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From Enron to credit default swaps

By Kshama V Kaushik & Kaushik Dutta
December 20, 2008 09:57 IST
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Unregulated energy market trading led to the Enron debacle -- that this was repeated with CDSs shows we've learnt little and new regulations like Sox were a sham.

Manic Monday, Tragic Tuesday, Black Friday. We are not short of monikers to describe the current financial market meltdown that has dragged the world into recession. But everyone is suffering from a short-to-medium term memory loss and a failure to learn from past mistakes.

The root cause of the current crisis, it is well-known, is an obscure financial instrument called Credit Default Swaps  which started in the US creating a new originate-and-distribute model of transferring risk in a security.

CDS is a contract that provides insurance against a bond issuer defaulting on its debt. CDS is supposed to provide peace of mind to the buyer by covering the risk of default.

These instruments began to get popular a decade ago -- in a booming economy, there was little perception of danger of corporate default and CDSs began to be regarded by banks, hedge funds and traders as an easy source of money because, while these agencies were tightly regulated, the credit swap market was  free to operate without restrictions.

The CDS market then expanded into riskier instruments including the secondary market where speculative investors would buy and sell CDSs without any connection with the actual underlying instrument.

It exploded over the past decade to more than $45 trillion by mid-2007, about twice the size of the US stock market.

Further, this and similar financial tools were kept out of reach of scrutiny by the Securities & Exchange Commission and the Commodities Futures Trading Commission (both market regulators) through the Commodity Futures Modernisation Act of 2000.

P>Thus, regulators could not verify whether financial institutions like hedge funds or investment banks had the assets necessary to cover losses that they were guaranteeing.

This is uncannily similar to the unregulated energy trading markets that led to Enron's collapse which triggered a chain of corporate collapses followed by intensive regulation.

In 2002, Enron ran a huge and almost completely unregulated derivatives exchange business that had little or no relation to any underlying fundamentals.

The profitable derivatives market attracted a frenzy of activity across small and large players, most of whom had scant understanding of the working of the market.

No one was required by law to post collateral to back up their positions or even disclose to investors the size of their huge derivatives position.

Furthermore, it was left to the originators to determine the fair value of these derivatives.

After Enron and the spate of corporate failures, stringent regulations were put in place all over the world; Sarbanes Oxley and its global clones required companies to develop strong and robust internal control systems, have real independent boards and increased personal liability of directors and auditors -- this also raised compliance costs for the entire corporate world. 

The crisis of 2008 reached a tipping point because of the liquidity crunch faced by banks and the entire financial sector in the US following the sub-prime mortgage crisis.

Investors in CDS markets took a hard look at whether parties insuring the instrument would, or more importantly, could pay up in the event of mass defaults.

There was a steady write-down in the value of CDS holdings among banks, insurers and re-insurers. Rating agencies woke up to the impending threat and began to downgrade financial institutions.

Downgrading rating of insurance companies was particularly devastating for market confidence because it called into immediate question the insurance coverage of banks and other corporates who had bought insurance covers from them, setting off a domino effect in the entire market.

The magnitude and the seriousness of the crisis can be estimated by the fact that in the Mecca of capitalism and laissez faire, the federal government took over management of two mortgage agencies, Freddie Mac and Fannie Mae, to ensure their financial soundness.

But the takeover of these two companies did not stem the bleeding; one by one, the seemingly-solid institutions either went bankrupt (Lehman) or were forced to sell cheap like Bear Stearns, Merrill Lynch, etc. AIG had to be rescued by the US government but only because its failure would have been disastrous, not only for investors but for the very credibility of the US capital market.

The root cause of the current crisis can be summed up as: new and unregulated financial instruments which propagate an originate-and-distribute model of transferring risk, inadequate understanding of financial nuances by players, allowing speculative investors to operate without any stakes of their own, and the role of regulators and rating agencies.

In short, there has been a complete breakdown of corporate governance and management incentives in financial institutions. The securitised instruments were off-balance sheet and that was one of the things that took Enron down.

It is inevitable that there will be a fresh round of regulations; unfortunately, regulation is often reactive and more inclined towards plugging loopholes exposed by innovative players who invariably seem to be a step ahead of regulators.

Once again, despite Enron and Sarbanes-Oxley, off-balance sheet items and special financial vehicles are responsible for much of the mayhem.

Also, poor risk management by financial institutions leaves investors wondering whether the magic formula of more independent directors touted as a remedy in the wake of Enron has had any effect; did the Board really have the capability to understand the intricacies of complex financial transactions?

The International Accounting Standards Board is already looking at requiring lenders to disclose their off-balance sheet interests in a strict form to improve the transparency of a bank's accounts.

In April 2008, the Basel Committee on Banking Supervision  recommended measures that include establishing higher capital requirements for certain complex structural credit products such as collateralised debt obligations, strengthening capital treatment of liquidity facilities extended to support off balance sheet vehicles such as asset-backed commercial paper conduits, strengthening capital requirements of banks' trading books, enhancing disclosures relating to complex securitisation exposures, strengthening risk management and supervisory practices including management of off-balance sheet exposures, capital planning processes.

The crisis of credibility that banks, financial institutions and particularly rating agencies face is something that will take time to recover and business will be subject to even higher levels of regulations. Enron had anyway raised the cost of compliance for global businesses but lessons of Enron have, sadly, not been learnt.

The authors are Chartered Accountants and authors of the book 'Corporate Governance: Myth to Reality'. Kaushik Dutta is a partner of Price Waterhouse

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Kshama V Kaushik & Kaushik Dutta
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