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Default swap faults: a dispute in the Enron bankruptcy case highlights troubling questions about credit default insurance

CFO: Magazine for Senior Financial Executives, Oct, 2004 by Ronald Fink

IT'S NO SECRET THAT BANKS' USE OF CREDIT DEFAULT swaps relies on an inefficiency in markets. Indeed, the elucidation of this inefficiency won economist Joseph Stiglitz a 2001 Nobel prize.

The inefficiency, which Stiglitz defined as "asymmetric information," arises whenever a buyer or seller has more information about a product or service than his counterpart does--which can provide the better-informed party with considerable economic advantage. And informational asymmetry is often inevitable when one party has conflicting interests in the transaction.

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Nowhere else in finance are such conflicts as fundamental as when banks buy or sell credit default swaps, derivative instruments that serve as insurance against a borrower's default. When the borrower involved fails to make timely payments of interest and principal, the buyer of the protection can exchange the debt it holds for cash from the seller of the swap. But when commercial banks are involved in the deals, the party on the other side has to worry that the lenders can profit from the use of information they have privately gleaned from borrowers in the course of assessing their creditworthiness.

While some might argue that there's nothing essentially wrong with such a zero-sum game, critics worry that the asymmetry inherent in credit default swaps contains the potential for serious abuse. As a result, banks have taken steps to strengthen the firewalls between their trading and lending desks.

But these initiatives, organized primarily by the International Swaps and Derivatives Association (ISDA), have been voluntary. And without the intercession of the Federal Reserve Board or the Office of the Comptroller of the Currency, there's no means of enforcing them. So far, the Fed and the OCC have let banks themselves police their use of credit default insurance, as the regulators have done with structured finance and other instances of Wall Street engineering.

In fact, Fed chairman Alan Greenspan has had nothing but praise for the proliferation of credit default swaps and other derivatives. That worries observers such as Chris Dialynas, a managing director of PIMCO, the nation's largest bond-investment firm. "There's no surveillance mechanism" Dialynas warns. "It's very, very difficult to know who's doing what."

TAINTED BY ENRON

Even so--or perhaps precisely for that reason--the market for credit default swaps has been booming. At the end of 2003, the notional value of these instruments had risen to $3.6 trillion, up six-fold in less than three years, according to the ISDA. Yet that could very well represent a high-water mark, thanks to the latest twist in the long-running bankruptcy proceedings of Enron Corp. Indeed, some participants and observers fear that the outcome of this Chapter 11 case could east a pall over the entire market for credit insurance.

Now at issue is whether buyers of some $2.4 billion in notes tied to Enron's creditworthiness and underwritten by Citigroup will get paid, and if so, how much they will receive and from whom. (Credit-linked notes are a form of default insurance that, unlike a swap, can be sold to multiple investors.) The investors, which include such powerful investment groups as Angelo Gordon & Co., Appaloosa Investment LP, and Elliot International LP, are appealing a July 15 decision by the bankruptcy court for the Southern District of New York to subordinate their claims to those of senior creditors.

Citigroup underwrote these notes in a deal known as Yosemite to reduce its own exposure to Enron. According to the Wall Street Journal, the bank's exposure by 1999 totaled almost $1.7 billion, or four times the bank's internal limit on exposure to the energy-trading company. While the securities these investors purchased were senior unsecured notes, Enron argued in court--and the judge agreed--that they did not deserve senior status. Why? Because Citigroup not only knew about the accounting fraud that brought down the energy company in late 2001, but also helped mislead investors, ultimately paying $101 million in a settlement with the Securities and Exchange Commission.

Enron's recovery plan, approved by the court on July 15, would give senior creditors about 20 cents on the dollar if the proposed sale of Enron's Portland General electrical-generation facility and CrossCountry Energy pipelines is successful. But all bets are off if the owners of the Enron notes convince the New York State Supreme Court to overturn the bankruptcy judge's decision to subordinate their claims. In that event, the investors could demand to have their claims included in the recovery plan, sending Enron's effort to emerge from Chapter 11 back to square one.

But a court decision in favor of Citigroup would cast "a real cloud on the horizon" for the credit insurance market, says Walter Pollard, a partner in the Boston law firm Goodwin Procter LLP who has negotiated credit default swap transactions on behalf of hedge funds. It is one thing for a bank to trade on inside information, says Pollard. In fact, he asserts that the market already takes that possibility into account when pricing credit derivatives. But Pollard contends that a ruling in favor of an underwriter involved in "truly toxic things" such as the fraudulent transactions at the heart of Enron's failure could give rise to "a concern that that will undermine the market" for all kinds of credit insurance. Adds Michael Gerity, an analyst for Fitch Ratings, a credit-rating firm: "It would be a pretty negative precedent."

Business Services Industry

Default swap faults: a dispute in the Enron bankruptcy case highlights troubling questions about credit default insurance

CFO: Magazine for Senior Financial Executives, Oct, 2004 by Ronald Fink

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