That’s because credit-default swaps create a potential moral hazard. Investors that purchase protection against a company’s default, observes Merritt, “might not have the same incentive to pursue a successful workout that a traditional bank lender would.” This, too, was acknowledged by CFO survey respondents, 27 percent of whom said that in general, derivatives and other financial innovations make restructuring more difficult.
Credit derivatives, of course, are not the only financial innovation that exposes corporations to banks’ penchant for risk transfer. Indeed, healthy companies are more likely to experience that when taking part in a structured financing, particularly securitization. Instead of lending a company its own money, the bank acts as a middleman, raising money for the company by selling bonds backed by company assets that represent future cash flow (such as receivables). For companies, securitization has the added benefit of being off balance sheet for accounting purposes (despite a slew of new disclosure rules).
In and of itself, securitization is a widely accepted practice. Securitization of trade receivables alone has grown from $2.4 billion in 1985 to $305 billion in 2004, and securitization overall is a $1.8 trillion market. But it and other forms of structured finance rely on techniques that were badly abused by Enron. “Transparency and the degree to which accounting and disclosure standards achieve their goals can be greatly diminished by the use of structuring, even when that structuring appears to comply with the standards,” wrote the SEC in a June study of off-balance-sheet liabilities required by Sarbanes-Oxley. That comment concerned lease accounting, but the SEC staff warned that it saw similar corruption of accounting standards for securitization and derivatives. “Interpretation No. 46(R), which addresses the consolidation of variable interest entities (including SPEs), could well suffer a similar fate. In some cases, securitizations and derivatives have been used in accounting-motivated transactions.”
Banks, of course, are painfully aware of this: many paid billions in fines and settlements over transactions they helped structure for Enron. “Recent events demonstrated that structured-finance transactions, in part because of their complexity, were subject to abuse,” notes M. David Krohn, a partner at law firm Alston & Bird LLP. (Krohn served as the lead structured-finance lawyer for Enron’s bankruptcy examiner, although a court-imposed gag order prevents him from commenting on the case.)
And where there’s structured financing, says Krohn, there are banks. “They market it, they structure it, they serve as counterparties for related derivatives contracts,” he says. This, in turn, creates another type of risk: reputational and legal risk, which has recently become a hot potato between banks and their clients.
In May 2004, banking regulators and the SEC issued proposed guidelines intended to help banks avoid reputational and legal risk stemming from “a wide array of structured-finance products, including financial derivatives for market and credit risk, asset-backed securities with customized cash-flow features, and specialized financial conduits that manage pools of purchased assets.”
While the responses from individual banks, particularly those involved with Enron, were understandably muted, their industry groups objected strenuously that far from reducing banks’ reputational and legal risk, the guidelines actually shifted more risk to banks by requiring that they police their corporate customers.