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Enron Mail |
Writer makes the timeless observation that the devil may be in the details.
-----Original Message----- From: =09Blair, Kit =20 Sent:=09Monday, November 26, 2001 1:15 PM To:=09Nelson, Kourtney; Cavanaugh, Darren; Stokley, Chris; Comnes, Alan; Sh= eppard, Kathryn; Reyes, Jim; Purcell, Mike; Gilbert, Scotty; Hall, Steve C.= (Legal); Clemons, Amy Subject:=09Fascinating article SuperModels=20 Why Enron investors are running for the exits=20 It's all about risk -- and the Houston energy company may be on the hook fo= r billions. Bailing now and taking $5 a share, sellers reason, is better th= an getting only pennies in bankruptcy.=20 By Jon D. Markman <http://moneycentral.msn.com/articles/common/bios.asp<;=20 In normal circumstances, shares of Houston energy-trading titan Enron shoul= d have stabilized around $10 after it agreed to a merger with crosstown riv= al Dynegy earlier this month. Instead, the stock price is retreating faster= than the Taliban. Why?=20 The answer, like everything associated with Enron, is complex. But the shor= t version is that investors fear that hidden problems will scotch the merge= r and force Enron to seek bankruptcy protection, potentially leaving its sh= ares worth pennies. While attention has so far focused on credit problems related to ill-disclo= sed limited partnerships, institutional investors are increasingly worried = about risks Enron faces in the market for financial derivatives known as "s= waps." Accentuating their concern: Billions of dollars' worth of Enron's ne= ar-term swap contracts -- instruments that ironically were invented to help= corporations limit risk -- will reportedly mature next month and are even = more hidden from investors' view than the deals that have gotten the firm i= nto trouble so far. On Wednesday afternoon, the bond-rating agency Fitch up= dated its opinion on Enron by stating it believed "there have been signific= ant cash collateral calls from wholesale trading customers well in excess o= f previous expectations."=20 Glenn Reynolds, chief executive of independent debt-research firm CreditSig= hts and a former chief credit officer at Lehman Bros., said the swaps marke= t is a very large but arcane investment arena that isn't followed by mainst= ream corporate bond analysts or equity analysts. Yet, he noted, "it's one o= f the biggest things that can still go badly wrong for Enron." How much is Enron on the hook for? Swaps exposure thus makes December a make-or-break month for the company, a= s its counterparties in complex deals glued together with billions in borro= wed funds frantically attempt to unwind positions in markets as disparate a= s currency, natural gas, bonds and metals. If Enron either made the wrong b= ets on too many of these deals, or contract covenants are breached that spu= r demands for hard-asset or cash collateral, the company could be forced to= seek the protection of bankruptcy court to prevent a run on its dwindling = treasury. Moreover, because the world of swaps and derivatives is so incestuous -- wi= th Company A able to pay its hundreds of millions in derivatives obligation= s to Company B only after it receives payments from Company C - some trader= s worry that Enron's potential inability to pay off on its swaps liabilitie= s could threaten the stability of the world's commodity-trading system.=20 No one is saying that this worst-case scenario is bound to happen. But rumo= rs of default risk can spread like financial smallpox in nervous markets --= even if they're never proved true. One story making the rounds on trading = floors, for instance, tied the historic collapse of U.S. government bonds i= n the third week of November to the belief that Enron had to sell vast quan= tities of short-term Treasury notes to make good on swap-related margin cal= ls. (Enron officials did not return calls for comment.) Experts noted that Enron's counterparty risks and scant disclosure on high = levels of borrowing remind them of the spectacular blowup of hedge fund Lon= g-Term Capital Management in 1998, which imperiled the world capital market= s until the Federal Reserve captained a bailout. That debacle ended when on= ce-generous banks and brokerages finally turned off the money spigot. Said = one veteran portfolio manager, who asked not to be identified: "This is sha= ping up to be LTCM 2. If Enron's lines of credit dry up, they're out of bus= iness -- end of story." Lots of credit and lots of deals To understand the problem more clearly it's important to understand what En= ron does for a living, and the role and utility of swaps.=20 Many investors think of Enron as an energy company or gas utility, but it h= as really operated more like a combination investment bank, market maker an= d hedge fund in the past few years. One of the key ways it earned income wa= s its role in selling risk-management instruments -- those swaps -- as a so= lution for whatever financial impairments that a company fretted over.=20 Let's say you run the risk-management operation of a metal-mining firm and = you're long copper futures as a hedge against the possibility that prices m= ight fall in six months. You want to lock in the price, so you enter into a= swap with Enron under rules of the International Swap Dealers Agreement, o= r ISDA. Accounting protocols allow you to keep this trade off your balance = sheet, so it's not disclosed anywhere for competitors, or investors, to mon= itor. One of Enron's roles was to find a company with the opposite problem = to yours -- let's say they want to be short copper futures -- and make the = match. Thus Enron helped you swap a risk that made you uncomfortable for a = risk that you felt you could control.=20 More often, Enron reportedly took the swap itself and laid off the risk by = using some other hedge, such as being long or short Eurodollars or U.S. Tre= asury notes. It might also find it profitable to be the one responsible for= actually delivering the physical product. At its peak, Enron is said to ha= ve been a counterparty on thousands of swaps per week. This business requires massive amounts of credit -- also known as "leverage= " -- because margins are slim; the only way to become super-successful is t= o do really big volume. It turned out that few of Long-Term Credit Manageme= nt's counterparties or bank lenders understood that the hedge fund had leve= raged itself by as much as 30:1 because of similar efforts to trade in high= volume. And likewise, one veteran analyst who asked not to be identified t= old me that he believes Enron might have been leveraged by as much as an as= tronomical 100:1 in some cases. Thomas Seims, chief economist at the Federal Reserve in Dallas and an autho= rity on swaps, told me that the crux of the issue is, "Do we know exactly w= hat their positions are -- and did they use swaps and leverage properly or = improperly? When we find out, we can determine the potential for a contagio= n effect."=20 The big question: How many deals? Why don't we know what their positions are? Legally, they're not required t= o reveal them -- and we already know that Enron has done an absolutely terr= ible job of disclosing information that securities laws and investment comm= unity conventions actually require. Swaps are similar to the proprietary tr= ading operation of major brokerages, but with one critical difference. Typi= cally stocks are fairly liquid and transaction terms do not vary much. But = swap contracts can have all sorts of covenants related to the creditworthin= ess of the counterparties. So for all anyone outside of Houston knows, ther= e could be any number of billion-dollar deals hanging out there with rules = that require Enron to put up collateral or pay off loans if their debt rati= ng falls below a certain rating threshold, such as BBB-, one step above jun= k. The surprise disclosure of such a clause in a previously hidden limited = partnership contract over a Brazilian deal is what caused Enron's stock to = plunge 20% on Tuesday, according to traders.=20 More importantly, one financial services executive pointed out, because Enr= on owns the market for many swaps, spread options and other thinly traded f= inancial instruments, they're the ones who set the mark-to-market price tha= t shows on their profit-and-loss statement. For example, every night an Enr= on trader must mark the value of a 15-year Chicago natural-gas swap on his = books. There is no closing or settlement price -- there's only what the Enr= on trader thinks the price should be. It is in these mark-to-market prices = of thousands of swap positions that Enron could theoretically hide hundreds= of millions in unrealized losses, if it chose to.=20 One prominent New York consultant to the energy risk-management industry to= ld me he's estimated that Enron could be forced to write off as much $1 bil= lion or more in failures related to its swap transactions. Why hasn't anyon= e focused on it? "The magnitude of Enron's partnership problems is so great= that after awhile you get numb, and no one is paying attention to this par= t of their operation." Philip K. Verleger Jr., a leading energy-industry economist and consultant,= also noted that one reason that Enron risks aren't easily quantified is th= at they "may not be price independent." That's an economist's way of pointi= ng out that the company -- a major player in a corner of the derivatives bu= siness called "delta hedging" -- may not have the capital required to maint= ain a futures position in all the puts or calls it sold to commodity produc= ers trying to offset risks that the price of things like natural gas or oil= might fall or rise sharply. If prices maintain above or below a level that= Enron forecast as likely to make it money in such a transaction, no proble= m. But if prices in the commodity change unexpectedly -- as oil prices did = earlier this month -- then Enron could find itself deep in the hole and for= ced to lean on thinning lines of credit to pay its obligation. Whirlwind merger deal no reassurance Verleger isn't mollified by the notion that Dynegy, which agreed to merge w= ith Enron, has studied the company's trading book thoroughly and decided it= was fine. "Dynegy probably was not able to see its whole book in a week," = he said. Added another trader, who declined to be identified: "How anyone c= ould do such fast due diligence is beyond me completely." Another trader sp= eculated that auditors at Dynegy -- a much smaller firm -- may have initial= ly given Enron a free pass on some disclosures because it was considered on= e of the cleverest and best-connected companies in the nation, with a chief= executive who was a major financial backer and friend of President George = W. Bush. Reynolds, the CreditSights executive, said that investors should beware wha= t he calls "omission risk" -- or the simple fact that "what you don't see i= s what gets you every time." He points out, for instance, that Enron had a = chance to tell investors about its ratings-related exposure in the Brazilia= n deal during a conference call with investors last week, but didn't. "It b= oggles the mind" that they have kicked away every opportunity to rebuild co= nfidence and credibility, he said. So what if gremlins pop out of the swaps closet? Reynolds believes that Dyn= egy will use broadly written escape clauses in its merger agreement to walk= away from its Enron merger if unexpected swap defaults -- called "fails" i= n the business -- emerge. He believes that Enron would then find it necessa= ry to seek the protection of bankruptcy court, because no other merger part= ner or bank is likely to follow in Dynegy's footsteps to the altar. In that event, Reynolds estimates Enron's stock -- which traded for $85 a y= ear ago -- could quickly sink to less than $2 from its current perch in the= mid-single digits. Since holders of more than 80 bonds and senior bank loa= ns would stand ahead of shareholders in bankruptcy proceedings, however, he= speculated that Enron shareholders would be lucky to end up with pennies.= =20 At the time of publication, Jon Markman did not own or control shares in an= y of the equities mentioned in this column,
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