As Enron spiraled into bankruptcy this week, some observers worried the shock wave from the Houston energy trader’s crash would set off a domino effect in the financial markets, just as the collapse of Long-Term Capital Management, the giant Connecticut hedge fund, did three years ago. Like LTCM, Enron traded exotic derivatives in a wide range of markets. Both firms supercharged their bets with enormous leverage. And both concealed their activities with extraordinary secrecy. In 1998, regulators were so concerned that LTCM’s money-losing bond bets would trigger a sequence of defaults costing trillions that the Federal Reserve quickly brokered a Wall Street rescue to avert a worldwide crisis. So when Enron announced on Dec. 2 that it had filed for Chapter 11 bankruptcy protection, the immediate question was: Who will the company take down, and how soon? “The quickness of it is just absolutely astonishing,” said
As Enron spiraled into bankruptcy this week, some observers worried the shock wave from the Houston energy trader’s crash would set off a domino effect in the financial markets, just as the collapse of Long-Term Capital Management, the giant Connecticut hedge fund, did three years ago.
Like LTCM, Enron traded exotic derivatives in a wide range of markets. Both firms supercharged their bets with enormous leverage. And both concealed their activities with extraordinary secrecy. In 1998, regulators were so concerned that LTCM’s money-losing bond bets would trigger a sequence of defaults costing trillions that the Federal Reserve quickly brokered a Wall Street rescue to avert a worldwide crisis.
So when Enron announced on Dec. 2 that it had filed for Chapter 11 bankruptcy protection, the immediate question was: Who will the company take down, and how soon? “The quickness of it is just absolutely astonishing,” saidPaul Kleindorfer, co-director of Wharton’s Risk Management and Decision Processes Center, who specializes in deregulation and has studied Enron.
If Enron failed to pay its debts and to fulfill its contract obligations on energy and other trades, counter-parties would suffer losses. Conceivably, the damage could spread beyond the gas, electricity and other energy markets in which Enron specialized, since investors suffering losses on energy trades might be forced to liquidate holdings in stocks, bonds or other securities to make good on their own obligations.
In its bankruptcy filing, Enron listed debts of $31.2 billion, and numerous companies hurried to disclose the extent of their own “exposure” in Enron-related loans, trades and investments. A few examples of potential losses:
- Pension funds from around the country indicated they could lose $4.9 billion, largely from holdings of Enron stock, now trading around $1, down from $90 a year ago.
- The list of creditors in Enron’s bankruptcy filing suggests Citigroup Inc. could lose $800 million and J.P. Morgan Chase & Co. could lose $500 million.
- John Hancock Financial Services Inc., the Boston insurance and financial-services company, said it had about $320 million in Enron-related investments.
- A Salomon Smith Barney Inc. analyst estimated that American life insurers had about $1.5 billion in Enron exposure. Others have put the figure as high as $3.5 billion. These would involve investment losses, such as holdings in Enron stock or debt, as well as claims paid in lawsuits against Enron directors and officers and financial-guarantee insurance.
The Enron-related losses appear large, but the disclosures so far are not on the LTCM scale. Indeed, even the energy markets where Enron was dominant appear likely to endure this shock without severe long-term damage.
The reason: Enron was an extreme player – a trailblazer to its admirers, a renegade to its critics. Other players aren’t so far out on the edge. “This is pretty idiosyncratic to Enron,” Kleindorfer said. Enron was the leader in the formation of the wholesale energy markets made possible by deregulation in the 1990s, and Enron was the biggest player. But a number of other companies have entered the business as well: Reliant, El Paso, Mirant, Duke, Dynegy, Williams, Cinergy and Calpine are the largest. Energy is also traded on the New York Mercantile Exchange or Nymex.
Enron, said Kleindorfer, served as both broker and counter-party in many transactions, putting it in a position to guarantee fulfillment of contracts it was involved in trading. Nymex members also must make guarantees, he said, but the exchange requires that traders make large cash deposits to assure that defaults will not swamp the exchange. Enron did not protect itself in this way, he said.
Analysts also have noted that the other energy-trading companies do not rely on off-balance-sheet transactions to the extent Enron did. Enron used this technique to keep debts off its books and to allow it to operate with little public disclosure. But when Enron’s fortunes started to sour, trading partners, investors, lenders and credit agencies began to worry about hidden surprises. The more conservative companies – more open and not leveraged as much – are less likely to suffer such a crisis of confidence. “To go to the wrong side of the line and damage investor confidence, or the confidence of those you do transactions with, is a terrible sin,” Kleindorfer said.
Seeing trouble mount, many trading companies hurried to trim their dealings with Enron. For instance, Calpine, the San Jose-based electricity generator and trader, said December 3 that it had reduced its contracts with Enron by 90% in the previous month. The remaining positions were financial hedges rather than contracts for physical delivery of energy products such as gas. The hedges could easily be replaced elsewhere, Calpine said.
Moody’s Investors Service, the rating company, announced Dec. 3, that a survey of 50 of the country’s largest public power utilities found they “are expected to face only minor exposure” to Enron’s collapse. “Most electric utilities over the past several years have put in place trading policies that provided for conservative risk tolerance, so that a failure by one counter-party would not have significant impacts, since the contract would represent only a small percentage of total activity,” said Moody’s vice president Dan Aschenback.
In fact, Aschenback added, many utilities had discontinued trading with Enron as the company’s problems snowballed, averting any losses. At the same time, bond-raters at Standard & Poor’s said bond insurers were “not threatened” by Enron defaults because Enron debts were widely dispersed among large pools of insured bonds.
Though Enron has let go more than 4,000 of its 21,000 employees, the company’s trading operation is still running, softening the blow to the energy-trading markets. The other big players can take over Enron’s share of the market, though “it’s my sense that the market will take some time to digest the Enron withdrawal,” said Ehud Ronn, director of the Center for Energy Finance Education and Research at the University of Texas at Austin.
To fill Enron’s shoes, other firms will have to raise the limits on trade sizes, he said, noting, however that there were only a few types of products in which Enron was the exclusive provider. “In the short term, we are likely to see wider bid-ask spreads, lower liquidity and probably greater volatility in the prices of energy – especially electricity prices,” Ronn said. But he expects no long-term damage to the energy markets.
Enron could survive bankruptcy without being liquidated, Kleindorfer added. But even if it does not, its trading system may be acquired by another company in a bankruptcy sale.
That system is valuable to the market because many other companies rely on it for essential data on energy prices. Many industry practices and software are built around the Enron model, according to Kleindorfer. “My own view is that this role will certainly be missed if Enron does not manage to emerge fairly quickly with its trading platform in place.” But it would not be a disaster, he added. It’s as if all of a city’s ATM machines went down – a big inconvenience for customers, but not the same as a banking collapse.
While there has been much hand wringing among the devastated Enron shareholders, there has been no serious talk in Washington of a government-backed rescue along the lines of Long-Term Capital Management. Instead, most of the rumblings involve cries for more stringent oversight of energy markets, including perhaps requirements for more disclosure of the risks participants take.
The Enron collapse is an indictment of that company’s management style, but not of deregulation, Kleindorfer said. In fact, a bill to further deregulate electricity markets is to be introduced in the U.S. Senate next week. The Enron debacle, Kleindorfer stated, “is not going to turn out the lights anywhere that I know of.”