ISDA PRESS REPORT - APRIL 30, 2001

ISDA PRESS REPORT - APRIL 30, 2001

Liquidity & The ISDA Master Agreement - Derivatives Week
Deregulation fails to deliver - Financial Times
Merchant Banking Capital Proposal Draws a Chorus of Industry Criticism - BNA
Euro swap spreads seen sideways, U.S. to narrow - Reuters
Fed's Greenspan's speech to Bond Market Assn - Reuters
Enron Offers Structured Weather Note - Derivatives Week

Liquidity & The ISDA Master Agreement
Derivatives Week - April 30, 2001

Ensuring liquidity should be the primary goal in negotiating an ISDA Master
Agreement (the "Agreement") for smaller, non-rated customers, such as a
hedge fund or a middle-market corporation. Often highly leveraged and with
little room for error, these customers should focus their efforts when
negotiating the Agreement with a dealer on limiting the dealer's opportunity
to terminate the Agreement. Unfortunately, however, customers (typically
through expensive outside counsel), often instead use up valuable
negotiating capital on esoteric legal issues that may only remotely affect a
customer's situation.

A dealer typically wants the right to terminate the Agreement at the first
sign of its customer's economic difficulties, such as a cross default or a
decline in the customer's net worth. Because of the fluctuating nature of
derivatives, a dealer wants to quickly terminate any growing exposure from
outstanding transactions as its customer's credit deteriorates. Early
termination of its Agreement with the dealer, however, may only further a
customer's growing liquidity crisis.

Upon early termination, a customer that is out-of-the-money on its trades
with the dealer may end up having to make large termination payments.
Depending on its agreements with other dealers, an early termination could
possibly give other dealers the right to terminate their agreements with the
customer. Even if the customer is in the money, it may not be able to
replace important terminated hedging transactions. Termination of the
Agreement may be the beginning of the end for a customer in economic
difficulty.

Cross Default

One of the most important signs of a customer's financial deterioration for
a dealer is the occurrence of a cross default by the customer with one of
its other creditors. Under the Agreement, a cross default takes place upon
the occurrence or existence of an event of default with respect to
"specified indebtedness". For the provision to apply, however, the parties
must affirmatively elect for the cross default provision to apply to either
or both parties.

The parties must also agree on the definition of specified indebtedness.
Specified indebtedness is defined in the Agreement to be "any obligation
(whether present or future, contingent or otherwise, as principal or surety
or otherwise) in respect of borrowed money." Dealers often will want to
expand the definition beyond the concept of "borrowed money" to include
obligations under other types of financial transactions, such as forwards,
repurchase agreements, securities lending agreements, or even exchange
derivatives such as futures and options. Dealers may even try to define it
to include any contractual obligations of the customer. The broader the
definition of specified indebtedness, the more likely that a cross default
will occur to the customer.

In addition, many of the new types of obligations added to the definition of
specified indebtedness, such as repos, are prone to technical defaults.
Although these technical defaults are generally cured or waived in the
ordinary course of business, they could provide an aggressive dealer with an
opportunity to terminate the Agreement upon their occurrence.

The parties must also agree on appropriate cross default thresholds. This is
the amount that a default must exceed before it will constitute a cross
default. Although the dealer will want a threshold of 2-3% of its equity for
itself, it will insist on a more modest number for the customer ranging from
$0-20 million. The smaller the threshold, the more likely that a cross
default will occur to the customer.

In addition, as with all cross default provisions, the customer should be
careful that the agreed upon threshold amount not be lower than its cross
default threshold in its other finance agreements. For example, if the
threshold were lower in the Agreement than the threshold under its loan
agreement, a small payment default on specified indebtedness might trigger
the cross default under the Agreement, which in turn might inadvertently
trigger the cross default under its other finance agreements.

A customer should insist that a cross default only occur upon the "cross
acceleration" of the other indebtedness, as opposed to merely the existence
of a default. Under the standard cross default language in the Agreement, an
event of default can occur upon a default under other indebtedness,
irrespective of whether the other creditor accelerates the specified
indebtedness. By requiring that the default result in an acceleration of the
underlying indebtedness, a dealer would not be able to terminate the
Agreement until the other creditor actually accelerated the specified
indebtedness.

Dealers generally resist a cross acceleration requirement because it limits
their ability to concurrently negotiate with its customer during any
work-out discussions the customer might be having with another lender. For
example, a creditor could persuade the customer to pledge additional
collateral in exchange for not accelerating the indebtedness. If the dealer
could not declare a cross default under the Agreement at that same time, it
would not be able to negotiate the same terms with the customer as did the
other customer's creditors.

Credit Event Upon Merger

A "credit event upon merger" is a termination event under the Agreement. It
occurs if a party participates in a merger (or enters into a similar type of
transaction) and the resulting entity is "materially weaker" after the
event. The rationale for the provision is that a party may not have entered
into the Agreement with the customer that is now materially weaker because
of a merger. Like the cross default, the parties must elect for the credit
event upon merger to apply.

Unfortunately, the term "materially weaker" is not defined in the Agreement.
The dealer may attempt to define an objective test that would measure when
the resulting entity becomes materially weaker. For example, the resulting
entity would be considered materially weaker if its credit rating were
materially affected or if it failed designated financial covenants.

The parties may also want to expand what is meant by a credit event upon
merger. The dealer may suggest that recapitalizations through the issuance
of new forms of stock or debt would constitute a credit event upon merger. A
customer may want to resist such a definitional change because of the
potential restrictions it could pose on its ability to change its capital
structure. The occurrence of such a change in its capitalization, however,
would still require the resulting entity to be materially weaker to
constitute a termination event.

Additional Termination Events

A dealer may insist on adding "additional termination events." Additional
termination events are generally treated under the Agreement similar to
events of default. If an additional termination event has occurred with
respect to a party, that party is referred to as the "affected party." Upon
the occurrence of such an event, the dealer would have the right to
terminate the Agreement at a time precisely when the customer most needs to
maintain its liquidity.

The most common additional termination events negotiated are those that
result from a change in the financial condition of the affected party. This
could be triggered by a credit downgrading or by the failure to maintain a
certain level of capital or net worth, or a failure to maintain certain
financial ratios.

An additional termination event could also result from a problem unique to
the counterparty such as the failure of an Affected Party to maintain a
certain legal or regulatory status. Failure to notify the non-affected party
of certain events or to deliver certain information could also be an
additional termination event. Finally, if the affected party is dependant on
the leadership or direction of certain individuals, the resignation or death
of such individuals could also result in early termination.

Son of First Method

Designating "first method" as a method for determining damages upon the
termination of the Agreement has become obsolete. The effect of first method
was to deprive the defaulting party of any payments upon the termination of
the Agreement in the event that the defaulting party was "in the money".
Now, however, dealers are often insisting on the right to delay making
payments to a customer upon an early termination of the Agreement until the
dealer is completely satisfied that the defaulting party has no further
payment obligations to it, something that could takes days or even weeks to
resolve.

Delaying payments on an early termination date, however, can result in
significant liquidity problems for a customer. Upon an early termination of
the Agreement, if the customer is in the money, it is probable that a
customer may be counting on the dealer's payment in order to meet any
obligations it has on the early termination date to other parties. If such
payments were withheld by the dealer, the customer would be unable to use
such amounts to meet its obligations with other counterparties, perhaps
triggering additional defaults under other agreements for the customer.

Limiting Cure Periods

The Agreement was drafted by ISDA with cure periods much more liberal than
may be typically seen in other finance contracts due to what drafters viewed
as the unique characteristics of the OTC derivatives market. Dealers,
however, have begun to limit these cure periods. For example, instead of
permitting a customer three business days to cure a payment default, the
dealers are narrowing it to one. Similarly, dealers are requesting only a
five-day cure period for breach of certain other provisions while the
agreement normally provides for 30. Narrowing of such cure periods may not
be in a customer's best interest. These more limited cure periods are
probably not sufficiently long for a customer experiencing economic
difficulties to resolve the underlying defaults.

Although there are numerous legal issues affecting the ISDA Master Agreement
that are negotiated, the most probable issues that may affect a smaller
customer deal with terminating the agreement upon the occurrence of some
financial difficulty. Because of that, the customer should focus its efforts
on limiting as much as possible these early termination opportunities.

Deregulation fails to deliver
Financial Times - April 30, 2001
By Geoff Dyer

The lights are not blazing at the presidential palace in the Brasilia
night-time as they once did. It is not because the staff are taking it easy,
however. The economy measure is aimed simply at saving energy. This is more
than just a symbolic gesture. Since the beginning of April, all government
offices, from that of the lowest bureaucrat to huge those in state-owned
corporations, have been under orders to cut energy consumption by 10 per
cent.

Private sector companies and ordinary households are also being urged to
trim their energy usage, before the lights go out involuntarily.

The saving measures are Brazil's last-ditch attempt to stave off a
full-blown energy crisis, and has prompted many comparisons with the partial
deregulation disaster in California. Yet, even with these cutbacks,
ministers have already admitted that Brazil will need some form of energy
rationing later in the year to avoid the risk of serious blackouts.

The official culprit for the energy shortage is the weather. Patchy rainfall
has left the reservoirs in the industrialised south-east of the country only
a third full, when they should normally be at half their capacity at this
time of year. Given that more than 90 per cent of Brazil's energy comes from
hydro-electric plants, this presents a serious problem.

Behind the unreliable weather, however, lies a generation of
under-investment. The debt crisis in the early 1980s cut off foreign
financing for the sector, while the fiscal problems that came with rampant
inflation in the late 1980s and early 1990s constrained the state's ability
to invest.

Liberalisation and privatisation during the past six years have not resolved
the problem. In the period 1995 to 1999, according to the National
Development Bank (BNDES), growth in generating capacity was 3.4 per cent a
year, while electricity consumption expanded annually by 4.4 per cent.

Like California, the deregulation of the Brazilian energy sector has been a
half-way house that has pleased neither supporters or critics. While most of
the electricity distribution companies have been sold off to the likes of
AES of the US and Spain's Endesa, the bulk of generation capacity - where
most of the new investment is needed - remains in public hands.

Political disputes have led to the persistent postponement of plans to sell
Furnas in the south-east and Chesf in the north-east. Meanwhile, the
government's fiscal austerity drive - agreed with and painstakingly
monitored by the International Monetary Fund - has tied its hands from
making the necessary new investments.

The regulatory environment has also been heavily criticised. The government
had been hoping to encourage a boom in gas-powered plants, especially using
the Bolivia-Brazil gas pipeline, which was opened in 1999. However, the new
thermal plants have come on stream more slowly than expected, partly because
would-be investors were worried about having to pay for the gas in dollars,
while their revenues would be in reals.

Neither has the government induced the investments in transmission networks
that might have alleviated the situation. The south of the country has
actually experienced normal rainfall this year. However, as Sandra Boente,
an analyst with Salomon Smith Barney, noted in a recent report:
"Unfortunately, there is not enough transmission capacity to shift that
excess power supply to the consumption centres in the south-east."

At least businesses cannot claim to have been surprised by the potential
energy crisis. Industry groups have been warning their members for several
years not to believe government pledges that there would be no rationing.

As a result, a some companies have invested heavily to create their own
generation facilities. Ambev, the largest brewer in Latin America, is
spending RDollars 60m on 10 different gas-fired power plants at its
factories with a total capacity of 61MW which it hopes to have in operation
by the end of next year. The plants will cover two-thirds of its energy
needs and also save up to 20 per cent on its production costs.

Another government tactic has been to lean on Petrobras, the state-owned oil
and gas giant, to take part in more thermo-electric plant projects. The
company has been authorised to invest in a further two plants, with capacity
of more than 1,000MW which takes the total number of plants in which it is
involved to 12.

Yet, it is Petrobras which has also contributed to the growing sense of
unease about both the country's energy sector and the government's
liberalisation policies. The sinking of the world's largest offshore oil
production platform off the coast of Rio de Janeiro in March was a huge blow
to national self-esteem. President Fernando Henrique Cardoso described the
event as "our Challenger", in a reference to the explosion of the US space
shuttle.

The accident followed a string of environmental disasters at Petrobras
operations, including a massive oil spill in Rio's Guanabara Bay which
endangered some of the city's beaches. And while the oil rig was staffed by
employees of the company, many of the accidents have occurred at facilities
where the operations have been outsourced to third-party companies.

In the public eye, at least, the result has been to tarnish the deregulation
of the sector, which has seen Petrobras lose its monopoly on exploration and
production of oil and a new management team try to make the company more
transparent and efficient.

The new-look Petrobras has been winning supporters among the financial
community, however, with record profits last year of RDollars 9.94bn - the
largest ever by a Brazilian company. These stemmed not just from the high
oil price but also from streamlined operations and increased production.

Merchant Banking Capital Proposal Draws a Chorus of Industry Criticism
BNA - April 30, 2001
By Richard Cowden

After opposing a March 2000 proposal to impose 50 percent capital charges on
merchant banking activities, several banking organizations now are making
the case that such charges are unnecessary altogether, according to comment
letters on a new proposal.

The Federal Reserve Board and the Office of the Comptroller of the Currency
Jan. 22 jointly issued the proposal to establish a rule governing capital
requirements for merchant banking activities approved by the 1999
Gramm-Leach-Bliley Act.

Under the agencies' proposed sliding scale, a financial holding company
making equity investments in nonfinancial companies that account for less
than 15 percent of its Tier I capital would be subject to an 8 percent
capital charge on such investment. Certain exceptions would include
investments made through a small business investment company.

An FHC investing between 15 and 25 percent of its Tier 1 capital in
nonfinancial companies would be subject to a 12 percent capital charge, and
an FHC making such investments accounting for more than 25 percent of its
Tier 1 capital would be assessed a 25 percent capital charge (15 DER A-19,
1/23/01).

Signaling their low expectations that they can fend off a sliding scale of
capital requirements in the proposal, many respondents addressed their
remarks to limiting the eventual rule's impact on existing investment
banking activities. The proposal asked for comments on whether certain kinds
of investments made prior to the March 13, 2000, the date of the original
proposal should be exempted from the rule.

Writing for the Securities Industry Association, James E. Reilly, chairman
of its holding company committee, said his organization "continues to
believe that the Agencies should allow firms to rely fully on internal
capital allocation models to control the risks of nonfinancial investment
activities." In the SIA's view regulators' concerns about the reliability of
such models "can be addressed through supervision and examination, as is
currently done in connection with capital allocation for market risk."

Richard Whiting, executive director and general counsel of the Financial
Services Roundtable, echoed that theme. In his comment letter, he wrote that
the January proposal "presents an unnecessarily burdensome array of
restrictions that are neither mandated by safety and soundness, nor in
keeping with the language or spirit of the Gramm-Leach-Bliley Act."

Whiting emphasized that the proposed capital requirement was not
contemplated by lawmakers when they enacted the GLB Act. "The Roundtable
believes that, more than any other provision of the GLB Act, the merchant
banking restrictions in both proposed and final rules have impeded non-bank
firms from becoming FHCs (financial holding companies)," Whiting said. "In
evaluating the merchant banking rules, it is important to note that neither
the traditional securities industry, nor the venture capital and private
equity investment industries, seem to have overcome their aversion to FHC
status under the GLB Act."

That comment reflected the sentiments of many in the financial services
sector that the capital rules will undercut the benefit of winning
permission for depository institutions to participate in merchant banking,
one of the centerpiece provisions of the GLB Act. Beth Climo, executive
director of the American Bankers Association Securities Association, wrote
in a comment letter that her group "remains concerned that any special
capital charge assessed against FHCs engaged in merchant banking activities
will further exacerbate the inequities between FHCs and non-FHCs engaged in
merchant banking activities."

Federal regulators have acknowledged the industry's concerns in this regard.
In his April 4 testimony before two subcommittees of the House Committee on
Financial Services, Federal Reserve Governor Laurence H. Meyer said the
proposed capital requirements would be a "bridge" to an eventual approach
that would use the FHCs' internal models.

Reilly wrote, "SIA recommends that if ... the Agencies determine to adopt
their capital proposal, the final rule should contain a 'sunset' provision
or, at minimum, a specific date by which the Agencies will formally
re-examine and re-evaluate the need for the capital haircuts."

Exemptions for SBICs

The capital proposal would exempt FHC investments in Small Business
Investment Companies up to 15 percent of Tier 1 capital. SBICs are licensed
and regulated by the Small Business Administration and provide equity
financing, long-term credit and technical support to small companies.
Despite this special exception, the proposed rule would include investments
in an SBIC toward the overall amount that would be considered in determining
the capital charge level to which the FHC would be subject. Groups
representing both large and small financial institutions criticized this
provision. Charlotte M. Bahin, director of regulatory affairs and senior
regulatory counsel for America's Community Bankers, wrote, "Imposing higher
capital charges on such investment activities by banking organizations may
well have a negative impact on this important source of capital."

Whiting wrote, "If it is concluded that no special capital charge is
appropriate for SBIC investments, we see no reason to conclude that a
non-SBIC investment should have a higher capital charge because there is a
certain level of SBIC investments."

Many commenters also voiced concerns that under the proposal a series of
other kinds of equity investments that had been authorized before passage of
the GLB Act also would count toward the total used in determining whether an
FHC exceeded the 15 percent or 25 percent thresholds. Those investment types
would include non-controlling equity investments made under sections 4©(6)
and 4©(7) of the Bank Holding Company Act; portfolio equity investments
made under Regulation K; and most equity investments by state-chartered
banks under section 24 of the Federal Deposit Insurance Act.

Grandfathered

The proposal would make existing permissible investments, such as those in
SBICs, subject to the capital charge rule as of March 13, 2000, the date of
publication of the original proposed rule. That provision also drew strong
criticism. Reilly wrote, "Imposing a capital charge on these investments,
without any evidence that such investments pose a safety and soundness risk,
would penalize institutions for engaging in long permissible activities ...
SIA respectfully submits that imposing a capital charge retroactively is
akin to altering the rules in the middle of the game, and doing so could
have adverse consequences."

Reilly also suggested that such investments should be grandfathered not only
from the March, 2000, date but from the date on which the agencies issue the
final capital rule.

Mixed Activities

Whiting addressed a feature of the proposal that he said could result in
inequities for FHCs that invest in companies whose operations involve a
mixture of activities. In some cases the firm in which the investment is
made may engage in activities that are clearly permissible under the Bank
Holding Company Act because they are "incidental and complementary" to
financial activities, while there may be questions about the permissibility
of other activities, he said.

Under the proposed rules, if an FHC invested in such a company, Whiting
wrote, it would have to do so under its merchant banking authority and might
have to wait for the Federal Reserve Board to rule on the permissibility
question. "Read literally," he wrote, "the special capital charge would
apply to the entire investment in a company even if its financial and
incidental activities represented 99 percent of its total revenues and
assets. We believe that such a result is illogical and inequitable."

Whiting suggested this matter could be dealt with by applying the capital
charge only to the amount of the investment that equals the portion of the
company's revenues that are not attributable to permissible activities.

Euro swap spreads seen sideways, U.S. to narrow.
Reuters - April 30, 2001
By Nigel Stephenson

LONDON, April 30 (Reuters) - Swap spreads have tightened markedly in recent
weeks as rate cut expectations have seen bond yield curves steepen but
analysts say that while dollar spreads could narrow further, euros could
steady or even widen.

The 10-year U.S. dollar swap spread has narrowed since the beginning of the
year, when the Federal Reserve embarked on a series of aggressive interest
rate cuts, to 80 basis points on Monday from 104 on December 28.

"Swap spreads are going to come in the U.S. because we still have a very
aggressive rate cut priced in," said Meyrick Chapman, derivatives analyst at
UBS Warburg.

Euro-zone swap spreads also narrowed in January but then moved out and
sideways until late March. The 10-year euro spread narrowed to 43 basis
points on Friday, close to one-year lows, from 56 on March 22. It stood at
44 on Monday.

"In Europe, the expectation of cuts has brought in swap spreads but we are
not getting any rate cuts right now and that is one of the reasons we might
move sideways," Chapman said.

His target was for the 10-year dollar swap spread to hit 65 basis points in
six months. The 10-year euro swap spread would narrow to just 38 or 39.

Swap spreads, the difference between the swap rate and the government bond
yield at any maturity, are gaining importance as a measure of bond
performance and of risk appetite.

A prime driver of the dollar swap spread has been the rapid steepening of
the yield curve. The 2-10 year Treasury spread has steepened to more than
100 basis points from 20 at the beginning of this year.

Chapman said the 2-10 year spread could widen to 120, having a further
positive impact on swap spreads.

Jim Reid, credit strategist at Barclays Capital, also said dollar swap
spreads could narrow further, to the low to mid-70s over three months.

SPREADS HELD BACK BY EMERGIBG MARKETS, EQUITIES

He said that while they were driven inwards by rate cuts, they had been held
back by concern over emerging markets and equities, which often see credit
underperform.

"If there is any stability in equity markets and any emerging markets
positive news flow, you are going to get swap spreads performing in
dollars."

He saw the 10-year euro swap spread moving out to 48 or 49 basis points over
three months.

With any lowering of interest rates in the euro zone expected to be modest
in comparison with the easing seen in the U.S., analysts said European
Central Bank cuts would not have a major impact on swap spreads.

"It is already pricing in probably a more aggressive rate cut than you could
possibly see for the next three months," Reid said.

"The risk reward is definitely for (euro swap spreads) to widen from here,"
he added.

Jose Sarafana, strategist at WestLB in Duesseldorf, said that after the
recent significant narrowing, euro-zone swap spreads could be ready for a
correction.

He recommended last week that investors consider switching into German
government bonds from peripheral euro-zone bonds, which would underperform
as swap spreads widened.

However, longer-term fundamentals supported a further narrowing of spreads.
He saw the 10-year at 40 by year-end.

"The economy is slowing, governments have to issue more debt than expected
and this should increase the supply. So we should see some underperformance
of government bonds versus credits."

Further steepening of the U.S. bond yield curve should see the 10-year
dollar swap spread at 65 basis points by year-end, Sarafana said.

Fed's Greenspan's speech to Bond Market Assn.
Reuters - April 27, 2001

WASHINGTON, April 27 (Reuters) - The following is a the full text of Federal
Reserve Chairman Alan Greenspan's speech delivered in Washington Friday on
"The Paydown of Federal Debt" to the Bond Market Association in White Sulfur
Springs, W.Va.:

"I am pleased to be with you this morning and note the Bond Market
Association's twenty-fifth anniversary. Over the years I have enjoyed being
associated with many of you in this audience. My very best wishes to Heather
Ruth on the last day of her tenure as president and congratulations to Micah
Green upon his appointment.

Today I want to address a subject in which your group and the Federal
Reserve share a keen interest--the paydown of the federal debt and its
implications for the economy and financial markets. While the magnitudes of
future federal unified budget surpluses are uncertain, they are highly
likely to remain sizable for some time. The dramatic improvement in
projections of the budget balance in recent years reflects, in large
part, the pickup in underlying productivity growth in the U.S. economy,
which has boosted corporate profits and household incomes and thereby tax
receipts. In effect, we built a tax structure on the assumption that the
economy would grow over time at rates around those seen from the early 1970s
to the mid-1990s, and this structure has generated considerably more revenue
as the economy's underlying growth rate has risen. Restraint
on expenditures also has contributed to the brighter outlook.

Tight limits on spending were imposed in response to the large deficits of
the 1980s and early 1990s, and defense spending was reduced following the
end of the Cold War.
Both the Office of Management and Budget and the Congressional Budget Office
have assumed that much of the accelerated productivity growth of the late
1990s is likely to be sustained through the next decade. No doubt, a period
of weakness in measured productivity is likely to accompany the current
slowdown in economic activity. However, there is little in the recent data
to suggest that any significant alterations in these agencies' longer-term
projections of structural productivity growth might be required.

Should we infer from these positive budget developments that unified budget
deficits are no longer conceivable? Hardly. The substantial surpluses in
retirement programs (especially social security) in recent years and in the
nearer-term budget projections are on a cash basis. Were we fully accruing
the benefit liabilities inferable from existing law, these retirement
programs would currently be in deficit, and contingent liabilities amounting
to about $10 trillion for social security alone would have been added to the
current debt to the public.

When the baby boom generation retires, and as the population subsequently
ages further, these contingent liabilities will come due and--barring an
offsetting surplus in the remainder of the government's budget--will be met
by the issuance of Treasury securities, shifting much of total federal
liabilities from contingent liability to debt to the public. At
that point, of course, the unified budget will be in deficit.

Of more relevance for the nearer term, current forecasts suggest that under
a reasonably wide variety of possible tax and spending policies, the
resulting surpluses will allow the Treasury debt held by the public to be
paid off. Moreover, well before the debt is eliminated--indeed, possibly
within a relatively few years--it may become difficult to further reduce
outstanding debt to the public because the remaining obligations will mostly
consist of savings bonds, well-entrenched holdings of long-term marketable
debt, and perhaps other types of debt that could prove difficult to reduce.
Whether economic developments and tax and budget choices will, in the end,
produce surpluses of the order of magnitude currently projected is open to
debate. But the probability of substantial continuing surpluses is
sufficiently high to require that, at a minimum, we begin to address their
potential implications for fiscal policy decisionmakers, financial markets,
and the Federal Reserve.

I have long argued that paying down the national debt is beneficial for the
economy: It keeps interest rates lower than they otherwise would be and
frees savings to finance increases in the capital stock, thereby boosting
productivity and real incomes. But the current budget projections are such
that we need to consider what path of debt reduction is best for the
economy. The issue is complicated: On the one hand, higher national saving,
by raising the nation's capital stock, leaves the country better prepared to
cope with the economic effects of the aging of the U.S. population--and one
way to achieve that higher saving is to run budget surpluses. On the other
hand, after a point, this increase in national saving comes at a cost. Once
Treasury debt reaches itsirreducible minimum, additional surpluses will, of
necessity, lead to the accumulation of substantial private--that is to say,
non-federal-assets either in the Treasury's general fund or in government
trust funds.

The decisions on how such funds should be invested by the government would
necessarily be political ones, and would lead to efforts by some groups to
obtain via the political process funding that they could not obtain, at
least at the same price, in private markets.

These efforts would likely result in distortions in the allocation of
capital that must be balanced against the benefit to the nation of the
increase in saving. In fact, it is the market-driven allocation of capital
and labor to their most productive uses that has fostered our recent
impressive gains in productivity and encouraged inflows of capital that have
enabled us to build an extraordinarily efficient capital stock despite quite
modest levels of domestic savings.

The effectiveness of our markets in allocating capital is one of our
nation's most valuable
assets. We need to be careful not to impair their functioning. It is,
regrettably, too easy to envision political pressure being exerted to use
government financing of investments to offset perceived capital market
imperfections. Experience suggests that in such cases the resulting returns
earned on the investments are likely to fall short of market standards.
Moreover, the social benefits of investment are likely to be very difficult
to measure in practice, opening the door to political interference in the
allocation of funds.

It is difficult, for example, to envision effective constraints being placed
on politically attractive investments by defined-benefit trust funds, such
as the social security trust fund. Benefits are guaranteed by government,
irrespective of any losses to the fund. Thus, one must presume that even if
our social security trust funds were to be so seriously impaired by
mismanaged government investment that they dried up, full benefits would be
highly likely to be forthcoming despite the fact that under current law the
social security trust fund has limited borrowing authority. As a result,
prospective beneficiaries would have no incentive to police the investment
policies of the trust fund.

To be sure, we do have about $3 trillion of assets administered in the
defined-benefit plans of state and local governments. While research in this
area has been limited, it does indicate that state and local pension funds
have tended to underperform private pension funds if required to direct a
portion of their investment within the state or to make "economically
targeted investments."

Some recent work has suggested that the negative effects of such
requirements may have been less important in recent years than they were in
the past, but that conclusion remains
speculative. Along the same lines, there is some evidence suggesting that
returns on state pension funds have been lower where the proportion of
trustees who are political appointees is higher.

Some have argued that methods could be devised to insulate government
investment decisions from the political process even in defined-benefit
funds, perhaps by limiting such investments to index funds. Even if such
methods were successful, the government would be investing only in publicly
traded securities, and so its investment might have an adverse effect on the
relative financing costs of smaller, often quite productive,
non-publicly-traded firms.

Over time, these effects would presumably be arbitraged away. But such a
process likely takes time, and capital market imperfections, in any event,
are likely to impede full arbitrage. Arguably, defined-contribution funds,
even if administered by a federal agency, could insulate investment policy
from political interference, as well as potentially freeing investment from
the straightjacket of holding only index funds. It is highly unlikely that
the beneficiaries of such funds would countenance politically convenient
investments in their retirement funds. Indeed, the $100 billion federally
managed Thrift
Savings Fund has been operated without such interference. I should note,
however, that conversion of social security from a defined benefit plan to a
defined contribution plan would fundamentally alter its nature.

One way to employ unified budget surpluses to finance increased investment
would be to convert such funds into individual retirement accounts owned and
administered by beneficiaries, with the presumption that the funds would be
fully dedicated to retirement. In such an instance, the resulting reduction
in government saving would be offset by a rise in private saving, so that
total domestic saving would be maintained, though the availability of newly
owned private assets could reduce the propensity to save out of income
somewhat.

Given concerns about the potential distorting effects of asset accumulation
by the Treasury or in government defined-benefit plans, we need to carefully
consider the appropriate path of debt paydowns. By addressing this issue
now, we can avoid an abrupt and potentially disruptive change in fiscal
policy as the level of Treasury debt reaches its irreducible minimum.

Despite the clear advantages of paying down the federal debt, I recognize
that doing so has some potential adverse consequences even before the
difficulties associated with government accumulation of private assets
arise. The Treasury market serves a number of useful purposes (in addition
to providing many of you with profitable employment). Most obviously,
Treasury debt provides an asset that is free of credit risk - a
characteristic that is desirable for many investors, especially in times of
economic or financial turbulence.

Treasury yields also provide a benchmark for the quoting and pricing of
risky debt. In addition, the size and liquidity of the Treasury market allow
market participants to hedge interest rate risks easily and at low cost.
Moreover, the liquidity of these securities enables participants to make
rapid adjustments to their portfolios in times of market volatility.

Thus, the elimination of Treasury debt does remove something of economic
value, and it will require that significant adjustments be made by market
participants. Indeed, with marketable Treasury debt held by the public--that
is, excluding the Federal Reserve but including foreign central
banks--having declined about 20 percent in recent years, to less than $2.5
trillion, some of these adjustments have already begun.

Reportedly, firms have increasingly turned to swaps, agency securities, and
even larger corporate debt issues to do their hedging. After a period of
transition, such shifts arguably should not have any significant adverse
effect on risk management. As hedging activity moves from the shrinking
Treasury market to alternative markets, the liquidity of those markets
should improve. Yields on the alternative hedging instruments likely will
track at least as closely with those on instruments commonly being hedged as
do Treasury yields.

Similarly, the loss of Treasury securities as benchmarks seems unlikely to
result in major difficulties for market participants because alternative
benchmarks are easy to envision. For example, in European bond markets,
swaps are already the most common benchmark. Even in the United States, the
Treasury bill market has lost its "benchmark status" in recent years, and
has been replaced in that role by the eurodollar and eurodollar futures
markets, with no evident adverse effects on the operation of short-term
credit markets. All of these alternative assets, of course, involve some
degree of credit risk . However, given sufficient demand, it seems likely to
me that you or your colleagues could produce a nearly riskless security.

For example, this could be accomplished with a very senior tranche of a
collateralized
debt obligation backed by high-grade corporate debt. In short, I am
confident that U.S. financial markets, which are the most innovative and
efficient in the world, can readily adapt to a paydown of Treasury debt by
creating private alternatives with many of the attributes that market
participants value in Treasury securities. Of course, the resulting
adjustments will not be perfect and, in some cases, will impose costs on
financial market participants, especially during the period of transition to
new products and procedures.

However, I believe that these costs are very likely to be outweighed by the
benefits to the
country of a higher capital stock and the resulting increases in
productivity and income that appear to be the consequence of debt reduction.
Moreover, competitive pressures and profit opportunities will provide a
strong incentive for you and your colleagues in the financial industry to
devise ways to minimize such costs.

Still, the lack of Treasury securities might be a bigger problem for
international investors than for domestic investors, because they may be
less well informed about U.S. corporations. As a result, international
investors--especially official ones--may have a strong preference for U.S.
government instruments. In such circumstances, foreign investors may reduce,
on net, their holdings of overall dollar assets as Treasury securities are
paid down. By itself, such diminution in the demand for U.S. dollar assets
would tend to raise interest rates for U.S. borrowers and, conceivably, put
downward pressure on the dollar's exchange rate.

However, the evidence of the past year and a half gives little support to
this notion: Foreign private investors, on net, have run off their holdings
of U.S. Treasury securities, while they have built up their holdings of
private dollar assets by an even larger amount, and the foreign exchange
value of the dollar has appreciated.

A final valuable feature of the Treasury market is that it is a remarkably
efficient system for funding federal government deficits. Because
demographic and other factors are surely likely to lead to the re-emergence
of deficits in the future, one might argue that it would be best to continue
to borrow at least limited amounts from time to time in order to keep the
market operating, so that it will be available when it is needed again.
While that is clearly an alternative, we should also keep in mind that
re-establishing the Treasury security market likely would not be all that
difficult. Borrowing needs, in all likelihood, would start out small, so the
market would have time to develop.

Moreover, I have great confidence in your ability--or that of your
successors--to initiate a new market for Treasury debt when that becomes
necessary. Like other financial market participants, the Federal Reserve
will also have to adjust to the loss of Treasury debt. Currently, Treasury
securities are the "permanent" assets that correspond to the currency that
is the Federal Reserve's main liability. Treasury securities have several
features that make them particularly attractive assets for the Federal
Reserve. First, the liquidity of the market allows the Federal Reserve to
make substantial changes in reserves in a short period of time, if
necessary. Second, the size of the market has meant that the effects of the
Federal Reserve's purchases on the prices of Treasury securities have been
minimal. Third, Treasury securities are free of credit risk . Thus, the
Federal Reserve does not itself take on such risk when it holds them. I
should point out that we do not eschew risk because we fear becoming
insolvent.

Rather, we believe that the effects of Federal Reserve operations on the
allocation of private capital are likely to be minimized when Federal
Reserve intermediation involves primarily the substitution in the public's
portfolio of one type of instrument that is free of credit risk
--currency--for another-Treasury securities. As I discussed earlier, it is
important that government holdings of assets not distort the private
allocation of capital, and this goal applies to the Federal Reserve System
as well as to the Treasury.

However, if the Treasury debt is paid down, as I trust it will be, then the
Federal Reserve will have to find alternative assets that still provide
substantial liquidity and minimize distortions to the private allocation of
capital. Even before that time, the Treasury market may become less liquid,
making it more difficult for the Fed to make purchases without affecting
market prices. Moreover, declining Treasury debt presumably would, at some
point, reduce the liquidity of the Treasury repurchase agreement (RP)
market, complicating the use of such operations in adjusting the short-term
supply of reserves.

In the short run, the Federal Reserve will continue to purchase a
substantial volume of Treasury securities. In order to minimize the effects
of its purchases on the market, however, it has established limits on the
fraction of individual issues that it will hold going forward. The Federal
Open Market Committee (FOMC), as you know, has also decided, on a temporary
basis, to allow the Open Market Desk at the Federal Reserve Bank of New York
to conduct RP operations with agency mortgage-backed securities as
collateral as well as with Treasuries and direct agency debt.

Other changes that are already allowed under current statutes could be
implemented to substitute, to a limited extent, for our holdings of Treasury
securities. For example, the Federal Reserve could purchase, outright,
Ginnie Mae securities, which are fully backed by the Treasury. It could
also further broaden the types of collateral allowed for RP operations,
perhaps including certain municipal obligations or those of foreign
governments. Such an expansion could reduce the effects of Federal Reserve
operations in the market for any particular type of collateral.

The FOMC has asked staff to explore all of these short-run alternatives.
Over a longer time horizon, more fundamental changes could be considered.
One possibility is to expand the use of the discount window by auctioning
such credit to financially sound depository institutions. Such auctions
would enhance our ability to adjust the supply of reserves as needed, and
because these loans would be fully collateralized, they would offer
considerable protection against credit risk.

Another possibility is to add new assets to those the Fed is currently
allowed by law to buy for its portfolio. These assets could be used to
provide a broader range of RP collateral, a process similar in concept to
the expanded use of the discount window, as well as ultimately being added
to our permanent portfolio. One would hope that such additions would help to
limit the distortions to particular markets caused by Federal Reserve
purchases.

Of course, what adjustments we make to our procedures--and when we make
them--depend on how rapidly the supply of Treasury securities dwindles and
on how long the Treasury market is not available. As I noted earlier,
demographic forces are likely to cause unified budget deficits to re-emerge
at some point in the future and fresh supplies of Treasury securities to be
issued. At that time, the Federal Reserve presumably would begin to shift
our portfolio back toward the Treasury market.

The timing and extent of the re-emergence of Treasury issuance will depend
on underlying productivity growth and, of course, on the degree of fiscal
discipline exercised by future American governments. Finally, in the period
ahead, the Federal Reserve will be seeking active consultations and
discussions with you and other market participants, as well as with the
Congress, before significant changes are made to Federal Reserve procedures
and methods. While the prospective paydown of Treasury debt presents us with
challenges, I am confident that, with your help, the Federal Reserve can
make the needed adjustments and will be able to continue to implement
monetary policy in the national interest.

The benefits of reducing our federal debt make the associated challenges
well worth meeting."
Enron Offers Structured Weather Note
Derivatives Week - April 30, 2001

Enron is offering via its Internet trading platform a structured weather
note that gives investors financial exposure to the weather in 19 U.S.
cities. Mark Tawney, Enron's Houston-based head of weather derivatives who
was in London last week, said the note mirrors the weather risk element of
the Kelvin weather bond Koch Energy Trading issued in November 1999. Tawney
believes that by guaranteeing to make a secondary market in the note, more
pension funds, hedge funds and mutual funds will invest in weather
derivatives. The note is most likely to be traded by bond holders, Axia (the
product of a merger between Koch Energy Trading and Entergy Trading and
Marketing) and speculative accounts. A weather derivatives official at Axia
declined comment.

Although the timing was not influenced by the downturn in equity markets,
Tawney said investor appetite for instruments with low correlation to the
equity markets should boost demand for the product.

Scott Marra
Administrator for Policy & Media Relations
ISDA
600 Fifth Avenue
Rockefeller Center - 27th floor
New York, NY 10020
Phone: (212) 332-2578
Fax: (212) 332-1212
Email: smarra@isda.org