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Financial Derivatives

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					Financial Derivatives



    Robert M. Hayes
         2002
Overview
   Definition of Financial Derivatives
   Common Financial Derivatives
   Why Have Derivatives?
   The Risks
   Leveraging
   Trading of Derivatives
   Derivatives on the Internet
   An Apologia for Derivatives
   The Dark Side of Derivatives
Definition of Financial Derivatives

 A financial derivative is a contract between two (or more)
  parties where payment is based on (i.e., "derived" from)
  some agreed-upon benchmark.
 Since a financial derivative can be created by means of a
  mutual agreement, the types of derivative products are
  limited only by imagination and so there is no definitive
  list of derivative products.
 Some common financial derivatives, however, are
  described later.
 More generic is the concept of “hedge funds” which use
  financial derivatives as their most important tool for risk
  management.
Repayment of Financial Derivatives

 In creating a financial derivative, the means for, basis
  of, and rate of payment are specified.
 Payment may be in currency, securities, a physical
  entity such as gold or silver, an agricultural product
  such as wheat or pork, a transitory commodity such as
  communication bandwidth or energy.
 The amount of payment may be tied to movement of
  interest rates, stock indexes, or foreign currency.
 Financial derivatives also may involve leveraging, with
  significant percentages of the money involved being
  borrowed. Leveraging thus acts to multiply (favorably
  or unfavorably) impacts on total payment obligations
  of the parties to the derivative instrument.
Common Financial Derivatives
   Options
   Forward Contracts
   Futures
   Stripped Mortgage-Backed Securities
   Structured Notes
   Swaps
   Rights of Use
   Combined
   Hedge Funds
 Options

 The purchaser of an Option has rights (but not obligations)
  to buy or sell the asset during a given time for a specified
  price (the "Strike" price). An Option to buy is known as a
  "Call," and an Option to sell is called a "Put. "
 The seller of a Call Option is obligated to sell the asset to
  the party that purchased the Option. The seller of a Put
  Option is obligated to buy the asset.
 In a “Covered” Option, the seller of the Option already
  owns the asset. In a “Naked” Option, the seller does not
  own the asset
 Options are traded on organized exchanges and OTC.
Forward Contracts


 In a Forward Contract, both the seller and the
  purchaser are obligated to trade a security or other
  asset at a specified date in the future. The price paid for
  the security or asset may be agreed upon at the time the
  contract is entered into or may be determined at
  delivery.
 Forward Contracts generally are traded OTC.
Futures
 A Future is a contract to buy or sell a standard
  quantity and quality of an asset or security at a
  specified date and price.
 Futures are similar to Forward Contracts, but are
  standardized and traded on an exchange, and are
  valued daily. The daily value provides both parties with
  an accounting of their financial obligations under the
  terms of the Future.
 Unlike Forward Contracts, the counterparty to the
  buyer or seller in a Futures contract is the clearing
  corporation on the appropriate exchange.
 Futures often are settled in cash or cash equivalents,
  rather than requiring physical delivery of the
  underlying asset.
Stripped Mortgage-Backed Securities

 Stripped Mortgage-Backed Securities, called "SMBS,"
  represent interests in a pool of mortgages, called
  "Tranches", the cash flow of which has been separated
  into interest and principal components.
 Interest only securities, called "IOs", receive the
  interest portion of the mortgage payment and generally
  increase in value as interest rates rise and decrease in
  value as interest rates fall.
 Principal only securities, called "POs", receive the
  principal portion of the mortgage payment and
  respond inversely to interest rate movement. As
  interest rates go up, the value of the PO would tend to
  fall, as the PO becomes less attractive compared with
  other investment opportunities in the marketplace.
Structured Notes
 Structured Notes are debt instruments where the
  principal and/or the interest rate is indexed to an
  unrelated indicator. A bond whose interest rate is
  decided by interest rates in England or the price of a
  barrel of crude oil would be a Structured Note,
 Sometimes the two elements of a Structured Note are
  inversely related, so as the index goes up, the rate of
  payment (the "coupon rate") goes down. This
  instrument is known as an "Inverse Floater."
 With leveraging, Structured Notes may fluctuate to a
  greater degree than the underlying index. Therefore,
  Structured Notes can be an extremely volatile
  derivative with high risk potential and a need for close
  monitoring.
 Structured Notes generally are traded OTC.
Swaps
 A Swap is a simultaneous buying and selling of the
  same security or obligation. Perhaps the best-known
  Swap occurs when two parties exchange interest
  payments based on an identical principal amount,
  called the "notional principal amount."
 Think of an interest rate Swap as follows: Party A
  holds a 10-year $10,000 home equity loan that has a
  fixed interest rate of 7 percent, and Party B holds a 10-
  year $10,000 home equity loan that has an adjustable
  interest rate that will change over the "life" of the
  mortgage. If Party A and Party B were to exchange
  interest rate payments on their otherwise identical
  mortgages, they would have engaged in an interest rate
  Swap.
Swaps
 Interest rate swaps occur generally in three scenarios.
  Exchanges of a fixed rate for a floating rate, a floating
  rate for a fixed rate, or a floating rate for a floating
  rate.
 The "Swaps market" has grown dramatically. Today,
  Swaps involve exchanges other than interest rates, such
  as mortgages, currencies, and "cross-national"
  arrangements. Swaps may involve cross-currency
  payments (U.S. Dollars vs. Mexican Pesos) and
  crossmarket payments, e.g., U.S. short-term rates vs.
  U.K. short-term rates.
Rights of Use
 A type of swap is represented by swapping capacity on
  networks using instruments called “indefeasible rights
  of use”, or IRUs. Companies buying an IRU might
  book the price as a capital expense, which could be
  spread over a number of years. But the income from
  IRUs could be booked as immediate revenue, which
  would bring an immediate boost to the bottom line.
 Technically, the practice is within the arcane rules that
  govern financial derivative accounting methods, but
  only if the swap transactions are real and entered into
  for a genuine business purpose.
Combined Derivative Products
 The range of derivative products is limited only by the
  human imagination. Therefore, it is not unusual for
  financial derivatives to be merged in various
  combinations to form new derivative products.
 For instance, a company may find it advantageous to
  finance operations by issuing debt, the interest rate of
  which is determined by some unrelated index. The
  company may have exchanged the liability for interest
  payments with another party. This product combines a
  Structured Note with an interest rate Swap.
Hedge Funds
 A “hedge fund” is a private partnership aimed at very
  wealthy investors. It can use strategies to reduce risk.
  But it may also use leverage, which increases the level
  of risk and the potential rewards.
 Hedge funds can invest in virtually anything anywhere.
  They can hold stocks, bonds, and government securities
  in all global markets. They may purchase currencies,
  derivatives, commodities, and tangible assets. They
  may leverage their portfolios by borrowing money
  against their assets, or by borrowing stocks from
  investment brokers and selling them (shorting). They
  may also invest in closely held companies.
Hedge Funds
 Hedge funds are not registered as publicly traded
  securities. For this reason, they are available only to
  those fitting the Securities and Exchange Commission
  definition of “accredited investors”—individuals with a
  net worth exceeding $1 million or with income greater
  than $200,000 ($300,000 for couples) in each of the two
  years prior to the investment and with a reasonable
  expectation of sustainability.
 Institutional investors, such as pension plans and
  limited partnerships, have higher minimum
  requirements. The SEC reasons that these investors
  have financial advisers or are savvy enough to evaluate
  sophisticated investments for themselves.
Hedge Funds
 Some investors use hedge funds to reduce risk in their
  portfolio by diversifying into uncommon or alternative
  investments like commodities or foreign currencies.
  Others use hedge funds as the primary means of
  implementing their long-term investment strategy.
Why Have Derivatives?
 Derivatives are risk-shifting devices. Initially, they were
  used to reduce exposure to changes in such factors as
  weather, foreign exchange rates, interest rates, or stock
  indexes.
 For example, if an American company expects payment
  for a shipment of goods in British Pound Sterling, it
  may enter into a derivative contract with another party
  to reduce the risk that the exchange rate with the U.S.
  Dollar will be more unfavorable at the time the bill is
  due and paid. Under the derivative instrument, the
  other party is obligated to pay the company the amount
  due at the exchange rate in effect when the derivative
  contract was executed. By using a derivative product,
  the company has shifted the risk of exchange rate
  movement to another party.
Why Have Derivatives?
 More recently, derivatives have been used to segregate
  categories of investment risk that may appeal to
  different investment strategies used by mutual fund
  managers, corporate treasurers or pension fund
  administrators. These investment managers may decide
  that it is more beneficial to assume a specific "risk"
  characteristic of a security.
The Risks

 Since derivatives are risk-shifting devices, it is
  important to identify and understand the risks being
  assumed, evaluate them, and continuously monitor and
  manage them. Each party to a derivative contract
  should be able to identify all the risks that are being
  assumed before entering into a derivative contract.
 Part of the risk identification process is a determination
  of the monetary exposure of the parties under the
  terms of the derivative instrument. As money usually is
  not due until the specified date of performance of the
  parties' obligations, lack of up-front commitment of
  cash may obscure the eventual monetary significance of
  the parties' obligations.
The Risks
 Investors and markets traditionally have looked to
  commercial rating services for evaluation of the credit
  and investment risk of issuers of debt securities.
 Some firms have begun issuing ratings on a company's
  securities which reflect an evaluation of the exposure to
  derivative financial instruments to which it is a party.
 The creditworthiness of each party to a derivative
  instrument must be evaluated independently by each
  counterparty. In a financial derivative, performance of
  the other party's obligations is highly dependent on the
  strength of its balance sheet. Therefore, a complete
  financial investigation of a proposed counterparty to a
  derivative instrument is imperative.
The Risks
 An often overlooked, but very important aspect in the
  use of derivatives is the need for constant monitoring
  and managing of the risks represented by the
  derivative instruments.
 For instance, the degree of risk which one party was
  willing to assume initially could change greatly due to
  intervening and unexpected events. Each party to the
  derivative contract should monitor continuously the
  commitments represented by the derivative product.
 Financial derivative instruments that have leveraging
  features demand closer, even daily or hourly
  monitoring and management.
Leveraging

 Some derivative products may include leveraging
  features. These features act to multiply the impact of
  some agreed-upon benchmark in the derivative
  instrument. Negative movement of a benchmark in a
  leveraged instrument can act to increase greatly a
  party's total repayment obligation. Remembering that
  each derivative instrument generally is the product of
  negotiation between the parties for risk-shifting
  purposes, the leveraging component, if any, may be
  unique to that instrument.
Leveraging

 For example, assume a party to a derivative instrument
  stands to be affected negatively if the prime interest
  rate rises before it is obliged to perform on the
  instrument. This leveraged derivative may call for the
  party to be liable for ten times the amount represented
  by the intervening rise in the prime rate. Because of
  this leveraging feature, a small rise in the prime
  interest rate dramatically would affect the obligation of
  the party. A significant rise in the prime interest rate,
  when multiplied by the leveraging feature, could be
  catastrophic.
Trading of Derivatives
 Some financial derivatives are traded on national
  exchanges. Those in the U.S. are regulated by the
  Commodities Futures Trading Commission.
 Financial derivatives on national securities exchanges
  are regulated by the U.S. Securities and Exchange
  Commission (SEC).
 Certain financial derivative products have been
  standardized and are issued by a separate clearing
  corporation to sophisticated investors pursuant to an
  explanatory offering circular. Performance of the
  parties under these standardized options is guaranteed
  by the issuing clearing corporation. Both the exchange
  and the clearing corporation are subject to SEC
  oversight.
Trading of Derivatives
 Some derivative products are traded over-the-counter
  (OTC) and represent agreements that are individually
  negotiated between parties. Anyone considering
  becoming a party to an OTC derivative should
  investigate first the creditworthiness of the parties
  obligated under the instrument so as to have sufficient
  assurance that the parties are financially responsible.
Mutual Funds and Public Companies
 Mutual funds and public companies are regulated by
  the SEC with respect to disclosure of material
  information to the securities markets and investors
  purchasing securities of those entities. The SEC
  requires these entities to provide disclosure to investors
  when offering their securities for sale to the public and
  mandates filing of periodic public reports on the
  condition of the company or mutual fund.
 The SEC recently has urged mutual funds and public
  companies to provide investors and the securities
  markets with more detailed information about their
  exposure to derivative products. The SEC also has
  requested that mutual funds limit their investment in
  derivatives to those that are necessary to further the
  fund's stated investment objectives.
Selling of Financial Derivatives
 Some brokerage firms are engaged in the business of
  creating financial derivative instruments to be offered
  to retail investment clients, mutual funds, banks,
  corporations and government investment officers.
 Before investing in a financial derivative product it is
  vital to do two things.
    First, determine in detail how different economic

      scenarios will affect the investment in the financial
      derivative (including the impact of any leveraging
      features).
    Second, obtain information from state or federal

      agencies about the broker's record.
Derivatives on the Internet
 In the past several years, trading of financial derivatives
  has become an active Internet e-commerce focus, with
  EnronOnline as among the most active sites. Leaving
  aside assessment of the reliability of e-commerce trading
  sites, the following are valuable sites for keeping track:
 For quick news bites, the best sources are maintained by
  some of the major financial news organizations:
    Bloomberg Online        www.bloomberg.com
    Reuters.com             www.reuters.com
    The Associated Press www.nytimes.com/aponline

    Bridge Financial        www.bridge.com
Derivatives on the Internet
 One very quick and easy analysis of developments in
  overnight markets and identification of key issues in
  today's markets is Marc Chandler's commentary:
    TheStreet.com        www.thestreet.com.
 For Canadian news, there are two national newspapers,
    The National Post    www.nationalpost.com and
    The Globe And Mail   www.theglobeandmail.com.
 Internationally,
    The New York Times www.nytimes.com,

    South China Morning Post www.scmp.com,

    The Washington Post www.washingtonpost.com

     The Financial Times www.ft.com/hippocampus
Derivatives on the Internet
 Risk measurement methodology can be found at
    J.P. Morgan's          www.riskmetrics.com.
    Credit Suisse First Boston CreditRisk+ site

     www.csfp.co.uk/csfpfod/html/csfp_10.htm
    The Global Association of Risk Professionals

     www.garp.com
    The Treasury Management Association (USA)

     www.tma-net.org
    The Treasury Management Association of Canada

     www.tmac.ca
    CIBC Wood Gundys School of Financial Products
An Apologia for Derivatives

   Derivatives are not new, high-tech methods.
   Derivatives are not purely speculative or leveraged.
   Derivatives are not a major part of finance.
   Derivatives are of value to companies of all sizes.
   Derivatives are tools to meet management objectives.
   Derivatives reduce uncertainty and foster investment.
   Derivatives can both reduce and enhance risk.
   Derivatives do not change the nature of risk.
   Derivatives reduce, not increase systemic risks.
   Derivatives do not call for further regulation.
The Dark Side of Derivatives
 Six examples will be used to illustrate some of the perils,
  especially ethical perils, in use of financial derivatives:
    Equity Funding Corporation of America (1973)

    Baring Bank (1994)

    Orange County, California (1994)

    Long Term Capital Management (1998)

    Enron (2001)

    Global Crossing (2002)

 Each of them represented an effort to use financial
  derivatives to produce inflated returns. Two cases were
  proven to be frauds. Two appear to have been innocent of
  fraud. Two are still to be seen.
 Each was a major financial catastrophe, affecting not
  only those directly involved but the world at large.
   The Steps on the Primrose Path
                                                         A B C D E   F
   1   deregulation                                              x
   2   wish to have stock price go up                    x ?   x x   x
   3   use of stock options as incentives                x x   x x   x
   4   use of hidden borrowing                           x ?   x x   x
   5   use of financial derivatives in risky gambles     x x x x x   x
   6   consulting by auditor on use of derivatives       x ? x x x   x
   7   use of deceptive accounting to hide risks         x x   ? x   x
   8   acquiescence of auditor in deception              x     ? ?   ?
   9   use of fraudulent entries to support deceptions   x x     ?   ?
  10   use of hidden partners                                    x   ?
  11   move from individual fraud to corporate fraud     x       ?   ?
  12   connivance of auditor in fraud                    x       ?   ?
  13   use of a Ponzi scheme to continue fraud           x       ?   ?
  14   profiting before the collapse                     x       x   x

(A) Equity Funding, (B) Baring Bank, (C) Orange County,
(D) Long Term Capital Management, (E) Enron, (F)Global Crossing
Equity Funding Corporation of America

   The insurance funding program
   The first scam
   The next scam
   The really BIG scam
   The final scam
   The house of cards collapses
   The fallout from Equity Funding
   An analysis of the causes
   The Lessons Learned
The insurance funding program - 1
 Equity Funding Corporation of America was founded
  in 1960. Its principal line of business was selling
  "funding programs" that merged life insurance and
  mutual funds into one financial package for investors.
 The deal was as follows: first, the customer would
  invest in a mutual fund; second, the customer would
  select a life insurance program; third, the customer
  would borrow against the mutual fund shares to pay
  each annual insurance premium. Finally, at the end of
  ten years, the customer would pay the principal and
  interest on the premium loan with any insurance cash
  values or by redeeming the appreciated value of the
  mutual fund shares. Any appreciation of the
  investment in excess of the amount paid would be the
  investor's profit.
The insurance funding program - 2

 The company had a huge sales force. The thrust of the
  salesman's pitch to a customer was that letting the cash
  value sit in an insurance policy was not smart; in fact,
  the customer was losing money. The customer was
  encouraged to let his money work twice by taking part
  in the above deal.
 The development of such creative financial investments
  was a trademark of Equity Funding in the early years
  of its existence. After going public in 1964, Equity
  Funding was soon recognized across the country as an
  innovative company in the ultraconservative life
  insurance industry.
The insurance funding program - 3
 This kind of leveraging of dollars is a concept used by
  sophisticated investors to maximize their returns. They
  use an asset they already own to borrow money in the
  expectation that earnings and growth will be greater
  than the interest costs they will incur. However, it's a
  concept that is fraught with risks for the investor and
  should not be promoted by an ethical company without
  fully informing the investor of the risks.
 Even so, there was nothing illegal or even immoral
  about the basic concept. Indeed, it was a captivating
  idea, except it didn't make enough money for the
  company or its executives. So some executives—led by
  the president, chief financial officer and head of
  insurance operations—got a little more creative with
  the numbers on their books.
The first scam
 "Reciprocal income“
    Preparing to take the company public in 1964, there
    was concern that its earnings were too low. To
    correct this "problem", the owners decided that
    Equity Funding was entitled to record rebates or
    kickbacks from the brokers through whom the
    company's sales force purchased mutual fund
    shares. The resulting income, called "reciprocal
    income" was used to boost 1964 net income for
    Equity Funding. So the fraud apparently began in
    1964 when the commissions earned on sales of the
    Equity Funding program were erroneously inflated.
The next scam
 Borrowing without showing liability
     In subsequent years, to supplement the reciprocal
      income so as to achieve predetermined earnings
      targets, the company borrowed money without
      recording the liability on its books, disguising it
      through complicated transactions with subsidiaries.
      The fraud expanded in 1965, when fictitious entries
      were made in certain receivable and income
      accounts.
     By 1967, revenues and earnings of Equity Funding
      had increased dramatically, and the stock price rose
      accordingly. Equity Funding began to take over
      other companies, and it became critical to maintain
      the price of the stock of Equity Funding so it could
      be used to pay for the companies being acquired.
The Really BIG Scam
 Reinsurance
 Fictitious policies
 Forging files
The Final Scam
 Killing off the policy holders
The computer makes it possible
 Although there were a number of other aspects to the
  fraud, the computer was used because the task of
  creating the bogus policies was too big to be handled
  manually. Instead, a program was written to generate
  policies which were coded by the now famous, or
  rather, infamous, code "99". When the fraud was
  discovered in 1973, about 70% of all of the company's
  insurance policies were fake.
The failure of the auditors
The house of cards collapses
The fallout from Equity Funding
 Accounting and auditing practices
 Insider trading
 The aftermath of Equity Funding
An analysis of the causes

 The Management
     Ethics and integrity of management and employees
     Management's philosophy and operating style
 The Auditors
     Lack of independence of the auditors
     Lack of professional skepticism of the auditors
     External impairments to the audit
The Management
 The ethics and integrity of management and employees
 Management's philosophy and operating style
The Auditors
 The independence of the auditors
 Professional skepticism of the auditors
The Lessons Learned
Baring Bank Bankruptcy
 Barings Bank was established in London in 1763 as a
  merchant bank, which allowed it to accept deposits and
  provide financial services to its clients as well as trade
  on its own account, assuming risk by buying and selling
  common real estate and financial assets.
 In early 1980, Barings set up brokerage operations in
  Japan. With its success in Japan, Barings decided to
  expand to Hong Kong, Singapore, Indonesia and
  several other Asian countries.
 By 1992, Barings subsidiary in Singapore had a seat on
  the SIMEX, but did not activate it due to lack of
  expertise in trading futures and option contracts.
Nick Leeson: both Front and Back
 Four months later Barings decided to activate its
  SIMEX seat. They appointed Mr. Nick Leeson as the
  general manager and charged him with setting up the
  trading operations in Singapore and running them.
 Mr. Leeson was in charge of both the front office and
  the back office. An important task in brokerage
  business, particularly in the settlement side, is
  uncovering and dealing with trading errors, which
  occur when the trading staff misread or mishear an
  instruction or a broker misunderstands a hand signal.
  When errors occur, brokerages book the losses or gains
  into a computer account called an "error account".
 For Mr. Leeson, errors recorded were sent to the home
  office in London and deducted against Mr. Leeson's
  branch earnings.
Account 88888
 Account 88888 was started when a phone clerk sold 20
  contracts instead of purchasing them. Mr. Leeson was
  unable to do anything about it until the next trading
  day because the market rose 400 points. That next
  trading day, Leeson established account 88888 and
  created fictitious transactions to cover up the error.
 Over the next few months Leeson hid some 30 large
  errors in account 88888. He relaxed his attitude
  towards errors, and when an important customer
  brought an error to Leeson's attention, he simply put
  the error into account 88888 without any further
  investigation.
The Collapse
 As the market moved, errors in account 88888 changed
  in value, and a $1 Billion loss was generated by open
  positions in account 88888. As the account grew bigger,
  margin calls also got bigger. London approved these
  large margin calls because of the large profits Leeson
  was posting.
 Barings’s problems arose because of serious failure of
  controls and management within Barings.
 Orange County Bankruptcy

 On December 6, 1994, Orange County in California
  became the largest municipality in U.S. history to declare
  bankruptcy. The county treasurer had lost $1.7 billion of
  taxpayers' money through investments in derivatives.
 The bankruptcy resulted from unsupervised investment
  activity of Bob Citron, the County Treasurer, who was
  entrusted with a $7.5 billion portfolio belonging to county
  schools, cities, special districts and the county itself.
Orange County—History

 In 1994, the Orange County investment pool had about
  $7.5 billion in deposits from the county government
  and almost 200 local public agencies (cities, school
  districts, and special districts). Borrowing $2 for every
  $1 on deposit, Citron nearly tripled the size of the
  investment pool to $20.6 billion. In essence, as the Wall
  Street Journal noted, he was "borrowing short to go
  long" and investing the dollars in derivatives—in exotic
  securities whose yields were inversely related to interest
  rates.
 Orange County—Period of Success

 Thus, Citron invested in financial derivatives and leveraged
  the portfolio to the hilt, with expectations of decreasing
  interest rates. As a result, he was able to increase returns on
  the county pool far above those for the State pool.
 Citron was viewed as a wizard who could painlessly deliver
  greater returns to investors. The pool was in such demand
  due to its track record that Citron had to turn down
  investments by agencies outside Orange County.
 Some local school districts and cities even issued short-term
  taxable notes to reinvest in the pool (thereby increasing
  their leverage even further).
Orange County—the collapse
 The investment strategy worked excellently until 1994,
  when the Fed started a series of interest rate hikes that
  caused severe losses to the pool. Initially, this was
  announced as a “paper” loss.
 Citron kept buying in the hope interest rates would
  decline.
 Almost no one was paying attention to what the
  treasurer was doing and even fewer understood it—
  until the auditors informed the Board of Supervisors,
  in November 1994, that he had lost nearly $1.7 billion.
 Shortly thereafter, the county declared bankruptcy and
  decided to liquidate the portfolio, thereby realizing the
  paper loss.
The Role of the Brokerage
 NY Times, June 3, 1998, Wednesday
 Merrill Lynch to Pay California County $400 Million

 Merrill Lynch & Co agrees to pay $400 million to settle
  claims that it helped push Orange County, Calif, into
  1994 bankruptcy with reckless investment advice; 17
  other Wall Street securities houses and variety of other
  companies that sold risky securities to county-run
  investment pool are expected to settle similar suits;
  county, which lost over $1.6 billion in high-risk
  investments, could end up recovering $800 million to $1
  billion; its financial condition has improved sharply;
  table on status of some major suits and criminal probe.
The Underlying Causes
 The immediate cause of the bankruptcy was Citron's
  mismanagement of the Orange County investment
  pool.
 However, he would not have been driven to strive for
  such high rates of return on the pool—nor would he
  have been able to invest as he did—had it not been for
  the fiscal austerity in the state that began with
  Proposition 13. That citizen initiative, and several
  subsequent initiatives, severely limited the ability of
  local governments to raise tax revenue.
 Recognizing the extreme fiscal pressure these initiatives
  placed on county governments, the state loosened its
  municipal investment rules—allowing treasurers, for
  the first time, to use Citron's kind of strategy.
Orange County is not Unique
 Orange County provides dramatic warning of the
  dangers of that kind of investment strategy and should
  deter others from following the same path.
 But the conditions and resulting imperatives that drove
  the county to gamble with public funds remain. The
  demand for smaller government, tax limits, and local
  autonomy continues, and many municipalities may find
  the specter of financial collapse looming—especially
  when the economy takes its next downturn.
 These conditions exist, to a greater or lesser degree, in
  counties across the state and nation, which makes the
  Orange County bankruptcy especially significant.
What needs to be done?
 Local governments need to maintain high standards for
  fiscal oversight and accountability. As noted in the state
  auditor's report following the bankruptcy, a number of
  steps should be taken to ensure that local funds are
  kept safe and liquid. These include having the Board of
  Supervisors approve the county's investment fund
  policies, appointing an independent advisory committee
  to oversee investment decisions, requiring more
  frequent and detailed investment reports from the
  county treasurer, and establishing stricter rules for
  selecting brokers and investment advisors. Local
  officials should adjust government structures to make
  sure they have the proper financial controls in place at
  all times.
What needs to be done?
 State government should closely monitor the fiscal
  conditions of its local governments, rather than wait for
  serious problems to surface. The state controller
  collects budget data from county governments and
  presents them in an annual report. These data should
  be systematically analyzed to determine which counties
  show abnormal patterns of revenues or expenditures or
  signs of fiscal distress. State leaders should discuss
  fiscal problems and solutions with local officials before
  the situation reaches crisis stage.
What needs to be done?
 Local officials should be wary about citizens' pressures
  to implement fiscal policies that are popular in the
  short run but financially disastrous over time.
  Distrustful voters believe there is considerable waste in
  government bureaucracy and that municipalities
  should be able to cut taxes without doing harm to local
  services. Local officials need to do a better job of
  educating voters about revenues and expenditures.
  State government should also note that there are no
  checks and balances against citizen initiatives that can
  have disastrous effects on county services. Perhaps
  legislative review and gubernatorial approval should be
  required for voter-approved initiatives on taxes and
  spending.
Long Term Capital Management
 Long Term Capital Management (LTCM), run by the
  former head bond trader and vice chairman of
  Salomon Brothers, a former vice chairman of the
  Federal reserve, and two Nobel Prize-winning
  economists, leveraged almost $5 billion into a $100
  billion portfolio full of derivatives, a 20/1 leverage
  ratio.
 The results obviously were spectacular while LTCM’s
  strategy worked, and were equally spectacular and
  disastrous when it didn’t. Few of LTCM’s investors
  and perhaps none of its lenders were aware of the
  magnitude of this fund’s gambles.
Long Term Capital Management
 If, as they say in the mutual fund literature, “past
  results are not indicative of future performance,” how
  should one go about evaluating a hedge fund? As with
  any other investment portfolio, the key is to understand
  the types of investments it currently owns, the overall
  strategy of the manager, and the tactics the manager
  intends to use or avoid. Getting answers to these
  questions is not only due diligence, but common sense.
 An article in the Financial Economists Roundtable (by
  Myron Scholes, one of the winners of the 1997 Nobel
  Prize for Economics and a principal in LTCM), alludes
  to risks in derivatives markets, but concludes that
  "there is no evidence the activities of these (derivatives)
  dealers pose a significant systemic risk".
The Near Bankruptcy and Bail-Out
 What happened at Long Term Capital Management?
  In 1998 it came close to going bankrupt! Only pressure
  from the U.S. federal government saved it.
 In Fall 1998, a bail-out of LTCM was arranged.
  Illustrious Wall Street institutions were cajoled into
  putting up $3.5billion to avert its bankruptcy.
 Time Magazine has a very rewarding article about the
  glaring inconsistency of this policy. eg Asian financial
  institutions must pay the penalty for taking too much
  risk, but very rich American investors will be bailed
  out.
Long Term Capital Management
 The New York Times has some great analysis. Check
  out the extraordinary leverage of the fund, and a piece
  about John Meriwether, fallen genius of LTCM and ex
  Salomon trader. (book: Liars's Poker) This article
  contains a naive fallacy from a Salomon Brothers
  veteran discussing roulette "because it is a
  mathematical certainty that red will come up
  eventually". Do these people really believe that? I
  would like to bet my entire capital leveraged by 20
  times that it isn't a mathematical certainty! Any
  takers?
Long Term Capital Management
 9/23/98 Prescient article from CNBC's David Faber
  about rumor's of Long Term Capital Management
  bailout.
 9/29/98 Banks Near Final Accord on Investment Fund's
  Rescue
 10/1/98 In 4 1/2 hours of testimony, Federal Reserve
  Chairman Alan Greenspan defended the bail out of
  LTCM. LTCM's failure threatened “substantial
  damage,” he said.
 10/2/98 Rumors of an emergency Fed Meeting to
  discuss liquidity issues related to Long-Term Capital
  Management spooked the market. Comment from the
  Fed: "As a matter of policy, we don't comment on these
  things". Interesting...
Long Term Capital Management
 10/5/98 MSNBC Columnist James O. Goldsborough
  has a great article about LTCM, and the high volume,
  high risk strategies. It repeats the roulette doubling up
  analogy.
 10/8/98 The Secret World of Hedge Funds
 10/10/98 In Archimedes on Wall Street, Forbes
  Magazine gives a good overview of what LTCM
  attempted to do. Good comparison of John Meriwether
  to Archimedes. Financial genius is a short memory in a
  rising market
 10/15/98 Alan Greenspan cut interest rates by another
  quarter point. A surprise move, as it was outside the
  regular FOMC meeting. What does Alan Greenspan
  know that we don't?. Could there be more hedge fund
  exposure?
Long Term Capital Management
 1bits2atoms.com Recommends
 Hedge Funds : Investment and Portfolio Strategies for
  the Institutional Investor (The Irwin Asset Allocation
  Series for Institutional Investors)-buy now from
  Amazon.comThe story of the 1929 stock market crash.
  Back then it was Investment Trusts and highly
  margined investors, this time highly leveraged Hedge
  Funds...?
Long Term Capital Management
 An interesting place to start researching hedge funds is
  the Hedge Fund Association. The Association's aim is
  to educate the investing public's and legislators'
  misperceptions of hedge fund volatility and risk.
 So why were investors in LTCM bailed out? Could the
  absence of the capital injection have resulted in a chain
  reaction of failures?
Enron Bankruptcy
   The Start as a Gas Pipeline Company in 1985
   Deregulation
   Enron Finance in 1990
   Enron’s Overseas Energy Projects
   Enron Communications and Internet Structure
   Enron Online and Internet Brokering
   Enron and the Market in Broadband
   The Catches—one after another!
   The Collapse
   Enron and E-Mail's Lasting Trail
   The Fallouts
Gas Pipeline Company in 1985

 In 1985, Kenneth Lay, using proceeds from junk bonds,
  combined his company, Houston Natural Gas, with
  another natural-gas pipeline to form Enron. From that
  start, the company then moved beyond selling and
  transporting gas to become a big player in the newly
  deregulated energy markets by trading in futures
  contracts. In the same way that traders buy and sell
  soybean and orange juice futures, Enron began to buy
  and sell electricity and gas futures.
Deregulation

 In the mid-1980s, oil prices fell precipitously. Buyers of
  natural gas switched to newly cheap alternatives such
  as fuel oil. Gas producers, led by Enron, lobbied
  vigorously for deregulation. Once-stable gas prices
  began to fluctuate.
 Then Enron began marketing futures contracts which
  guaranteed a price for delivery of gas sometime in the
  future.
 The government, again lobbied by Enron and others,
  deregulated electricity markets over the next several
  years, creating a similar opportunity for Enron to trade
  futures in electric power.
Enron Finance in 1990
 In 1990, Lay hired Jeffrey Skilling, a consultant with
  McKinsey & Co., to lead a new division—Enron
  Finance Corp.
 Skilling was made president and chief operating officer
  of Enron in 1997.
 Even as Enron was gaining a reputation as a "new-
  economy" trailblazer, it continued—to some degree
  apparently against Skilling's wishes—to pursue such
  stick-in-the-mud "old-economy" goals as building
  power plants around the world.
Enron's Overseas Energy Projects
 Enron’s energy projects sprouted in places no other
  firm would go but appear not to have earned it a dime.
  With operations in 20 countries, Enron Corp. set out in
  the early 1990s to become an international energy
  trailblazer.
 Enron launched bold projects in poverty-ravaged
  countries such as Nigeria and Nicaragua. It set up huge
  barges—with names like Esperanza, Margarita and El
  Enron—in ports around the world to generate power
  for energy-starved cities.
 Enron's international investment totaled more than $7
  billion, including over $3 billion in Latin America,
  $1 billion in India and $2.9 billion to develop a British
  water-supply and waste-treatment company.
Enron's Support from the U.S.
 The U.S. government has been a major backer of
  Enron's overseas expansion. Since 1992, Overseas
  Private Investment Corp provided about $1.7billion for
  Enron's foreign deals and promised $500million more
  for projects that didn't go forward. The Export-Import
  Bank put about $700 million into Enron's foreign
  ventures. Both agencies provide financing and political-
  risk insurance for foreign projects undertaken by U.S.
  companies.
 Enron enlisted U.S. ambassadors and secretaries of
  State, Commerce and Energy to buttonhole foreign
  officials on Enron’s behalf. It cultivated international
  political connections, recruiting former government
  officials and relatives of heads of state as investors and
  lobbyists.
Enron's Incentives to Risk
 Like other parts of Enron's vast operation, its
  international division was fueled by intense internal
  competition and huge financial incentives. Executives
  pocketed multimillion-dollar bonuses for signing
  international deals under a structure that based their
  rewards on the long-term estimated value of projects
  rather than their actual returns. The system
  encouraged executives to gamble without regard to
  risk.
Enron's Overseas Boondoggle
 In reports to investors, the company played down or
  obscured what analysts and others saw as inevitable
  losses. But in an interview with academic researchers in
  2001, Jeffrey K. Skilling, who then was chief operating
  officer, conceded that Enron "had not earned
  compensatory rates of return" on investments in
  overseas power plants, waterworks and pipelines.
  Skilling said the projects had fueled an "acrimonious
  debate" among executives about the wisdom of its
  heavy foreign investments.
Enron's Overseas Partnerships
 An internal investigation released this month showed
  that two foreign projects, in Brazil and Poland, were
  entangled in Enron's off-the-books partnerships,
  accounting devices controlled by then-Chief Financial
  Officer Andrew S. Fastow that shielded huge debts
  from investors. Those arrangements allowed Enron to
  present a more optimistic report to investors.
 Other partnerships also were involved: “Whitewing”,
  with interests in Turkey, Brazil, Colombia, and Italy;
  Ponderosa, with interests in Brazil, Colombia, and
  Argentina.
Enron Communications
 January 21, 1999: “Enron Communications, Inc.,
  introduced today the Enron Intelligent Network (EIN),
  an application delivery platform … that will enhance
  the company’s existing … fiber-optic network to create
  next generation applications services. The EIN brings
  to market a reliable, bandwidth-on-demand platform
  for delivering data, applications and streaming rich
  media to the desktop.
 “The Enron Intelligent Network architecture is based
  on a unique approach to networking through
  distributed servers … that supports the development
  and maintenance of distributed applications across
  network environments.”
Enron Communications

 “In November 1999, Enron Communications (as a
  wholly owned subsidiary of Enron) joined with Inktomi
  Corporation in a strategic alliance in which the Inktomi
  Traffic Server cache platform was to be integrated into
  the Enron Intelligent Network. The objective was to
  offer high quality network performance and bandwidth
  capacity to support broadband content distribution
  and e-business services. The integration of Inktomi's
  caching software into the Enron Intelligent Network
  was to enhance the ability of Enron Communications to
  seamlessly and selectively push content to the desktop
  while handling massive volumes of high bit rate
  network traffic in a scalable manner.”
Enron Communications

 About Inktomi: ”Inktomi develops and markets
  scalable software designed for the world's largest
  Internet infrastructure and media companies.
  Inktomi's two areas of business are portal services,
  comprised of the search, directory and shopping
  engines; and network products comprised of the
  Traffic Server network cache and associated value-
  added services. Inktomi works with leading companies
  including America Online, British Telecom, CNN,
  Excite@Home, GoTo.com, Intel, NBC's Snap!,
  RealNetworks, Sun Microsystems, and Yahoo!. The
  company has offices in North America, Europe and
  Asia.”
 EnronOnline
 EnronOnline was launched Nov. 29, 1999.
 “EnronOnline offers customers a free, Internet-
  based system for conducting wholesale transactions
  with Enron as principal.”
 “EnronOnline is your best tool for trading energy-related
  products and other commodities quickly, simply and
  efficiently. Our Web-based service combines real-time
  transaction capabilities with extensive information and
  customization tools that increase your knowledge of what's
  happening around the world-even as it happens.
  EnronOnline sharpens your sense of the marketplace to
  make you a more knowledgeable trader.”
EnronOnline
 “No matter what commodity you want to buy or sell,
  you're almost certain to find a live, competitive quote
  on EnronOnline. We cover markets all over the world
  including gas, power, oil and refined products, plastics,
  petrochemicals, liquid petroleum gases, natural gas
  liquids, coal, emission allowances, bandwidth, pulp
  and paper, metals, weather derivatives, credit
  derivatives, steel and more. EnronOnline covers almost
  every major energy market in the world. And we're
  not sitting still. We're adding new markets and new
  products all the time.”
 An ironic example of "Trading Markets":
       Credit Risk Management Tools,
       including Bankruptcy Swaps
EnronOnline Claims

   Real-Time Pricing
   Fast, Free, Secure Execution
   Price Limit Orders
   Option Contracts
   Market News and Quotes
   Industry Publications
   Weather Insights
   Complete Customization Capabilities
Brokering (?) over the Internet

 Note that Enron served NOT just as a broker
  but as a Principal—an active participant in
  transactions.
Enron High-bandwidth Venture
 December 3, 1999: "Cutting the red ribbon for
  bandwidth commodity trading, high-bandwidth
  application service company Enron Communications Inc.
  Friday introduced its new approach to bandwidth."
 "This is 'Day One' of a potentially enormous market,"
  said Jeff Skilling, Enron president and chief operating
  officer. He compared the present inflexible agreements
  for pre-set capacity amounts to pre-reform "oil contracts
  in the 1970s, natural gas contracts prior to 1990 and
  electric power contracts prior to 1994."
 May 2, 2000: “Enron Corp. announced today the
  expansion of EnronOnline to include products for the
  purchase and sale of bandwidth capacity.”
Enron Broadband Trading Strategy

 The Purpose: Effect on Enron Stock Prices
 The Technique
     Step 1. Sell to an affiliated partnership
     Step 2. Set an internal value on the sale
     Step 3. Sell from one partnership to another
     Step 4. Act as underwriter for the sale
 The Lack of Substance
 The Beginning of the Collapse
 The Collapse
The Catches—one after another!

   Acting as Principal in transactions!
   Failing really to make money
   Creating trading shell companies
   Acting as partner in transactions!
   Playing games with financial reporting
   Being Greedy
The Collapse

   Sudden announcement of losses in Oct 2001
   File for bankruptcy in Dec 2001
   Bankruptcy
   Congressional Investigations began in Dec 2001
   Attempted destruction of documents
Enron and E-Mail's Lasting Trail

 It is almost impossible to hide transactions:
      Paper records at the source
      Local computer system records
      Internet communication records
      Recipient records
      Paper records at the destination
End of Enron’s Overseas Energy Program
  In mid-February 2002, Overseas Private Investment
   Corp., which backed many of Enron’s overseas energy
   projects, moved to stem its $1-billion Enron exposure
   by canceling $590 million in loans to the company, once
   one of its largest clients. Enron had missed deadlines
   for OPIC requirements in financing projects in Brazil,
   an OPIC spokesman said. OPIC's decision shifted more
   of the burden for the troubled projects from the U.S.
   government to Enron's creditors, lenders and partners.
The Fallouts of Enron Collapse
 On the Workers
     Reduction in force by 6,000 workers
     Effects on their retirement accounts
 On the Stock Market
     Effects of “sophisticated accounting”
     Effects on Internet-related stocks
     Effects on Communications-related stocks
 On the Accounting Profession
     Effects of conflicts-of-interests:
               Combining Auditing & Consulting
 On the Halls of Government
     Effects on Energy Policy-Making
     Effects on Political funding
  Effects on the Accounting Profession
Biggest Accounting Firms
The accounting industry is dominated by the aptly named Big Five, followed by much
smaller firms whose client lists includes mainly mid-size and small companies.


                          2001 U.S.      U.S.        Total      2001 global
                           revenue     Partners    U.S. Staff     revenue
                          (billions)                             (billions)
PricewaterhouseCoopers          $8.1       2,784       43,134          $19.8
Deloitte & Touche                6.1       2,283       28,992           12.4
Ernst & Young                    4.5       1,934       22.526            9.9
Andersen                         4.3       1,620       27,788            9.3
KPMG                             3.2       1,471       17,577           11.7
BDO Seidman .                    0.4         306        2,054            2.2
Grant Thornton                   0.4         272        2,962            1.7
McGladney & Pullen               0.2         493        2,530            1.6
Source: Public Accounting Report
March 15, 2002. The Los Angeles Times, page A1

U.S. Indicts Enron Auditor Over Shredding
Andersen faces an obstruction of justice charge after failing to reach a plea
agreement with prosecutors.

By Edmund Sanders and Jeff Leeds, Los AngelesTimes Staff Writers

WASHINGTON -- Federal prosecutors Thursday hit accounting firm Andersen
with a criminal indictment for allegedly orchestrating the "wholesale destruction"
of tons of Enron Corp. documents, raising new doubts about Andersen's survival.

The one-count indictment is the first of what Justice Department officials hinted
could be a string of criminal charges arising from the collapse of energy giant
Enron, which filed for Chapter 11 bankruptcy protection Dec. 2 amid an accounting
scandal.

Reacting swiftly to the indictment, the government today suspended Enron Corp.
and Andersen from entering into new federal contracts.
March 15, 2002, New York Times

Andersen Charged With Obstruction in Enron Inquiry
By Kurt Eichenwald

WASHINGTON, March 14 — In the first criminal charge ever brought against a
major accounting firm, Arthur Andersen has been indicted on a single count of
obstruction of justice for destroying thousands of documents related to the Enron
investigation, the Justice Department announced today.

The indictment, handed up by a grand jury last week and unsealed today, describes
a concerted effort by Andersen to shred records related to Enron in four of the
firm's offices, in Houston, Chicago, London and Portland, Ore. It was the first
criminal charge stemming from the government's investigation of Enron's collapse
in December.

"Obstruction of justice is a grave matter, and one that this department takes very
seriously," Larry D. Thompson, deputy attorney general, said at the Justice
Department. "Arthur Andersen is charged with a crime that attacks the justice
system itself by impeding investigators and regulators from getting at the truth."
Global Crossing Bankruptcy
 January 29, 2002: “Global Crossing Ltd, which spent
  five years and $15 billion to build a worldwide network
  of high-speed Internet and telephone lines, files for
  bankruptcy after failing to find enough customers to
  make network profitable; had attracted many notable
  business and political figures, including Democratic
  National Committee chairman Terry McAuliffe,
  former Pres George Bush, Tisch family and former
  ARCO chairman and big Republican fund-raiser
  Lodwrick Cook.”
 This is the largest bankruptcy of a telecommunications
  company.
The History
 Global Crossing was formed in 1999 from a merger of a
  Bermuda-based fiber-optic cable company with a local
  U.S. telecom company.
 In the ensuing years, it developed a 100,000-mile global
  network of fiber-optic cables—including links that
  traverse the Atlantic Ocean—linking more than 200
  cities in 27 countries in the Americas, Asia and Europe.
 It was regarded as one of the most promising of the
  new generation of telecom companies that sprang up in
  the late 1990s, and had secured a stock market value of
  $75bn.
The History
 While it incurred more than $12bn debts, its assets are
  believed to be worth nearly $24bn, almost twice as
  much as its debts.
 About mid-2000, things began to turn sour for the
  telecom industry. Optimistic network operators had
  completed huge infrastructures just as a nationwide
  economic slowdown curtailed corporate spending for
  such services. That left not only Global Crossing but
  other network companies with insufficient revenue to
  pay the massive debt they had accumulated to build
  their costly networks.
 In fact, Global Crossing has never reported annual
  profit since its creation, and by the first quarter of
  2001, cash was running short.
Accounting Practices

 Global Crossing then entered into swaps with other
  networks, using indefeasible rights of use, or IRUs.
 Global Crossing would buy an IRU and book the price
  as a capital expense, which could be spread over a
  number of years. But the income from IRUs was
  booked as current revenue.
 Technically, the practice is within the arcane rules that
  govern financial derivative accounting methods, but
  only if the swap transactions are real and entered into
  for a genuine business purpose.
Allegations disputed
 But there was the possibility that these transactions
  were not for legitimate business purposes and indeed
  were potentially fraudulent.
 Such concerns are a direct result of the revelations
  about misleading accounting methods used by the
  failed energy trader Enron.
 Global Crossing has said it will launch an independent
  probe of its accounts (by a company other than
  Anderson). "Recent happenings in the industry have
  brought a lot of attention to accounting," a spokesman
  said (but without mentioning Enron).
 Global Crossing has said it will look into allegations of
  impropriety by a former employee.
The Former Employee
 At the center of the controversy is Joseph Perrone, the
  company's former executive vice president of finance
  and former outside auditor. For 31 years he had been
  an auditor and partner with the Big Five accounting
  firm Arthur Andersen & Co.
 By the time he joined Global Crossing in May 2000,
  Perrone was intimately familiar its operations, having
  directed Andersen's work in connection with Global's
  1998 initial public offering, which raised about $400
  million.
 Though it is common for outside auditors to jump ship
  and go in-house at the companies they audit, Perrone's
  move was unusual because he was so highly placed at
  Andersen.
The Incentives
 To lure Perrone from Andersen, Global Crossing
  offered him a $2.5-million signing bonus on top of a
  base salary of $400,000 and a target annual bonus of
  $400,000, according to SEC filings. Perrone also
  received 500,000 Global Crossing stock options, along
  with shares in its sister company, Asia Global Crossing
  Ltd., which were to vest over a three-year period.
  Perrone also is chief accounting officer at Asia Global
  Crossing.
 This all piqued the interest of SEC officials, who
  questioned whether Perrone's hiring "impaired"
  Andersen's independence. Ultimately, the SEC was
  satisfied that Andersen "met the requirements for
  independence."
The Incentives
 “Chairman Gary Winnick could lose control if
  bankruptcy plan is accepted, but the blow would be
  softened by stock deals that reaped him more than $730
  million.
 Company shares traded for more than $60 as recently
  as March 2000. They have now fallen more than 99
  percent, to 13.5 cents, in over-the-counter trading after
  being de-listed by the New York Stock Exchange.
THE END

				
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