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Enron Mail |
ISDA PRESS REPORT - NOVEMBER 19, 2001
ACCOUNTING * Japanese Accounting Changes - The Nikkei Weekly CREDIT DERIVATIVES * ISDA addresses successor/convertible issues - IFR * New York dealers go it alone on default swap clause - IFR ENERGY * What Enron Did Right - The Wall Street Journal OPERATIONS * FpML group joins ISDA - IFR Japanese Accounting Changes November 18, 2001 - Derivatives Week (Learning Curves) There have been major changes to accounting standards in Japan which, by the time they have all been implemented will have brought Japanese accounting standards broadly into line with international norms. These changes are comprehensive and include the introduction of fair value --or mark-to-market--accounting. This last change, although seemingly innocuous will be particularly powerful in its impact. But What Has All This To Do With Derivatives? The introduction of mark-to-market accounting requires listed Japanese companies to record their holding of marketable property assets and securities at current market value rather than at book value. This means that balance sheets will no longer be buttressed by assets valued at inflated bubble economy levels. But most crucially profit streams will become exposed to movements in equity markets, as the definition of securities includes the cross shareholdings which bind members of Japan's Keiretsu and other business groupings. These are substantial in Japan, accounting for perhaps 40% of all shareholdings. The unwinding of cross shareholdings is undoubtedly one of the factors behind the recent weakness of Tokyo stock prices, not least as foreign buyers who had been soaking up much of the unwound cross held shares coming onto to the market have been notably absent over the past few months. Hence there has been much talk about how best to unwind these cross shareholdings without further depressing the market. Where possible firms with mutual shareholdings have been seeking arrangements that are effectively straight swaps. But derivatives can also play their part. Many corporates with large shareholding disposal programmes have been actively seeking to hedge their equity exposure as they embark on their share sale process. Often they have effected this through the use of call options. Thus if the market falls they have at least benefited from the premium earned at the time of the sale of the call option and if the market rises and the option is called by the purchaser then the shares have been successfully disposed of, but without further dampening an already weak market. Financial institutions have also been combining a similar strategy with stock lending, thereby gaining both the option premium and a lending fee. Certainly many market observers have been reporting an increase in such call option trades over the past year or so. Moreover even for firms that do not wish to sell down their equity portfolios, the increased profit volatility which will result from having to revalue portfolios and book these changes though the profit and loss account will significantly increase the attractions of hedging. Allied to this and flowing from the realisation of the full extent of the weakness of many Japanese financial institutions, there has also been an increase in the use of credit derivatives which has allowed investors to sell the risk of entering into a transaction with a Japanese bank. This market has been cyclical, rising and falling with the changes in perceptions of the true financial state of the country's banking sector. However the underlying demand is there. The Flip Side In the same way that Japanese banks and corporates must book the true value of their equity portfolios they must also report the true market value of their derivatives positions. And there is concern that this will only serve further to expose the weakness of the banks in particular. So it has been reported that the Japanese Bankers' Association (zenginkyo) has been lobbying the accounting standards making body, the Japan Institute of Certified Public Accountants, for a further delay in the introduction of the mark to market requirement for derivatives. This is in addition to the one-year delay already secured. The original delay was portrayed as in response to difficulties arising out of the consolidation of the Japanese banks around three or four major groupings, but most market observers suspect that this was only a smokescreen to cover up for the ineffective hedging strategies of the major banks, most notably macro hedging. Now the bankers' representative body is suggesting the deadline be extended further, perhaps indefinitely. This may get the banks at least part way out of the short-term crunch they are under from greater disclosure requirements, but with the Japanese economy continuing to deteriorate, with serious consequences for the size of the non-performing loans problem, the Japanese financial system will have to face the music sometime. ISDA addresses successor/convertible issues IFR - November 17, 2001 Standard documentation aimed at clarifying which company should serve as reference entity for credit default swaps in the event of a demerger or other structural change, such as a consolidation, will be put forward by the International Swaps and Derivatives Association this week. While the successor issue has been debated since the break-up of National Power of the UK, the imminent break-ups of AT&T and BT into smaller entities has underscored the need for improved documentation. Ambiguity arose out of the 1999 ISDA credit derivative definitions because they defined the successor as the entity that assumes "all or substantially all" of the original company's relevant obligations. AT&T's demerger plans, for example, create no clear successor under ISDA's 1999 definitions. To eliminate the uncertainty for those that bought or sold protection on companies that do not produce a clear successor, ISDA's supplement on successor issues uses a tiered set of numerical standards, said Kimberley Summe, general counsel of ISDA. Chip Goodrich, managing director in the legal department at Deutsche Bank and chairman of ISDA's documentation committee, said that he did not expect extensive comments on the new documentation, as possible resolutions to the issue had been thoroughly debated by market participants. Under the standard, a new entity that receives 75~/~ of the original company's bonds and loans after a demerger would be deemed the reference obligation for a credit default swap. If the 75% test is not applicable, then a 25% test applies. If more than 25% of the underlying's obligations are held by a new reference entity then the credit derivative transaction must be broken up into several separate transactions of equal weight, said Goodrich, who also sits on ISDA's credit derivatives market practice group. In the event that no successor company assumes 250/o of the original company's obligations, another set of rules come into play. The entity that receives the highest percentage of the original company's loans and bonds becomes the sole successor. Should the debt be evenly split between two entities in this category, -the one that assumes the highest percentage of obligations (loans, debt and other borrowed money) is deemed the successor. No successor will be appointed if the original reference entity continues to exist. In a separate development, ISDA published a supplement to the ISDA 1999 credit definitions that specifies "not contingent" as one of the delivery obligation characteristics. This clarifies that convertible exchangeable or accreting bonds qualify to be delivered, said Goodrich. "It's a clarification of what was implicit in the definition in the past," he added. This has become an issue because of the surge of activity in hedging of convertible bonds this year and the debate last month over whether Railtrack's convertible bond was deliverable under existing swap contracts. Most of the major dealers made an immediate move to use of the new ISDA language by adopting it as standard in default swap contracts last week. New York dealers go it alone on default swap clause IFR - November 17, 2001 By John Macaskill Abandonment of the obligation acceleration clause is unlikely to cause a rift within the credit derivatives trading community as serious as the one that developed over the restructuring clause earlier this year. All the same, last week's unilateral move by the main New York dealers took European traders and default swap end users by surprise. It came almost exactly a year after a similar decision by the most active New York dealers to drop restructuring as a standard credit event for US corporate default swaps. That move threatened a schism within the credit derivatives market, and a reduction in overall liquidity because of different trade practices being followed in different regimes. Damage to liquidity The threat was headed off by traders and users of credit derivatives from both Europe and the US, who worked on committees co-ordinated by the International Swaps and Derivatives Association (ISDA) to agree a modified definition of the restructuring clause as a credit event. The new definition was agreed at the end of April and released in May, but liquidity in the default swap market was hit in the early months of the year by the uncertainty caused by the debate. The issue of obligation acceleration had not been a great concern for dealers until Moody's indicated that it was uncomfortable with the inclusion of what it viewed as a "soft" credit event in the default swaps that back credit-linked notes and collateralised debt obligations. Obligation acceleration and obligation default are two clauses that can trigger default swap exercises under the standard 1999 ISDA credit derivatives definitions. Dealers have been aware that the payment of an obligation might be accelerated owing to the breach of a covenant on a bond or loan. This might trigger exercise on a default swap, when there was still a chance that the covenant could be made whole before the fundamental default event - failure to make a debt payment - had taken place. Most dealers decided that this was not a major issue, however, mainly because there do not appear to have been any examples of obligation acceleration triggering a default swap, and because covenant breaching will almost certainly come at the same time as failure to pay on a liability. However, Moody's turned the debate into an economic issue for dealers by objecting to incorporation of the clause in the swaps used to back synthetic collateralised debt obligations. Dealers have been making enormous profits from synthetic securitisation this year. Three of the top credit derivatives trading houses have each sold over US$10bn of swap-backed issuance this year, and a string of dealers have sold between US$2bn and US$10bn. This is high margin business, with fees of over 100bp for a deal often seen. Profit drag Moody's applies a 25% increase to the default probability used for the COO's it rates if they are backed by swaps featuring the obligation acceleration clause. Banks can cut this charge by incorporating language that specifies a timeframe for covenant breaches to be cured. None the less, the clause can still be a significant drag on their CDO income. It is also an economic issue for Moody's, because swaps without the obligation acceleration clause match more closely the criteria of its historical default database - one of its major assets. "It was never clear to us how obligation acceleration as a credit event had any meaning in these transactions," said Noel Kirnon, managing director responsible for collateralised debt obligations and derivatives at Moody's. He welcomed last week's move to drop the clause as a standard feature of default swaps traded in the US. Derivatives dealing heads in New York echo this sentiment and point out that buyers of credit protection will still be able to request that obligation acceleration is included as a feature in a swap. In the first few days of trading without standard inclusion of the clause last week, there was no evidence of a price basis opening up between contracts with the clause and those without, indicating that it is not yet being viewed as an economic factor by buyers of protection. "It is basically a redundant credit event," said the US head of credit derivatives at one bank. "For protection buyers it does not particularly weaken the power of the contract," he added. European objections There were some objectors to the move among dealers active in the US market, as UBS and Commerzbank declined to drop the clause for standard contracts. The other big dealers moved in step, however. These include Citigroup, CSFB, Deutsche Bank, Goldman, JP Morgan Chase, Lehman and Merrill. Some dealers would also like to change use of the repudiation/moratorium clause in default swaps to make it clear that it cannot be used to apply to a corporate credit, but no change in market practice is expected. The essential credit derivative settlement debates in recent months - over successor entity and convertible deliverability - have been resolved on a global basis. There is no indication that European traders and end users of default swaps will fall into line with the contract shift made in the US last week, however. "The New York dealers' decision was surprising, but it wasn't the first time they have moved unilaterally," said one European trader. "Europe will stick with obligation acceleration and the repudiation/moratorium," he predicted. What Enron Did Right The Wall Street Journal - November 19, 2001 By Samuel Bodily and Robert Bruner This is a rough era for American business icons. Subject to the vagaries of age (Jack Welch), product failure (Ford/Firestone tires), competition (Lucent, AT&T), technology (Hewlett-Packard and Compaq), and dot-bomb bubbles (CMGI), managers and their firms remind us that being an icon is risky business. The latest example is Enron, whose fall from grace has resulted in a proposed fire sale to Dynegy. Once considered one of the country's most innovative companies, Enron became a pariah due to lack of transparency about its deals and the odor of conflicts of interest. The journalistic accounts of Enron's struggles drip with schadenfreude, hinting that its innovations and achievements were all a mirage. We hold no brief regarding the legal or ethical issues under investigation. We agree that more transparency about potential conflicts of interest is needed. High profitability does not justify breaking the law or ethical norms. But no matter how the current issues resolve themselves or what fresh revelations emerge, Enron has created an enormous legacy of good ideas that have enduring value. Deregulation and market competition. Enron envisioned gas and electric power industries in the U.S. where prices are set in an open market of bidding by customers, and where suppliers can freely choose to enter or exit. Enron was the leader in pioneering this business. Market competition in energy is now the dominant model in the U.S., and is spreading to Europe, Latin America, and Asia. The winners have been consumers, who have paid lower prices, and investors, who have seen competition force the power suppliers to become much more efficient. The contrary experience of California, the poster child of those who would re-regulate the power industry, is an example of not enough deregulation. Innovation and the "deintegration" of power contracts. Under the old regulated model of delivering gas and electricity, customers were offered a one-size-fits-all contract. For many customers, this system was inflexible and inefficient, like telling a small gardener that you can only buy manure by the truckload. Enron pioneered contracts that could be tailored to the exact needs of the customer. To do this, Enron unbundled the classic power contract into its constituent parts, starting with price and volume, location, time, etc., and offered customers choices on each one. Again, consumers won. Enron's investors did too, because Enron earned the surplus typically reaped by inventors. Arguably, Enron is the embodiment of what economist Joseph Schumpeter called the "process of Creative Destruction." But creative destroyers are not necessarily likable, pleasant folks, which may be part of Enron's problem today. Minimization of transaction costs and frictions. Enron extended the logic of deintegration to other industries. An integrated paper company, for instance, owns forests, mills, pulp factories, and paper plants in what amounts to a very big bet that the paper company can run all those disparate activities better than smaller, specialized firms. Enron argued that integrated firms and industries are riddled with inefficiencies stemming from bureaucracy and the captive nature of "customers" and "suppliers." Enron envisioned creating free markets for components within the integrated chain on the bet that the free-market terms would be better than those of the internal operations. The development of free-market benchmarks for the terms by which divisions of integrated firms do business with each other is very healthy for the economy. Exploiting the optionality in networks. In the old regulated environment, natural gas would be supplied to a customer through a single dedicated pipeline. Enron envisioned a network by which gas could be supplied from a number of possible sources, opening the customer to the benefits of competition, and the supplier to the flexibility of alternative sourcing strategies. Enron benefited from controlling switches on the network, so that they could nimbly route the molecules or electrons from the best source at any moment in time to the best use, and choose when and where to convert molecules to electrons. This policy, picked up by others in the industry, created tremendous value for both customers and suppliers. Rigorous risk assessment. The strategy of tailored contracts could easily have broken the firm in the absence of a clear understanding of the trading risks that the firm assumed, and of very strong internal controls. Enron pioneered risk assessment and control systems that we judge to be among the best anywhere. Particularly with the advent of Enron Online, where Enron made new positions valued at over $4 billion each day, it became essential to have up-to-the-second information on company-wide positions, prices and ability to deliver. The unexpected bad news from Enron has little to do with trading losses by the firm, but with fears among trading partners about Enron's ability to finance its trading activity. In a world where contracts and trading portfolios are too complex to explain in a sound bite, counterparties look to a thick equity base for assurance. It was the erosion in equity, rather than trading risk, that destroyed the firm. A culture of urgency, innovation and high expectations. Enron's corporate culture was the biggest surprise of all. The Hollywood stereotype of a utility company is bureaucratic, hierarchical, formal, slow, and full of excuses. And the stodgy images of a gas pipeline company -- Enron only 15 years ago -- is even duller and slower. Enron became bumptious, impatient, lean, fast, innovative, and demanding. It bred speed and innovation by giving its professionals unusual freedom to start new businesses, create markets, and transfer within the firm. Success was rewarded with ample compensation and fast promotion, and an open-office design fostered brainstorming. The firm's organization and culture was by all accounts not a safe haven for those who believe the role of a large corporation is to fulfill entitlements for jobs. This was a lightning rod for the firm's detractors. And yet, it could serve as a model for more hide-bound enterprises to emulate. Enron was a prolific source of compelling new ideas about the transformation of American business. It created a ruckus in once-quiet corners of the business economy. It rewrote the rules of competition in almost every area in which it did business. It thrived on volatility. The proposed sale of Enron to Dynegy risks the loss of a major R&D establishment, especially given Dynegy's track record as a second mover following Enron's lead. Beyond what is likely to be a difficult and time-consuming antitrust review, Dynegy's greater challenge will be to find a way to make Enron's spirit of innovation its own. Or so we all should hope, because prosperity depends on the ability of firms to reinvent themselves and remake their industries. FpML group joins ISDA IFR - November 17, 2001 The International Swaps and Derivatives Association last week announced plans to incorporate FpML.org, a non-profit industry body dedicated to developing a business information exchange standard for electronic dealing and processing of financial derivative transactions. "FpML.org's funding is stable. But the founding members recognise that [the standard] is broadly beneficial to the industry and that working with ISDA is the best way to continue developing it," said Brian Lynn, vice-president of etrading at JP Morgan Chase in New York. "This is an exciting and important step toward derivatives technology development that is consistent with other ISDA efforts to provide an effective structure for derivatives documentation and trading," said Robert Pickel, executive director and chief executive of ISDA. "We have common membership and have been talking to each other for a while," he added, noting that FpML.org's language uses ISDA documentation and terms as its foundation. Financial product Mark-up Language's (FpML) chief virtue is that it addresses straight-through processing. It offers a basis for achieving straight-through processing of trades, back office systems and settlement systems. Greater automation reduces the time it takes to close a deal and the rate of error. In 1999, the industry spent roughly US$1bn processing OTC derivatives transactions, and at some firms about 20%-30% of that figure represented documentation errors, said JP Morgan's Lynn. The manual confirmation matching processes required today is not included in the 20%-30% figure, he added. In theory, liquidity should also receive a boost from a move to greater automation. "For smaller end users it means that there is less work involved in entering into a transaction," said Lynn. No decision on linking FpML's transaction standards with ISDA master and netting agreements has been made yet, but such a move is likely in the future. ISDA initiatives aimed at providing members with extensible mark-up language (XML) resources for netting and negotiating, storing and archiving ISDA master agreements seem to point in this direction, as FpML is an XML solution. ISDA's interactive web and CD-ROM based documentation library is in an XML format currently. "The integration of FpML into ISDA will mean speeding up the development of the standard and expansion of its coverage consistent with our original mission. The goals of FpML.org and ISDA are similar as both have worked towards technological advancement in standard setting," said Philippe Khuong-Huu, a managing director at Goldman Sachs, and chairman of FpML.org's board of directors. Joining forces with ISDA will also help raise the profile of FpML, but awareness of its potential is not a problem said Lynn. "The issue is deploying systems that use the standard." Two multi-dealer trading systems for interest rate derivatives that are being tested now, Reuters' Dealing for Swaps and SwapsWire, plan to go live using FpML. FpML use at individual banks is done on a proprietary basis for now. No banks yet operate on XML on a company-wide basis. FpML.org's architectural working group, and its working groups covering interest rate, foreign exchange and equity derivatives, will continue to exist as sub-groups of ISDA's new FpML committee. ISDA's FpML committee will retain responsibility for approving new versions of the standard. "Vendors will continue to be represented on the standards committee and on working groups," said Lynn. FpML standards currently exist for interest rate derivative products and forward rate agreements. Foreign exchange and equity derivatives standards arc nearing completion. **End of ISDA Press Report for November 19, 2001** THE ISDA PRESS REPORT IS PREPARED FOR THE LIMITED USE OF ISDA STAFF, ISDA'S BOARD OF DIRECTORS AND SPECIFIED CONSULTANTS TO ISDA ONLY. THIS PRESS REPORT IS NOT FOR DISTRIBUTION (EITHER WITHIN OR WITHOUT AN ORGANIZATION), AND ISDA IS NOT RESPONSIBLE FOR ANY USE TO WHICH THESE MATERIALS MAY BE PUT.
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