Finance

The Surety Thing

Bankers, insurers square off over Enron's pre-paid transactions. At stake: who's on the hook for $1 billion?

Tim Reason
CFO Magazine

July 25, 2002

On Tuesday, bankers from both Citigroup and J.P. Morgan Chase appeared before the Senate Permanent Subcommittee on Investigations. Members of that subcommittee, chaired by Senator Carl Levin (D-Mich.), are looking into the role that banks played in the apparent financial subterfuge -- and eventual implosion -- at Enron Corp.

But unlike so many witnesses who have appeared before Congressional panels of late, executives from the two banks did not did not take the Fifth. Nor did they go on the defensive.

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Instead, the bankers used the committee appearance as a forum to defend the legitimacy of structured finance. In often heated testimony, representatives from the two financial giants argued that they did not help Enron disguise loans as revenues by crafting "prepaid deals" for the Houston-based energy company (in prepaid deals, energy traders get their money up front by agreeing to deliver commodities at a later date).

In fact, the witnesses argued that the prepaid transactions (which covered natural gas trades between Enron and two special purpose entities, or SPEs, apparently set up by the banks) were merely types of structured finance -- and that such deals are common in corporate fundings. In fact, they claimed that Enron's auditor, Arthur Andersen, blessed the energy company's financial treatment of the now-controversial deals.

Yet, the financial firestorm touched off by the prepaid transactions suggests that the structured instruments, if not unusual, were certainly risky. Indeed, it appears that both J.P. Morgan Chase and Citigroup, as well as J.P. Morgan Chase's insurance counterparties and Salomon Smith Barney (Citigroup's investment bank), banked heavily on Enron's sterling reputation in the market -- even as they artificially bolstered that reputation through the questionable financing arrangements.

It also appears that, in their eagerness to pursue deals with an industry high-flyer, both the banks and the counterparties ignored the cumulative impact of the loans on Enron's creditworthiness.

Who's Stuck?
The impact seems pretty clear now. But in testimony on Tuesday, representatives from both banks denied any wrong-doing, noting that a prepaid deal is a common structured finance technique.

Maybe so. But both institutions have taken a PR and financial hammering from the deals.

A court case scheduled to begin in December will determine whether Morgan Chase will suffer an additional $1 billion blow from Enron meltdown. The bank has sued 11 insurance companies for refusing to pay off on $956 million in surety bonds -- bonds that Morgan Chase took out as protection in case the gas trades with Enron went south.

But attorneys for the defendants claim the insurers don't have to pay off because Morgan Chase and Enron misrepresented the gas deals as real commodities trades, and not as financial transactions.

One industry-watcher believes J.P. Morgan Chase probably took out surety bonds for the transactions because they are generally cheaper than traditional forms of credit enhancement like letters of credit.

"If you risk-adjusted the exposure," says one credit analyst, "the pricing wasn't anywhere close to the risk [the insurers] were taking on."

Indeed, some bankers at Morgan Chase apparently had sizeable doubts about the reliability of the surety bonds. In court filings, attorneys for Morgan Chase claim that the bank actually required letters from each insurer's attorney, guaranteeing that the surety bonds would act as demand instruments. Similar to letters of credit, those instruments would have to be paid on demand -- regardless of circumstances.

Demand, But No Payment
To some seasoned finance-watchers, it's surprising that bankers at J.P. Morgan Chase would turn to a cheap and relatively novel type of credit-risk insurance to cover their substantial exposure on the Enron gas deals--no matter how many attorneys' letters they had.

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