Big investment banks eventually managed to standardize the contracts. J.P. Morgan and Credit Suisse launched credit derivatives products lines in 1997. Others followed, and in 1999 the International Swaps and Derivatives Association (ISDA), the industry's trade group, issued formal rules. The market began to quickly swell. In 1997, $55 billion in debt was covered by credit derivatives contracts; by the fourth quarter of 1999, that figure topped $287 billion.

The massive run-up spawned a recapitulation of age-old debates. Proponents of financial innovation argue that products like credit derivatives are nothing less than tools of progress -- market-oriented weapons that protect against instability and risk. But critics contend that new, untested markets always give con men and unscrupulous wheeler-dealers more room to hide.

Altogether, by the end of 1997, derivatives contracts represented more than $25 trillion in real assets. The question of whether the government should regulate the market or let it grow, untethered by red tape, began to heat up, fueled by some high-profile derivatives failures.

"Congress started saying that we need to regulate this stuff," recalls Greenberger, who was then the director of trading and markets at the CFTC. "Dingell [Rep. John Dingell, D-Mich., a ranking member of the House Commerce Committee] wanted to introduce legislation creating a derivatives exchange."

Enter Enron. The energy trader was fast leaving behind its commodity trading and delivery roots, and moving ever more aggressively into the world of pure finance. Enron, unsurprisingly, opposed the formalization of derivatives regulation. In April 1993, aggressive Enron lobbying had encouraged the CFTC to grant a broad exemption to the trading of energy derivatives, in which electricity dealers and wholesalers sign contracts that let both sides hedge against future price swings. But energy derivatives were just one front on which Enron's executives were advancing.

"They had an exciting agenda," said one East Coast finance professor who did some consulting for the company. Some of the brightest minds in finance and risk management wanted to work with Enron because, he said, "they were trying to move forward."

Wall Street also opposed derivatives legislation, but for slightly different reasons. The big banks argued that new laws would be too costly. Derivatives were not like the futures contracts used to lock in prices on grain and other commodities, they argued, so the CFTC should leave them alone. The SEC seemed willing to go along.

There was one dissenting voice. Brooksley Born, a Clinton appointee who became the head of the CFTC in 1996, refused to accept the industry's stance. "In late 1997 and early 1998, she said the emperor has no clothes," says Greenberger. "She said that derivatives are futures contracts and that the CFTC had jurisdiction."

On May 7, in a 62-page report, the CFTC announced that changes in the derivatives market "require the commission to review its regulations." Born called for public comment and hearings.

But Enron refused to buckle. Protests from Wall Street's major players drew more attention than Enron's opposition, but a July 4, 1998, Washington Post article revealed that Enron was forging ahead at that very moment in an attempt to create an entirely new market for "weather derivatives" -- in which contracts on energy supplies would be dependent on bets as to whether the weather was hot or cold. Such contracts would be exactly the kind of new product that CFTC regulators would likely examine.

A handful of legislators, including Sen. Phil Gramm, R-Texas, kept the forces of regulation at bay. For Gramm, derivatives deregulation was a family affair: His wife, Wendy Gramm, chairwoman of the CFTC from February 1988 to January 1993, had earlier shepherded through the exemption that (in April 1993) let Enron trade energy derivatives without federal oversight. (A few months after passage of the exemption, she quit the CFTC and took a seat on Enron's board of directors.) Enron also found a set of allies in the U.S. Treasury Department, the Federal Reserve and the SEC. All three agencies, though headed by Born's fellow Clinton appointees, scorned the new CFTC proposal. They even issued a rare joint statement declaring that "we have grave concerns about this action and its possible consequences. We seriously question the scope of the CFTC's jurisdiction in this area."

Congress, caught in the middle of a regulatory turf war that involved some of the country's most generous campaign donors, also declined to show interest in regulation. It maintained this stance even as, in September 1998, the huge hedge fund Long Term Capital Management warned the Fed that, in part because of its derivatives strategy, it was about to go under -- and threatened to drag several major banks down with it.

But despite the link between LTCM and derivatives, calls for regulation fell on deaf ears. After organizing a bailout of LTCM, Fed chairman Alan Greenspan -- along with SEC chairman Arthur Levitt; William J. Rainer, Born's replacement at the CFTC; and Lawrence Summers, secretary of the treasury -- penned a 42-page report that favored less, rather than more regulation.

Congress followed suit, passing the Commodity Futures Modernization Act in December 2000.

"The CFMA made it clear that this kind of trading would be exempted," Greenberger says. "Only a handful of congressmen and senators probably realized that they were enacting this deregulatory provision."

Brooksley Born "had it just right," and should be considered a hero, adds Martin Mayer, a finance expert and author of more than a dozen books on the U.S. banking system. "The whole political establishment, from Rubin and Greenspan and Levitt and Phil Gramm, turned on her."

And Enron forged on, stepping up its involvement in derivatives markets dramatically. The company's spokespeople failed to return calls for comment; Born also refused to comment because her law firm now represents several Enron creditors. But observers argue that the CFMA essentially let Enron move forward with its plan to aggressively court derivatives buyers and sellers.

By the end of 2000, a year after the launch of Enron's Web-based trading site EnronOnline, the company's derivatives business had more than quintupled in a single year. Assets increased from $2.2 billion to $12 billion; derivative-related liabilities increased from $1.8 billion to $10.5 billion.

It's not clear how much of this growth came from credit derivatives, although S&P's finding of $3.3 billion in exposure at Enron suggests that it played a major role. But regardless, Frank Partnoy, a law professor at the University of San Diego who cited Enron's derivative growth figures in testimony before Congress on Jan. 24, argues that Enron should never have been able to become such a powerful derivatives player. The financial and government institutions that protect the financial markets shouldn't have let the company gain so much as a foothold, he says.

"The collapse of Enron makes plain that the key gatekeeper institutions that support our system of market capitalism have failed," he told the Senate Committee on Governmental Affairs. "The institutions sharing the blame include auditors, law firms, banks, securities analysts, independent directors and credit rating agencies."

Specifically, Partnoy argues that the derivatives market is too easy to penetrate because all that's required is "credit worthiness and decent reputation." If one of the nation's three credit-rating agencies -- Moody's, Standard & Poor's or Fitch IBCA -- give a company an investment grade rating, it can essentially act like J.P. Morgan Chase or Citigroup, two of the world's biggest banks. But Enron was able to offer credit without being required to keep a set amount of capital in place, as banks are. And whereas traders dealing with securities or futures contracts must pass difficult licensing exams, companies that trade only in derivatives often can do as they please.

Enron managed to become a major player in the derivatives market not just by taking advantage of these loopholes. The company also built up its reputation through a mix of deceit, hobnobbing and bravado. Its high credit rating was maintained by hiding billions of dollars of debt in off-balance sheet partnerships. Its gravy train included prominent economists, politicians and journalists. By dint of ceaseless self-promotion, executives like Ken Lay and Jeffrey Skilling made Enron's name synonymous with successful financial innovation.

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