The first Enron case to come to trial was in the United Kingdom. Structured finance professionals watched with bated breath as Mr. Justice Cook dismissed WestLB's claims against J.P. Morgan Chase. After all, we're paid to come up with legal and creative financial solutions, even if some of the financial side effects are often counterintuitive.
German bank WestLB refused to pay US$165 million on a letter of credit related to transactions with offshore special-purpose entities J.P. Morgan Chase and Enron North American Corp (ENAC). Mr. Cook ruled that Enron wasn't in breach of U.S. Generally Accepted Accounting Principles, and therefore the transactions were not in violation of securities laws.
The original allegation was that J.P. Morgan Chase realized these transactions constituted a disguised loan and had conspired with Enron to wrongfully account for funds. But as Mr. Cook correctly observed, at the time, even though the prepay transactions were financings, it was proper to account for them as price risk management activities or as trading liabilities instead of as debt. WestLB lost its case but may appeal.
J.P. Morgan Chase and insurers agreed to a settlement just before another case was about to go to trial in January 2003 in the Southern District Court of New York. Insurers claimed that New York law prohibited them from insuring loans and that J.P. Morgan Chase knew the transactions involved were disguised loans. Jed Rackoff, the judge in the case, ruled that a senior J.P. Morgan official's email describing the transactions as "disguised loans" could be used in the trial, but he dismissed claims that J.P. Morgan aided in Enron's financial fraud.
Accounting for complex transactions is in itself complex, and sometimes the accounting rule doesn't make good risk management sense. Mr. Cook could not make something retroactively illegal just because we may not like the end result. Recently, Fannie Mae's chief executive, Franklin Raines, stepped down under criticism after--among other allegations--Fannie Mae accounted for complex transactions in a way that may have made more sense than the actual accounting rule. If companies can be punished for aggressively interpreting rules to get around their flaws, it would be perverse to claim that companies also can be punished for following the rules.
New arguments will be heard in the United States. At issue now is whether banks that profited from covering their exposure to Enron knew enough to realize that Enron teetered on the brink of bankruptcy.
Hedge Funds Try to Recover Losses
Banks lent hundreds of millions of dollars to Enron, sometimes even when they were well over their credit limits. It was only natural that they would try to reduce exposure. Some of these banks were in the vanguard of creating well-publicized credit risk concentration management programs that told them to do just that. The trouble is that even if the bank overall lost hundreds of millions due to Enron's bankruptcy, it made money on the portion of the exposure it hedged with outside investors, many of whom were hedge funds that sold protection either in the form of credit derivatives or credit-linked notes.
Insider information is tricky. If you have it you can't use it, unless you are willing to risk the prospect of humiliation, fines and jail time. Even then, it isn't simple. First you have to be sure you really have it. Even if you really do have it and know you really have it, you still have to guess what it means.
If you guess wrong and you use it and lose money, you may still be in the clear. No one wants to believe you are that incompetent. When was the last time someone was arrested for losing money because of insider information? If you guess right and you make money, you may still be in the clear if no one figures it out. But if you make money and you didn't have insider information, you still can be unjustly accused of profiting from insider information.
So which is it? Were the banks trying to profit from their insider knowledge of Enron's clever (as many believed at the time) structured finance transactions by taking on as much exposure as possible before they were told by their credit committees to reduce exposure, or did the banks and investment banks use insider information about Enron's foolishly aggressive (as few suspected at the time) structured finance transactions to transfer their exposure to unwary investors?
If the banks knew that Enron teetered on the brink of bankruptcy, how did they discover the gravity of Enron's financial status? Since these transactions employed offshore special-purpose vehicles and off-balance sheet swaps, how would an individual investment bank get information on what other investment banks were doing? One independent credit analyst who followed Enron told me recently: "How was I supposed to figure out Enron was engaged in all of those transactions?" And why would structured finance professionals continue to engage in complex structured finance transactions if they knew Enron was about to go under? It could be because they thought they eventually could completely hedge themselves with combinations of surety bonds, credit-linked notes, credit derivatives and letters of credit. Or were they simply passengers on the Titanic who didn't anticipate the iceberg?
Rather than endure public proceedings, many investment banks agreed to large settlements with the U.S. Securities and Exchange Commission. Details are publicly available on the ). For instance, in the summer of 2003, without admitting or denying allegations of SEC complaints, Citigroup settled with the SEC in response to allegations it assisted Enron Corp. and Dynegy Inc. in manipulation of their reported financial results. It paid US$101.25 million to settle the Enron-related allegations and US$18.75 million to settle the Dynegy-related allegations. J.P. Morgan Chase was charged with aiding and abetting Enron Corp's securities fraud and aiding and abetting Enron's manipulation of its reported financial results. J.P. Morgan Chase settled the charges for US$135 million. Similarly, Merrill Lynch settled Enron-related charges for a permanent anti-fraud injunction and US$80 million. CIBC settled for US$80 million, and its executives agreed to pay US$600,000 to compensate fraud victims.
One conspiracy theory says that all of the investment banks communicated and knew Enron was in the gravest extreme, but these transactions were private and confidential, and most structured finance professionals agree that fierce competitors would rather sell money markets than divulge information about transactions they consider proprietary.
Will hedge funds be able to prove that banks knew enough about Enron's overall financial picture to have engaged in intentional inappropriate use of insider information when they bought protection from the hedge funds? After all, the banks were overexposed, presumably because they liked Enron as a credit risk, but their own research told them it was prudent to hedge large exposures, even if they thought Enron was sound. The debate rages among structured finance professionals, but the courts ultimately may decide the outcome, unless parties agree on a settlement.
Hedge Funds Try to Recover "Hedged" Value
Hedge funds also have had bad experiences as protection buyers. While most credit default swap contracts settle quickly, hedge funds have discovered that isn't always true, especially where huge sums are involved. Eternity Global Master Fund Ltd. sued J.P. Morgan when J.P. Morgan refused to pay off on the US$14 million in Argentina credit protection contracts Eternity had purchased. In a case decided in July 2004, the U.S. District Court for the Southern District of New York dismissed Eternity's complaint alleging breach of contract, fraud and negligent misrepresentations by J.P. Morgan, but the court affirmed Eternity's contract claim. The case for the contract claim has yet to be litigated. In separate litigation, J.P. Morgan also was sued by another hedge fund, HBK Master Fund LP.
At issue is the definition of restructuring. Did Argentina's "voluntary debt exchange" in November of 2001 meet the definition of a restructuring? The Republic of Argentina gave bondholders the option to turn in their bonds in exchange for secured loans backed by certain Argentine federal tax revenues. J.P. Morgan claimed this didn't meet the definition of restructuring, at least for the protection it sold to Eternity.
J.P. Morgan's story was different when it wanted to collect on the protection it bought from Daehon, a South Korean Bank. J.P. Morgan claimed the "voluntary debt exchange" met the definition of restructuring under the credit default protection contract it had with the South Korean Bank.
When J.P. Morgan bought protection from the South Korean Bank, it used different contract language than when it sold protection to Eternity Global Master Fund. Experienced market makers try to make sure they can collect without having to pay, for identical credit events. Other market professionals and I have long cautioned credit protection buyers about this kind of language arbitrage.
Credit Derivatives at Risk
The credit derivatives market experienced a 44% increase in 2004, and the British Banker's Association estimates that the credit derivatives market was around US$4.8 trillion in size at the end of 2004. It is estimated to reach US$6.5 trillion by the end of 2005 and US$8.2 trillion by the end of 2006.
In addition to credit default swaps, hedge funds also engage in total return swaps with banks and investment banks. These transactions essentially are financings in which hedge funds also act as credit protection providers by posting up to 20% collateral and, if necessary, the hedge funds immediately top up that collateral if the price of the bonds or other financial instruments they finance drop. Many total return swaps are not included in the total figures for the credit derivatives market reported by the BBA.
Banks and hedge funds both buy and sell credit default protection, but on average, banks are net buyers of credit protection and hedge funds are usually net sellers of credit protection. The banks need the hedge funds to make a credit derivatives market as much as hedge funds need banks for financing. It is estimated that hedge funds may make up to 30% of the credit derivatives market.
J.P. Morgan arguably is the most sophisticated participant in the credit derivatives market. While the definition of restructuring is at issue in its contracts with Eternity, there is a larger issue for the market as a whole. Did J.P. Morgan engage in documentation arbitrage at the expense of a less experienced hedge fund? Did it intentionally buy protection using broad language while selling protection using narrow language? Did it earn a high premium for selling protection on which it had little chance of paying off while paying a smaller premium for protection on which it had a high probability of collecting? Whether or not J.P. Morgan intentionally attempted to arbitrage the language of credit default swap contracts, hedge funds are right to raise a legal challenge when the language of a contract is ambiguous.
The International Swap and Derivatives Association has tried to get market participants to adopt its template language for credit derivative contracts. Recent litigation shows why this is a bad idea for market participants for several reasons. Two main reasons are that documents presented as "standard" often have subtle changes, and even the original ISDA language contains definitions too vague for specific credit protection needs.
There is no reason to accept "standard" documentation from investment banks, and savvy hedge funds will be more wary of documentation language arbitrage in future. One large hedge fund complained about being overcharged and undereducated when dealing with large investment banks. Hedge funds will need to hold on to their wallets and watch their language.
Janet Tavakoli is the president of Tavakoli Structured Finance, a Chicago-based firm that provides consulting and expert-witness services. Ms. Tavakoli has more than 20 years of experience in senior investment banking positions, trading, structuring and marketing structured financial products. Ms. Tavakoli will address the International Monetary Fund in April on structured financial products. She is a former adjunct professor of derivatives at the University of Chicago's Graduate School of Business, and she has recently authored a pair of books on the credit markets: Credit Derivatives & Synthetic Structures (John Wiley & Sons, 2nd edition, 2001) and Collateralized Debt Obligations & Structured Finance (John Wiley & Sons, 2003).
Contact Bob Keane with questions or comments at: firstname.lastname@example.org">.