Financial Derivatives
Robert M. Hayes
2002
Overview
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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
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Options
Forward Contracts
Futures
Stripped Mortgage-Backed Securities
Structured Notes
Swaps
Rights of Use
Combined
Hedge Funds
Options
 The purchaser of an Option has rights (but not obligations)
to buy or sell the asset during a given time for a specified
price (the "Strike" price). An Option to buy is known as a
"Call," and an Option to sell is called a "Put. "
 The seller of a Call Option is obligated to sell the asset to
the party that purchased the Option. The seller of a Put
Option is obligated to buy the asset.
 In a “Covered” Option, the seller of the Option already
owns the asset. In a “Naked” Option, the seller does not
own the asset
 Options are traded on organized exchanges and OTC.
Forward Contracts
 In a Forward Contract, both the seller and the
purchaser are obligated to trade a security or other
asset at a specified date in the future. The price paid for
the security or asset may be agreed upon at the time the
contract is entered into or may be determined at
delivery.
 Forward Contracts generally are traded OTC.
Futures
 A Future is a contract to buy or sell a standard
quantity and quality of an asset or security at a
specified date and price.
 Futures are similar to Forward Contracts, but are
standardized and traded on an exchange, and are
valued daily. The daily value provides both parties with
an accounting of their financial obligations under the
terms of the Future.
 Unlike Forward Contracts, the counterparty to the
buyer or seller in a Futures contract is the clearing
corporation on the appropriate exchange.
 Futures often are settled in cash or cash equivalents,
rather than requiring physical delivery of the
underlying asset.
Stripped Mortgage-Backed Securities
 Stripped Mortgage-Backed Securities, called "SMBS,"
represent interests in a pool of mortgages, called
"Tranches", the cash flow of which has been separated
into interest and principal components.
 Interest only securities, called "IOs", receive the
interest portion of the mortgage payment and generally
increase in value as interest rates rise and decrease in
value as interest rates fall.
 Principal only securities, called "POs", receive the
principal portion of the mortgage payment and
respond inversely to interest rate movement. As interest
rates go up, the value of the PO would tend to fall, as
the PO becomes less attractive compared with other
investment opportunities in the marketplace.
Structured Notes
 Structured Notes are debt instruments where the
principal and/or the interest rate is indexed to an
unrelated indicator. A bond whose interest rate is
decided by interest rates in England or the price of a
barrel of crude oil would be a Structured Note,
 Sometimes the two elements of a Structured Note are
inversely related, so as the index goes up, the rate of
payment (the "coupon rate") goes down. This
instrument is known as an "Inverse Floater."
 With leveraging, Structured Notes may fluctuate to a
greater degree than the underlying index. Therefore,
Structured Notes can be an extremely volatile
derivative with high risk potential and a need for close
monitoring.
 Structured Notes generally are traded OTC.
Swaps
 A Swap is a simultaneous buying and selling of the
same security or obligation. Perhaps the best-known
Swap occurs when two parties exchange interest
payments based on an identical principal amount,
called the "notional principal amount."
 Think of an interest rate Swap as follows: Party A holds
a 10-year $10,000 home equity loan that has a fixed
interest rate of 7 percent, and Party B holds a 10-year
$10,000 home equity loan that has an adjustable
interest rate that will change over the "life" of the
mortgage. If Party A and Party B were to exchange
interest rate payments on their otherwise identical
mortgages, they would have engaged in an interest rate
Swap.
Swaps
 Interest rate swaps occur generally in three scenarios.
Exchanges of a fixed rate for a floating rate, a floating
rate for a fixed rate, or a floating rate for a floating
rate.
 The "Swaps market" has grown dramatically. Today,
Swaps involve exchanges other than interest rates, such
as mortgages, currencies, and "cross-national"
arrangements. Swaps may involve cross-currency
payments (U.S. Dollars vs. Mexican Pesos) and
crossmarket payments, e.g., U.S. short-term rates vs.
U.K. short-term rates.
Rights of Use
 A type of swap is represented by swapping capacity on
networks using instruments called “indefeasible rights
of use”, or IRUs. Companies buying an IRU might
book the price as a capital expense, which could be
spread over a number of years. But the income from
IRUs could be booked as immediate revenue, which
would bring an immediate boost to the bottom line.
 Technically, the practice is within the arcane rules that
govern financial derivative accounting methods, but
only if the swap transactions are real and entered into
for a genuine business purpose.
Combined Derivative Products
 The range of derivative products is limited only by the
human imagination. Therefore, it is not unusual for
financial derivatives to be merged in various
combinations to form new derivative products.
 For instance, a company may find it advantageous to
finance operations by issuing debt, the interest rate of
which is determined by some unrelated index. The
company may have exchanged the liability for interest
payments with another party. This product combines a
Structured Note with an interest rate Swap.
Hedge Funds
 A “hedge fund” is a private partnership aimed at very
wealthy investors. It can use strategies to reduce risk.
But it may also use leverage, which increases the level
of risk and the potential rewards.
 Hedge funds can invest in virtually anything anywhere.
They can hold stocks, bonds, and government securities
in all global markets. They may purchase currencies,
derivatives, commodities, and tangible assets. They
may leverage their portfolios by borrowing money
against their assets, or by borrowing stocks from
investment brokers and selling them (shorting). They
may also invest in closely held companies.
Hedge Funds
 Hedge funds are not registered as publicly traded
securities. For this reason, they are available only to
those fitting the Securities and Exchange Commission
definition of “accredited investors”—individuals with a
net worth exceeding $1 million or with income greater
than $200,000 ($300,000 for couples) in each of the two
years prior to the investment and with a reasonable
expectation of sustainability.
 Institutional investors, such as pension plans and
limited partnerships, have higher minimum
requirements. The SEC reasons that these investors
have financial advisers or are savvy enough to evaluate
sophisticated investments for themselves.
Hedge Funds
 Some investors use hedge funds to reduce risk in their
portfolio by diversifying into uncommon or alternative
investments like commodities or foreign currencies.
Others use hedge funds as the primary means of
implementing their long-term investment strategy.
Why Have Derivatives?
 Derivatives are risk-shifting devices. Initially, they were
used to reduce exposure to changes in such factors as
weather, foreign exchange rates, interest rates, or stock
indexes.
 For example, if an American company expects payment
for a shipment of goods in British Pound Sterling, it
may enter into a derivative contract with another party
to reduce the risk that the exchange rate with the U.S.
Dollar will be more unfavorable at the time the bill is
due and paid. Under the derivative instrument, the
other party is obligated to pay the company the amount
due at the exchange rate in effect when the derivative
contract was executed. By using a derivative product,
the company has shifted the risk of exchange rate
movement to another party.
Why Have Derivatives?
 More recently, derivatives have been used to segregate
categories of investment risk that may appeal to
different investment strategies used by mutual fund
managers, corporate treasurers or pension fund
administrators. These investment managers may decide
that it is more beneficial to assume a specific "risk"
characteristic of a security.
The Risks
 Since derivatives are risk-shifting devices, it is
important to identify and understand the risks being
assumed, evaluate them, and continuously monitor and
manage them. Each party to a derivative contract
should be able to identify all the risks that are being
assumed before entering into a derivative contract.
 Part of the risk identification process is a determination
of the monetary exposure of the parties under the terms
of the derivative instrument. As money usually is not
due until the specified date of performance of the
parties' obligations, lack of up-front commitment of
cash may obscure the eventual monetary significance of
the parties' obligations.
The Risks
 Investors and markets traditionally have looked to
commercial rating services for evaluation of the credit
and investment risk of issuers of debt securities.
 Some firms have begun issuing ratings on a company's
securities which reflect an evaluation of the exposure to
derivative financial instruments to which it is a party.
 The creditworthiness of each party to a derivative
instrument must be evaluated independently by each
counterparty. In a financial derivative, performance of
the other party's obligations is highly dependent on the
strength of its balance sheet. Therefore, a complete
financial investigation of a proposed counterparty to a
derivative instrument is imperative.
The Risks
 An often overlooked, but very important aspect in the
use of derivatives is the need for constant monitoring
and managing of the risks represented by the derivative
instruments.
 For instance, the degree of risk which one party was
willing to assume initially could change greatly due to
intervening and unexpected events. Each party to the
derivative contract should monitor continuously the
commitments represented by the derivative product.
 Financial derivative instruments that have leveraging
features demand closer, even daily or hourly
monitoring and management.
Leveraging
 Some derivative products may include leveraging
features. These features act to multiply the impact of
some agreed-upon benchmark in the derivative
instrument. Negative movement of a benchmark in a
leveraged instrument can act to increase greatly a
party's total repayment obligation. Remembering that
each derivative instrument generally is the product of
negotiation between the parties for risk-shifting
purposes, the leveraging component, if any, may be
unique to that instrument.
Leveraging
 For example, assume a party to a derivative instrument
stands to be affected negatively if the prime interest
rate rises before it is obliged to perform on the
instrument. This leveraged derivative may call for the
party to be liable for ten times the amount represented
by the intervening rise in the prime rate. Because of
this leveraging feature, a small rise in the prime
interest rate dramatically would affect the obligation of
the party. A significant rise in the prime interest rate,
when multiplied by the leveraging feature, could be
catastrophic.
Trading of Derivatives
 Some financial derivatives are traded on national
exchanges. Those in the U.S. are regulated by the
Commodities Futures Trading Commission.
 Financial derivatives on national securities exchanges
are regulated by the U.S. Securities and Exchange
Commission (SEC).
 Certain financial derivative products have been
standardized and are issued by a separate clearing
corporation to sophisticated investors pursuant to an
explanatory offering circular. Performance of the
parties under these standardized options is guaranteed
by the issuing clearing corporation. Both the exchange
and the clearing corporation are subject to SEC
oversight.
Trading of Derivatives
 Some derivative products are traded over-the-counter
(OTC) and represent agreements that are individually
negotiated between parties. Anyone considering
becoming a party to an OTC derivative should
investigate first the creditworthiness of the parties
obligated under the instrument so as to have sufficient
assurance that the parties are financially responsible.
Mutual Funds and Public Companies
 Mutual funds and public companies are regulated by
the SEC with respect to disclosure of material
information to the securities markets and investors
purchasing securities of those entities. The SEC
requires these entities to provide disclosure to investors
when offering their securities for sale to the public and
mandates filing of periodic public reports on the
condition of the company or mutual fund.
 The SEC recently has urged mutual funds and public
companies to provide investors and the securities
markets with more detailed information about their
exposure to derivative products. The SEC also has
requested that mutual funds limit their investment in
derivatives to those that are necessary to further the
fund's stated investment objectives.
Selling of Financial Derivatives
 Some brokerage firms are engaged in the business of
creating financial derivative instruments to be offered
to retail investment clients, mutual funds, banks,
corporations and government investment officers.
 Before investing in a financial derivative product it is
vital to do two things.
 First, determine in detail how different economic
scenarios will affect the investment in the financial
derivative (including the impact of any leveraging
features).
 Second, obtain information from state or federal
agencies about the broker's record.
Derivatives on the Internet
 In the past several years, trading of financial derivatives
has become an active Internet e-commerce focus, with
EnronOnline as among the most active sites. Leaving
aside assessment of the reliability of e-commerce trading
sites, the following are valuable sites for keeping track:
 For quick news bites, the best sources are maintained by
some of the major financial news organizations:
 Bloomberg Online
www.bloomberg.com
 Reuters.com
www.reuters.com
 The Associated Press www.nytimes.com/aponline
 Bridge Financial
www.bridge.com
Derivatives on the Internet
 One very quick and easy analysis of developments in
overnight markets and identification of key issues in
today's markets is Marc Chandler's commentary:
 TheStreet.com
www.thestreet.com.
 For Canadian news, there are two national newspapers,
 The National Post
www.nationalpost.com and
 The Globe And Mail
www.theglobeandmail.com.
 Internationally,
 The New York Times www.nytimes.com,
 South China Morning Post www.scmp.com,
 The Washington Post www.washingtonpost.com
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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
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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
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deregulation
wish to have stock price go up
use of stock options as incentives
use of hidden borrowing
use of financial derivatives in risky gambles
consulting by auditor on use of derivatives
use of deceptive accounting to hide risks
acquiescence of auditor in deception
use of fraudulent entries to support deceptions
use of hidden partners
move from individual fraud to corporate fraud
connivance of auditor in fraud
use of a Ponzi scheme to continue fraud
profiting before the collapse
A B C D E
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(A) Equity Funding, (B) Baring Bank, (C) Orange County,
(D) Long Term Capital Management, (E) Enron, (F)Global Crossing
Equity Funding Corporation of America
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The insurance funding program
The first scam
The next scam
The really BIG scam
The final scam
The house of cards collapses
The fallout from Equity Funding
An analysis of the causes
The Lessons Learned
The insurance funding program - 1
 Equity Funding Corporation of America was founded
in 1960. Its principal line of business was selling
"funding programs" that merged life insurance and
mutual funds into one financial package for investors.
 The deal was as follows: first, the customer would
invest in a mutual fund; second, the customer would
select a life insurance program; third, the customer
would borrow against the mutual fund shares to pay
each annual insurance premium. Finally, at the end of
ten years, the customer would pay the principal and
interest on the premium loan with any insurance cash
values or by redeeming the appreciated value of the
mutual fund shares. Any appreciation of the investment
in excess of the amount paid would be the investor's
profit.
The insurance funding program - 2
 The company had a huge sales force. The thrust of the
salesman's pitch to a customer was that letting the cash
value sit in an insurance policy was not smart; in fact,
the customer was losing money. The customer was
encouraged to let his money work twice by taking part
in the above deal.
 The development of such creative financial investments
was a trademark of Equity Funding in the early years
of its existence. After going public in 1964, Equity
Funding was soon recognized across the country as an
innovative company in the ultraconservative life
insurance industry.
The insurance funding program - 3
 This kind of leveraging of dollars is a concept used by
sophisticated investors to maximize their returns. They
use an asset they already own to borrow money in the
expectation that earnings and growth will be greater
than the interest costs they will incur. However, it's a
concept that is fraught with risks for the investor and
should not be promoted by an ethical company without
fully informing the investor of the risks.
 Even so, there was nothing illegal or even immoral
about the basic concept. Indeed, it was a captivating
idea, except it didn't make enough money for the
company or its executives. So some executives—led by
the president, chief financial officer and head of
insurance operations—got a little more creative with
the numbers on their books.
The first scam
 "Reciprocal income“
Preparing to take the company public in 1964, there
was concern that its earnings were too low. To
correct this "problem", the owners decided that
Equity Funding was entitled to record rebates or
kickbacks from the brokers through whom the
company's sales force purchased mutual fund
shares. The resulting income, called "reciprocal
income" was used to boost 1964 net income for
Equity Funding. So the fraud apparently began in
1964 when the commissions earned on sales of the
Equity Funding program were erroneously inflated.
The next scam
 Borrowing without showing liability
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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
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Ethics and integrity of management and employees
Management's philosophy and operating style
 The Auditors
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Lack of independence of the auditors
Lack of professional skepticism of the auditors
External impairments to the audit
The Management
 The ethics and integrity of management and employees
 Management's philosophy and operating style
The Auditors
 The independence of the auditors
 Professional skepticism of the auditors
The Lessons Learned
Baring Bank Bankruptcy
 Barings Bank was established in London in 1763 as a
merchant bank, which allowed it to accept deposits and
provide financial services to its clients as well as trade
on its own account, assuming risk by buying and selling
common real estate and financial assets.
 In early 1980, Barings set up brokerage operations in
Japan. With its success in Japan, Barings decided to
expand to Hong Kong, Singapore, Indonesia and
several other Asian countries.
 By 1992, Barings subsidiary in Singapore had a seat on
the SIMEX, but did not activate it due to lack of
expertise in trading futures and option contracts.
Nick Leeson: both Front and Back
 Four months later Barings decided to activate its
SIMEX seat. They appointed Mr. Nick Leeson as the
general manager and charged him with setting up the
trading operations in Singapore and running them.
 Mr. Leeson was in charge of both the front office and
the back office. An important task in brokerage
business, particularly in the settlement side, is
uncovering and dealing with trading errors, which
occur when the trading staff misread or mishear an
instruction or a broker misunderstands a hand signal.
When errors occur, brokerages book the losses or gains
into a computer account called an "error account".
 For Mr. Leeson, errors recorded were sent to the home
office in London and deducted against Mr. Leeson's
branch earnings.
Account 88888
 Account 88888 was started when a phone clerk sold 20
contracts instead of purchasing them. Mr. Leeson was
unable to do anything about it until the next trading
day because the market rose 400 points. That next
trading day, Leeson established account 88888 and
created fictitious transactions to cover up the error.
 Over the next few months Leeson hid some 30 large
errors in account 88888. He relaxed his attitude
towards errors, and when an important customer
brought an error to Leeson's attention, he simply put
the error into account 88888 without any further
investigation.
The Collapse
 As the market moved, errors in account 88888 changed
in value, and a $1 Billion loss was generated by open
positions in account 88888. As the account grew bigger,
margin calls also got bigger. London approved these
large margin calls because of the large profits Leeson
was posting.
 Barings’s problems arose because of serious failure of
controls and management within Barings.
Orange County Bankruptcy
 On December 6, 1994, Orange County in California
became the largest municipality in U.S. history to declare
bankruptcy. The county treasurer had lost $1.7 billion of
taxpayers' money through investments in derivatives.
 The bankruptcy resulted from unsupervised investment
activity of Bob Citron, the County Treasurer, who was
entrusted with a $7.5 billion portfolio belonging to county
schools, cities, special districts and the county itself.
Orange County—History
 In 1994, the Orange County investment pool had about
$7.5 billion in deposits from the county government
and almost 200 local public agencies (cities, school
districts, and special districts). Borrowing $2 for every
$1 on deposit, Citron nearly tripled the size of the
investment pool to $20.6 billion. In essence, as the Wall
Street Journal noted, he was "borrowing short to go
long" and investing the dollars in derivatives—in exotic
securities whose yields were inversely related to interest
rates.
Orange County—Period of Success
 Thus, Citron invested in financial derivatives and leveraged
the portfolio to the hilt, with expectations of decreasing
interest rates. As a result, he was able to increase returns on
the county pool far above those for the State pool.
 Citron was viewed as a wizard who could painlessly deliver
greater returns to investors. The pool was in such demand
due to its track record that Citron had to turn down
investments by agencies outside Orange County.
 Some local school districts and cities even issued short-term
taxable notes to reinvest in the pool (thereby increasing
their leverage even further).
Orange County—the collapse
 The investment strategy worked excellently until 1994,
when the Fed started a series of interest rate hikes that
caused severe losses to the pool. Initially, this was
announced as a “paper” loss.
 Citron kept buying in the hope interest rates would
decline.
 Almost no one was paying attention to what the
treasurer was doing and even fewer understood it—
until the auditors informed the Board of Supervisors,
in November 1994, that he had lost nearly $1.7 billion.
 Shortly thereafter, the county declared bankruptcy and
decided to liquidate the portfolio, thereby realizing the
paper loss.
The Role of the Brokerage
 NY Times, June 3, 1998, Wednesday
 Merrill Lynch to Pay California County $400 Million
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 Merrill Lynch & Co agrees to pay $400 million to settle
claims that it helped push Orange County, Calif, into
1994 bankruptcy with reckless investment advice; 17
other Wall Street securities houses and variety of other
companies that sold risky securities to county-run
investment pool are expected to settle similar suits;
county, which lost over $1.6 billion in high-risk
investments, could end up recovering $800 million to $1
billion; its financial condition has improved sharply;
table on status of some major suits and criminal probe.
The Underlying Causes
 The immediate cause of the bankruptcy was Citron's
mismanagement of the Orange County investment
pool.
 However, he would not have been driven to strive for
such high rates of return on the pool—nor would he
have been able to invest as he did—had it not been for
the fiscal austerity in the state that began with
Proposition 13. That citizen initiative, and several
subsequent initiatives, severely limited the ability of
local governments to raise tax revenue.
 Recognizing the extreme fiscal pressure these initiatives
placed on county governments, the state loosened its
municipal investment rules—allowing treasurers, for
the first time, to use Citron's kind of strategy.
Orange County is not Unique
 Orange County provides dramatic warning of the
dangers of that kind of investment strategy and should
deter others from following the same path.
 But the conditions and resulting imperatives that drove
the county to gamble with public funds remain. The
demand for smaller government, tax limits, and local
autonomy continues, and many municipalities may find
the specter of financial collapse looming—especially
when the economy takes its next downturn.
 These conditions exist, to a greater or lesser degree, in
counties across the state and nation, which makes the
Orange County bankruptcy especially significant.
What needs to be done?
 Local governments need to maintain high standards for
fiscal oversight and accountability. As noted in the state
auditor's report following the bankruptcy, a number of
steps should be taken to ensure that local funds are
kept safe and liquid. These include having the Board of
Supervisors approve the county's investment fund
policies, appointing an independent advisory committee
to oversee investment decisions, requiring more
frequent and detailed investment reports from the
county treasurer, and establishing stricter rules for
selecting brokers and investment advisors. Local
officials should adjust government structures to make
sure they have the proper financial controls in place at
all times.
What needs to be done?
 State government should closely monitor the fiscal
conditions of its local governments, rather than wait for
serious problems to surface. The state controller
collects budget data from county governments and
presents them in an annual report. These data should
be systematically analyzed to determine which counties
show abnormal patterns of revenues or expenditures or
signs of fiscal distress. State leaders should discuss
fiscal problems and solutions with local officials before
the situation reaches crisis stage.
What needs to be done?
 Local officials should be wary about citizens' pressures
to implement fiscal policies that are popular in the
short run but financially disastrous over time.
Distrustful voters believe there is considerable waste in
government bureaucracy and that municipalities
should be able to cut taxes without doing harm to local
services. Local officials need to do a better job of
educating voters about revenues and expenditures.
State government should also note that there are no
checks and balances against citizen initiatives that can
have disastrous effects on county services. Perhaps
legislative review and gubernatorial approval should be
required for voter-approved initiatives on taxes and
spending.
Long Term Capital Management
 Long Term Capital Management (LTCM), run by the
former head bond trader and vice chairman of
Salomon Brothers, a former vice chairman of the
Federal reserve, and two Nobel Prize-winning
economists, leveraged almost $5 billion into a $100
billion portfolio full of derivatives, a 20/1 leverage
ratio.
 The results obviously were spectacular while LTCM’s
strategy worked, and were equally spectacular and
disastrous when it didn’t. Few of LTCM’s investors and
perhaps none of its lenders were aware of the
magnitude of this fund’s gambles.
Long Term Capital Management
 If, as they say in the mutual fund literature, “past
results are not indicative of future performance,” how
should one go about evaluating a hedge fund? As with
any other investment portfolio, the key is to understand
the types of investments it currently owns, the overall
strategy of the manager, and the tactics the manager
intends to use or avoid. Getting answers to these
questions is not only due diligence, but common sense.
 An article in the Financial Economists Roundtable (by
Myron Scholes, one of the winners of the 1997 Nobel
Prize for Economics and a principal in LTCM), alludes
to risks in derivatives markets, but concludes that
"there is no evidence the activities of these (derivatives)
dealers pose a significant systemic risk".
The Near Bankruptcy and Bail-Out
 What happened at Long Term Capital Management?
In 1998 it came close to going bankrupt! Only pressure
from the U.S. federal government saved it.
 In Fall 1998, a bail-out of LTCM was arranged.
Illustrious Wall Street institutions were cajoled into
putting up $3.5billion to avert its bankruptcy.
 Time Magazine has a very rewarding article about the
glaring inconsistency of this policy. eg Asian financial
institutions must pay the penalty for taking too much
risk, but very rich American investors will be bailed
out.
Long Term Capital Management
 The New York Times has some great analysis. Check
out the extraordinary leverage of the fund, and a piece
about John Meriwether, fallen genius of LTCM and ex
Salomon trader. (book: Liars's Poker) This article
contains a naive fallacy from a Salomon Brothers
veteran discussing roulette "because it is a
mathematical certainty that red will come up
eventually". Do these people really believe that? I
would like to bet my entire capital leveraged by 20
times that it isn't a mathematical certainty! Any
takers?
Long Term Capital Management
 9/23/98 Prescient article from CNBC's David Faber
about rumor's of Long Term Capital Management
bailout.
 9/29/98 Banks Near Final Accord on Investment Fund's
Rescue
 10/1/98 In 4 1/2 hours of testimony, Federal Reserve
Chairman Alan Greenspan defended the bail out of
LTCM. LTCM's failure threatened “substantial
damage,” he said.
 10/2/98 Rumors of an emergency Fed Meeting to
discuss liquidity issues related to Long-Term Capital
Management spooked the market. Comment from the
Fed: "As a matter of policy, we don't comment on these
things". Interesting...
Long Term Capital Management
 10/5/98 MSNBC Columnist James O. Goldsborough
has a great article about LTCM, and the high volume,
high risk strategies. It repeats the roulette doubling up
analogy.
 10/8/98 The Secret World of Hedge Funds
 10/10/98 In Archimedes on Wall Street, Forbes
Magazine gives a good overview of what LTCM
attempted to do. Good comparison of John Meriwether
to Archimedes. Financial genius is a short memory in a
rising market
 10/15/98 Alan Greenspan cut interest rates by another
quarter point. A surprise move, as it was outside the
regular FOMC meeting. What does Alan Greenspan
know that we don't?. Could there be more hedge fund
exposure?
Long Term Capital Management
 1bits2atoms.com Recommends
 Hedge Funds : Investment and Portfolio Strategies for
the Institutional Investor (The Irwin Asset Allocation
Series for Institutional Investors)-buy now from
Amazon.comThe story of the 1929 stock market crash.
Back then it was Investment Trusts and highly
margined investors, this time highly leveraged Hedge
Funds...?
Long Term Capital Management
 An interesting place to start researching hedge funds is
the Hedge Fund Association. The Association's aim is to
educate the investing public's and legislators'
misperceptions of hedge fund volatility and risk.
 So why were investors in LTCM bailed out? Could the
absence of the capital injection have resulted in a chain
reaction of failures?
Enron Bankruptcy
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The Start as a Gas Pipeline Company in 1985
Deregulation
Enron Finance in 1990
Enron’s Overseas Energy Projects
Enron Communications and Internet Structure
Enron Online and Internet Brokering
Enron and the Market in Broadband
The Catches—one after another!
The Collapse
Enron and E-Mail's Lasting Trail
The Fallouts
Gas Pipeline Company in 1985
 In 1985, Kenneth Lay, using proceeds from junk bonds,
combined his company, Houston Natural Gas, with
another natural-gas pipeline to form Enron. From that
start, the company then moved beyond selling and
transporting gas to become a big player in the newly
deregulated energy markets by trading in futures
contracts. In the same way that traders buy and sell
soybean and orange juice futures, Enron began to buy
and sell electricity and gas futures.
Deregulation
 In the mid-1980s, oil prices fell precipitously. Buyers of
natural gas switched to newly cheap alternatives such
as fuel oil. Gas producers, led by Enron, lobbied
vigorously for deregulation. Once-stable gas prices
began to fluctuate.
 Then Enron began marketing futures contracts which
guaranteed a price for delivery of gas sometime in the
future.
 The government, again lobbied by Enron and others,
deregulated electricity markets over the next several
years, creating a similar opportunity for Enron to trade
futures in electric power.
Enron Finance in 1990
 In 1990, Lay hired Jeffrey Skilling, a consultant with
McKinsey & Co., to lead a new division—Enron
Finance Corp.
 Skilling was made president and chief operating officer
of Enron in 1997.
 Even as Enron was gaining a reputation as a "neweconomy" trailblazer, it continued—to some degree
apparently against Skilling's wishes—to pursue such
stick-in-the-mud "old-economy" goals as building
power plants around the world.
Enron's Overseas Energy Projects
 Enron’s energy projects sprouted in places no other
firm would go but appear not to have earned it a dime.
With operations in 20 countries, Enron Corp. set out in
the early 1990s to become an international energy
trailblazer.
 Enron launched bold projects in poverty-ravaged
countries such as Nigeria and Nicaragua. It set up huge
barges—with names like Esperanza, Margarita and El
Enron—in ports around the world to generate power
for energy-starved cities.
 Enron's international investment totaled more than $7
billion, including over $3 billion in Latin America,
$1 billion in India and $2.9 billion to develop a British
water-supply and waste-treatment company.
Enron's Support from the U.S.
 The U.S. government has been a major backer of
Enron's overseas expansion. Since 1992, Overseas
Private Investment Corp provided about $1.7billion for
Enron's foreign deals and promised $500million more
for projects that didn't go forward. The Export-Import
Bank put about $700 million into Enron's foreign
ventures. Both agencies provide financing and politicalrisk insurance for foreign projects undertaken by U.S.
companies.
 Enron enlisted U.S. ambassadors and secretaries of
State, Commerce and Energy to buttonhole foreign
officials on Enron’s behalf. It cultivated international
political connections, recruiting former government
officials and relatives of heads of state as investors and
lobbyists.
Enron's Incentives to Risk
 Like other parts of Enron's vast operation, its
international division was fueled by intense internal
competition and huge financial incentives. Executives
pocketed multimillion-dollar bonuses for signing
international deals under a structure that based their
rewards on the long-term estimated value of projects
rather than their actual returns. The system
encouraged executives to gamble without regard to
risk.
Enron's Overseas Boondoggle
 In reports to investors, the company played down or
obscured what analysts and others saw as inevitable
losses. But in an interview with academic researchers in
2001, Jeffrey K. Skilling, who then was chief operating
officer, conceded that Enron "had not earned
compensatory rates of return" on investments in
overseas power plants, waterworks and pipelines.
Skilling said the projects had fueled an "acrimonious
debate" among executives about the wisdom of its
heavy foreign investments.
Enron's Overseas Partnerships
 An internal investigation released this month showed
that two foreign projects, in Brazil and Poland, were
entangled in Enron's off-the-books partnerships,
accounting devices controlled by then-Chief Financial
Officer Andrew S. Fastow that shielded huge debts
from investors. Those arrangements allowed Enron to
present a more optimistic report to investors.
 Other partnerships also were involved: “Whitewing”,
with interests in Turkey, Brazil, Colombia, and Italy;
Ponderosa, with interests in Brazil, Colombia, and
Argentina.
Enron Communications
 January 21, 1999: “Enron Communications, Inc.,
introduced today the Enron Intelligent Network (EIN),
an application delivery platform … that will enhance
the company’s existing … fiber-optic network to create
next generation applications services. The EIN brings
to market a reliable, bandwidth-on-demand platform
for delivering data, applications and streaming rich
media to the desktop.
 “The Enron Intelligent Network architecture is based
on a unique approach to networking through
distributed servers … that supports the development
and maintenance of distributed applications across
network environments.”
Enron Communications
 “In November 1999, Enron Communications (as a
wholly owned subsidiary of Enron) joined with Inktomi
Corporation in a strategic alliance in which the Inktomi
Traffic Server cache platform was to be integrated into
the Enron Intelligent Network. The objective was to
offer high quality network performance and bandwidth
capacity to support broadband content distribution
and e-business services. The integration of Inktomi's
caching software into the Enron Intelligent Network
was to enhance the ability of Enron Communications to
seamlessly and selectively push content to the desktop
while handling massive volumes of high bit rate
network traffic in a scalable manner.”
Enron Communications
 About Inktomi: ”Inktomi develops and markets
scalable software designed for the world's largest
Internet infrastructure and media companies.
Inktomi's two areas of business are portal services,
comprised of the search, directory and shopping
engines; and network products comprised of the Traffic
Server network cache and associated value-added
services. Inktomi works with leading companies
including America Online, British Telecom, CNN,
Excite@Home, GoTo.com, Intel, NBC's Snap!,
RealNetworks, Sun Microsystems, and Yahoo!. The
company has offices in North America, Europe and
Asia.”
EnronOnline
 EnronOnline was launched Nov. 29, 1999.
 “EnronOnline offers customers a free, Internetbased 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
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Real-Time Pricing
Fast, Free, Secure Execution
Price Limit Orders
Option Contracts
Market News and Quotes
Industry Publications
Weather Insights
Complete Customization Capabilities
Brokering (?) over the Internet
 Note that Enron served NOT just as a broker
but as a Principal—an active participant in
transactions.
Enron High-bandwidth Venture
 December 3, 1999: "Cutting the red ribbon for bandwidth
commodity trading, high-bandwidth application service
company Enron Communications Inc. Friday introduced
its new approach to bandwidth."
 "This is 'Day One' of a potentially enormous market,"
said Jeff Skilling, Enron president and chief operating
officer. He compared the present inflexible agreements for
pre-set capacity amounts to pre-reform "oil contracts in
the 1970s, natural gas contracts prior to 1990 and electric
power contracts prior to 1994."
 May 2, 2000: “Enron Corp. announced today the
expansion of EnronOnline to include products for the
purchase and sale of bandwidth capacity.”
Enron Broadband Trading Strategy
 The Purpose: Effect on Enron Stock Prices
 The Technique
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Step 1. Sell to an affiliated partnership
Step 2. Set an internal value on the sale
Step 3. Sell from one partnership to another
Step 4. Act as underwriter for the sale
 The Lack of Substance
 The Beginning of the Collapse
 The Collapse
The Catches—one after another!
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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
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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:
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Paper records at the source
Local computer system records
Internet communication records
Recipient records
Paper records at the destination
End of Enron’s Overseas Energy Program
 In mid-February 2002, Overseas Private Investment
Corp., which backed many of Enron’s overseas energy
projects, moved to stem its $1-billion Enron exposure
by canceling $590 million in loans to the company, once
one of its largest clients. Enron had missed deadlines
for OPIC requirements in financing projects in Brazil,
an OPIC spokesman said. OPIC's decision shifted more
of the burden for the troubled projects from the U.S.
government to Enron's creditors, lenders and partners.
The Fallouts of Enron Collapse
 On the Workers
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Reduction in force by 6,000 workers
Effects on their retirement accounts
 On the Stock Market
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Effects of “sophisticated accounting”
Effects on Internet-related stocks
Effects on Communications-related stocks
 On the Accounting Profession
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Effects of conflicts-of-interests:
Combining Auditing & Consulting
 On the Halls of Government
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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.
revenue
(billions)
PricewaterhouseCoopers
$8.1
Deloitte & Touche
6.1
Ernst & Young
4.5
Andersen
4.3
KPMG
3.2
BDO Seidman .
0.4
Grant Thornton
0.4
McGladney & Pullen
0.2
Source: Public Accounting Report
U.S.
Partners
2,784
2,283
1,934
1,620
1,471
306
272
493
Total
U.S. Staff
43,134
28,992
22.526
27,788
17,577
2,054
2,962
2,530
2001 global
revenue
(billions)
$19.8
12.4
9.9
9.3
11.7
2.2
1.7
1.6
March 15, 2002. The Los Angeles Times, page A1
U.S. Indicts Enron Auditor Over Shredding
Andersen faces an obstruction of justice charge after failing to reach a plea
agreement with prosecutors.
By Edmund Sanders and Jeff Leeds, Los AngelesTimes Staff Writers
WASHINGTON -- Federal prosecutors Thursday hit accounting firm Andersen
with a criminal indictment for allegedly orchestrating the "wholesale destruction"
of tons of Enron Corp. documents, raising new doubts about Andersen's survival.
The one-count indictment is the first of what Justice Department officials hinted
could be a string of criminal charges arising from the collapse of energy giant
Enron, which filed for Chapter 11 bankruptcy protection Dec. 2 amid an accounting
scandal.
Reacting swiftly to the indictment, the government today suspended Enron Corp.
and Andersen from entering into new federal contracts.
March 15, 2002, New York Times
Andersen Charged With Obstruction in Enron Inquiry
By Kurt Eichenwald
WASHINGTON, March 14 — In the first criminal charge ever brought against a
major accounting firm, Arthur Andersen has been indicted on a single count of
obstruction of justice for destroying thousands of documents related to the Enron
investigation, the Justice Department announced today.
The indictment, handed up by a grand jury last week and unsealed today, describes
a concerted effort by Andersen to shred records related to Enron in four of the
firm's offices, in Houston, Chicago, London and Portland, Ore. It was the first
criminal charge stemming from the government's investigation of Enron's collapse
in December.
"Obstruction of justice is a grave matter, and one that this department takes very
seriously," Larry D. Thompson, deputy attorney general, said at the Justice
Department. "Arthur Andersen is charged with a crime that attacks the justice
system itself by impeding investigators and regulators from getting at the truth."
Global Crossing Bankruptcy
 January 29, 2002: “Global Crossing Ltd, which spent
five years and $15 billion to build a worldwide network
of high-speed Internet and telephone lines, files for
bankruptcy after failing to find enough customers to
make network profitable; had attracted many notable
business and political figures, including Democratic
National Committee chairman Terry McAuliffe, former
Pres George Bush, Tisch family and former ARCO
chairman and big Republican fund-raiser Lodwrick
Cook.”
 This is the largest bankruptcy of a telecommunications
company.
The History
 Global Crossing was formed in 1999 from a merger of a
Bermuda-based fiber-optic cable company with a local
U.S. telecom company.
 In the ensuing years, it developed a 100,000-mile global
network of fiber-optic cables—including links that
traverse the Atlantic Ocean—linking more than 200
cities in 27 countries in the Americas, Asia and Europe.
 It was regarded as one of the most promising of the
new generation of telecom companies that sprang up in
the late 1990s, and had secured a stock market value of
$75bn.
The History
 While it incurred more than $12bn debts, its assets are
believed to be worth nearly $24bn, almost twice as
much as its debts.
 About mid-2000, things began to turn sour for the
telecom industry. Optimistic network operators had
completed huge infrastructures just as a nationwide
economic slowdown curtailed corporate spending for
such services. That left not only Global Crossing but
other network companies with insufficient revenue to
pay the massive debt they had accumulated to build
their costly networks.
 In fact, Global Crossing has never reported annual
profit since its creation, and by the first quarter of
2001, cash was running short.
Accounting Practices
 Global Crossing then entered into swaps with other
networks, using indefeasible rights of use, or IRUs.
 Global Crossing would buy an IRU and book the price
as a capital expense, which could be spread over a
number of years. But the income from IRUs was
booked as current revenue.
 Technically, the practice is within the arcane rules that
govern financial derivative accounting methods, but
only if the swap transactions are real and entered into
for a genuine business purpose.
Allegations disputed
 But there was the possibility that these transactions
were not for legitimate business purposes and indeed
were potentially fraudulent.
 Such concerns are a direct result of the revelations
about misleading accounting methods used by the
failed energy trader Enron.
 Global Crossing has said it will launch an independent
probe of its accounts (by a company other than
Anderson). "Recent happenings in the industry have
brought a lot of attention to accounting," a spokesman
said (but without mentioning Enron).
 Global Crossing has said it will look into allegations of
impropriety by a former employee.
The Former Employee
 At the center of the controversy is Joseph Perrone, the
company's former executive vice president of finance
and former outside auditor. For 31 years he had been
an auditor and partner with the Big Five accounting
firm Arthur Andersen & Co.
 By the time he joined Global Crossing in May 2000,
Perrone was intimately familiar its operations, having
directed Andersen's work in connection with Global's
1998 initial public offering, which raised about $400
million.
 Though it is common for outside auditors to jump ship
and go in-house at the companies they audit, Perrone's
move was unusual because he was so highly placed at
Andersen.
The Incentives
 To lure Perrone from Andersen, Global Crossing
offered him a $2.5-million signing bonus on top of a
base salary of $400,000 and a target annual bonus of
$400,000, according to SEC filings. Perrone also
received 500,000 Global Crossing stock options, along
with shares in its sister company, Asia Global Crossing
Ltd., which were to vest over a three-year period.
Perrone also is chief accounting officer at Asia Global
Crossing.
 This all piqued the interest of SEC officials, who
questioned whether Perrone's hiring "impaired"
Andersen's independence. Ultimately, the SEC was
satisfied that Andersen "met the requirements for
independence."
The Incentives
 “Chairman Gary Winnick could lose control if
bankruptcy plan is accepted, but the blow would be
softened by stock deals that reaped him more than $730
million.
 Company shares traded for more than $60 as recently
as March 2000. They have now fallen more than 99
percent, to 13.5 cents, in over-the-counter trading after
being de-listed by the New York Stock Exchange.
THE END