Writer makes the timeless observation that the devil may be in the details.

 -----Original Message-----
From: 	Blair, Kit  
Sent:	Monday, November 26, 2001 1:15 PM
To:	Nelson, Kourtney; Cavanaugh, Darren; Stokley, Chris; Comnes, Alan; Sheppard, Kathryn; Reyes, Jim; Purcell, Mike; Gilbert, Scotty; Hall, Steve C. (Legal); Clemons, Amy
Subject:	Fascinating article

SuperModels 
Why Enron investors are running for the exits 
It's all about risk -- and the Houston energy company may be on the hook for billions. Bailing now and taking $5 a share, sellers reason, is better than getting only pennies in bankruptcy. 
By Jon D. Markman <http://moneycentral.msn.com/articles/common/bios.asp> 

In normal circumstances, shares of Houston energy-trading titan Enron should have stabilized around $10 after it agreed to a merger with crosstown rival Dynegy earlier this month. Instead, the stock price is retreating faster than the Taliban. Why? 

The answer, like everything associated with Enron, is complex. But the short version is that investors fear that hidden problems will scotch the merger and force Enron to seek bankruptcy protection, potentially leaving its shares worth pennies.

While attention has so far focused on credit problems related to ill-disclosed limited partnerships, institutional investors are increasingly worried about risks Enron faces in the market for financial derivatives known as "swaps." Accentuating their concern: Billions of dollars' worth of Enron's near-term swap contracts -- instruments that ironically were invented to help corporations limit risk -- will reportedly mature next month and are even more hidden from investors' view than the deals that have gotten the firm into trouble so far. On Wednesday afternoon, the bond-rating agency Fitch updated its opinion on Enron by stating it believed "there have been significant cash collateral calls from wholesale trading customers well in excess of previous expectations." 

Glenn Reynolds, chief executive of independent debt-research firm CreditSights and a former chief credit officer at Lehman Bros., said the swaps market is a very large but arcane investment arena that isn't followed by mainstream corporate bond analysts or equity analysts. Yet, he noted, "it's one of the biggest things that can still go badly wrong for Enron."

How much is Enron on the hook for?
Swaps exposure thus makes December a make-or-break month for the company, as its counterparties in complex deals glued together with billions in borrowed funds frantically attempt to unwind positions in markets as disparate as currency, natural gas, bonds and metals. If Enron either made the wrong bets on too many of these deals, or contract covenants are breached that spur demands for hard-asset or cash collateral, the company could be forced to seek the protection of bankruptcy court to prevent a run on its dwindling treasury.

Moreover, because the world of swaps and derivatives is so incestuous -- with Company A able to pay its hundreds of millions in derivatives obligations to Company B only after it receives payments from Company C - some traders worry that Enron's potential inability to pay off on its swaps liabilities could threaten the stability of the world's commodity-trading system. 

No one is saying that this worst-case scenario is bound to happen. But rumors of default risk can spread like financial smallpox in nervous markets -- even if they're never proved true. One story making the rounds on trading floors, for instance, tied the historic collapse of U.S. government bonds in the third week of November to the belief that Enron had to sell vast quantities of short-term Treasury notes to make good on swap-related margin calls. (Enron officials did not return calls for comment.)

Experts noted that Enron's counterparty risks and scant disclosure on high levels of borrowing remind them of the spectacular blowup of hedge fund Long-Term Capital Management in 1998, which imperiled the world capital markets until the Federal Reserve captained a bailout. That debacle ended when once-generous banks and brokerages finally turned off the money spigot. Said one veteran portfolio manager, who asked not to be identified: "This is shaping up to be LTCM 2. If Enron's lines of credit dry up, they're out of business -- end of story."

Lots of credit and lots of deals
To understand the problem more clearly it's important to understand what Enron does for a living, and the role and utility of swaps. 

Many investors think of Enron as an energy company or gas utility, but it has really operated more like a combination investment bank, market maker and hedge fund in the past few years. One of the key ways it earned income was its role in selling risk-management instruments -- those swaps -- as a solution for whatever financial impairments that a company fretted over. 

Let's say you run the risk-management operation of a metal-mining firm and you're long copper futures as a hedge against the possibility that prices might fall in six months. You want to lock in the price, so you enter into a swap with Enron under rules of the International Swap Dealers Agreement, or ISDA. Accounting protocols allow you to keep this trade off your balance sheet, so it's not disclosed anywhere for competitors, or investors, to monitor. One of Enron's roles was to find a company with the opposite problem to yours -- let's say they want to be short copper futures -- and make the match. Thus Enron helped you swap a risk that made you uncomfortable for a risk that you felt you could control. 

More often, Enron reportedly took the swap itself and laid off the risk by using some other hedge, such as being long or short Eurodollars or U.S. Treasury notes. It might also find it profitable to be the one responsible for actually delivering the physical product. At its peak, Enron is said to have been a counterparty on thousands of swaps per week.

This business requires massive amounts of credit -- also known as "leverage" -- because margins are slim; the only way to become super-successful is to do really big volume. It turned out that few of Long-Term Credit Management's counterparties or bank lenders understood that the hedge fund had leveraged itself by as much as 30:1 because of similar efforts to trade in high volume. And likewise, one veteran analyst who asked not to be identified told me that he believes Enron might have been leveraged by as much as an astronomical 100:1 in some cases.

Thomas Seims, chief economist at the Federal Reserve in Dallas and an authority on swaps, told me that the crux of the issue is, "Do we know exactly what their positions are -- and did they use swaps and leverage properly or improperly? When we find out, we can determine the potential for a contagion effect." 

The big question: How many deals?
Why don't we know what their positions are? Legally, they're not required to reveal them -- and we already know that Enron has done an absolutely terrible job of disclosing information that securities laws and investment community conventions actually require. Swaps are similar to the proprietary trading operation of major brokerages, but with one critical difference. Typically stocks are fairly liquid and transaction terms do not vary much. But swap contracts can have all sorts of covenants related to the creditworthiness of the counterparties. So for all anyone outside of Houston knows, there could be any number of billion-dollar deals hanging out there with rules that require Enron to put up collateral or pay off loans if their debt rating falls below a certain rating threshold, such as BBB-, one step above junk. The surprise disclosure of such a clause in a previously hidden limited partnership contract over a Brazilian deal is what caused Enron's stock to plunge 20% on Tuesday, according to traders. 

More importantly, one financial services executive pointed out, because Enron owns the market for many swaps, spread options and other thinly traded financial instruments, they're the ones who set the mark-to-market price that shows on their profit-and-loss statement. For example, every night an Enron trader must mark the value of a 15-year Chicago natural-gas swap on his books. There is no closing or settlement price -- there's only what the Enron trader thinks the price should be. It is in these mark-to-market prices of thousands of swap positions that Enron could theoretically hide hundreds of millions in unrealized losses, if it chose to. 

One prominent New York consultant to the energy risk-management industry told me he's estimated that Enron could be forced to write off as much $1 billion or more in failures related to its swap transactions. Why hasn't anyone focused on it? "The magnitude of Enron's partnership problems is so great that after awhile you get numb, and no one is paying attention to this part of their operation."

Philip K. Verleger Jr., a leading energy-industry economist and consultant, also noted that one reason that Enron risks aren't easily quantified is that they "may not be price independent." That's an economist's way of pointing out that the company -- a major player in a corner of the derivatives business called "delta hedging" -- may not have the capital required to maintain a futures position in all the puts or calls it sold to commodity producers trying to offset risks that the price of things like natural gas or oil might fall or rise sharply. If prices maintain above or below a level that Enron forecast as likely to make it money in such a transaction, no problem. But if prices in the commodity change unexpectedly -- as oil prices did earlier this month -- then Enron could find itself deep in the hole and forced to lean on thinning lines of credit to pay its obligation.

Whirlwind merger deal no reassurance
Verleger isn't mollified by the notion that Dynegy, which agreed to merge with Enron, has studied the company's trading book thoroughly and decided it was fine. "Dynegy probably was not able to see its whole book in a week," he said. Added another trader, who declined to be identified: "How anyone could do such fast due diligence is beyond me completely." Another trader speculated that auditors at Dynegy -- a much smaller firm -- may have initially given Enron a free pass on some disclosures because it was considered one of the cleverest and best-connected companies in the nation, with a chief executive who was a major financial backer and friend of President George W. Bush.

Reynolds, the CreditSights executive, said that investors should beware what he calls "omission risk" -- or the simple fact that "what you don't see is what gets you every time." He points out, for instance, that Enron had a chance to tell investors about its ratings-related exposure in the Brazilian deal during a conference call with investors last week, but didn't. "It boggles the mind" that they have kicked away every opportunity to rebuild confidence and credibility, he said.

So what if gremlins pop out of the swaps closet? Reynolds believes that Dynegy will use broadly written escape clauses in its merger agreement to walk away from its Enron merger if unexpected swap defaults -- called "fails" in the business -- emerge. He believes that Enron would then find it necessary to seek the protection of bankruptcy court, because no other merger partner or bank is likely to follow in Dynegy's footsteps to the altar.

In that event, Reynolds estimates Enron's stock -- which traded for $85 a year ago -- could quickly sink to less than $2 from its current perch in the mid-single digits. Since holders of more than 80 bonds and senior bank loans would stand ahead of shareholders in bankruptcy proceedings, however, he speculated that Enron shareholders would be lucky to end up with pennies. 

At the time of publication, Jon Markman did not own or control shares in any of the equities mentioned in this column,