ISDA PRESS REPORT - NOVEMBER 19, 2001

ACCOUNTING
	*	Japanese Accounting Changes - The Nikkei Weekly

CREDIT DERIVATIVES
	*	ISDA addresses successor/convertible issues - IFR
	*	New York dealers go it alone on default swap clause - IFR

ENERGY
	*	What Enron Did Right - The Wall Street Journal

OPERATIONS
	*	FpML group joins ISDA - IFR

Japanese Accounting Changes
November 18, 2001 - Derivatives Week (Learning Curves)

There have been major changes to accounting standards in Japan which, by the
time they have all been implemented will have brought Japanese accounting
standards broadly into line with international norms. These changes are
comprehensive and include the introduction of fair value --or
mark-to-market--accounting. This last change, although seemingly innocuous
will be particularly powerful in its impact. 

But What Has All This To Do With Derivatives? 

The introduction of mark-to-market accounting requires listed Japanese
companies to record their holding of marketable property assets and
securities at current market value rather than at book value. This means
that balance sheets will no longer be buttressed by assets valued at
inflated bubble economy levels. But most crucially profit streams will
become exposed to movements in equity markets, as the definition of
securities includes the cross shareholdings which bind members of Japan's
Keiretsu and other business groupings. These are substantial in Japan,
accounting for perhaps 40% of all shareholdings. 

The unwinding of cross shareholdings is undoubtedly one of the factors
behind the recent weakness of Tokyo stock prices, not least as foreign
buyers who had been soaking up much of the unwound cross held shares coming
onto to the market have been notably absent over the past few months. 

Hence there has been much talk about how best to unwind these cross
shareholdings without further depressing the market. Where possible firms
with mutual shareholdings have been seeking arrangements that are
effectively straight swaps. But derivatives can also play their part. 

Many corporates with large shareholding disposal programmes have been
actively seeking to hedge their equity exposure as they embark on their
share sale process. Often they have effected this through the use of call
options. Thus if the market falls they have at least benefited from the
premium earned at the time of the sale of the call option and if the market
rises and the option is called by the purchaser then the shares have been
successfully disposed of, but without further dampening an already weak
market. 

Financial institutions have also been combining a similar strategy with
stock lending, thereby gaining both the option premium and a lending fee.
Certainly many market observers have been reporting an increase in such call
option trades over the past year or so. Moreover even for firms that do not
wish to sell down their equity portfolios, the increased profit volatility
which will result from having to revalue portfolios and book these changes
though the profit and loss account will significantly increase the
attractions of hedging. Allied to this and flowing from the realisation of
the full extent of the weakness of many Japanese financial institutions,
there has also been an increase in the use of credit derivatives which has
allowed investors to sell the risk of entering into a transaction with a
Japanese bank. This market has been cyclical, rising and falling with the
changes in perceptions of the true financial state of the country's banking
sector. However the underlying demand is there. 

The Flip Side 

In the same way that Japanese banks and corporates must book the true value
of their equity portfolios they must also report the true market value of
their derivatives positions. And there is concern that this will only serve
further to expose the weakness of the banks in particular. So it has been
reported that the Japanese Bankers' Association (zenginkyo) has been
lobbying the accounting standards making body, the Japan Institute of
Certified Public Accountants, for a further delay in the introduction of the
mark to market requirement for derivatives. This is in addition to the
one-year delay already secured. The original delay was portrayed as in
response to difficulties arising out of the consolidation of the Japanese
banks around three or four major groupings, but most market observers
suspect that this was only a smokescreen to cover up for the ineffective
hedging strategies of the major banks, most notably macro hedging. Now the
bankers' representative body is suggesting the deadline be extended further,
perhaps indefinitely. 

This may get the banks at least part way out of the short-term crunch they
are under from greater disclosure requirements, but with the Japanese
economy continuing to deteriorate, with serious consequences for the size of
the non-performing loans problem, the Japanese financial system will have to
face the music sometime. 


ISDA addresses successor/convertible issues
IFR - November 17, 2001

Standard documentation aimed at clarifying which company should serve as
reference entity for credit default swaps in the event of a demerger or
other structural change, such as a consolidation, will be put forward by the
International Swaps and Derivatives Association this week.

While the successor issue has been debated since the break-up of National
Power of the UK, the imminent break-ups of AT&T and BT into smaller entities
has underscored the need for improved documentation. 

Ambiguity arose out of the 1999 ISDA credit derivative definitions because
they defined the successor as the entity that assumes "all or substantially
all" of the original company's relevant obligations. AT&T's demerger plans,
for example, create no clear successor under ISDA's 1999 definitions.

To eliminate the uncertainty for those that bought or sold protection on
companies that do not produce a clear successor, ISDA's supplement on
successor issues uses a tiered set of numerical standards, said Kimberley
Summe, general counsel of ISDA.

Chip Goodrich, managing director in the legal department at Deutsche Bank
and chairman of ISDA's documentation committee, said that he did not expect
extensive comments on the new documentation, as possible resolutions to the
issue had been thoroughly debated by market participants.

Under the standard, a new entity that receives 75~/~ of the original
company's bonds and loans after a demerger would be deemed the reference
obligation for a credit default swap. If the 75% test is not applicable,
then a 25% test applies. If more than 25% of the underlying's obligations
are held by a new reference entity then the credit derivative transaction
must be broken up into several separate transactions of equal weight, said
Goodrich, who also sits on ISDA's credit derivatives market practice group.

In the event that no successor company assumes 250/o of the original
company's obligations, another set of rules come into play. The entity that
receives the highest percentage of the original company's loans and bonds
becomes the sole successor.

Should the debt be evenly split between two entities in this category, -the
one that assumes the highest percentage of obligations (loans, debt and
other borrowed money) is deemed the successor. No successor will be
appointed if the original reference entity continues to exist.

In a separate development, ISDA published a supplement to the ISDA 1999
credit definitions that specifies "not contingent" as one of the delivery
obligation characteristics. This clarifies that convertible exchangeable or
accreting bonds qualify to be delivered, said Goodrich. "It's a
clarification of what was implicit in the definition in the past," he added.

This has become an issue because of the surge of activity in hedging of
convertible bonds this year and the debate last month over whether
Railtrack's convertible bond was deliverable under existing swap contracts.
Most of the major dealers made an immediate move to use of the new ISDA
language by adopting it as standard in default swap contracts last week.


New York dealers go it alone on default swap clause
IFR - November 17, 2001
By John Macaskill

Abandonment of the obligation acceleration clause is unlikely to cause a
rift within the credit derivatives trading community as serious as the one
that developed over the restructuring clause earlier this year. All the
same, last week's unilateral move by the main New York dealers took European
traders and default swap end users by surprise.

It came almost exactly a year after a similar decision by the most active
New York dealers to drop restructuring as a standard credit event for US
corporate default swaps. That move threatened a schism within the credit
derivatives market, and a reduction in overall liquidity because of
different trade practices being followed in different regimes.

Damage to liquidity
The threat was headed off by traders and users of credit derivatives from
both Europe and the US, who worked on committees co-ordinated by the
International Swaps and Derivatives Association (ISDA) to agree a modified
definition of the restructuring clause as a credit event. The new definition
was agreed at the end of April and released in May, but liquidity in the
default swap market was hit in the early months of the year by the
uncertainty caused by the debate.

The issue of obligation acceleration had not been a great concern for
dealers until Moody's indicated that it was uncomfortable with the inclusion
of what it viewed as a "soft" credit event in the default swaps that back
credit-linked notes and collateralised debt obligations.

Obligation acceleration and obligation default are two clauses that can
trigger default swap exercises under the standard 1999 ISDA credit
derivatives definitions. Dealers have been aware that the payment of an
obligation might be accelerated owing to the breach of a covenant on a bond
or loan. This might trigger exercise on a default swap, when there was still
a chance that the covenant could be made whole
before the fundamental default event - failure to make a debt payment - had
taken place.

Most dealers decided that this was not a major issue, however, mainly
because there do not appear to have been any examples of obligation
acceleration triggering a default swap, and because covenant breaching will
almost certainly come at the same time as failure to pay on a liability.

However, Moody's turned the debate into an economic issue for dealers by
objecting to incorporation of the clause in the swaps used to back synthetic
collateralised debt obligations.

Dealers have been making enormous profits from synthetic securitisation this
year. Three of the top credit derivatives trading houses have each sold over
US$10bn of swap-backed issuance this year, and a string of dealers have sold
between US$2bn and US$10bn. This is high margin business, with fees of over
100bp for a deal often seen.

Profit drag
Moody's applies a 25% increase to the default probability used for the COO's
it rates if they are backed by swaps featuring the obligation acceleration
clause. Banks can cut this charge by incorporating language that specifies a
timeframe for covenant breaches to be cured. None the less, the clause can
still be a significant drag on their CDO income.

It is also an economic issue for Moody's, because swaps without the
obligation acceleration clause match more closely the criteria of its
historical default database - one of its major assets. "It was never clear
to us how obligation acceleration as a credit event had any meaning in these
transactions," said Noel Kirnon, managing director responsible for
collateralised debt obligations and derivatives at Moody's. He welcomed last
week's move to drop the clause as a standard feature of default swaps traded
in the US.

Derivatives dealing heads in New York echo this sentiment and point out that
buyers of credit protection will still be able to request that obligation
acceleration is included as a feature in a swap. In the first few days of
trading without standard inclusion of the clause last week, there was no
evidence of a price basis opening up between contracts with the clause and
those without, indicating that it is not yet being viewed as an economic
factor by buyers of protection.

"It is basically a redundant credit event," said the US head of credit
derivatives at one bank. "For protection buyers it does not particularly
weaken the power of the contract," he added.

European objections
There were some objectors to the move among dealers active in the US market,
as UBS and Commerzbank declined to drop the clause for standard contracts.
The other big dealers moved in step, however. These include Citigroup, CSFB,
Deutsche Bank, Goldman, JP Morgan Chase, Lehman and Merrill.

Some dealers would also like to change use of the repudiation/moratorium
clause in default swaps to make it clear that it cannot be used to apply to
a corporate credit, but no change in market practice is expected.  The
essential credit derivative settlement debates in recent months - over
successor entity and convertible deliverability - have been resolved on a
global basis.

There is no indication that European traders and end users of default swaps
will fall into line with the contract shift made in the US last week,
however.  "The New York dealers' decision was surprising, but it wasn't the
first time they have moved unilaterally," said one European trader. "Europe
will stick with obligation acceleration and the repudiation/moratorium," he
predicted.


What Enron Did Right
The Wall Street Journal - November 19, 2001
By Samuel Bodily and Robert Bruner

This is a rough era for American business icons. Subject to the vagaries of
age (Jack Welch), product failure (Ford/Firestone tires), competition
(Lucent, AT&T), technology (Hewlett-Packard and Compaq), and dot-bomb
bubbles (CMGI), managers and their firms remind us that being an icon is
risky business. The latest example is Enron, whose fall from grace has
resulted in a proposed fire sale to Dynegy.

Once considered one of the country's most innovative companies, Enron became
a pariah due to lack of transparency about its deals and the odor of
conflicts of interest. The journalistic accounts of Enron's struggles drip
with schadenfreude, hinting that its innovations and achievements were all a
mirage.

We hold no brief regarding the legal or ethical issues under investigation.
We agree that more transparency about potential conflicts of interest is
needed. High profitability does not justify breaking the law or ethical
norms. But no matter how the current issues resolve themselves or what fresh
revelations emerge, Enron has created an enormous legacy of good ideas that
have enduring value.

Deregulation and market competition. Enron envisioned gas and electric power
industries in the U.S. where prices are set in an open market of bidding by
customers, and where suppliers can freely choose to enter or exit. Enron was
the leader in pioneering this business. 

Market competition in energy is now the dominant model in the U.S., and is
spreading to Europe, Latin America, and Asia. The winners have been
consumers, who have paid lower prices, and investors, who have seen
competition force the power suppliers to become much more efficient. The
contrary experience of California, the poster child of those who would
re-regulate the power industry, is an example of not enough deregulation.

Innovation and the "deintegration" of power contracts. Under the old
regulated model of delivering gas and electricity, customers were offered a
one-size-fits-all contract. For many customers, this system was inflexible
and inefficient, like telling a small gardener that you can only buy manure
by the truckload. Enron pioneered contracts that could be tailored to the
exact needs of the customer. 

To do this, Enron unbundled the classic power contract into its constituent
parts, starting with price and volume, location, time, etc., and offered
customers choices on each one. Again, consumers won. Enron's investors did
too, because Enron earned the surplus typically reaped by inventors.
Arguably, Enron is the embodiment of what economist Joseph Schumpeter called
the "process of Creative Destruction." But creative destroyers are not
necessarily likable, pleasant folks, which may be part of Enron's problem
today.

Minimization of transaction costs and frictions. Enron extended the logic of
deintegration to other industries. An integrated paper company, for
instance, owns forests, mills, pulp factories, and paper plants in what
amounts to a very big bet that the paper company can run all those disparate
activities better than smaller, specialized firms. Enron argued that
integrated firms and industries are riddled with inefficiencies stemming
from bureaucracy and the captive nature of "customers" and "suppliers."
Enron envisioned creating free markets for components within the integrated
chain on the bet that the free-market terms would be better than those of
the internal operations. The development of free-market benchmarks for the
terms by which divisions of integrated firms do business with each other is
very healthy for the economy. 

Exploiting the optionality in networks. In the old regulated environment,
natural gas would be supplied to a customer through a single dedicated
pipeline. Enron envisioned a network by which gas could be supplied from a
number of possible sources, opening the customer to the benefits of
competition, and the supplier to the flexibility of alternative sourcing
strategies. Enron benefited from controlling switches on the network, so
that they could nimbly route the molecules or electrons from the best source
at any moment in time to the best use, and choose when and where to convert
molecules to electrons. This policy, picked up by others in the industry,
created tremendous value for both customers and suppliers. 

Rigorous risk assessment. The strategy of tailored contracts could easily
have broken the firm in the absence of a clear understanding of the trading
risks that the firm assumed, and of very strong internal controls. Enron
pioneered risk assessment and control systems that we judge to be among the
best anywhere. Particularly with the advent of Enron Online, where Enron
made new positions valued at over $4 billion each day, it became essential
to have up-to-the-second information on company-wide positions, prices and
ability to deliver. 

The unexpected bad news from Enron has little to do with trading losses by
the firm, but with fears among trading partners about Enron's ability to
finance its trading activity. In a world where contracts and trading
portfolios are too complex to explain in a sound bite, counterparties look
to a thick equity base for assurance. It was the erosion in equity, rather
than trading risk, that destroyed the firm.

A culture of urgency, innovation and high expectations. Enron's corporate
culture was the biggest surprise of all. The Hollywood stereotype of a
utility company is bureaucratic, hierarchical, formal, slow, and full of
excuses. And the stodgy images of a gas pipeline company -- Enron only 15
years ago -- is even duller and slower. Enron became bumptious, impatient,
lean, fast, innovative, and demanding. It bred speed and innovation by
giving its professionals unusual freedom to start new businesses, create
markets, and transfer within the firm. 

Success was rewarded with ample compensation and fast promotion, and an
open-office design fostered brainstorming. The firm's organization and
culture was by all accounts not a safe haven for those who believe the role
of a large corporation is to fulfill entitlements for jobs. This was a
lightning rod for the firm's detractors. And yet, it could serve as a model
for more hide-bound enterprises to emulate.

Enron was a prolific source of compelling new ideas about the transformation
of American business. It created a ruckus in once-quiet corners of the
business economy. It rewrote the rules of competition in almost every area
in which it did business. It thrived on volatility.

The proposed sale of Enron to Dynegy risks the loss of a major R&D
establishment, especially given Dynegy's track record as a second mover
following Enron's lead. Beyond what is likely to be a difficult and
time-consuming antitrust review, Dynegy's greater challenge will be to find
a way to make Enron's spirit of innovation its own. Or so we all should
hope, because prosperity depends on the ability of firms to reinvent
themselves and remake their industries.


FpML group joins ISDA
IFR - November 17, 2001

The International Swaps and Derivatives Association last week announced
plans to incorporate FpML.org, a non-profit industry body dedicated to
developing a business information exchange standard for electronic dealing
and processing of financial derivative transactions.

"FpML.org's funding is stable. But the founding members recognise that [the
standard] is broadly beneficial to the industry and that working with ISDA
is the best way to continue developing it," said Brian Lynn, vice-president
of etrading at JP Morgan Chase in New York.

"This is an exciting and important step toward derivatives technology
development that is consistent with other ISDA efforts to provide an
effective structure for derivatives documentation and trading," said Robert
Pickel, executive director and chief executive of ISDA. "We have common
membership and have been talking to each other for a while," he added,
noting that FpML.org's language uses ISDA documentation and terms as its
foundation.

Financial product Mark-up Language's (FpML) chief virtue is that it
addresses straight-through processing. It offers a basis for achieving
straight-through processing of trades, back office systems and settlement
systems. Greater automation reduces the time it takes to close a deal and
the rate of error.  In 1999, the industry spent roughly US$1bn processing
OTC derivatives transactions, and at some firms about 20%-30% of that figure
represented documentation errors, said JP Morgan's Lynn.

The manual confirmation matching processes required today is not included in
the 20%-30% figure, he added. In theory, liquidity should also receive a
boost from a move to greater automation. "For smaller end users it means
that there is less work involved in entering into a transaction," said Lynn.

No decision on linking FpML's transaction standards with ISDA master and
netting agreements has been made yet, but such a move is likely in the
future. ISDA initiatives aimed at providing members with extensible mark-up
language (XML) resources for netting and negotiating, storing and archiving
ISDA master agreements seem to point in this direction, as FpML is an XML
solution. ISDA's interactive web and CD-ROM based documentation library is
in an XML format currently.

"The integration of FpML into ISDA will mean speeding up the development of
the standard and expansion of its coverage consistent with our original
mission. The goals of FpML.org and ISDA are similar as both have worked
towards technological advancement in standard setting," said Philippe
Khuong-Huu, a managing director at Goldman Sachs, and chairman of FpML.org's
board of directors.

Joining forces with ISDA will also help raise the profile of FpML, but
awareness of its potential is not a problem said Lynn. "The issue is
deploying systems that use the standard."

Two multi-dealer trading systems for interest rate derivatives that are
being tested now, Reuters' Dealing for Swaps and SwapsWire, plan to go live
using FpML. FpML use at individual banks is done on a proprietary basis for
now. No banks yet operate on XML on a company-wide basis.

FpML.org's architectural working group, and its working groups covering
interest rate, foreign exchange and equity derivatives, will continue to
exist as sub-groups of ISDA's new FpML committee. ISDA's FpML committee will
retain responsibility for approving new versions of the standard.

"Vendors will continue to be represented on the standards committee and on
working groups," said Lynn.
FpML standards currently exist for interest rate derivative products and
forward rate agreements. Foreign exchange and equity derivatives standards
arc nearing completion.

**End of ISDA Press Report for November 19, 2001**

THE ISDA PRESS REPORT IS PREPARED FOR THE LIMITED USE OF ISDA STAFF, ISDA'S
BOARD OF DIRECTORS AND SPECIFIED CONSULTANTS TO ISDA ONLY.  THIS PRESS
REPORT IS NOT FOR DISTRIBUTION (EITHER WITHIN OR WITHOUT AN ORGANIZATION),
AND ISDA IS NOT RESPONSIBLE FOR ANY USE TO WHICH THESE MATERIALS MAY BE PUT.