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 investorsindividuals 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
executivesled by the president, chief financial officer and
head of insurance operationsgot 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.
Baringss 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 CountyHistory

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 derivativesin exotic
securities whose yields were inversely related to interest
rates.
 Orange CountyPeriod 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 Countythe 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 ituntil 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 poolnor would he have been
able to invest as he didhad 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 rulesallowing 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 loomingespecially 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 LTCMs
strategy worked, and were equally spectacular and
disastrous when it didnt. Few of LTCMs investors and
perhaps none of its lenders were aware of the
magnitude of this funds 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
Enrons Overseas Energy Projects
Enron Communications and Internet Structure
Enron Online and Internet Brokering
Enron and the Market in Broadband
The Catchesone 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 divisionEnron
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 continuedto some degree
apparently against Skilling's wishesto pursue such
stick-in-the-mud "old-economy" goals as building
power plants around the world.
Enron's Overseas Energy Projects
Enrons 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
bargeswith names like Esperanza, Margarita and El
Enronin 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
Enrons 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
companys 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 Principalan 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 Catchesone 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 Enrons Overseas Energy Program
In mid-February 2002, Overseas Private Investment
Corp., which backed many of Enrons 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 cablesincluding links that
traverse the Atlantic Oceanlinking 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