Derivatives Under Fire
IDD - May 20, 2002

A Wall Street derivatives professional was considering how his business had changed since Enron Corp. declared bankruptcy and dragged all types of financial derivatives into the muck of its wide-ranging scandal.

He explains it this way: One potential customer came to his firm looking for a way to move earnings from the current year to the next two years to smooth out the balance sheet; another came hoping to run some liabilities through a subsidiary. Both were turned away.

"There's a clear line in the sand. I'll do a transaction that has clear business purposes but I won't do one that's cosmetic or trying to fool someone," says the head of derivative capital markets at one of the top bank players. "We're not going to do deals whose sole objective is to modify ratings agency views or attempt to recharacterize debt. Those are going to be much more scrutinized."

For Wall Street, such deals had become part of the booming business in over-the-counter (OTC) derivatives-a high margin business that has fattened the firms' bottom lines at a time when M&A and equity underwriting fees are hard to find. To understand how important this business is, consider the fact that at J.P. Morgan Chase, some 20% of its revenues last year came from derivatives.

Ever since one of the derivatives market's biggest players-Enron-imploded last fall, the complexity and the risks associated with these instruments have come under fire. OTC derivatives have always flourished in the gray areas; many were created precisely to get around regulations or other market impediments.

Yet at a time when demand for certain derivatives-particularly those offering a hedge for credit risk-is growing by leaps and bounds, worry about the risks of such products is likewise increasing exponentially. Now the special purpose entities (SPEs) that are used to house some of the most popular new derivatives products-synthetic CDOs (collateralized debt obligations)-and over a decade ago were created by Wall Street firms to handle their derivatives business outside the eyes of regulators, could be in for a setback.

If new accounting rules or regulations are instituted, it's likely that instead of being hidden from view, at least some of the business will have to be disclosed, capitalized and the positions marked to market. The rest will be more expensive to finance. That may make these derivatives less risky-but they will also be less profitable.

"Think, Prohibition," cracks one consultant, in reference to what many industry players see as an almost hysterical approach emanating from Capitol Hill on the subject. Even New York Federal Reserve Bank President William McDonough warned last week that if companies didn't produce better derivatives exposure, it could spark a regulatory over-reaction.

If regulators are overreacting, it may be because it isn't the first time derivatives have caused trouble. In fact, they have played prominent roles in just about every market crisis in recent years. In 1994, Orange County lost $1.6 billion and went bankrupt playing the derivatives market, and in the global market crisis of 1998, Long-Term Capital almost took down the entire system by its derivatives bets. Enron was able to put its losing derivatives positions in its SPEs, allowing it to mask its problems and build up its debt outside the eye of shareholders before it went under in one of the most far-reaching corporate scandals ever seen.

The leverage of derivatives-which is unlimited in the unregulated over-the-counter market-gives them potential for abuse, allowing players to take speculative positions or engage in complicated and little-understood trading strategies. "There's always a question with the end users," says Tanya Azarchs, a derivatives analyst at Standard & Poor's. "Are they using an instrument to hedge or making leveraged bets?" she asks. The lack of disclosure-the off-balance nature of SPEs for example-compounds the problem.

But at the same time, the derivatives market allows investors and companies the ability to mitigate the financial risks of buying currencies and commodities, and allows them to hedge the risk of holding stock or debt of publicly traded companies.

The newest market, for credit derivatives, is a way to allow major banks to continue to underwrite loans, and mitigate the risk of holding them at the same time. In addition, insurance companies and hedge funds can offset the risk they take on by buying corporate bonds or pieces of loans. Derivatives have also become key to the housing market; Fannie Mae and Freddie Mac have $700 billion in derivatives they use to hedge the interest rate risk of the home mortgages they buy. But because little is known about the housing agencies' derivatives positions, critics are concerned that a sudden, dramatic move in interest rates could cost the companies' shareholders, and taxpayers, billions in losses.

Who's buying, who's selling

The worry about derivatives has forced a number of companies, such as J.P. Morgan Chase and Dell Computer Corp., to come clean about how they are playing the derivatives game. It all boils down to risk: Who's selling it, who's buying it and whether a company can explain it adequately enough to satisfy both shareholders and regulators. Around Wall Street, the potential for vilification of all derivatives is no small area of concern. "When there's a car accident, " asks risk management consultant Leslie Rahl, "do you blame the driver? Or do you blame the car?"

The drivers are many. There are the investment banks such as J.P. Morgan, Deutsche Bank, and Merrill Lynch & Co., which serve as dealers and come up with new and ever-more-creative derivatives products. There are insurance companies, banks and other corporations that need the products to hedge risks or use them to bolster their bottom line. And there are investors such as hedge funds, pension funds and other institutional investors who play derivatives for speculative purposes.

But in these market conditions each will have to contend with heavy regulatory attention and newfound shareholder vigilance without any relief from the forces that made such complex products necessary in the first place. It's new and tricky ground to cover.

"Hedging is here to stay. It's not as if Enron is going to change that and it's not as if hedging appropriate financial risk is going away," says Brian Stephens, a partner in KPMG's financial services practice. "But the products may be more plain vanilla with less bells and less whistles. People are thinking, If we can't articulate this, maybe it's something we shouldn't do.'"

Even some of the simplest derivatives don't look so good these days. Take the case of Dell, and how it had to come clean in a recent 10-K filing about its options market antics.

Like many technology companies in the heyday of the bull market, Dell got into the habit of selling put options on its own stock. These transactions, almost always done over the counter with a firm such as Morgan Stanley or Goldman Sachs taking the other side before selling at least some of the position in the public market, were meant to let Dell rake in the options' premium against the unlikely odds the share price would fall below the strike price of the options. When it did, Dell was forced to buy back its own shares at prices higher than current market levels.

That strategy worked well until the wheels came off the equity market and Dell shares plummeted to $25 from $50 in the past two years, and the company was forced to buy back 68 million shares to fulfill its end of the options contract. To meet those obligations, Dell had to shell out $3 billion in its 2002 fiscal year. During the late 1990s, no one thought much about the practice, which was commonly followed by tech companies. With the stock rising, the options expired worthless, and the earnings brought a burst of octane to inspire yet more confidence in their shares.

OTC options deals like Dell's are a simple-enough equation to understand: The stock goes up, the options play is a win; the stock falls too far and it's a loser. The popularity of such strategies typically wanes with changes in market conditions.

FASB as antagonist

Many of the games played in the derivatives market came to light due to a change in accounting rules that went into effect in 2000. After years of delay, and despite the railings of industry, the Financial Accounting Standards Board in 1999 passed a rule, known as FAS 133, that required companies to provide a higher level of transparency in including derivative instruments when providing financial results. Specifically, unless a derivatives position could meet the FASB's standards as a hedge, it would have to be marked to market on the balance sheet, with a commensurate impact on earnings.

"What FAS 133 has done is force companies to disclose everything and the what-if' scenarios," says one veteran options trader. That of course took some of the wind out of the market. "The reason people do OTC derivatives in the first place is because they didn't want to talk about it."

If derivatives players groaned about FAS 133, they are even more upset about the FASB's next act. The FASB is currently studying a way to reinterpret guidelines for derivatives consolidation into corporate balance sheets. The group is studying FASB 94, which is the rule that governs SPEs.

To avoid the problems incurred by Enron, which had legal responsibility for its SPEs although they could be found nowhere on its balance sheet, the FASB proposed two weeks ago that if any third party is holding less than 10% of the equity in an SPE-contrasted to the 3% demanded today-the SPE must be consolidated into the parent company's balance sheet. The change is aimed at ensuring SPEs have enough independent participants to avoid being built simply for a company or its executives to manipulate balance sheets.

"This change alone would increase the number of SPEs that would be consolidated," according to a KPMG report to clients in March. Those that aren't consolidated would be more expensive for companies to set up, as they are now financed by issuing debt, but more equity issuance would be required under the new rules.

"Structures unconsolidated under the new rules would likely incur significantly higher financing costs for asset transfers or lease arrangements because the returns paid to the equity investors are higher than the returns paid to debt investors," according to KPMG's analysis.

FASB spokeswoman Sheryl Thompson says the board is meeting this week to discuss the SPE consolidation issue. And while the 10% limit has been "tentatively" decided upon, the group will focus the rule on ensuring that any SPE is of "economic substance." She says the group will issue an exposure draft in the second quarter of this year, followed by the public comment period with an eye on finalizing standards by the end of 2002.

While some discount the risk of new FASB regulation to the overall derivatives market, one New York trader is concerned. "The risk is that they come out with the most draconian rules. One can only imagine what they'll do," he says. "One possible outcome is that all securitization will end up on the books."

If special purpose entities or CDOs are measured differently on corporate balance sheets, that could hurt the players that use them as a hedge. "A lot of these structures have built-in derivatives that reduce volatility and reduce risk to investors," says KPMG's Stephens.

But few doubt that new derivatives abuses will sprout to replace them. Rahl, who runs Capital Markets Risk Advisors, says she's not a big believer in rigid rules governing derivatives practices. "Those only encourage creative financial engineers to work around them," she says.

Big business

The OTC derivatives business has become one of the more competitive on the Street, and like most other businesses, it has become the Valley of the Giants for all the obvious reasons. "As a dealer, you have to have the willingness and ability to take risk, the distribution to sell product and innovative people who are doing interesting transactions," says John McEvoy, the president of Creditex, an electronic credit derivatives trading platform.

The OTC market grew up as an alternative to exchange-traded futures and options for a number of reasons. It allowed customized solutions to problems, it offered unlimited leverage, and it was done behind closed doors. But unlike the exchange-traded business, there's no exchange to absorb the risk of losses. As a result, the strength of individual counterparties is critical for both dealers and investors.

The result is that there is new worry about the creditworthiness of Fannie Mae and Freddie Mac's counterparties, with their huge derivatives book, as there also has been about the leading credit derivatives player, J.P. Morgan Chase, which has credit derivatives exposure on some $24 trillion worth of debt, the so-called notional value. In recent disclosures to investors, the bank outlined which percentage of its derivatives counterparties were investment-grade and which ones were not. It even broke that down further, noting that 39% of its counterparties are rated AAA/AA.

The argument is that credit derivatives actually lessen risk all around. "People are getting paid to take on risk and people are paying to get rid of it," says Creditex's McEvoy. "There's actually a greater dispersion of risk (with credit derivatives)."

But the banks are taking on the risk; whether they are getting paid enough is a matter of some dispute, especially given the concentration of this market. "I think the worry is that the big derivatives dealers are very big, and no one knows what their exposure is," says S&P's Azarchs. "The landscape is far too consolidated. There are not enough corporate lenders and not enough dealers."

According to a J.P. Morgan investor presentation, less than 0.4% of its balance sheet is exposed to OTC credit derivatives. Firms such as Deutsche Bank and Bank of America have similar exposure levels, according to J.P. Morgan, even though the notional value of their business is a mere fraction of what J.P. Morgan does.

Players acknowledge that while there's risk, there's still money to be made. Because credit derivatives are a relatively new market, bid/offer spreads are sweet, structuring fees on newfangled products, such as synthetic CDOs, are hefty, and there's still room for arbitrage. "Over the past year or so, credit derivatives is certainly the biggest area of trading expansion on the Street," says Creditex's McEvoy.

While banks tend to run the derivatives business out of their main units, securities firms opt for doing them out of unregulated subsidiaries, although the financials of those units mostly do get consolidated onto the firm's balance sheets.

The business suits the biggest firms best. But around the edges, smaller firms such as Bear, Stearns & Co. and Lehman Brothers and some second-tier banks such as ABN Amro and First Union are currently in the market, says McEvoy.

Even though analysts like Azarchs worry about concentration, some believe that issue will get worse, not better. "Right now, there are a lot of clients going to a lot of banks. They're shopping around a little bit," says Peter D'Amario, a consultant with Greenwich Associates. "But there isn't enough business to go around for six or seven banks. It can't be sustained long-term."

The case for secrecy

There may be many good reasons for shedding light on the OTC derivatives market, but dealers worry that it will lose its raison d'etre as a result. Consider the OTC equity derivatives market. Investors and corporations like to use it without letting the rest of the world know, for fear of diluting their stock positions or price. Even in the wake of Enron, that rationale hasn't changed much, according to one head trader at a large New York firm's derivatives desk.

"There's still an element of people who do exchange look-alikes or structured positions upstairs for the sole purpose of anonymity," he says. "There are buy-writers and synthetic traders who want to do things that won't hit the tape. Private banks, mutual funds, hedge funds are all still doing that."

Another trader lays out the case for the OTC market: "Why don't I do it on a listed exchange? I pay less; I'm worried about the market impact; and I have a big balance sheet and am able to do it myself."

While corporations such as Dell and Microsoft Corp. have cooled their penchant for selling put options against their own stock, other tech companies and their executives will still sell put options instead of buying stock outright because they want exposure but don't want to risk short-term capital.

Other equity derivatives corporate clients, the trader says, are now "taking a deep breath and seeing what's going to happen" with both the market and the regulatory environment.

That's not too damaging in the grand scheme of things. What professionals are more worried about are companies looking to the derivatives market to smooth out balance sheets when core businesses weaken. That appears to be on the wane. The corporate side of that business, says the New York OTC equities desk chief, is showing signs of companies being "hesitant" to do anything that's too complex.

For one thing, their bankers often won't let them anymore, as many firms have instituted new, informal guidelines. Scrutiny of these markets is tough to ascertain because there's almost no disclosure and little public interplay in the actual vehicles themselves. Indeed, only when an Enron blows up do derivative positions and investor interests intersect closely enough to get the attention of regulators.

The credit derivatives boom

The big question is what will happen to the booming credit derivatives market, the fastest growing derivatives business. The value of the underlying assets of the credit derivative market swelled to $918.9 billion from $631.5 billion over the last six months of 2001 alone, according to the International Swaps and Derivatives Association.

On the one hand, the high profile bankruptcies of Enron, Global Crossing Ltd., and Kmart Corp. have, according to credit market pros, brought more players into the credit derivatives game looking for hedges. In fact, as the Enron bankruptcy was unfolding late last year, the credit derivatives market was on its way to a watershed year. Many new structures have been developed as investors and lenders seek to protect themselves against more corporate defaults.

One major investment bank executive says his derivatives team has met with 25 Fortune 500 companies since Enron declared bankruptcy, a clientele the firm hadn't seen that often in the past. "Everyone-utilities, technology firms, retail companies-is realizing they have to manage credit risk better."

The jury's still out in many ways, but the Enron collapse and subsequent high profile bankruptcies may turn out to have been the best thing to ever happen to the over-the-counter derivatives market, pros say. It not only showed the market could withstand pressure and remain liquid, but gave investors a shining example of the kind of risk that really exists and the need to hedge against it.

Until now, most of the players in the credit derivatives market have been lenders. But industry estimates see participation by money managers and insurance companies increasing to 40% of the credit derivatives market in two years from around 15% today. That growing customer base should guarantee continued competition among Wall Street's top-tier firms. Goldman Sachs, which has yet to become a major player, is rumored to have raked in $500 million in credit derivatives business last year. Goldman could not be reached for comment.

Non-believers learned how credit derivatives could protect them when a federal court ruled in March that 11 insurance companies could withhold almost $1 billion worth of payments on surety bonds to J.P. Morgan. Those bonds were designed to insure against the failure of a party to pay off its end of a commercial transaction, specifically oil and gas contracts between a J.P. Morgan-run partnership, Mahonia, and Enron.

Ironically while J.P. Morgan is the biggest credit derivatives player, it was Citigroup that laid off its Enron risk in the derivatives market. Had J.P. Morgan used credit derivatives instead of buying the surety bond, the entire case could have been averted, say market participants.

The credit derivatives market seems to be bearing out that point of view. In early April-even as politicians and the press continued to skewer accounting giant Arthur Andersen and Enron over derivatives and SPEs-Goldman Sachs auctioned a $1 billion pool of credit default swaps on 113 companies on Creditex, the largest ever attempted on an electronic platform. (Credit default swaps pay out when a company defaults on its debts.)

The deal was seen as an important event in the small credit derivatives community because such deals typically happen in a more clandestine way to keep spreads juicy, and aren't posted publicly for general consumption. Perhaps more significant, though, was that the deal was completed easily and is a type of transaction that has become commonplace in size and substance.

"At this point in time, corporate America can no longer ignore credit risk," says James Vore, executive director in the credit derivatives group at Morgan Stanley in New York. "January of 2002 was our busiest month ever."

That seems to be a constant refrain across the credit derivatives landscape. "All of us, when Enron happened, wondered what it was going to mean to the market," says Creditex's McEvoy. "The impact was two-fold. It showed people this market works because contracts were fulfilled and it showed people who have not diversified their books, that maybe they should consider credit derivatives."

Insurance companies, hedge funds and every stripe of institutional investor now look regularly to the credit derivatives markets ever since the contracts were standardized in 1999 by ISDA. "This greatly improved transparency in the market," says Morgan Stanley's Vore, "And made credit derivatives more bond-like than ever."

Until that time, credit derivatives contracts typically ran 15 pages. Now, with standardization they're no more than four, and the contracts clearly stipulate what constitutes a credit event and how the contracts are settled in the case of a bankruptcy. "In 1998, if you said I want IBM at 50' to Merrill, J.P. Morgan and Deutsche Bank, it meant three different things. Now, things are structured and well-documented."

Also key is the development of collateral agreements that ensure counterparties have cash or Treasurys equal to the value of the derivatives positions they take. "This wasn't a lesson learned in Enron," says one trader. "This was learned in Long-Term Capital," the hedge fund that blew up in 1998 after utilizing highly speculative, highly leveraged derivatives positions.

In the case of single-name default swaps, investors get simple protection from credit defaults. In recent weeks, according to McEvoy, companies sought credit swaps on entities ranging from Goldman Sachs to Portugal. Users buy and sell these either to hedge or to arbitrage bond market positions.

Others are looking to so-called "first-to-default baskets," in which the seller agrees to make a contingent payment to the buyer for the first "credit event" to affect a company in a pool but has no exposure to subsequent credit problems.

Synthetic CDO boom

The part of the business that's gaining more breadth is the synthetic CDO, which is a portfolio of credit default swaps-but which is extremely complicated. Because these are done through SPEs, their future growth could be crimped if the FASB or other regulations force them on the balance sheet.

Here's how it works: A synthetic CDO could have $1 billion in notional value built from $100 million pieces for each entity in the pool. Sellers will step up to get paid a premium for assuming the risk on the different tranches of the synthetic CDOs. "It's a matter of carving up cash flows," Creditex's McEvoy says.

Unlike standard CDOs, which are built from cash and bond positions, synthetics primarily use credit derivatives and have overall credit ratings of around BAA1 compared with the BAA3 levels typically met in the standard CDO.

CDO managers use credit derivatives in order to generate the necessary periodic income to cover the interest payouts to the CDO investors. They also use interest rate derivatives to help them pay floating rates in CDO tranches, as well.

Firms such as Mass Mutual Financial Group and Trust Company of the West are jumping into the game and looking to CDO management as a potentially lucrative revenue stream. "With all the defaults we've had, the market is saying: We like credit derivatives but we want someone looking over our portfolio,'" says one New York trader.

Those managers can switch in and out of individual credits, making the CDO more dynamic than the static vehicles that led the growth of the market.

Pros say the Enron bankruptcy may have increased investor appetite for derivatives of all types because, according to Morgan Stanley's Vore, "the market needs a way to transfer credit risk and credit derivatives are a highly effective mechanism for that purpose."

"Post-Enron, shareholders have become very educated about counterparty credit risk," he explains. "As credit derivatives continue to gain acceptance in the marketplace and are understood as a way to manage risk, shareholders may begin to ask corporate executives, Are you hedging our credit risk? If not,why not.'"

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