy markets in the wake of the Enron collapse.''

In a Jan. 31 letter to committee Chairman Jeff Bingaman, D-N.M., Erickson said he did not ``sign on'' to the Jan. 29 testimony to the committee by CFTC Chairman James Newsome in support of the Commodity Futures Modernization Act of 2000, which exempts OTC energy products and electronic trading from federal regulation.

``In the wake of Enron, I believe that it is more important than ever for the Commodity Futures Trading Commission to inform Congress of the potential risks associated with the unregulated trading of derivatives,'' Erickson wrote. ``We have an affirmative duty to re-examine the rationale behind Enron operating a financial marketplace without direct oversight by any federal financial regulator.''

If Congress mandates reporting and capital requirements, such action would ``in no way [undermine] past contracts or contracts in the future,'' said Randall Dodd, director of the Derivatives Study Center, a Washington, D.C.-based nonprofit industry watchdog. To claim that federal oversight would stunt growth of the OTC derivative market, which stands at $50 trillion in the U.S., $750 billion of which was on Enron's books, is ``not intellectually honest,'' according to Dodd. In addition, ``no one has ever successfully sued and gotten out of a derivatives contract based on changes to the Commodity Exchange Act,'' he said.

The International Swap and Derivatives Assn. in New York, however, calls the Feinstein bill ``very troubling'' because it reverses exemptions not only for energy derivatives but for other financial products as well.

Congress, backed by the Clinton administration and the Federal Reserve, approved regulatory exemptions for OTC derivatives in the 2000 Commodity Futures Modernization Act. ``The current form of the [Feinstein] legislation kicks back or reduces a lot of legal certainty that was afforded to the OTC derivatives market'' in the act, said ISDA Policy Director Stacy Carey. ``We don't think OTC derivatives trading in energy caused either the Enron bankruptcy or the California energy crisis.''

Other industry sources echoed that claim. One noted that removing the exemption would add new uncertainty to the OTC market, creating the ``ultimate oxymoron.'' The bill could take a financial instrument ``that is supposed to hedge risk and in turn subject those financial instruments themselves to a high level of uncertainty based on non-market factors -- the judgment of regulators,'' he said.

The concern is whether FERC would be authorized to adjust a contract retroactively based on a just and reasonable test or some other standard without the criteria being ``very, very explicit and very, very detailed so parties trading know what can be expected,'' he said. The question of how FERC and the CFTC would interact in overseeing the OTC market also must be addressed, he said.

FERC is only beginning to develop its understanding of these financial instruments, while CFTC historically is less focused on consumer protection, according to the industry participant. A call for regulation would benefit from a detailed study, he noted. Capitol Hill needs to ``see if there is any way to achieve consumer protections without throwing a wet blanket over the market,'' the source added.

Craig Goodman, president of the National Energy Marketers Assn., said that energy markets ``have already identified and punished companies that have problems similar to Enron's. I would caution regulators and legislators not to overreact, to act prudently and wise in their actions, or it could threaten the retirement security of other pension plans and companies as well.''

Goodman maintained that a task force being assembled by NEM intends to craft its own solutions to the problem of risk valuation and to provide greater financial accountability. NEM hopes to have the task force work completed in time to present at its annual meeting in June.

``Energy markets are in a state of transition. While wholesale markets have formed and are functioning, all stakeholders recognize the need not just for liquidity and transparency, but for depth,'' Goodman said. ``We're reaching out to Wall Street, to ratings institutions and large financial institutions and banks to participate on our task force so that we can find a consensus position to take to the regulators.''

One market player suggested that the lawmakers look at the companies involved rather than at the market products, and see that there is support among traders for oversight of electronic exchanges, such as IntercontinentalExchange and TradeSpark. ``If electronic exchanges fell under the CFTC, there would not be huge objections,'' he said.

Ed Krapels, director of gas and power services at Energy Security and Analysis Inc., agreed that disclosure for online exchanges, akin to information available from the New York Mercantile Exchange, would be good for the market. ``You don't want to stifle the OTC, but you want some information to show if there is depth behind the market,'' he said. ``Some form of disclosure, even with lag time, is better than nothing.''

ISDA would prefer that Congress look at what the group believes caused Enron's downfall -- its accounting procedures -- and not the OTC trading activity. EOL remains a viable trading platform bought out by UBS Warburg, said Carey. ``It wasn't a situation where EnronOnline went bankrupt and that caused the collapse.''

But Dodd countered that derivatives played a key role in Enron's demise because the energy trading giant used them to ``perpetuate the shenanigans.'' Enron used derivatives extensively to create its web of partnerships that were then used to fabricate Enron's income and hide its debt and losses. Enron's fall ``couldn't have been done without derivatives,'' said Dodd.

A key problem was that Enron's derivatives dealers were not backed with enough capital, he said, citing former Enron Chief Executive Officer Jeffrey Skilling's statement to Congress that his company suffered ``a run on the bank.'' Unlike banks or securities traders, companies like Enron are not subject to regulation and capital requirements for trading these instruments.

While Congress approved legislation two years ago to exempt energy derivatives, Dodd predicted more lawmakers would support reversing that law now. ``It will be very hard to vote against [Feinstein's bill] in the current context,'' he said. ``Right now, it would be embarrassing to vote against this amendment to bring these markets to some degree of oversight and supervision.''

· Industry frets over Feinstein's OTC proposal

February 25, 2002

Megawatt Daily

Legislation to put over the counter energy derivatives under the regulatory tent of federal agencies is worrying the trading industry, as market participants anticipate some form of oversight following the Enron debacle.

Insiders called legislation, S. 1951, by Sen. Dianne Feinstein (D-Calif.) a ``knee-jerk reaction'' aimed at the wrong culprits to the nation's largest bankruptcy. But an independent derivatives market watcher said the measure was ``a good beginning'' to protect the market and rein in the ability to abuse derivatives to the detriment of the industry.

Feinstein plans to offer the legislation as an amendment to the broad Senate energy bill, S. 517, when it comes to the floor as early as this week. Her measure, aimed at shining light on EnronOnline, would repeal exemptions and exclusions for bilateral derivatives and electronic energy markets from oversight of the Commodity Futures Trading Commission. Dealers in energy derivatives would face registration, transparency, disclosure and reporting requirements. Firms running online trading platforms also would have to maintain enough capital to back their deals and keep their books open for possible investigation and regulatory enforcement.

Support for the measure as an amendment on the floor this week was unknown, but Feinstein, a member of the Senate Energy Committee and the Senate Judiciary Committee, could pursue the bill as a stand-alone measure later this year.

If Congress mandates reporting and capital requirements, that ``in no way undermines past contracts or contracts in the future,'' said Randall Dodd, director of the Derivatives Study Center, a Washington non-profit industry watchdog. The International Swap and Derivatives Assn. in New York, however, believes the Feinstein bill is ``very troubling.'' ISDA Policy Director Stacy Carey said, ``We don't think OTC derivatives trading in energy caused either the Enron bankruptcy or the California energy crisis.''

While Congress cleared legislation two years ago to exempt energy derivatives, Dodd predicted more lawmakers would support reversing that law now. ``Right now, it would be embarrassing to vote against this amendment to bring these markets to some degree oversight and supervision,'' he said.

At least one CFTC commissioner agrees that trading operations such as EnronOnline deserve regulatory oversight. Thomas Erickson, a Clinton nominee serving through 2003, told the Senate Energy and Natural Resources Committee that because of the ``gaping holes'' in the current law ``none of our federal regulators can give you any assurance that there was no manipulative or fraudulent activity in energy markets in the wakes of the Enron collapse.''

In a Jan. 31 letter to the committee, Erickson said he did not ``sign on'' to the Jan. 29 testimony to the committee by CFTC Chairman James Newsome in support of the Commodity Futures Modernization Act of 2000, which exempts OTC energy products and electronic trading from federal regulation.

``In the wake of Enron, I believe that it is more important than ever for the CFTC to inform Congress of the potential risks associated with the unregulated trading of derivatives,'' Erickson wrote. ``We have an affirmative duty to reexamine the rationale behind Enron operating a financial marketplace without direct oversight by any federal financial regulator.''

· DERIVATIVES REGULATION: `KNEE-JERK' REACTION, OR NECESSARY PROTECTION?

February 25, 2002

Electric Utility Week

Legislation to pull over-the-counter energy derivatives under the regulatory tent of federal agencies is worrying the industry that trades these innovative products. But many market participants expect some form of oversight following the Enron debacle, in which that company's slick derivatives dealing is seen by many as playing a big role.

In interviews last week, industry insiders called a bill, S. 1951 by Sen. Dianne Feinstein (D-Calif.) a ``knee-jerk reaction'' aimed at the wrong culprits in the nation's largest bankruptcy. But an independent derivatives market watcher said the measure was ``a good beginning'' to protect the market and rein in companies' ability to abuse derivatives to the detriment of the industry.

Feinstein plans to offer the legislation as an amendment to the broad Senate energy bill, S. 517, when it comes to floor debate as early as this week. Her measure, aimed at shining the light on EnronOnline, would repeal exemptions and exclusions for bilateral derivatives and electronic energy markets from oversight by the Commodity Futures Trading Commission.

Dealers in energy derivatives would face registration and transparency, disclosure and reporting requirements. The bill expands Federal Energy Regulatory Commission jurisdiction over derivative trades. Firms running online trading platforms also would have to maintain enough capital to back their deals and keep their books open for possible investigation and regulatory enforcement.

Support for the measure as an amendment on the floor this week was unknown, but Feinstein, a member of the Energy and Natural Resources Committee and the Judiciary Committee, could pursue her bill, introduced Feb. 14, as a stand-alone measure later this year.

If Congress mandates reporting and capital requirements, such action ``in no way undermines past contracts or contracts in the future,'' said Randall Dodd, director of the Derivatives Study Center, a Washington non-profit industry watchdog. To claim that federal oversight would stunt growth of the OTC derivative market, which stands at $50-trillion in the United States, $750-billion of which was on Enron's books, is ``not intellectually honest,'' according to Dodd. In addition, ``no one has ever successfully sued and gotten out of a derivatives contract based on changes to the Commodity Exchange Act,'' he said.

The concern is whether FERC would be authorized to adjust a contract retroactively based on a ``just and reasonable'' standard or some other standard without the criteria being ``very, very explicit and very, very detailed so parties trading know what can be expected,'' he said. The question of how FERC and the CFTC would interact in overseeing the OTC market also must be addressed, he said.

FERC is only developing its understanding of these financial instruments while CFTC historically is less focused on consumer protection, according to the industry participant. A call for regulation would benefit from a detailed study, he noted. Capitol Hill needs to ``see if there is any way to achieve consumer protections without throwing a wet blanket over the market,'' the source added.

One market player suggested that the lawmakers look at the companies involved rather than at the market products, and see that there is support among traders for oversight of electronic exchanges, such as the IntercontinentalExchange and Tradespark. ``If electronic exchanges fell under the CFTC, there would not be huge objections,'' he said, adding that the power products on the exchanges ``look and smell like standard products.''

Ed Krapels, ESAI director of gas and power services, agreed that disclosure for online exchanges, akin to information available from the New York Mercantile Exchange, would be a good thsing for the power market. ``You don't want to stifle the OTC, but you want some information to show if there is depth behind the market,'' he said. ``Some form of disclosure, even with lag time, is better than nothing.''

ISDA would prefer that Congress looked at what the group believes caused Enron's downfall -- its accounting procedures -- and not the OTC trading activity. EnronOnline remains a viable trading platform bought out by UBS Warburg, said Carey. ``It wasn't a situation where EnronOnline went bankrupt and that caused the collapse.''

But Dodd counters that derivatives played a key role in Enron's demise because the energy trading giant used them to ``perpetuate the shenanigans.'' Enron used derivatives extensively to create its web of partnerships that were then used to fabricate Enron's income and hide its debt and losses. Enron's fall ``couldn't have been done without derivatives,'' said Dodd.

A key problem was that Enron's derivatives dealers were not backed with enough capital, he said, recalling former Enron CEO Jeffrey Skilling's statement to Congress that his company suffered ``a run on the bank.'' But unlike banks or securities traders, companies like Enron are not subject to regulation and capital requirements for trading these instruments.

· DERIVATIVE BILL CALLED `KNEE-JERK' BY INDUSTRY, PRAISED BY WATCHDOGS

February 25, 2002

Power Markets Week

In interviews last week, industry insiders called a bill, S. 1951 by Sen. Dianne Feinstein (D-Calif.), a ``knee-jerk reaction'' aimed at the wrong culprits in the nation's largest bankruptcy. But an independent derivatives market watcher said the measure was ``a good beginning'' to protect the market and rein in companies' ability to abuse derivatives to the detriment of the industry.

Feinstein plans to offer the legislation as an amendment to the broad Senate energy bill, S. 517, when it comes to floor debate as early as this week. Her measure, aimed specifically at EnronOnline, would repeal exemptions and exclusions for bilateral derivatives and electronic energy markets from oversight by the Commodity Futures Trading Commission.

In a Jan. 31 letter to committee Chairman Jeff Bingaman (D-NM) obtained last week, Erickson said he did not ``sign on'' to the Jan. 29 testimony to the committee by CFTC Chairman James Newsome in support of the Commodity Futures Modernization Act of 2000, which exempts OTC energy products and electronic trading from federal regulation.

``In the wake of Enron, I believe that it is more important than ever for the Commodity Futures Trading Commission to inform Congress of the potential risks associated with the unregulated trading of derivatives,'' Erickson wrote. ``We have an affirmative duty to reexamine the rationale behind Enron operating a financial marketplace without direct oversight by any federal financial regulator.''

If Congress mandates reporting and capital requirements, such action would ``in no way undermines past contracts or contracts in the future,'' said Randall Dodd, director of the Derivatives Study Center, a Washington non-profit industry watchdog. To claim that federal oversight would stunt growth of the OTC derivative market, which stands at $50-trillion in the United States, $750-billion of which was on Enron's books, is ``not intellectually honest,'' according to Dodd. In addition, ``no one has ever successfully sued and gotten out of a derivatives contract based on changes to the Commodity Exchange Act,'' he said.

One market player suggested that the lawmakers look at the companies involved rather than at the market products, and see that there is support among traders for oversight of electronic exchanges, such as the IntercontinentalExchange and Tradespark. ``If electronic exchanges fell under the CFTC, there would not be huge objections,'' he said, adding that the power products on the exchanges ``look and smell like standard products.''

Ed Krapels, ESAI director of gas and power services, agreed that disclosure for online exchanges, akin to information available from the New York Mercantile Exchange, would be a good thing for the power market. ``You don't want to stifle the OTC, but you want some information to show if there is depth behind the market,'' he said. ``Some form of disclosure, even with lag time, is better than nothing.''

ISDA would prefer that Congress looked at what the group believes caused Enron's downfall--its accounting procedures--and not the OTC trading activity. EnronOnline remains a viable trading platform bought out by UBS Warburg, said Carey. ``It wasn't a situation where EnronOnline went bankrupt and that caused the collapse.''

But Dodd counters that derivatives played a key role in Enron's demise because the energy-trading giant used them to ``perpetuate the shenanigans.'' Enron used derivatives extensively to create its web of partnerships that were then used to fabricate Enron's income and hide its debt and losses. Enron's fall ``couldn't have been done without derivatives,'' said Dodd.

While Congress cleared legislation two years ago to exempt energy derivatives, Dodd predicted more lawmakers would support reversing that law now. ``It will be very hard to vote against [Feinstein's bill] in the current context,'' he said. ``Right now, it would be embarrassing to vote against this amendment to bring these markets to some degree of oversight and supervision.''

· Banking on Derivatives: Investors need to relearn the oldest lesson on Wall Street

February 18, 2002

Christopher Whalen

Barron's

As life imitates art, so gambling imitates investing. From the Great Gold Rush to day-trading New Economy Internet stocks, Americans often have mistaken gambling for investing. The executives, employees, creditors and owners of Enron are but the latest sad examples in a long tradition of confusion and mischief.

Benjamin Graham and David Dodd defined investment in their 1934 book, Security Analysis: "An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative." Regarding speculation, including most equity investments, the authors concluded: "The value of analysis diminishes as the element of chance increases."

Other Wall Street analysts had shifted from measuring current earnings and asset values to guessing at their future trend. "The records of the past were proving an undependable guide to investment; and the rewards offered by the future had become irresistibly alluring," said Graham and Dodd, sarcastically.

A continuing fascination with the future finds expression today in the derivatives markets. Data from the Bank for International Settlements shows that the $19.5 trillion market in exchange-traded derivatives increased 31% between 1998 and 2001, far above the growth rate of the $10 trillion U.S. economy. More ominous is the $90 trillion market for over-the-counter derivatives, which grew 6% last year alone, according to Randall Dodd (no relation to the late David Dodd) at the Center for Derivatives Research in Washington.

Derivatives that settle in cash are agreements in which one side makes or receives a payment from or to the other party, depending on the outcome of some future event -- not much different from the implicit contracts that rule the craps table. Most exchange-traded futures and options contracts settle in kind, but virtually all other derivatives settle in cash, meaning that there is no connection to the underlying market upon which the contract is based.

Cash settlement and the high growth rate of the game suggest that OTC derivatives constitute a speculative pyramid that will implode without a steady inflow of new participants. To this end, the major banks have pushed legal changes that have made "swaps," as OTC derivatives are generically known, exempt from regulation and superior to other creditors in bankruptcy. Their argument has been that bankrupt companies must be able to net out their derivative positions with all their counterparties, or else the bankruptcy will bring down the entire market.

Most users of OTC derivatives assume that these instruments are legally enforceable. Yet one prominent bankruptcy lawyer notes that the legal "safe harbor" for OTC derivatives has never been tested in court. She says the Enron litigation might provide one of the first opportunities to test hundreds or thousands of derivatives in dispute. On the other hand, maybe not: "The financial institutions want to avoid giving a federal judge the opportunity to rule whether derivatives are really contracts," says this lawyer.

Professionals who trade derivatives take umbrage at suggestions that their innovative market and a Las Vegas casino are different versions of the same game, both designed to separate suckers from their cash. When used prudently, derivatives can manage risk on bona fide commercial or banking transactions. Yet exchange-traded derivatives now loom larger than the underlying markets in most commodities, public securities, and currencies. And speculative trading in OTC derivatives far outstrips what can politely be called hedging. The derivative tail literally wags the cash market dog for stocks and bonds, and the major U.S. money center banks are the casino operators (and credit providers).

Author Martin Mayer once said that derivatives are about shifting risk to the dumbest guy in the room, but such jokes are hardly funny. Giants like Citibank and J.P. Morgan Chase lend to clients like Enron, raise money from investors, and deal in swaps of all descriptions -- with virtually no disclosure to the public or regulators. Just as Enron fraudulently boosted current earnings by booking fees for derivative contracts that stretched over years, America's largest banks pad their earnings via fees from derivatives and related loans. Yet derivatives can destroy both clients and the dealer banks.

Are the big banks already dead men walking due to unrealized losses on derivatives? A well-informed Washington observer, who once was a senior official of the General Accounting Office, warns that the banks may not yet know: "Watch out for the big hedge funds. They've borrowed heavily from the banks to speculate in derivative plays that nobody really understands. Just like Long-Term Capital Management, when their plays go against them, they tend to trust their computers and double their bets. Like LTCM, they could wind up losing big and owing billions to the banks."

LTCM, Enron and Allied Irish Banks head a growing list of speculative fiascoes that suggest Washington and Wall Street have eradicated the legal distinction between investing and gambling. Wall Street's best minds were Enron's inspiration and they will cause similar disasters in the future. The crime of Enron is not just that employees lost billions in a restrictive 401(k) plan, but that any investor was foolish enough to purchase shares in this hedge fund in drag. Enron pretended to create a new marketplace for energy, but traded anything and everything, up to and including derivatives based on the weather.

Consider how Enron's derivative activities distorted the market for memory chips and personal computers, almost on a whim. My colleague Fred Ramberg, a 20-year veteran of the semiconductor equipment industry who heads research at Fechtor Detwiler & Co. in Boston, reports that months before Enron's bankruptcy, the company began selling naked calls on dynamic random access memory chips known as DRAMs. By August, Enron Global Semiconductor Services was offering end-users "DRAM Price Risk Management" contracts with a $4 limit price for generic 128-megabit DRAMs.

An Enron slide show presented last August makes clear that trading derivatives, and not any particular commodity or product, was the company's real interest. An Enron official claims to have offered PC manufacturers like Dell and Compaq contracts to hedge the cost of buying DRAM chips. Dell denies doing any trades. Compaq confirms that it did talk with Enron, but also says no trades occurred. Several other DRAM manufacturers admitted to "talking" with Enron, says Ramberg.

There was a rise in DRAM prices in November and December, and many analysts think it was attributable to rising demand for memory chips. In turn, that may indicate a future rebound in PC stocks. But Ramberg believes the rebound in the DRAM prices was exaggerated by Enron's foray into trading memory chips. It may have been just a demonstration run for DRAM makers, but it moved the market. Moving the market, of course, is what speculation is all about.

The answer to the Enron problem and the larger question of derivatives is not more regulation, but rather punishment for the fraudulent and education for the ignorant. Congress must reverse itself and remove from federal law the safe harbor protection it wrongly afforded OTC derivatives. There is no reason for the exemption, save the enthusiasm of some lawmakers to service the banking industry. If other forms of speculation, in stocks and commodities, are regulated, OTC derivatives should not be exempt or, worse, held senior to contracts for real goods and services in a bankruptcy. Provisions in the pending bankruptcy reform legislation that give derivatives further special treatment must also go.

Enron was a derivative-trading company, the latest creation of Wall Street's gaming culture, and it surely won't be the last as long as we pretend investing and gambling are the same thing. There isn't anything immoral about speculating, but such risky activities must be voluntary, with informed consent. The SEC cannot protect investors before the fact any more than state gaming commissions can protect compulsive gamblers; they just clean up the mess and punish the obvious perpetrators. The sooner investors refocus on what is and is not investing, the less pain they will suffer from future scams.

Christopher Whalen is a New York writer and investment banker.

· Up In Smoke -- Enron used political ties to rid itself of regulators. But in the end, its supposed free-market trailblazing only burned investors.

Houston Post, February 7, 2002, and

Dallas Observer, Feb 07, 2002

Brian Wallstin and Tim Fleck

Late in the afternoon of July 31, 2000, a who's who of Republicans -- Texans as well as national party officials -- jammed into the elevators of a downtown Philadelphia office building a few blocks from the GOP National Convention. When the doors slid open on the 50th floor, they spilled into the Top of the Tower banquet room for piles of pasta and prime beef, free-flowing liquor, and the heady aroma of curried favor.

These guests of the Enron Corporation gazed from the peak of the pink granite shaft on Arch Street onto a view that stretched into three states. In this moment, with Enron favorite son George W. Bush prepared to accept his party's presidential nomination, the party crowd must have felt they could see all the way to the White House.

Enron's shares were selling for $90 on the New York Stock Exchange that summer. Hard-driving traders at the company's electronic-power emporium, Enron Online, were getting $275 per megawatt-hour in California's deregulated energy market.

The company was already the largest marketer of natural gas and electricity in the world. With the prospect of a friend in the White House, maybe even a Republican-led Congress, the future seemed to hold no limits. Politicos paid tribute with their presence to a company that had morphed itself in only a decade from a stodgy gas pipeline company to a self-hyped capitalist dream machine in the 1970s, had learned early that free enterprise works best when political wheels are greased with cash. By the mid-1990s, Enron had worked Congress and legislators in all 50 states for deregulation of everything from electricity to obscure target trading markets. The company was hailed as a pioneer, its top executives worshiped as geniuses, and Wall Street pegged its worth at $70 billion.

Bush may have called him Kenny Boy, but in Houston, Ken Lay was the man. Bonus week sent traders scurrying to Porsche dealers, renting private jets, and crowding into the city's best restaurants.

The millions in campaign contributions, the lobbyists lured off government payrolls, the corporate jet he put at the disposal of elected officials, all seemed like acts of charity in his continuing crusade for less government oversight into Enron's affairs.

And two of his biggest allies had taken Enron toward that goal. Senator Phil Gramm had led the move to free the company from federal restraints in the exotic commodity derivatives markets and to exempt it from key financial-reporting requirements. Wife Wendy Gramm had done her part years earlier as a commodities commission chair who was now an Enron director.

Enron lobbyist George Strong was working the door of the Enron festivities that afternoon in Philadelphia. Strong, whose political work typically favors Democrats, recalls the rousing reception that greeted the Gramms as they stepped from the elevator at the Top of the Tower.

"When they came in," Strong remembers, "I thought, 'Wow, this is really great.'"

A company once grew up around an idea that made all the sense in the world: Buy a commodity that somebody wanted to sell and then sell it for a profit to someone who wanted to buy it. The idea was so appealing that, after hearing that the chief executive was a genius, people flocked to it.

No one knew the details about who was buying and selling or how much profit was made. Occasionally some wary individual would ask, but the company would always explain that secrecy was key, since its competitors would undoubtedly steal the idea. Meanwhile, investors were mailed statements every so often, informing them that their cash contributions had increased in value.

That attracted more investors, and the company hired people to handle all the buying and selling. It paid them commissions on the profits they turned, and the employees agreed to reinvest a portion of their earnings to help the business grow.

Then, at the height of the company's success, someone took a closer look and realized the company's liabilities far exceeded its assets. Investors began to suspect the statements they received in the mail were bogus. Pretty soon there was no more buying and selling and no more investors.

In the simplest terms, that is the rise and fall of the great Enron Corporation. It is also the story of the Old Colony Foreign Exchange, started in Boston just after World War I by a former produce vendor named Charles Ponzi.

Ponzi's idea was to speculate in International Postal Coupons. For instance, a coupon bought in Spain for a penny could be exchanged in the United States for six cents. The problem was that the expenses of trading those coupons in world markets ate up Ponzi's profit. But rather than admit to a bad idea, Ponzi kept his scheme alive by using new investors' cash to pay dividends to earlier backers.

The truth emerged when it was discovered that Ponzi was part owner of Hanover Trust, which wrote the dividend checks. Auditors found the only thing keeping Old Colony solvent was the continued issuance of worthless stock.

Like Ponzi, Enron wouldn't own up to its failure. When the company's top executives discovered they couldn't trade water or high-speed Internet access like oil and gas, they formed partnerships to keep losses off the balance sheets. Failed businesses were shifted onto the partnerships' accounts, which triggered loans that Enron booked as earnings.

However, this isn't called a Ponzi scheme. It's "derivative" financing or, more precisely, a debt-equity swap that allowed Enron to borrow from itself to cover losses and keep shares trading at a premium. When Enron filed for bankruptcy on December 2nd, shareholders finally learned the company had created more than 870 off-balance-sheet subsidiaries.

From the formation of the first of those partnerships in 1997, 29 Enron executives and board members sold $1.1 billion in company stock. In the wake of the company's collapse, shareholders -- untold numbers of retirees and pension-fund investors, including Enron's own employees -- are down $70 billion.

It may turn out to be a coincidence that the brass began cashing out at precisely the time Enron's insider trading of derivatives -- or "structured financing," as the company called it -- started to spin out of control.

But long before that, back in the beginning, there was just the Enron idea that made perfect sense. Trying to become the premier trader in new commodities -- broadband, water, power production, pipeline capacity and more -- would take more than a mastery of this new marketplace.

Commodity and derivatives dealings had been restricted by government for good reason. Enron, to realize its dreams, would have to first master the finer art of political influence in the highest places. When that time came, Enron chief Ken Lay was more than ready.

Lay had been developing political friendships since the 1970s, when he was a minor Washington lobbyist for a Florida gas company. By the time he ascended to the helm at Enron in 1985, Lay had become a friend to then-Vice President George H.W. Bush and an energy adviser to the Reagan White House.

In 1985, around the time Houston Natural Gas and Internorth were merging into Enron, the Reagan-Bush administration deregulated the natural-gas industry by ordering pipeline companies to sell excess capacity to whoever wanted it.

When then-Texas governor George W. Bush "restructured" the state's power markets in 1999, he was following a trend Lay had inspired in Washington and relentlessly pursued to a successful end in two dozen states.

Lay and his contributions had cultivated many political connections, but his wisest investment was in the political future of Texas senator Phil Gramm and his wife, Dr. Wendy Lee Gramm.

Common ground was plentiful. All three emerged from modest backgrounds and went on to earn Ph.D.s in economics. Their professional interests meshed with their philosophical sharing of a passionate distaste for government interference of any type with commercial enterprise. Some of the regulations they despised the most dealt with commodity markets, which traditionally had been regulated by the government. Such exchanges post prices, maintain bid-driven markets, and enforce credit standards to protect the players. The Commodity Futures Trading Commission regulates these exchanges.

The commission has less authority in dealing with over-the-counter commodity trading. Those buyers and sellers negotiate derivative contracts with banks, securities firms, and broker-dealers. The terms and prices don't have to be reported to the exchanges.

Derivatives were once known as leverage contracts, which had been the tools of trade for notorious foreign-exchange scams known as bucket shops. Randall Dodd, director of the Derivatives Strategy Institute in Washington, D.C., explains that exchanges regulated by the government, such as the New York Mercantile Exchange, have avoided major collapses through oversight.

"They trade these same derivatives contracts on the NYMEX," Dodd says. "Those markets work fine because everyone is holding capital, there is government surveillance, there are reporting standards -- all these safety provisions that prevent it from failing."

The Gramms and other deregulation supporters argue that over-the-counter derivatives constitute capitalism at its purest. In fact, in the traditional open-cry pits found at the Chicago Board of Trade and NYMEX, Enron wouldn't have found a market for hangar slots. But off-exchange, the theory goes, if someone can turn something into a commodity, the buyers and sellers will appear.

Enron's transformation from a pipeline company began in 1989, when it and other companies began lobbying to open up the over-the-counter derivatives market. Lay's strongest ally was in a prime position to help: then-President George H.W. Bush had just appointed Wendy Gramm to chair the Commodity Futures Trading Commission. She quickly issued a lengthy report that argued to reduce CFTC oversight of certain commodity trading.

Two years later, Gramm led the push to open the door for Enron even wider by heading the effort to exempt over-the-counter derivatives from commission control. That allowed Enron to break free of the spot market for natural gas. It also enabled the company to customize derivative contracts for customers looking for long-term price stability in the market.

Gramm had previously announced she would be leaving the commission. A week after delivering the rule change for congressional approval, she departed.

Five weeks later, Gramm had a new position: Lay appointed her to Enron's board of directors. The position paid about $30,000 a year, plus stock options. One CFTC member called the timing "horrible." Lay told The Washington Post that it was "convoluted" to suggest Gramm was brought on board for any reason other than her brilliance.

Enron's extended leg-room in the over-the-counter market brought it trouble almost immediately. In 1993, TGT, an Enron subsidiary in Great Britain, entered into a "take or pay" contract with companies pumping natural gas from the J-Block field in the North Sea. Enron agreed to take 260 million cubic feet of gas per day for 10 years to supply one of its own power plants and to sell to others.

But when the contract matured and Enron had to take delivery, demand for natural gas was down and the price had dropped by half. Enron tried to litigate its way out of the mess, but a British court ruled that the meaning of "take or pay" was pretty clear. The failed deal cost Enron $537 million in 1997. Bob Young, a derivatives consultant with New York-based ERisk, says the massive loss should have raised concerns inside the company.

Young believes that trading in the "short end," meaning locking in prices for three to five years, is a safe bet because everyone has the same idea what the commodity will cost in that time frame. But he explains that there are no markets for pegging prices in the more distant future, such as 15 years out.

"No one knows what the price is going to be," he says, "so you have to base it on expectations, which can change."

In retrospect, the J-Block debacle appears to be just one of many problems Enron faced in 1997. After all, that's when it formed the first of its subsidiaries to shield transactions from the balance sheet. One of the more infamous was called LJM, for the initials of CFO Andrew Fastow's three children.

The J-Block contract suggested to Young that Enron wasn't managing its trading books closely enough. Traders are supposed to adjust the value daily on long-term contracts, a practice called mark-to-market accounting. A responsible trader will watch for price decreases that reduce the long-term value of contracts. If that happens, the trader will try to hedge the lost value by making another trade that promises a better outcome.

The flaw in such accounting of unregulated derivatives was the potential for a harried or unscrupulous trader to inflate long-term contract values, knowing no one outside the company would have access to the information. Traders for any company might decide to impress their bosses or increase their bonuses by setting unrealistic future prices then simply ignoring any subsequent changes in the commodity's price.

"It's a real conflict of interest," Young says. "A trader can set the market almost however he wants, then manipulate the market value to his own benefit. He just tells his boss the trade has been booked and he wants to be paid for that value now."

Whatever problems were escalating within the walls of Enron's far-flung enterprises, the exterior looked sleeker than ever. The corporation concentrated more and more resources into the heady stuff of derivatives trading. It invested in broadband, coal, water, pulp, paper, and more. World market analysts were wowed by the new and novel initiatives into expanding economic markets.

Executive Jeff Skilling showed the brash style with personalized license plates -- WLEC -- for "world's largest energy company."

As that target came within Enron's sights, there were a few pesky chores to be taken care of first. Creative bookkeeping had spawned more and more sleight-of-hand subsidiaries to mask accurate numbers from corporate balance sheets. And government was trying to get in the way again, this time with the audacity of proposals to require proper accounting and oversight to the wide-open field of derivatives.

Lay would soon be returning to the front to break more regulatory leashes. This time, he was better armed than ever with political largesse.

"Lay concluded early on, as any smart lobbyist does, that it doesn't do any good to support somebody that might be right ideologically but can't get elected," says former Enron lobbyist and consultant George Strong, who has known Lay for a quarter-century. "With very few exceptions, you'll find that Enron was pretty astute on making decisions on who to give money to."

The fight against reporting requirements would require a well-connected Senate commander, Phil Gramm.

Senator Gramm first attacked the Financial Accounting Standards Board, which had recommended that derivatives be included on companies' balance sheets. At a Senate banking committee hearing in 1997, Gramm challenged FASB chairman Ed Jenkins to reach a "broader consensus" from the business community. Jenkins replied that the standards board held 123 public meetings before concluding that reporting practices for derivatives were inconsistent, allowing different companies to report the same transactions differently.

"I don't question that you've had extensive hearings," Gramm snapped. He recited a list of opponents to the FASB standard, which included Chase Manhattan Bank and Citicorp. "Are these people against the public's right to know? If we are going to maintain generally accepted accounting principles, part of your job, it seems to me, is getting general acceptance."

"The focus of the FASB is on consumers," Jenkins argued, "users of financial information such as investors, creditors and others." He explained that corporate reports need to give accurate finances and "not influence behavior in any particular direction."

Soon after, Wendy Gramm told the House banking committee that derivatives markets would suffer from "unnecessary or overly burdensome regulatory costs." Gramm, a professor at George Mason University's James Buchanan Center for Political Economy, described her views as "comments that reflect the public interest rather than any special interest."

What she didn't put on record, however, was any mention of her job as paid director for a company that planned to become the world's largest corporation by dealing in over-the-counter derivatives. Gramm is currently on the board of two other firms that put investor funds to work in the derivatives market: Invesco Funds and Longitude, a company that develops software to help dealers keep track of prices and trading positions.

In 1998, antiregulation forces advanced with the GOP's new majority in both the House and Senate. Phil Gramm was elevated to chairman of the Senate Banking Committee, which oversees legislation on any financial regulations. As the general, Gramm raked in enormous contributions from those who stood to gain the most from derivatives deregulation: Enron and those in the banking and securities industry.

Enron donated more than $100,000 in individual and corporate contributions to Gramm's political campaigns, including $10,000 from Ken and Linda Lay, according to the nonpartisan Center for Responsive Politics. (Lay was also regional chairman of Gramm's failed presidential bid in 1996.) The banking and securities industry has provided him with more than $2 million since 1989.

Michael Greenberger, the former chief of the CFTC's trading and marketing division, says the debate over off-exchange derivatives has been smothered by special interests. Even modest attempts to study the issue trigger a rush of lobbyists to Capitol Hill.

"The Enrons of this world, the investment banks, the commercial banks individually and through trade associations, are lobbying the congressional branch and the executive branch and whoever they need to lobby 24 hours a day, seven days a week for this kind of stuff," says Greenberger.

Enron, tasting victory, launched Enron Online. The computerized trading platform would standardize the company's long-term derivatives contracts, to close such deals in seconds rather than the hours formerly needed. That would increase trading volume exponentially.

That online debut was diminished by a November 1999 White House capital-management task force report recommending more financial disclosures from hedge funds. The report also recommended proceeding slowly with unproven online markets such as Enron Online. And then-futures trading commission chairman Brooksley Born also echoed those sentiments about derivatives trading.

Gramm argued that risk to individual investors was small. It is up to institutional investors, such as banks, to make sure their money is safe, he explained. "People who lend money ought to know who they're lending money to," he said at the time.

Fueled by objections from the securities industry to the continuing debate, Gramm led an effort to impose a moratorium on new derivatives regulations. That ended in May 2000 when the senator agreed to co-sponsor the Commodity Futures Modernization Act.

Gramm signed on to the bill after the original sponsor, Senator Richard Lugar of Indiana, agreed to amend it to allow sweeping deregulation of the over-the-counter derivatives market. The bill also exempted companies that trade derivatives electronically, such as Enron Online, from disclosing details of trades. It became known as the Enron Exemption.

Enron had, indeed, been very successful in keeping government out of its affairs, beginning with natural gas deregulation in 1985. But whatever opportunities the company once saw in an open marketplace were squandered during its transformation from a real business into "an old-time Wild West casino gone crazy," says Greenberger, the former futures-commission division chief.

But rather than walk away from the table down a little, Enron upped the stakes. The over-the-counter futures franchise it won from Congress gave traders the power to place even more bets on a house account that had already been drained.

Publicly, though, Enron had plenty of bluff left in it. With its shares trading at a respectable $84 last year, newly named CEO Jeff Skilling nonetheless chided a group of analysts, saying shares should have been selling for $126.

Pressures increased for the company to explain indecipherable accounting that had kept massive debts off the balance sheets. "We don't want anyone to know what's on those books," CFO Andy Fastow said at one point. "We don't want to tell anyone where we're making money."

Or where they were losing it. In late March, a deal to distribute Blockbuster videos over the Internet via Enron Broadband collapsed. Then the company revealed it was owed $570 million by the bankrupt California utility company Pacific Gas & Electric. Worse, analysts started questioning the company's ethics after Fastow's financial stake in Enron's off-balance-sheet partnerships was revealed.

In mid-August, Skilling stepped down as CEO after just seven months. Shares had sagged to $43. Lay returned as interim CEO and in a series of meetings and e-mail messages, urged employees to continue "talking up" Enron. Lay himself, on the other hand, was bailing out, eventually cashing in more than $600 million worth of shares. Meanwhile, employees were locked out of liquidating pension shares as the price plummeted even faster.

When the SEC began investigating the company in October, Enron shifted more than $1 billion in losses back to its balance sheet, then admitted another $1.2 billion write-down was on the way.

Enron's trading operation stalled under the revelations. Suddenly there was no more buying and selling. The biggest corporate collapse in history reached its stunning nadir with the December 2nd bankruptcy filing. More than 4,500 people were laid off.

It could take years of forensic accounting to pin down how $70 billion disappeared. But this much is already known: Enron was an energy company like the Money Store is a U.S. mint. The company might have owned 37,000 miles of pipelines, but it had leveraged its value making markets where none existed.

Which, of course, isn't a crime. But it isn't a very good idea, either.

The formal exercise in assessing blame is under way in a dozen governmental venues. On January 24th, members of the House Governmental Affairs Committee grilled executives from Arthur Andersen, Enron's accountants, over the shredding of Enron audit records and conflicts of interest as both company consultants and auditors. Andersen pointed fingers at Enron for misleading auditors and at the legal giant Vinson & Elkins for endorsing suspect bookkeeping practices and helping to create the troublesome partnerships.

An Enron probe led by University of Texas law professor William C. Powers suggested massive financial fraud. Lay canceled scheduled testimony before a Senate panel after the Powers report came out. His likely defense -- and that of other executives -- is that he wasn't involved in the decisions that came to devastate the Enron empire. The appearance of his mournful wife, Linda, on national television indicates the spin control has begun on what has already spun so out of control.

Because Wendy Gramm is married to the ranking Republican on the Senate Banking Committee, her public inquisition should highlight the agenda.

High on the list of questions for investigators is why she and other Enron directors agreed to waive an ethics policy so executive Fastow could arrange a stake in the company's silent subsidiaries and whether or not she knew they were used to inflate earnings. Someone will ask if her fiduciary duty to shareholders may have been compromised by the $915,000 to $1.8 million in salary, fees, stock options, and dividends she received since joining Enron's board in 1993. (The figures are from SEC filings reviewed by Tyson Slocum of the D.C. watchdog group Public Citizen.)

Other inquiries may center on whether Gramm's appointment to the Enron board was a payback for being such a strong supporter of energy derivatives and unregulated commodity trading. One question to be posed is how much, if anything, Wendy Gramm shared with her husband about what Enron hoped to gain from Congress. And what she knew as a member of Enron's auditing committee.

The senator told a reporter recently that "most of the time" he and his wife talk about household chores and college football. Gramm has denied that his decision not to seek reelection, made less than a month after Skilling's departure, had anything to do with Enron. Public Citizen's Slocum isn't so sure, saying the timing is more than coincidental.

"Enron would have been a major campaign issue," he says. "The Democrats would have gone ballistic: 'What? Your wife was on the board of directors? She was on the audit committee? Why didn't you protect these workers who were laid off?'"

"The 'Who Shot John' over the politics of all this, I think, is beside the point," says Greenberger. "What I think we have to worry about is that, because [derivatives] are only brought to people's attention when there is an emergency, nobody knows how many more companies are out there trading these things. Nobody knows whether there are destabilizing trades that are being made that could bring other corporations down as well."

The latest revelations indicate that Enron's own board may have already known of the questionable financial and accounting practices 18 months ago -- at the GOP convention reception where they and the rest of the free-marketeers saluted George W. Bush and the Gramms. Loyalists and their political allies had a damning descent from the luxurious trappings they savored in their time at the Top of the Tower. But their legacy of deregulation means plenty of others are still jostling in line for that dizzying ride to the top.

This story originally appeared in the Houston Press, that city's alternative newsweekly.

· · ENRON: HOW GOOD AN ENERGY TRADER? Without the accounting tricks, the company is not such a dynamo in its core business

February 11, 2002

Peter Coy in New York and Stephanie Anderson Forest in Dallas, with Dean Foust in Atlanta and Emily Thornton in New York

BusinessWeek

Enron Corp. fooled a lot of people about its profitability for a long time. One way it did so was by appearing to do one thing very well: It dominated the trading of natural gas and electricity. It had the biggest market share in the booming business, and year after year posted higher earnings. Such success helped convince investors and analysts it could do equally well in trading other commodities, from pulp to airtime. And it gave Enron's black-box accounting the benefit of the doubt. Few quibbled with a company with such a genius for coining profits.

But exactly how good was Enron at trading energy? A new picture is emerging of the business that accounted for the bulk of Enron's $100 billion in revenue in 2000. Yes, it was profitable. Potential buyers who examined Enron's books estimate its energy-trading unit earned about $3 billion before taxes in the two years through last November. But Enron's profits were volatile--its traders took on more risk than the company has let on. And observers say the company smoothed out its profit stream by suppressing both the spikes and the dips in trading. The actions made Enron look better than it really was. ``If they had played it straight, they still would have had decent results,'' says energy trader Art Gelber, head of Gelber & Associates in Houston. ``But they would have lost their image of being so good that nothing could go wrong.''

The growing evidence that even Enron's core business was not as stellar as believed has caused investors to lose confidence in the entire sector. Since Oct. 15, Mirant is off 63%, Dynegy is down 44%, Calpine is off 58%, and Williams is down 38%. Investors not only fear that some rivals may use accounting gimmickry similar to Enron, they're also concerned that increasing competition will erode profit margins from trading.

Much of the worry stems from the fact that energy-trading earnings are based on so-called mark-to-market accounting. Energy traders must book all the projected profits from a supply contract in the quarter in which the deal is made, even if the contract spans many years. That means companies can inflate profits by using unrealistic price forecasts, as Enron has been accused of doing. If a company contracted to buy natural gas through 2010 for $3 per thousand cubic feet, an energy trading desk could aggressively assume it would be able to supply gas in each year at a cost of just $2, for a $1 profit margin. Fearing such manipulations, investors are simply discounting the traders' profits from long-term contracts. ``These stocks are being treated as if [the contracts] didn't exist,'' says John E. Olson, an analyst with Sanders Morris Harris Inc. in Houston.

Enron, which did not respond to questions about its trading and accounting practices, had ample opportunity to abuse mark-to-market accounting. For one, it specialized in exotic contracts that entailed delivering energy over long periods of time. Enron had some contracts going as far out as 24 years--some signed by its small, unprofitable retail business known as Enron Energy Services. The valuations it used to book profits on such contracts are now widely believed to have been significantly inflated. ``That's valuation by rumor. There's no way for those results to be taken seriously,'' says Robert F. McCullough, a power-industry consultant in Portland, Ore.

Still, about three-quarters of Enron's trading volume involved relatively short-term contracts for gas and electricity, where futures prices are well-established. For those short-term deals, fictional forecasts are much harder to justify and more easily spotted. Also, Enron's risk managers, responsible for determining the actual profitability of deals, had more control in the core energy business than elsewhere in the company. Overall, mark-to-market abuses were less prevalent in energy trading than in other sectors, such as Enron Energy Services, people familiar with the company say.

The more common game in Enron's trading business was to smooth earnings rather than inflate them. While that may seem like a comparatively minor infraction, it had huge consequences. It gave the appearance that Enron's earnings stream was highly reliable, which helped to pump up the stock price. Efforts to justify that valuation led the company as a whole into increasingly desperate efforts to achieve growth and hide losses.

Frank Partnoy, a University of San Diego law professor who is writing a book on Enron, testified before the Senate Committee on Governmental Affairs on Jan. 24. According to his reports from several insiders, traders created a slush fund known as a ``prudency'' account. Partnoy says they used the account to even out the reported profitability of trades, putting money into the prudency account when trades were exceptionally profitable and withdrawing money to dampen the losses from bad trades. Randall Dodd, director of the Washington-based Derivatives Study Center, says Enron also smoothed income using swap deals. In such cases, a stream of payments could be shifted either forward or backward in time, depending on when the company or the traders themselves wanted to recognize income.

Enron's trading business had another undisclosed problem. It took on far more risk than it had let on to achieve the profits it made. Its reported value at risk from trading averaged $66 million a day in 2000. That means the company calculated there was a 5% chance of losing or making at least that much on any given day. The number had tripled from 1999 as trading volume and risk-taking grew, and insiders say it stayed at the higher level in 2001. And even that may understate the risk. Partnoy says people told him Enron deliberately reduced its trading portfolio's riskiness on the day each month when the value at risk was measured.

The revelations of the accounting gimmickry have left former rivals in the trading business with a big problem: the need to distance themselves from Enron's practices to regain investors' confidence. ``Enron wasn't disclosing, and yet it was trading at high multiples. So in a way [the market was] incentivizing companies for not providing information,'' says Jeffrey A. Dietert, a stock analyst at Simmons & Co. International.

Now, companies are disclosing financial information in numbing detail. Duke Energy emphasizes that only a fifth of its energy business is valued on a mark-to-market basis--and of that, over half is for contracts lasting two years or less. Others are also pushing hard to convince investors there is real money to be made in energy trading. ``The competitive wholesale markets have proven they are robust, viable--and they will continue,'' says S. Marce Fuller, CEO of Mirant Corp. Enron's fall actually gave a boost to rivals by freeing up customers and slightly widening the profit margins on trades.

Still, profits aren't what they once were. Increased competition has cut gross margins from about 5% five years ago to about 1% or 2% now, according to one industry analyst. ``My suspicion is the margins may be pretty flat for a long time,'' predicts analyst Dietert.

The toughest task ahead may be faced by Enron's former energy-trading operation, which is about to be taken over by the Swiss-owned investment bank UBS Warburg. Assuming federal antitrust authorities give the nod to the deal, UBS Warburg plans to rebuild the unit slowly and operate it with tighter controls. ``Entering into energy trading does not mean extending our appetite for risk,'' says UBS President Peter A. Wuffli in Zurich. Such conservatism, of course, might drive away Houston-based traders who earned as much as $1 million a year in Enron's freewheeling culture. But the new operators make no apologies. ``We are risk-management junkies,'' says John Costas, CEO of UBS Warburg. After the biggest bankruptcy ever, everyone in the business is singing that tune.

Games Enron Traders Played

MISMARKING TO MARKET

Traders made unrealistic assumptions about future commodity prices so that their deals would look more profitable and their bonuses would be bigger.

CREATING SLUSH FUNDS

Many also stashed some money from profitable trades in ``prudency'' accounts, which they could draw on to cover bad trades. That made results look less volatile.

USING SWAPS

Through the use of complex financial instruments known as swaps, trading desks shifted profits from deals forward or backward in time to smooth earnings.

Photograph: ON THE FLOOR: Investors now give energy companies little or no credit for long-term deals PHOTOGRAPH BY PAUL HOWELL/LIAISON/GETTY IMAGES Illustration: Chart: TAINTED CHART BY RAY VELLA/BW

· How Will Washington Read the Signs? Regulation of Derivatives

February 10, 2002

Daniel Altman

The New York Times

After Long-Term Capital Management imploded in 1998, the Commodity Futures Trading Commission quickly called for the regulation of over-the-counter derivatives markets. In the end, Congress decided to take only minimal action. Did that help limit the damage from Enron's fall, or did it make it worse?

Long-Term Capital, a giant hedge fund, had held trillions of dollars in derivatives -- complex contracts linked to securities or commodities --on its books. Enron, though not a hedge fund, sold a variety of derivatives, from energy to plastics.

Had Enron been regulated as a financial institution, investors might have been protected. First, it would have had to certify its business practices and report its activities, giving investors a better idea of the risks. Second, its leveraged trades would have been backed with more collateral, limiting its ability to make huge bets. Finally, it would have had to set up its derivatives business with separate financing.

Enron was not required to do any of those things. ''There is a gap there,'' said Annette L. Nazareth, director of the S.E.C.'s division of market regulation. ''If they had been a broker-dealer, they would have been regulated; if they had been a futures commission merchant, they would have been regulated.''

Officials of the derivatives industry counter that Enron's collapse posed little threat to the financial system. ''This institution went bankrupt, and the documentation and legal principles in place allowed for an extremely orderly clearing and unwinding of positions,'' said Robert G. Pickel, executive director of the International Swaps and Derivatives Association.

But even as an orderly process, Enron's demise might have been less harmful to investors had the government regulated derivatives traders more carefully, said Randall Dodd, director of the Derivatives Study Center, a nonprofit research institute. With regulation of its trading, Enron might have been forced, both by rules and the discipline of an informed market, to take smaller risks.

Yet the contrast between the lack of market-shaking effects now and the disruption caused by Long-Term Capital in 1998, when the government had to persuade a coalition of big banks to stabilize the financial system, is likely to dampen enthusiasm for new rules. Daniel Altman

· CALIFORNIA POWER CRISIS What was role of Enron in state's crisis?

February 9, 2002

Craig D. Rose STAFF WRITER

The San Diego Union-Tribune

Perhaps nothing underscores the degree to which a link between Enron Corp. and the California power crisis has been ignored as a moment during a congressional hearing this week.

Former chief executive Jeffrey Skilling was describing the company's condition as of last spring. Enron, he said, faced "terrible problems" because California's electricity crisis had been "solved." Within a few months, of course, Enron's problems exploded.

The reaction to Skilling's comment? Silence.

No one on the panel explored why good news for California might have meant bad news for Enron, or vice versa. The silence added to the frustration of California consumer activists who believe Enron played a large and still-unexplored role in the crisis that has raised rates by 40 percent and cost the state $50 billion by some estimates.

"In the hierarchy of Enron's victimhood, no one should rank higher than California consumers," said Michael Aguirre, a San Diego attorney pressing a class-action case against energy suppliers. "But in the hierarchy of the investigation, California consumers are not even on the victims' list."

Revelations regarding Enron's role in California and its potential to influence the state crisis continue to emerge despite the tight focus of ongoing congressional investigations on how the company's collapse affected investors and employees.

Consider the following, and the questions some consumer activists and energy experts say they raise:

An energy consultant from Oregon told Congress that electricity prices fell 30 percent after Enron declared bankruptcy. Was Enron's huge, unregulated trading operation contributing to higher prices?

A San Diego-based expert in financial trading told a Senate committee that Enron would have been unable to derive $2 billion in electricity trading profits over two years unless it was fleecing an unsophisticated buyer. Was the state simply overmatched in dealing with energy companies like Enron?

The director of a Washington, D.C., think tank that studies derivatives -- the complex financial contracts that became an Enron specialty -- said the Houston company evolved into a massive yet unregulated financial institution, one whose trades could be valued at $850 billion by the time of its bankruptcy.

All this without being subject to any of the rules typically in place to ensure the stability and safety of a financial institution, such as a bank or insurance company. And the largest segment of Enron's trading operation by far was devoted to electricity. The most active market, in all likelihood, was California.

Nonetheless, much of Enron's intense trading business in electricity and natural gas -- a key commodity in generating electricity -- remains beyond the reach of state investigators seeking to understand California's crisis and seemingly beyond the interest of federal investigators.

To be sure, there are exceptions.

Sen. Dianne Feinstein has been particularly concerned with Enron's activity in the natural-gas market and how that may have affected electricity prices. Most California generating plants use natural gas as their fuel.

The senator said she is also concerned about Enron's dominance in electronic trading, which also was unregulated. Next week, she plans to introduce legislation that would regulate online trading and empower the Federal Energy Regulatory Commission to oversee other unregulated trading activities.

"The problem is that Enron On-Line was both a buyer and seller of electricity and at the same time was the one setting prices," said Feinstein, noting that Enron also controlled at least 70 percent of the natural-gas trades in the state.

"Enron had the ability to manipulate prices and gouge consumers," she said.

Sen. Barbara Boxer is also pressing to open a General Accounting Office investigation into Enron's role in the state.

But Frank Partnoy, a University of San Diego law professor and expert in sophisticated trading transactions, said the company's role in the crisis would require special expertise to explore.

Getting a full explanation of the California crisis, Partnoy said, would likely require a task force assembled by the Securities and Exchange Commission, the Commodities Futures Trading Commission and the Treasury Department. Those agencies, he added, could combine the expertise needed to penetrate the complex trading that characterizes deregulated energy markets.

For the record, a spokesman for Skilling yesterday cautioned against reading too much into his comments about how the taming of the California crisis affected Enron.

In the meantime, other companies continue to emulate the Enron model and fill the void left by the company's decline. Sempra Energy, for example, last week acquired Enron's industrial metals trading business.

"People are asking the question whether there are other Enrons -- and there are," said Randall Dodd, director of the Derivatives Study Center in Washington, D.C.

Several energy companies, he added, have financial activities similar to Enron's.

Most of those companies continue to be active in California and promote deregulation in other states. And the debacle that deregulation wrought here must be examined in light of deeper investigation into Enron, said a consumer activist.

"There are two big dots on the map -- Enron and California," said Doug Heller of the Foundation for Taxpayer and Consumer Rights in Santa Monica. "And they have to be connected."

· TRADING FIRMS, UNDER THE GUN, EMBRACE BROADER DISCLOSURE, FIND `NEW METRICS'

February 4, 2002

Power Markets Week

Merchant traders began rushing into the new post-Enron era of greatly expanded financial disclosure last week, hurried along by Wall Street analysts and investors who want assurances that companies are not misrepresenting profits and risks from power trading operations.

As more power trading companies, particularly Williams, moved into the crosshairs of skittish and skeptical investors, companies began pouring out detailed explanations of how they value their trading books and where their potential profits and risks are under mark-to-market accounting. And in the wake of greatly expanded disclosures by several companies, a new set of key metrics--a new way to evaluate power trading companies--is quickly emerging.

The new fondness for disclosure comes in the wake of alleged abuses by Enron of mark-to-market accounting and efforts by accounting rulemakers to lessen the potential for abuse and expand disclosure of the impact of mark-to-market on earnings (see story, page 3).

At the same time, Wall Street analysts are aggressively prodding merchant power firms to avoid the Enron mistake of leaving investors in doubt about the value of their trading operations.

At least one firm, Salomon Smith Barney, came out last week with its trading and marketing ``disclosure wish list,'' which it believes companies must quickly adopt, lest valuations are further ``impaired.''

``We think the merchant energy industry needs to climb the `wall of understanding' with investors,'' Salomon said. ``As it does so, we think valuations will become clearer and will in fact improve. As the black box gives way to greater clarity, investors should come to this industry.''

The industry appears to be getting the message. According to Commerzbank analyst Andre Meade, at least two companies, Duke Energy and Dynegy, have won kudos in the investment community for providing for the first time explicit value at risk (VAR) and mark-to-market (MtM) information in their 2001 earnings reports released Jan. 17 and Jan. 23, respectively.

Indeed, he notes, Duke and Dynegy stock last week fared better than any of the other top-ten merchant firms, most likely as a result of the new disclosures.

What both Duke and Dyngey provided were numbers on the total present value of their trading operations on an accrued accounting basis, as well as on an MtM basis. They both then provided a schedule, both year-by-year, and by groupings of years, as to when cash would be realized from their MtM book (see chart below).

``What investors have been worried about,'' says Meade, ``is MtM.'' The reason has to do with the fact, he notes, that mark-to-market accounting, as opposed to accrued accounting, requires long-term non-cash contracts to be recorded as profits and losses, and to be recognized immediately. Moreover, these speculative earnings are volatile, and trading shops must model forward curves to mark them to, and have those forward curves reviewed by outside accountants.

For investors who must also take into account a company's other contingent liabilities, the picture can be confusing. ``They (investors) look at balance sheets and conclude that `cash earnings' of a given company are not as good as `reported earnings,''' says Meade. This problem has to be addressed, he says, since allegations of manipulating the numbers or hiding a company's real financial condition ``can emerge, and do damage quickly'' to a company's stock and reputation.

According to Terry Francisco, a spokesman for Duke, that company had been considering disclosing more data for several months, even before the Enron crisis. He notes that the company had been hearing analyst complaints about MtM in monthly and quarterly meetings dating back to early last year. ``It's clear though--and our CFO, Robert Brace, has said as much--that our decision to disclose these numbers was escalated by the Enron situation,'' Francisco says.

``What we eventually did, though, was replace words with numbers, since we had been telling analysts about our breakouts for some time.'' What Duke has attempted to do, according to Francisco, is ``give analysts an idea of how much of our portfolio can move at any time, given the movement of price.'' He says, ``We have always told analysts that the breakout between our accrual book and our MtM book is 80/20. The numbers we have submitted, we believe, validate this.''

Moreover, he says, ``We wanted to show the `realization period' of our MtM portfolio. Our MtM portfolio gets realized pretty quickly--with 55% within two years, by end 2003.''

What Duke's and Dynegy's numbers address are concerns raised and outlined in a 76-page report entitled ``Merchant Energy Primer'' that Salomon Smith Barney issued Jan 22,

In its analysis, the report says that ``Certain companies and the media have paid considerable attention to cash earnings versus non-cash earnings. We believe investors, in asking for companies' cash earnings, are concerned about two questions: does the company have adequate liquidity; and does the company have quality earnings?''

The report said, ``In our view, investors' increased attention to Energy Merchants' liquidity is appropriate, especially in light of recent credit ratings downgrades and off-balance sheet levels. The `cash is king' mentality is appropriate for the sector, given its tumultuous 2001 performance.''

If judged by what can only be called the ``old metrics,'' such as share price-to-earnings ratios (P/E), return on invested capital (ROIC) and debt-to-capital ratios, the merchant energy industry isn't doing badly, according to the chief author of the Salomon report, Raymond Niles. Merchant energy companies as a group are trading at a P/E multiple of approximately 10, below the 14 of the financial services industry, Niles says, a lower multiple that ``reflects both low spark spreads and the Enron crisis,'' with both likely to prove transitory.

But several ``new metrics'' are beginning to be defined for these still-young merchant trading firms, measures that investors want looked at and that analysts say must be considered.

``VAR,'' says Niles, is a ``key metric'' and ``critical management tool'' that represents a merchant's unhedged exposure to market movements in price and other factors, such as how much risk a merchant is carrying.

Unfortunately, Niles notes, there is not a standard calculation of VAR, and as a result, ``many companies calculate and disclose slightly different VAR metrics.''

But he says investors should be seeking, and companies offering, commodity price risk information. Niles argues that an average daily VAR for the reporting period should be used, ``not VAR as of a certain date.'' And VAR, he says, ``should be calculated based on a 95% confidence interval with a single day time horizon.''

He notes, for example, that Reliant Energy, El Paso, Constellation, Sempra, AEP and Williams present a VAR for commodity price risk ``separately identified.'' He notes that Duke and Mirant use an average daily VAR. Duke calls its VAR a DER, or daily earnings at risk.

Merchants that have a high VAR, relative to the size of their portfolios, speculate more and are riskier propositions, Niles says. ``This is true for two main reasons: mark-to-market accounting requires non-cash trading profits and losses to be recognized immediately; and merchant profits from heavy speculation are less likely to reflect actual cash at the end of the transaction.''

Notes Niles, ``So far, we have seen highly speculative players bled out of the industry, such as Power Company of America, which failed during the 1998 price spike. For most of the top-tier energy merchants, speculation is a highly delimited activity.''

While all merchants speculate, it's the structured products that are ``at the top of the food chain'' of the complex products merchants offer.

Structured products, he notes, generate higher profits because the client is getting a product, an energy product, ``that is based on more than one basic instrument.'' Clients, he says, ``will pay a premium for structured products that fit their needs.''

Another new metric to consider for trading firms is the return on VAR. To do so, one compares the trading operation's earnings before interest and taxes, or EBIT, to the amount of what is at risk, or the VAR.

According to the Salomon report, in the third quarter of 2001, Reliant Resources had an EBIT/VAR of 93.68. That compares with Duke's 83.93, while the EBIT/VAR for William was 15.26.

Says Niles, ``Williams can be seen to have the highest value at risk, but this doesn't necessarily mean that Williams is automatically the riskiest operation among the group. Because they are frequent users of tolling agreements--which get marked to market--as a means to acquire power, these agreements are included in William's VAR calculation.''

``Compare William's VAR to companies that own and maintain significant generation facilities. Contracts against these facilities are typically accounted for under accrual accounting and are not usually used in the calculation of other companies VAR. `` ``We believe as disclosures become more standardized in the industry, VAR will become a better tool with which to compare companies,'' Niles says. He also says, ``Investors should realize that not all VAR numbers are created equal.''

MtM accounting is a double-edged sword, according to Niles and other analysts. Its advantages, he argues, are in short-term trading earnings. Simply put, he says, ``It forces companies to constantly value their trading assets at fair value. In this manner, positions that have declined in value are reported as liabilities, and positions that have increased in value are reported as assets. The corresponding gains and losses are reported as non-cash earnings.''

Where MtM gets dicey, however, is in highly illiquid markets, including, according to Niles, ``long-dated contracts and highly niche commodities,'' and he notes that it is the long-dated contracts Williams has to account for in its tolling agreement with AES that is causing that company problems.

MtM accounting is difficult to implement ``for electricity contracts with durations longer than seven to eight years, natural gas contracts longer than 10 years, and niche or newly developing commodities markets,'' Niles says.

The problem, he notes, is that MtM accounting ``allows companies to value these assets themselves and record internally determined mark-to-market gains and losses, although many merchants verify their internal calculations with outside consultants and third parties. Obviously, there is considerable potential for conflicts of interest.''

``This is part of the reason,'' said the Salomon report, ``why we recommend investors look for merchants with short portfolio durations.''

Tougher and broader financial disclosure requirements can address many of the perceived problems associated with the unregulated over-the-counter derivatives market that energy firms are involved in, and the mark-to-market accounting they use, according to Randall Dodd, director of the Derivatives Study Center in Washington D.C.

Saying that ``investors can't currently tell how a company's position is likely to change in time,'' Dodd argues that companies should have to disclose their capital requirements and their collateral requirements associated with derivatives.

Moreover, he says that these disclosures should be reported to a federal agency with which they are registered to trade in derivatives. He says, ``This would be the best way to protect against fraud and manipulation.'' He specifically points to the Commodity Futures Trading Commission as the logical federal agency to be put in charge of overseeing the OTC market. The CFTC currently oversees trading on the New York Mercantile Exchange.

In part because of what is an inevitable drumbeat for disclosure reform due to Enron, Salomon is encouraging companies to enhance their reporting on their own.

On its ``disclosure wish list'' for trading and marketing firms, the Salomon report said that the ``lack of clear and complete metrics to measure and compare trading and marketing performance has hurt valuations of the entire merchant group.''

It says that ``companies have the power in their own hands to improve their valuations by providing some or all of this information.''

On the list are average daily VAR calculated during the reporting period; commodity price, interest rate and currency breakout; and an all-in VAR that includes both physical and financial risk.

Also on the ``wish list'' is the suggestion to include a percentage of corporate earnings that are MtM versus accrual; ratio of cash earnings to [generally accepted accounting principles] earnings; trading and marketing earnings by type of activity (speculation, market making and structured contract); and percent of current accrual and MtM portfolio that will be realized into cash, on a yearly basis, over the next five years.

· TRUE OR FALSE: ENRON PROVES MONEY CAN'T BUY FAVORS

February 3, 2002

CRAIG GILBERT

The Record, Bergen County, NJ

AMID THE OUTCRY over Enron, supporters of campaign reform have made at least two arguments about the role political donations played in the saga.

One is that Enron executives got favors in turn for millions in campaign gifts.

Another is that Enron's lavish giving made it impossible for the government to intervene in the firm's demise and help victimized workers without looking corrupt.

Can both be true?

That big money buys favors? That it also does the opposite creates such a taint that politicians are paralyzed to act?

"There's truth in both statements," House Democratic leader Dick Gephardt recently insisted, although he owned up to the contradiction.

That's just one wrinkle in an unfolding debate over the political lessons of the Enron debacle.

The story has been a public relations boon to the campaign reform movement. Supporters of a high-profile bill to rein in big donations won enough support in the House late last month to force Republican leaders to schedule a vote on the measure. A similar bill, co- written by Wisconsin's Russ Feingold, passed the Senate last year, then died in the House.

But just as there's deep disagreement over that bill, there's sharp debate over the meaning of Enron.

The bill's opponents say the firm's rise and fall offers no particular rationale for sweeping new campaign laws, including a ban on unlimited "soft money" gifts to parties. Enron gave more than $3 million in soft money to the two parties over the past 10 years and more than $2 million to federal candidates, according to the Center for Responsive Politics.

"What did all of Enron's contributions get them? They're broke.

There are going to be some people going to jail," said Rep. F. James Sensenbrenner Jr., R-Wis., chairman of the House Judiciary Committee.

While the Bush campaign got lots of Enron cash, the argument goes, the administration spurned Enron's desperate pleas for help; the system worked.

Rep. Mark Green, R-Wis., said: "There are lots of good reasons for campaign finance reform. But Enron probably isn't one of them."

Green notes the company gave money to many powerful people in both parties, "yet when Enron probably wanted their help the most, their favors the most, their friends weren't there."

He said the Enron saga argues more for lobbying reform and "reform of our corporate reporting system."

That's one view.

The bill's backers have another: that Enron is vivid proof of the problems they're trying to fix.

Here is a closer look at some of their arguments, and whether the high-profile reform plan before Congress addresses the issues raised by the Enron scandal.

Argument No. 1: that as Enron grew into an energy giant, it did get something for its money relief from oversight and accountability, thanks to Congress and regulators.

What breaks came Enron's way?

Reform groups point to a series of decisions helpful to the firm by such agencies as the Securities and Exchange Commission and Federal Energy Regulatory Commission. In some cases, federal lawmakers lobbied regulators on Enron's behalf.

"That's how Enron got to these regulatory agencies, by establishing very close relations with members of Congress," said Tyson Slocum of Public Citizen, an advocacy group that supports campaign finance reform.

One example that has captured attention is a complex bill enacted at the very end of the Clinton presidency, the Commodity Futures Modernization Act. The measure liberalized rules for the burgeoning market in financial instruments known as over-the-counter derivatives.

One provision exempted trading in energy futures from the oversight of the Commodity Futures Trading Commission. It broadened and wrote into law an exemption granted earlier by regulators.

The change allowed Enron to trade privately instead of on regulated public exchanges. There wasn't much public debate or media coverage. A few critics spoke out against it, including the head of the commission, who warned that energy trading would fall into a "regulatory gap."

"It was huge. This gave them not only a green light, but much wider running room to operate," said economist Randall Dodd of the Derivatives Study Center, a non-profit group that takes a critical view of the financial markets.

Dodd said one result of the provision was to "make the impact of (Enron's) failure much bigger."

The energy exemption has drawn even more interest because of the role of Senate Republican Phil Gramm of Texas. Gramm got nearly $100,000 in Enron contributions over the past 10 years, according to the Center for Responsive Politics.

Gramm had a prime role in the bill but says he wasn't involved in the provision that benefited Enron. But Gramm's wife, Wendy, helped craft the original energy exemption when she was chairwoman of the Commodity Futures Trading Commission in the early 1990s, then joined Enron's board weeks after leaving the agency.

Argument No. 2: that when Enron began to unravel, its history of campaign giving was so conspicuous that government officials were reluctant to intervene, even properly, in the company's collapse. As noted above, this claim is in rather stark conflict with argument No. 1, that contributions help the giver, which is an article of faith among reformers.

But in a breakfast meeting with reporters last week, Gephardt questioned whether the administration could have acted earlier "when they found out this thing was imploding, to safeguard the pensions of the people that were there."

Gephardt suggested that big donations might make an administration less willing to act on a problem "because they're worried about the appearance of impropriety." He called that "the question we ought to look at going forward."

Another reform supporter, Sen. Fred Thompson, R-Tenn., went even further with this line of thinking last week.

"I don't know when corporate executives are going to realize that far from buying anything with these large amounts of money, they're taking themselves out of play. They can't get legitimate redress of their concerns," Thompson said.

Argument No. 3: that whether or not Enron's contributions influenced the behavior of government officials, they create a terrible perception.

This is the most popular argument among reformers and requires no evidence of a quid pro quo.

* "I don't know what Enron got or didn't get," said Gephardt.

But with all the money the firm gave, he said, "people are going to suspect, whether it actually turns out to have happened or not, that they got something they shouldn't have gotten."

Feingold also makes this case.

"Perhaps there isn't a quid pro quo," he said in a recent interview.

"The issue here has always not just been the reality of impropriety but the appearance of impropriety, and that is just overwhelming."

Would Feingold's bill, in theory, address the issues that reformers say are raised by Enron?

Yes and no.

The Enron scandal has prompted numerous lawmakers who received contributions from the company to publicly renounce the gifts, even modest donations made years ago. Green, who is one of almost 200 current House members to get contributions from Enron ($1,500 between 1997 and 2000), said recently that he was sending it back, in a check directed to a fund for Enron workers. He sees nothing wrong "in any way" with the contributions he got, but said "I suspect those employees need it more than I do."

But Green also points out that such gifts still would be legal under Feingold's bill and its companion in the House. In fact, the bill allows for bigger contributions to federal candidates than under current law.

On the other hand, the measure would outlaw the unlimited "soft money" donations that can now be made to parties, a type of giving that has exploded in recent years and figured prominently in the Clinton fund-raising scandals.

Enron gave roughly $3.5 million to the parties since 1990, more to Republicans than Democrats, according to the Center for Responsive Politics. Reformers argue that those gifts are more troubling, both because they're unregulated and because no individual office-holders have to answer to voters for the money. It all goes to the party.

"There is no accountability in soft money," Rep. Zack Wamp, R- Tenn., said last week. "None."

Craig Gilbert writes for Knight Ridder / Tribune Information Services.

· Accounting rules on value of retail deals questioned in autopsy of Enron

February 1, 2002

Platts Retail Energy

The accounting procedure used to value long-term natural gas and electricity supply deals for retail customers is just one of the aspects of Enron's operation that is receiving increased attention as Congress delves into the company's demise and how to prevent others.

By taking advantage of mark-to-market accounting practices, Enron Energy Services could hide losses and erroneously report profits, officials acknowledged. While other companies use mark-to-market principles, ``we won't pull an Enron and exaggerate the value of a contract,'' said Bob Dickerman, president of Sempra Energy Solutions.

Mark-to-market accounting, required under rules adopted in recent years by the Financial Accounting Standards Board, involves recording the value of deals based on forward prices, allowing a company that agreed to supply gas or power at a fixed price to optimistically project future energy prices below the contract price. The company could then record the difference as profit as soon as a deal is signed, even though fluctuating prices change the value of the deal over time.

``The goal of mark-to-market is to let you see those changes over time because we have supplies acquired for those deals,'' said Janie Mitcham, president of Texas purchases for Reliant Energy Wholesale Group. The idea is ``to know what your outstanding risks are, and if you're effectively hedged, those effects are minimal,'' she said.

Mitcham works side-by-side with Reliant's retail sales group because ``we need to know what they're selling and hedge our risk.'' Accounting for the commodity sales using mark-to-market techniques is another way of making sure the company does not have unhedged positions. ``Just because we use the same accounting principles doesn't mean that we'll have the same issues'' as Enron, Mitcham said.

Dickerman echoed those comments, noting that one of his primary responsibilities ``to our shareholders and management is to make sure that our mark-to-market accounting is done accurately.''

The Securities and Exchange Commission has urged trading firms and other corporations to begin immediately, in 2001 financial reports, to boost disclosure in several areas, including valuation of energy trading contracts and the impacts of mark-to-market practices on earnings.

Randall Dodd, director of the Derivatives Study Center in Washington, D.C., says many of the perceived problems associated with the unregulated over-the-counter (OTC) derivative market that energy firms are involved in, and the mark-to-market accounting they use, can ``at least'' be addressed by rule changes in financial disclosure requirements.

``Investors can't currently tell how a company's position is likely to change in time,'' Dodd said, arguing that companies should have to disclose their capital requirements and their collateral requirements associated with derivatives, and that they should have to report this to a federal agency with which they are registered to trade in derivatives. ``This would be the best way to protect against fraud and manipulation,'' he said, adding that the Commodity Futures Trading Commission would be the logical federal agency to be put in charge of overseeing the OTC market.

Dickerman and Mitcham said they have no problems with increased reporting requirements for retail sales. ``We want Wall Street to recognize the value of our unit, and in some sense, the more we disclose the better, as long as everyone else is playing by the same rules,'' he said. ``The lesson from all of this is if you're honest and truthful, you'll have nothing to hide.''

Reliant will welcome ``whatever level of disclosure is required,'' added Mitcham. The company has very tight risk-control policies in place and ``there's a lot of checks and balances to see that each group is aware of where we stand,'' she said

Those checks and balances obviously were not in place at Enron, a law professor and former derivatives trader with Morgan Stanley testified before Congress last week. The first detailed allegations that Enron abused mark-to-market accounting to hide losses came from Frank Partnoy of the University of San Diego Law School, who reviewed the Enron case for the Senate Governmental Affairs Committee, chaired by Sen. Joe Lieberman, (D-Conn.).

In his testimony, Partnoy said it appears that Enron traders mismarked forward price curves and manipulated the amount of profits and losses reported in financial statements. ``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,'' Partnoy, who reviewed the case over several weeks, said. ``It appears that Enron traders selectively mismarked their forward curves, typicallyto hide losses.''

As Enron transformed itself from an energy company to a derivatives trading firm ``it made billions trading derivatives, but it lost billions on virtually everything else it did, including projects in fiber-optic bandwidth, retail gas and power, water systems and even technology stocks,'' said Partnoy. Current financial reporting rules allow companies ``to make accounting standards diverge from economic reality. Enron used financial engineering as a kind of plastic surgery, to make itself look better than it really was. Many other companies do the same.'' He urged lawmakers to consider legislation ``explicitly requiring that financial statements describe the economic reality of a company's transactions.''

Partnoy emphasized that he had no first-hand knowledge of Enron's trading operations, but argued that if ``even if a fraction of the information'' he had uncovered proves correct, ``it will be very troubling indeed.''

Lieberman said his panel will examine numerous aspects of how and why Enron was allowed to hide its debt and losses from regulators, including issuing subpoenas to the company and its former auditor, Arthur Andersen, to turn over documents. ``After we have collected that information and conducted additional interviews, we will report our findings to the public in hearings and a report later this year,'' he said.

· Enron's Web of Complex Hedges, Bets Finances: Massive trading of derivatives may have clouded the firm's books, experts say.

January 31, 2002

Michael A. Hiltzik

Los Angeles Times

As accountants and investigators begin poring over Enron Corp.'s books, they are likely to collide head-on with a factor that makes its finances particularly impenetrable--the extent to which the company relied on financial instruments known as commodity derivatives to inflate income, hide losses and misrepresent the true nature of its business.

Although to this day Enron is generally known as an energy trading company, a close review of financial records and interviews with accounting experts show that at its heart it had become a massive trading operation in derivatives, which are financial contracts that can entail significant risks.

Missteps in such trading have cost highly sophisticated investors billions in past years. Among other cases, derivatives trading was behind Orange County's bankruptcy filing in 1994 and the failure of Barings Bank in 1995.

Derivatives, which come in many forms, allow investors to bet with other investors on changes in an underlying asset or index, such as stocks, interest rates, weather or electricity prices. Properly used, derivatives are effective at hedging against an almost infinite variety of business risks ranging from crop failures to changes in interest rates and oil prices. But they can sharply exaggerate market gains or losses.

There are signs that, in the company's hands, derivatives evolved into more than risk-hedging devices. They became tools of fiscal concealment and manipulation, some experts say.

Among other things, derivatives allowed Enron to inflate the value of its assets and transactions while understating their risks and obscuring their real nature, they say.

"Enron used derivatives to manipulate accounting standards and tax reporting," said Randall Dodd, head of the Derivatives Study Group, an economics watchdog. "They used them to fabricate income. It was a bit of a shell game."

Enron spokesman Mark Palmer on Wednesday declined to discuss the company's accounting. He said the issue "is being investigated by a special committee of our board, the Securities and Exchange Commission and the Department of Justice. They may reveal facts that may lead us to take further action."

It is still unclear to investors and government investigators how big a role losses on these contracts played in Enron's collapse. Nor is the full extent of the damage yet known. Some analysts believe the company still may be losing money on some contracts.

Much Derivatives Trading Unregulated

Enron could engage in its complex trading strategy without fear of regulatory intervention because the government explicitly exempted much derivatives trading from oversight. That's at least in small part because of a ruling by the Commodity Futures Trading Commission's former chairwoman, Wendy L. Gramm, just five weeks before she joined the Enron board in 1993. Gramm is the wife of Sen. Phil Gramm (R-Texas).

The trading market for the contracts has blossomed in the last decade, with nearly $100 trillion traded worldwide as of last June, according to the Bank for International Settlements.

Most of these were so-called over-the-counter or OTC derivatives--those not traded on a registered futures or options exchange, but rather contracts between big investors.

Enron did not entirely conceal that aspect of its business. As early as October 1999, its then-chief financial officer, Andrew S. Fastow, told CFO Magazine that the company's finance business would "buy and sell risk positions."

"Enron may have been just an energy company when it was created in 1985," said Frank Partnoy, a law professor at the University of San Diego who testified before the Senate last week. "But by the end it had become a full-blown OTC derivatives trading firm."

The world of derivatives was almost tailor-made for the aggressively secretive Enron. Accountants still have not settled on a consistent way to represent their value and risk on a company's books. The relevant standard set by the Financial Accounting Standards Board, an independent agency that sets guidelines for corporate auditors, is Rule 133--a behemoth that stands at more than 800 pages.

Enron's derivatives-related assets soared to $21 billion in 2000 from $3.1 billion the year before, according to the company's 2000 annual report. This enormous growth, apparently related to its Internet trading system, Enron Online, made it the fifth-largest commodity derivatives dealer in the U.S., according to figures compiled by Swaps Monitor, a market research firm.

Nevertheless, the company also reported last year that its net financial exposure to derivatives was only $66 million. Although that figure tripled from the year before, analysts contend that it is absurdly low, considering that a large portion of the contracts covered long-term energy deals subject to dramatic price fluctuations.

"Clearly these values are no longer credible," said Robert McCullough, a Portland, Ore., energy consultant.

Enron's accounting treatment of these highly complex transactions, including stock options and loan guarantees, raises the possibility that millions more in liabilities lie concealed in transactions yet to be unwound.

In one deal alone, a financing arrangement with a partnership called Whitewing, formed to hold a melange of Enron assets including a Brazilian utility and European power plants, Enron's exposure to losses may be as much as $2.1 billion rather than the $600 million the company has disclosed.

"These are transactions evolving daily, but disclosed only periodically," said McCullough, who analyzed the deal. "This is a bucking bronco by any investment standard."

Moreover, because trades in OTC contracts are entirely unregulated, "OTC derivatives dealers don't have to register, report, maintain a capital base," Dodd said. "You could set up a lemonade stand and run a $250-billion derivatives book."

Former regulator Gramm's ruling covered only a small category of swaps negotiated between two parties. But it helped open the floodgates to a huge variety of derivatives contracts, which were labeled "swaps" to fit within the ruling.

Still, it was unclear whether all OTC derivatives could remain unregulated indefinitely.

Banks, hedge funds and traders, including Enron and its fellow energy trading companies, strove desperately to keep government hands off. They argued that the participants in the market were mostly huge institutions savvy enough to protect themselves from fraud without government help.

When the Commodity Futures Trading Commission proposed in 1998 regulating the OTC market, "the large derivative interests, including Enron, went up in arms," recalled I. Michael Greenberger, then the commission's director of trading and markets and now a law professor at the University of Maryland.

The traders won the battle in December 2000, when Congress passed a law rendering OTC derivatives permanently exempt from regulation.

Around that time, Enron's participation in the market mushroomed.

Enron's ability to keep losses off its books through complex swaps and option contracts is demonstrated in its deal with Raptor, one of the investment partnerships about which Enron Vice President Sherron S. Watkins raised questions in a now-famous anonymous letter in August to Chairman Kenneth L. Lay.

Enron had transferred to Raptor ownership of $1.2 billion in shares in Rhythms NetConnections, a high-tech company whose stock had rocketed in value after Enron invested in it. Enron recorded the transfer as a financial gain, but did not clearly disclose that it also entered a derivatives contract that required it to cover Raptor's losses if Rhythms declined in value, as it eventually did.

Inside the web of this transaction, hundreds of millions of dollars in losses in Rhythms fell through the cracks, unrecorded on Enron's books. The complexity confounded Watkins.

"I can't find an equity or debt holder that bears that loss," Watkins told Lay. Nevertheless, she suspected the truth--that the losses belonged on Enron's books. "If it's Enron," she wrote, "then I think we do not have a fact pattern that would look good to the SEC or investors."

In at least one case, Enron apparently used derivatives to help inflate the value of an asset as it was transferred off its books. This may have allowed the company to revalue similar assets that remained in its hands, using the inflated value as a benchmark.

The asset in question was "dark" fiber-optic cable that Enron transferred in June 2000 to LJM2, a partnership managed by Fastow, then its own CFO. At the time the real value of dark fiber--installed data lines not yet equipped to carry traffic--was conjectural. About 40 million miles of fiber optics had been installed in the U.S., but within a year a glut would bankrupt several communications companies.

LJM paid $100 million in cash and credit to Enron, which promptly claimed a $67-million profit on the deal, suggesting that the real value of the fiber was $33 million.

LJM subsequently transferred most of the fiber to yet another Enron-associated partnership, this time for $113 million. This step implicitly revalued the fiber at more than triple its original value.

Supporting the second sale, however, was a derivative issued by Enron, in effect covering any loss the buyers might incur if the fiber's value collapsed, as it did during 2001.

Eventually Enron would have to declare the loss on its own books. But Watkins' letter suggests that this would not happen until the partnerships were closed out in 2002 and 2003--years after Enron reported a profit from the original sale.

'Not the Only One of Its Kind'

Analysts suspect deals like this were more common than Enron has disclosed.

"It seems likely that the 'dark fiber' deal was not the only one of its kind," Partnoy said last week in testimony before Congress.

He and others also believe that Enron traders may have manipulated their profit and loss figures by improperly valuing derivative contracts in illiquid markets--that is, those in which there is so little activity that a small transaction can move prices sharply. These include contracts to deliver energy at some point far in the future; indeed, the company disclosed that at year-end 2000, it held about $13 billion in energy contracts denominated in terms of up to 24 years.

Palmer, the Enron spokesman, rejected any suggestion that the company's traders manipulated energy prices. "This is stuff that's in the past and been investigated by half the Western world," he said, referring to probes of West Coast electricity price spikes during the power crisis last year. "We need to look ahead, not engage in this sort of proctology."

Accountants are well aware that such derivatives are prone to "mismarking."

"We recognize that some fair values are more difficult to set than others," said Timothy S. Lucas, director of research and technical activities for the Financial Accounting Standards Board. "In some cases, we may not have a really good idea of fair value."

To some professionals this is only a further sign that Congress erred in removing OTC derivatives from regulatory oversight.

"OTC derivatives are as powerful as futures and securities," Greenberger said. "If there's anything we're learning, it's that the big boys maybe can't take care of themselves."

· Enron: The Fallout: Firm's Downfall Raises Concern Over Derivatives --- U.S. Lawmakers Push for More Oversight

January 29, 2002

Michael Schroeder

The Asian Wall Street Journal

WASHINGTON -- As the significant role that derivatives played in Enron Corp.'s downfall comes into focus U.S. lawmakers and regulators are lining up in favor of more oversight of these risky investments.

While the Houston-based company's core energy operations involved natural-gas and electricity transmission, its largest and most-profitable business was trading derivatives -- unregulated financial instruments that derive their value from an underlying commodity or wager on the future. Now, information is surfacing that Enron's derivatives trading may have been used to mask weakness in the company's other businesses such as fiber-optic bandwidth, retail gas and power, and water systems.

"Enron was more of a hedge fund than an energy company," said Rep. Richard Baker, a Louisiana Republican and chairman of a Financial Services Committee panel that is looking into the derivatives issue, in an interview.

After listening to testimony at his committee's Enron hearing last week, Senate Governmental Affairs Chairman Joseph Lieberman said he would hold a hearing specifically on the need for derivatives regulation. The Connecticut Democrat was responding in part to the testimony of San Diego University law professor Frank Partnoy, who outlined a series of methods that he said Enron used "to create false profit and loss entries for the derivatives Enron traded."

To ensure that Enron met Wall Street quarterly earnings estimates, it used derivatives and off-balance-sheet partnerships, or so-called special-purpose vehicles, to hide losses on technology stocks and debts incurred to finance unprofitable businesses, Mr. Partnoy said. In addition, he said, "it appears that some Enron employees used dummy accounts and rigged valuation methodologies." The entries, he said, "were systematic and occurred over several years, beginning as early as 1997."

Based on independent research and conversations with Enron traders, Mr. Partnoy said he learned that some traders apparently hid losses and understated profits, which had the effect of making derivatives trading appear less volatile than it was. Randall Dodd, director of the Derivatives Study Center, an independent, nonpartisan Washington group, said in an interview that he has reached similar conclusions. Mr. Dodd is advising three government agencies and three congressional committees investigating Enron.

Declining to address specific allegations, Enron spokesman Vance Meyer said in a statement, "Derivatives were not our business. They complemented our core business of buying and selling natural gas and power." Mr. Meyer also said: "I think it's safe to say that we are not going to agree with every view about Enron presented in the congressional hearings, but we do respect the process and hope, when all is said and done, that something positive will come out of it."

In 1989, the energy company, originally a utility that produced and transported natural gas and electricity, had begun shifting its focus to energy trading. The derivatives included not only Enron's very profitable trading operations in natural-gas derivatives, but also the more-esoteric financial instruments it began trading recently -- such as fiber-optic bandwidth and weather derivatives.

During 2000 alone, Enron's derivatives-related assets increased from $2.2 billion to $12 billion, with most of the growth coming from increased trading through its EnronOnline, an Internet trading system, according to Enron's financial reports. Mr. Dodd figures that if Enron were a bank, it would rank as the 10th largest derivatives dealer.

Innovations in technology and finance have helped obliterate clear distinctions between banks, brokerage firms and newer hybrids, such as Enron. But financial regulators hew to decades-old divisions of authority, continuing to keep a close watch on banks, brokerage firms and conventional exchanges, while leaving new entrants such as Enron to police themselves.

In late 2000, Congress passed legislation that exempted from regulation over-the-counter derivatives, which are contracts arranged among sophisticated buyers and sellers such as banks, Wall Street firms and public companies. The measure had support from both parties, as well as the Federal Reserve and the administration of President Bill Clinton.

Advocates of derivatives say the instruments give companies, investors and lenders a way to reduce their exposure to many kinds of financial risks. Most regulators and financial-industry executives insist that the country's financial system remains sound.

But the Enron scandal spotlights an enormous void in the nation's system of financial regulation, and it is rekindling a thorny debate over just how that gap should be filled.

· Hearings Heat Up on the Hill - New Trading Rules Could Result.

January 28, 2002

Manimoli Dinesh, Jeff Gosmano.

Natural Gas Week

Congress last week kicked off several high-profile hearings on Enron's sudden downfall that are sure to bring politics and theater into full play.

Democrats continue to make political hay out of ties between President George W. Bush and White House officials to Texas-based Enron. Adding to the drama are reports of document destruction by Enron and its former auditor Andersen.

But lost amid all the scandal is the possibility that stricter rules may be imposed on energy trading, with far-reaching consequences for the industry.

Rep. W.J. "Billy" Tauzin (R-Louisiana) is keenly interested in studying the working of "energy trading structures" and legislation cannot be ruled out if he thinks there is room for improvement, said a House aide.

The Senate Energy Committee will - at a Jan. 29 hearing - focus on the impact of Enron's collapse on the energy market. Officials from the Commodity Futures Trading Commission (CFTC) and New York Mercantile Exchange (Nymex) have been invited to testify.

Little is known of the committee's legislative intentions, but Chairman Jeff Bingaman (D-New Mexico) has some concerns over existing rules for energy markets. "The structures to regulate these emerging market forces, particularly with respect to trading in natural gas and electricity, are not fully developed, as the collapse of Enron has shown," Bingaman wrote in an opinion piece.

In addition to current efforts to bring greater transparency to energy markets, Enron's collapse has turned interest once again to the regulation of over-the-counter (OTC), or derivatives, markets.

"There are several congressional offices that are developing a responsible legislative response to Enron's failure. It is designed to introduce capital standards and reporting requirements to these unregulated and non-transparent OTC derivatives markets," said Randall Dodd, director of the Derivatives Study Center, a non-profit research organization.

A Senate panel last Thursday set the stage for reforms to rules and laws, as lawmakers and experts pointed out fundamental flaws in the existing system, including derivatives trading, that failed to warn of the financial troubles of collapsed energy trading giant Enron.

Chairman Joe Lieberman (D-Connecticut) said the key issues to be addressed in the aftermath of the Enron debacle are how to restore investor confidence and protect retirement security, as well as whether to regulate derivatives trading and deregulate energy markets. Lieberman said he would seek documents from both federal agencies - the Securities and Exchange Commission (SEC), the Labor Department, the CFTC, and the Federal Energy Regulatory Commission - and the White House to determine "what they knew and did regarding Enron's regulation."

Lieberman said the committee would also consider whether regulatory agencies need additional powers to "prevent this kind of massive investor rip-off from occurring again." His plan is to collect information and carry out additional investigations before releasing a report this year.

With Enron known to have lobbied heavily to exempt energy trading from regulation, several experts zoomed in on this issue as well.

Frank Partnoy, professor of law at the University of San Diego, said at the hearing that Enron was essentially a trading firm, with its derivatives-related assets and liabilities ballooning five-fold in 2000 alone. He said the key problem involved the confluence of derivatives and special-purpose entities, which are also unregulated.

Enron entered into derivatives transactions with these entities to shield volatile assets from quarterly financial reporting and to inflate the value of certain Enron assets, according to Partnoy. He added that he has credible information indicating that some Enron employees used dummy accounts and rigged valuation methodologies to create false profit and loss entries for the derivatives Enron traded.

Partnoy and other witnesses held the major financial market gatekeepers - accounting firms, banks, law firms, and credit rating agencies - partly responsible for the Enron scandal. "Congress should consider expanding the scope of securities fraud liability by making it clear that these gatekeepers will be liable for assisting companies in transactions designed to distort the economic reality of financial statements," said Partnoy.

Arthur Levitt, former SEC chairman, warned that no amount of rulemaking and legislation would change behavior. "We have to have a system that is trustworthy and need participants that are trustworthy," he said. He also said there may be more companies like Enron out there.

Some industry groups are speaking out. "When people sort through the issue, I think that most will conclude that additional trading regulations are not necessary," said Stacy Carey, policy director of the International Swaps and Derivatives Association.

When Enron's troubles began, she notes that "the lights didn't go out," which demonstrates that the current energy trading environment works.

· Enron's Aggressive Lobbying in Washington Sometimes Backfired

January 28, 2002

Glen Justice in Washington with reporting by Steve Stroth in Chicago and Bob Parry in Washington.

Editors: Gettinger, Willen

Bloomberg

Washington -- Representative Joe Barton threw Enron Corp.'s then-Chief Executive Officer Jeffrey Skilling out of his office in 1999 for pushing too hard for legislation to force states to open their electricity markets to competition.

``He was very intense and very assertive that the company's position was the only one that was acceptable in a philosophical or moral sense,'' said the Texas Republican, the bill's sponsor and chairman of a House energy subcommittee. ``I encouraged him to leave sooner rather than later.''

So it often went for Enron's lobbying efforts in Washington, where the company pushed bills in Congress, sought regulatory changes and protected an expanding array of interests over the last decade, from pipeline safety to broadband communications.

Deploying people from both parties to blanket the White House, Capitol Hill and a handful of federal agencies, the company won some and lost some -- and often alienated Washington officials with an uncompromising and headstrong approach, according to lawmakers, competitors and lobbyists.

``They had this attitude that `We're Enron, dammit,''' said Jeff MacKinnon, a lobbyist with a firm representing Edison Electric Institute, a trade group that often opposed Enron. ``It was part of their corporate arrogance. It was well known that they didn't work well with others.''

Enron successfully got Vice President Dick Cheney and other top administration officials to lobby for its interests in India. It got its trading business exempted from the Commodity Futures Modernization Act of 2000. Yet when it came to its lodestar issue -- federal deregulation of energy markets -- Enron came up empty. And when the company went bankrupt in December, it received subpoenas rather than help from the nation's capital.

Washington Money

Enron spent $2.1 million on lobbying in 2000. That's almost double its 1997 bill, bringing it to the level of other companies its size such as United Parcel Service Inc.

The lobbying as bolstered by more than $2.4 million in campaign contributions in the last election -- part of almost $6 million since 1989, according to the Center for Responsive Politics, which tracks campaign finance. The company gave to 43 percent of the House, 71 percent of the Senate and was the 12th-largest contributor to President George W. Bush's presidential race.

Enron's Washington office had about two dozen lobbyists, regulatory lawyers and staff, and used several outside firms that addressed specific issues.

Big-Name Lobbyists

It hired former Senate Energy Committee Chairman J. Bennett Johnston, a Democrat, to push policies on carbon dioxide emissions, former New York Representative Bill Paxon, a Republican, to lobby on electricity deregulation, and former Montana governor Marc Racicot to advise it on California's energy crisis.

Racicot, a friend of Bush who was named chairman of the Republican National Committee, was criticized for his ties to the company and decided to forgo lobbying while he holds the post.

Enron also had Quinn Gillespie & Associates working on deregulation. Jack Quinn was the lobbyist and former Democratic White House counsel who helped secure a pardon for fugitive commodities trader Marc Rich. Ed Gillespie is a former aide to Republican House Majority Leader Richard Armey.

All that came in addition to the handful of Enron lobbyists in cities such as New York and Minneapolis who worked with local lobbying shops to boost the company's agenda in state governments.

`Their Own Best Interests'

Enron relied on its own executives as its primary voice.

``In their mind, they knew their own best interests,'' said Rick Davis, campaign manager for Republican Senator John McCain, who worked with Enron as a lobbyist in Puerto Rico. ``They would get people who could get meetings, then make their own pitch.''

The company has former employees working in the White House, the Pentagon and the Commerce Department and elsewhere. Its strongest force was former chairman Kenneth Lay, Bush's longtime friend, adviser and financial backer.

Lay wasn't shy about using his connections.

Last February, he talked with Curt Hebert, then chairman of the Federal Energy Regulatory Commission (FERC) and Washington's top electricity regulator.

In a widely publicized conversation that led Democrats to call for an investigation, Hebert said Lay offered him a deal: if he changed his position on deregulation of the energy grid, Enron would support keeping him in his post in the new administration. Lay recalled it differently, saying it was Hebert who asked for his support at the White House.

Whatever the case, Hebert didn't change his position and later lost the job. Lay said there was no tie between the events, and an August report by the General Accounting Office, the investigative arm of Congress, found nothing improper.

Winning on the Margins

Enron was often successful behind the scenes.

For example, Cheney, Bush's economic adviser Larry Lindsey and others in the administration were part of a drive to help Enron resolve a dispute with India over a troubled power plant project as late as November, according to government records.

The quarrel involved the Dabhol Power Co., a power generator and Enron's largest overseas investment. The company's only customer, an Indian electricity board, had more than $250 million in unpaid bills, payments guaranteed by in part by India's government.

In November, the Overseas Private Investment Corp, a U.S. agency with $360 million in risk insurance and loan guarantees tied up in Dabhol, wrote a letter to Indian officials.

``The acute lack of progress in this matter has forced Dabhol to rise to the highest levels of the United States government,'' it said.

In June, Cheney met with Indian leaders to discuss Dabhol, government records show. Lindsey met with India's national security adviser, Brajesh Mishra, in November, without discussing Dabhol after the White House Counsel's office recommended it, administration officials said.

Lindsey was paid $50,000 by Enron in 2000 to serve on an advisory board and, last year, directed a White House review of the effects of Enron's potential collapse.

Derivative Regulation

In another case, Enron got active on a bill overhauling how derivatives are regulated. Derivatives are complex financial instruments involving private contracts whose value is based on an underlying commodity, stock, bond, currency or other asset. Enron was an active trader and did not want to be regulated like an exchange.

The Commodities Futures Modernization Act of 2000 effectively exempted trading systems like Enron's from regulation by the Commodities Futures Trading Commission, which oversees the Chicago Board of Trade and other futures exchanges.

``The bill eliminated all federal oversight of the over-the-counter derivatives market,'' said Randall Dodd, a former economist with the CFTC who is now director of the Derivatives Studies Center.

The `Enron Exemption'

Enron stood with many other companies as part of the Energy Group, a consortium of power companies such as Koch Industries Inc. that wanted to avoid regulation. They were represented by Ken Raisler at Sullivan & Cromwell, a former CFTC general counsel.

Raisler said Enron was ``one of the more active participants'' in the consortium. ``We were looking for hands-on help explaining the business on Capitol Hill and at the CFTC,'' he said. ``They had resources.''

A piece of the act also specifically exempted energy futures traded under a system like Enron's, said Michael Greenberger, former director of the CFTC's Division of Trading and Markets who now teaches law at the University of Maryland.

It came to be known as the ``Enron Exemption.'' ``It was an exemption created to match Enron's peculiar way of trading,'' Greenberger said.

`That Idea Died Very Hard'

Enron's primary objective was never met. For years, the company threw all its weight behind a bill to open electricity markets, going so far as to run image ads in the 1997 Superbowl to tout the value of deregulation.

It wasn't enough to overcome the local utilities, however, which have their own strong lobby and close ties to their local Congress members.

``A consensus emerged that a federal mandate for retail competition was not the thing to do,'' said Tom Kuhn, president of the Edison Electric Institute, which represents investor-owned electric utilities, and a classmate of Bush's at Yale University.

For Enron, he said, ``that idea died very hard.''

The company responded in pragmatic fashion. When it became clear that deregulation legislation was not going to happen, Enron began to turn to the FERC to get favorable regulatory changes – a strategy that was cemented with Bush's election. The president appoints all five FERC commissioners with Senate confirmation.

That put the company in the position of fighting to empower the FERC -- a regulator. Enron has a case pending in the U.S. Supreme Court where it argued that FERC should be able to order local utilities to open their transmission.

`Dramatic Pivot'

Enron's pragmatism sometimes raised the hackles of the Republican Party faithful.

``They were completely non-ideological,'' Rick Davis said. ``They are all about what's good for Enron.''

Such was the case when Enron called for the U.S. to ratify the international treaty on global warming, known as the Kyoto protocol.

Many Republicans and the Bush administration opposed the international treaty to cut carbon dioxide and other ``greenhouse gases.'' Enron hoped it would open a market in CO2 credits that companies could trade through Enron, as they do with credits for sulfur-dioxide emissions under the Clean Air Act.

Though he rarely mentioned Kyoto specifically, Lay began speaking out, and wound up opposite the administration when Bush walked away from the accord last year.

``Their CO2 position was a dramatic pivot from their presumed free-market ideology,'' said Chris Horner, a senior fellow at the Competitive Enterprise Institute who worked in Enron's Washington office briefly in 1997.

`Not How Washington Works'

Many who worked with Enron say its tactics often rankled.

``The personality of the company was such that they needed to run the show,'' said Randy Davis, a lobbyist with Stuntz, Davis & Staffier who represents a group of investor-owned utilities. ``Or they didn't want to participate in the show.''

Barton, who was Enron's third-largest House recipient of campaign contributions since 1989 with $28,000, said, ``When they had a policy position, they tended to want it heard immediately and adopted immediately. That's just not how Washington works.''

Competitors saw it too. Erle Nye, chief executive officer and chairman of TXU Corp., the largest utility in Texas, and chairman of the Edison Electric Institute, gave the company credit for promoting deregulation while criticizing its approach.

``I never liked their style,'' he said. ``They were so overbearing, so aggressive.''

Washington Office Sacked

Joe Hillings, Enron's former general manager for federal government affairs, declined comment. In interview in October 2000, he agreed the company was aggressive.

``We pull out the stops on everything,'' he said.

Hillings painted a picture of a dynamic office that regularly reviewed and reshaped priorities. He said that Lay was ``very public policy minded'' and intimately involved with the Washington office, along with other high company officials. And, he defended Enron and its strategies under his tenure.

``We are human beings in this office and we are not always picture-perfect,'' he said.

The company's approach began to soften after it began to reshape the office in October 2000.

Hillings retired and Cynthia Sandherr, another Enron lobbyist who had been Barton's legislative director, left to represent Enron affiliate New Power Co. of Purchase, New York. Sandherr didn't return phone calls.

`Dem-ron'

In their place came Linda Robertson, an assistant Treasury secretary for legislative affairs in the Clinton administration and a Democrat. The move caused waves in Republican circles. Some Capitol Hill aides began calling the company ``Dem-ron.''

Employees say the Washington office was being re-drafted to reflect Enron's business interests and that control was shifting toward Houston. Office desks were re-arranged to resemble a trading floor.

``That's when they were more effective,'' MacKinnon said, ``but they weren't asking for much.''

On Dec. 3, one day after Enron filed for bankruptcy, much of the lobbying staff received notice they were no longer employed. Outside lobbyists, such as Bracewell & Patterson, walked away from their contracts -- in that case a roughly $1 million tab.

The company's work has since shifted toward the legal arena. Enron hired lawyer Robert Bennett, who represented former president Bill Clinton in his impeachment fight.

When Lay sought assistance, contacting Treasury Secretary Paul O'Neill, Commerce Secretary Don Evans and Federal Reserve Chairman Alan Greenspan, the administration did not act.

Some lawmakers have returned or given away campaign contributions after the bankruptcy. Such was the case with Representative Martin Frost, a Texas Democrat, who gave his $1,000 to charity.

``When they really needed help,'' said Rick Davis, ``nobody really lifted for them.''

· Congressmen Plan New Rules to Regulate Derivatives Trade

January 28, 2002

Manimoli Dinesh, Jeff Gosmano.

The Oil Daily

Stating that the Enron scandal has "exposed gaping holes" in federal oversight of markets, Rep. Peter DeFazio (D-Ore.) on Friday announced plans to craft legislation that would set new rules for over-the-counter (OTC) trade, including energy derivatives.

DeFazio joined Reps. Dennis Kucinich (D-Ohio) and Bernie Sanders (I-Vt.) in a three-pronged effort. Kucinich and Sanders will offer separate pieces of legislation to reform corporate auditing and protect worker pensions. The three members will work in tandem to promote the passage of these measures, aides said.

"The collapse of Enron and Long-Term Capital, both of which were heavily involved in derivatives, highlight the need to strengthen federal oversight of financial markets to protect the integrity of these markets and to protect consumers from spectacular failure that could spread to the entire financial system," DeFazio said.

There has been renewed focus in Congress on unregulated derivatives markets, amid suggestions that Enron used derivatives to manipulate its financial statements. Enron was a leader in US energy derivatives trade.

For now, most traders and executives at trading exchanges are keeping quiet on the issue of reforms. "This is not an environment where people want to shout 'no regulation,'" said one executive.

But some industry groups are speaking out. "When people sort through the issue, I think that most will conclude that additional trading regulations are not necessary," said Stacy Carey, policy director of the International Swaps and Derivatives Association.

With Enron's troubles, "the lights didn't go out," she said, arguing that this demonstrates that the current energy trading environment works.

Regulation of derivatives was a hot topic when the Commodity Futures Modernization Act (CFMA) was debated in 2000.

In response to concerns after the collapse of the Long-Term Capital Management hedge fund and Russia's economic crisis in the late 1990s, the CFMA gave derivatives legal certainty and ensured that the terms of contracts were enforceable. This headed off the threat that a party with heavy, negative exposure might argue that OTC contracts were really unauthorized futures deals, and renege on the arrangement.

But at the same time, the CFMA ruled that only energy futures exchanges would be subject to regulation. A special clause essentially freed energy and metals derivatives trade from regulation, limiting oversight to requirements on preventing fraud and manipulation. The main beneficiaries of this ruling were two electronic platforms, EnronOnline and the Big Oil-backed IntercontinentalExchange.

CFMA enjoyed strong support, but a sizable number of members were concerned about the exemption of derivatives from federal oversight. Rep. Carolyn Maloney (D-N.Y.), a critic of the oil industry, had warned that trades would not leave the audit trail available to reconstruct fraud.

At that time, the regulated New York Mercantile Exchange also protested strongly that it was put at a disadvantage by the lack of derivatives regulation. It expressed concern that the CFMA would encourage migration of energy trading to unregulated markets.

Congress, in a hurry to wrap an already prolonged session, passed CFMA in December 2000 as part of an appropriations bill.

DeFazio's proposed legislation would establish "safety and soundness" rules for derivatives and make the markets transparent. In order to prevent regulatory loopholes, the legislation would merge the Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC) into a single independent regulatory body - the Securities and Derivatives Oversight Commission (SDOC).

In addition to the current functions of CFTC and SEC, the new regulatory body would regulate OTC derivatives. Derivatives dealers would have to register with the SDOC and report to federal regulators on their market activities. Further, they would also have to maintain adequate capital as a financial institution, and collateral on their transactions.

A DeFazio aide was confident that the proposed legislation would garner interest and support, saying "it is a changed atmosphere now," after the Enron debacle.

Randall Dodd, director of the non-profit Derivatives Study Center, supports such regulation.

He argued that Enron's derivatives dealing business was not separately capitalized, and that this contributed to the firm's decline.

· Building the House of Enron: As Enron's Derivatives Trading Comes Into Focus, Gap in Oversight Is Spotlighted

January 28, 2002

The Wall Street Journal

WASHINGTON -- As the significant role that derivatives played in Enron Corp.'s downfall comes into focus, lawmakers and regulators are lining up in favor of more oversight of these risky investments.

"Enron was more of a hedge fund than an energy company," said Rep. Richard Baker (R., La.), chairman of a Financial Services Committee panel that is looking into the derivatives issue, in an interview.

But the Enron scandal spotlights an enormous void in the nation's system of financial regulation, and it is rekindling a thorny debate over just how that gap should be filled.

As a publicly traded company, Enron routinely provided the SEC with general information about its finances but wasn't obliged to divulge to any agency detailed information about its over-the-counter trading activities.

In the wake of Enron's bankruptcy, federal energy regulators say they plan rules for energy-derivatives accounting. Treasury Secretary Paul O'Neill said derivatives regulations may need modernizing.

"In this case, I think it's fair to say it may be that our rules and regulations have gotten behind practices," Mr. O'Neill said in a recent interview on the "Charlie Rose Show."

· Enron debacle intensifies campaign finance debate. Lawmakers question whether firm benefited from contributions

January 27, 2002

CRAIG GILBERT, Journal Sentinel staff

The Milwaukee Journal Sentinel

Washington -- Amid the outcry over Enron, supporters of campaign reform have made at least two arguments about the role political donations played in the saga.

One is that Enron executives got favors for their millions in campaign gifts.

Another is that Enron's lavish giving made it impossible for the government to intervene in the firm's demise -- and help victimized workers -- without looking corrupt.

Can both things be true?

That big money buys favors? That it also does the opposite -- creates such a taint that politicians are paralyzed to act?

"There's truth in both statements," House Democratic leader Dick Gephardt insisted Friday, although he owned up to the contradiction.

That's just one wrinkle in an unfolding debate over the political lessons of the Enron debacle.

The story has been a public relations boon to the campaign reform movement. Supporters of a high-profile bill to rein in big donations won enough support Friday in the House to force Republican leaders to schedule a vote on the measure. A similar bill, co-written by Wisconsin's Russ Feingold, passed the Senate last year, then died in the House.

But just as there's deep disagreement over that bill, there's sharp debate over the meaning of Enron.

"What did all of Enron's contributions get them? They're broke. There are going to be some people going to jail," said F. James Sensenbrenner Jr. (R-Menomonee Falls), chairman of the House Judiciary Committee.

While the Bush campaign got lots of Enron cash, the argument goes, the administration spurned Enron's desperate pleas for help; the system worked.

Rep. Mark Green said: "There are lots of good reasons for campaign finance reform. But Enron probably isn't one of them."

Green (R-Green Bay) notes that the company gave money to many powerful people in both parties, "yet when Enron probably wanted their help the most, their favors the most, their 'friends' weren't there."

He said the Enron saga argues more for lobbying reform and "reform of our corporate reporting system."

That's one view.

The bill's backers have another: that Enron is vivid proof of the problems they're trying to fix.

Here is a closer look at some of their arguments, and whether the high-profile reform plan before Congress addresses the issues raised by the Enron scandal.

Free rein?

Argument No. 1: As Enron grew into an energy giant, it did get something for its money -- relief from oversight and accountability, thanks to Congress and regulators.

One example that has captured attention is a complex bill enacted at the end of the Clinton presidency, the Commodity Futures Modernization Act. The measure liberalized rules for the burgeoning market in financial instruments known as over-the-counter derivatives. One provision exempted trading in energy futures from the oversight of the Commodity Futures Trading Commission.

The change allowed Enron to trade privately instead of on regulated public exchanges.

Spotlight on Gramm

The energy exemption has drawn even more interest because of the role of Sen. Phil Gramm (R-Texas). Gramm got nearly $100,000 in Enron contributions over the past 10 years, according to the Center for Responsive Politics.

Argument No. 2: When Enron began to unravel, its history of campaign giving was so conspicuous that government officials were reluctant to intervene, even properly, in the company's collapse.

But in a breakfast meeting with reporters Friday, Gephardt questioned whether the administration could have acted earlier "when they found out this thing was imploding, to safeguard the pensions of the people that were there."

Gephardt suggested that big donations might make an administration less willing to act on a problem "because they're worried about the appearance of impropriety."

Gephardt called that "the question we ought to look at going forward."

Another reform supporter, Sen. Fred Thompson (R-Tennessee), went even further with this line of thinking last week.

Perception clouded

Argument No. 3: That whether Enron's contributions influenced the behavior of government officials, they create a terrible perception.

This is the most popular argument among reformers -- and requires no evidence of a quid pro quo.

"I don't know what Enron got or didn't get," Gephardt said.

But with all the money the firm gave, he said, "people are going to suspect, whether it actually turns out to have happened or not, that they got something they shouldn't have gotten."

Feingold also makes this case.

"Perhaps there isn't a quid pro quo," he said in a recent interview. "The issue here has always not just been the reality of impropriety but the appearance of impropriety, and that is just overwhelming."

Would Feingold's bill, in theory, address the issues that reformers say are raised by Enron?

Yes and no.

The Enron scandal has prompted numerous lawmakers who received contributions from the company to publicly renounce the gifts, even modest donations made years ago. Green, who is one of almost 200 current House members to get contributions from Enron ($1,500 between 1997 and 2000), said Friday that he was sending it back, in a check directed to a fund for Enron workers. He sees nothing wrong "in any way" with the money he got but said "I suspect those employees need it more than I do."

On the other hand, the measure would outlaw the unlimited "soft money" donations that can now be made to parties.

"There is no accountability in soft money," Rep. Zack Wamp (R- Tennessee) said last week. "None."

· Enron's Fall Prompts Scrutiny of OTC Trade.

January 24, 2002

Manimoli Dinesh.

The Oil Daily

Congress is set to kick off today several high-profile hearings on Enron's sudden downfall that will likely bring politics and theater into full play (see table,p2).

Lost amid all the scandal is the possibility that stricter rules may be imposed on energy trading, with far-reaching consequences for the industry.

The 10 congressional hearings announced so far, with two scheduled today, will not want for high drama. Democrats are expected to make political hay out of ties between President Bush and White House officials to Texas-based Enron. Adding to the drama are reports of document destruction by both Enron and its former auditor Andersen.

But beyond this, Congress is also starting to examine whether changes are necessary in the operation of private energy trading markets.

The committees likely to take a lead role on that issue will be the House Energy and Commerce Committee and the Senate Energy and Natural Resources Committee.

Rep. W.J. "Billy" Tauzin (R-La.) is keenly interested in studying the working of "energy trading structures" and legislation cannot be ruled out if he thinks there is room for improvement, said a House aide. The House committee will hold a hearing today on the shredding of Enron documents by Andersen and will follow up with a hearing next week on a range of issues the committee is probing.

The Senate Energy Committee will at a Jan. 29 hearing focus on the impact of Enron's collapse on the energy market. Officials from the Commodity Futures Trading Commission and New York Mercantile Exchange (Nymex) have been invited to testify.

Little is known of the committee's legislative intentions, but Chairman Jeff Bingaman (D-N.M.) has some concerns over existing rules for energy markets. "The structures to regulate these emerging market forces, particularly with respect to trading in natural gas and electricity, are not fully developed, as the collapse of Enron has shown," Bingaman wrote in an opinion piece.

In addition to current efforts to bring greater transparency to energy markets, Enron's collapse has turned interest once again to the regulation of over-the-counter (OTC), or derivatives, markets.

Nymex was clearly unhappy with the Commodity Futures Modernization Act, particularly a provision that exempted derivatives exchanges from regulation. "There are several congressional offices that are developing a responsible legislative response to Enron's failure. It is designed to introduce capital standards and reporting requirements to these unregulated and non-transparent OTC derivatives markets," said Randall Dodd, director of the Derivatives Study Center, a non-profit research organization.

Stacey Carey, policy director of the International Swaps and Derivatives Association, challenged the need for reform, saying that trade in derivatives is not what caused Enron's financial collapse. "We don't think regulation is warranted. It could have negative effects on the global derivatives market," she said.

But Dodd argues that, "OTC derivatives were used extensively by Enron to construct these deceitful partnerships that hid debts and fabricated incomes."

Congress is also likely to consider tightening standards for the accounting industry. In particular, members are concerned over accounting firms performing the dual role of auditor and consultant to a client, as Andersen did in the case of Enron.

There is some embarrassment in Congress that lawmakers thwarted former Securities and Exchange Commission Chairman Arthur Levitt from making changes to this effect. Levitt will be the star witness at the Senate Government Affairs Committee hearing today. Tougher laws for employer-sponsored pension plans in order to protect employees are also being mulled.

As for Enron, it is will face scrutiny for securities fraud and alleged tax evasion. The Senate Finance Committee is looking into those aspects. Enron Chairman Ken Lay is expected to testify in the Senate Commerce Committee on Feb. 4.

· Enron case sparks Congressional push for energy derivatives regulation

January 16, 2002

Justin Cole

AFX News

WASHINGTON (AFX) - The collapse of Enron Corp has sparked a push in Congress for more Federal regulation of one of the company's key areas of operation, that of over-the-counter (OTC) energy derivatives, Congressional aides and lobbyists said.

Enron, through its EnronOnline internet marketplace which it launched in 1999, came to control a quarter of all US wholesale energy trades, but the OTC derivatives trades fell outside the regulatory scope of the Securities and Exchange Commission and the Commodity Futures Trading Commission.

The Houston-based energy firm had lobbied federal regulators, Congress and the White House for years to exempt its derivatives trading from oversight, they said.

Enron was able to hold at bay members of Congress who had been trying to regulate OTC derivatives markets since 1994, including Democratic Congressman Edward Markey.

Now, in the wake of Enron's collapse, Markey and his allies are planning a new regulatory push, a spokesman for his office said.

"He's just as interested in it as when he proposed regulating them in the first place. He's going to reintroduce his bill and see if he does any better this time than last time," the spokesman said.

He declined to address any specifics that Markey's bill is likely to address.

"I can't address the scope yet, cause we're still mulling it over, and taking the old bill and working on it," the spokesman added.

The value of Enron's OTC energy trades is difficult to quantify because the company did not discuss its derivatives trading, but the market for credit derivatives has grown in value to some 360 bln usd, according to the Office of the Comptroller of the Currency.

Tyson Slocum, an energy research director for Public Citizen, a nonprofit consumer advocacy organization, told AFX News that he is working with several members of the House of Representatives to help draft new legislation which would also seek to regulate energy derivatives trading.

Slocum said the legislation being drafted with the House lawmakers would stop other energy groups like Enron who participate in derivatives trading from operating "unregulated power auctions."

Trading would instead be regulated by a listed exchange like the New York Mercantile Exchange or the Chicago Board of Trade where counterparties could gain a clearer insight into contract prices and volumes, he explained.

Enron's ability to operate its privately run EnronOnline outside of the scrutiny of regulators like the SEC and CFTC was made possible by a policy initiated by Wendy Lee Gramm, the wife of retiring Texas Republican Senator Phil Gramm, when she was the chairman of the CFTC in 1993.

Enron petitioned the CFTC in 1993 asking the agency not to regulate energy derivatives contracts. Wendy Gramm subsequently initiated a policy which exempted derivatives trading from the commission's oversight.

"We want to undo what Wendy Gramm did in 1993 at the Commodity Futures Trading Commission where the CFTC refused to regulate energy derivatives contracts," Slocum said.

After leaving the CFTC, Gramm was named to Enron's board of directors where she rose to become chairwoman of the firm's audit committee.

The energy group's ability to operate EnronOnline out of the reach of federal regulators was further consolidated in Dec 2000 when Congress quietly passed the Commodity Futures Modernization Act.

One of the act's co-sponsors was the then head of the Senate Banking Committee, Phil Gramm.

Public Citizen's Slocum said the legislation he is assisting with would also seek to repeal sections of this act.

Randall Dodd, a professor of finance at American University in Washington and a director of the Derivatives Study Center which was set up in the wake of the Long Term Capital Management hedge fund collapse in 1998, also believes Congress made a mistake in deregulating derivatives trading.

"Congress made a big mistake thirteen months ago when they completely deregulated OTC derivatives markets, and extended that to energy derivatives as well. The derivatives markets play a very critical role in these markets," Dodd said.

Dodd believes the OTC derivatives markets, like that run by EnronOnline -- which has now been purchased in principle by UBS Warburg -- should be subject to fraud and manipulation oversight.

The size of these markets now makes it necessary that there is more reporting transparency, licensed brokers and a designated dealer bringing parties together, Dodd argues.

"Those markets are wrought with fraud, and the great thing about the licensing process is that you can run security checks on the guys that are doing the trading," he added.

Dodd worked at the CFTC as an economist from 1997-2000, and says that more than half of the agency's resources at that time were going into enforcement actions against fraud.

The House legislation that Public Citizen is helping to draft is also looking to tighten up the regulations overseeing US companies' offshore subsidiaries.

· Enron woes an echo of Long-Term Capital

January 14, 2002

Kathleen Day

The Hamilton Spectator

The head of Enron Corp. warned Treasury Secretary Paul O'Neill in late October that Enron's financial troubles could be as disruptive to world financial markets as the near collapse of Long-Term Capital Management in 1998. O'Neill turned to Peter R. Fisher for help.

Fisher, now undersecretary of the Treasury, worked at the Federal Reserve Bank of New York during the Long-Term Capital crisis and helped orchestrate a $3.6 billion rescue by 14 of its largest lenders, including J.P. Morgan Chase, which is also a major lender to Enron.

O'Neill, Fisher and others decided that Enron was no Long-Term Capital and it needed no federal intervention to help stem its problems.

Enron filed for bankruptcy Dec. 2.

Other market watchers, however, see parallels between the two companies' woes, largely because both traded in complex, risky and largely unregulated financial contracts known as over-the-counter derivatives.

Derivatives are used to hedge against or speculate about changes in the price of commodities such as cocoa and gasoline or financial instruments such as stocks, bonds, interest rates and currencies.

"I've been saying for weeks the Enron and Long-Term Capital situations are the same," said Michael Greenberger, professor of law at the University of Maryland School of Law.

"The parallel ingredients here are that both companies traded in products which essentially have the same volatility and risk, whether you are trading in energy derivatives or in the sophisticated financial derivatives that investment and commercial banks are engaged in."

In fact, Greenberger said, "the indications are that Enron was moving away from energy derivatives and into those financial derivatives."

The complexity of Enron's balance sheet makes it hard to fathom, even for experts.

But Enron itself said it was distinctly different from other energy companies: its deals involving delivery of gas, power and other products were a small part of its overall business.

The vast majority involved derivatives.

Randall Dodd, an economist and director of the Derivatives Study Center, a non-profit research organization set up after Long-Term Capital's demise, said the two companies shared other traits.

There was little market transparency about either business, so the market had to take their word on the value of the derivatives.

And there were no requirements -- as there are for banks -- that each hold enough cash as a cushion against possible losses on the financial contracts.

In 1998, Fisher and his boss, New York Fed Bank president William McDonough, decided Long-Term Capital's problems, if left unchecked, could unravel securities markets, which were already suffering because of Russia's decision to default on some bonds a few months earlier. Fisher would not comment last week.

Enron's attorney, Robert Bennett, said company head Kenneth Lay believed he had an obligation to alert the administration to Enron's increasingly precarious condition and the possibility that the largest energy trader in the U.S. could fall into bankruptcy.

"He asked them for nothing," Bennett said.

Dodd said Enron's problems created "substantial damage" throughout the U.S. economy, where investors and employees lost billions in stock value.

Still, he said, "the difference is that Enron's failure, although it has inflicted damage throughout the economy and even internationally, didn't result in the systematic meltdown that regulators thought Long-Term Capital's failure posed."

· Trades by Enron Recall Earlier Crisis Over Risky Investments

January 11, 2002

Kathleen Day, Washington Post Staff Writer

The Washington Post

When the head of Enron Corp. warned Treasury Secretary Paul H. O'Neill in late October that Enron's financial troubles could be as disruptive to world financial markets as the near collapse of Long-Term Capital Management in 1998, O'Neill turned to Peter R. Fisher for help.

O'Neill, Fisher and others decided that Enron was no Long-Term Capital and that it needed no federal intervention to help stem its problems.

Enron filed for bankruptcy Dec. 2.

Derivatives are used to hedge against or speculate about changes in the price of commodities such as cocoa and gasoline or financial instruments such as stocks, bonds, interest rates and currencies.

"I've been saying for weeks the Enron and Long-Term Capital situations are the same," said Michael Greenberger, professor of law at the University of Maryland School of Law. "The parallel ingredients here are that both companies traded in products which essentially have the same volatility and risk, whether you are trading in energy derivatives or in the sophisticated financial derivatives that investment and commercial banks are engaged in."

In fact, Greenberger said, "the indications are that Enron was moving away from energy derivatives and into those financial derivatives."

The complexity of Enron's balance sheet makes it hard to fathom, even for experts. But Enron itself said it was distinctly different from other energy companies: Its deals involving delivery of gas, power and other products were a small part of its overall business. The vast majority involved derivatives.

Randall Dodd, an economist and director of the Derivatives Study Center, a nonprofit research organization set after Long-Term Capital's demise and funded by the Ford Foundation, said the two companies shared other traits: There was little market transparency about either's business, so the market had to take their word on the value of the derivatives. And there were no requirements -- as there are for banks -- that each hold sufficient cash as a cushion against possible losses on the financial contracts.

In 1998, Fisher and his boss, New York Fed Bank President William McDonough, decided Long-Term Capital's woes, if left unchecked, could unravel securities markets, which were already in relative chaos because of Russia's decision to default on some bonds a few months earlier.

Fisher would not comment yesterday.

Enron's attorney, Robert Bennett, said Lay believed he had an obligation to alert the administration to Enron's increasingly precarious condition and the possibility that the nation's largest energy trader could fall into bankruptcy. "He asked them for nothing," Bennett said.

Dodd said Enron's problems have created "substantial damages" throughout the U.S. economy, where investors and employees lost billions in stock value, and even other players in the energy markets suffered when the collapse put downward pressure on prices.

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