Structured Finance On Trial

["Henry C.K. Liu" <hliu@xxxxxxxxxxxxxx>]

The Leven Subcommittee in the Senate fingered Morgan Chase and
Citigroup, two of the world's largest banks, as culprits in helping
Enron Corp. arrange billions of dollars in loans that disguised its
deteriorating financial condition, and  worked to hide the details of
some deals from investors. The banks used "prepay forward commodity
transactions" (PFCT) to turn loans into incomes for Enron. PFCT is a
common form of structured finance.  Senator Leven had the smoking gun in
an internal e-mail of Nov 1998 within Chase describing Enron "loves
these ptct deals as they allow Enron to hide funded debts from equity
analysts".

The thrust of the hearing is that there should be more disclosure of
off-balance sheet debts or liabilities.  The focus on disclosure is
misleading.  With more disclosure, these deals would not have been made
because their whole purpose was to evade disclosure. Several witnesses
remarked that there was nothing wrong with these deals if full
disclosure was made. Its like saying that murder is ok if no killing is
involved.

Derivatives can be used to restructure transactions so that liability
positions can be moved off balance sheet, floating rates can be changed
into fixed rates (and vice versa), currency denominations can be
changed, interest or dividend income can become capital gains (and vice
versa), liability can be turned into assets or revenue, payments can be
moved into different periods in order to manipulate tax liabilities and
earnings reports, and high yield securities can be made to look like
convention AAA investments.

So what is full disclosure? To tell the investing public that structured
finance is an elaborate arrangement to change the appearance of the real
financial condition? By the way, before you invest in this company, we
would like to tell you that the income reported is not real?

The problem is that while Enron's bankers are in the hot seat,
structured finance is on trial.  But structured finance in so widespread
that if it is stalled by full disclosure, the financial system as it
currently exists will end.

Finance capitalism is operating with less and less reliance on capital.
Capital has become a notional value in structured finance. Credit is no
longer anchored by equity but by circular hedges. Debt-to-equity ratio
is no longer a relevant consideration. Practically all US major
businesses nowadays, with their high debt leverage, would have negative
real equity if the price/earning (P/E) ratio were to return to
historical norms. Blue chips are being shut out of the unsecured
short-term commercial paper market. Corporate credit ratings are
inflated by exorbitant market capitalization value, which in turn
reflects irrational P/E ratios. Even now, during what many on Wall
Street contend to be a savage bear market, the Standard & Poor's 500
Index yields 25 times earnings. It would have to fall by another 41
percent to reach the median valuation prevailing since 1957.

Such a decline can happen in a period of days in this age of program
trading and socialized risk, even with circuit breakers and trading
curbs. When that happens, structured finance will be a sea of dead and
wounded in counterparty casualties, regardless of who won and who lost.

The day of reckoning has arrived.

Henry C.K. Liu