Financial Derivatives

SOUMENDRA ROY
 Overview
• Definition of Financial Derivatives
• Common Financial Derivatives
• Why Have Derivatives?
• The Risks
• Leveraging
• Trading of Derivatives
• An Apologia for Derivatives
• The Dark Side of Derivatives
DEFINITION OF FINANCIAL DERIVATIVE
• 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 are present
• More generic is the concept of “hedge funds” which
use financial derivatives as their most important
tool for risk management.
REPAYMENT OF FINANCIAL DERIVATIVE
• 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 DERIVATIVE
• 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.
• 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
Floating rate for a fixed rate
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 cross market
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 PRODUCT
• 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.
• Institutional investors, such as pension plans and limited
partnerships, have higher minimum requirements.
• These investors have financial advisers or are savvy enough
to evaluate sophisticated investments for themselves.
• 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.
• 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.
• 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
 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.
• 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
 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