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In The News

2006

· CNBC TV interview, December, 29, 2006

· Investor Business Daily, November 8, 2006

· Human Resources, November, 2006

· The Advocate, October 27, 2006

· Kevin McKern, October 19, 2006

· Forbes, October 16, 2006

· BNA – Bureau of National Affairs, October 4, 2006

· Oil Daily, October 3, 2006

· Power Markets Weekly, October, 2006

· Market Regulation, October 2, 2006

· Hedge Funds, September 22, 2006

· BNA – Bureau of National Affairs, September 21, 2006

· Business Week, September 20, 2006

· Gas Daily, September 20, 2006

· Gas Daily, July 20, 2006

(also in Energy Trader and Coal Trader)

· Energy Trader, May 8, 2006

· Times-Picayune (of New Orleans), May 6, 2006

· Inside FERC, May 5, 2006

· The Plain Dealer (Cleveland), May 5, 2006

(also in Standard (Syracuse, NY), Star-Ledger, and Newhouse News Service)

· Seattle Times, April 22, 2006

· Wall Street Journal, April 7, 2006

· New York Times, March 15, 2006

· CA Magazine, March, 2006

· Catholic News Service, February 16, 2006

· Bloomberg Market Magazine, February 2006

· Greenwire, January, 16, 2006

· New York Times, January 15, 2006

· Investor’s Business Daily

November 8, 2006

Sarbanes-Oxley Likely To Stand With Democrats

BY DANIEL DEL'RE AND BEN STEVERMAN

INVESTOR'S BUSINESS DAILY

Posted 11/8/2006

U.S. Rep. Barney Frank, D-Mass., could barely get proposals considered, let alone passed into law, when he pushed Congress to look into executive pay levels and scrutinize hedge funds earlier this year.

That will probably change when Democrats take charge of Congress in January.

Frank is assumed to become chairman of the House Financial Services Committee, giving him considerable power over a range of financial regulations and corporate governance issues important to investors.

Regulatory changes, however, are unlikely to be sweeping or surprising, observers said, as legislators have already tipped their hand by introducing policies to regulate hedge funds and expose excessive executive compensation.

"My assessment is that it's not going to create a major shift," said Lucian Bebchuk, director of the Harvard University Program on Corporate Governance. However, Democrats will be able to slow the momentum for rolling back previous reforms, he said.

Calls to revamp the Sarbanes-Oxley Act, for example, will probably stall in a Democrat-led Congress. The legislation was enacted in the wake of the Enron scandal to reform financial reporting. Much of corporate America has assailed the act as costly and time consuming, especially for smaller companies. But studies show most financial fraud is committed by smaller public firms. If anything, Congress may clarify Section 404 pertaining to internal accounting controls, said Randall Dodd, director of the Financial Policy Forum.

What's more, legislators seem content to let the Public Company Accounting Oversight Board, created by the act, determine how the law should be applied.

"I don't think that there's a general sense that it's worthwhile or necessary to change Sarbanes-Oxley, said Nell Minow, chief executive of the Corporate Library, a governance think tank. "My sense is that any effort to water it down is dead for the moment."

Interest in regulating hedge funds could resurface, especially if Frank decides to hold hearings on the issue. Some policymakers are concerned with the amount of pension money flowing into these largely unregulated investment pools. That concern has heightened since Amaranth Advisors lost about $6 billion on energy trades this year.

Many expect the new Congress to strengthen the SEC's ability to oversee the hedge fund industry, which manages $1.5 trillion, according to most estimates.

Earlier this year, a federal court struck down SEC rules that forced hedge funds to register, saying the commission had overstepped its congressional mandate.

This ruling effectively put the ball in Congress' court to strengthen the SEC's regulatory purview, said Marie DeFalco, attorney with Lowenstein Sandler.

"I think it's more likely than before that we will see reformulation of the hedge fund rules," she said.

Congress could take what DeFalco termed a "minimalist" approach by requiring hedge funds to register. This would let the SEC audit hedge funds and require them to keep records of their investments.

Stricter regulations would require them to file public financial reports, disclose large bond or stock holdings, and put up collateral for large trades.

Frank has also been a vocal critic of "sky-high executive pay." The SEC has already enacted policies to enforce clearer disclosure of compensation so that perquisites cannot be obscured in footnotes or left out altogether. Most observers say Frank can add teeth to this by reintroducing legislation that would let shareholders approve executive compensation packages.

"Disclosure is nice, but it doesn't do much good unless investors have the authority to act on the information," said Minow.

Frank may be a sponsor of other investor-friendly resolutions, said Minow. For example, he may support legislation to give shareholders a greater say over approving board directors.

The congressman issued a statement Wednesday acknowledging "the great amount of interest in the agenda of the committee."

His statement added, "Right now it is too premature to discuss any agenda items that the committee will or will not consider next year."

· Human Resources

November, 2006

Practitioners Seek Clarification of Auto Enrollment Rule

401(k) practitioners who were interviewed about the proposed automatic enrollment default investment alternatives regulation said the proposal is timely, but expressed some concerns with the proposed rule and asked for clarifications.

All noted that their comments were subject to further review and study of the proposed rule. They will be filing more extensive written comments with the Department of Labor. Written comments are due by November 13.

"The department has moved swiftly to provide clarity," said Dallas Salisbury, president of the Employee Benefit Research Institute (EBRI; Washington, D.C. www.ebri.org), which conducts public policy research and education on economic security and employee benefits. However, he expressed concern over the exclusion of money market and stable value funds from the proposed rule's protected class of investments.

While commending the department for promptly issuing its proposed regulation, Nell Hennessy, president and chief executive officer of investment adviser Fiduciary Counselors Inc. (Washington, D.C.; www.fiduciarycounselors.com), said "the proposed regulation does not include any capital preservation alternatives."

"I was disappointed with the requirement that the qualified default investment alternatives had to be managed by an investment manager or a registered investment company," C. Frederick Reish of the employee benefits law firm Reish, Luftman, Reicher, and Cohen (Los Angeles; www.reish.com) noted. "It is very common for plans to use asset allocation models, where the underlying funds in the plan are used to populate the models," he said.

Default investment funds should not be automatically redirected immediately, and the two conditions for automatically directed funds are "inadequately addressed," added Randall Dodd, director of Financial Policy Forum (Washington, D.C.; www.financialpolicy.org), a research institute that studies financial markets, the regulation of financial markets, and their impact on the economy.

Larry H. Goldbrum, general counsel for the Society of Professional Administrators and Recordkeepers' Institute (SPARK; Simsbury, Conn.; www.rgwuelfing.com/spark1.shtml), which provides research, education, testimony, and comments on behalf of the retirement services industry, said the institute would like clarification or slight modification of the 30-day notice requirement, among other provisions of the proposed rule.

Praise for Timeliness

"The department did a good job in issuing a timely proposed regulation under the Pension Protection Act," said Jon Breyfogle, a principal in the Groom Law Group (Washington, D.C.; www.groom.com), an employee benefits specialty law firm. "It suggests that they will get a final regulation out in time for people to rely on it in early 2007. The department deserves some credit for this," he said.

"The department should be commended for developing this thoughtful proposal so quickly," according to Chris Wloszczyna, spokesman for the Washington, D.C.-based Investment Company Institute, a trade organization for the U.S. fund industry. "The department proposal will help encourage more plans to use automatic enrollment. In addition, the default investment provision will improve the ability of workers to prepare for their retirement needs," he said.

"Overall, there is no doubt that this is very good news for the retirement of American workers," according to Ed Ferrigno, vice president of Washington Affairs for the Profit Sharing/401(k) Council of America (PSCA: Chicago, www.psca.org), which represents its members' interests to federal policymakers and offers assistance with profit-sharing and 401(k) plan design.

"We welcome the department's quick action on this vital area and look forward to commenting on the regulations and working rapidly toward final guidance," said Mark Ugoretz, president of the ERISA Industry Committee, which represents the employee benefits and compensation interests of America's major employers.

"The American Benefits Council is very pleased with the department's proposed default investment regulation," Jan Jacobson, director of retirement policy for the American Benefits Council, added. However, Jacobson explained that the Council plans to file written comments in response to the proposed rule to address a few technical issues, such as fiduciary relief.

Relief Beyond 404(c) Plans

"The proposed regulation is written to extend relief beyond just 404(c) plans," Groom's Breyfogle said, adding that "this creative and flexible approach is a favorable development."

According to Breyfogle, the proposed regulation is not just limited to default investments in connection with an automatic enrollment program but would, for example, be available when a plan transitions from one recordkeeper to a new one or from one investment option to another.

"I think plan sponsors will find this to be a very valuable option when they change record keepers or investment options," Breyfogle pointed out.

Automatic Redirection

Rather than automatically redirecting funds immediately, "they should be held in a low risk, fixed income account, something akin to a money market mutual fund account, for six weeks before being transferred," Financial Policy Forum's Dodd noted.

"This solves several problems," Dodd said. One is it avoids temptation by an investment manager to cheat or a pensioner to feel cheated when funds are transferred during times when price movements are substantial. Large price changes make the timing of such transfers critical, and the recent back dating and spring loading of stock options demonstrate the importance of these concerns, Dodd added.

The six-week period also would allow the participant time to make an informed decision, Dodd said. After six weeks, the transfer date becomes automatic and thus "less susceptible to shenanigans."

One of the conditions of the fiduciary relief is that the participant or beneficiary must have had the opportunity to direct the investment but fails to do so, ABC's Jacobsen said.

"Depending on how this requirement is interpreted, it could have a detrimental effect on plan sponsors attempting to change the default investment from something like a money market fund to one of the investment options described in the proposed regulation," she said. "Plan sponsors may not know which money market fund investors chose to invest in the fund versus participants who were simply defaulted into the fund," Jacobsen concluded.

Funds and Models

"Plans with automatic enrollment will have participants withdrawing their money within a shorter time horizon, either because they unwind the automatic election or they leave within months or a couple of years," Fiduciary Counselor's Hennessy said. The department "needs to provide a safe default alternative [for capital preservation alternatives] as well as the long-term blend."

An employer with mainly young workers and high turnover might do better for these workers with money market and stable value fund options, given the propensity to cash out small accounts, according to EBRI's Salisbury. The proposed rule is limited to equity weighted options only and will cause some employers to avoid automatic plan features resulting in many workers having no savings instead of some savings, he added.

Notice Requirement

The 30-day notice to participants should be modified to accommodate those plans that have immediate eligibility, SPARK's Goldbrum said. Under such circumstances it may not be feasible to provide the required 30-day notice. Goldbrum suggested a clarification in the regulations. For plans with immediate eligibility, the notice requirement may be satisfied when participants are provided with enrollment materials.

The proposed regulation calls for the participant to be provided with any material provided to the plan, according to Goldbrum. The language "any material provided to the plan" could require plan sponsors to provide affected participants with information that is not typically made available to participants on a regular basis or is supplied only upon request by the participant, such as fund prospectuses and amendments, fund annual reports, and proxies, he said.

The effect would be that plan sponsors will be required to provide passive participants with more information than they typically offer to participants who actively manage their assets, Goldbrum said. This requirement should be modified or clarified to specify that those participating in qualified default investment alternatives need only be provided the same information that is made available to participants who make affirmative investment elections.

The participant must be able to transfer out of the default investment fund without incurring a penalty, Goldbrum added. This requirement should be clarified or modified to address situations where the qualified default investment alternatives may impose a redemption fee on shares that are redeemed after a short holding period. It should be clarified as to whether these fees that are imposed on all investors in a fund would constitute a penalty, he said.

· The Advocate

October 27, 2006

Summit hits on energy attitudes

GARY PERILLOUX

John Felmy was working a tough crowd Thursday at LSU's Energy Summit 2006.

On a day when Exxon Mobil Corp. announced the second-highest quarterly earnings on record in the U.S. - $10.5 billion worth - Felmy speaks as perhaps the nation's leading apologist for the oil and gas industry, serving as chief economist for the American Petroleum Institute.

And what a year 2006 has been: $3-a-gallon gasoline, multibillion-dollar investments culminating in ultra-low sulfur diesel, congressional strife over drilling in the Arctic National Wildlife Refuge and those record oil profits.

"Unscrupulous politicians" and others have been taking shots at the industry all year, Felmy said, first blaming oil companies for soaring crude prices and expensive refined products. Then, when gasoline prices tumbled in the fall, nearly half the respondents in a USA Today poll thought the industry intentionally trimmed prices to get Republicans elected in November, he said.

"That's how bad off we are," said Felmy, referring to the poll.

While Felmy spoke on the final day of LSU's energy conference, U.S. Rep. Ed Markey, D-Mass., was telling constituents, "Coming just a few days before Halloween, Exxon Mobil's latest earnings reports may be a treat for their shareholders, but they're a dirty trick for American consumers."

Said Felmy, "My goal in life is to build a refinery (in Markey's district)."

Demagoguery aside, the oil economist said $60-a-barrel oil equates to a $1.43 base gasoline cost. Toss in 47 cents in average national taxes (38.4 cents in Louisiana) and the price of a gallon of gas nearly reaches pump prices before distribution, marketing and profits are figured in.

Similarly, while global oil companies are reaping 10 percent profit margins on an admittedly huge scale, refineries produced 6 percent profits in the most recent quarter, he said.

The media have made much of no new U.S. refineries being built since 1976, but expansions of existing refineries are simply more efficient, Felmy said. He said the equivalent of 12 new refineries, doing 200,000 barrels a day, has been added via expansions in the past decade.

That still leaves the nation 3.3 million barrels a day short of its 20.6 million-barrel demand for gasoline. Imports bridge the gap, and companies have reason to be cautious, Felmy said.

By 2030, Exxon Mobil projects demand for on-road fuel will be lower than it is today, he said.

Projections of oil and gas demand - and the infrastructure needed to deliver it - formed the heart of the two-day LSU conference. And where money and power are discussed, so, too, are politics.

On Wednesday, a Washington, D.C., attorney who's the executive director of the Center for Liquefied Natural Gas grimaced after U.S. Sen. Diane Feinstein, D-Calif., was praised for introducing unsuccessful legislation to regulate energy trading.

"I haven't gotten over my hyperventilation attack when I heard Sen. Feinstein's name mentioned in a positive light," said Bill Cooper, the liquefied natural gas proponent.

Of 45 LNG facilities proposed along U.S. coastlines - many of them on the shores of Louisiana and Texas - experts see only seven to nine coming to fruition, he said. The facilities take super-cooled natural gas from special ships, revaporize the gas and deliver it to consumers via pipelines.

Ship contents aren't under pressure, but "the biggest misconception we face is people think this is a moving time bomb," he said. Instead, "it's a big Thermos bottle."

While Cooper cited environmental studies predicting an LNG open-loop system would kill just eight adult redfish a year, environmentalists counter that potentially far more fish would be killed because the systems would destroy fish eggs by circulating cooled-down water into the Gulf of Mexico.

For that reason, Gov. Kathleen Blanco has opposed LNG terminals that don't use a closed system of recirculated water.

Randall Dodd, the fan of the Feinstein legislation, does think government could do more to stop energy spikes.

Dodd bristled at the school of thought espoused by the conference's opening speaker, Heritage Foundation analyst Ben Lieberman.

It was Lieberman who blamed Washington for complacent energy attitudes in the 1990s that enabled today's high-cost energy environment.

Specifically, Lieberman said, had President Clinton not refused to sign a bill allowing drilling in the Arctic National Wildlife Refuge, another million barrels of oil a day would be available now, easing hurricane disruptions and tight global markets.

Now, there would be a 10-year lead time to produce in the refuge if environmental objections were overcome. In the 1990s, both presidents Bush and Clinton erred on the side of restricting offshore drilling, Lieberman said.

Environmental issues aside, Dodd said other energy price culprits exist that "free market fundamentalism" won't fix.

Hedge funds and over-the-counter energy derivatives aren't sufficiently regulated, creating an energy trading market that's like the Wild, Wild West, Dodd said.

In the summer 2006, consumption and production were substantially changed but crude oil prices soared to $77 a barrel and gasoline to $3 a gallon.

True, Middle East tensions rattled markets, Dodd said, but industrial consumers keep leaner oil and gas inventories these days. Volatile markets cause them to increase orders as a hedge against rising prices.

Meanwhile, unregulated hedge funds outside the petrochemical industry take bigger positions to exploit profits. Producers who have more incentive to sell at tomorrow's expected higher prices, require higher prices today.

And the cycle continues.

"There's your theory; there's your partial explanation," said Dodd, who advocates a real-world government crude oil reserve that could be cushion volatile markets and ease price spikes that deaden the economy.

The Strategic Petroleum Reserve, tapped only once in the past two decades, doesn't do much good, Dodd said.

Others disagreed about the source of oil spikes.

"We still import a lot of oil and probably will continue to do so forever," said Michael Curole, a senior Shell staff engineer, later adding that high prices stem from that equation. "The price of oil is dictated by the government of Saudi Arabia ... by putting additional oil on the market or taking it off the market."

Hundreds of millions of barrels a day can have the effect, Curole said.

And demand won't dry up any time soon.

By 2030, the U.S. will be producing an estimated 10 billion barrels of oil per day and consuming 28 billion barrels, said Michael Schaal, director of the federal Energy Information Administration's oil and gas division.

While the administration forecasts $57 a barrel oil in 2030, that price could vary from $34 to $96.

And it's that price volatility that keeps developers of the import-driven LNG technology walking the floors at night.

If the oil price is $34, an estimated 7.4 trillion cubic feet of liquefied natural gas would be imported in 2030, Schaal said. At $96, LNG imports shrink to 1.9 trillion cubic feet.

The cost of shipping would become prohibitive at the higher prices, and domestic exploration - like today - would become decidedly more robust.

· Kevin McKern

October 19, 2006

Hedge Funds and Credit Derivatives

Hedge funds have gotten rich from credit derivatives. Will they blow up?

The downfall of Amaranth Advisors, the hedge fund that lost $6 billion in a
single week by betting on natural gas, was a special case. There was no
domino effect taking down energy traders generally, no meltdown of an
industry. But if you want to fret over the next financial catastrophes, turn
your gaze away from energy futures and focus on something far more obscure:
credit default swaps. Hedge funds are neck-deep in these derivatives, and if
something goes wrong, the pain will be widespread.

A credit swap is an insurance policy on a bond, often a junk bond. The
fellow selling the swap--writing the policy, that is--collects a premium. If
nothing goes wrong, he pockets the premium and looks like a financial
genius. But if the bond defaults, the swap seller has to make good. The
notional amount--the aggregate of bonds, loans and other debt covered by
credit default swaps--is now $26 trillion. This is a staggering sum, twice
the annual economic output of the U.S.

Hedge funds account for 58% of the trading in these derivatives, says
Greenwich Associates, a financial research firm. Selling protection has been
a big moneymaker for funds like $23 billion (assets) D.E. Shaw and $12
billion Citadel, say market participants, and for specialized outfits like
Primus Guaranty (nyse: PRS - news - people ) in Bermuda, which took in $57
million in the first half of 2006 selling protection on $1.6 billion in
debt.

With corporate debt defaults low these days, the temptation is high to write
insurance policies on bonds. A hedge fund can make $60,000 to $1 million a
year selling protection on $10 million in bonds. It's like finding money in
the street. Unless, of course, the economy suddenly enters a recession. If
that happens, hedge funds addicted to the credit market will be in deep
trouble. "A lot of [hedge funds] have sold insurance, are sitting on the
premiums--and are bare-ass," says Charles Gradante, cofounder of Hennessee
Group, which tracks hedge fund performance. "If there is a Long Term
Capital-type systemic risk potential out there, it's in the [credit swap]
market."

There must be a lot of investors--or credit speculators--who are cavalier
about corporate defaults because junk bonds are trading at yields only
modestly higher than the yields on safe U.S. Treasury bonds. The chart
displays the yield spread, as calculated by Moody's Investors Service,
between junk bonds rated speculative and seven-year Treasurys. Saks bonds
with a 97TK8 coupon due October 2011, for example, are now yielding 7.6%, or
287 basis points (2.9 percentage points) over seven-year Treasurys, compared
with a 700-basis-point spread to Treasurys four years ago. Today's tight
spreads don't leave much of a cushion to cover defaults.

There is a close correlation between yield spreads and credit default swap
prices. That's because selling a credit swap is equivalent to buying the
corporate bond on margin. If you buy a junk bond with borrowed funds, you
collect the high coupon on the bond while paying out a lower amount,
presumably not too much more than what the U.S. government pays to borrow
money. Either way--with a swap or a margined bond trade--you pocket the
spread, unless and until the corporate bond gets into trouble, at which
point you're sitting on a painful capital loss.

The credit-derivatives business is dominated by 14 dealers. Among them:
jpmorgan Chase, Citigroup (nyse: C - news - people ), Bank of America (nyse:
BAC - news - people ), Goldman Sachs (nyse: GS - news - people ) and Morgan
Stanley (nyse: MS - news - people ). All have staggering amounts of
derivatives on their books: JPMorgan's notional exposure was $3.6 trillion
as of June 30, according to the Federal Deposit Insurance Corp., which is
almost three times assets and 30 times capital. Credit derivatives at
Wachovia Corp. (nyse: WB - news - people ) have jumped sevenfold since 2003
to $170 billion, more than three times capital. Banks love derivatives
because they provide multiple ways to make money. Revenue from all types of
derivatives will hit $34 billion or so this year at U.S. banks and
securities firms, says Tower Group (nasdaq: TWGP - news - people ), a
financial-research outfit, with hedge funds generating much of the money.

Hedge funds also buy the potentially toxic waste that banks create when they
bundle credit derivatives into so-called synthetic deals. By separating a
portfolio of derivatives into different tranches, banks can create virtually
default-proof securities for conservative investors--if somebody else is
willing to buy riskier "equity" tranches whose value vaporizes when as few
as one or two of the underlying bonds default. Banks once kept such tranches
on their books as a cost of doing business. Now, says Fitch Ratings, hedge
funds are buying them to goose returns.

Regulators say there's no reason to worry--yet. All big banks require hedge
funds to back up their swaps with cash collateral that is adjusted daily,
says Kathryn Dick, deputy comptroller for credit and market risk at the
Office of the Comptroller of the Currency.

But banks can make only rough guesses at the value of swaps and thus how
much collateral their counterparties need to ante up. Even the smartest guys
can come up shorthanded. Ask Charlie T. Munger, vice chairman of Warren
Buffett's Berkshire Hathaway (nyse: BRKA - news - people ), which lost $404
million unwinding credit, interest-rate and foreign-exchange derivatives
positions in its General Re unit. "When we ran it off, it didn't run off at
anything like book value," Munger says. "I would bet a lot of money there
are some terrible valuations on the books of corporate America."

JPMorgan, the most forthcoming of the big derivatives dealers, figures it
could lose $65 billion over several years if everybody on the other side of
a derivatives trade went broke. A scary number when compared with the bank's
$110 billion in capital. Implausible, too, because most of its
counterparties are big financial institutions.

Hedge funds and other smaller players are much more exposed. Like swaps on
interest rates and foreign currency, credit swaps outstanding dwarf the
underlying bonds in circulation. That can be a problem when a creditor
defaults, as with Delphi (nyse: DPH - news - people ) and other auto parts
makers earlier this year. With most swaps, the buyer of protection has to
hand over defaulted bonds to get its money, tough to do if, as with Delphi,
$20 billion in protection has been written on just $2 billion in bonds.
Calamity was averted by the International Swaps & Derivatives Association,
which held an auction to determine the amount of cash protection buyers
would get.

The derivatives market weathered its last near-death experience in early
2005, when credit agencies downgraded the debt of General Motors (nyse: GM -
news - people ) and Ford (nyse: F - news - people ), devastating the value
of the most risky synthetic derivatives. Hedge funds thought they'd been
smart by locking in a three-to-four-percentage-point spread by selling
protection on those tranches and buying it on less risky ones. Suddenly,
though, they had to close out their moneylosing positions. So many funds had
made the same bet that it "magnified the deleveraging process," in the dry
words of the Bank for International Settlements. Translation: "Banks refused
to buy or sell," says Randall Dodd, a former Commodity Futures Trading
Commission economist who now runs the Financial Policy Forum, a Washington
think tank. "These guys couldn't trade out of their positions."

Bottom-fishing investment banks eventually bailed hedge funds out of their
problems. But Dodd and other critics wonder if banks have extracted enough
collateral from their hedge fund clients to protect themselves in a wider
crisis. "No one has good facts on these things," says David Hsieh, professor
at Fuqua School of Business at Duke University, "because hedge funds are
private investments."

· Forbes

October 16, 2006

Daniel Fisher

OutFront - A Dangerous Game

Hedge funds have gotten rich from credit derivatives. Will they blow up?

The downfall of Amaranth Advisors, the hedge fund that lost $6 billion in a single week by betting on natural gas, was a special case. There was no domino effect taking down energy traders generally, no meltdown of an industry. But if you want to fret over the next financial catastrophes, turn your gaze away from energy futures and focus on something far more obscure: credit default swaps. Hedge funds are neck-deep in these derivatives, and if something goes wrong, the pain will be widespread.

A credit swap is an insurance policy on a bond, often a junk bond. The fellow selling the swap--writing the policy, that is--collects a premium. If nothing goes wrong, he pockets the premium and looks like a financial genius. But if the bond defaults, the swap seller has to make good. The notional amount--the aggregate of bonds, loans and other debt covered by credit default swaps--is now $26 trillion. This is a staggering sum, twice the annual economic output of the U.S.

Hedge funds account for 58% of the trading in these derivatives, says Greenwich Associates, a financial research firm. Selling protection has been a big moneymaker for funds like $23 billion (assets) D.E. Shaw and $12 billion Citadel, say market participants, and for specialized outfits like Primus Guaranty in Bermuda, which took in $57 million in the first half of 2006 selling protection on $1.6 billion in debt.

With corporate debt defaults low these days, the temptation is high to write insurance policies on bonds. A hedge fund can make $60,000 to $1 million a year selling protection on $10 million in bonds. It's like finding money in the street. Unless, of course, the economy suddenly enters a recession. If that happens, hedge funds addicted to the credit market will be in deep trouble. "A lot of [hedge funds] have sold insurance, are sitting on the premiums--and are bare-ass," says Charles Gradante, cofounder of Hennessee Group, which tracks hedge fund performance. "If there is a Long Term Capital-type systemic risk potential out there, it's in the [credit swap] market."

There must be a lot of investors--or credit speculators--who are cavalier about corporate defaults because junk bonds are trading at yields only modestly higher than the yields on safe U.S. Treasury bonds. The chart displays the yield spread, as calculated by Moody's Investors Service, between junk bonds rated speculative and seven-year Treasurys. Saks bonds with a 97TK8 coupon due October 2011, for example, are now yielding 7.6%, or 287 basis points (2.9 percentage points) over seven-year Treasurys, compared with a 700-basis-point spread to Treasurys four years ago. Today's tight spreads don't leave much of a cushion to cover defaults.

There is a close correlation between yield spreads and credit default swap prices. That's because selling a credit swap is equivalent to buying the corporate bond on margin. If you buy a junk bond with borrowed funds, you collect the high coupon on the bond while paying out a lower amount, presumably not too much more than what the U.S. government pays to borrow money. Either way--with a swap or a margined bond trade--you pocket the spread, unless and until the corporate bond gets into trouble, at which point you're sitting on a painful capital loss.

The credit-derivatives business is dominated by 14 dealers. Among them: jpmorgan Chase, Citigroup, Bank of America, Goldman Sachs and Morgan Stanley. All have staggering amounts of derivatives on their books: JPMorgan's notional exposure was $3.6 trillion as of June 30, according to the Federal Deposit Insurance Corp., which is almost three times assets and 30 times capital. Credit derivatives at Wachovia Corp. have jumped sevenfold since 2003 to $170 billion, more than three times capital. Banks love derivatives because they provide multiple ways to make money. Revenue from all types of derivatives will hit $34 billion or so this year at U.S. banks and securities firms, says Tower Group, a financial-research outfit, with hedge funds generating much of the money.

Hedge funds also buy the potentially toxic waste that banks create when they bundle credit derivatives into so-called synthetic deals. By separating a portfolio of derivatives into different tranches, banks can create virtually default-proof securities for conservative investors--if somebody else is willing to buy riskier "equity" tranches whose value vaporizes when as few as one or two of the underlying bonds default. Banks once kept such tranches on their books as a cost of doing business. Now, says Fitch Ratings, hedge funds are buying them to goose returns.

Regulators say there's no reason to worry--yet. All big banks require hedge funds to back up their swaps with cash collateral that is adjusted daily, says Kathryn Dick, deputy comptroller for credit and market risk at the Office of the Comptroller of the Currency.

But banks can make only rough guesses at the value of swaps and thus how much collateral their counterparties need to ante up. Even the smartest guys can come up shorthanded. Ask Charlie T. Munger, vice chairman of Warren Buffett's Berkshire Hathaway, which lost $404 million unwinding credit, interest-rate and foreign-exchange derivatives positions in its General Re unit. "When we ran it off, it didn't run off at anything like book value," Munger says. "I would bet a lot of money there are some terrible valuations on the books of corporate America."

JPMorgan, the most forthcoming of the big derivatives dealers, figures it could lose $65 billion over several years if everybody on the other side of a derivatives trade went broke. A scary number when compared with the bank's $110 billion in capital. Implausible, too, because most of its counterparties are big financial institutions.

Hedge funds and other smaller players are much more exposed. Like swaps on interest rates and foreign currency, credit swaps outstanding dwarf the underlying bonds in circulation. That can be a problem when a creditor defaults, as with Delphi and other auto parts makers earlier this year. With most swaps, the buyer of protection has to hand over defaulted bonds to get its money, tough to do if, as with Delphi, $20 billion in protection has been written on just $2 billion in bonds. Calamity was averted by the International Swaps & Derivatives Association, which held an auction to determine the amount of cash protection buyers would get.

The derivatives market weathered its last near-death experience in early 2005, when credit agencies downgraded the debt of General Motors and Ford, devastating the value of the most risky synthetic derivatives. Hedge funds thought they'd been smart by locking in a three-to-four-percentage-point spread by selling protection on those tranches and buying it on less risky ones. Suddenly, though, they had to close out their moneylosing positions. So many funds had made the same bet that it "magnified the deleveraging process," in the dry words of the Bank for International Settlements. Translation: "Banks refused to buy or sell," says Randall Dodd, a former Commodity Futures Trading Commission economist who now runs the Financial Policy Forum, a Washington think tank. "These guys couldn't trade out of their positions."

Bottom-fishing investment banks eventually bailed hedge funds out of their problems. But Dodd and other critics wonder if banks have extracted enough collateral from their hedge fund clients to protect themselves in a wider crisis. "No one has good facts on these things," says David Hsieh, professor at Fuqua School of Business at Duke University, "because hedge funds are private investments."

· BNA

October 04, 2006

Michael W. Wyand

Practitioners Seek Clarifications of Automatic Enrollment Proposal

Practitioners told BNA Sept. 28 that the Labor Department's automatic enrollment and default investment proposal is timely but expressed some concerns with the proposed rule and asked for clarifications.

All the practitioners interviewed by BNA said their comments were subject to further review and study of the proposed rule. They will be filing more extensive written comments with the department. Written comments are due by Nov. 13.

“The department has moved swiftly to provide clarity,” said Dallas Salisbury, president of the Washington, D.C.-based Employee Benefit Research Institute, which conducts public policy research and education on economic security and employee benefits. However, he expressed concern over the exclusion of money market and stable value funds from the proposed rule's protected class of investments.

While commending the department for promptly issuing its proposed regulation, Nell Hennessy, president and chief executive officer of Washington, D.C.-based Fiduciary Counselors Inc., told BNA “the proposed regulation does not include any capital preservation alternatives.” Fiduciary Counselors is an investment adviser registered with the Securities and Exchange Commission under the Investment Advisers Act.

“I was disappointed with the requirement that the qualified default investment alternatives had to be managed by an investment manager or a registered investment company,” C. Frederick Reish of the Los Angeles-based employee benefits law firm Reish, Luftman, Reicher, and Cohen, told BNA. “It is very common for plans to use asset allocation models, where the underlying funds in the plan are used to populate the models,” he said.

Default investment funds should not be automatically redirected immediately, and the two conditions for automatically directed funds are “inadequately addressed,” said Randall Dodd, director of the Washington, D.C.-based Financial Policy Forum, a research institute that studies financial markets, the regulation of financial markets, and their impact on the economy.

Larry H. Goldbrum, general counsel for the Simsbury, Conn.-based SPARK Institute, which provides research, education, testimony, and comments on behalf of the retirement services industry, said the institute would like clarification or slight modification of the 30-day notice requirement, among other provisions of the proposed rule.

Praise for Timeliness.

“The department did a good job in issuing a timely proposed regulation under the Pension Protection Act,” said Jon Breyfogle, a principal in the Washington, D.C.-based Groom Law Group, an employee benefits specialty law firm. “It suggests that they will get a final regulation out in time for people to rely on it in early 2007. The department deserves some credit for this,” he said.

“The department should be commended for developing this thoughtful proposal so quickly,” Chris Wloszczyna, spokesman for the Washington, D.C.-based Investment Company Institute, a trade organization for the U.S. fund industry, told BNA. “The department proposal will help encourage more plans to use automatic enrollment. In addition, the default investment provision will improve the ability of workers to prepare for their retirement needs,” he said.

“Overall, there is no doubt that this is very good news for the retirement of American workers,” said Ed Ferrigno, vice president of Washington Affairs for the Chicago-based Profit Sharing/401(k) Council of America, which represents its members' interests to federal policymakers and offers assistance with profit-sharing and tax code Section 401(k) plan design.

“We welcome the department's quick action on this vital area and look forward to commenting on the regulations and working rapidly toward final guidance,” said Mark Ugoretz, president of the ERISA Industry Committee, which represents the employee benefits and compensation interests of America's major employers.

“The American Benefits Council is very pleased with the department's proposed default investment regulation,” Jan Jacobson, director of retirement policy for ABC, told BNA. However, Jacobson said that ABC plans to file written comments in response to the proposed rule to address a few technical issues, such as fiduciary relief.

The Proposed Rule.

The department published Sept. 27 the first major proposed regulation to implement provisions of the PPA by making it easier for fiduciaries of Section 401(k) plans and other participant-directed defined contribution plans to adopt automatic enrollment and default investment plan design features (186 PBD, 9/27/06; 71 Fed. Reg. 56,806, 9/27/06).

The PPA Section 624(a) amended Employee Retirement Income Security Act Section 404(c), by adding a new ERISA Section 404(c)(5) to provide relief accorded by Section 404(c)(1) to fiduciaries that invest participant assets in certain types of default investment alternatives in the absence of participant investment direction.

Under the proposed regulation, a fiduciary would not be liable for any loss as a result of automatically investing a participant's account in a qualified default investment alternative (QDIA), provided certain conditions are met. However, the fiduciary would remain liable for the selection and monitoring of a qualified default investment alternative.

The department said the proposed rule, by providing relief from fiduciary liability, is expected to tilt plan sponsors' default investment preferences away from near risk-free fixed income instruments toward QDIAs.

Relief Beyond Section 404(c) Plans.

“The proposed regulation is written to extend relief beyond just Section 404(c) plans,” Groom's Breyfogle said, adding that “this creative and flexible approach is a favorable development.”

According to Breyfogle, the proposed regulation is not just limited to default investments in connection with an automatic enrollment program but would, for example, be available when a plan transitions from one recordkeeper to a new recordkeeper or from one investment option to another investment option.

“I think plan sponsors will find this to be a very valuable option when they change record keepers or investment options,” Breyfogle said.

PSCA's Ferrigno said his organization are currently studying “some of the finer points” of the proposed regulation such as relief beyond Section 404(c), he said.

Automatic Redirection.

Rather than automatically redirecting funds immediately, “they should be held in a low risk, fixed income account, something akin to a money market mutual fund account, for six weeks before being transferred,” Financial Policy Forum's Dodd said.

“This solves several problems,” Dodd said. One is it avoids temptation by an investment manager to cheat or a pensioner to feel cheated when funds are transferred during times when price movements are substantial. Large price changes make the timing of such transfers critical, and the recent back dating and spring loading of stock options demonstrates the importance of these concerns, Dodd said.

The six-week period also would allow the participant time to make an informed decision, Dodd said. After six weeks, the transfer date becomes automatic and thus “less susceptible to schenanigans,” he said.

“Any automatic directed fund should meet the two conditions, which are inadequately addressed in the current version of the rule, Dodd said. The fund should have low management fees; the benchmark for what is low should be the electronic transfer fund and should never exceed 1 percent, he said.

The alternative investment also should be a broad index of securities such as the S&P 500, Nasdaq composite, or Lehman Brothers bond index, Dodd said. “The 'investment service' alternative is questionable without more clear and strict guidelines on management fees,” he said.

One of the conditions of the fiduciary relief is that the participant or beneficiary must have had the opportunity to direct the investment but fails to do so, ABC's Jacobsen said.

“Depending on how this requirement is interpreted, it could have a detrimental effect on plan sponsors attempting to change the default investment from something like a money market fund to one of the investment options described in the proposed regulations,” she said. “Plan sponsors may not know which money market fund investors chose to invest in the fund versus participants who were simply defaulted into the fund,” Jacobsen said.

Funds and Models.

“Plans with automatic enrollment will have participants withdrawing their money within a shorter time horizon, either because they unwind the automatic election or they leave within months or a couple of years,” Fiduciary Counselor's Hennessy said. The department “needs to provide a safe default alternative [for capital preservation alternatives] as well as the long-term blend,” she said.

An employer with mainly young workers and high turnover might do better for these workers with money market and stable value fund options, given the propensity to cash out small accounts, EBRI's Salisbury said. The proposed rule is limited to equity weighted options only, and will cause some employers to avoid automatic plan features resulting in many workers having no savings instead of some savings, he said.

“While I would like all workers to think of the Section 401(k) plan as a long-term retirement plan, the facts say otherwise,” Salisbury said. “The EBRI Section 401(k) plan has neither loans or hardship withdrawals because I view it as a retirement plan, but many plans with auto enrollment have these short term features. Since the law allows such nonretirement provisions, it makes no sense for them to issue a regulation that ignores these realities,” he said.

“Workers will be the losers of this particular paternalistic strait jacket,” Salisbury said. Stable value funds, for example, have produced higher returns than the interest credit in many cash balance plans for the last several years, he said.

“It is very common for plans to use asset allocation models where the underlying funds in the plan are used to populate the models,” Reish said, expressing disappointment that qualified default investment alternatives had to be managed by an investment manager or a registered investment company.

“While generally accepted investment principles are utilized in constructing the models, they are not 'managed' by either a mutual fund or an investment manager,” Reish said. “In my opinion, that needs to be corrected before the regulation is finalized.”

Notice Requirement.

The 30-day notice to participants should be modified to accommodate those plans that have immediate eligibility, SPARK's Goldbrum said. Under such circumstances it may not be feasible to provide the required 30-day notice. Goldbrum suggested a clarification in the regulations that for plans with immediate eligibility, the notice requirement may be satisfied when participants are provided with enrollment materials.

The proposed regulation calls for the participant to be provided with any material provided to the plan, Goldbrum said. The language “any material provided to the plan” could require plan sponsors to provide affected participants with information that is not typically provided to participants on a regular basis or is provided only upon request by the participant, such as fund prospectuses and amendments, fund annual reports, and proxies, he said.

The effect would be that plan sponsors will be required to provide passive participants with more information than they typically provide to participants who actively manage their assets, Goldbrum said. This requirement should be modified or clarified to specify that participants invested in QDIAs need only be provided or offered the same information that is otherwise provided or made available to participants who make affirmative investment elections.

The participant must be able to transfer out of the default investment fund without incurring a penalty to do so, Goldbrum said. This requirement should be clarified or modified to address situations where the QDIA may impose a redemption fee on shares that are redeemed after a short holding period. This should be clarified as to whether redemption fees that are imposed on all investors in a fund would constitute a penalty, he said.

· BNA

September 21, 2006

Michael W. Wyand

Advisory Council - Speakers Discuss Issues on Investment

Of Plan Assets in Cross Trades, Hedge Funds

Speakers Sept. 20 expressed a variety of

views about pension plan participation in

cross trades and investment in hedge funds

in statements before a working group of

the Department of Labor's ERISA Advisory

Council.

The council's Working Group on Plan Asset

Rules, Exemptions, and Cross Trading is

reviewing whether the department should

clarify or modify the existing plan asset

regulation regarding hedge funds and if

the department should issue broader

exemption relief for cross trading.

According to the speakers, a cross trade

is a purchase and sale of securities

between two client accounts of the same

investment manager. A hedge fund is an

investment company that raises funds from

institutional investors and high income

individuals and pursues investment

strategies with high degrees of leverage

and/or complexity.

"There is room for a thoughtful expansion

of the ability of investment professionals

dealing with plan assets to use cross

trading to benefit plans, but generally

speaking, only for large plans that have

the resources and sophistication to

protect their interests," said Norman

Stein, a University of Alabama School of

Law professor who specializes in employee

benefits and tax law.

"Cross trading, subject to appropriate

regulatory constraints, can still save

some plans money," Stein said. However,

"any liberalization of cross trading

should create two regulatory regimes, one

for larger plans, and one for smaller

plans," he added.

"Large plans are equipped to protect

themselves from illegal costs and to

minimize legal costs of cross trading,"

Stein said. "I suspect that small plans

are not in such a position," he said.

Expanding Cross Trading

However, the Labor Department should allow

more use of cross trading "to ensure that

ERISA covered investors are allocated the

same opportunities for reducing

transaction costs through cross trades

that are available to non-ERISA

investors," said Henry H. Hopkins, chief

counsel and vice president of T. Rowe

Price Group Inc., who also represented the

Investment Adviser Association and the

Investment Company Institute.

Hopkins applauded Congress' adoption of

exemptive relief for cross trade

transaction involving actively managed

ERISA covered accounts. The cross trade

provision, using Securities and Exchange

Commission Rule 17a-7 under the Investment

Company Act as the framework, is

comprehensive in its inclusion of

conditions intended to protect the

interests of plan investors, he said.

Hopkins urged the working group to

recommend to the department that the need

for regulatory consistency is fundamental

to any approach taken by the department in

proposing regulations regarding the

content of policies and procedures to be

adopted by investment managers who intend

to make available cross trade

opportunities to ERISA covered accounts.

Other speakers on the same panel as

Hopkins who supported and expanded on his

statements included Scott M. Lopez,

director of global equity trading for

Wellington Management Company LLP; Mary

McDermott-Holland, senior vice president

for Franklin Portfolio Associates LLC; and

William A. Schmidt, a Washington, D.C.,

fiduciary lawyer.

In addition, Lopez, McDermott-Holland, and

Schmidt recommended that the $100 million

minimum plan assets threshold requirement

of the department's cross trade exemption

is something the department could

reexamine so more ERISA plans could

participate in cross trades. They opposed

the limit because it penalizes small plans

based on their size from benefiting from

the cost savings of cross trades.

Hedge Funds

"There are several types of potential

problems arising from pension fund

investment in hedge funds," including

fraud, liability, and market risk, Randall

Dodd, director of the Financial Policy

Forum, told the group.

"This investment class [hedge funds] is

fraught with a different set of investment

challenges, if not dangers, than

conventional or traditional investment

vehicles," Dodd said, adding that the

regulatory approach needs to be different

for hedge funds.

"It would be a grave mistake for the

department to further erode these [ERISA]

protections in the belief that hedge funds

of all entities are somehow immune from

conflicts of interest or the temptation to

put their interests above those of their

plan clients," Damon A. Silvers, associate

general counsel for the AFL-CIO, told the

working group. He did say the AFL-CIO was

not opposed to plans investing in hedge

funds as long as it is only a "reasonable

proportion" of a plan's assets.

Silvers said an argument made by advocates

for further weakening ERISA coverage of

hedge funds is that hedge funds are a

superior form of investing that should be

given a regulatory subsidy. "Of course

anyone with any sense of history and

market dynamics should be extremely

skeptical of the claim that any one group

of market actors will systematically

outperform the underlying economics of the

markets they operate in over time," he

said.

"Do not change one iota of the current

plan asset regulations to accommodate

ERISA plan investment in hedge funds,"

Stein urged the working group. "It is not

a good idea," he stressed.

· Business Week

September 20, 2006

Are There More Amaranths Lurking?

Bill Holland

The company's misfortunes may signal a need for tightening government controls on over-the-counter, energy-derivatives players

From Platts Oilgram News

Billion-dollar bets on the spread between March, 2007, and April, 2007, gas futures prices blew up in the face of Greenwich (Conn.)-based Amaranth Advisors, leading to $5 billion in losing positions the fund is now trying to liquidate, officials and analysts familiar with the situation told Platts Sept. 19.

"They were long March and short April," former commodities regulator Michael Greenberger said, citing his own sources on futures trading desks within the industry. Greenberger, who headed the Commodity Futures Trading Commission's division of trading and markets in the late 1990s through the Enron collapse, said it appeared Amaranth was hoping to capitalize on the spread between prices at the end of the heating season and the start of the cooling season—a premium of $2.14 per million British thermal units (MMBtu) that collapsed in two weeks to 75 cents by Sept. 18, when Amaranth threw in the towel.

LIQUIDITY PROBLEM.  On Sept. 18, Amaranth Managing Partner Nicholas Maounis told investors in his fund that "a dramatic move in natural gas prices" had forced Amaranth to get out of the gas market and would prompt Amaranth to post its first-ever yearly losses. The 64% drop in the spread between the March and April contracts began slowly in late August and early September, but came crashing down by more than $1 per MMBtu in the past three trading days.

Amaranth's contracts were not on the New York Mercantile Exchange (NYMEX), Greenberger explained, but were over-the-counter trades with big investment banks like Goldman Sachs (GS ) acting as market-makers and counterparties. That complicates Amaranth's attempt to unwind itself, because an OTC contract nine months out is decidedly less liquid than its counterpart on the NYMEX, sources said.

A Goldman Sachs spokesman would not say how big the bank's exposure to Amaranth might be.

SECTOR NOT PANICKING.  Goldman Sachs is not the only bank acting as a broker or lender to Amaranth; both JP Morgan (JPM ) and Merrill Lynch (MER ) have been handling gas trades for the hedge fund, according to sources familiar with the fund. Representatives of those two investment banks did not return calls for comment.

Randall Dodd, president of the Washington-based Financial Policy Forum, said Amaranth's collapse highlights cracks in the nation's capital structure and, because of the unregulated nature of both energy derivatives and hedge funds, policymakers have no idea how deep those cracks are.

"We don't know how many more Amaranths are out there," Dodd said. "Several falling is a problem for the whole financial system."

In a Sept. 19 report, Merrill Lynch hedge fund analyst Mary Ann Bartels said whatever sickness Amaranth caught did not seem to be spreading across the sector. "Despite the carnage in the energy markets, large speculators did not panic and liquidate, which is contrarian bearish and could indicate further downside for energy," Bartels said.

"BORDERS ON SINFUL."  According to Greenberger, "the positions Amaranth took were too large to have any relationship with the underlying fundamentals"— trades that if made on a regulated exchange such as NYMEX would have likely earned disapproval.

The Commodity Futures Trading Commission (CFTC) "would have either talked them down or threatened them down," Greenberger surmised. He said Amaranth's woes highlight the need for the CFTC or Congress to start tightening the presently nonexistent reins on OTC energy derivatives.

"It borders on being sinful," Greenberger asserted. "The CFTC has turned a blind eye to these markets, making them unreliable as a hedging vehicle."

FEINSTEIN'S PUSH.  "We are aware of the situation," a CFTC spokesman said, declining to confirm or deny whether the commission was looking into market misbehavior on the part of Amaranth.

The political fallout from Amaranth's troubles had reached Capitol Hill by the afternoon of Sept. 19. Sen. Dianne Feinstein (D-Calif.), who has a bill before the Senate to require OTC energy traders to report their positions daily, reiterated her call for more regulation.

"This is a graphic and very expensive example of the need for legislation that would increase transparency and accountability in the energy markets so the federal government could determine if speculation or manipulation is occurring," Feinstein told Platts.

· Gas Daily

Regulator who opposes OTC oversight resigns

July 20, 2006

The path toward stepped-up regulation of over-the-counter energy trading may have gotten a little smoother Wednesday with the resignation of Commodity Futures Trading Commission member Sharon Brown-Hruska.

Brown-Hruska's departure to take a consulting position in Washington improves the chances that a bill sponsored by California Democratic Senator Dianne Feinstein will pass during this session of Congress, said Randall Dodd, director of the Derivatives Study Center at the Economic Policy Forum, a Washington think tank. "Of course it helps things that she's no longer on the commission," he said.

Among other provisions, Feinstein's bill would add new reporting and record-keeping requirements to OTC energy trading exchanges, primarily Atlanta-based IntercontinentalExchange (GD 4/26).

Brown-Hruska has been a frequent critic of increased regulation of OTC markets, saying in January that "there is never a shortage of individuals ... who see price movements as the result of manipulation or abuse" and that proposals for more government intervention "wouldn't do much to rein in prices" (GD 1/27).

The White House had no word Wednesday on whom it might nominate to replace the former economics professor and CFTC staff regulator.

"We want to see a commissioner who recognizes there are some bad actors out there," American Public Gas Association Vice President for Regulatory Affairs Les Fyock said Wednesday. "We want to see a commissioner who will see when the CFTC doesn't have the tools it needs, and then makes an effort to get them."

APGA, which represents municipally owned utilities, has long campaigned for more oversight of a gas market it sees as too speculative, volatile and vulnerable to manipulation.

A Feinstein spokesman said the senator hopes "the president will appoint someone who will actively oversee all commodity markets, including those in energy, and enforce the CFTC's jurisdiction to prevent speculators from impacting the prices of crude oil and natural gas."

Dodd asserted that Brown-Hruska is "such a strong believer in the 'magic' of the free market that she should have been in show business." He said the ideal CFTC commissioner to take her place would be someone who could identify "when markets fail to police themselves. Get away from simple free market theories and appoint people who really understand these markets."

But realistically, Dodd said he expects Bush to use the post to reward his supporters. "Look, you are in the last two years of a lame duck administration. This will become a political payoff."

In an interview with Platts, Brown-Hruska said she is "a big fan of Senator Feinstein" even though they don't see eye to eye on some issues involving markets.

"She's tried very hard to find solutions to the problems her constituents face," the commissioner said. "Those solutions don't directly solve those problems. The California energy crisis was a failure of regulation, not deregulation."

Brown-Hruska said she hopes her four years of service on the five-member CFTC leave a legacy that regulation should only be done after careful and "solid" analysis. "I'm hopeful that they will think about the costs and benefits of their actions. The right approach is to not impose regulations that won't deliver the benefits."

Brown-Hruska said her sudden resignation wasn't meant to be a surprise but said the offer from NERA Economic Consulting to become a vice president in the firm's securities and finance practice was too good to pass up. "I've done my service to the country and had an opportunity come along."

Moving to a private consulting firm will also free her to be more outspoken in defense of free markets, Brown-Hruska said. "Sometimes as a commissioner, you had to take one for the team. I'm excited to be a free agent again."

Brown-Hruska was appointed to the CFTC by President Bush in 2002 and named acting chairman in 2004, a post she held for roughly a year until a new chairman was appointed last year. Her term expires in November 2009.

"I hope I've had an impact," she said. "I will continue to be a real voice for markets, this time where the rubber meets the road, at the ground level."

· Energy Trader

May 8, 2006

Feinstein's limited bill has better chance, ignores most opaque part of OTC market

Bill Holland

While Democratic Senator Dianne Feinstein of California is seen as having her best opportunity yet to win a Senate vote on her years-long effort to increase oversight of over-the-counter markets for electricity, natural gas and other energy commodities, her pending bill would have no impact on the most opaque part of the OTC market ? the dealmaking that takes place off electronic exchanges like the IntercontinentalExchange and is done through brokers or directly between counterparties.

Feinstein's bill, co-sponsored by Republican Senator Olympia Snow of Maine and Democratic Senators Carl Levin of Michigan and Maria Cantwell of Washington, would require electronic exchanges, like the IntercontinentalExchange, to keep trading records for at least five years and report large positions held by traders, similar to requirements placed on futures trading on the NYMEX.

While the bill would also require trading companies themselves to maintain records for each "reportable contract" for five years and provide those records to the Department of Justice or the Commodity Futures Trading Commission, a key provision limits the definition of a "reportable contract" to deals executed on an electronic trading platform. Reportable deals would also include those done on ICE Futures, the former International Petroleum Exchange located in London, in which the underlying commodity has a physical delivery point in the United States.

Feinstein has failed to come up with the votes for more far-reaching legislation for four years. But with the current outcry over high energy prices, and because this year's legislation is more limited and aimed primarily at ICE, industry observers and other players in the debate say she has a better chance than in previous years.

And although critics of her efforts say they will do nothing to lower gas or gasoline prices, Feinstein is clearly tying her bill to the politics of high gasoline prices. The bill is called the "Oil and Gas Traders Oversight Act of 2006," and when Feinstein and her co-sponsors introduced the bill, they called the energy industry's explanations for the spiraling costs of oil and gas "smoke and mirrors."

"Part of the energy market provides transparency, part does not," Feinstein said in a statement when she announced the legislation. "If you trade on the NYMEX, a record is kept, an audit trail is there. But if you make a trade on an electronic platform, no records are kept, and there is no audit trail.

"In essence, the federal government is blind," Feinstein said.

Sources on the senators' staffs expect the bill, S. 2642, which would amend the Commodities Exchange Act, to be incorporated into the Senate's version of the CFTC's reauthorization (S. 1566). That would narrow the Senate's gap with the House of Representatives version of CFTC reauthorization (H.R. 4473), which calls for all gas traders to keep records and make reports to the CFTC.

Presently, the Senate version makes no changes to record-keeping and monitoring of the cash and derivatives markets. The Senate version of the CFTC's reauthorization has cleared committee and is waiting to be scheduled for consideration by the full Senate, said Keith Williams, majority spokesman for the Agriculture Committee.

While the senators believe increasing recordkeeping requirements will give the CFTC the ability to better exercise its existing authority to police the markets for fraud and manipulation, the IntercontinentalExchange ? the market most affected by the Senate measure ? opposes the changes as unnecessary.

"Respectfully, we believe the amendment is well intentioned but won't achieve what is desired," ICE's General Counsel Johnathan Short said in an interview. "We believe ICE's many-to-many market is highly transparent," he said.

ICE sees its platform providing significant transparency to the opaque OTC market, and questions why Feinstein's bill is aimed at ICE ? the one transparent part of the OTC market ? while ignoring the still-opaque portion of the OTC market in which deals are done through brokers and directly between counterparties.

For natural gas, are no recordkeeping or reporting requirements for the non-ICE part of the OTC market. For electricity, companies are required to report physical transactions quarterly to the Federal Energy Regulatory Commission. But the use of those reports for market surveillance is limited because companies do not have to report financial transactions, and are not required to report the dates on which they did the transactions but only the dates the electricity was delivered.

"If you're going to cover the OTC market, cover the whole thing," Short said. The non-ICE portion of the OTC market, he said, "remains untouched and completely opaque."

By restricting recordkeeping requirements to ICE deals, Short said, the Feinstein legislation could drive deal-making off the more transparent ICE screen and into the less transparent corners of the OTC market where companies deal directly and through brokers. "The window ICE has provided into the previously totally opaque market could be impacted," he said. "You could impact a very valuable and transparent window."

In a letter to Feinstein last week, the company had even tougher words.

Feinstein's contention that traders on ICE leave no audit trail is patently false, ICE CEO Jeffrey Sprecher wrote the California lawmaker. "Not only does ICE provide an audit trail but it provides one that cannot be replicated by other parts of the OTC marketplace (voice brokers, bilateral trading parties, etc.)," the company said.

Sprecher also noted that the CFTC itself does not want more mandated regulatory authority over the gas markets. "The CFTC has stated on several occasions that it has the necessary tools to oversee the contract markets it regulates. The CFTC did not request additional recordkeeping requirements with respect to OTC transactions in exempt commodities," CFTC Chairman Rueben Jeffrey wrote to Feinstein in March.

Mark Stultz, spokesman for the Natural Gas Supply Association, a trade group for producers, wouldn't speculate on the bill's chances of passage, although he did note that "everyone is scrambling to find a solution" to high energy prices.

"There already is a cop on the beat to police the markets," Stultz said ? several cops, in fact: the CFTC, the Federal Energy Regulatory Commission, the Federal Trade Commission, and, ultimately, the Justice Department.

Even more outspoken against further regulation of the OTC gas markets has been CFTC Commissioner Sharon Brown-Hruska. In a series of speeches to industry groups this winter, Brown-Hruska has steadily dialed up her rhetoric against further regulation.

Routinely collecting trading data to be used for regulation creates a "moral hazard" Brown-Hruska told the Natural Gas Customer Council in Washington last month.

"When market participants begin to rely on the government's efforts to police markets instead of relying on their own due diligence when negotiating contracts," Brown-Hruska said, "participants will tend to bring less information to the markets and the pricing mechanism becomes less efficient."

Further, Brown-Hruska contends that requiring more reporting in the name of market transparency will in fact result in less transparency as traders will migrate to trading platforms that require less disclosure.

"Another problem that can result from placing greater reporting requirements on exempt markets is that it may cause participants to move their trading to less transparent venues. Often the trading on exempt markets is bilateral, though participants use a trading platform to communicate and execute their trades," Brown-Hruska said. "Because of the bilateral nature of these trades, they could easily be moved entirely off the platform, where they could become less transparent to regulators and the markets."

But advocates of more oversight and transparency for OTC energy markets discounted the notion that more formal recordkeeping and oversight of ICE would drive traders elsewhere.

"The first refuge of scoundrels," Randall Dodd, the director of the Financial Policy Institute and head of its Derivatives Study Group, said of that argument. "They'll move to another market, they'll move offshore. Nonsense. Traders use ICE because they want the liquidity and the counterparty credit assurance."

Dodd's group has been calling for increased regulation of the OTC markets for several years, advocating not only increased reporting requirements but guarantees of capital adequacy on the part of traders.

"The social consequences of allowing this market to go unregulated amounts to a dereliction of public duty," Dodd said. "I think traders ought to be registered, have reporting requirements, reporting prices and volumes, and that dealers have collateral requirements."

Arguments that such measures would cut into the efficiency of the gas markets fall on deaf ears with Dodd. "It's cheaper to drive your car without insurance but we don't let people do it," Dodd said.

Dodd has watched Feinstein unsuccessfully attempt to regulate the gas markets since the California energy crisis in 2001 and thinks this year's political climate may give her the votes she needs to get new requirements on the books.

"I don't think ICE is fighting it, or they aren't fighting it as hard as they are other things," Dodd said. Lawmakers this year "need to be looking like they are doing something" about high energy prices, Dodd noted, and maybe just as importantly, "[former Texas Republican Senator] Phil Gramm has left."

"They have a couple of Republicans on the thing and the bill is narrower than it has been in the past," Dodd said.

· Cleveland, The Plain Dealer

(also the Star-Ledger on May 7, 2006)

Futures traders steer oil prices

Fear can top supply and demand as key motivator to buy or sell

Friday, May 05, 2006

Katherine Reynolds Lewis

Newhouse News Service

Raymond Carbone blinked in wonder at the electronic display ringing the New York Mercantile Exchange's stadium-like trading floor.

Crude oil futures were closing at a record $75.17 per barrel, up a whopping $3 in just a matter of hours.

As a trader for Paramount Options, he is getting used to the feeling. It has become common for oil prices to climb on Friday afternoons before the markets close for the weekend.

On this day, April 21, traders on the Nymex floor were worried Nigerian rebels would attack an oil field - or worse, the United States would bomb Iran. That would mean a jolt to the world's petroleum supply and mind-boggling run-ups in oil prices.

They know the key to trading is staying ahead of the curve, so they furiously bought futures that would mean big bucks if prices rose - which had the self- fulfilling effect of driving up prices. Barring an international crisis over the weekend, they'd sell when they returned to work.

A fellow trader leaned over to Carbone. "If Iran is not a smoldering heap by Monday, we're going lower," he predicted.

Any economics student knows prices are determined by supply and demand.

When more oil is extracted from the ground or refined into gasoline, prices fall. When millions of Chinese workers start trading in their bicycles for automobiles, prices rise.

But lately, the energy markets have become defined by something more powerful: fear.

With oil supply stretched drum-tight, any little disruption can make prices swell or collapse. Futures traders risk hundreds of thousands of dollars on a comment by a Saudi Arabian oil minister or a meteorologist's prediction about the path of a storm.

As a result, the impact of people like Carbone on the lives of average Americans has never been greater. More so than big oil companies, filling stations and world leaders, it's the guys making cryptic hand gestures in the trading pit who tell the world what oil should cost.

Traders consume information about politics, terrorism, weather and geology, and watch other traders buy and sell.

When a trader believes oil prices are likely to go higher, he buys futures contracts, hoping to profit. When he thinks oil is overvalued, he sells. The net effect of all these actions is a constant tweaking of oil prices to reflect both the fundamental supply-demand situation and the ever- varying risk of a major crisis.

Commodities markets have recently attracted hedge funds, pension managers and even wealthy individuals seeking different assets to buy, as real estate and stocks have cooled.

"The amount of money invested in commodities has tripled in the last three years," said James Cordier, president of Liberty Trading Group, a futures broker in Tampa, Fla. "Are in vestment funds adding to the price of crude oil? Yes. People do not invest in commodities to bet on prices to go down."

It's easy to imagine that energy traders are raking in all the cash that disappears from your wallet when gasoline, natural gas and electricity prices soar. But for every winner in the futures market, there is an equal loser.

"It's a zero sum game," Carbone said. "If I made a dollar someone else had to lose a dollar."

Unlike a barrel of oil or bushel of corn, you can't see or touch a future. A futures contract is simply an agreement to buy or sell a fixed amount of a commodity, like oil, at a set date and location. To buy futures, a trader on a futures exchange makes an offer. If there's a seller who likes his price, voila, a futures contract has just been created.

The exchange itself is merely the location for trading, and anyone in the world can participate, through a commodities broker.

Under Nymex terms, one crude oil futures contract is an agreement to buy 1,000 U.S. barrels (42,000 gallons) of a specified quality of light, sweet crude oil. Most traders, though, don't actually want the oil. In practice, less than 1 percent of futures contracts result in the delivery of a commodity.

Instead, people holding a futures contract make sure to sell an equivalent contract before the delivery date, so the two transactions cancel out and result in a profit or loss.

Speculators are important to the market because they often step in when nobody else wants to buy or sell a certain contract. In fact, economists have found that the more traders in the market, the smaller the gap will be between the buying and selling price for commodities.

Those in the fray of futures trading have a message for Americans concerned about high energy prices.

"Get ready. It's going to get worse before it gets better," Liberty Trading's Cordier said.

Across the country, policy- makers and consumer advocates concerned about high gas prices have questioned whether speculation is driving energy prices artificially high or exaggerating price swings.

"Speculators have the potential to reduce volatility because when prices go up they sell, and when prices fall they buy. Other times the speculators might add to the volatility, because if prices go up they jump on the bandwagon and drive prices up," said Randall Dodd, director of the Financial Policy Forum, a Washington, D.C., nonprofit research group that studies financial markets. "Speculators can play a positive role, but they don't always."

In the end, oil prices are going to be determined predominantly by the supply - the amount producers can pump from the ground - and the ever-growing demand.

"Blaming the futures markets for high commodity prices is like blaming a thermometer for it being hot outside," said Walter Lukken, a member of the U.S. Commodity Futures Trading Commission.

· Times-Picayune

Oil market is running on fear; Futures trading can drive prices higher in volatile times
By Katherine Reynolds Lewis, Newhouse News Service

May 6, 2006

Raymond Carbone blinked in wonder at the electronic display ringing the New York Mercantile Exchange's stadium-like trading floor.

Crude oil futures were closing at a record $75.17 per barrel, up a whopping $3 in just a matter of hours.

As a trader for Paramount Options, he is getting used to the feeling. It has become common for oil prices to climb on Friday afternoons before the markets close for the weekend.

On this day, April 21, traders on the Nymex floor were worried Nigerian rebels would attack an oil field -- or worse, the U.S. would bomb Iran. That would mean a jolt to the world's petroleum supply and mind-boggling run-ups in oil prices.

They know the key to trading is staying ahead of the curve, so they furiously bought futures that would mean big bucks if prices rose -- which had the self-fulfilling effect of driving up prices. Barring an international crisis during the weekend, they'd sell when they returned to work.

A fellow trader leaned over to Carbone. "If Iran is not a smoldering heap by Monday, we're going lower," he predicted.

Any economics student knows prices are determined by supply and demand. When more oil is extracted from the ground or refined into gasoline, prices fall. When millions of Chinese workers start trading in their bicycles for automobiles, prices rise.

But lately, the energy markets have become defined by something more powerful: fear.

With oil supply stretched drum-tight, any little disruption can make prices swell or collapse. Futures traders live in the heart of the beast, risking hundreds of thousands of dollars on a comment by a Saudi Arabian oil minister or a meteorologist's prediction about the path of a storm.

As a result, the impact of people like Carbone on the lives of average Americans has never been greater. More so than big oil companies, filling stations and world leaders, it's the guys making cryptic hand gestures in the trading pit who tell the world what oil should cost.

Traders consume information about politics, terrorism, weather and geology, and watch other traders buy and sell.

When a trader believes oil prices should be higher, he buys futures contracts, hoping to profit. When he thinks oil is overvalued, he sells. The net effect of all these actions is a constant tweaking of oil prices to reflect both the fundamental supply-demand situation and the ever-varying risk of a major crisis.

Commodities markets have recently attracted hedge funds, pension managers and even wealthy individuals seeking different assets to buy, as real estate and stocks have cooled.

They're swayed by research that shows commodities returns move in the opposite direction from stocks and bonds, said Philip Verleger, an energy economist and consultant based in Aspen, Colo. Their hope is if the stock market tanks or if inflation takes off, at least they'll make money in commodities.

These investors have the net effect of driving prices higher simply because they increase the demand for commodities, some experts argue.

"The amount of money invested in commodities has tripled in the last three years," said James Cordier, president of Liberty Trading Group, a futures broker in Tampa, Fla. "Are investment funds adding to the price of crude oil? Yes. People do not invest in commodities to bet on prices to go down."

It's easy to imagine that energy traders are raking in all the cash that disappears from your wallet when gasoline, natural gas and electricity prices soar. But for every winner in the futures market, there is an equal loser.

"It's a zero sum game," Carbone said. "If I made a dollar someone else had to lose a dollar."

Unlike a barrel of oil or bushel of corn, you can't see or touch a future. A futures contract is simply an agreement to buy or sell a fixed amount of a commodity, such as oil, at a set date and location.

To buy futures, a trader on a futures exchange makes an offer. If there's a seller who likes his price, voila, a futures contract has just been created.

The exchange itself is merely the location for trading, and anyone in the world can participate, through a commodities broker.

Under Nymex terms, one crude oil futures contract is an agreement to buy 1,000 U.S. barrels of a specified quality of light, sweet crude oil.

Most traders, though, don't actually want the oil. In practice, less than 1 percent of futures contracts result in the delivery of a commodity.

Instead, people holding a futures contract make sure to sell an equivalent contract before the delivery date, so the two transactions cancel out and result in a profit or loss.

Producers and consumers of goods from soybeans and rubber to electricity use futures to protect, or hedge, themselves against an unforeseen change in price. They can trade with each other, or they can buy from traders who are simply looking to make a profit.

Speculators are important to the market because they often step in when nobody else wants to buy or sell a certain contract. In fact, economists have found that the more traders in the market, the smaller the gap will be between the buying and selling price for commodities. This reduces costs for commodities companies, which eventually should lower price tags for grocery shoppers and utility customers.

On the trading floor, it helps to be tall and solidly built, with strong legs supporting you in the crush. The louder you yell, the more quickly you can execute trades. Your day lasts from the opening bell at 10 a.m. ET to the close of trading at 2:30 p.m.

"It's like if you spent four and a half hours on a football field or a basketball court," independent energy trader Eric Bolling said. "When you're done you're not only physically done, you're mentally done."

Bolling lost a shirtsleeve during the first war with Iraq. Carbone just had a double hernia operation that he blames on trading -- the larger of the two hernias was on the left side, where he's pushed most often.

Those in the fray of futures trading have a message for Americans concerned about high energy prices.

"Get ready. It's going to get worse before it gets better," Liberty Trading's Cordier said.

Commodities such as coffee and cocoa typically are produced by poor countries, such as Honduras and Colombia, so producers also participate in the futures market to protect themselves against a drop in prices. But wealthy oil producers like Saudi Arabia don't need to hedge against lower prices, Cordier said. That creates an imbalance in the market where more people are buying, so supply-demand economics dictates that energy prices will rise.

"The only way to curtail high prices in energy is to reach a level where people stop using so much," he said.

Carbone, the New York trader, agrees.

Traders have lost a lot of money in the past three years betting that oil prices couldn't go higher than $50 a barrel, then $60 a barrel, and then $70, he said. There are so many events that could push oil prices up, and not a lot that could bring them down, that most people are protecting themselves from higher prices.

"There's the fear of waking up to $100 crude oil," Carbone said, remembering his shock at the buy orders flooding the market the week crude oil topped $75.

"That week was about defying gravity," he said. "It made me shake off fundamentals and look at any weakness as an opportunity to buy. Close your eyes and buy. If you think about it too much, it'll be $1 higher before you know it."

Across the country, policymakers and consumer advocates concerned about high gas prices have questioned whether speculation is driving energy prices artificially high, or exaggerating price swings.

"Speculators have the potential to reduce volatility because when prices go up they sell, and when prices fall they buy. Other times the speculators might add to the volatility, because if prices go up, they jump on the bandwagon and drive prices up," said Randall Dodd, director of the Financial Policy Forum, a Washington, D.C., nonprofit research group that studies financial markets. "Speculators can play a positive role but they don't always."

Nymex President James Newsome told a House Agriculture Committee hearing on April 27 that speculators held 24 percent of gasoline futures positions in 2005, up from 22 percent the year before, whereas commercial companies held 76 percent.

In the end, oil prices are going to be determined predominantly by the supply -- the amount producers can pump from the ground -- and the ever-growing demand from China, India and the United States, with our love of sport utility vehicles and suburban living.

"Blaming the futures markets for high commodity prices is like blaming a thermometer for it being hot outside," said Walter Lukken, a member of the U.S. Commodity Futures Trading Commission.

· INSIDE FERC

Bill Holland

May 5, 2006

Feinstein bill has better prospects, ignores non-ICE portion of OTC market

While Democratic Senator Diane Feinstein of California is seen as having her best opportunity yet to win a Senate vote on her years-long effort to increase oversight of over-the-counter markets for natural gas, electricity and other energy commodities, her pending bill would have no impact on the most opaque part of the OTC market ? the dealmaking that takes place off electronic exchanges like the IntercontinentalExchange and is done through brokers or directly between counterparties.

Feinstein's bill, co-sponsored by Republican Senator Olympia Snowe of Maine and Democratic Senators Carl Levin of Michigan and Maria Cantwell of Washington, would require electronic exchanges, like the IntercontinentalExchange, to keep trading records for at least five years and report large positions held by traders, similar to requirements placed on futures trading on the NYMEX.

While the bill would also require trading companies themselves to maintain records for each "reportable contract" for five years and provide those records to the Department of Justice or the Commodity Futures Trading Commission, a key provision limits the definition of a "reportable contract" to deals executed on an electronic trading platform. Reportable deals would also include those done on ICE Futures, the former International Petroleum Exchange located in London, in which the underlying commodity has a physical delivery point in the US.

Feinstein has failed to come up with the votes for more far-reaching legislation for four years. But with the current outcry over high energy prices, and because this year's legislation is more limited and aimed primarily at ICE, industry observers and other players in the debate say she has a better chance than in previous years.

And although critics of her efforts say they will do nothing to lower gas or gasoline prices, Feinstein is clearly tying her bill to the politics of high gasoline prices. The bill is called the "Oil and Gas Traders Oversight Act of 2006," and when Feinstein and her co-sponsors introduced the bill, they called the energy industry's explanations for the spiraling costs of oil and natural gas "smoke and mirrors."

"Part of the energy market provides transparency, part does not," Feinstein said in a statement when she announced the legislation. "If you trade on the NYMEX, a record is kept, an audit trail is there. But if you make a trade on an electronic platform, no records are kept, and there is no audit trail.

"In essence, the federal government is blind," Feinstein said.

Sources on the senators' staffs expect the bill, S. 2642, which would amend the Commodities Exchange Act, to be incorporated into the Senate's version of the Commodity Futures Trading Commission's reauthorization (S. 1566). That would narrow the Senate's gap with the House of Representatives version of CFTC reauthorization (H. 4473), which calls for all gas traders to keep records and make reports to the CFTC.

Presently, the Senate version makes no changes to record-keeping and monitoring of the cash and derivatives markets. The Senate version of the CFTC's reauthorization has cleared committee and is waiting to be scheduled for consideration by the full Senate, said Keith Williams, majority spokesman for the Agriculture Committee.

While the senators believe increasing record-keeping requirements will give the CFTC the ability to better exercise its existing authority to police the markets for fraud and manipulation, the IntercontinentalExchange ? the market most affected by the Senate measure ? opposes the changes as unnecessary.

"Respectfully, we believe the amendment is well intentioned but won't achieve what is desired," ICE's General Counsel Johnathan Short told Platts. "We believe ICE's many-to-many market is highly transparent," he said.

ICE sees its platform providing significant transparency to the opaque OTC market, and questions why Feinstein's bill is aimed at ICE ? the one transparent part of the OTC market ? while ignoring the still-opaque portion of the OTC market in which deals are done through brokers and directly between counterparties. There are no record-keeping or reporting requirements for the non-ICE part of the OTC market.

"If you're going to cover the OTC market, cover the whole thing," Short said. The non-ICE portion of the natural gas OTC market, he said, "remains untouched and completely opaque."

By restricting record-keeping requirements to ICE deals, Short said, the Feinstein legislation could drive deal-making off the more transparent ICE screen and into the less transparent corners of the OTC market where companies deal directly and through brokers. "The window ICE has provided into the previously totally opaque market could be impacted," he said.

In a letter to Feinstein last week, the company had even tougher words.

Feinstein's contention that traders on ICE leave no audit trail is patently false, ICE CEO Jeffrey Sprecher wrote the California lawmaker. "Not only does ICE provide an audit trail but it provides one that cannot be replicated by other parts of the OTC marketplace (voice brokers, bilateral trading parties, etc.)," the company said.

Since Feinstein's bill only adds regulations to electronic trading platforms trading in gas contracts, ICE said it feels unfairly singled out. It is the only electronic trading platform trading gas contracts. Its frequently mentioned peer, Houston Street, trades crude and refined product contracts.

Sprecher also notes that the CFTC itself does not want more mandated regulatory authority over the gas markets. "The CFTC has stated on several occasions that it has the necessary tools to oversee the contract markets it regulates. The CFTC did not request additional recordkeeping requirements with respect to OTC transactions in exempt commodities," CFTC Chairman Rueben Jeffrey wrote to Feinstein in March.

Mark Stultz, spokesman for the Natural Gas Supply Association, a trade group for producers, wouldn't speculate on the bill's chances of passage, although he did note that "everyone is scrambling to find a solution" to high energy prices.

"There already is a cop on the beat to police the markets," Stultz said ? several cops, in fact: the CFTC, the Federal Energy Regulatory Commission, the Federal Trade Commission, and, ultimately, the Justice Department.

Even more outspoken against further regulation of the OTC gas markets has been CFTC Commissioner Sharon Brown-Hruska. In a series of speeches to industry groups this winter, Brown-Hruska has steadily dialed up her rhetoric against further regulation.

Routinely collecting trading data to be used for regulation creates a "moral hazard" Brown-Hruska told the Natural Gas Customer Council in Washington last month. "When market participants begin to rely on the government's efforts to police markets instead of relying on their own due diligence when negotiating contracts," Brown-Hruska said, "participants will tend to bring less information to the markets and the pricing mechanism becomes less efficient."

Further, Brown-Hruska contends that requiring more reporting in the name of market transparency will in fact result in less transparency as traders will migrate to trading platforms that require less disclosure.

"Another problem that can result from placing greater reporting requirements on exempt markets is that it may cause participants to move their trading to less transparent venues. Often the trading on exempt markets is bilateral, though participants use a trading platform to communicate and execute their trades," Brown-Hruska said. "Because of the bilateral nature of these trades, they could easily be moved entirely off the platform, where they could become less transparent to regulators and the markets."

But advocates of more oversight and transparency for OTC energy markets discounted the notion that more formal record-keeping and oversight of ICE would drive traders elsewhere.

"The first refuge of scoundrels," Randall Dodd, the director of the Financial Policy Institute and

head of its Derivatives Study Group, said of that argument. "They'll move to another market, they'll move offshore. Nonsense. Traders use ICE because they want the liquidity and the counterparty credit assurance."

Dodd's group has been calling for increased regulation of the OTC markets for several years, not only advocating increased reporting requirements but guarantees of capital adequacy on the part of traders.

"The social consequences of allowing this market to go unregulated amounts to a dereliction of public duty," Dodd told Platts. "I think traders out to be registered, have reporting requirements, reporting prices and volumes, and that dealers have collateral requirements."

Arguments that such measures would cut into the efficiency of the gas markets fall on deaf ears with Dodd. "It's cheaper to drive your car without insurance but we don't let people do it," Dodd said.

Dodd has watched Feinstein unsuccessfully attempt to regulate the gas markets since the California energy crisis in 2001 and thinks this year's political climate may give her the votes she needs to get new requirements on the books.

"I don't think ICE is fighting it, or they aren't fighting it as hard as they are other things," Dodd said. Lawmakers this year "need to be looking like they are doing something" about high energy prices, Dodd noted, and maybe just as importantly, "[former Texas Republican Senator] Phil Gramm has left."

"They have a couple of Republicans on the thing and the bill is narrower than it has been in the past," Dodd said.

· The Seattle Times

The sky isn't falling

By Carol Tice
Special to The Seattle Times

Saturday, April 22, 2006 - 12:00 AM

Hardly a day goes by without some piece of alarming global economic news. Recent months have brought us such nail-biters as terrorist attacks, fears of avian flu, skyrocketing oil prices, the Iraq war's soaring cost, pension plans going bust.

It's enough to make you want to spend like there's no tomorrow — or stuff your money in your mattress and then crawl into bed.

And that's what plenty of Americans are doing — the spending part, at least.

Time to get a grip.

Financial experts say most people should worry less about the things they can't control and more about how much they're saving. Bad stuff will happen, but it's difficult to forecast which of those dark clouds on the horizon will turn out to be a cyclone.

While we fret, Americans' personal-savings rate has hit a record low of minus 0.8 percent. Not good.

To secure your financial future, you've got basically two choices: Save tons of money or grow your money faster than inflation. Choice No. 2 means taking some risks with your cash — global catastrophes or no.

So here, we'll hold your hand as financial experts tackle some of the scary questions for nervous savers.

SCARY POSSIBILITY NO. 1

Q . How can someone who's worried about international issues — say, the possible rise of China as the future pre-eminent world power, or a decline in U.S. economic might — make any financial moves?

A. Remember, it's hard to predict how another country will fare over time. In the 1980s, forecasters thought Japan's booming economy would soon eclipse our own. Didn't happen.

Though some may worry about China eclipsing the U.S., given the country's penchant for periodic repressive crackdowns, an economic bust in China is as likely as a boom, argues Harold Evensky, Miami-based editor of "The Investment Think Tank" (2004, Bloomberg Press).

For those worried about a U.S. economic decline, Evensky suggests investing in foreign stock funds, which often rise when U.S. stock markets are sinking.

The main thing to remember is that no matter what happens to the U.S. economy, you're going to want to retire, says South Seattle Community College financial-planning instructor Bob Davis. So keep saving.

After Great Britain declined from its status as top world power, he points out, the country's citizens still wanted to retire when they got older. They still saved money and invested it in stocks and bonds to make that possible.

Spreading your savings among the four major categories — stocks, bonds, cash and real estate — is the time-tested way to soften the impact of unpleasant economic surprises.

SCARY POSSIBILITY NO. 2

Q . Could another domestic terrorist attack trigger a stock-market crash?

A . Terrorist attacks can cause market downturns. But data from 20 years of past major events shows the stock market generally bounces back pretty quickly, says financial instructor Davis. The trick is not to panic and sell when the market tanks.

After both the stock-market mini-crash of 1987 and the Iraq/Kuwait war, the stock market recovered most of its lost ground within six months, he notes. It took several years to bounce back after the Sept. 11, 2001 attack, but now the Dow Jones Industrial Average, often used to gauge how the U.S. stock markets are faring, is higher than before the attack.

Since most people who put retirement money into stocks are planning to hold them for the long term — and even a 60-year-old retiree should plan to own stocks for decades to come — such temporary market setbacks shouldn't have much of an impact on their savings in the long haul.

SCARY POSSIBILITY No. 3

Q. Social Security and pensions appear to be in jeopardy. How can we plan?

A . If you're young, expect Social Security to kick in later and pay out less than promised right now, advise experts. Most believe, though, that the plan will survive in some form. So save more, or prepare to work longer.

If you're nearing retirement age, you likely won't see any change.

Watch carefully plans for proposed changes to Social Security. "Most of the proposals to fix it are going to harm people more than any likelihood that the system is broken," says Randall Dodd, director of the Financial Policy Forum in Washington, D.C., which evaluates financial-market stability.

News is indeed scary on the pension front. With even flourishing companies such as IBM phasing out their pension plans, investment author Evensky says traditional pension plans may be headed for the scrapheap.

Best strategy for pensionholders: Get as much information as possible from your company so you can make informed choices to safeguard your money. Some plans allow lump-sum withdrawals — a worthwhile option if a pension seems shaky.

SCARY POSSIBILITY NO. 4

Q There are concerns that the twin deficits — the national debt and the foreign-trade debt — will cause interest-rate spikes or a decline in the dollar's value. What to do?

A . If you can, own some international stock funds; these are stocks of overseas companies who do business in foreign currencies. But don't pull all of your money out of the U.S. stock market on dollar-value fears, the experts say. It's difficult to predict exactly when such changes will happen, and betting on a dollar crash could be risky and costly.

Some money managers believe the best hedge against a weakening dollar is to buy gold, a commodity that's seen a sharp run-up in value over the past year.

Senior market strategist Emanuel Balarie of California-based Wisdom Financial, for example, recommends his clients have at least 15 percent of their portfolio in some form of gold — stocks in gold-mining companies, gold bullion, coins, gold futures. (A caution: Futures, essentially commitments to buy gold at a future date at an agreed-upon price, are riskier than the average person probably would want to gamble on.)

High interest rates are a legitimate fear, says the financial forum's Dodd. They tend to depress corporate spending, possibly triggering an economic slowdown, and to slow the real-estate market, as mortgage payments rise.

Interest rates around the world often mirror U.S. rates; there could be ripple effects abroad, making foreign stocks less of an effective counter-measure.

Some large investors and institutions will have the means to buffer their portfolio returns against the impact of high interest rates by using complex instruments such as hedge funds, which profit by successfully predicting future stock prices.

Ordinary folks' best bet: Retirees should keep a portion of their money in cash, then hunker down. Evensky's mantra is that retirees should keep all the money they think they'll need for the next five years in cash, to guard against having to sell when the market is down.

SCARY POSSIBILITY NO. 5

Q . What about rising oil prices?

A . It's hard to predict all of the impacts higher oil prices could have — on car sales or airlines, for instance — in part because no one knows how long oil prices will remain high.

Some have tried to profit from the price rise by switching into oil-and-gas sector stock funds, but the experts advise against this, saying people who try to ride investment waves usually end up getting in when they're crashing.

Staying broadly diversified, concludes Scott Budde, managing director of financial-services firm TIAA-CREF in New York, is still a better insurance policy against upheaval in a particular economic sector.

SCARY POSSIBILITY No. 6

Q . Some say Puget Sound's real-estate ride is over — with interest rates up and few economists foreseeing more record-breaking home sales or price increases. Is the long-term investment value of our homes in doubt?

A . Some say the ride's over but others say it continues, just not at the breakneck speeds of the past two years. In any case, if you have a home with reasonable financing, history shows your investment is fairly solid. However, new investments should be approached with more caution. Buy-and-sell "flipping" now is riskier in our area. (See p. 8 for more about real-estate investing.)

SCARY POSSIBILITY NO. 7

Q . Some say we should worry that retiring boomers will all cash out their stock portfolios at once, possibly causing a market downturn.

A . Likely won't be a problem, says Dodd. "At the same time the boomers are retiring, there will be a global surge of people under age 30. That will mean an increase in global savings."

— Suzanne Monson contributed the real-estate information.

· Wall Street Journal

Wall Street Journal Online

April 7, 2006

Fearing a Fed Fallout

History Says a Financial Calamity Follows

Rate-Lifting Campaigns; So Far, So Good

By MARK GONGLOFF

Something seems to be missing from the latest round of Fed tightening: A calamity.

In the past 30 years or so, Federal Reserve campaigns to raise interest rates have routinely been followed by bad news for some bank, currency, hedge fund or stock market. But despite the Fed's current crusade -- the longest span of tightening in more than 25 years -- there have been no major blowups -- yet.

Nearly two years ago, just after the Fed began the first of 15 consecutive rate increases, David Rosenberg, Merrill Lynch's chief North American economist, wrote a research report listing the financial meltdowns that had followed past credit-crunching periods. They include:

Long Island's Franklin National Bank, originator of the bank credit card, the drive-up teller window and, oddly enough, a no-smoking policy on bank floors, collapsed under the weight of currency bets gone bad in 1974, in what was then the biggest bank failure in American history. That disaster happened to follow a Fed tightening episode lasting from 1971 to 1974.

Oklahoma City's Penn Square Bank, which loaned money to energy explorers when oil prices were high, collapsed in 1982 after a recession and falling oil prices led borrowers to default, a milestone in a chain of events culminating with the 1984 collapse of Continental Illinois, then one of the 10 biggest banks in the U.S. That slow-motion disaster, along with a Mexican debt crisis, happened to follow a Fed tightening campaign that lasted from 1980 to 1981.

Black Monday, Oct. 19, 1987, the worst day in the history of the U.S. stock market, came not long after a Fed tightening episode lasting from Dec. 1986 to Sept. 1987. The Fed cut rates for a few months after the collapse, but soon started raising them again, all the way to 1989, after which the savings and loan industry imploded and the U.S. housing market and economy stumbled.

In December 1994, at roughly the same time Mexico began to suffer a peso crisis, it was revealed that interest-rate derivative bets made by Orange County, Calif., had gone horribly wrong. Both episodes came in the middle of the Fed's 1994 to 1995 tightening campaign.

The Fed's 1999 to 2000 rate increases were followed by an even more noteworthy crackup: the tech-stock bubble.

"The Fed has had a part in past meltdowns," says Milton Ezrati, senior economic and market strategist at Lord Abbett in Jersey City, N.J. "Typically they overdo it and pay a price."

Fair to Blame the Fed?

Why haven't we seen a similar debacle after 21 months of Fed tightening, the longest credit-strangling campaign since 1976 to 1979?

For one thing, it isn't at all certain how much the Fed had to do with every one of these past episodes. Illegal tomfoolery played a role in many of them, including Franklin National, the S&L industry and the O.C. Political turmoil hurt the peso in 1994. It can be argued that the stock-market stumbles of 1987 and 2000, along with the housing-market bust of the early 1990s, were long-overdue corrections.

What's more, the Fed has carried rates higher on its tiptoes, taking painstaking care, as if it were hauling a truckload of nuclear waste. While many financial meltdowns begin when investors are caught wrong-footed by sudden shifts in rates, the Fed's moves have been as well-telegraphed as a Kremlin election.

Meanwhile, interest rates are rising from unusually low levels -- the lowest since the Kennedy administration. And long-term rates have stayed stubbornly low even as the Fed ratchets up short-term rates. Randall Dodd, director of the Financial Policy Forum, a nonprofit group in Washington that studies derivatives and financial markets, suggests that many more financial dislocations have been caused by rising long-term rates than by rising short-term rates.

That's because holders of long-term debt are more vulnerable to changes in rates than holders of short-term debt. For both kinds of debt, rates and prices move in opposite directions. But because of their different "convexity," or sensitivity to rate changes, a jump in long-term bond rates causes more pain for long-term bond prices than a similar jump in short-term rates hurts short-term prices. "When long-term rates start moving a lot, we may see a serious problem emerging," Mr. Dodd says. "We are more apt to see customers with large losses they can't cover."

For what it's worth, long-term yields have been rising lately.

More Risk

And there is no question that rising interest rates of any sort can have bad consequences. For example, bank profits have suffered as rising short-term rates and flat long-term rates have closed the normal gap between the two. Mr. Dodd says that could force banks to court trouble by taking on too much risk to chase more yield.

In fact, risk is already the new black. Goldman Sachs took on record levels of risk in the first quarter and vowed to take on more, and other Wall Street firms have moved in the same direction. Main Street is engaged in risky business, too: Global investors threw a record $262 billion at private-equity funds last year, small-cap stock indexes are at all-time highs, and colleague Scott Patterson recently reported that more than $20 billion has flowed2 into emerging-market stock funds so far this year, matching the total inflow for 2005 and roughly five times the amount of money pumped into emerging-market funds in 2004, according to the research firm Emerging Portfolio Fund Research.

Emerging markets, often the scene of post-Fed meltdowns, seem to be especially vulnerable to rising interest rates. A 2001 paper by Harvard economist Jeffrey Frankel and New York University's Stern School of Business economist Nouriel Roubini found that the J.P. Morgan Emerging Markets Bond Index falls by 34% for every one percentage-point increase in the average inflation-adjusted ("real") lending rate in the Group of Seven industrialized nations.

UBS analysts estimate that G7 real interest rates have risen two percentage points since April 2004. But instead of falling, the EMBI has gained nearly 21% during that time, according to J.P. Morgan, and the EMBI yields just two percentage points more than the 10-year U.S. Treasury note -- meaning investors think emerging-market debt is only slightly riskier than U.S. Treasury debt, compared with 10 percentage points in October 2002.

It seems something's got to give. "We are in a situation similar to that which existed in the spring of 1997, when threats existed to market stability and a lot of people didn't want to see it," Citigroup Vice Chairman William Rhodes, also Vice Chairman of the Institute of International Finance, told reporters at a development-bank meeting in Brazil this week. "I am not predicting a new Asia crisis, but it is interesting to see the similarities that are present."

'Cracks in the Glass'

Maybe something is giving. Last month, when it became clear that the European Central Bank and the Bank of Japan would join the Fed in raising rates, investors started fleeing previously beloved emerging-market hot spots, such as Iceland, whose currency has tumbled 14.5% against the dollar amid credit worries, while its once-high-flying stock market has fallen some 20%.

"I think these are the kinds of little cracks in the glass you see before things really break wide open," says Michael Panzner, author of "The New Laws of the Stock Market Jungle." Mr. Panzner agrees with Warren Buffett that the next financial mess is most likely brewing somewhere in the derivatives market.

But the biggest victim of rising rates might be less exotic, and closer to home -- literally -- and we may be seeing the early stages of its decline. The average rate on a 30-year fixed mortgage rose last week to the highest since September 2003, and sales of new and preowned homes have been on the decline for months in the U.S., with the inventory of unsold homes rising.

And Fed policy usually does its maximum damage after a four-to-five-quarter lag, says Mr. Rosenberg of Merrill Lynch, meaning the worst for the housing market may be yet to come.

"I'm not trying to paint an Armageddon scenario," he says, "just to point out that these Fed cycles have this nasty tendency of exposing and covering and then purging the excesses of the day."

· New York Times

March 15, 2006

Reader Responses

Below are excerpts of reader responses to “Who's Afraid of Banking at Wal-Mart?”

-----

The key word in David Leonhardt's column on Wednesday supporting Wal-Mart's application to obtain a federally insured industrial loan bank in Utah is "imagine." But he is no John Lennon.

This issue is not about lowering the cost of banking services, as he imagines. Wal-Mart does not even claim to be trying to lower ATM fees and the price of other consumer banking services. What its executives say they want is to raise funds cheaply and have direct access to the nation's Fed wire and automated clearing house. Besides, the US banking sector is already awash in competition among nearly 9,000 banks and another 9,000 credit unions. Why should one more bank matter?

The actual problem with a Wal-Mart bank is that it combines the ownership and control of a bank and a commercial firm. The separation of ownership has been a pillar of financial stability in this country and a disaster when the principal was violated during the 1920s and early 1930s. Mr. Leonhardt makes no case for dismissing these concerns.

The Wal-Mart bank would also lack regulation as a bank holding company, and in these days of large, complex financial institutions the only hope of prudential regulation is with consolidated regulation and supervision. This is reckless policy at a time when the nation's need to attract foreign capital depends crucially on the safety and soundness of our financial system.

The industrial loan bank charter that Wal-Mart is applying for amounts to regulatory loophole the size of a Wal-Mart. Its special allowances create an uneven field of competition that is inconsistent with market efficiency.

Indeed, America's working people need cheaper financial services. The way to do this is expand credit unions. They are already providing low cost banking, and they do so without pernicious lending practices and without threatening the safety and soundness of the financial system.

Imagine there were no hate for Wal-Mart, and there would still be a pubic-policy concern with the safety, soundness and efficiency of our financial system and how it is effected by the combination of banking and commercial ownership of depository institutions and their lack of adequate prudential regulation.

Randall Dodd Director, Financial Policy Forum

I discuss the separation of banking and commerce in a sidebar to the column, available at http://www.nytimes.com/2006/03/14/business/15leonside.html - David Leonhardt

CA Magazine

Vanilla or Rocky Road

By Yan Barcelo
Illustration: John Ueland

Are they a terrible disaster waiting to happen? Or are over-the-counter derivatives the main contributing factor to the stability of the banking system? What’s the reality?

In rooms where scores of traders sit hunched over computer screens, banks from all over the world trade credit derivatives contracts sometimes worth astronomical amounts. These contracts, traded without any regulatory supervision, concentrate incredible levels of risk into the hands of a few dozen banks. If an unforeseen event were to shake the financial world, some of these institutions could collapse, bringing down with them the world’s economic and financial systems, and we would be faced with a financial version of the avian flu pandemic that medical authorities have been warning us about.

Ever since IBM and the World Bank effected the first debt swap in April 1981, the over-the-counter (OTC) derivatives sector has accumulated a lot of bad press. A March 1994 article in Fortune magazine compared them to alligators in a swamp, lurking in the global economy. The chairman of the American Stock

Exchange, a competitor, called them "the 11-letter four-letter-word."

The most bruising attack came from none other than supreme investment guru Warren Buffett. In his 2002 annual report letter to shareholders of Berkshire Hathaway, published in Fortune in March 2003, Buffett characterized OTC derivatives as "financial weapons of mass destruction."

Of course, not everyone shares this view. In a May 2005 speech before the Federal Reserve Bank of Chicago, then US Federal Reserve Chairman Alan Greenspan, another demi-god of finance, repeated a line that has become his leitmotiv: "As is generally acknowledged," he said, "the development of credit derivatives has contributed to the stability of the banking system by allowing banks, especially the largest, systemically important banks, to measure and manage their credit risks more effectively."

Good or bad, derivatives have reached epic proportions. (Unless otherwise specified, this article deals only with OTC derivatives, as opposed to exchange-traded derivatives, such as options and commodities futures.) The Bank for International Settlements (BIS), the only organization that collates world numbers on the sector, reports that total notional values stood at US$248 trillion at the end of 2004, a 26% increase for 2004, following a 39% increase in that year. Since 1990, when the total figure was US$7 trillion, annual growth has averaged 31.6%. (The concept of notional value is best explained using an example from the world of exchange-traded options. A $10,000 option on copper would give the operator a right on a $1-million contract to buy or sell the copper. This underlying amount of $1 million gives the contract its notional value and determines whether profits or losses will be realized on the option. If the price of the contract increases by 1%, i.e., $10,000, the operator realizes a profit of the same amount, and vice-versa in the event of a loss.)

DERIVATIVES 100000000000001

Towering derivatives notional values are built from three basic brick types that individually are quite elementary in structure: OTC options, forwards (futures negotiated over-the-counter) and swaps. OTC options and forward contracts
are tailor-made to suit a counterparty’s specific needs but are structured like their exchange-traded counterparts.

Swaps are the darlings of derivatives and represent the vast majority of deals. In their basic form, they are an agreement between two parties to exchange cash flows on the basis of the notional amount of an underlying asset or liability: loans, currencies, commodities, indexes.

The plain vanilla swap brings into play two counterparties that want to change
the interest rate structure on their liabilities. Bank A, which pays a fixed rate on its deposits, say 2.5%, agrees to pay an equivalent fixed rate to Cie B. In return, Cie B, which pays a variable rate on its dept portfolio, now pays a variable rate to A. This variable rate usually evolves in reference to the LIBOR rate (CDOR in Canada), to which is added a basis point spread to match the level of the fixed
rate. If the CDOR rate goes up, B pays more and more to A while being held to a fixed-rate income from A. If the CDOR moves downward, B’s position becomes increasingly profitable while A’s involves a lost profit opportunity.

On such a swap transaction, the bank can make money several ways. For example, at the moment of selling a fixed rate of 2.5%, it knew it could turn around and sign another contract in which it could receive a rate of 2.58%, which it closes.

Why go to this trouble? The swap allows each party to better manage interest rate risks while avoiding Cie B the cost of selling its loans and signing up new ones. In a swap, "corporations generally prefer to receive a floating rate and
pay a fixed one," says André de Haan, partner at Ernst & Young’s financial services group in Toronto. "They want to eliminate interest rate risk from their balance sheet by changing debt from floating to fixed. Most banks are at the other end: they have large deposits on which they pay fixed, but they would prefer everything to float."

Relatively similar and simple structures prevail in foreign exchange swaps, foreign currency swaps and equity swaps, all prevalent in bank deals. Swap structures often take on exotic forms, especially when combined with options and forward contracts: roller-coaster swaps, corridor swaps, bull swaps, and an infinite variety of swaptions. "Some second and third generation structures are contingent on many other events," points out a financial derivatives specialist, "and their complexity becomes such that you need to call in the rocket
scientist-type financial engineers to structure the financial models to evaluate their validity." Credit default swaps (CDS) are probably the most recent avatars where exchanges between counter-parties take on an unheard-of form: loan default insurance. One party, usually an institutional investor, insures a loan or obligtion, usually held by a bank, in exchange for the equivalent of a monthly or quarterly premium. If the issuer of the obligation defaults, the investor has to pay the bank any loss incured.

CDSs belong to the most recent strand of products — credit derivatives, which are growing by leaps and bounds. In 2004, they jumped by 134% in the US according to the Office of the Comptroller of the Currency. The newest segment in credit derivatives are collateralized debt obligations (CDO), a new departure on "asset-backed securitization." Portfolios typically containing 100 titles of debt are cut in tranches of credit riskiness, priced accordingly, and sold to institutional investors. The more recent CDOs have become "synthetic," meaning they contain CDSs and, in their Russian doll variety, other CDOs, which tends to complicate complexity a little more. They also allow greater leverage, similar to what we find in options.

In the US, which holds the largest concentration of derivatives with the UK, bank derivatives grew by 23.6% in 2004, totalling US$87.5 trillion in notional value. According to a report by the US Treasury Department’s Office of the Comptroller of the Currency, trading profits are exploding well above volumes. Profits from derivatives and cash instruments rose to a record US$4.44 billion in the first quarter of 2005 from US$2.2 billion in the fourth quarter of 2004.

Typical of all major national markets, in the US 96% of derivatives are concentrated in a handful of banks: J.P. Morgan, Bank of America, Citibank, Wachovia and HSBC-USA. J.P. Morgan is in a category by itself, holding US$44.9 trillion of derivatives, more than half the US total and a fifth of the world total. In Canada, the six leading banks hold a notional value of $8.24 trillion, Royal Bank of Canada leading the pack with a $2.5-trillion derivatives book.

Perspective, perspective
Let’s put these numbers in perspective. the US gross domestic product (GDP) stood at US$12 trillion at the end of 2004, 7.3 times smaller than US bank derivatives notional values, 20 times smaller than world totals. In the US, J.P. Morgan’s derivatives book represents four times GDP; in Canada, Royal Bank’s represents 2.5 times a GDP of $1.02 billion.

Derivatives dwarf all other financial assets: the market capitalization of US stocks presently hovers at US$13 trillion, global stock market capitalization amounts to US$26.4 trillion, and notional values of exchange-traded derivatives total US$31 trillion in the US, US$52.8 trillion globally.

However, referring only to the gargantuan size of derivatives notional values can be misleading. Typically, notional values serve only as reference and are not exchanged. The real money flows represent only a fraction of the notional values from which they derive. That is why BIS speaks of the gross fair market value of OTC derivatives, which it establishes at US$9.1 trillion at the end of 2004, or 3.6% of total notional value.

"This is the sum of all derivatives that are in the money and of out of the money options that have a time value," explains Randall Dodd, director of the Derivatives Study Center at the Financial Policy Forum in Washington, DC.

René Stulz, professor of banking and monetary economics at Ohio State University, gives a good accountant’s point of view. "Suppose the whole world had to write off all derivatives contracts. For each swap contract, one party would write off an asset, the positive value of the contract at that time, and the counterparty would write off a liability. Now, add up the positive value of all contracts at that time. By this measure, the aggregate value of OTC derivatives outstanding in June 2003 was US$7.9 trillion according to BIS (US$9.1 trillion in December 2004). This amount is large, but not compared with the notional amount of contracts outstanding."

Another key measure is net exposure, which BIS establishes even lower: US$2.08 trillion. Jeffery Gunther and Thomas Siems, researchers at the Federal Reserve Bank of Dallas, put that number in perspective in relation to the 10 largest US banks. "For the 10 as a group," they wrote in a 2003 study, "the notional value of derivatives is very high, greatly exceeding total assets. But their current credit exposure, or the risk associated with the possibility that the other party to a derivatives contract may not make a required payment, is much smaller. By this measure, the derivatives exposure of the top 10 is only about 7% of total assets. This compares with an 8% capital ratio and a loan-to-asset ratio of 51%." (For a view on the building blocks of derivatives towers, see "Derivatives 100000000000001," p. 38.)

Virtues and blow-outs
The virtues of derivatives are apparently many. The most often stated are improved risk management for financial institutions, institutional investors and corporations, and the discovery of accurate price information.

A 1999 study by Wayne Guay in the Journal of Accounting and Economics shows that "when firms start using derivatives, their stock return volatility falls by 5%, their interest rate exposure falls by 22% and their foreign exchange exposure falls by 11%."

Of course, these virtues shine when companies use derivatives for hedging purposes. When used to speculate, though they can produce handsome profits, their virtues can turn into vicious blow-outs. The short history of derivatives is littered with stories of $100-million to $1-billion losses at corporations such as Gibson Greetings, Procter & Gamble, Metallgesellschaft and Allied Irish Banks, while others simply went under: Orange County, Barings Bank, Enron and, most recently, China Aviation Oil, a Singapore-based jet fuel importer bankrupted by trading losses of US$550 million. Of course, the most outstanding crisis remains that of Long-Term Capital Management in 1998 (see p. 42, "The day financial rocket scientists looked like idiot-savants").

More intense shades of risk
Financial derivatives have not generated many risks that financial institutions were not already familiar with. Traditional categories still hold: operational risk, interest rate risk, currency risk, credit risk, liquidity risk. However, derivatives have pushed these categories to unprecedented levels, prompting banks through the ’90s to give their executives such exotic titles as director of integrated market risk assessment and VP of portfolio risk management.

Of course, managing risk has not eliminated it. In most cases, it simply pushed it outside the institution where it tends to become less visible.

There is one kind of risk that was practically unheard of before derivatives: systemic risk, somewhat the equivalent of the old bank runs, but where banks, in this modern version, could potentially run from one another. Following the LTCM fiasco, it is an overarching theme every central banker and commercial banker has become acutely aware of, and many papers have been published proposing ways to contain that risk, arguing, or trying to, it has effectively been contained.

But many informed observers remain unconvinced. In his Fortune article, Buffett recognized that taken individually derivatives have unquestionable virtues. However, he added, "the macro picture is dangerous and getting more so."

THE DAY FINANCIAL ROCKET SCIENTISTS
LOOKED LIKE IDIOT-SAVANTS

The mother of all derivatives blowouts remains the 1998 collapse of Long-Term Capital Management, in New York. Founded in 1993 by golden boy John Merriwether who made a fortune for Salomon Brothers’ bond-arbitrage group, the new hedge fund attracted billions of dollars from private investors. It also showed off a board of directors boasting stellar credentials, specifically Nobel laureates Robert Merton and Myron Scholes who, along with Fischer Black, devised the famed Black-Merton-Scholes option pricing model, which is still fundamental in derivatives pricing today.

Calling LTCM a hedge fund is slightly misleading. When it played a convergence arbitrage strategy between US Treasury bonds and leading swap rates, the fund wasn’t hedging anything. It was acting as a gambling house, betting that the spread slowly moving outside its normal historical range would inevitably bounce back to the norm. Certain that the mathematics of Merton and Scholes perfectly reflected financial reality, the further the spread widened, the more they piled on bets, shorting treasury bonds in the expectation that prices would eventually fall, buying risky US and European corporate bonds, certain they would rise. The fund applied the same strategy to many other market spreads involving various financial instruments then ventured into equity trades versus takeover stocks and into total return swaps.

Reality did not cooperate. The impossible happened. In August 1998, the Russian government, one of the parties to the transactions, defaulted on its bond payments, causing spreads to de-converge as investors worldwide rushed to
security. At that moment, with only US$4.7 billion in investment capital, LTCM controlled US$125 billion in assets, enjoying a 26-to-1 leverage ratio with major banks that thought LTCM could do no wrong.

Within days, margin calls flooded in, LTCM hemorraging money at the rate of hundreds of millions of dollars a day. By early September 1998, investors had lost 92% of their year-to-date investment, and by the end of that month, the Federal Reserve Bank of New York convened 14 leading US and European banks to an emergency meeting where they were "invited" to bail out LTCM with an injection of US$3.6 billion in exchange for a 90% stake in the company.

"When LTCM faced bankruptcy," explains Randall Dodd, director of the Financial Policy Forum, "the swaps market froze up and, as a result, the markets for mortgages, mortgage- and asset-backed securities and corporate bonds were
disrupted by the inability to price those instruments against a benchmark." For a few days, the global financial system teetered at the brink of an abyss. With his typical flair for understatement, then Fed Chairman Alan Greenspan reported before the House Banking Committee in October 1998: "Had the failure of LTCM triggered the seizing up of markets, substantial damage could have been inflicted on many market participants, including some not directly involved with the firm, and could have potentially impaired the economies of many nations, including our own."

And Buffett hits on the key systemic weak point. "Large amounts of risk, particularly credit risk, have become concentrated in the hands of relatively few derivatives dealers, who, in addition, trade extensively with one another. The troubles of one could quickly infect the others." Echoed a BIS analyst months later in a Financial Times article: "There are probably just a half-dozen of the large players. They are all inter-connected, and should something happen to one of them, this could cause huge damage to the OTC market."

What damage? To make things clearer, let’s suppose the Asian central banks, which actually purchase 80% of US treasury bills, suddenly stop buying them. Not likely, you think, but as John Lonski, chief economist with Moody’s in New York, says: "The shocks that hit capital markets are usually those that seemed the least likely."

In less than a few weeks, long-term interest rates in the US would jump by 500 basis points. Following this shock, countless parties to derivatives contracts would see their credit conditions deteriorate and could no longer honour their commitments. One bank, more exposed than the others, would be strangled by the resulting shortage of cash. It would call on the Fed and other international banks, particularly the IMF, but these institutions, reeling from the cut-off of Asian credit, would be unable to react swiftly. The bank would then recall a large number of loans, forcing many enterprises to effect massive layoffs to stave off bankruptcy. The problems of the first bank would spread to others with which it signed millions of derivatives contracts that it could no longer honour. These banks, now just as fragile, would call numerous loans, resulting in more layoffs and bankruptcies. Inevitably, the real estate market would collapse, consumption would drop dramatically, thereby reducing the income of companies, which would conduct more layoffs and fail to repay their bank loans, making the banks’ situation worse and sending the economy into a spiral leading to a depression. Add to this scenario the high level of leverage in the derivatives sector and "all conditions are ripe for a cascading effect leading to a fiasco," says François Dupuis, assistant chief economist and strategy developer with Mouvement Desjardins in Montreal.

The dealers criticized by Buffett act in effect as private exchanges with unprecedented levels of risk concentration. J.P. Morgan alone, with its US$44.9-trillion derivatives book, is nearly twice the size of all publicly trading derivatives exchanges in the US, which include big players such as the Chicago Board of Trade, the Mercantile Exchange and the New York International Securities Exchange. In Canada, Royal Bank’s $2.5-trillion derivatives book is bigger than total capitalization of the TSX ($1.58 trillion) and total notional value of all contracts traded on the Montreal Exchange ($462 billion).

But contrary to their publicly traded counterparts, these private exchanges are very private. Even though they constitute the largest segment of the financial industry, they are essentially unregulated. In the US, the Commodity Futures Modernization Act of 2000 explicitly insulated the OTC derivatives market from the regulation that applies to publicly exchange-traded options and futures. To justify such an astounding decision, legislators contended that OTC derivatives involve mature players who know what they are doing and will do what is necessary to self-regulate.

Must we then conclude that players in the regular exchanges are immature adolescents who can’t control themselves? And what about the LTCM fiasco? Were all those profit-happy rocket scientists, arbitrageurs and heavy-weight bankers as mature and in control as the legislators made them out to be? Dodd is categorical: "The absence of regulations is an open invitation to theft and fraud."

Yet the regulations and controls that operate on exchanges have proven efficient to this day. Ever since its creation in April 1973, the Chicago Board Options Exchange has experienced none of the shocks of the OTC derivatives market and in the stock exchanges. But no such controls are applied by the large OTC derivatives houses, such as daily trading-stops in case of distress, up-front collateral requirements, the obligation to maintain a liquid market and an independent clearinghouse.

OTC players form a rather cozy club: the margin level that the ISDA standardized contracts impose (misleadingly called collateral requirements) are established according to the credit rating of each player — and this credit can obviously deteriorate, sometimes quite quickly. On exchanges, points out Léon Bitton, vice-president of R&D at the Montreal Exchange, the margin calls don’t care who you are or what your credit rating is. "A margin call is set according to the size and the specific volatility of your contract," he snaps.

Furthermore, these collateral requirements (like margin calls) in the OTC market increase sharply when a derivatives counterparty becomes distressed and suffers a downgrade. This can exacerbate the troubles of a counterparty and require cash from him at the very moment he might be short of it, points out Dodd. He believes asking for collateral at the outset, as exchanges demand, would be a much better idea. "It would increase the cost of dealing in derivatives, which is not a bad thing," he says. "It would better reflect the risk of entering into this kind of activity."

Rocket equations that crash
Of course, banks closely monitor their derivatives positions and carry all sorts of calculations, simulations and stress testing to determine their value at risk. They know a sudden movement of 80 basis points in interest rates or currency levels could wreak havoc on their portfolios.

But a February 2004 article in The Economist, ominously titled "The Coming Storm," hit on a particularly soft spot. Bank models "assume a certain level of losses for moves of a given magnitude," it states. "The problem comes for the tiny number of crises when markets move much more and, to add insult to injury, banks’ assumptions about the diversity of their portfolios are shown to be wrong. In other words, the models, says one regulator with a chuckle, are of least use when they are most needed."

Indeed, research increasingly shows that the valuation models that stand at the core of the whole derivatives market are flawed in relation to the frequency and the magnitude of disruptive crises. "Most models are based on the assumption that a 3.5 standard deviation contains nearly 100% of event probabilities, says Dupuis of the Mouvement Desjardins. "But we now see that a lot of events went way beyond that limit. The 1987 stock crash equated 22 standard deviations and the LTCM meltdown stood at between five and eight standard deviations. ‘Normal’ law claims that to be impossible."

But normal law does not take into account the inherent multipliers of human greed and fear. When things are on a roll, speculators pile their bets sky-high, as they did at LTCM, thinking things can only come back within the range of "normality." On a bell curve, we could say that they are transforming the thin ends into fat tails. Then, when the impossible occurs, the phenomenon of crowded exits kicks in where everybody sells sells sells to take cover. The bell curve takes the form of a cowboy hat, where the ends instead of tapering off to infinity shoot up. Conclusion: the global net exposure of US$2.08 trillion BIS reports for the derivatives industry is probably greatly underestimated and bank capital requirements should be significantly enhanced. The reason is simple: a systemic shock that would multiply banks’ net exposure by five would run most of them into technical bankruptcy.

Edgy?
Are derivatives the weapons of mass destruction that Buffett denounces? Or are they "a speculative pyramid that will implode without a steady inflow of new participants," as New York investment banker Christopher Whalen wrote in February 2002 in Barron’s? They certainly give that impression to many observers. But then, derivatives do seem to carry a lot of good.

Yet the problem is disconcertingly simple: we really don’t know what to expect. "Trust us," say the bankers who jealously guard all information that is not within the minimal requirements of bank regulators. What are the concentrations of counterparty exposures? What is the net degree of leverage of hedge funds? Are there pockets of risk slowly growing out of control? Answers would contribute to fathom the total risks and payoffs of derivatives. But no one has the slightest idea. No one. Not even the players themselves.

Let’s imagine that a stock exchange like the New York Stock Exchange was not regulated. Stock prices would not be made public, no major transaction, not even insider trades, would be recorded and brokerage firms would not be required to completely separate their sales activities from their analyst activities. In short, the players would be calling the shots. In the event of another shock like the 1987 crash, we would only find out about it when a few large brokerages or investment corporations declared bankruptcy. Yet the market we are talking about doesn’t have a total US value of US$13 trillion, but rather US$84 trillion, i.e., seven times the market value of US enterprises. Shouldn’t this be cause for concern?

The game is set up so we can’t learn from past accidents, as the turmoil around the GM and Ford bond recent downgrades to junk status could have been occasion to. "There were only rumours because this near-systemic meltdown — in the words of a senior representative of the securities industry — occurred in OTC derivatives markets where there are no reporting requirements and hence no real transparency," says Dodd, a strong proponent of regulating the sector.

Whose economy?
The final verdict on derivatives is hinted at by Peter Bernstein in Against the Gods: The Remarkable Story of Risk: "Derivatives have value only in an environment of volatility; their proliferation is a commentary on our times. Over the past 20 years or so, volatility and uncertainty have emerged in areas long characterized by stability. Until the early 1970s, exchange rates were legally fixed, the price of oil varied over a narrow range, and the overall price level rose by no more than 3% or 4% a year. … Derivatives are symptomatic of the state of the economy and of the financial markets, not the cause of the volatility that is the focus of so much concern."

But Bernstein does not go all the way. He neglects to point out that systematic volatility was ushered into world markets when the US abandoned the gold exchange standard in 1971 and committed the world to a floating-exchange regime of a dollar-exchange standard. Since producers need stability to ensure revenues, profits and investment projects, if they don’t find it in the market, they will buy it. Derivatives are the new insurance business that caters to the risk aversion of economic producers, and "the producer’s loss aversion gives the speculator a built-in advantage," notes Bernstein. Notwithstanding his statement, many observers consider that this new insurance business itself adds to the volatility and turbulence of markets.

That’s why calls are increasingly heard for a new international monetary system inspired from the Bretton Woods Conference. Symptomatic was the resolution passed by the Italian chamber of deputies on April 6, 2005. Pointing to a "widening of the gap between the real economy and the purely financial economy … and the explosion of the financial derivatives bubble," the chamber commits the government to arrange with other governments "an international conference at the level of heads of state and government similar to that held in Bretton Woods in 1944, to create a new and more just global monetary and financial system."

Meanwhile, the number of financial products continues to grow at a dizzying rate, far from the scrutiny of regulators and financial institutions. The scaffolding of debt erected thanks to these products seems to be holding for now, but when the inevitable shock hits, its solidity will be severely tested. When that day comes, if only one major player is destabilized, the problems could spread to the entire banking system in a classic domino effect. If the collapse cannot be contained rapidly, the consequences could be dramatic, some even predict a financial and economic Armageddon.

Unlike the avian flu pandemic that experts worldwide say is inevitable, is there still time to intervene in the case of OTC credit derivatives?

Catholic News Service

Win-win sought for U.S. federal ‘07 farm bill

By Mark Pattison
2/16/2006

WASHINGTON -- The next farm bill isn't due to be passed for another year, but some people are already strategizing various win-win scenarios for farmers, consumers, rural towns and the environment.

Those elements would include utilizing farms as sources for renewable energy, limiting commodity payments and focusing on rural economic development beyond crop subsidies.

The projected federal deficit, though, could alter federal farm policy, conferees were told Feb. 14 at the Catholic Social Ministry Gathering in Washington, co-sponsored by five agencies of the U.S. bishops and 12 national Catholic organizations.

The 2002 farm bill, which added $73.5 billion in new federal funds over 10 years for rural communities, was written in a time of budget surpluses, said Mark Halverson, minority staff director and chief counsel for the Senate Agriculture Committee.

The budget reconciliation measure passed by Congress earlier in February cut rural economic development funds, conservation programs and renewable energy initiatives, Halverson said, but not crop subsidies.

Subsidies in and of themselves do not constitute rural economic development, Halverson said, pointing to a map showing that in the top 25 percent of U.S. counties receiving subsidy payments, economic growth is below the U.S. norm; there were as many counties recording negative economic growth as those showing above-average growth.

Currently about 10 percent of U.S. farms collect 72 percent of all subsidy money, according to Halverson, and of those 4 percent collect fully half of the subsidies. "We've been interested in trying to reform that," Halverson said.

The figures reflect the growing concentration in farming that was highlighted by the so-called farm crisis of the early 1980s when economics forced 80,000 farmers to quit, retire, sell their land or let their farms be repossessed. But throughout the 20th century, Halverson said, while the U.S. population rose 270 percent, the number of U.S. farms shrank 60 percent.

The scope of the farm bill has expanded over time, Halverson noted, in part perhaps because coalitions were formed around certain issues to ensure its passage. Farm bills have passed by narrower margins over the past 20 years.

School lunch programs, Halverson said, have been a regular part of recent farm bills. While nearly every senator represents farmers, the same is not true of House members. "Framers of the next few farm bills will have to embrace a wider vision of agriculture than in the past," he added.

"The other factor that will play into this will be international trade negotiations," Halverson said. Domestic farm programs, among them crop subsidies, may have to be adjusted depending on what kind of trade agreements are approved in the future.

Randall Dodd, director of the Financial Policy Forum, said trade agreements thus far have hurt smaller farmers, and the U.S. government has not sought to reduce the inequality caused by trade agreements. "We don't see the losers being compensated by the gainers to make a truly equitable farm policy," he said.

"What has happened with NAFTA (the North American Free Trade Agreement) is that you can't compete with (and) your scale can't compare with those big mechanized farms in the Midwest," Dodd added. Low domestic prices ruin the small U.S. farmer, and exported commodities because of domestic overproduction ruin the small farmer in the countries importing U.S. commodities.

Dodd, who grew up on a Texas farm and still has relatives farming in Texas, used biblical allusions to stress the fragility of the farm enterprise.

In Chapter 6 of the New Testament Book of Revelation, he pointed out, the third figure of the Four Horsemen of the Apocalypse was agrarian -- famine -- who said, "A ration of wheat costs a day's pay, and three rations of barley cost a day's pay, but do not damage the olive oil or the wine." In Revelation, the figure holds a scale, considered a symbol of a food shortage with a corresponding rise in price.

U.S. farmers "have a tough time offsetting (bad years) even with the good years," Dodd said. "Even in the Bible, Joseph had the advantage, because the seven fat years came first, before the seven lean years."

Copyright (c) 2006 Catholic News Service/U.S. Conference of Catholic Bishops

Refco's Collapse Reveals Decades of Quarrels With Regulators

(Bloomberg) –

Edward Robinson in New York at edrobinson@bloomberg.net

In October 1997, the word went out on the cavernous floor of the Chicago Mercantile Exchange: Refco Inc. was in trouble.

Through the futures pits, where sweating young traders bark orders to buy and sell contracts on pork bellies, cattle and currencies, people were buzzing that customers of the New York- based futures brokerage had begun hemorrhaging money on their trades, says Erik Schmidt, then a Merc trader. A chain reaction of devaluation, default and bankruptcy in East Asia was rocking world markets. Suddenly, it seemed Refco might be on the hook for its customers' bad bets.

As talk spread of Refco's doom, Tone Grant, then president of the firm, issued a statement on Oct. 30 insisting the brokerage was sound. ``There is no problem at Refco,'' Grant said.

Only there was. Its clients' trades during the 1997-1998 Asian market meltdown eventually cost Refco about $300 million. As the losses mounted, Grant was soon replaced by Refco's financial architect, presumptive savior and, prosecutors now allege, its ultimate destroyer: Phillip Bennett.

For the next seven years, Bennett illegally propped up Refco by hiding as much as $720 million of unrecoverable debts, prosecutors say. Unbeknownst to customers, regulators or investors, Bennett allegedly shuffled hundreds of millions of dollars between Refco's accounts and a New York-based affiliate he controlled.

Bennett, who'd been Refco's chief financial officer for 15 years before rising to chief executive officer in 1998, conducted his shell game more than a dozen times, prosecutors say.

Seeming Success

To the outside world, Refco and its CEO seemed to vault from one success to another. While allegedly concealing the precarious state of his firm's finances, Bennett, 57, built Refco into the largest independent futures brokerage in the U.S.

In 2004, Thomas Lee, one of Wall Street's biggest buyout artists, invested $507 million in Refco. In 2005, Bennett hired Bank of America Corp., Credit Suisse First Boston Inc. and Goldman Sachs Group Inc. to take his brokerage public in a $583 million initial public offering.

Last Aug. 10, British-born Bennett, who'd proved his mettle on the rugby fields of the University of Cambridge, assumed a place among the chieftains of Wall Street. That day, Refco stock, priced at $22 per share in the IPO, began trading on the New York Stock Exchange. The deal netted Bennett, with a 38 percent stake in the firm, $1 billion. To mark the event, Bennett himself rang the Big Board's opening bell on Sept. 9.

Empire in Ruins

A month later, Bennett's empire was in ruins. After a new controller discovered the CEO's covert debt and the firm went public with the news on Oct. 10, Refco unraveled in the space of seven days. Its stock plunged to 65 cents from $29, wiping out almost $3 billion of shareholder value.

As the shares cratered, Refco clients pulled $3.1 billion from the firm. Fatally wounded, Refco filed for bankruptcy on Oct. 17, owing creditors about $16.8 billion. It was the most spectacular implosion in the futures market since 233-year-old Barings Plc was felled in 1995 by a 25-year-old rogue trader named Nick Leeson.

Once hailed as Refco's rescuer, Bennett has now been charged with securities fraud, conspiracy and six other felonies in a 23- page indictment filed in U.S. District Court in Manhattan on Nov. 10. Bennett has pleaded not guilty. His lawyer, Gary Naftalis, declined to comment.

Free on a $50 million bail bond pending trial, Bennett has surrendered his British passport to the U.S. Attorney's Office in New York. He now wears an electronic monitor strapped to his ankle and is restricted to the New York/New Jersey area.

Park Avenue Penthouse

The executive has a penthouse on Park Avenue and a horse farm in Peapack-Gladstone, New Jersey, where the late Jacqueline Kennedy Onassis kept a country estate. The investigations into what went on at Refco -- and the legal battles over who will shoulder the blame and investors' losses -- have only just begun.

The seeds of Refco's destruction were planted more than three decades ago, when the firm's co-founder, Ray Friedman, began fostering a culture of bending, and sometimes breaking, the rules. Refco had the worst record in the U.S. futures industry.

Since 1983, when Bennett became CFO, regulators such as the U.S. Commodity Futures Trading Commission had punished Refco 140 times for keeping sloppy records, filing false trading reports, inadequately supervising its traders and other violations, according to enforcement records compiled by the Washington-based National Futures Association, a self-regulatory organization that governs the more than 4,200 firms involved in futures trading in the U.S.

Tangling With Regulators

A key Refco unit that Bennett himself had established, Refco Capital Corp., tangled with the CFTC more than a decade before the brokerage foundered.

In 1994, the CFTC fined Refco $1.2 million for secretly shuttling money from client accounts to cover Refco Capital's own debts -- a forerunner of the toxic fraud prosecutors say Bennett later perpetrated as CEO. Refco paid that fine, without admitting or denying guilt, and promised to keep its hands off the money in such segregated accounts, which, under U.S. securities law, can't be mingled with a firm's own capital.

Refco failed to clean up its act. In 1995, a Refco broker helped a Beverly Hills, California, money manager named S. Jay Goldinger defraud his clients by illegally dealing out profits and losses among customer accounts, according to the CFTC.

The next year, Refco Capital, which Bennett had set up to finance customers' trades, once again manipulated a client's account without that customer's knowledge. A federal judge later ruled that that move, while technically legal, was nonetheless ``disreputable.''

Over the Edge

``Refco was a firm that said, `Show us where the edge is,' and then they played just over it,'' says a former U.S. commodities exchange official who was involved in regulating Refco during the 1980s and 1990s.

Prosecutors in Bennett's criminal case have focused on financial transactions between Refco and another, offshore unit, Refco Capital Markets LLC. The world of futures, options and other derivatives, which are instruments linked to underlying stocks, bonds or commodities, is split between those that are traded on exchanges such as the Merc and those traded off such bourses, or over the counter.

In the U.S., brokers of exchange-traded futures are regulated by the CFTC. Domiciled in Bermuda and operated out of New York, Refco Capital Markets brokered over-the-counter derivative and currency trades and was therefore beyond the reach of U.S. regulators.

`Fertile Ground'

``These unregulated parts of the industry offer fertile ground for fraud, manipulation and other shenanigans,'' says Randall Dodd, director of the Derivatives Study Center, a Washington-based research and policy group.

More revelations may be at hand. The CFTC is still conducting its investigation of Refco and its finances. The U.S. Securities and Exchange Commission is in the midst of its own, separate probe.

Refco's implosion and the charges leveled against its CEO have stunned investors and industry colleagues. Under Bennett, Refco appeared to have put its troubled past behind it, says Gary DeWaal, general counsel for Fimat USA Inc., the New York-based securities unit of Paris-based Societe Generale SA. Former Refco employees are staggered.

``It was like you just told me my brother is an ax murderer,'' says Daniel Yovich, 42, a former Refco grain futures broker on the Chicago Board of Trade who quit Refco after the firm went bankrupt.

Thomas H. Lee Stake

The reverberations of Refco's failure have been felt throughout the financial world. Investors have lost billions of dollars. Bennett's biggest shareholder, Lee's Boston-based buyout firm, Thomas H. Lee Partners LP, saw the value of its 38 percent stake in Refco dive to about $19 million on Jan. 4 from $1.5 billion on Sept. 7 -- an 87 percent plunge.

The list of Refco's other stockholders reads like a who's who of money managers. Among them are Maverick Capital Ltd., the Dallas-based hedge fund firm run by Lee Ainslie; T. Rowe Price Group Inc., the Baltimore-based money manager founded in 1937; and New York-based TIAA-CREF, which manages $350 billion in assets.

Now come the lawyers. Refco shareholders have sued Bank of America, CSFB and Goldman Sachs, claiming those firms failed to scrutinize Refco properly when underwriting the firm's IPO.

Investors have also sued Lee's firm and Chicago-based Grant Thornton LLP, Refco's auditor, saying they should have spotted Bennett's alleged scheme. Three Thomas H. Lee funds, in turn, have sued Refco for fraud, alleging Bennett and other executives hid the debt to induce their investment.

Lack of Controls

Spokespeople for Bank of America, CSFB, Goldman Sachs and Thomas H. Lee declined to comment. Grant Thornton spokesman John Vita says the accounting firm told Refco that it lacked adequate financial controls before the brokerage went public.

In an era of high-profile corporate scandals, Refco's investment banks and auditors failed investors by not spotting the alleged fraud, says David Scott, a lawyer representing FrontPoint Financial Services Fund LP, a Greenwich, Connecticut- based hedge fund that owns 142,000 Refco shares.

FrontPoint is suing Refco's underwriters claiming they committed securities fraud by misrepresenting Refco's financial condition in the registration statement filed with the SEC.

``Given what happened with Enron and WorldCom, you'd think there would be a heightened sense of responsibility to make sure all the i's were dotted and t's crossed,'' Scott says.

If Refco's underwriters fail to prove they conducted adequate due diligence, they could face combined damages of as much as $2.7 billion, the market value lost after Refco disclosed the hidden debt, says Michael Perino, a securities law professor at St. John's University in New York.

Odd Man Out

Bennett, a numbers man who spent his days poring over spreadsheets in his 23rd-floor office in the World Financial Center in lower Manhattan, didn't fit in with the traders, brokers and salesmen at the heart of Refco.

As CEO, he seldom ventured onto the trading floors to slap backs or socialize, says Bradley Reifler, who joined Refco in 1982, a year after Bennett, and rose to become head of institutional sales and trading before leaving the firm in 2000.

``He hated salesmen; they were a necessary evil,'' says Reifler, 46, now CEO of Pali Capital Inc., a New York-based securities brokerage.

Reifler, Friedman's grandson, says he walked into Bennett's office one day to find Bennett crawling around on the floor, as if he were looking for a contact lens.

``What are you doing?'' Reifler says he asked Bennett.

``I'm looking for your customers, Brad,'' Bennett replied, according to Reifler.

Co-Founder Convicted

Bennett wasn't the first maverick to run Refco. Friedman, the firm's co-founder, was a felon. In 1955, Friedman, then a poultry wholesaler, was convicted of conspiracy to defraud the government by making false statements, according to U.S. Justice Department records. He drew a five-year prison sentence. Friedman served two years before he was paroled.

In 1966, he was pardoned by U.S. President Lyndon Johnson, according to government records. Three years later, Friedman and his stepson, Thomas Dittmer, opened Ray Friedman & Co., a commodities trading firm in Chicago.

In the trading pits of the Merc and the Board of Trade, Friedman and Dittmer soon developed a reputation for making high- stakes bets. They traded for themselves as well as for clients. When Dittmer made a killing, he flew his friends to Las Vegas to celebrate, says Martin Mayer, who wrote about Refco in his book ``Markets: Who Plays, Who Risks, Who Gains, Who Loses'' (W.W. Norton, 1988).

`Wing and a Prayer'

``They took big net positions and held on for the ride,'' says Richard Dennis, a fellow Chicago commodities trader who's now based in New York. ``It was outright speculation on a wing and a prayer.''

Friedman and Dittmer didn't always play by the rules. In 1983, the CFTC fined Dittmer $150,000 and the firm, by that time called Refco, $375,000 for violating trading limits designed to prevent people from cornering markets. That year, Friedman retired to Palm Beach, Florida, but he kept trading through his old firm. In 1992, the CFTC fined Refco $440,000 and Friedman $150,000 for breaking trading limits on pork belly futures.

Friedman died in 2004, at the age of 91. Dittmer, 63, stepped down as chairman of Refco in 1999 and retreated to the U.S. Virgin Islands. He didn't return telephone calls.

``They were market roughnecks, even by Chicago standards,'' Mayer says of the pair.

Cambridge Degree

It was into this milieu that Phillip Roger Bennett stepped in 1981, at the age of 33. After graduating from Cambridge with a degree in geography, Bennett had spent the 1970s in the commodity and commercial lending departments of Chase Manhattan Corp., working in New York, Toronto, Brussels and London.

As a credit and lending officer, he arranged loans for commodities investors. Unlike Friedman and Dittmer, Bennett was no trader. What he brought to the firm was a decade of experience bankrolling traders.

It was a valuable skill at Refco. Futures brokerages operate in a world of razor-thin profit margins. In fiscal 2005, for example, Refco financial statements put the firm's profit margin at 2.8 percent. Goldman Sachs, by comparison, reported a margin of about 22 percent in its most recent fiscal year. To stoke revenue and profit, Refco needed to find a way to encourage its customers to make bigger trades and thereby generate more commissions for the firm.

`Like a Used-Car Dealer'

That's where Bennett came in. In 1982, the year after he joined Refco, Bennett established Refco Capital, a customer finance unit. Extending credit to clients was a vital step toward increasing trading volume and thus profit, says Sol Waksman, president of Barclay Group, a research firm in Fairfield, Iowa.

At times, Refco was so eager to fatten its profit margins that Bennett's unit staked millions of dollars on traders with poor credit histories, a Refco broker says.

``Refco was like a used-car dealer: no money down, no credit, no problem,'' says the broker, who asked not to be named because he still works for the firm.

Bennett and Grant, who had also joined Refco in 1981, began transforming Refco from a firm that focused on trading for itself to one that executed transactions for clients, Mayer says. Bennett extended credit to those new customers to encourage them to trade.

``All I know is that I went to the bathroom one day, and when I came back, Tone and Phil had turned the whole business around,'' Mayer quoted Dittmer as saying in his book.

Dubai Client

Bennett's plan for Refco didn't always go smoothly. In January 1992, Eastern Trading Co., one of the largest gold and silver bullion traders in Dubai, opened a new account with Refco.

Bennett and Grant had traveled to Dubai in the early 1980s and met personally with Mohammad Ashraf-Mohammad Amin, the firm's founder, and his four sons, who were the firm's partners, according to a lawsuit that Eastern Trading later filed against Refco in 1997, after the relationship soured. Eastern Trading told Refco that it wanted to trade futures and options to hedge against price swings in precious metals.

In 1995, Zahid Ashraf, the firm's managing partner in charge of commodity trading, started using the Refco account to place speculative currency trades with Eastern's capital, according to an opinion summarizing the facts in the case written by a three- judge panel in the U.S. Seventh Circuit Court of Appeals in Chicago.

In March 1995, Zahid lost $22 million in three days on the British pound and other currencies.

`Much Larger Commissions'

``But as the increase in scale translated into much larger commissions for Refco, and Eastern was a substantial and reputable firm and Zahid its managing partner, Refco was content,'' U.S. Circuit Court Judge Richard Posner wrote for the appeals court on Oct. 10, 2000.

Posner, 66, is a senior lecturer in law at the University of Chicago and the author of books on subjects ranging from his specialty, law and economics, to intelligence reform and the Clinton impeachment.

By 1996, Zahid's losses were so steep that the Refco account no longer had enough money to secure Eastern Trading's credit line. Even so, Refco Capital continued to lend Zahid money to trade, according to the opinion.

From April to July 1996, the face value of Zahid's sterling futures and options trades ballooned to $4 billion. Finally, in July 1996, Refco liquidated Eastern Trading's account and recorded a debit balance of $28 million.

Undisclosed Loss

Rather than book that $28 million as a loss, Refco Capital shifted its own money into Eastern's depleted account, without the Dubai firm's knowledge, according to the opinion. Bennett's firm asked Eastern to write a promissory note committing the Dubai firm to repaying that sum to Refco. That way Refco wouldn't have to disclose the loss to the CFTC in its capital requirement reports.

Eastern Trading sued Refco in 1997, accusing the brokerage of fraud for not stopping Zahid or alerting it to his losses. In February 1999, a federal jury in Chicago ruled that Eastern was responsible for Zahid's money-losing trades and ordered the Dubai firm to pay Refco $14 million, the balance on the promissory note. Eastern appealed, and the Seventh Circuit upheld the verdict.

Commenting on Refco Capital's move to hide Eastern Trading's debit from regulators, Judge Posner wrote: ``Although the rigmarole may have been for the disreputable purpose of fooling the Commodity Futures Trading Commission, we do not think an appropriate sanction is a forfeiture of Refco's valid claim and a windfall to its defaulting customer.''

Bleeding Money

As Zahid's losses ballooned, trouble was brewing elsewhere at Refco. Goldinger, the Beverly Hills money manager, had also started trading through the brokerage. He, too, was bleeding money, this time on bets on U.S. Treasury futures on the Chicago Board of Trade. In 1995, Goldinger's firm, Capital Insight Brokerage Inc., lost $100 million on bad wagers on interest rates.

To prop up Capital Insights, Goldinger, now 52, embarked on a Ponzi-like scheme, according to SEC and CFTC enforcement records. He shifted any trading profits to the accounts of clients who asked for their money back while shunting losses to accounts that seemed dormant.

To do that, Goldinger directed a Refco broker, Constantine Mitsopoulos, to assign winning and losing trades to specific accounts after the close of trading each day. In one account, Goldinger recorded losses for four months straight and then recorded profits for two months in a row before the account was closed, according to CFTC enforcement records.

Without admitting or denying guilt, Refco paid a $6 million fine to the CFTC to settle the case in May 1999. Goldinger eventually pleaded guilty to fraud and served a year in a halfway house. Without admitting or denying guilt, Mitsopoulos paid a $1 million fine to the CFTC for record-keeping violations.

Food on Foot

Goldinger now runs a charity in Los Angeles called Food on Foot that feeds the homeless. In 2002, he received a Point of Light community service award from U.S. President George W. Bush. ``I didn't go out in style,'' Goldinger says. He declined to comment further on his case.

While Goldinger no longer follows the markets, he says he has learned of Refco's demise. ``I saw the headlines,'' he says. ``It's a sad day when anything like that happens.''

Theodore Eppenstein, a New York lawyer who sued Goldinger and Refco and recovered $46 million for 13 defrauded investors, says the Goldinger case shows Refco was willing to break the rules to keep a lucrative client like Goldinger, who generated more than $10 million in commissions annually.

``Goldinger was playing God,'' Eppenstein, 59, says of the scam. The best way to protect investors in a case such as this would have been for regulators to terminate the offending broker's trading privileges, he says. That didn't happen.

`Just Pay the Fine'

``Fines and cease-and-desist orders won't make a dent in their pocketbooks or their cultures,'' Eppenstein says of the scandal-plagued firms.

A former regulator at a U.S. commodities exchange says Refco considered fines a cost of doing business. The attitude was, ``You got a problem with regulators? Just pay the fine, and move on,'' the ex-regulator says.

By the late 1990s, a new catastrophe was looming half a world away. In July 1997, Thailand let its currency, the baht, plunge, setting in motion a train of Asian currency devaluations that steamrolled not only Refco and its clients but banks around the world.

As Asian markets reeled, eight Refco customers lost more than $300 million, leaving the firm on the hook for those losses, according to a person familiar with an internal review that Refco conducted this past October, after Bennett's hidden debt came to light.

Bennett Takes Over

On Oct. 1, 1998, Dittmer named Bennett CEO. ``Phil brings to the job a bulletproof track record of sound decision making and a recognized financial stature,'' Dittmer said in a statement that day. Grant didn't return telephone calls seeking comment.

Bennett moved rapidly to burnish Refco's sullied image. In January 1999, he hired Dennis Klejna, who had served as the CFTC's director of enforcement from 1983 to 1995, as general counsel to police the firm. Bennett then hired Joseph Murphy from HSBC Futures Americas, a unit of London-based HSBC Holdings Plc, to run Refco LLC, the firm's regulated U.S. futures brokerage.

Klejna and Murphy wouldn't have tolerated the kind of rule breaking that had marked Refco's past, says Scott Early, general counsel at the CBOT from 1983 to 1994 and now in private practice at Foley & Lardner LLP in Chicago. ``Joe and Dennis were brought in with a clear mandate that this firm was going to be run in compliance with the law,'' Early says.

New Hires

Bennett's new hires pleased his regulators in Washington. ``People were hopeful that the company was getting the message and getting out of this cycle of running into regulatory problems every year,'' says Geoffrey Aronow, director of enforcement at the CFTC from 1995 to 1999 and now a lawyer at Heller Ehrman White & McAuliffe LLP in Washington.

With Klejna at his side, Bennett settled the Goldinger case, ending a four-year investigation. Klejna and Murphy both declined to comment.

Bennett also began hunting for new sources of capital to strengthen Refco. In 1999, he cemented an alliance with Vienna- based Bawag P.S.K. Bank, which is controlled by Austria's trade unions. Bawag bought 10 percent of Refco for an undisclosed sum.

Bennett was eager to show the futures industry that Refco was on solid ground. ``Getting that capital infusion was the first step in the process,'' says Cynthia Zeltwanger, CEO of Fimat USA. In 2004, Bawag sold its Refco stake for $220 million.

Acquisition Spree

Bennett also embarked on a series of acquisitions -- 16 in all -- that would eventually transform Refco into the largest independent U.S. futures brokerage and the fourth-largest in the world.

In January 2000, Refco bought Chicago-based Lind-Waldock & Co., the largest U.S. discount retail futures broker, for an undisclosed sum. In 2005, Refco spent $208 million to acquire Cargill Investor Services, the captive broker of the agricultural giant Cargill Inc., based in Wayzata, Minnesota. From 2000 to 2005, Refco's U.S. customer accounts almost doubled to $4.1 billion.

Bennett also pushed into overseas markets by acquiring Trafalgar Commodities Ltd., a London energy trading firm, for an undisclosed price, and MacFutures Ltd., a London firm that runs so-called electronic trading arcades, where traders are seated at machines rather than hollering at each other in a pit. In addition, Refco bought brokerages in India and Taiwan. By 2005, Bennett's firm had operations in 14 countries.

Refco and its CEO were on a roll, and brokers were eager to sign up.

`Like Winning the Lottery'

``I thought it was like winning the lottery,'' says Yovich, the grain trader, describing how he felt when he joined Refco in March 2005. ``The leads were real solid: Customers were calling us and saying, `Will you be my broker?'''

Soon Refco caught the attention of a deep-pocketed investor: $12 billion Thomas H. Lee Partners. The buyout firm, founded in 1974 by its namesake, is perhaps best known for its 1992 purchase of Snapple for $135 million. Lee sold that company two years later to Quaker Oats Co. for $1.7 billion.

Lee took a big gamble on Refco, and the bet made Bennett and Grant rich. The pair held 90 percent of Refco's equity in an affiliate they controlled, New York-based Refco Group Holdings Inc. Lee's firm paid $507 million in cash for a 57 percent stake in Refco and then transferred an additional $550 million in cash to Refco Group Holdings.

After the deal closed, Grant bowed out of the affiliate, leaving Bennett in sole control. As part of the deal, Refco issued $600 million of bonds due in 2012 and borrowed $800 million from a group of banks led by Bank of America, which would later help underwrite Refco's IPO.

Tension Mounted

``Everyone seeing that deal understood that an outfit like Lee wouldn't put that kind of money into a company like this without taking it apart and putting it back together again,'' says David Hardy, CEO of London-based LCH.Clearnet Ltd., Europe's No. 1 derivatives clearing house.

The deal with Lee soon propelled Refco toward an IPO, and tension mounted inside the firm, says Yovich, the Refco grain trader. Compliance officers scrutinized brokers to ensure they obeyed all the rules, no matter how technical, he says.

Yovich says he was reprimanded for sending his clients an e- mail that excerpted information from a commodity exchange's Web site. A compliance officer upbraided Yovich, saying his message might violate copyright laws.

``They were so anal and uptight about following everything to the letter before the IPO, but here was the CEO who was running a shell game with half a billion dollars,'' Yovich says.

IPO Clock Ticking

As the clock ticked down to a Big Board IPO, Bennett kept shuffling money through the firm's accounts, according to his indictment. Since 1999, Bennett had executed a series of transactions to make it appear that debt owed by Refco Group Holdings had been paid. In reality, the money to settle those debts came from Refco, prosecutors say.

Just six months before Refco went public, on Feb. 23, 2005, Refco Capital Markets, the Bermuda-based, unregulated brokerage, loaned $345 million to Liberty Corner Capital Strategy LLC, a hedge fund firm based in Summit, New Jersey, and a Refco customer.

The same day, Liberty Corner loaned the $345 million to Refco Group Holdings and pocketed $2.6 million in interest for its trouble. Refco Group Holdings then paid the money to its corporate parent, Refco Inc.

On Feb. 28, when the company's financial reporting period ended, it appeared that Refco Group Holdings' debt had been paid. On March 8, the loan was unwound and the $345 million debt was again owed by Refco Group Holdings. Bennett repeated a similar transaction in August, the month of the IPO, according to prosecutors.

Opening Bell

Liberty Corner, a Refco customer since 1999, was involved in the transactions 10 times from 2002 to 2005, says Kevin Marino, the hedge fund firm's lawyer. He says Liberty Corner had no knowledge that the loans were possibly illegal.

``The transactions proposed by Refco appeared to be perfectly legitimate,'' Marino says. Federal prosecutors haven't targeted Liberty as part of Bennett's criminal case, he says.

Refco's new shareholders were none the wiser. On Sept. 9, Bennett, flanked by NYSE CEO John Thain, Thomas H. Lee Partners Co-president Scott Schoen, Refco Capital Markets President Santo Maggio, Murphy and Klejna, rang the Big Board's opening bell. Initially priced at $22, Refco stock soared 25 percent on its first day of trading, on its way to a high of $30.12 on Sept. 7.

A month later, Refco began to fall apart. Refco controller Peter James, who'd been hired in August, made a startling discovery. Bennett and Refco Group Holdings were actually responsible for the debt.

Bennett Confronted

On Oct. 6, Refco's three-member audit committee, led by Ronald O'Kelley, CEO of Atlantic Coast Venture Investments Inc. in Naples, Florida, confronted Bennett, and he acknowledged the hidden debt, according to a lawsuit Bawag filed against Refco as part of the bankruptcy proceedings. The board demanded that Bennett pay the debt immediately and asked him to take a leave of absence.

That same day, Bennett asked Bawag, his old backer, to lend Refco Group Holdings $420 million as a ``financing proposal,'' according to Bawag's lawsuit.

The Austrian bank says that neither Bennett nor Refco said it wanted the loan to pay off the hidden $430 million debt. As collateral, Bennett pledged his 48 million shares of Refco stock, then valued at $1.2 billion, and he agreed to pay an 875,000 euro ($1.1 million) fee.

Bombshell News

The loan was wired into an account at Refco Capital Markets at 6 a.m. New York time on Monday, Oct. 10. Less than two hours later, Refco went public with its bombshell news. Over the next 24 hours, Refco customers began to bolt, according to a former Refco broker, who says he lost 40 percent of the capital he managed within two weeks.

By then, Refco had filed a Chapter 11 petition to restructure 23 units, including Bermuda-based Refco Capital Markets. Bawag sued Refco for fraud on Nov. 16, and, the next day, Bawag CEO Johann Zwettler said he would resign by the end of the year to minimize the damage to the Austrian bank.

As of Jan. 4, the value of the Refco shares that Bennett had pledged as collateral on the loan had plunged to about $20 million. London-based Man Group Plc, the world's largest publicly traded hedge fund firm, bought Refco's U.S.-licensed futures brokerage, Refco LLC, on Nov. 26 for $319 million in cash and assumed debt.

On Dec. 19, Refco appointed Harrison J. Goldin, the former New York City comptroller who served as a court-appointed examiner in the Enron Corp. bankruptcy case, as CEO.

`Slept Through'

Refco now joins the list of companies felled by financial scandals since Enron collapsed in December 2001. ``Enron was the wake-up call, but with Refco, the underwriters, the accounting firms, the company officers and the SEC all slept through the second alarm,'' Eppenstein says.

Bennett's travails have only just begun. Since his arrest, he has spent his days at his lawyer's midtown Manhattan office, helping construct his defense, his lawyer, Naftalis, said in court. No trial date has been set.

Bennett's freedom -- and the fortune he made at Refco -- now hang in the balance. If convicted, he could spend the rest of his life in prison, prosecutors say. The U.S. Attorney's Office is also seeking disgorgement of $700 million from Bennett.

Last August, Bennett was the billionaire king of Refco, standing in the vanguard of the $20 trillion futures industry. Now he's just another criminal defendant, left with countless hours to ponder his case and the downfall of his firm.

Greenwire

January 16, 2006 Monday

ENERGY MARKETS: With Enron down, banks, hedge funds line up to profit on trading


The energy trading industry is making a comeback after being crippled by the 2001 Enron scandal, analysts said last week. With energy markets being a high profit sector, investors are eager to get involved. That means banks and several hedge funds are hiring more energy traders. While Wall Street is usually fickle about its commitment to commodities trading, the huge profits earned by Goldman Sachs and Morgan Stanley inspired other banks to get into the game.

"The whole market is hot right now," said Justin Pearson, managing director of Human Capital, a search firm based in London for energy traders. "Everybody is talking about expansion." But with Enron's collapse still fresh on some people's minds, not everyone is supportive of the resurgence of energy trading by banks and hedge funds. "It is an effort by banks to move into the terrain that Enron abandoned in their bankruptcy," said Randall Dodd, director of the Financial Policy Forum, a nonprofit group in Washington that studies the regulation of financial markets. "This is moving that risk into our core financial infrastructure, so the consequence of a failure becomes even larger" (Alexei Barrionuevo, New York Times, Jan. 15). Calif. AG tells judge Sempra's proposed settlement worth much less than $2B California Attorney General Bill Lockyer (D) and the state's Department of Water Resources and the Electricity Oversight Board last week told a judge that Sempra Energy's proposed antitrust settlement was worth less than the nearly $2 billion value claimed by class-action attorneys who made the deal. Earlier this month, Sempra Energy agreed to pay more than $377 million in cash to settle a series of lawsuits relating to the company's role in the 2000-01 California energy crisis. Sempra, the parent company of San Diego Gas & Electric and Southern California Gas Co., continued to deny allegations it had conspired to limit natural gas supplies to raise prices prior to the crisis. In addition to the $377 million in cash paid over the next 10 years, Sempra will forfeit an additional $300 million in energy discounts to California customers over the next six years. Lawyers said said the settlement's value -- in cash paid and discounts on electricity and natural gas -- is as high as $1.9 billion. While the settlement does not eliminate all lawsuits against Sempra, it halted a San Diego trial that began in October in which Sempra risked being convicted of antitrust charges for conspiring (Greenwire, Jan. 5). "We're not hostile to a settlement. Ratepayer relief is always a good thing," William Kissinger, an attorney representing the water resources department, told Superior Court Judge Ronald Prager. "We wanted to bring to your attention some concerns we have about the way the settlement is being presented." California's lawyers and attorneys for utilities Pacific Gas & Electric Co. and Southern California Edison Co. said that a proposed public notice should be rewritten to reflect the possibility that the settlement would be worth much less than $1.7 billion. Attorney Pierce O'Donnell, who helped forge the settlement deal, dismissed the state's objections, saying that the notice, to be published in newspapers and magazines in the coming weeks, didn't have to include an "encyclopedic description" of the settlement's terms (Elizabeth Douglass, Los Angeles Times, Jan. 14). -- LK

· New York Times

January 15, 2006

Energy Trading, Post-Enron

By ALEXEI BARRIONUEVO

HOUSTON

FROM the windows of the trading floor at Centaurus Energy, you can see the glittering tower where Enron once had its headquarters with the crooked "E."

But this is no Enron. Created by John D. Arnold, Enron's former wunderkind trader of natural gas, Centaurus is part of a new breed of low-profile hedge funds that dabble in energy.

Enron, once the country's seventh-largest company, introduced its modern trading floor on national television and boasted of its ambition to be the world's leading energy company, only to collapse spectacularly in 2001 and set off a wave of investigations into corporate malfeasance.

Centaurus eschews most publicity and operates out of the eighth floor of a nondescript building near a highway, its glass doors tinted with light blue to prevent visitors from seeing what happens inside.

When Mr. Arnold, 31, created Centaurus in 2002 with $8 million of his own money, the energy trading industry was on its knees, incapacitated by the fraud and irrational exuberance at Enron. Since then, Centaurus has amassed $1.5 billion in assets under management and has hired big-name traders like Greg Whalley, a former Enron president.

The industry that Enron made infamous - energy trading - is springing to life again.

Volatile energy markets and record-high commodity prices are prompting renewed interest from investors eager to play in the sector. That has pushed banks and a growing number of hedge funds to hire more energy traders and brainy quantitative minds to back their bets on energy prices. In Houston, New York and London, a scramble for top trading talent has ensued that rivals the cutthroat hiring frenzy of the late 1990's.

"The whole market is hot right now," said Justin Pearson, managing director of Human Capital, a search firm based in London for energy traders. "Everybody is talking about expansion."

And helping to lead the industry's resurgence are traders from Enron like Mr. Arnold, who is not under any legal scrutiny, and those from other companies who lost their jobs after the 2001 blowup. Most have landed on their feet at banks, hedge funds or oil companies like BP and Chevron.

BUT with that revival come questions from some financial market analysts about whether energy trading will be better able to withstand another potential meltdown. While banks have stepped in with their superior balance sheets, credit ratings and trading skills to fill the liquidity void left by Enron, the latest ramp-up in trading has also been marked by an air of secrecy underscored by the proliferation of hundreds of hedge funds that are speculating on everything from crude oil to electricity in both regulated and unregulated markets. Many funds are being aided by investments from banks, which are also buying up distressed power plants and other remnants of the collapsed sector.

At least two funds suffered big losses last summer. And some industry officials question whether the funds are contributing to higher energy prices, or at least stoking more price volatility.

"The government can't assure the public that the over-the-counter market isn't being manipulated," said Randall Dodd, director of the Financial Policy Forum, a nonprofit group in Washington that studies the regulation of financial markets.

The resurgence of energy trading comes as investigations continue into the conduct of traders during the years when Enron ruled. Federal officials in Houston and San Francisco have charged 22 traders at six energy companies, including Enron, with crimes. So far, 12 have pleaded guilty or have been found guilty of trying to manipulate markets or falsely report trades to industry publications. The Commodity Futures Trading Commission, which regulates futures exchanges, has settled 30 cases with individual traders and energy companies accused of trading shenanigans, ordering a total of $298 million in civil penalties.

Traders at Enron were among those who took advantage of California's poorly constructed deregulation law and helped to bring about the state's energy crisis of 2000 and 2001. They concocted schemes to manipulate electricity markets and to maximize Enron's profit, using names like Fat Boy and Death Star to describe the strategies. Some bantered casually in 2000 about how they were "stealing" from California and sticking it to "Grandma Millie" by overcharging for power, according to audiotapes of their conversations that have been made public.

Ultimately, Enron's failure was not tied directly to the actions of traders, who made hundreds of millions of dollars for the company. But company traders were speculating on energy prices - despite the company's assurances to the contrary - and aggressive accounting of risky long-term energy contracts made Enron even more susceptible to a blowup.

The taint of scandal and shame can still be felt today in Houston. The days of excess, when young traders held sway at the steakhouses and nightclubs downtown, celebrating their trading success while California suffered, seem long gone.

"We don't really discuss what we do," Mr. Arnold said recently while standing on the Centaurus trading floor. "We're not like T. Boone," he added, referring to the legendary Texas oilman and commodities trader T. Boone Pickens, whose views on the natural gas market had just been broadcast on CNBC on a flat-screen television hanging above the trading floor.

While having little of Enron's braggadocio, Centaurus derives much of its strength from its collapse. More than half of the 17 traders at Centaurus once worked at the company.

After joining Enron out of college in 1995, Mr. Arnold was credited with booking $750 million in profits for Enron in 2001 by trading natural gas contracts. He was 26. He was rewarded with an $8 million bonus, the largest paid to any Enron employee in 2001.

But some rivals were skeptical about just how good a trader Mr. Arnold was. He has said that about $150 million of the $750 million in 2001 trading profit had resulted from his role as market maker in gas trades on Enron Online, the company's Internet trading platform. Some traders have said that Enron Online was dominant enough to enable Enron to set market prices. And, they add, his big 2001 followed a rocky 2000 in which he lost more than $200 million.

Few doubt his trading abilities these days. Mr. Arnold started Centaurus in August 2002 with three employees trading out of a single large room with a kitchen. Today, the company employs 36 people, including a full-time meteorologist. It has been closed to new investment for two years. "He is in a league of his own," said Peter C. Fusaro, co-founder of the Energy Hedge Fund Center, an online information center created last year to monitor the sector.

"He went out and proved everybody wrong," said Jim Schwieger, a former natural gas trader at Enron.

Even as Mr. Arnold has become wealthier, he has tried to remain low-key. But last year he attracted some unwanted attention when he demolished a historic home in the stately River Oaks section of Houston. Preservationists bemoaned the loss of the 77-year-old property, known as Dogwoods, valued with its land at $4.9 million, saying that Mr. Arnold acted insensitively. He declined to discuss the situation; a new home is being built there.

MOST of the energy traders who lost their jobs have found banks and hedge funds eager to hire them during the industry rebound. Mr. Schwieger, 52, spent 23 years at Enron and was laid off shortly after publicly criticizing Kenneth L. Lay, then Enron's chief executive, at an employee meeting in October 2001, shortly before the company imploded; Mr. Lay is scheduled to stand trial on fraud and conspiracy charges later this month. Last June, Mr. Schwieger joined Citigroup's growing energy trading team in Houston.

Vincent J. Kaminski, the former managing director of research at Enron - who warned his superiors at Enron of dangers the company faced - heads a team of quantitative gurus supporting Citigroup's traders.

Wall Street banks are notoriously fickle about their commitment to commodities trading. But the eye-popping profits earned by the market leaders, Goldman Sachs and Morgan Stanley, have spurred other banks to get into the game. In 2004, Goldman and Morgan Stanley earned about $2.6 billion combined from commodities trading, most of that from energy, according to Sanford C. Bernstein & Company in New York.

Even UBS, the Swiss bank that inherited 600 employees from Enron's former trading operation in Houston but whittled down that number to just 70, has revived its interest in building a stronger trading team and is hiring again.

In February 2002, shortly after Enron declared bankruptcy, UBS took over Enron's natural gas and power trading operation and Enron Online. With little volatility to trade around, UBS started firing traders and switched off the Internet trading platform. By May 2003, it had closed the Houston operation, which was in Enron's new tower across the street from its former headquarters, and moved the remaining traders back to its trading base in Stamford, Conn.

Today, the 40-story tower where Enron's traders worked briefly is owned and occupied by Chevron. What had been a sixth-floor trading room the size of a city block is now filled with exploration and production geologists and geophysicists working in earth-tone cubicles, said Mickey Driver, a spokesman for Chevron. The oil company has its own energy traders scattered on other floors.

Even as UBS has started to build its trading business again, it has been bitten by a furious wave of poaching. Last summer, Louise Kitchen, a former trader at Enron who helped to create Enron Online, bolted from UBS to Deutsche Bank, where she joined Mark Ritter, her former boss at UBS's Houston operation, who left in May. The new hedge funds are sucking scarce talent away from the banks. At least 450 hedge funds with an estimated $60 billion in assets are focused on energy and the environment, including 200 devoted exclusively to various energy strategies, according to Mr. Fusaro of the Energy Hedge Fund Center. New funds arrive on the scene with barely a whisper, without brochures or Web sites. In London, hedge funds are quietly sprouting up in Mayfair town houses, Mr. Fusaro said.

Investors in some hedge funds continue to be dazzled by annual returns of close to 100 percent. That is far better than the best exchange-traded funds - Energy Select Spyder and Vanguard Energy Vipers, which returned 35 percent in the first nine months of 2005 - and natural-resources mutual funds, which averaged a 31 percent return in the same period last year.

But not all hedge funds are stars, or even on par with exchange-traded or mutual funds. A sampling of 30 hedge funds by the Energy Hedge Fund Center, for example, showed an average return of 25 percent in 2004 and only 9 percent in the first nine months of 2005 - far worse than the average for mutual funds, which tend to charge much smaller fees and take smaller risks.

With higher returns comes bigger risk-taking, and some firms have taken a bath recently. Two hedge funds in the Chicago area suffered big losses last summer largely from wrong bets on energy commodities like natural gas; prices rose strongly in the fall as demand strengthened and Hurricanes Katrina and Rita disrupted supplies from the Gulf of Mexico.

One of the funds, Citadel Investment Group, lost at least $150 million and the other, Ritchie Capital Management, more than $100 million. Citadel's head of energy trading, Scott Rose, resigned in September. Despite the losses, Citadel's "energy business has rebounded strongly in the fourth quarter," the company said in a statement. Justin Meise, a Ritchie spokesman, declined to comment. Some lawmakers and consultants argue that the government has done little to shore up the energy markets most susceptible to manipulation. The Federal Reserve relaxed rules in 2003 so that commercial banks like Citigroup could take possession of physical commodities like oil in storage tanks, something that broker-dealers like Goldman and Merrill Lynch could already do. The move allowed the banks to serve as dealers in commodities derivatives, financial contracts whose value fluctuates according to the price of an underlying commodity like oil or electrical power.

"It is an effort by banks to move into the terrain that Enron abandoned in their bankruptcy," said Mr. Dodd, the director of the Financial Policy Forum. "This is moving that risk into our core financial infrastructure, so the consequence of a failure becomes even larger."

As early as October 2002, less than a year after Enron declared bankruptcy, the Commodity Futures Trading Commission started to write rules exempting commodities hedge funds from regulatory oversight. Some in Congress, including Senator Dianne Feinstein, Democrat of California, have expressed concern about the potential for manipulation in the over-the-counter derivative markets. But efforts to bring more scrutiny have failed, with the likes of Alan Greenspan, the departing Federal Reserve chairman, arguing against regulation. Mr. Greenspan has contended that hedge funds add liquidity to the market.

A debate continues to rage about whether hedge funds are contributing to higher energy prices.

The funds are borrowing as much as 10 times what they invest in some trades, analysts and traders say, contributing to short-term volatility that has complicated the energy purchases of many large energy users.

"There's a tremendous amount of fear and frustration out there," said Arthur Gelber, president of Gelber & Associates, an energy consulting and advisory firm in Houston that manages the energy purchases for some 20 utilities and chemical companies.

Dennis Knautz, the chief executive of Acme Brick, a company in Fort Worth that makes bricks for residential construction, said that excessive trading by hedge funds is artificially pushing up prices for natural gas and making it tough to hedge his energy costs, which make up as much as 40 percent of the company's manufacturing costs.

STUDIES by the New York Mercantile Exchange and the Commodity Futures Trading Commission have disputed the notion that hedge funds are having an undue influence on pricing or volatility. Mr. Fusaro and many traders have scoffed at the studies, saying that they focused only on certain months, missing price run-ups. Hedge funds and other accounts are holding 47 percent of open futures contracts on the New York Mercantile Exchange, up from about 20 percent in 2004.

Mr. Arnold, for his part, said he has not "seen any correlation between the increased hedge fund participation and volatility." In general, he said, "the more market participation and liquidity, the more efficient and less volatile a market is."

But the soaring price changes have made some veteran traders nervous. "The intra-day volatility is just huge," Mr. Schwieger said. "When I was at Enron, it was nothing to be 2,000 contracts long or 2,000 contracts short. Now I would be terrified to be 500 long or short. Because that means I could lose $5 million. That terrifies me."

There is one conclusion that few would challenge: hedge funds are driving up the price for top trading talent. Bonuses were up 50 percent, on average, in 2005 for traders, compensation specialists say, and banks were paying traders as much as $5 million in total compensation, with top traders at trading houses making more than twice that much.

The scramble is so intense that some firms have been paying bonuses months in advance and guaranteeing two years of bonuses regardless of whether the traders actually deliver profits, Mr. Pearson said.

Traders like Mr. Arnold can earn well more than $10 million a year, compensation specialists say. Hedge funds typically offer top traders a management fee of up to 2 percent of assets and a "performance fee," generally a 20 percent cut of profits, to operate a fund. Mr. Arnold declined to discuss his compensation.

Younger traders, especially, are lured to hedge funds by the casual work environment and the chance to make money on their own. Mr. Arnold was offered a chance to go to UBS and was approached by other banks, but he decided to start Centaurus instead. "I liked the idea of being able to shape an organization as I saw fit," Mr. Arnold said, "rather than wrestling with an entrenched bureaucracy."

At National Energy Trading, a small hedge fund founded in Houston in early 2004 by Michael Whalen, a former natural gas trader at Mirant and Cinergy, the atmosphere was übercasual on a recent trading day. Mr. Whalen, in jeans and a long-sleeved purple T-shirt, sat in front of four computer screens. He bantered calmly on a microphone with brokers in New York, Houston and Louisville, Ky., while trading instant messages with more than a dozen other brokers. Gift baskets filled with wine and Champagne and a football were scattered on the floor.

"I would take this any day," said Mr. Whalen, 35, adding that there was "no politics" and "no bonus time."

"We trade for ourselves," he said.

But the past is never too far behind for some energy traders. Even as he builds his fund, Mr. Whalen has yet to resolve charges from the futures trading commission that he reported false trades and tried to manipulate natural gas markets in 2000 and 2001. He declined to comment about the case.

Some traders accused of improprieties have been forced to sell their homes and cars and have sunk into depression.

"These are regular folks who found a niche and were good at it, and it blew up on them," said George S. Glass, a psychiatrist in Houston who is treating a few traders currently under legal scrutiny. "They feel singled out" for what they considered "normal practice at the time in their industry," Dr. Glass added. "They will probably always believe that."

Simon Romero contributed reporting from Houston for this article.

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