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Sunday, Nov 22, 2009
How did Enron break into the elite Wall Street world of bankruptcy insurance?
Feb 5, 2002 | Congressional investigations, class-action lawsuits, campaign contributions and 401K reform. Paper shredding, books cooking and wives crying for "Today Show" cameras.
Enron's collapse has generated so many huge stories that it's been easy to miss one of the most ironic and self-revealing of all its myriad ventures. Enron, now famous for the largest corporate bankruptcy in American history, was also a big player in the relatively new market for buying and selling bankruptcy protection.
Enron's whiz kids dabbled in a wide variety of high-finance maneuvers. But its presence in the market for what are technically called "credit derivatives" was eye-opening -- or should have been, to anyone paying attention. The credit derivative game is dominated primarily by huge banks -- just seven institutions handle 96 percent of the multibillion-dollar business.
With good reason. Credit derivatives are designed to minimize risk. They are, in their simplest form, insurance policies on other assets. By buying a credit derivative, a bank, for instance, will pay another entity to assume the risk of a loan that it fears will not be paid back. If its hunch proves correct, the seller of protection will have to cover the loan. Since credit derivatives carry the potential for sudden, huge payouts, buyers rarely want to purchase credit derivatives from a risky provider. So sellers tend to be big and rich enough to handle large defaults without going bankrupt.
So what was a supposed energy trader from Texas doing in a market that epitomized Wall Street? According to derivatives experts, the Houston company bluffed and cajoled its way to the table, pretending to be bigger and more stable than it really was. At the same time, it used its formidable lobbying power in Washington to ensure that federal oversight over precisely this type of market was to all practical purposes nonexistent, and then proceeded to screw it up on a vast scale.
Operating without a net -- or a watchdog -- Enron trotted into one of the world's most complex financial arenas and made a colossal, billion dollar mess, inserting risk into a market designed specifically to avoid it. According to Standard & Poor's, the credit rating agency, Enron's collapse has thrown at least $3 billion worth of credit derivatives contracts into limbo. So far, Enron's bankruptcy hasn't set off a wider financial panic, but according to some experts, the credit derivatives fiasco nevertheless reveals larger systemic problems. The company's push into credit derivatives not only proves that it's possible to dupe some of the best financial minds in the world, but it also exposes potentially dangerous loopholes in the U.S.'s financial regulatory system. The SEC regulates the investment banks that typically dominate credit derivative trading. But Enron wasn't a bank -- so it escaped supervision.
Because derivatives markets are easy to enter and disclosure rules are weak, some experts believe that it's only a matter of time before another rogue derivatives player surfaces, fails and sends even greater shock waves through the system.
"There are other potential time bombs ticking," says Michael Greenberger, a law professor at the University of Maryland and the former director of trading and markets at the Commodity Futures Trading Commission (CFTC). "We don't know how many other companies like Enron are out there."
