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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.

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.

But that choice may indicate that Morgan Chase bankers did not believe Enron was a substantial default risk. Observers note that few institutions know how to lay off credit risk better than JP MorganChase. The fact that the bank's management is now slugging it out in court to recoup a billion dollars from surety insurers must surely be seen as an embarrassment for the bank.

Not surprisingly, representatives for Morgan Chase have slammed the issuers of the surety bonds. In court filings, the bank's attorneys have even taken a shot at "the common practice of the insurance industry of accepting premiums and then vigorously litigating with the insured over coverage."

According to JP MorganChase spokesman Adam Castellani, the insurance companies promised the bank the surety bonds would be paid on demand. "Now," says Castellani, "it appears they never intended to pay on demand."

Defenders of the insurance companies, however, note that sureties have already paid out $250 million in paid-forward sale contracts directly related to Enron. They insist, however, that they are not required to pay in cases of fraud.

Willing to Chance It
The argument that insurance companies were tricked into insuring a disguised loan -- and therefore are not on the hook -- is not necessarily supported by court documents.


Memos between reinsurer General Re and Chubb & Son Inc., for instance, suggest that at least some insurers were aware that transactions of the kind underwritten for Enron and Morgan Chase served primarily "to raise low-cost capital that does not show up as a loan on the borrower's balance sheet."

Moreover, an internal memo from Kemper Insurance dated April 26, 2001 (and later obtained by J.P. Morgan Chase) seems to show that Kemper employee James Crinnion considered the outstanding surety bonds to be quite risky.

Farther down in the note, however, Crinnion concedes that Enron's stature makes it a risk worth taking. "From all accounts Enron is a large enough account with a strong balance sheet, cash flow and available credit facilities to warrant Kemper to issue such onerous bonds," Crinnion wrote. "Based on Enron's financial strength I would recommend these long-tail financial guarantees as an acceptable risk on a going forward basis."

But, Crinnion added, "I would not recommend we write these types of obligations in the future."

According to Robert Roach, chief investigator for the Senate subcommittee, Enron received a total of approximately $8 billion in pre-paid financing over six years from J.P. Morgan Chase and Citigroup. "Enron's practice of using prepay transactions to understate debt and overstate cash flow from operations made its financial statement look much stronger," Roach noted in his testimony on Tuesday.

But a Salomon Smith Barney banker who helped set up the structure and issue the bonds which Citigroup used to extend trade-related financing to Enron, says the deals did not seem unusual to her. In testimony on Tuesday, Maureen Hendricks, a senior advisor from Salomon Smith Barney, said she "had absolutely no reason to believe that there was anything wrong with… Enron's accounting treatment [of the transactions]." Although she says she knew that Enron's obligations would not be recorded as debt, and the cash would be treated as coming from operations and not from finanancing, she accepted the fact that "Arthur Andersen had fully vetted the accounting treatment."

Hendricks went on to intimate that Citigroup bankers had been taken in by the accounting at Enron. "It appears that the audited financial statements, upon which we relied, were not accurate and did not fairly present Enron's financial condition," she told lawmakers.

But some observers found that comment puzzling. As Roach noted, in 2000 (the last year Enron submitted a 10-K to the SEC), the Houston-based trading company's numbers would have looked substantially worse -- without help from the transactions set up by Salomon Smith Barney, Citigroup, and JP MorganChase.

"If Enron had properly accounted for these transactions," Roach testified, "its total debt would have increased by about 40 percent to about $14 billion, and its funds flow from operations would have dropped by almost 50 percent, to about $1.7 billion." He added: "These are dramatic changes."

Editor's note: To read more about the role of banks in Enron's prepaid transactions, click here.




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