Enron, a derivatives trading firm, filed the largest bankruptcy in U.S. history on December 2, 2001. The media has framed the scandal as a simple morality play pitting good against evil, with the Texas firm’s top management and the Bush administration competing for the latter role. Naturally, neoconservatives blame the Clinton administration for the entire scandal. Both ignore the larger issue: an unstable U.S. credit structure, which I discussed at length in “Economic Liberty and American Manufacturing” (Views, January).
At its peak, Enron’s stock sold for $90.75. Today, it fetches less than one dollar per share. How did such a large firm, with more than 20,000 employees, disappear into bankruptcy in a matter of months? Public records and economic reasoning tell the story. Enron’s 2001 annual report, filed last April with the Securities and Exchange Commission, explained its business model: Enron’s operations “are principally engaged in the transportation of natural gas through pipelines to markets throughout the United States; the generation, transmission and distribution of electricity . . . ; [and] the marketing of natural gas, electricity and other commodities and related risk management and finance services worldwide.” Translation: Enron used derivatives to trade financial markets, tell-ing the SEC it used “offsetting or hedging transactions, to manage exposures to market price movements . . . ”
Derivatives are described by the Washington Post as “complex, risky and largely unregulated financial contracts,” which again ignores the larger issue: the taxpayer-backed liability concerns raised by the involvement of an agency backed by the full faith and credit of the U.S. government. The collapse of Long-Term Capital Management in 1998 involved leverage and large New York banks serving as counter-parties to derivative transactions. One observer remarked that the financial system nearly “froze up.” In a larger crisis, a big bank with counter-party exposure would face two options: bankruptcy or bailout by the Federal Reserve under the “too big to fail” principle. Enron’s top management, before it was rebuffed by the Bush administration, apparently also thought the company belonged in that category.
A derivative is a hybrid financial instrument that changes in value in concert with a related or underlying security, fixed-income instrument, currency, interest rate, or stock-market index. They are popular with small speculators who trade hybrid stocks that change in value based on an underlying index like the S&P 500. Derivatives can also hedge risk. An automotive company denominating its foreign sales in a local currency like the Mexican peso could use them to hedge against a crisis like the 1994 peso devaluation. The large Enron operation created more exotic versions regulated by the Commodity Futures Trading Commission, but a 1992 rule-making process initiated by the CFTC’s outgoing chair, Wendy Gramm, exempted energy swap derivatives from public scrutiny (Financial Times, January 6). Mrs. Gramm also serves on Enron’s board. The popular media focuses on large Enron campaign contributions to Sen. Phil Gramm (R-TX), her husband. A plausible alternative explanation is that the Gramms, both economists, believed derivatives can insure individuals and the credit structure against risk. If so, they join LTCM’s finance professors in learning a bitter lesson. Senator Gramm reported that his family lost $686,000 in deferred compensation that was set aside for his wife in an account tied to the value of Enron stock. The bankruptcy filing means that the account is worthless.
The Enron bankruptcy provides greater ironies. The Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 138 (“Accounting for Derivative Instruments and Hedging Activities”) in June 2000. It is an amendment to an earlier FASB statement (No. 133), which requires all derivatives to be recorded on corporate balance sheets at fair value. One aim of this is to provide transparency for the kind of off-balance-sheet derivative activity that bankrupted Enron. Buried in a 2001 Enron SEC filing is the following statement: “The total impact of Enron’s adoption of SFAS No. 133 on earnings . . . is dependent upon certain pending interpretations, which are currently under consideration . . . by the FASB. While the ultimate conclusions . . . could impact the effects of Enron’s adoption of SFAS No. 133, Enron does not believe such a conclusion would have a material effect . . . ” Really? An Enron Report of Unscheduled Material Event, filed with the SEC on November 8, 2001, disclosed “the financial activities of a wholly-owned subsidiary” limited partnership, key to the bankruptcy and based in the Cayman Islands, “which engaged in derivative transactions with Enron to permit Enron to hedge market risks.” The failed LTCM hedge fund was also based in the Caymans.
Markets need information (transparency) to function efficiently. But even obvious warning signs have been ignored. Orange County, California, declared bankruptcy in 1994, after its treasurer bet the wrong way on derivatives, basing his actions on the movement of interest rates. Today, government units in most states are still not required to provide transparency. New York banks faced significant counter-party exposure in the 1998 LTCM collapse before the Federal Reserve brokered a controversial deleveraging of liabilities.
The U.S. Comptroller of the Currency reports commercial-bank derivative transactions on a quarterly basis. In September 2001, the notional amount of derivatives held by banks increased to a staggering $47.8 trillion.