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
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
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
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