ISDA PRESS REPORT - DECEMBER 26, 2001

CREDIT DERIVATIVES
ISDA publishes credit survey - Risk

ENERGY
Enron's Success Story - The Wall Street Journal
 
The International Swaps and Derivatives Association released its first
survey of the global over-the-counter credit derivatives market last month,
showing a total notional outstanding volume of credit derivative
transactions of $631.5 billion as of the end of the first half of this year.
ISDA, which compiled information from 83 firms, hopes the survey will
provide a benchmark from which to chart future growth in the credit
derivatives market. This survey, and the others that have been done by Risk,
the British Bankers' Association (BBA), the US Office of the Comptroller of
the Currency (0CC) and the Bank for International Settlements (BIS) have all
used different methodologies on different samples, and have generated
varying results.

Risk's survey last year showed significantly higher total notional volumes
$810 billion. The BBA survey released in July 2000 also gave a higher
figure, forecasting $893 billion for the end of 2000. The BJS plans to
publish its triennial figures on the credit derivatives market later this
year.

Upward trend
According to ISDA, while still modest in relation to interest rate products,
the credit derivatives market is expected to remain on a strong upward trend
compared to more mature derivatives product areas. Most major dealers say
there has been a big increase in their credit derivatives volumes.  Mike
Brosnan, deputy comptroller of risk evaluation at the 0CC, pointed to a
challenge in assembling these surveys:
"When you conduct a survey, some people may or may not respond, hence the
data could be incomplete. 

A problem with a survey is: who is the enforcer?' The OCC. which carries out
its own quarterly review of the US derivatives market, showed a decline in
the credit derivatives market, from $426 billion at the end of 2000 to $351
billion at the end of second-quarter 2001.
Brosnan attributes the decline in the credit derivatives market to
uncertainty among users, relating to restructuring issues sparked off by the
US life insurer Conseco's debt restructuring last year. However, according
to Tim Frost, head of JP Morgan's credit derivatives business in London, the
decline evidenced in the OCC's figures really comes down to a change in
reporting methods that occurred in 2000 from gross-to-net notional figures
on outstanding credit derivatives contracts. 


Enron's Success Story
The Wall Street Journal - December 26, 2001

The collapse of Enron was many things -- a gratifying slap in the face to
corporate hubris and an exposure of the Alfred E. Neuman club of stock
analysts, rating agencies and the SEC. It may even prove to be a fascinating
look into criminal minds. But there is one thing, for sure, it wasn't -- a
market failure. To the contrary, Enron's implosion was confirmation of the
principles that govern competitive markets.

Enron's success and failure ran along the lines set down in any
microeconomics text. The company discovered a new product -- mostly ways of
trading energy in the derivatives market -- that allowed producers and users
to lay off risk. This new product was wildly popular and, as the innovator,
Enron made lovely above-market returns. But those abnormal returns attracted
other firms into the business and Enron's advantage was gradually "competed
away." Each new market entrant put the squeeze on Enron's margins.

What happened next is still a matter of speculation, but there are several
theories that seem reasonable.

Bad hedging. Although Enron started out as a plain vanilla energy company,
it shed those hard assets that could have underpinned its financial business
and morphed into a trading company and then, quickly, into a hedge fund. 

The Dismal Science
 
A trading company can make money no matter which direction the market goes
by simply trading and taking its money from creating a market. If prices are
falling, then suppliers rush into the market to get contracts that nail down
prices; if prices are rising, then users rush in to get contracts. Traders
can make money either way. Indeed, in this model, a volatile market is the
best of all possible worlds.

But with its margins -- and cash -- getting squeezed, Enron started
borrowing money and pretty soon it was running with remarkable leverage,
thus becoming a giant hedge fund. When things started to go wrong, Enron's
traders quite possibly were panicked into trying to hit a home run. That is,
they started taking big bets on the direction of the market, perhaps taking
aggressively long positions in energy. A successful hedge fund, however,
depends on adequately hedging bets, especially leveraged ones. But as Enron
started to lose money on its big bets, observers guess that the
insufficiency of its hedges began to look lethal.

There are also more complicated theories that argue Enron was hiding its
slowing growth in earnings with various accounting strategies.

Bad trading. Enron's main technique to pump up earnings probably revolved
around a loose-as-a-goose process for the accounting of energy derivatives.
Called mark-to-market, the technique involves evaluating contracts at "fair
value" prices. Since some of these contracts stretched out for 20 years, the
futures market provides no firm prices. And, absent a liquid market with
clear prices, "fair value" becomes a mug's game in which companies can
vastly inflate value. 

These overstated gains, of course, were also unrealized, noncash gains. In
September 2000, Jonathan Weil, a reporter for the Journal, took a look at
Enron's second quarter and found that absent noncash earnings, Enron would
have had a loss. Mr. Weil later found that for the year as a whole,
unrealized trading gains accounted for more than half of the company's
originally reported pretax profits. Hardly a confidence-builder in the
quality of Enron's earnings.

When their derivative strategies started to go sour, this theory runs, Enron
removed the contracts from its financial statements and hid them in special
entities created for just that purpose.

Bad Assets. Another theory locates Enron's earning problems in their hard
assets. Enron had a bunch of huge and underperforming assets, like its
broadband company, water company and power plants in India and Brazil. In
order to hustle those assets and associated debts off its financial reports,
the company created some limited partnerships to buy these dogs -- either
with bank loans or money provided by Enron itself. These partnerships
(allegedly) transferred enough control to third parties to get them off
Enron's balance sheet. 

Enron guaranteed these deals with "make good" provisions backed by Enron
stock -- a promise that Enron would make good any losses in the value of the
partnerships. When the value of the assets tanked, the make-good provisions
kicked in, resulting, for example, in the enormous write-down in shareholder
equity in November.

Depending on which theory one accepts, there are two bottom lines.

The first holds that the sagging earnings problem was fatal and that it is
entirely possible Enron was in the process of liquidating itself. Jim Chanos
of Kynikos Associates hypothesizes that Enron's cost of capital was higher
than its returns on invested capital. A second argues that if Enron's
managers had been content to accept the fact that in competitive markets
their "first mover" advantage was going to be competed away, and had been
willing to endure slower earnings growth, it would not be in bankruptcy
today.

Enron's collapse also says something valuable about the energy trading
markets: Competitive markets worked just as expected. As questions were
raised about the quality of Enron's earnings -- and, just as important, not
answered -- investors grew wary. Although the stock opened the year trading
in the 80s, it started drifting down as investors bailed. The stock had
already lost half its value and was trading below 40 before the company
announced a big third-quarter loss and made its first disclosure of
accounting "mistakes" in October.

At the same time, traders outside the company had begun to unwind positions
and do business with other firms. At the end of September, Enron had 25% of
the energy-trading market. Just two months later, its business had
disappeared but that disappearance didn't cause the tiniest ripple in the
market. The swift collapse of what once was a $77 billion dollar company
failed to generate either a price spike or a supply interruption because the
market was sufficiently liquid and deep to absorb it.

In short, no matter how one views the purposes or operations of a
competitive market, the history of Enron proves that the market works pretty
much as expected. And thus the story of Enron is, so far, a success story.

**End of ISDA Press Report for December 26, 2001**

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Scott Marra 
Administrator for Policy and Media Relations
International Swaps and Derivatives Association 
600 Fifth Avenue 
Rockefeller Center - 27th floor 
New York, NY 10020 
Phone: (212) 332-2578 
Fax: (212) 332-1212 
Email: smarra@isda.org