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A pending face-off between bankers and insurers may put an end to a cheap source of credit enhancement.
Tim Reason, CFO Magazine
September 1, 2002
In a trial guaranteed to embarrass both sides, J.P. Morgan Chase & Co. will square off in court this December against 11 insurance companies to demand payment of almost $1 billion in commercial surety bonds. The insurers have refused to pay, claiming the gas trades they thought they were guaranteeing were actually an elaborate financial sham that allowed J.P. Morgan to provide disguised loans to now-bankrupt Enron Corp.
The case has far-reaching implications, including the peculiar possibility that evidence the bank uses to recoup its losses subsequently may be used against it in a criminal securities case by Manhattan district attorney Robert M. Morgenthau, who is currently investigating the bank's dealings with Enron, or as evidence in the Enron class-action suit, which names J.P. Morgan as a defendant.
Even before the trial begins, however, it is a blow to the already troubled surety bond market. Since the beginning of 2000, insurers have reported almost $1 billion in direct losses from commercial surety bonds alone. Meanwhile, traditional, plain-vanilla types of sureties widely used by U.S. businesses are already more expensive and harder to come by. If insurers lose the case, "I think certain boards of directors at insurance companies would look hard at their involvement in the surety business," predicts Brian Driscoll, president of Boston-based J. Barry Driscoll Insurance Agency. "The financial losses could also chase some reinsurers out of the business, and restrict the flow of capital and support into an already restricted market."
Boom and Bust
The current crisis only adds to commercial sureties' already checkered past.
Traditional surety bonds, called contract sureties, are widely used in the construction industry to guarantee completion of work. If the contractor (the principal that purchases the bond) fails to finish the bonded work, the surety company pays the property owner (the obligee), and then recoups the money by completing the work itself. By contrast, commercial sureties are typically used to guarantee performance that has a financial component. For example, most states require a company that self-insures for workers' compensation to post surety bonds to guarantee coverage if it becomes insolvent.
During economic booms, however, insurance companies have often expanded commercial surety bonds into hybrid products that look more like bank offerings. "The traditional surety concept of third-party guarantee moves from performance of contract to payment of debt," says Mark Reagan, CEO of the construction practice for Willis, a global insurance broker. "That's not suretyship, that's financial guaranty." Lloyd's of London, he says, has banned financial guaranty sureties since the end of the Boer War in 1902, when speculative ventures fueled by military spending and underwritten by the insurance consortium collapsed.
But insurance companies haven't learned from history, he says. In the 1970s, when corporate computer use began to soar, Lloyd's stretched its own rules by writing "insurance" on the residual value of computers after leases expired. "Again, they failed tremendously," declares Reagan.
Surety companies dabbling in mortgage guarantee bonds in the 1970s also suffered disastrous consequences. And a similar fate befell companies that wrote surety bonds in the 1980s to guarantee the activities of partners involved in real-estate investment trusts. When the real-estate market imploded in the early 1990s, "surety companies took it right on the chin," recalls Driscoll, who is also president of the National Association of Surety Bond Producers (NASBP).
Both Driscoll and Reagan say history is repeating itself today. "Every time the insurance world gets near these financial guaranties--where it's a credit underwrite instead of a performance underwrite--they get creamed," says Reagan.
What Lies Beneath
That age-old pitfall is the crux of the pending case: Did the insurers provide a performance "guarantee" or a financial "guaranty"?
J.P. Morgan initiated the suit after the 11 insurance companies refused to pay out on $956 million in six surety bonds. The bonds were written against paid-forward gas trades between Enron and a special-purpose entity erected by J.P. Morgan named Mahonia.
The insurers claim they were tricked into backing disguised, off-balance-sheet loans to Enron, not actual gas trades. They allege that J.P. Morgan, through Mahonia, paid Enron up front for gas and oil that Enron would deliver a year later. At the same time, they say, Enron secretly contracted to buy the gas back from Mahonia at a higher price--the difference in price representing interest on the loan. They also claim Mahonia--based in Jersey in the Channel Islands--never had the ability or intent to use the gas.
In March, the judge in the case ruled that the transactions were suspicious enough to deny J.P. Morgan's request for summary judgment. "These arrangements now appear to be nothing but a disguised loan--or at least have sufficient indicia thereof that the court could not possibly grant judgment to [J.P. Morgan]," wrote Judge Jed S. Rakoff.
Although initially insistent that the trades were real, J.P. Morgan's lawyers have since shifted their argument to claim that the insurance companies understood what they were getting into. "Nothing about the transactions was disguised," says an amended complaint filed on June 28. "Long before Enron failed, and indeed before one or more of the surety bonds at issue were written, the [insurers] knew that the deals were part of a structured financing transaction for Enron's general corporate benefit."
"The insurance companies' allegations have no merit and are simply an attempt to get out of paying a straightforward claim," declares J.P. Morgan spokesman Adam Castellani. The bank argues that the language in the surety bonds was ironclad, and has submitted marketing materials from the Surety Association of America (SAA) as evidence that the surety bonds were trumpeted as alternatives to letters of credit--which generally must be paid on demand regardless of circumstances.
"Surety bonds are marketed as alternatives to letters of credit," confirms SAA president Lynn M. Schubert. But defenders of the products say all types of guarantees are void in cases of fraud, pointing out that J.P. Morgan has also been forced to sue for payment of a $165 million letter of credit related to Enron, which Westdeutsche Landesbank Girozentrale has refused to pay for much the same reason. And, says Schubert, surety companies already have paid out more than $250 million for Enron-related forward sale contracts they considered to be legitimate. "The point of these disputes is not whether letters of credit or surety bonds are better security," she says, "it's whether the underlying transaction was misrepresented."
Naive vs. Greedy
That does seem to be the question, although the answer--whatever it turns out to be--won't reflect particularly well on either side. As evidence that they did not intend to provide a financial guaranty, the insurers cite the fact that under New York State's "Appleton" law, such guaranties must be issued through monoline carriers--which they did not do. But internal insurance-company memos obtained by J.P. Morgan show that as early as 1998, "possible Appleton law violations" were raised as concerns in the Mahonia transactions. "Insurance companies tread around the Appleton law very softly," comments the NASBP's Driscoll, "and quite closely, and certainly over it."
J.P. Morgan also obtained a November 2000 letter from General Reinsurance Corp. to Chubb, which suggests the nature of the transactions was clear to at least some insurers. In the letter, the reinsurer refuses to back Chubb for bonds of the type written for Mahonia. "It seems the predominant purpose for future flow transactions is to raise low-cost capital that does not show up as a loan on the borrower's balance sheet," wrote General Re vice president James D. McMahon. "We conclude that the surety is taking on risk at well below market price and has substantial additional exposure when compared to financial guarantee insurers, a combination that we feel will eventually cause severe loss."
That low price is likely to have sold J.P. Morgan on the bonds. But the bank's own expertise in credit risk, say observers, raises questions about whether its choice of such underpriced instruments was appropriate for a structured financing arrangement.
The insurers, in fact, have cited those low prices as further proof that they didn't understand the nature of the transaction, says Mark Puccia, managing director of Standard & Poor's Financial Services Rating Service. But that's no excuse, he says. "Either they were naive about what they were accepting, or they were grossly underpricing the business and certainly weren't putting up the amount of capital they should have for this kind of risk." Either way, he says, "the insurers were playing in a ballgame they never should have been playing in."
"Stupid's a hell of a defense," agrees Willis's Reagan. "And, at best, Morgan was extremely aggressive in its lending to Enron. The killer revelations will come out in court. The surety underwriters will look like clowns and the Morgan guys will look like the overreaching, greedy bastards they were."
Evaporating, or Just Sweating?
Not surprisingly, the J.P. Morgan case has made surety providers increasingly cautious. Last December, Chubb demanded collateral on a number of energy-related surety bonds, including $570 million in outstanding bonds used by energy company Aquila (formerly UtiliCorp) to secure long-term gas-supply contracts. "We have no reason to doubt [Aquila's] continued ability to perform," admitted Chubb CFO Weston M. Hicks in an official announcement. "Our request for collateral was a prudent action for us to take in the wake of losses and potential losses from Enron surety bonds."
Aquila, however, is crying foul in court, saying the insurer initially tried to pull out of the bonds altogether, and arguing that Chubb has no right to demand collateral unless Aquila is likely to default. In Securities and Exchange Commission filings, Aquila reports that "[i]f the insurance company were to prevail, this would have a material adverse impact on our liquidity and financial position."
Companies outside the energy sector are also feeling the backlash. At Kmart, for example, "the surety companies required cash collateral in the wake of the Enron filing, which turned out to be a huge drain on Kmart's cash flow," says company spokesman Jack Ferry. In fact, Kmart, which used surety bonds to underwrite workers' compensation and liabilities relating to the sale of guns and alcohol, described "the evaporation of the surety market" as one of the main reasons for its January 22 bankruptcy filing.
"The surety market evaporated for Kmart," retorts SAA's Schubert, noting that surety companies backed away from the retailer's business after performing the same type of risk analyses done by Kmart's suppliers and banks. Nonetheless, notes S&P's Puccia, "surety writers are going to look long and hard at backing self-funded workers' comp programs."
Companies that do buy workers' compensation insurance--which requires collateral--also face a problem because insurers won't accept surety bonds as collateral, says Driscoll. "Insurers are requiring letters of credit because they say sureties are too hard to collect. Isn't that ironic?"
Meanwhile, the fallout from commercial surety is also being felt in the mainstay of the surety business--the construction contract surety. "Limits are getting harder and premiums have definitely gone up," says John Pourbaix, executive director of Construction Industries of Massachusetts, a trade association. "If you can't get a surety bond, you can't bid on public work."
"There is no question that the surety providers' troubles ripple down through all aspects of the market," says Thomas Stone, CFO of Cianbro Corp., which lost one of its three co-surety companies this year. So far, obtaining surety credit has not been a significant issue for Cianbro, but Stone attributes that in part to the amount of time he and other senior managers spend maintaining the company's relationships with the remaining providers.
Indeed, says Reagan, workers' comp and other standard types of commercial surety bonds are still available--albeit at a higher price and with much stricter underwriting. "For healthy companies with clear, concise, understandable financials, there are facilities available," he says.
Ultimately, then, the impact of Enron's depredations in the surety market is much the same as it has been throughout the financial markets. "The irritation for good companies will come from having to explain that they are good companies," says Reagan. "The real expense is having to have a cleaner, healthier, stronger balance sheet."
Tim Reason is a staff writer at CFO. Intern Kelly Morgan contributed additional research to this story.
Who's who in the billion-dollar surety- bond squabble.
In December, J.P. Morgan Chase will have its day in court against these 11 insurance companies (and their better-known parent companies), which are countersuing. Both sides allege fraud.
Source: U.S. Southern District Court of New York
No Sure Thing
Commercial surety losses have mounted dramatically.
Direct Premiums Earned
Direct Losses Incurred
Direct Loss Ratio
*Results for 2001 are projected and include some reserves posted in the J.P. Morgan case.
S ource: Surety Association of America
Enron and on and on...
In the ultimate in creative financing, it is now alleged that Enron turned debt into revenue--with a little help from J.P. Morgan Chase & Co. The bank and its rival Citigroup are now the subject of congressional, federal, and Manhattan district attorney investigations on charges they extended more than $8 billion in disguised loans to Enron through round-trip gas trades--which the energy company could book as trading revenue.
"We have never understood and do not believe that these transactions served in any way to improperly alter or impact Enron's corporate earnings," says J.P. Morgan spokesman Adam Castellani.
But Enron's main problem wasn't earnings, it was debt. The structured financing deals with Citigroup and J.P. Morgan not only concealed debt and appeared to improve Enron's cash flow, they also appeared to almost double the energy company's coverage of interest on existing long-term debt.
In explaining the paid-forward transactions with Enron in his July testimony before the Senate, J.P. Morgan managing director Jeffrey Dellapina testified that "Enron also advised [J.P. Morgan] that the rating agencies wished to see more cash generated from its growing trading activities." Of course, the rating agencies' interest in cash stemmed from concerns about Enron's debt coverage--it was ultimately their downgrade of Enron's credit rating that sent the company into its death spiral.
That, in turn, left hundreds of creditors lined up in bankruptcy court--including, of course, J.P. Morgan, which is a lead creditor. "We have been one of the parties substantially harmed by [Enron's] failure, incurring hundreds of millions of dollars in losses," Dellapina told Congress. Now investigators would like to know if the bank was also one of the parties that contributed to that failure. --T.R.