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Financial Engineering

How derivatives debacles and off-balance-sheet shenanigans sank a concept.
David M. Katz, CFO.com | US
December 31, 2002

These days, you're about as likely to hear CFOs speak glowingly of financial engineering as oral surgery.

Indeed, the phrase "financial engineering" is now an investor relations no-no. This is hardly surprising. Given the recent uproar over less-than-forthright corporate accounting, any suggestion that a company's numbers have been tarted up makes for some real bad press.

Ironically, though, financial engineering has actually fallen out of favor at least twice over the last decade.

At the beginning of the 1990s, the term was linked mainly to the use of derivatives, which was then starting to take off. Constructed by Wall Street's quantitative whizzes — the financial engineers — the instruments not only helped companies hedge risks, they held out the promise of huge investment gains. From 1987 through 1996, the average worldwide growth rate in the face value of the interest-rate swaps, interest-rate options, and currency swaps was 40 percent a year, according to a study by the International Swaps and Derivatives Association.

Those big bucks lured fools and scoundrels, however. Experts said a lack of market savvy spawned the whopping derivatives losses absorbed by, among others, Proctor and Gamble ($137 million) and Orange County California ($1.7 billion) in 1994. The next year, a rogue trader named Nick Leeson sent venerable Barings Bank down the tubes with $1.3 billion in options and futures losses on the Singapore monetary exchange.

Those early derivatives disasters gave the image of financial engineering its first real tarnishing. The concept staged a rally during the midst of the economic boom, however. Rather than laying off corporate risk, this sort of financial engineering aimed to sweep liabilities off the balance sheet of corporations, via securitizations and special-purpose entities (SPE's).

The star of that show? Enron, of course.

Not that there was — or is — anything wrong with much of what's being done off parent-company books. Properly handled, off-balance-sheet entities can fund legitimate new ventures without diluting the shares of parent company stockholders. Securitization, for its part, can enable a company to raise money without incurring debt or to shift risk to willing counterparties. All well and good.

The problems crop up when companies use financial engineering to game the system. "While a transaction may be engineered to achieve a valid business purpose, such as reducing the cost of capital or managing risk exposures, it also may be engineered simply to achieve a specific accounting result by arbitraging the accounting standards," Annette Nazareth, the Securities and Exchange Commission's director of market regulation, told a Senate subcommittee in December.

Playing fast and loose with accounting and legal standards was not uncommon in the heady days of the late nineties. Take the case of one big U.S. corporation that was looking to remove some of the costs of a $1 billion construction project from its balance sheet via a securitization. One of the largest investment banks was involved in the arrangement.

A lawyer who represented the construction company says it sought to accommodate its giant client and securitize the payment stream for the half-done, half-paid-for project. The lawyer told the construction firm, however, that the arrangement didn't satisfy the legal criteria for securitization and that the deal shouldn't be done. At that point in the negotiations, the investment bankers stepped in and asked the lawyer, "Everybody's doing it — what is your problem with securitizing this?"

Such widespread abuse, culminating in the Enron fiasco, has spawned a reaction by regulators and standard setters. The SEC, for instance, will soon promulgate its final SPE rules. Further, the Financial Accounting Standards Board is on a fast track to develop a guidance on company consolidation of off-balance-sheet units. The Sarbanes-Oxley Act's requirement that auditors must not consult should also give auditors less reason to look the other way when a client's contemplating an SPE abuse.

Have we seen the last of financial engineering? Despite being given the scarlet-letter treatment, the phrase hangs on in university finance departments and among software makers. Derivatives practitioners still flaunt it. Still, considering the pejorative pounding it's taken in the last decade, expect the quantitative types to come up with a more flattering term sooner rather than later.




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