Fictitious Capital and Enron

[Steve Diamond <sdiamond@xxxxxxx>]

>From Doug Noland's Credit Bubble Bulletin:

Reading through Frank Partnoy's (attorney, law professor, former Morgan
Stanley derivative salesman, and author of F.I.A.S.C.O) candid and
informative testimony (http://www.senate.gov/~gov_affairs/012402partnoy.htm)
presented this week before the Committee on Governmental Affairs, I could
not help but ponder to what extent Enron exemplifies a microcosm of the
contemporary U.S. Credit system.  We can only hope that fraudulent
activities have not risen to epidemic proportions but, regrettably, we just
have no way of knowing. Fraud and malfeasance have a way of only making
their way to the surface after a particular asset class falters (like energy
and Enron!).   We are today forced to wait for the protracted boom in
mortgage finance and asset-backed securities to run its course.  Yet the
profound shift to off-balance sheet entities and vehicles, derivative
contracts, and other sophisticated instruments, certainly makes any
discussion of transparency or accurate risk assessment a bad joke.  It is
surely not comforting to learn how entangled our nation's largest accounting
firm and bank, not to mention Wall Street and Washington, were in the Enron
sham.

I remember back to early 1998 when I read in the Financial Times of the
explosion in ruble derivative hedging contracts throughout the Russian
banking system.  This piece of information, along with the knowledge that
the global leveraged speculating community had been aggressively
accumulating large holdings of high-yielding Russian government bonds, was
sufficient to appreciate that the Russian financial system had "drunk the
poison."  There was, nonetheless, no way of knowing when crisis would
erupt - in fact, the boom survived for many months - only that when the
speculative flows eventually reversed this Bubble would quickly implode into
illiquidity, dislocation and financial collapse.  The structure of the debts
and degree of systemic leverage, the nature of the hedging instruments, and
the character of the financial players involved ensured it. The day the
foreign speculators began any meaningful attempted to liquidate holdings
(get their money back!), the Russian debt market and ruble would tank.   The
Russian banks would then be called upon to pay against their derivative
"insurance," although they would by then be hopelessly insolvent.  The ruble
and government bond market would swiftly collapse and this sordid financial
scheme would be over.

The Russian debacle offered a potent mixture of fraud and wild speculative
excess (wrapped in the presentable garb of contemporary finance), with the
critical assumption that Western policymakers would not tolerate a market
collapse. It is worth noting how the most spectacular Bubbles and consequent
devastating busts occur to markets holding the most faith in the muscle of
authority.  Ignoring the fraud, it was at best a complex contemporary
financial scheme with the age-old problem that foreign players would have no
opportunity to exit the Bubble quietly.  The idea that legitimate insurance
protection could be purchased from highly leveraged and exposed financial
players was similarly ridiculous, in an intriguing contemporary twist to
traditional schemes. It is unfortunate that there has been little
appreciation for the critical role the availability of such "insurance"
played in fostering the speculative Bubble.  It was a key enticement that
altered risk perceptions for the leveraged speculators, while presenting
irresistible opportunities to Russian bankers and fraudsters alike.   This
"insurance" thus guaranteed the degree of interrelated market excess and
malfeasance that would end in spectacular simultaneous collapse in the bond,
currency, and "insurance" markets - Russian financial collapse.  There were
critical pertinent lessons from the Russian experience that were not
learned.

A sense of "déjà vu all over again" came over me this week when I read David
Gonzales' article, "Enron Footprints Revive Old Image of Caymans," in Monday
's New York Times: "Today, there are more than 400 banks and 47,000
partnerships registered or licensed in the Cayman Islands.  The banks
include about a dozen full-service institutions, with the rest being
offshore banks that by law must be affiliated with either a local or
overseas bank. By some estimates, Cayman banks hold $800 billion in American
money - a figure that last year led Robert M. Morgenthau, the district
attorney in Manhattan, and others investigating tax cases to question how
much of it was there to keep it from the reach of tax collectors.  But
Cayman bankers and officials, long accustomed to these criticisms, said that
most of that figure represents money from major American banks that has been
booked in Cayman accounts in order to gain interest, among other advantages.
'Those $800 billion are not physically in the Cayman Island, it is all in
New York,' said Conor O'Dea, managing director of Bank of Butterfield. ' It
is booked with banks in the Cayman Island.  It is not a wire transfer.  We
would love to have $800 billion in deposits.'"

And this week from the Bank of International Settlements (BIS): "Banks in
the BIS reporting area continue to make use of credit risk mitigants to
limit their exposure to the United States.  As a result, even though total
contractual claims on the United States remained stable at $2.6 trillion
during the third quarter, banks ultimate risk exposure fell further to 95%
of contractual claims.  The sectoral composition of international claims on
the United States shifted further towards the non-bank private sector and
away from the public sector.  During the first three quarters of 2001,
claims on the non-bank private sector rose by 5 percentage points to 58%
while claims on the public sector fell by 2 percentage points to 12%.
Purchases of US agency securities, in particular bonds issued by Fannie Mae
and Freddie Mac, appear to be behind this shift.

Consolidated claims on offshore financial centers rose by 4% between
end-June and end-September to $893 billion, driven by lending to financial i
ntermediaries in the Caribbean.  The events of 11 September increased
insurance companies demand for bank finance, thereby boosting claims on
Bermuda, an important center for international insurance.  Hedge funds, many
of which are domiciled in the Cayman Islands and other offshore financial
centers, enjoyed large inflows of funds during the three quarter of 2001,
and this supported increased borrowing from banks.  Securitization activity
in offshore centers also lifted bank claims."

We don't know a lot, but we do know that offshore financial centers are the
motherland for the explosion of off-balance sheet "special purpose
 vehicles," derivative trading and financial insurance.  Out there somewhere
are over $100 trillion notional OTC derivative contracts, as well as hedge
funds with "capital" are in the range of one-half trillion and positions
some multiple of "capital."  We know, as well, that the offshore centers
have come to account for a significant portion of trading in U.S. debt and
equities.  We see that there was $724 billion of total trading in long-term
U.S. securities during November in the "Caribbean," about one-third of total
foreign trading.  The Cayman Islands alone accounted for $102 billion, or
45%, of total foreign trading in U.S. agency securities during the month.
In addition, we know that many mortgage and asset-backed securities trusts,
along with the myriad of sophisticated securities and instruments, are
domiciled offshore.  This is especially noteworthy in regard to the
asset-backed security market that saw outstanding issues balloon from about
$850 billion to surpass $2 trillion in less than five years.  Inarguably,
these offshore centers have become the critical, if undecipherable,
financial engineering epicenter in a sophisticated tangled web of
unprecedented Credit and speculative excess - the debt, derivatives,
"insurance" sanctum instrumental in providing the attractive face of
legitimacy to the body of a monstrous financial scheme.  It is today asking
too much to give Wall Street the benefit of the doubt.

It has been fascinating to watch the marketplace's determination to ignore
accounting issues slowly evolve into fear of widespread irregularities. All
the while, there is careful tip-toeing around the fact that if you don't
like the accounting at Williams Companies, Tyco, IBM and GE (to name just a
few) you are bound to absolutely despise the financial statements presented
by the major U.S. financial institutions.

Let's return to Mr. Partnoy's testimony: "The first answer to the question
of why Enron collapsed relates to derivatives deals between Enron and
several of its 3,000-plus off-balance sheet subsidiaries and partnerships.
Such special purpose entities might seem odd to someone who has not seen
them used before, but they actually are very common in modern financial
markets.  Structured finance is a significant part of the U.S. economy, and
special purpose entities are involved in most investors' lives, even if they
do not realize it.   For example, most credit card and mortgage payments
flow through special purpose entities, and financial services firms
typically use such entities as well. The key problem at Enron involved the
confluence of derivatives and special purpose entities.  Enron entered into
derivatives transactions with these entities to shield volatile assets from
quarterly financial reporting and to inflate artificially the value of
certain Enron assets.

Specifically, Enron used derivatives and special purpose vehicles to
manipulate its financial statements in three ways.  First, it hid speculator
losses it suffered on technology stocks.  Second, it hid huge debts incurred
to finance unprofitable new businesses, including retail energy services for
new customers.  Third, it inflated the value of other troubled businesses,
including its new ventures in fiber-optic bandwidth..."

We have no doubt that the use of derivatives and off-balance sheet entities
for the purpose of hiding losses has become a widespread practice.  How else
can one explain that a historic bursting of the NASDAQ Bubble and telecom
debt collapse, as well as the endless barrage of non-tech corporate
bankruptcies and defaults, has not resulted in huge losses for a large
number of U.S. financial intermediaries?   Many even go so far as to
celebrate the lack of bank failures and the supposed strong capital position
of the U.S. banking system, while we are left instead to ponder "the dog
that didn't bark" - the who, what, and where of massive loss concealment.

"Transactions designed to exploit.accounting rules have polluted the
financial statements of many U.S. companies.  Enron is not alone. In short,
derivatives enabled Enron to avoid consolidating these special purpose
entities. Enron used financial engineering as a kind of plastic surgery, to
make itself look better than it really was.  Many other companies do the
same."

Mr. Partnoy's Plastic Surgery analogy is wonderful analysis. I can only add
that when it comes to financial engineering and excess making things appear
much better than they are, the issue is not Enron but the entire U.S.
financial system and economy.  And I do apologize, but when it comes to
analogies I can muster no literary discipline.  For years, the scalpel of
Wall Street finance worked like magic as it imparted on the skin of the U.S.
economy a new seductively youthful and vibrant appearance.  Seemingly, the
system could on a daily basis bask in the intense rays of Credit and
speculative excess without a care in the world.  After awhile, a game of
pretend turned to neurotic self-delusion, with the recipient believing the
New Age look and deep, dark complexion were natural and everlasting.  But
time does have a way of flying by, and that dangerous bedfellow denial
becomes increasingly powerless in deflecting the toll of accumulating
degeneration.  Wall Street surgeons now work frantically in a desperate
attempt to hide the multiplying skin cancers that seem to increasingly pop
up all over.  At some point the patient stops worrying about his appearance
and becomes acutely focused on survival.  We're just not there yet.  We're
still very much in denial.

"Enron is not the only example of such abuse; accounting subterfuge using
derivatives is widespread.  I believe Congress should seriously consider
legislation explicitly requiring that financial statements describe the
economic reality of a company's transactions.  Such a broad standard -
backed by rigorous enforcement - would go a long way towards eradicating the
schemes companies currently use to dress up their financial statements."

"Enron's risk management manual stated the following: 'Reported earnings
follow the rules and principles of accounting.  The results do not always
create measures consistent with underlying economics.   However, corporate
management's performance is generally measured by accounting income, not
underlying economics.  Risk management strategies are therefore directed at
accounting rather than economic performance.'"

Enron as microcosm?  There is absolutely no doubt that the true health of
the entire U.S. economy has been both severely distorted and misrepresented.
As Partnoy pointed out, "most of what Enron represented as its core
businesses were not making money."  Accounting subterfuge disguised this key
fact.  We would strongly argue that the true wealth creating capacity of the
U.S. economy has been grossly misrepresented.  Ignoring the issue of fraud,
there is absolutely no doubt that throughout the entire U.S. system
financial "profits" mask what should be considered a distressing decline in
true economic profits.  While Wall Street strategists are unvexed as they
net Fannie Mae's almost $2 billion 4th quarter "profits" against some huge
losses suffered throughout the goods producing sector, this gimmickry only
masks profound structural deterioration in the soundness of the real
economy.  The Enron situation provides a very apt illustration: "While Enron
gained more than $16 billion from these [derivative] activities in three
years," cash flows waned and debt structures became increasingly perilous.
Only the continued conspiratorial charade played by management, the
auditors, bankers, rating agencies, and Wall Street analysts could keep the
pyramid from collapsing.  It is really only a case of once you begin living
a lie it's very difficult to return to honesty.   In finance lies tend to
mushroom, but the truth of cash flows and debt structures does come out in
the end.

"The credit rating agencies in particular have benefited greatly from a web
of legal rules that essentially require securities issuers to obtain ratings
from them (and them only), and at the same time protect those agencies from
outside competition and liability under the securities laws.  They are at
least partially to blame for the Enron mess. An investment-grade credit
rating was necessary to make Enron's special purpose entities work, and
Enron lived on the cusp of investment grade. The importance of credit
ratings at Enron and the timing of Enron's bankruptcy filing are not
coincidences; the credit rating agencies have some explaining to do."

We have myriad problems with the reality that structured finance has come to
absolutely dominate the U.S. Credit system.  Some of our concerns are
clearly illuminated with the Enron debacle.  Financial schemes are really
leveraged confidence games, so debt ratings become an instrumental component
of the manipulation.  And the longer the scheme plays out, the larger the
borrowings, the greater the expropriation of value from shareholders and
creditors, and the more paramount becomes the perception of soundness for
the underlying financial structure.  In the case of Enron, despite the
deterioration of the core businesses and cash flows, the rating agencies
were obviously very reluctant to cut the debt ratings lifeline.  Surely they
understood that any move against Enron would be catastrophic.  This is such
a conspicuously flawed process, and we certainly will not be relying on the
accuracy of rating agencies' assessment of the key players throughout the
"structured finance" edifice, including the GSEs, Credit insurers,
securitizers, money center banks, and Wall Street securities firms, along
with all the various related entities, vehicles and instruments.  Instead of
more objective and appropriate ratings, the pressure on the agencies will
become only more intense, as the wagons are circled around a faltering
Credit system confronting an increasingly serious crisis of confidence.
Like Enron, the U.S. Credit Bubble won't survive without the preponderance
of top ratings throughout "structured finance."

"Derivatives based on credit ratings - called "credit derivatives" - are a
booming business and they raise serious systemic concerns.  The rating
agencies seem to know this.  Even Moody's appears worried, and recently
asked several securities firms for more detail about their dealings in these
instruments.  It is particularly chilling that not even Moody's - the most
sophisticated of the three credit rating agencies - knows much about these
derivatives deals."

Credit derivatives are a major accident in the making.  We have discussed on
several occasions our view that writing insurance against potential Credit
or market losses is not a legitimate business (see Its Wildness Lies In
Wait - 10/12/01).  Such losses are not "insurable events," since they are
particularly non-random, highly interdependent, and unpredictable.  And
unlike true insurers, players in this arena are not accumulating pools of
insurance reserves to settle calculable future claims, but are instead
relying on sophisticated models and dynamic hedging strategies.  We view
Credit derivatives more in terms of a speculative financial scheme than an
insurance marketplace.  There are, no doubt, already huge losses hidden
somewhere in the darkness of Credit default swaps and other derivatives, but
this arena has become such a critical cog in the greater Credit scheme that
the guise of legitimacy must be staunchly defended. Our greatest fear,
however, is that Credit and "swap" derivatives and arrangements have become
an integral aspect of "hedging" the massive and unrelenting U.S. current
account deficits.   We certainly cringe when we read in BIS pronouncements
that international banks "continue to make use of credit risk mitigants to
limit their exposure to the United States."

There is the distinct possibility that these "risk mitigants" have become
the KEY factor accommodating the Credit-induced flood of dollars into the
global financial system that have thus far been so easily "recycled" back to
the aggressive U.S. financial players.  It is an unusual circumstance of the
U.S. financial sector inundating the global system with dollar denominated
liquidity that then finds a home, likely with either speculators or
financial institutions hedging dollar exposure (or planning to hedge when
the dollar weakens).  Why not play the U.S. Credit Bubble while "insurance"
is cheap and readily available?  And as Mr. Partnoy testified, "The
temptations associated with derivatives have proved too great for many
companies, and Enron is no exception."  Indeed, writing "insurance" against
rising interest rates and/or a declining dollar has been extremely
rewarding, with the consequence an increasingly subverted market processes.
This, in reality, reeks of a Russian-style precarious financial Bubble.

I continue to read imaginative conjecture as to recent dollar strength, but
we see it disturbingly consistent with the type of market dynamics
associated with dangerous speculative excess and the consequent prevalence
of "dynamic hedging" strategies.  In truth, our fears would be somewhat
allayed if revelations of the massive Enron fraud, rising concern of
systemic accounting irregularities, and heightened stress throughout the
U.S. financial sector would have by now given impetus to some air coming out
of the dollar Bubble. But degenerative speculative markets have a strange
but telling propensity for simply overpowering the sway of deteriorating
underlying fundamentals - for a while.   At the same time, we are only more
resolute in our view that little of the unrelenting foreign flows into
dollar assets are stable long-term investment.  Rather, flows are almost
certainly of a short-term, speculative "hot money" variety playing U.S.
interest rates and spread trades.  Secondly, there are corresponding
unfathomable currency and related derivative positions that are locked in
trend-following trading strategies.  Thus, the greater the speculative flows
into U.S. dollar assets, the greater the derivative positions to be
dynamically traded, the greater their self-reinforcing character dominates
the market, and the greater the gulf between market prices and true
underlying fundamentals. But that's precisely why they're called Bubbles and
why the end with accidents.  The consequences of such dysfunctional monetary
processes are a precarious proclivity toward market dislocation, speculative
blow-offs, and market collapse, such as we have witnessed repeatedly
throughout the emerging markets, Russia, the Internet, telecom and
technology sectors, the energy markets, and elsewhere.  These precarious
dynamics should by now be recognized as an inherent feature of contemporary
finance.

So if "risk mitigants" have been so widely used by foreign banks to offload
U.S. exposure, may we ask to whom?  This line of analysis becomes
particularly troubling when all signs point to the thinly capitalized and
highly exposed U.S. financial sector and leveraged speculators as the
repositories for escalating dollar risk. These acutely vulnerable entities
have plenty of direct U.S. Bubble exposure to manage, and clearly lack the
wherewithal to provide any meaningful systemic dollar protection for the
global financial community. Come the day the dollar Bubble bursts, there
will a very limited market for the dynamic hedgers to offload risk, as these
strategies dictate.  Market dislocation appears guaranteed, with only the
timing in doubt. Using Mr. Partnoy's comparison of LTCM to Enron, I will say
that if my fears prove justified, the U.S. financial sector has the
potential to make the Russian collapse look like a "lemonade stand." I make
such a statement with the utmost seriousness, and I am likely one of the few
analysts that will take great satisfaction if proved absolutely wrong.

We have found ourselves, once again, at an important crossroads.  The
question as to the soundness of the U.S. financial sector is proceeding to
the forefront.  In the past, any hint of a dampening of confidence in the
U.S. financial system was greeted with visions of aggressive Fed rates cuts
and salivations for speculative trading profits.  For some time, faltering
technology stock prices and escalating corporate debt problems was a boon to
Wall Street "structured finance" that deals predominantly in the fabrication
of "top-rated" securities and the design, marketing and implementation of
interest rate "arbitrage." I once wrote, rather incorrectly, "financial
crisis is not Christmas."  In fact, acute financial fragility has been a
gift to Wall Street, providing the impetus for financial engineering to
expand tremendously over the past few years.  It is today very important to
appreciate that this several year speculative blow-off of an historic bull
market in "structured finance" has had profoundly negative consequences for
the structure of both the U.S. financial system and economy.  It has been a
desperate elevation of the lie we have been living.

Yet the bullish contingent blindly and erroneously interprets the
proliferation of financial engineering as a sustainable manifestation of
valuable "innovation" and financial system "efficiency." Today, however, the
spotlight is being turned on the murky world of Wall Street finance and the
myriad of off-balance sheet "special purpose" vehicles, agreements, and
instruments.  We don't expect illumination to be comforting for anyone.
There is furthermore the harsh reality that the Fed today has little room to
grease the market's concerns with another dab of speculative profits.
During structured finance's bull run the lack of transparency was of
considerable advantage.  Now, with confidence waning, opaque is transformed
into a distinct disadvantage with potentially momentous ramifications for
the Credit apparatus.  There is quite a dilemma, as Wall Street structured
finance must continue to run on all cylinders to generate the enormous
Credit required to sustain the Bubble, in the face of what will be
heightened scrutiny. This will prove no small feat.  Whether it was by
default or otherwise, financial engineering commands the U.S. Credit system
and there is no turning back.

The euphoria and wild Credit market excess over the past year has easily
been the most intense since that experienced during the second half of 1993.
The unavoidable consequence of that melee was 1994's market dislocation that
nearly brought the U.S. financial system to its knees (while rocking Mexico
and the global financial system).  If it weren't for the GSEs ballooning
their balance sheets - establishing their role as buyers of first and last
resort to speculators trapped in leveraged holdings of mortgage securities
and related derivatives - the world would be a much different place today.
But how much longer will they maintain this most extraordinary capacity?
There is absolutely no doubt that the amount of systemic leverage and
speculation makes 1993's Credit market speculation look like a "lemonade
stand."   These types of speculative Bubbles breed irrational exuberance,
and the extreme exuberance has been commensurate with the degree of
speculation.  It is our view that the marketplace has underestimated the
impact its own euphoria (and consequent Credit excess) would impart onto the
U.S. economy, in terms of demand, pricing and maladjustments.  The liquidity
and speculation-driven marketplace has been all too anxious to disregard the
ramifications of last year's extreme excesses throughout mortgage finance,
the $1 trillion money supply expansion, and the extremely easy conditions
throughout consumer finance, in combination with booming government and
service sectors.  We remember all to well the "efficacy" of the Mexican and
LTCM bailouts (and other "reliquefications") and will be waiting to spot
consequences of the most recent round of excess.

So we have today a confluence of faltering confidence in "structured
finance," an increasingly impaired U.S. financial sector, an exceedingly
maladjusted (hence unpredictable) U.S. economy hinting that the near-term
surprise could come on the upside, unprecedented leverage and speculation
permeating the U.S. financial sector, unparalleled foreign liabilities and
related derivative positions, and a Fed that shot its bullets. There is
furthermore the wildcard of foreign economies and central bankers, and the
potential that this most unusual period of intense synchronized monetary
ease could be interrupted.  I am, I believe justifiably, sticking with my
analysis that we have been witnessing the worst-case scenario unfold right
before our eyes. The wild volatility that has inflicted the financial stocks
should be recognized as a clear warning of approaching trouble. We have
stated in the past that rising rates, widening spreads and a weak dollar are
manageable, but not in confluence.  We'll be monitoring closely for such a
development.  But the stakes could not be higher and, hence, the "system"
will surely "pull out all the stops" to keep this scheme from imploding.  We
should expect no less.

---------------------------------

Stephen F. Diamond
School of Law
Santa Clara University
sdiamond@xxxxxxx