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Enron fallout puts motivation on the books

By Kurt Eichenwald
NY TIMES NEWS SERVICE, NEW YORK
Tuesday, Sep 23, 2003, Page 9

Financial institutions have long been responsible for knowing their customers before doing business with them. But now, in an odd ripple effect from Enron's collapse, a standard is emerging that banks and investment houses need to know their customers' intentions as well -- and could be on the hook for huge sums of money if they don't.

That is the conclusion lawyers, bankers and other industry participants have drawn from last week's unusual settlement between Merrill Lynch & Company and federal prosecutors investigating Enron. The settlement, which allowed Merrill to avoid prosecution in connection with Enron deals that the government said were illegal, requires the firm to avoid certain types of transactions with corporations if it suspects the primary purpose of those deals is to mask the clients' true financial condition.

The Merrill settlement is just the latest step in a line of actions by regulators, prosecutors and the courts that have effectively established a new level of liability for bankers and investment houses involved in a business known as structured finance, which is worth hundreds of billions of dollars. The result, market participants said, has been the creation of a new level of private oversight for a business that had, until Enron collapsed largely from its misuse of structured finance, encouraged an "anything goes" mentality.

"The implications of all this is that lenders have to think about, in ways they haven't before, what ways their funds are being put to use," said David Eisenberg, a partner with Simpson Thacher & Bartlett, who heads its division that deals with the structured finance.

"It is just a heightened level of responsibility, and a new form of lender liability is potentially embedded in this trend," he said.

Structured finance began to emerge in the late 1970s and quickly became one of the largest approaches used by corporations to raise cash. In essence, rather than borrowing simply based on its own credit rating, a corporation could move an individual asset into a separate legal entity and then borrow against that asset's value. Because the separate entity, known as a special purpose vehicle, was legally distinct from the corporation, a lender could seize the asset it held even if the company sought bankruptcy protection. In other words, banks gained extra security for their loans, with the result being that the financing was less expensive.

The problems emerged when companies like Enron realized that those separate legal entities could then be used to buy assets from the company, allowing it to book income.

In essence, an ethereal marketplace had been created, with "sales" done for the benefit of the company often without a real buyer on the other side of the table. Banks and investment houses eagerly lent money into those deals, booking big fees as Enron and other companies used the deals to make their financial performance appear better than it actually was.

Such deals, however, were far more important to the companies than they were to the banks and investment houses that participated in the structured finance business. By most estimates, such deals made up less than 10 percent of the total market for structured finance, which was largely focused on providing financing for entities that held such "plain vanilla" assets as mortgages and car loans.

That is why, even though market participants say there is a new rigor in the structured finance business, the overall volume of business has not been affected much.

For example, according to Moody's Investors Service, the total amount of issuance of what is known as asset-backed securities reached its highest level ever in the first half of the year, at US$205.4 billion.

"All the public talk has been about the 10 percent of the business," said Brian Clarkson, the senior managing director in charge of structured finance at Moody's.

"But at the end of the day, that's the tail wagging the dog," he said.

But in that 10 percent, as the industry watches giants like J.P. Morgan Chase, Citigroup and now Merrill enter into settlements with government regulators, far tighter controls have been put into place. Now, market participants said, bankers spend as much time analyzing the potential effect that a deal could have on their employer's reputation as they do examining the relevant legal and accounting rules.

"You have added a whole layer of reputational risk and therefore people are now stepping back and saying, `Does what we are doing make sense?"' said Jason Kravitt, a senior partner who founded the securitization practice at Mayer Brown Rowe & Maw.

"I don't think anybody objects to that," he said.

The result of that has been much more care in putting deals together.

"We are seeing more scrutiny being conducted, and we are seeing people take their liability much more seriously," Clarkson said. "Now, everybody is dotting their i's and crossing their t's much more than they used to. And I think that is quite positive."

Several institutions, including J.P. Morgan and Citigroup, have established their own voluntary standards for structured deals. Transactions with no economic substance that might be used to make a company's performance look better "come under tremendous scrutiny," said Bill Winters, head of the credit and rates business at J.P. Morgan.

"They don't happen anymore," he said.

The pressure comes not only from the government, but from investors as well. Ultimately, a vast majority of structured finance deals are sold as securities to investors; indeed, many individual investors have indirect interests in them through instruments like money market accounts.

Now, market participants said, sophisticated investors are playing a large role in pushing the market to adopt standards and practices designed to reduce the chance that the market will be harmed by another corporation abusing structured finance.
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