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 Interview with Nick Kochan of The Banker magazine for the February 2002 issue

Enronitis and Irish Eyesitis: Lessons from Enron and Allied Irish Eyes

5 February 2002

Derivatiphobia, the spine-chilling fear of anything associated with the "D" word shows no sign of disappearing. The latest virulent strains, Enronitis and Irish Eyesitis, is now causing widespread panic. In  ("Enron: virtual company, virtual profits", February 4, 2002) The Financial Times listed as a means of squaring a circle "Use derivatives". 

But The Equitable Life experience demonstrated, firms also crash through failing to use derivatives to manage risk. Mark-to-market accounting is being blamed. But the problem often is not the derivative per se or the accounting treatment, but the assumptions used to calculate present value and the transparency of the methodology used. Deliberately understating value is just as unsatisfactory as overstating it. Perhaps the balance has swung too far towards blind faith in calculations that boards and shareholders do not adequately understand, and more dangerously, are too embarrassed to demand justification. I wrote in <Key financial instruments: understanding and innovating in the world of derivatives> "Every dealer worth hiring is intelligent enough to out-smart his management accounting / bonus system.  Accounting reports seldom accurately reflect the risk and good dealers can outwit their auditors. Moreover, individual performance bonuses can encourage at best "accounting engineering" a "double-or-quit" attitude or outright fraud. Dealers have a free option. Employers don’t sue them for losses. Bonuses should be based on team performance as conspiracies seldom hold firm for long. Ensure sound character of Treasury staff. This is just as important as technical ability and ensures that Treasury performance targets are realistic." Warren Edwardes, delphi risk management

One lesson from the Enron case is the danger of employees putting all their pension eggs in one basket - especially their employer's basket." says Warren Edwardes, ceo of banking innovation and risk consultancy Delphi Risk Management. "There has been a shift away from final-salary pension schemes to money-purchase schemes. But unlike final-salary schemes all risks on money-purchase pensions are borne by employees. The shift in the risk burden to employees should be accompanied by a shift in responsibility and authority. Corporate pension schemes should be valued and quoted daily. And employees should have the right to transfer their pension funds away from their firm's scheme to an external fund manager of their choice or even to the pension scheme run by another firm. Thus Enron employees could have had the right to move their pension scheme to Microsoft's pension scheme or vice versa, subject to performance or even to a self-selected diversified pension portfolio. Fully portable and unitised pensions would especially protect employees in firms where the pension funds invest in the parent company, such as at Maxwell's Mirror or at Enron. It is sad to lose one's job. But foolhardy to lose one's pension at the same time.  Warren Edwardes, delphi risk management

"The Enron case also shows the dangers of overconfidence in subjective valuations especially those of future uncertain income streams perhaps spanning over a decade which are then securitised and sold off to unsuspecting investors. There are a large number of 'principal finance' boutiques who specialise in buying staid companies with attractive cash flows. Do these financiers value the future cash flows on their investments on the same rose-tinted accounting basis as Enron had? But it is just as dangerous to undervalue investments not bought as it is to overvalue investments purchased. Market conditions change and it is incumbent on investors and bankers to continuously revalue their assets - objectively."  Warren Edwardes, delphi risk management 

Some top of the head thoughts on Enron....There seem to be two factors in Enron that interest me. The first involves the arrangements whereby JP Morgan had its loans repaid not in cash, but in electricity or oil futures contracts. There seem to be two areas of risk here that need covering, first, the possibility that Enron doesn't deliver the electricity (as now, presumably because it no >longer trades), second, given the fact that these are futures, there must be a possibility that the price of the electricity or oil will fluctuate. The first risk is covered by JP Morgan which sells credit derivatives to other banks to offset some of the risk of default. I am afraid I do not understand how credit derivatives work in this context. How is the bank that buys the credit derivative rewarded? Or does JP Morgan pay the bank a percentage of the credit/risk which the other bank assumes.  Nick Kochan, The Banker magazine 

I do not have first hand knowledge but the electricity contracts will probably have been forward contracts not futures contracts. Futures are exchange traded forward contracts and are revalued daily with gains and losses settled daily. So they have no intrinsic value being built up. Forward contracts on the other hand are bilateral and therefore a value positive or negative will be built up as electricity changes in value. There are basically two kinds of derivatives - forward contracts and options. Forwards are commitments to buy or sell something in the future, irrespective of the price when the contracts mature. There is no fee involved. The parties take a view as to whether the price is going to rise or fall. The contracts are symmetric. Options provide the buyer the right but not the obligation to buy or sell something. They are insurance policies. The buyer pays an insurance premium and then has no further obligation. The option seller's has an obligation to pay up on the insurance policy but its income is limited to the premium received. The contracts are asymmetric. A bank or insurance company that buys the credit derivative is betting that the risk on the company as perceived by the market will improve. It is up to the buyer to do its analysis correctly. But what if the bank getting rid of the risk to the insurance company is itself in a position to trigger a default? It is like taking out a bet with a boxer who may decide to take a dive.   http://dc3.co.uk/bet.htm     http://dc3.co.uk/credit.htm    Warren Edwardes, delphi risk management

JP Morgan  has also brought in insurance companies to cover the possibility of default. I assume here J P Morgan pays the insurance company a 'premium' weighted on the size of the credit covered. But how usual is it to involve insurance companies, indeed, is this, as some suggest, the route of the future. The issue here is financial engineering racing ahead of regulation.
Nick Kochan, The Banker magazine
see Regulatory change required to meet blurred financial edges http://dc3.co.uk/finance.htm  My letter Published by The Financial Times on 23 July 1997   There is a growing overlap between banking and insurance perhaps because there is a difference in risk management methodologies and regulation. This is likely to continue for some time and is a major area of growth in the markets. In a decade or so there will, perhaps, just be financial institutions that combine both banking and insurance technologies. If The Equitable Life had not ignored the risk on its interest rate guarantees and used derivatives it would not have fallen. Its losses through not using derivatives were a multiple of the losses that brought down Barings which fell through derivatives mismanagement. Warren Edwardes, delphi risk management

The fluctuating price of energy can clearly be hedged with dynamic products such as options priced against changing energy prices. Assuming options were in place, would they be the responsibility of JP Morgan or Enron. The issue here would seem to be ownership of the commodity contracts. I assume JP Morgan owns the contracts as this is there eventual means of loans repayment.
Nick Kochan, The Banker magazine
The options could have been those written by Enron or JP Morgan. JP Morgan could have stood in the middle and sold on options it had bought from Enron. Or the contracts could have been back to back.

The second big issue that I detect, is JP Morgan's 'collusion' with Enron, and one must assume Arthur Andersen, in devising a scheme linked to a client's tax objectives.  Again two issues arise. First, such schemes require activities to occur off balance sheet. This makes them complex, from the point of view of regulators, rating agencies and ultimately shareholders.  So it is very difficult for non-insiders to understand a bank's exposure. This of course must be one reason why the scheme is devised. But this problem is as old as the hills.
Nick Kochan, The Banker magazine
Caveat emptor. JP Morgan and Andersen will have to mount damage limitation campaigns to defend themselves beyond legal liabilities. They will have to protect their reputations. If a bank is perceived to indulge in sharp practice a Treasurer will be reluctant to stick his neck out to deal with it. After all if a deal goes wrong, a treasurer will be criticised ex post: "Didn't you read about those dodgy deals that bank did last year?". There would be no upside benefit. Warren Edwardes, delphi risk management

More problematic is the proximity of the bank to the client. Banks are desperate for fees, but they need to be able to pull back when the client's systemic risk outweighs the financial reward. Here one wonders whether the bank knew it was being sucked into the Enron internal crisis, or whether Enron pulled wool over its eyes.
Nick Kochan, The Banker magazine
The old story: "If you owe a thousand then you are in trouble. If you owe a billion, then the bank is in trouble!" Warren Edwardes, delphi risk management

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