Investors eye credit derivatives market for clues to failing firms

Friday 22nd February 2002

Enron's demise has spawned many sons-of-Enron stories, with other US companies that have accounting irregularities, especially off-balance-sheet items, getting caned on sharemarkets.

The accounting industry is going through much soul-searching as it confronts conflicts of interest between activities such as auditing and consulting. Debate has opened up in areas previously largely ignored such as how to treat share options for employees, with some arguing that such options should be recorded as staff remuneration in company accounts.

There may be ramifications for the New Zealand sharemarket as investors wake up and start to question the quality of accounting practices here. If accounting could go so horribly wrong in the US, which has prided itself on its Gaap standards and has a robust regulatory regime to punish wrongdoers, not to mention a vigorously litigious civil suit industry driven by hyperactive legal specialists paid by performance fees, what may have happened here in our laxer environment?

The Stock Exchange may need to start taking a much harder line on disclosure for listings that fail to report on time, re-state their accounts, or have off-balance-sheet items or stock options, in the interests of reporting transparency.

Was it possible to see Enron's problems coming before the market finally got the bad accounts restatement news in late October 2001? Yes, according to Forbes.com.

The whistle was blown early on in a little-known wholesale derivatives market called the credit derivatives market. The cost of insuring Enron's credit through derivatives exploded in August 2001, a telling warning signal of trouble to come.

The public has been largely unaware of credit derivatives because prices are not published in newspapers the way share prices or credit ratings are. Credit derivatives are used to insure against debt default.

The market was set up about six years ago by major banks such as Deutsche Bank and J P Morgan in response to events such as the Asian crisis and Russia's default. It has grown from about $US50 billion in 1996 to around $US1.5 trillion in 2001 and now generates some $US1 billion in profits for intermediaries.

Enron's demise is likely to ensure the credit derivatives market becomes even larger than ever.

In an article headlined "Someone Knew," Forbes columnist Robert Lenzner describes in some detail how the credit derivatives market works. He quotes Sunil Hirani, co-founder of the intermediary Creditex as saying: "It's like taking out extra fire insurance just as your house starts smoking. What's the biggest risk in the financial system? Credit risk. Everyone has it. And it's the least-managed risk in the system."

Credit derivatives are usually based on tranches of $US10 million of debt and normally run for a five-year span. The seller wants to insure against default by the borrowing company.

The derivatives are sold at multiples of basis points (hundredths of a per cent) of the interest rate applicable to the debt. The buyer takes the risk that he has paid a low price for the credit derivative and will profit if the company's financial position deteriorates, driving up the cost of credit derivatives for its debt even further and creating him a profit on resale.

The buyer will lose if he has paid too much for the derivative and prices for it subsequently fall, obliging him to pay the original basis points price annually for the remainder of the contract's life unless he can sell out at a loss. The seller takes the risk that the company will default, in which case he will have to pay the buyer the difference between the face value of the debt principal less the market value of the debt at time of default.

Each 100 basis points swing in the price of credit derivatives works out to be worth about 5% of the debt principal to the winning party.

Mr Lenzner gives the specific example of US retailer J C Penney, which had problems with suppliers in 2001. At the time, credit derivative prices for J C Penney blew out to 750 basis points, or $750,000 per $US10 million of the company's debt. Subsequently the retailer sorted out its problems and credit derivatives for its debt fell to 450 basis points.

The buyer at 750 basis points was obliged to pay out $US750,000 per annum for the life of the contract unless he could sell it to someone else for the prevailing 450 basis points and booked an upfront loss. Clearly the market is not for the faint-hearted and, as in the case of J C Penney, it can get expectations wrong over whether default will happen.

The credit derivatives market usually moves on company debt outlook before credit ratings agencies and share prices and therefore is a leading indicator. In the Enron case chief executive Jeffrey Skilling resigned on August 15, 2001.

By October 25 last year, the day Enron confessed to fudged accounts and its share price fell over 50%, credit derivatives on the company's debt had hit 900 basis points.

One company presently in the gun over feared debt default is international clothing retailer The Gap, with credit warnings and downgrades by Moody's, along with a fall in share price, preceded by sharp increase in the price of credit derivatives covering its borrowings.

Many more US companies, even those that might be thought quite sound, are facing higher credit derivatives pricing as investor nervousness grows about further falls in credit ratings and worsening outlook for debt repayment.

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