of Credit Derivatives
Derivatives: Market Info and awareness
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Rating agency S&P has formulated criteria applicable to special purpose vehicles used for synthetic securitisation transactions. The SPE criteria are applied by the rating agencies to apply asset-backed or structured finance ratings to transactions. Structured finance ratings deviate from usual rating principles under which the rating of a security issued by an entity cannot be better than the rating of the entity itself. If the issuing entity is an SPE, it is a bankruptcy-remote entity and therefore, the obligations of the issuer are actually satisfied by the available assets of the entity, free from claims of any other claimants.
S&P has come out with certain points on synthetic transactions that are modifications/ clarifications on the earlier criteria in respect of structured finance SPEs. These are available on the rating agency's website here.
Links For more on SPEs, see here.
Rating agency Fitch is launching a survey of the fast growing credit derivatives market. The survey will query the banks and institutions active in the yet-narrow credit derivatives market.
The objective of the survey, which will be in the form of a targeted questionnaire, will be to achieve a better understanding of institutions' total net credit derivative exposure. Fitch will be focusing on 'sellers' of credit derivatives, namely those who provide protection against credit losses, particularly through the use of single name credit default swaps and investments in CDOs. "Although banks are the most active participants in the overall credit derivative sector, hedge funds are also becoming a meaningful part of the buyer's market, and insurance/monolines/reinsurance companies have rapidly emerged as key players in the sellers market," said a Fitch official.
This survey is part of a continuing effort to capture risks associated with participation in the credit derivatives market. Subsequent efforts will focus on, among other things, the operational risk and basis risk of broker dealers and the management of counterparty risks by protection buyers. In an attempt to improve disclosure in this relatively opaque market, Fitch intends to publish the results of its market survey and other research on a macro basis. Further, it is possible that selective rating actions may be appropriate in certain instances.
Links Several other similar surveys, including the one by FSA, UK have gone into the risks associated with credit derivatives. See for the FSA paper below.
Rating agency Standard and Poor's has issued a press release objecting to the liberal language on evidence of a credit event as proposed in ISDA's Credit Derivative Definitions, 2002, now under final stages of drafting.
A credit event is basic to the making of any settlement under a credit derivative contract, and the happening of a credit event, under the current (1999) Definitions, is to be confirmed by a "publicly available information". ISDA now wants to replace the requirement of confirmation by "reasonable support", such that if a publicly available information reasonably supports the credit event, the protection payments will be triggered under the contract.
S&P has objected to this change. According to S&P, this will further widen the gap, already existing, between the definition of "default" in rating parlance and a credit event under a CDS conntract. "S&P feels that the use of this new language would result in an increased frequency of Credit Events, some of which may not have been captured in the historical data that S&P's default studies were based on," said Terry McCarthy, Associate Director in Standard & Poor's Structured Finance group. "Secondly, the language does not promote clarity and the use of it will result in an increased number of disputes, resulting in litigation and a less liquid credit default swap market."
In the meantime, ISDA is busy giving final shape to the 2002 Definitions, which will replace the 1999 version. A fourth draft of the 2002 ISDA Credit Derivatives Definitions was distributed to the Credit Derivatives Market Practice Committee on November 26, 2002, and the final product is scheduled for delivery by end of the year.
Links For more on ISDA definitions, see our page here.
This was perhaps one of the few investment banking segments still upbeat after Enron and Worldcom, but after reports of credit-derivatives-losses faced by German banks particularly Commerzbank, there is trepidation all around among banks dealing in credit derivatives.
Commerzbank's equity prices have fallen by some 70% after S&P cut its ratings, apparently after the former was reported having lost on credit derivatives trades. Commerzbank is not the only one - Deutsche is reportedly cutting down thousands of jobs. Another bank active in credit derivatives market - HypoVereinsbank - is also expected to report losses.
There have been several gloomy remarks by top bankers. The finance director of HSBC recently has been quoted as saying that his bank is concerned about the growing bad debts of international banks and the impact it might have on the system. An article in Business Week of 11th Oct looks at a debt crisis on the horizon as the credit spreads on investment grade debt have risen to historical levels at about 275bps. "Amid the current climate of market fear -- of credit-derivatives losses, withdrawn credit lines, and high-profile debt downgrades of some big financial institutions -- it could take just one large bank failure to fracture the financial system", says this article.
Links See below for Alan Greenspan's comments about the positive role of credit default swaps in smoothing credit risks.
Several recent deals, reports and events bear testimony to the strengthening credit derivatives market in Singapore. Singapore financial press is talking about it - as one could see from an article in Business Times of 25th Sept.carries a story titled "Credit derivatives market growing fast in S'pore: Banks beef up staff as their better yield lure investors and corporates" The report says that the credit derivatives market is exploding in Singapore - spurred by bankruptcies - and some banks here are trying to get a slice of the action. Investors have entered the picture lured by the enhanced yield of credit derivatives. The report quotes market practitioners who feel it is the fastest growing business in Singapore in recent times.
There have been several interesting credit derivatives deals in the past. Players like DBS Bank, Standard Chartered, ABN Amro have been active issuing credit linked notes to inoestors referenced to US, European and Asian clients. While these are stand-alone transactions, the CDO activity has also stepped up of late.
Deutsche Bank recently came out with an arbitrage synthetic CDO wherein bonds of USD 106 million were offered to provide protection against loans worth USD 1.33 billion, referenced to 148 credits spread over the World. Reportedly, this is the largest arbitrage deal in the region. Essentially, with this kind of an arbitrage deal, Deutsche is creating a capacity to sell protection in the market, backed largely by synthetic liability, that is, super-senior swap.
Also recently, ST Asset Management (STAM), a new unit of the Singapore Technologies group, has hit the road in a quest to raise US$200 million CDO, which also will invest in both cash transactions and synthetic transactions. This consists of a team that hails from OUB Asset Management.
Every word that he says is hairsplit and enlarged by the market players: in his recent address in London, Greenspan had several words of praise on 25th Sept for both securitisation and credit derivatives. Greenspan was on tour of London.
Greenspan said thanks to financial innovation, the U.S. economy more shock-resistant, asserting the economy has "held firm" through terrorist attacks, a stock market crash and a slump in business investment. Addressing a meeting of central bankers, the Fed chairman consistently praised the innovative powers of world financial markets and urged regulators not to interfere. In the U.S., he said, the country's massive secondary-mortgage market has helped keep the economy afloat by letting homeowners cash in on increases in property prices.
Referring to credit derivatives, he said financial instruments such as credit default swaps, collateralized debt obligations and credit-linked notes have also helped make the economy shock- resistant. "Such instruments appear to have effectively spread losses from defaults by Enron, Global Crossing, Railtrack, WorldCom and Swissair in recent months from financial institutions with large short-term leverage to insurance firms, pension funds, or others with diffuse long-term liabilities or no liabilities at all," he said.
The US Office of Controller of Currencye, which has recently been collecting and publishing quarterly data on US insured banks' derivatives, including credit derivatives, recently published the Q2 report. The results are hardly surprising. The notional amount of derivatives in insured commercial bank portfolios increased by $3.8 trillion in the second quarter,to $50.1 trillion.Generally,changes in notional volumes are reasonable reflections of business activity but do not provide useful measures of risk. In the second quarter, credit derivatives increased by $54 billion,to $492 billion.
The levels of concentration remain high with JP Morgan and Citibank holding a major part of the market. However, on a comparison with data for the previous quarter, it seems the extent of holding of JP Morgan has come down.
AMOUNT OF DERIVATIVE CONTRACT OF THE 25
Note: The rankings above are based on the aggregate derivatives volumes.
British Bankers Association (BBA) which has bee tracking the growth of global credit derivatives almost since their inception came out with a recent survey wherein it expects credit derivatives volumes to touch USD 2 trillion by end of 2002 and zoom up to USD 4.8 trillion by end of 2004.
The BBA survey was cited in a report in Financial Times of 17th Sept. The British Bankers' Association estimates that at the end of last year, the global market for credit derivatives reached USD 1,189bn, more than estimated by the BBA in its earlier surveys."Confidence among market participants for continued growth and development of the credit derivatives market remains high, and in a difficult economic environment credit derivatives have proven their worth as efficient risk-transfer and pricing instruments," said Roger Brown, executive director of the BBA.
In terms of significance, London still takes about 50% of the total market, followed by New York. The composition of reference names has changed drastically over time and currently, corporate credits are far more significant constituent of the market than sovereigns. The survey says corporate credits took 60% of the market activity in 2001, while sovereign trading was only 15%, compared to 54% in 1996. Single name CDS continues to be the most important product forming 45% of the market.
Links see also our page on credit derivatives market here.
Credit-linked notes, little known outside of the world of high finance, came into focus before the Permanent Sub-Committee on Investigations, currently investigating the role of certain financial institutions in the Enron demise. Professionals from S&P, Citibank and JP Morgan tried to explain the meaning of credit-linked notes.
Enron-referenced CLNs, called Yosemite, raised a funding of USD 750 million and it is now revealed that almost the whole of the proceeds of these notes were invested in funding the now-infamous prepaid transactions of Enron. Prepaid commodity swaps are where Enron would raise a money upfront for sales in future, clearly in the nature of debt. The center of controversy is that Enron used to account for the commodity swaps as not a debt but "cash from operations". However, as far as the CLNs are concerned, it is an issue that needs an answer from all concerned as to how could a CLN, referenced to a default by Enron, itself invest all its money in Enron and therefore, be an exposure into Enron itself. It sounds strange that an investment into Enron's prepaids provided protection to Citibank against an Enron default, because if Enron would default at all, it must also default on the pre-paids.
Both Citibank and Standard and Poor's in their testimony has mainly harped on the nature of CLNs, and have made it clear that the investments of the CLN proceeds were made in Enron obligations. It is now for the Congress and the people to decide if these financial engineering was a sustainable structure or a house of straw.
Even as Citi's role in structuring Yosemite and prepaid swaps unfolds, Wall Street's liberal use of SPEs will increasingly continue to baffle those who are not part of the financial fraternity. JPM's connection with Mahonia, another SPE connected with Enron, are currently being probed. The investigators seem to be going on the theory that since Mahonia, though structured as most SPEs are and therefore independent, was nothing but an extension of JPM. For the first time, the public will come to know the complex ownership structure of SPEs, which may be expected to make SPEs look all the more queer. One would not be surprised if the very device of an SPE becomes untouchable!
More to come: Investigations continue, and testimonies are expected today as well- we will bring more content soon. Be on the watch out!
In its quarterly review of the state of the derivatives market for second quarter 2002, the Bank for International Settlements has reviewed the developments in the credit derivatives market. This is for the first time that the quarterly review devotes a substantial space to credit derivatives developments.
"Recent months have been eventful for the credit derivatives markets, with the default of Argentina and the collapse of Enron leading investors to attach greater importance to the availability of liquid instruments for the hedging and trading of sovereign and corporate risk", notes the review.
Talking of the infirmities of nascency, the review records that the restructuring controversy erupted once again in course of claims relating to Argentina - relating to the exchange of shorter-dated securities by the Argentinan government for longer-dated paper, albeit carrying a higher rate of return. In order to avoid such controversies, credit derivatives dealers have been narrowing down to a more constricted definition of credit events [see below our news report]. "In spite of these amendments, significant disagreement remains over the issue of debt restructuring. Although credit default swaps can be traded both with and without restructuring clauses, European banks have tended to offer contracts with ISDA’s 1999 terminology, while since May 2001 US dealers have been offering contracts with a narrower definition of restructuring", notes the review.
A Standard and Poor's press release of 18th July says that rated credit-default swaps and credit-linked notes are becoming widely accepted in the asset-backed market, as the passage of time has given the instruments a track record and investors' comfort level with including such transactions in their portfolios has increased. Credit default swaps come for rating by rating agencies primarily for two reasons - either for rated issuance of CLNs, or for credit assessment before a synthetic asset purchase by a CDO trustee.
The rating agency says that its structured finance synthetics group also reviews various forms of securities repackaging, or repacks, as they are often called. The most basic form of repack is geared to retail investors. This structure typically involves the placement of rated corporate bonds into a trust and the issuance of rated certificates in $25 minimum denominations. There may be a slight modification of the stated coupon. The new certificate rating is solely dependent on the rating of the corporate bonds held by the trust and serving as the only collateral in the transaction
As the latest security device is the first thing we think of after hearing of the robbery next door, a series of high-profile corporate bankruptcies and accounting frauds has triggered a substantial jump in credit derivatives volumes.
A report in Financial Times of 5th July says: "The volatility in the corporate debt markets surrounding high-profile names such as WorldCom, France Telecom and Vivendi has placed banks' credit derivative trading desks at the heart the action." The same report that the London desk of JP Morgan is reportedly concluding 140 trades a day, which is double their usual number.
The same report also suggests that protection sellers against names with substantial premiums are now expecting the premium to be paid in advance rather than the usual mode of quarterly settlement in arrears.
The accounting standard on financial instruments IAS 39 is due for a revision. The International Accounting Standards Board has proposed a recast of the accounting standard - an exposure draft has been published.
IAS 39 also contains provisions for accounting for derivatives - largely in tune with FAS133. There are no major changes that specifically affect accounting for credit derivatives. However, te following are notable:
This controversy has been smouldering underneath for quite sometime and there were indications before that it has been settled out of the Court - but that was not to be. Nomura is apparently suing [report in Financial Times June 5] CSFB as to whether convertible bonds were acceptable as deliverable obligations.
The root of the controversy lies in the definition of "deliverable obligations" which carries, usually in market practice, a "not contingent" clause. "Deliverable obligations" are the obligations of the reference entity which can be delivered in a physical settlement on a credit event in a credit default swap. The reference obligation, that is, the obligation with reference to which a default swap is written, is a broadly-defined term such as "borrowed money" leaving it open for the protection buyer to find a suitable deliverable obligation and deliver the same to the protection buyer when the default takes place. Naturally, the protection buyer scouts around the market to find the obligation of the reference entity quoting the cheapest after default, and delivers the same.
One of the features of a deliverable obligation is "Not Contingent" which as per ISDA documentation means an obligation where the repayment of principal and payment of interest is committed, and not contingent. Therefore, an equity share is not a deliverable obligation. However, the issue in dispute is: whether a convertible bond is? Understandably, if a reference entity defaults, its convertible bonds are likely to trade at the least, since value of equity is nil on bankruptcy, and the value of convertibles is close to that. The view taken by legal experts is that convertibles are convertible at the option of the bondholder, and therefore, they are as much a non-contingent obligation as anything else.
Nomura had bought protection against Railtrack from CSFB in 2000. Last year, Railtrack went into receivership. Nomura bought Railtrack convertibles and sought to deliver them, which CSFB refused to accept, forcing Nomura to sell convertibles and deliver plain debt. That is what the lawsuit relates to - as to whether it was right for CSFB to have refused to accept convertibles.
In Nov. 2001, ISDA has brought out an amendment to the 1999 definitions including convertibles, exchangeable debt and accreting debt as "not contingent". However, these amendments do not apply to deals prior to that date.
UK regulators have been the most vocal on regulatory needs for the credit derivatives market. From the papers of David Rule and the comments of Deputy Governor Clementi, to Sir Howard Davies famous comment equating CDOs to the "toxic side of the securitisation market", UK regulators have often shaken the City's derivatives dealers.
Now, it comes with the first official discussion paper, and an elaborate one at at - a 95 pager that examines the growth of credit derivatives and CDOs, perceived risks, risk transfers, regulatory treatment etc. While credit derivatives transfer credit risks, in part at least, to the insurance markets as insurance companies are prominent protection sellers, the second part of the paper concerns alternative risk transfers whereby insurance risk is sold into the capital markets. Both are the devices of cross-sector risk transfers - banking sector transferring risk into the insurance sector and vice versa. The discussion paper then highlights the risks inherent in such inter-sectoral risk transfers and raises questions for market participants to ponder over.
FSA press release quotes the head of the Prudential Standards division: "Risk transfers, such as credit derivatives, can be a benefit if they are well-managed. But they are a risk to the unwary. Managed well, they can diversify a firm’s risk; managed badly they will concentrate it".
Comments on the paper are due by 31st July 2002.
Links Full text of the FSA paper, press release and related material are here on the FSA site.
How UK financial press reacted : Financial Editor of the Independent took the FSA paper as a warning to the City. He said the FSA "has issued a warning that firms in the Square Mile might be inadvertently exposing themselves to legal claims associated with an increasingly popular financial instrument that helps banks dump risk on insurance companies." The Guardian emphasised that insurance companies will henceforth be required to disclose protection provided to capital markets as that is not insurers' traditional business. The Financial Times however took it as an approval rather than a censure. It said the FSA "has given a relatively clean bill of health to the fast-growing market in credit derivatives but also warned participants they need to be careful."
Your comments Your comments are welcome for publication on this site as well. Do write to me. A response to FSA discussion will be going from this site as well - your comments will help us to prepare a reply.
As more credit derivatives are being transferred to capital markets, it is evident that protection buyers cannot depend on less definitive, broad-based credit events. The market is gradually growing in consensus on more narrow credit events which will make the market more transparent.
According to a feature in Financial Times of 25th April, the European market players have also followed the footsteps of the US players and dropped restructuring and moratorium as events of default for OTC derivatives. As far as capital market transactions are concerned, such events were rarely used for synthetic CDOs. ISDA recently met in Berlin where the need for simplicity and standardisation, primarily in documentation, was emphasised.
ISDA will be working with representatives of the US and European default swap markets in the coming months to reach a common solution, ahead of the publication of ISDA's new credit derivatives definitions which updates its 1999 handbook, says the story.
Documentation infirmities have dogged the credit derivatives market several times: in particular restructuring, leading to a great toning down of the restructuring definition by ISDA in April last year.
ISDA's recent survey of end-2001 volume of credit derivatives was pleasing, though may not be surprising, as most market practitioners were aware of a growing global interest in credit derivatives. The end-2001 surevy shows that credit default swap volumes increased over 45% from ISDA’s Mid-Year Survey in June. Eighty ISDA member institutions participated in the Survey.
ISDA first published survey results relating to June last year. Credit default swaps grew to $918.9 billion as at end-2001 from the $631.5 billion reported at mid-year. While modest compared with interest rate and currency products, the volumes are expected to remain on an upward trend compared with more mature derivative product areas. ISDA surveyed total notional outstanding volumes for single-name credit default swaps, default swaps on baskets of up to ten credits, and portfolio transactions of ten or more credits.
A recent issue of an IMF publication on Global Financial Stability Report contains a detailed account of credit derivatives developments and recounts the promises and pitfalls of devices of risk transfers. On the impact fo credit derivatives on the economy, the article says: "Particularly as the markets mature and grow over time, credit risk transfers have the potential to enhance the efficiency and stability of credit markets overall and improve the allocation of capital. By separating credit origination from credit risk bearing, these instruments can make credit markets more efficient. They can also help to reduce the overall concentration of credit risk in financial systems by making it easier for nonbank institutions to take on the credit risks that banks have traditionally held."
Having said that, the article goes headlong into the risks that credit derivatives pose to the system. To quote: "At the same time these instruments and markets are currently being driven by regulatory arbitrage, involve nontraditional players, and are adding to the complexity of financial transactions and markets."
The article explains how credit derivatives contribute to complexity. First, they are reducing transparency about the institutional distribution of credit risk and its concentration. Second, while they are dispersing credit risk to a broader set of market participants, they may be creating or magnifying channels through which the distress associated with credit events would spread across institutions and markets (including through the web of rapidly shifting counterparty exposures). Third, these instruments seem to have created demand for credit risk by a much larger and different set of market participants, generally less, or even, not regulated as well as banks, and not necessarily having the experience required for properly pricing or managing these risks. Finally, by their very nature, credit risk transfer mechanisms are by and large leveraged instruments, and they can add to the total amount of credit that is internally created within the financial system. This increases the potential for mispricing and misallocation of capital.
Credit derivatives have grown in popularity in difficult times, and arguably, times could not be more difficult than now. With USD 115 billion in debt losses over 2001, and USD 31 billion only in Jan 2002, credit derivatives have made their presence felt. At the same time, several players have learnt the risks of investing in risk-based assets. In general, the CDO market has sustained 9-11, Argentina and Enron.
The article also narrates the oft-repeated pitch of legal uncertainties in OTC transactions and gives 3 instances of legal differences. One, in Railtrack's administration order as to whether convertibles will be accepted as deliverable instruments. Two, close-out nettng legislation has still not been passed by several countries including USA where it has been in the works for almost 4 years. Three, JPM's dispute over surety bonds, which is not exactly a credit derivative deal.
The article also examines at length the issue of retail investor participation in credit derivatives, either directly or through financial intermediaries.
Link Here is the link to the IMF publication.
JP Morgan launched early this week an index-linked synthetic product that may herald a new generation of credit derivative products. JPM will offer for trading, from coming Monday, a tradable swap-linked note based on a weighted index of the 100 most liquid European corporate bonds.
The new, five-year instrument called JECI (JP Morgan European Credit Index-Linked Security), will be a unique tradable index-based European credit instrument in the market.
Earlier, a similar-looking instrument was launched 0n February 27 by Morgan Stanley called Euro Tracers, a tradable security based on corporate debt from a select pool of 30 European companies. However, Euro Tracers was an investment product, while JP Morgan's instant tool is a synthetic instrument.
We will come out with more details on this interesting innovation.
Data about credit derivatives volumes reported by US banks as released by the Office of Controller of Currency (OCC), USA show that while other aggregate OTC derivatives volume fell from a notional value of USD 51.284 trillion in Q3 to USD 45.386 trillion in Q4 of 2001, credit derivatives grew from USD 360 billion to USD 395 billion over the same period. While credit derivatives are still a very small part of the total OTC derivatives market, they are growing faster than any other derivative segment.
The market continued to be focused in a few key names. The top 7 banks held more than 80% of the market to the extent of USD 383 billion, while the remaining 362 banks held volumes of only USD 13 billion.
The lion in the credit derivatives market, taking the lion's share, was JP Morgan - commanding a share of USD 262 billion, which is approximately 66% of the total market. The runner up is Citigroup, which is far behind with a volume of USD 68 billion.
Links See our country page on USA here.
Credit derivatives are still a very small portion of the OTC derivatives market in Japan, but the data on derivative positions on major Japanese institutions as revealed by the Bank of Japan [Yoshikuni statistics] shows that credit derivatives bucked the trend of falling derivatives volumes.
During the second half of 2001, while interest rate derivatives declined 5.1 percent and foreign exchange-related contracts declined by 5.3 percent, credit derivatives increased by 21.8 percent. The data does not exactly specify the volume of credit derivatives but by deduction, it seems the outstanding volume should be close to 0.1 trillion USD.
Links For more on credit derivatives market in Japan, see our page here.
Greenwich Associates recently published the results of a survey conducted by them relating to North American market for credit derivatives. The survey was based on 230 interviews with banks and institutions in USA and Canada carried out in summer, 2001. The results of why people use credit derivatives and why they do not are not surprising, yet interesting to note.
The reasons as to why users use credit derivatives are expectedly varied based on the user. On the buy side of protection are the banks who look at it essentially as a hedge. On the sell side of protection are the insurance companies and hedge funds who are looking for incremental returns. In the survey, 50% of the respondents have indicated incremental returns as a motive, while 48% look at it as an investment class. A 33% of the respondents looked at it as an arbitrage opportunity. On the risk management side, 34% and 31% respectively looked at as hedge against bonds and hedge against loans. 16% of the respondents were interested in it as a speculative investment.
Regulators have often been perturbed as to the increasing use of credit derivatives for profit making as against its intended wholesome use as a diversification of risks and synthetically creating positions in portfolios not owned by the protection sellers. To an extent, the survey lends crebibility to the regulatory fears.
As for people who do not use credit derivatives, 28% of the respondents did not use the instrumenet because they thought they did not need it while 25% said they had not had enough time to understand or evaluate them. A 17% were driven away for lack of liquidity.
Links Abstracts from the survey are available here.
JP Morgan will be pressing for an early court ruling on its surety bonds that purported gave it protection against Enron's commodity repurchase deals. We have covered this dispute on our site before - see link here.
JP Morgan had entered into oil and gas repurchase agreements with Enron whereby it had paid USD 965 million, to be recovered by resale of the commodities. The contracts were routed through a Channel Islands SPE called Mahonia, which itself is under a cloud currently. This exposure was covered by getting surety bonds from several guarantors, which includes 11 insurance companies. The guanrantors are now alleging that the underlying deal was not actually a commodity purchase-sale deal but a disguised financial transaction which was not guaranteed by them.
Visitor comments: Responding to our earlier story on Enron surety bonds, one of our visitors wrote an extremely articulate comment, which we are reproducing:
The Enron scandal is fraught with allegations of fraud and deception, which certainly gives credibility to the sureties’ defense that the prepaid forward contract they guaranteed was a sham intended to disguise a loan as a commodity purchase. On the other hand, sureties have had limited experience with guarantees of this type. By venturing into an area that is well outside their core competence, the sureties may just as well be victims of their own inexperience or negligence. Guarantees of construction contracts are the primary source of premium for the surety industry and, consequently, most surety underwriters specialize in underwriting construction contractors (i.e. Contract Surety). This is a very specialized skill where bond risks are well defined and the financial analysis techniques necessary to evaluate the creditworthiness of a principal are specific to the construction industry. These underwriting skills, however, are not necessarily exportable to other types of surety bonds or industries.
Financial guarantees are not Contract Surety obligations but instead fall into a different classification commonly referred to as "Commercial Surety." Most Commercial Surety bonds are relatively small and many do not require a sophisticated level of knowledge to underwrite properly. Commercial surety, however, also includes some of the largest and most hazardous bonds written by the industry, as evidenced by the Enron bonds.
It appears the court needs to address some critical questions. Were the sureties truly misled or did they simply lack the expertise to identify the risks inherent in a forward contract and underwrite accordingly? How could the sureties have understood they were guaranteeing a prepaid forward contract and not recognize the credit risks inherent in such an instrument? How does an industry that derives most of its revenue from the guarantee of construction contracts obtain the skills necessary to underwrite complex financial guarantees? Why did the sureties believe they could safely assume a risk that J.P. Morgan, an expert in the field, was not willing to accept? Did the sureties perform their due diligence and carefully peruse the underlying contracts to ensure that they fully understood the obligation or did they rely on extraneous information and assumptions? Did the decision-makers have the experience, education and financial skills necessary to properly evaluate complex financial transactions?
The sureties are obviously not entirely responsible for the problems they have with Enron. The deceptive management and accounting practices at Enron fooled many, including rating agencies and Wall Street analysts. In that respect, the sureties are victims like many others. But the defense that the bonds should be voided because the contract was misleading is questionable and one that should be examined closely by the court. It is possible that proper underwriting could have avoided the problem.
- Larry Byers Federal Way, Washington
Do you have any views in the matter? Please feel free to write back.