Some interesting info on the Refco implosion

[ftr23532]

Here’s an egregiously long post about the http://www.msnbc.msn.com/id/9753706/site/newsweek/">Refco implosion of last year and some related topics. This was originally going to be an additional post http://www.democraticunderground.com/discuss/duboard.php?az=view_all&address=125x125543">this thread involving the two topics of Blackstone and the buyout of Clear Channel by the Mitt Romney-founded Bain Capital and Thomas H. Lee Partners, but the post has sort of blown up in length into something that maybe warrants its own thread. There isn't anything that directly relates to 9/11 here, other than giving another example of the deep corruption taking place within many significant sectors of the world's financial systems and the important role that the futures market, and derivatives in general, have played in shaping the economy and modern financial fraud.

Refco was the leading US commodities futures trader when it imploded last year. The futures market has exploded in size in the last couple of decades and is a major force in the global economy. It is also a largely unregulated market and appears to be a tool of choice for financial shenanigans.

First off, let's take a look at the role commodities futures played in BCCI's http://fortherecordessays.blogspot.com/2006/11/part-10-look-at-world-of-money_11.html">money-laundering, via Capcom, with an excerpt from http://www.fas.org/irp/congress/1992_rpt/bcci/21capcom.htm">John Kerry's BCCI report:

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Capcom Operations

Capcom operated as a broker in the London and Chicago commodities markets. Commodities markets should be distinguished from the stock markets, which are more or less "cash markets" designed for "direct investment." As author Martin Mayer has explained, "you own what you buy and your success is a function of the success of the company in which you have purchased shares."(12) According to Mayer, futures markets, in contrast to cash markets, do not offer the investor the "commodity that underlies the activity." Mayer has written that futures investors:

"trade contracts to purchase or sell that commodity on a future date. The contract is inescapable. Those who purchase must stand ready to receive the commodity at a specified delivery point at this price on a specified date (or to buy an offsetting obligation from someone who has a contract to deliver to that point on that date, thus permitting the "clearing corporation" that serves the exchange to extinguish both contracts.) Those who sell futures contracts must stand ready to deliver the commodity to the delivery point for this price on the specified date (or buy in someone else's contract to accept delivery.) As a result future's markets are not situations where everyone can win.(13)

The commodities markets in the U.K. and the U.S. are not restricted, regulated or supervised as stringently as the banking industry or the securities markets.(14)

Moreover, the commodities markets can sustain almost limitless volume, a necessary prerequisite for crime on the scale of that contemplated by BCCI since fraudulent transactions may be hidden in a multitude of legitimate ones. In a letter to the directors, the Chairman of Capcom, Larry Romrell, reported that 165 million in trading during the first four months of operation, and profits of 883,393. That trend continued until 1988 leading Akbar to boast to agent Mazur: "We have contracted 165,000 contracts totalling $53 billion with Drexel Burnham," and later, "we have done over $90 billion total in 1988."(15)

While the number of contracts and dollar volume seems unbelievable, a commodities company can artificially create massive volume by many small or no-risk trading methods. Indeed, the volume generated by Capcom helped it to generate respectability and acceptance with reputable banks and brokers.(16) For example, listed under "Auditors and Advisers" in Capcom's 1987 Annual Report were the following major international banks: Manufacturers Hanover Trust Company, London, National Westminster Bank Plc, Manufacturers Hanover Trust Company, New York, Deutsche Westminster Bank, A.G., and National Westminster Bank, plc. Elsewhere, Capcom noted its ties to Dean Witter Reynolds, American Express Bank, Refco, Prudential Bache Trading Corp., and Sumitomo Trust and Banking, Ltd.(17) Like BCCI, Capcom attempted to buy legitimacy to assist its rapid expansion.

It’s not all that surprising for a number of reasons, including the fact that Refco was a major player in this market in the late 80’s. It’s also worth noting that the http://www.nytimes.com/2006/10/25/business/worldbusiness/25refco.html?ex=1319428800&en=24334a729aa7065b&ei=5088&partner=rssnyt&emc=rss&pagewanted=print">charges against Refco’s management following in 2005 don’t necessarily appear to a involve Capcom/http://www.chron.com/disp/story.mpl/special/enron/1506136.html">Enron-style of fraud with criminal transactions being hidden as a needles in a haystack of the high-volume and complicated financial instruments (although, that could have easily taken place too given the nature of this industry). Instead, it appears to involve the more mundane hiding of massive debts via a series of offshore and complicit companies and faulty accounting, which can BCCI and Enron both had their fair share of too.

Now let's take a look at Thomas H. Lee Partners, http://news.bbc.co.uk/2/hi/business/6155284.stm">the new co-owner of Clear Channel, http://www.washingtonpost.com/wp-dyn/content/article/2005/10/14/AR2005101402043.html">and its involvement in the Refco debacle:

Crisis at Refco Raises Questions About Accounting

By Ben White and Terence O'Hara
Washington Post Staff Writers
Saturday, October 15, 2005; Page D01

NEW YORK, Oct. 14 -- Futures-trading firm Refco Inc. teetered on the edge of insolvency Friday, as scandal threatened to take down another major U.S. company, four years after the collapse of Enron Corp.

The rapid fall of Refco, which on Friday began shutting down one of its largest operating units, raised questions that many investors hoped were answered after accounting scandals at Enron, WorldCom Inc. and other big companies.

Among those questions was how such a long list of brand-name advisory firms could scrutinize Refco's books and not find the alleged fraud, which prosecutors have described as a scheme by former chief executive Phillip R. Bennett to keep as much as $545 million in bad debts off of the company's books, inflating earnings and bolstering Refco's stock price.

Bennett was arrested on Tuesday and on Wednesday was charged with stock fraud for allegedly misleading investors who bought shares in Refco's initial public offering in August. The company said Friday that it was beginning to shut down one of its main operating units, Refco Securities LLC. Refco's stock price has plunged because of the scandal, wiping out more than $1 billion in shareholder value. The company's bonds also have plummeted.

The rapid descent into scandal has embarrassed firms that advised Refco and signed off on its books, a group that includes public accounting firm Grant Thornton LLP, private equity firm Thomas H. Lee Partners and Wall Street investment banks Goldman Sachs, Credit Suisse First Boston and Banc of America Securities LLC.

A spokesman for Thomas H. Lee, the Boston-based private equity firm that helped bring Refco public and remains one of its largest shareholders, declined to comment on Friday, citing ongoing criminal and regulatory investigations and the possibility of shareholder lawsuits against Refco. Media representatives for Goldman, Credit Suisse and Banc of America also declined to comment.

But executives at several of those firms privately echoed the Grant Thornton statement, saying the alleged fraud was perpetrated at the highest level and was so well concealed that even diligent investigation could not have detected it.

Accounting and corporate-governance experts on Friday questioned that assessment. They said the alleged fraud appears to have been fairly straightforward.
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The Refco http://www.slate.com/id/2128196/">implosion was also a pretty scary event http://www.guardian.co.uk/frontpage/story/0,16518,1592055,00.html">at the time (like a mini-Enron) and it also sounds like there was more than just the hiding of debt http://today.reuters.com/news/articleinvesting.aspx?type=bondsNews&storyID=2006-10-24T223448Z_01_N24225928_RTRIDST_0_CRIME-REFCO-UPDATE-3.XML">taking place:

UPDATE 3-Former Refco CFO indicted on fraud charges
Tue Oct 24, 2006 5:34 PM ET

(Adds comment from Bennett's lawyer)

By Anna Driver

NEW YORK, Oct 24 (Reuters) - The former chief financial officer at bankrupt brokerage Refco Inc. <RFXCQ.PK> was indicted on Tuesday for allegedly participating in a scheme to defraud the company's investors, resulting in losses of more than $1 billion, prosecutors said.

Former CFO Robert Trosten is accused of helping Phillip Bennett, who was the company's chief executive officer, to hide from investors and auditors hundreds of millions of dollars in debt owed to Refco by a company controlled by Bennett, the U.S. Attorney's Office in Manhattan said.

He and Bennett are also accused of defrauding purchasers of $600 million in notes sold by Refco in 2004. That note sale was made in connection with Thomas H Lee Partners L.P. purchase of a majority interest in Refco.

Prosecutors also added new fraud charges against Bennett, who already faces accusations he hid $430 million of bad customer debt by shifting it to off-balance sheet entities each year from 1999 to 2005.

The revised indictment filed on Tuesday also charges Bennett with defrauding the purchasers of $583 million of Refco's common stock in its initial public offering in August 2005, prosecutors said.

The government said in court papers filed in April they had planned to expand their case against Bennett.

The Manhattan-based futures brokerage went into bankruptcy on Oct. 17, just a few months after its IPO and a week after it was disclosed it was owed the $430 million by Refco Group Holding, the entity controlled by Bennett.
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Thomas H Lee Partners http://www.boston.com/business/articles/2005/10/18/lee_could_face_suits_over_role_in_scandal_plagued_refcos_ipo/">potential legal troubles over http://www.post-gazette.com/pg/05297/594194.stm">its role http://www.boston.com/business/globe/articles/2005/08/12/buyout_firm_triples_money_in_refco_ipo/">in Refco's IPO even popped up in June 2005 regarding its http://www.marketwire.com/mw/release_html_b1?release_id=90732">lack of disclosure to the SEC and potential investors about a $1 billion lawsuit filed against Refco in France.

In the end, though, it looks like Thomas H. Lee Partners, along with Refco's creditors, http://biz.yahoo.com/ap/060908/refco_senior_lenders.html?.v=1">will be paid back quite a bit:

AP
Refco Seeks Court OK of Settlement
Friday September 8, 11:30 am ET
Refco Seeks Court OK of $642M Settlement With Senior Lenders

WASHINGTON (AP) -- Refco Inc. has agreed to pay its senior lenders more than $642 million under a settlement the collapsed brokerage hopes will speed the conclusion of its bankruptcy case.

Refco said in papers filed Thursday in bankruptcy court that the deal with its lenders, led by Bank of America Corp., will help ensure there is enough money to pay its other creditors by cutting off interest on its bank debt, which has been accumulating at a rate of $6 million a month.

Judge Robert Drain of the U.S. Bankruptcy Court in Manhattan scheduled a hearing on the settlement for Sept. 27.

The proposed deal calls for Refco to pay its senior lenders $642 million, the amount the brokerage owed at the time of its Chapter 11 filing last October. Refco also has agreed to pay interest on the loan that accrued both before and after its bankruptcy filing, plus up to $13.5 million in lenders' fees.

In return, Bank of America will drop its claims based on allegations that Refco engaged in fraud when it provided the lenders with misleading financial information related to the loans.

In August 2004, Bank of America N.A., Credit Suisse Group and Deutsche Bank AG arranged $875 million in loans and a $600 million debt offering for Refco as part of a large investment made by Thomas H. Lee Partners LP, the Boston-based private-equity firm that helped take Refco public a year later.
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Don't forget, these are the same financial giants that baffled observers with their inability to see this financial fraud in the first place. http://fortherecordessays.blogspot.com/2006/11/part-10-look-at-world-of-money_11.html">It sure pays to be diligently unaware!

Under the settlement, Refco has also agreed to turn over the cash it receives from Austrian bank Bawag P.S.K.

Bawag has agreed to pay $675 million for its role in Refco's collapse.

The proposed deal between Refco and its senior lenders is separate from the oft-delayed settlement involving Refco's cash-rich offshore unit, Refco Capital Markets Ltd.

Court approval of that settlement has been held up by squabbling among Refco's creditors over the ownership of the assets in RCM's possession. Marc Kirschner, the court-appointed trustee of RCM asked Judge Drain on Thursday to rule that about $2.4 billion held by the unit is exclusively the property of RCM.

Refco was once the largest independent commodity broker in the United States. It filed for Chapter 11 bankruptcy protection last October after a scandal over allegations that former Chief Executive Phillip Bennett had hidden hundreds of millions in bad debt.

Since then, the company has sold its flagship business to Man Group PLC's brokerage unit, Man Financial, and is in the process of winding down its remaining operations.

BAWAG
So what's the deal with this BAWAG bank? It was merely at the heart of a major scandal http://www.brusselsjournal.com/node/955">that rocked Austrian politics this year:

Austrian Bank Scandal: When Socialists Play With Money
From the desk of Chris Gillibrand on Tue, 2006-04-04 22:53

A major banking scandal is rocking the Austrian political elites – left and right. A bank owned by the Socialist trade union (which is close to the Socialist Party SPÖ, currently in opposition) loses billions in shady hedge deals while the union strike fund evaporates in the Caribbean and the bank gets implicated in a corruption case in Israel. Meanwhile the bank is financed by the European Investment Bank (EIB), and an Austrian Finance Ministry official (married to the Socialist ex-chief of the bank) ignores a crucial report and is appointed to the Executive Board of the European Central Bank (ECB). The Conservative Finance Minister claims to know nothing – after just having sold the Government-owned Post Office Savings Bank (PSK) to the socialist bank. Welcome to Austria, presently presiding the European Union council of ministers.

Let me introduce!

The Bank für Arbeit und Wirtschaft AG, BAWAG or in English, ‘Bank for Employment and Commerce’ was founded in 1922 by the Socialist Chancellor Karl Renner. Up until now the majority stakeholder in the Bank has been the Austrian Trades Union Federation, the ÖGB. With the repurchase of the shares of the Bayerische Landesbank in 2004, it is now wholly-owned by the ÖGB. The bank’s original intent, from which it has strayed far, was to extend cheap credits to the needy.
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Looting a bank intended for the needy...yeah, that sounds like an apt example of the prevailing morality of our elites.

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Almost all of the members of the BAWAG Supervisory Board are fully paid up socialists and trade unionists. The two exceptions are Albert Hochleitner, the ex-CEO of Siemens Austria, and Leo Wallner, the chairman of the state-owned monopoly, Casinos Austria. Günter Weninger, chairman of the Supervisory Board, who has now been forced to resign, also has a day job as the Finance Chief of the ÖGB. He started professional life as an electrician which has given rise to suggestions in the Austrian press that he might have to return to his original trade. The Managing Board has eight members, four of whom have now resigned. The CEO, Johann Zwettler had already resigned in October 2005. He and his predecessor, Helmut Elsner, are now under police investigation.

BAWAG opened up operations in the Caribbean in 1995 under the direction of Wolfgang Flöttl, the son of the then CEO, Walter Flöttl. The idea was that these investments should hedge risk. When it was made public that the son received $2 billion from BAWAG without the father seeking the formal approval of the Supervisory Board, the Caribbean business got closed after a year. The extent of Supervisory Board knowledge is still questioned.

After the departure of Flöttl Senior, the business was then reopened by Flöttl’s successor, Helmut Elsner, with Supervisory Board approval after only one year. Elsner was already known as Flöttl’s “man for big business.” Living well, he enjoyed a service penthouse provided on the top of the BAWAG offices in Vienna as had his predecessor, Flöttl. Also provided with a penthouse was the head of the socialist trade union ÖGB, Fritz Verzetnitsch.

This time around, Flöttl Junior invested in high-risk funds and the business clocked up a massive loss of almost €1 billion which threatened the solvency of BAWAG in 2000. The Bank was only saved by a guarantee from the ÖGB (trade union dues amount to 1% of members salaries, so they have accumulated quite a lot of money to play with). The losses themselves were systematically covered up in offshore accounts in the Caribbean and accounts at a US futures broker called REFCO. The union strike fund went walkabouts as collateral in the Caribbean and disappeared.

On 1 December 2000, the Finance Minister (then and now) Karl-Heinz Grasser (from the ÖVP, the conservative Austrian People’s Party) commissioned the National Bank of Austria to do an audit of BAWAG. It was highlighted in the report that the banking system and national banking laws had been violated. There was neither mention of the losses in the Caribbean nor of the ÖGB guarantee. BAWAG received a copy together with the banking oversight authorities in the Finance Ministry. Grasser claims never to have seen a copy of this report.

Why were the Finance Ministry reluctant to expose themselves on this issue highlighted in this report? This could be explained by the fact that BAWAG were finally given clearance by the European Commission to acquire the Austrian Post Office Savings Bank (PSK) from the Austrian Government in November 2000. Not only did this acquisition give BAWAG a new client base (previously many of its banking products had been sold through the network of trade union branches and membership has been declining) but it gave BAWAG a needed liquidity at that time. The Austrian Government (consisting of the People’s Party ÖVP and Jörg Haider’s party) pocketed the money from the privatisation and all were happy behind the scenes. A total merger was finally achieved in 2004.

And the Austrian far-Right gets to play along too. Great.

However, the ignorance and inaction of the Finance Ministry is astounding given that there are two State Commissioners nominated to oversee the affairs of the BAWAG Group; for BAWAG, none other than the Chef de Cabinet of the Finance Ministry and for PSK, the Head of Directorate General III in the Federal Chancery.

No more audits were performed on BAWAG in the following years. Neither the Governor of the National Bank of Austria, Klaus Liebscher who is near to the Austrian People’s Party nor his Deputy, Gertrude Tumpel-Gugerell, who was responsible for financial market oversight thought them necessary. A separate Financial Market Oversight Authority (FMA) was set up in 2002. Finance Ministry staff were transferred to the FMA but not the incriminating report.

Gertrude Tumpel-Gugerell is herself “near” to the Socialist Party; so near in fact that her husband is Herbert Tumpel, President of the Chamber of Workers. Herr Tumpel has a past-life as Chairman of the Supervisory Board of BAWAG when the Flöttls were undertaking transactions under the codeword “Special Business.”

Frau Tumpel was Executive Director responsible for financial markets in the National Bank of Austria from 1997 to 2003 and was appointed Deputy-Governor in 1998. In 2002, she became a member of the Supervisory Board of the FMA on its establishment and Chair of the Banking Advisory Committee of the European Union. Already, a Member of the Banking Supervision Committee of the European Central Bank in 1999, she gave up all these posts to be a Member of the Executive Board of the ECB from 2003 onwards. She and five other members are responsible for the day-to-day running of the Eurozone, reporting to the Governing Council (the Executive Board plus the Governors of the National Central Banks). Why has no sound been heard from this direction?

The scandal breaks

BAWAG Caribbean ventures avoided the news until October 2005 when its former partner REFCO filed for bankruptcy. The 2004 Annual Report of BAWAG records: “The successful cooperation with the REFCO Group will be continued without an equity stake, so that the BAWAG PSK Group will continue to benefit from this access route to international customers in the future.”

In the event, what this really meant was a personal loan of $410 million to the CEO of REFCO, Phillip Bennett, only hours before the company went bankrupt. The collateral for the loan was REFCO shares which became instantly worthless. A warrant has been issued in Austria for Bennett’s arrest. Curiously, an arrest warrant for Flöttl Junior has just been withdrawn by an Austrian judge.
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So BAWAG uses Refco to hide its losses, and then turns around and loans to Refco's CEO to hide Refco's own looting. Yeah, that sounds about right. And here's an interesting question: If Flottl Junior's owned a house in Bermuda, who might his neighbors be? And the answer: http://www.bermudasun.bm/main.asp?SectionID=24&SubSectionID=270&ArticleID=29005&TM=55971.78">Ross Perot and Silvio Berlusconi.

When the extent of the exposure to the Caribbean business was made known in late March 2006 the Supervisory Board Chairman, Weninger resigned. At this stage the use of the strike funds as collateral was also discovered and trade union leader Fritz Verzetnitsch instantly resigned both as ÖGB Chairman and Member of Parliament.

BAWAG itself is so public minded that it has a representative on the Technical Expert Group of the EU’s European Financial Reporting Advisory Group. As the Bible says, you should not ignore the plank in your own eye when trying to remove the specks in other people’s eyes.

BAWAG always had the reputation of being a cutting-edge bank. Via REFCO, they were involved in the PIPE (Private Investment in Public Equity) market which was often used as finance of last resort for near bankrupt companies. They were the first bank in Europe to offer loans over the internet. While, over the years BAWAG showed considerable reluctance to enter the markets of Central Europe, outside the immediate scandal some of their strategic moves, have been what might be called “interesting” not to say “opportunistic.”

Check out http://www.thestreet.com/stocks/brokerages/10263382.html">this article for some more info on the PIPE market, and how BAWAG was a quiet major investor in at least four hedge funds that appear to be major players in the PIPE, which appears to be a market where companies in need of money look to private investors willing to buy shares in the company at discounted rates (it's another one of those "murky, yet booming" markets). Refco apparently http://www.thestreet.com/stocks/brokerages/10263382_2.html">worked closely with these four hedge funds, allowing them to resell their cheaply-acquired stocks.

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In Israel, there has been an extraordinary investment (among others) in a casino in Jericho, jointly funded by among others, the Palestine Authority, Casinos Austria and BAWAG. This was burned out during the Intifada but there appear to have been plans for another casino with the same ownership line-up in Southern Gaza! BAWAG is heavily involved in the still open corruption allegations against members of Sharon’s family.
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Also note the involvement of folks like http://www.thestreet.com/stocks/brokerages/10263382_2.html">Solomon Obstefeld and http://www.thestreet.com/stocks/brokerages/10263382_3.html">Martin Schlaff in BAWAG's PIPE business.

Schlaff was another figure http://www.jpost.com/servlet/Satellite?cid=1136102664496&pagename=JPost%2FJPArticle%2FPrinter">implicated in the Sharon corrupt scandal. Obstefeld was http://www.birminghambar.org/data/SlipOpinions/11thCir/01-16006.htm">implicated (although not convicted) in the largest insurance fraud in US history: the looting of the National Heritage Life Insurance company for $450 million. The figures at the center of that scandal, Shalom Weiss, was eventually caught http://www.thetimes-tribune.com/site/news.cfm?newsid=13809680&BRD=2185&PAG=461&dept_id=416046&rfi=6">hiding out in Austria. One of the trading firms Mr. Weiss used, Pacific International, apparently had a number of http://www.rgm.com/articles/pacific.html">mafia-connected clients.

It's also worth noting that penny stocks (and the shorting of them) appear to be a http://www.businessweek.com/1997/50/b3557003.htm">favorite http://www.businessweek.com/magazine/content/03_20/b3833128.htm]target] of the http://www.sptimes.com/2003/07/14/news_pf/Columns/In_the_shadows_of_the.shtml">mafia's http://www.businessweek.com/1997/12/b3519127.htm">activity on Wall Street. Because it involves selling shares to private investors at a discounted the price, the PIPE market is seen as one http://www.nytimes.com/2006/08/13/business/yourmoney/13pipes.html?ex=1313121600&en=54b7ff5cde985d3b&ei=5088&partner=rssnyt&emc=rss">ripe for abuse via http://www.thestreet.com/stocks/brokerages/10263382_3.html">insider-trading and short-selling. A lot of these mob activities specifically favored penny-stocks (which are easier to manipulate), so it’s interesting that BAWAG's affiliated firm that dealt with the PIPE market, LH Financial, is a major player in the PIPE market http://www.thestreet.com/stocks/brokerages/10263382.html">and almost exclusively deals with penny-stocks. [br />

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Stranger still, BAWAG opened a representative office in a hotel in Libya in October 2005, a strange enthusiasm even given the improving relations with the EU and the large number of other countries where BAWAG is not yet represented. The launch was attended by a delegation of twenty-five from Austria including none other than Ewald Nowotny, former socialist politician and vice-President of the European Investment Bank (EIB) from 1999 until 2003. He is now Honorary vice-President of the EIB. At the age of 29, he was appointed Chairman of the Board of Directors of the Austrian Post Office Savings Bank (PSK), a post he held until 1978.

The EIB is the EU’s financing institution. It was created by the Treaty of Rome. The members of the EIB are the EU Member States of the European Union, who have all subscribed to the Bank’s capital. In the EIB’s own words:

* The EIB enjoys its own legal personality and financial autonomy within the Community system. The EIB's mission is to further the objectives of the European Union by providing long-term finance for specific capital projects in keeping with strict banking practice.
* It thereby contributes towards building a closer-knit Europe, particularly in terms of economic integration and greater economic and social cohesion.
* As an institution of the Union, the EIB continuously adapts its activity to developments in Community policies.
* As a Bank, it works in close collaboration with the banking community both when borrowing on the capital markets and when financing capital projects.
* The EIB grants loans mainly from the proceeds of its borrowings, which, together with "own funds" (paid-in capital and reserves), constitute its "own resources".
* Outside the European Union, EIB financing operations are conducted principally from the Bank's own resources but also, under mandate, from Union or Member States' budgetary resources.

The EIB has been extremely active in providing loans to BAWAG and to BAWAG/PSK.

It may be a coincidence but at the time of writing this article, records of the above loans have disappeared from the EIB website.

Of great curiosity value are what seems like two loans signed on 6 October 2005, just a few days before the REFCO scandal broke for €180 million – the first for €100 million for a global loan focusing “on projects of limited scale in the fields of environmental protection and improvement as well as infrastructure, energy, health, education and SMEs situated to more than 70% in regional development areas” and the second for €80 million “for financing for small and medium scale ventures.” It maybe that the second sum is included in the first.

Another loan for €20 million was signed on 17 March 2006 also for “financing for small and medium scale ventures.” It maybe that this loan is also the final tranche of the initial loan. Loans, therefore, of at least €100 million and possibly €200 million were made (depending on how one interprets the descriptions and dates of the transactions.)

A further line of credit for €100 million for “the financing of projects of limited scale in the fields of infrastructure, environmental protection and improvement, rational use of energy, health and education located in regional development areas” was published on 6 March 2006 as being under consideration.

Why such big loans so recently? On what basis did the EIB approve this financing? Did they not ask the Austrian Finance Ministry about the state of BAWAG’s finances? Why did not the Finance Ministry inform them? Surely even just the business in Israel and first news of the Caribbean scandal should have sounded alarm bells.

It can, therefore, be of no surprise that the new Chief Executive of BAWAG is going to be… Ewald Nowotny who declared on 23 March 2006 that “the bank’s balance sheet was now ‘clean and solid.’” He assures everyone that there are no more dead bodies in the cellar.
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Yep, the European Union's financing institution, whose purpose is to "http://www.eib.org/about/">contribute toward the integration, balanced development and economic and social cohesion of the Member Countries", loves to lend to BAWAG. And Ewald Nowotny - an Austrian socialist politician that was also the VP of the EIB and a former Chairman of the Board of the PSK bank that was sold to BAWAG in a privatization scheme that enriched the Austrian far-Rightist government in 2004 - is now BAWAG's new CEO and wants to assure us it's all good in BAWAG's financial bowels.

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“Social partnership”

So cosy are the political relationships in Austria even after the partial collapse of the notorious proporz system that ex-People’s Party politician, Christoph Leitl, now the Head of the Austrian Chamber of Economics and President of Eurochambres declared that he had “respect” for trade union leader Verzetnitsch on his resignation. Short of a complete meltdown of BAWAG, it would have been in his interest to say this if any of his members are owing money to this socialist bank. Here they are together at a “Dialogue of the Social Partners” event organised by the Diocese of Linz in February.
(see pic http://www.brusselsjournal.com/node/955">in article)
Leitl has now praised the crisis management of the ÖGB und BAWAG! Needless to say, when questioned, he does not support the resignation of Tumpel from the Chamber of Workers.

Cosy indeed; the Austrian President, Prime Minister, Leitl himself and even the left-leaning Bishop of Linz were honoured guests among the 500 people who attended Verzetnitsch’s 60th birthday party in May 2005 (entitled “60 years for the Socialist Movement”!). The “Social Partners” collected €72000 for the newly established “Verzetnitsch Education Fund for Young People” by the end of the evening. Given the fate of the strike funds, one can only hope that this money is in safe keeping – but it was a BAWAG account. As their advertising runs, “BAWAG saving is safe, easy and lucrative.” Another advert more believably urges “Jet Set with Friends.”

Now the scandal has broken, the Socialist Party SPÖ is distancing itself from its old friends in the fly-by-night banking world. It has have been quick to support the sale of BAWAG, as it is a major embarrassment in the upcoming elections, which it had been predicted to win even under Alfred Gusenbauer, a leader who occupies a charisma free-zone all of his own. After all, if you run a Bank for your own interests and not those of your customers, you will treat the country and her voters in the same way.
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So who ends up footing the bill for the whole Refco/BAWAG mess? The members of the Austrian trade union federation, whose http://www.bloomberg.com/apps/news?pid=10000087&sid=aaqyDjVW4WSc&refer=top_world_news">sale of BAWAG http://asia.news.yahoo.com/060612/3/2lssx.html">may not even cover the debt its incurred over the fraud.

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Austria in truth has never recovered from the shock of the artillery bombardment of the Karl-Marx-Hof at the centre of “Red Vienna” in 1934 by the Christian Social conservative predecessors of the Austrian People’s Party. The elites now justify to themselves that they have to do everything to avoid such a crisis ever again, but a high price has to be paid in terms of corruption (or at least a good appearance of it) and contempt for a normal democratic process with an effective opposition. And the Austrian state presently has other threats than communists within. The time of the unbreakable “Social Partnership” of the Chamber of Workers (represented by Tumpel), the Trade Unions Federations (represented by Verzetnitsch) and the Chamber of Economics (represented by Leitl) should be long gone. Ironically, it is self-serving and no longer serves the interests of society or of ordinary Austrians outside the elites.

We are Europe

If the BAWAG affair comes to be seen as “business as usual in Austria,” Vienna could loose its place in banking as the mini-Frankfurt-on-the-Danube. Even as the BAWAG scandal broke, it was revealed that the Hypo Adria Alpe Bank has run up €328 million in losses in a mere two weeks of foreign exchange trading, prompting descriptions in the Austrian press of “third-world standards.” Surely this Austria is not the same country as the one holding the Presidency of the EU!

With the slogan “Youth can’t wait – We are Europe,” the ÖGB Youth Movement demonstrated outside the recent EU Youth Minister’s Meeting in Bad Ischl. You bet the Socialists can’t wait – after all Verzetnitsch started his climb to penthouse life within this same youth movement. In reality, Austria is an all too accurate mirror of the “social partnership” model that is also practiced by the European institutions.

And here's a bit more on the relationship between Refco and BAWAG...based on http://www.bloomberg.com/apps/news?pid=10000086&sid=a50aqPG7x7qo">this Bloomberg article, it sounds like the Refco's infusion of BAWAG capital, not long after Phillip Bennett took over, http://www.bloomberg.com/apps/news?pid=10000086&sid=a50aqPG7x7qo">allowed it to start gobbling up lots of other firms to become the largest commodity futures trader in the US:

...
Bennett Takes Over

On Oct. 1, 1998, Dittmer named Bennett CEO. ``Phil brings to the job a bulletproof track record of sound decision making and a recognized financial stature,'' Dittmer said in a statement that day. Grant didn't return telephone calls seeking comment.

Bennett moved rapidly to burnish Refco's sullied image. In January 1999, he hired Dennis Klejna, who had served as the CFTC's director of enforcement from 1983 to 1995, as general counsel to police the firm. Bennett then hired Joseph Murphy from HSBC Futures Americas, a unit of London-based HSBC Holdings Plc, to run Refco LLC, the firm's regulated U.S. futures brokerage.

Klejna and Murphy wouldn't have tolerated the kind of rule breaking that had marked Refco's past, says Scott Early, general counsel at the CBOT from 1983 to 1994 and now in private practice at Foley & Lardner LLP in Chicago. ``Joe and Dennis were brought in with a clear mandate that this firm was going to be run in compliance with the law,'' Early says.

New Hires

Bennett's new hires pleased his regulators in Washington. ``People were hopeful that the company was getting the message and getting out of this cycle of running into regulatory problems every year,'' says Geoffrey Aronow, director of enforcement at the CFTC from 1995 to 1999 and now a lawyer at Heller Ehrman White & McAuliffe LLP in Washington.

With Klejna at his side, Bennett settled the Goldinger case, ending a four-year investigation. Klejna and Murphy both declined to comment.

Bennett also began hunting for new sources of capital to strengthen Refco. In 1999, he cemented an alliance with Vienna- based Bawag P.S.K. Bank, which is controlled by Austria's trade unions. Bawag bought 10 percent of Refco for an undisclosed sum.

Bennett was eager to show the futures industry that Refco was on solid ground. ``Getting that capital infusion was the first step in the process,'' says Cynthia Zeltwanger, CEO of Fimat USA. In 2004, Bawag sold its Refco stake for $220 million.

Acquisition Spree

Bennett also embarked on a series of acquisitions -- 16 in all -- that would eventually transform Refco into the largest independent U.S. futures brokerage and the fourth-largest in the world.

In January 2000, Refco bought Chicago-based Lind-Waldock & Co., the largest U.S. discount retail futures broker, for an undisclosed sum. In 2005, Refco spent $208 million to acquire Cargill Investor Services, the captive broker of the agricultural giant Cargill Inc., based in Wayzata, Minnesota. From 2000 to 2005, Refco's U.S. customer accounts almost doubled to $4.1 billion.

Bennett also pushed into overseas markets by acquiring Trafalgar Commodities Ltd., a London energy trading firm, for an undisclosed price, and MacFutures Ltd., a London firm that runs so-called electronic trading arcades, where traders are seated at machines rather than hollering at each other in a pit. In addition, Refco bought brokerages in India and Taiwan. By 2005, Bennett's firm had operations in 14 countries.
...

And here's a bit more from that article on Refco's regulatory history:

...
The seeds of Refco's destruction were planted more than three decades ago, when the firm's co-founder, Ray Friedman, began fostering a culture of bending, and sometimes breaking, the rules. Refco had the worst record in the U.S. futures industry.

Since 1983, when Bennett became CFO, regulators such as the U.S. Commodity Futures Trading Commission had punished Refco 140 times for keeping sloppy records, filing false trading reports, inadequately supervising its traders and other violations, according to enforcement records compiled by the Washington-based National Futures Association, a self-regulatory organization that governs the more than 4,200 firms involved in futures trading in the U.S.

Tangling With Regulators

A key Refco unit that Bennett himself had established, Refco Capital Corp., tangled with the CFTC more than a decade before the brokerage foundered.

In 1994, the CFTC fined Refco $1.2 million for secretly shuttling money from client accounts to cover Refco Capital's own debts -- a forerunner of the toxic fraud prosecutors say Bennett later perpetrated as CEO. Refco paid that fine, without admitting or denying guilt, and promised to keep its hands off the money in such segregated accounts, which, under U.S. securities law, can't be mingled with a firm's own capital.

Refco failed to clean up its act. In 1995, http://www.findarticles.com/p/articles/mi_qn4155/is_19991001/ai_n13833803">a Refco broker helped a Beverly Hills, California, money manager named S. Jay Goldinger defraud his clients by illegally dealing out profits and losses among customer accounts, according to the CFTC.

The next year, Refco Capital, which Bennett had set up to finance customers' trades, once again manipulated a client's account without that customer's knowledge. A federal judge later ruled that that move, while technically legal, was nonetheless ``disreputable.''

Over the Edge

``Refco was a firm that said, `Show us where the edge is,' and then they played just over it,'' says a former U.S. commodities exchange official who was involved in regulating Refco during the 1980s and 1990s.

Prosecutors in Bennett's criminal case have focused on financial transactions between Refco and another, offshore unit, Refco Capital Markets LLC. The world of futures, options and other derivatives, which are instruments linked to underlying stocks, bonds or commodities, is split between those that are traded on exchanges such as the Merc and those traded off such bourses, or over the counter.

In the U.S., brokers of exchange-traded futures are regulated by the CFTC. Domiciled in Bermuda and operated out of New York, Refco Capital Markets brokered over-the-counter derivative and currency trades and was therefore beyond the reach of U.S. regulators.

`Fertile Ground'

``These unregulated parts of the industry offer fertile ground for fraud, manipulation and other shenanigans,'' says Randall Dodd, director of the Derivatives Study Center, a Washington-based research and policy group.

More revelations may be at hand. The CFTC is still conducting its investigation of Refco and its finances. The U.S. Securities and Exchange Commission is in the midst of its own, separate probe.

Refco's implosion and the charges leveled against its CEO have stunned investors and industry colleagues. Under Bennett, Refco appeared to have put its troubled past behind it, says Gary DeWaal, general counsel for Fimat USA Inc., the New York-based securities unit of Paris-based Societe Generale SA. Former Refco employees are staggered.

``It was like you just told me my brother is an ax murderer,'' says Daniel Yovich, 42, a former Refco grain futures broker on the Chicago Board of Trade who quit Refco after the firm went bankrupt.
...

And here's an article giving a http://www.thestreet.com/markets/matthewgoldstein/10248928.html">possible motive for Bennett's rather brazen fraud:

Matthew Goldstein
Refco and the IPO Motive
By Matthew Goldstein
Senior Writer
10/21/2005 4:18 PM EDT

One of the hardest questions to answer in the Refco (RFX:NYSE) scandal is why Phillip R. Bennett, a Cambridge-educated master trader seemingly assured of a lucrative Wall Street career, would want to cook the books at a company he helped build.

Federal prosecutors, in charging the former Refco CEO with securities fraud, suggest Bennett's main motive in hiding some $430 million in uncollectible debts was the brokerage's initial public offering in August.

But Bennett's alleged deception goes back as far as 1998, years before Thomas H. Lee Partners sank $507 million into Refco and set the stage for its $583 million IPO.

Unless Bennett is a soothsayer, it's hard to imagine he could have known the Boston-based buyout firm would knock on his door in 2004. But an examination of the record suggests that some type of public sale of Refco stock was on Bennett's mind when his plot allegedly began to form.

Indeed, as early as 1999, a year after Bennett allegedly began the scheme to burnish Refco's balance sheet, there was a talk on Wall Street about a Refco IPO. The speculation was spurred, in part, by the decision of Austria's Bank Fur Abeit und Wirtchaft, or Bawag, to take a 10% equity stake in the New York brokerage that year.

Bawag sold its interest when Thomas H. Lee Partners entered the picture in 2004. The bank surfaced again this week when it acknowledged it lent Bennett the money to pay off his $430 million debt to Refco. Bawag's involvement in the Refco mess has led to calls for an investigation from some Austrian politicians.

The possibility of an IPO got more momentum when Thomas Dittmer, Refco's longtime chairman, stepped down in December 1999 and turned over the reins to Bennett. Until then, Dittmer, having invested about $100 million, had a 51% equity stake in Refco, a firm he had led for 20 years. The other equity owners were Bennett, former Refco president Tone Grant, and Bawag.

Under Dittmer's stewardship, Refco grew from a small commodities brokerage into an international powerhouse. Shelly Jacobs, a former Refco broker, says Dittmer was the "glue that held the whole place together.''

But Dittmer, who took over Refco from his stepfather, Ray E. Friedman, was also a controversial figure. It was during Dittmer's tenure that the brokerage paid an $8 million fine to settle charges that it had helped manipulate customer accounts. The fine assessed by the Commodity Futures Trading Commission in May 1999 was hefty at the time.

Dittmer's departure was seen by many on Wall Street as part of an effort by Refco to clean up a renegade image. A number of other management changes were effected around this time. In setting with the CFTC, Joseph Murphy, who had just joined Refco as its new president, said, "Refco has begun the process of putting any issues with federal regulators or futures exchanges behind us.''

Refco executives were less vocal about the terms under which Dittmer left the company. A trade publication, Securities Week, reported in December 1999 that Dittmer's separation agreement included a provision that afforded him a lucrative post-departure payout in the event Refco ever went public or was bought.

In its IPO registration statement, Refco reported that within the past year it made an $861.7 million payment to a "former shareholder'' for sale of an interest in the predecessor company. Refco has not identified the shareholder. The payout was reported Friday by the New York Post, though the newspaper said the recipient remains a mystery.
...

If Dittmer was the recipient of the $861.7 million payout, that would come in handy since he declared his plans to return Wall Street http://www.usatoday.com/money/industries/brokerage/2005-11-08-dittmer-usat_x.htm">just weeks after Refco's collapse.

...
If Dittmer received the money, the payout would cast an interesting new light on Bennett's possible motivation for allegedly concealing the bad debts on Refco's books. At the very least it would help explain why Bennett was worried about the appearance of Refco's books at a time when the company was still seven years away from an IPO.

"There is no question if these were credit loses that would have definitely reduced the performance of the firm,'' says Peter Nerby, a senior credit officer with Moody's Investors Service. "That would have affected how we would have viewed the creditworthiness of the company.''

A Refco spokesman declined to comment on the hefty payout. Dittmer could not be reached for comment. Bennett's lawyer, Gary Naftalis, could not be reached for comment.

Nerby says that acknowledging the losses up front, instead of concealing them, would have reduced earnings at Refco and possibly reduced its capital. And Refco was "a thinly capitalized firm to begin with,'' he says

A reduction in working capital would have been particularly troublesome for Refco in the late 1990s, when it first considered the idea of an IPO. It would have jeopardized the firm's then-AA credit rating and made it far more costly to borrow money.

If Refco had revealed the true state of its finances, Bennett might have had a hard time convincing Bawag to invest in the brokerage. It certainly would have caused Thomas H. Lee Partners to walk away in 2004.

And don't you love how the largest commodities future broker in the US was a "thinly capitalized firm to begin with."

So here's a http://www.usatoday.com/money/industries/brokerage/2005-11-08-refco-usat_x.htm">interesting article on Dittmer and Refco co-founder Ray E. Friedman's background:

Refco's flameout ends history of ups, downs
By Elliot Blair Smith, USA TODAY

During the Vietnam War, Army Lt. Thomas Dittmer served the military as a social liaison to the White House, where he attended state dinners and made small talk with politicians and visiting businessmen and danced with their daughters.

Fresh off the Midwest plains, Dittmer used his White House connections to pay his stepfather a favor that otherwise would have been beyond either's reach. The man Dittmer called Pop was an obscure Sioux City, Iowa, businessman named Ray E. Friedman, who had been convicted more than a decade earlier of selling substandard chickens to Army troops during the Korean War. Friedman served two years in federal prison for that offense.

In June 1966, President Lyndon Johnson pardoned him. Last week, Dittmer, in a rare interview, confirmed to USA TODAY that he had helped rehabilitate his late stepfather's criminal record.

LBJ's intervention might have been the last time the reclusive Dittmer and the flamboyant Friedman welcomed Washington's influence. By the time of the presidential pardon, Friedman was on the rise again, amassing a fortune at the Chicago Mercantile Exchange. He traded cattle futures at a raucous new market there, launched in November 1964, that was prone to traders' excesses.

...

So Dittmer and his stepfather Ray E. Friedman were connected enough to get Friedman a pardon by Johnson. It could just be that Friedman's involvement in the cattle market and working at the White House was enough to get a Texas president to grant him a pardon, but there could be more under that rock so it’s a topic worth looking into. In an article about Dittmer http://query.nytimes.com/gst/fullpage.html?res=9B06EED91231F936A25757C0A9679C8B63">marrying NY socialite Sandy Hill in 2001 it lists his parents, Evelyn Robertson and Marlin Dittmer, are listed in that article, so maybe they have some historical clout too (or not…who knows).

...
Dittmer left the Army in 1966 and moved to Chicago to learn the commodities trade. Three years later, he and Friedman formed a partnership called Ray Friedman & Co. Eventually, the firm moved to New York, was renamed Refco and grew into a global trading powerhouse. Along the way, Friedman and Dittmer created riches for themselves and select clients while frequently clashing with regulators and less-fortunate investors.

Now, Refco courts ruin amid another criminal investigation. Dittmer's successor, Refco CEO Phillip Bennett, 57, was charged by federal authorities with a felony count of securities fraud last month. Today, Refco's regulated commodities trading business will be auctioned off in bankruptcy court while management and creditors sort out the tangled affairs of its unregulated investment businesses in the months to come.

Federal authorities acted after internal auditors at Refco accused Bennett of manipulating the firm's financial statements to disguise a $430 million personal debt to it. Bennett repaid the IOU and denies wrongdoing. But Refco investors responded to the scandal by pulling billions of dollars of capital. The liquidity drain forced the firm to seek bankruptcy-court protection from creditors.

Amid civil and criminal investigations, Refco's flameout is one of the most spectacular financial failures in U.S. history. More than $1 billion in investor capital evaporated between its initial public offering in August and its Oct. 17 bankruptcy filing. That is the swiftest crash of a public company on record.

Refco's unraveling is all the more remarkable because the firm handled more trades than do most of the world's financial exchanges. Its edge was electronically matching buyers and sellers through its own unregulated global trading platform.

"Refco — if they wouldn't have gone broke — in five years they would have been the exchange," says Dittmer. "That is the right business model." The legendary trader, now 63, cashed out the family stake in the firm and retired to a private life in the British Virgin Islands in 1999.

In what promises to be a major development in the easily spooked futures markets, Dittmer now plans to return to Wall Street, prompted by Refco's collapse and its effect on his and his stepfather's legacy.

He considered making an offer for Refco's assets in bankruptcy court, backed by Dubai, a member of the United Arab Emirates. Now Dittmer plans to form a venture with nephew Bradley Reifler to compete with it. Reifler, 45, Friedman's grandson, is a former star trader at Refco who says he left in 2000 after Bennett refused to sell him a stake in the firm.

...

It looks like the Dubai bidder http://www.khaleejtimes.com/DisplayArticle.asp?xfile=data/business/2005/October/business_October384.xml§ion=business&col">was rejected.

...
Las Vegas visitor

Friedman became a frequent visitor to Las Vegas, where he bought a hotel and casino. He hobnobbed with celebrities and showcased his card-playing skills. Back home, he showered gifts on a local panhandler who awaited him each day and a Native American youth for whom he arranged college tuition.

Whatever he spent, he made back in the markets.

But Refco's principals gave preferential treatment to some customers over others, according to some of the nearly 300 Commodity Futures Trading Commission enforcement actions, arbitration cases and customer reparations complaints brought against the firm and its principals since its founding.

One beneficiary of Refco's trading prowess in the late 1970s was Hillary Clinton, the wife of then-governor of Arkansas Bill Clinton and now a U.S. senator from New York. She converted a $1,000 short-term investment in cattle futures at Refco's Little Rock office into a $100,000 portfolio. Clinton's profits provoked a flurry of controversy on Capitol Hill after her husband was elected president, but neither she nor Refco were formally charged with any related wrongdoing.
...

Yep, Refco was part of http://www.washingtonpost.com/wp-srv/politics/special/whitewater/stories/wwtr940527.htm">Hillary's commodity controversy.

...
Friedman and Dittmer also benefited by trading for themselves, relatives and friends. In 1983, the CFTC fined Refco and Dittmer $525,000 and suspended him from trading for four months for allegedly trying to corner some farm commodity markets.

Friedman and his wife retired to Palm Beach that year, but he continued to trade commodities. At 78, he, too, was sanctioned by government authorities in March 1992 when the CFTC issued fines of $590,000 against him and Refco, and suspended the septuagenarian for two months for allegedly trying to corner the frozen pork-bellies market.

Friedman's grandson, Reifler, also got caught up in the family trading frenzy, according to a customer-reparations complaint filed with the CFTC at the same time. Texas business executive Perry Esping, now deceased, complained that he lost $2.3 million by following a family trading strategy through Reifler that Friedman's grandson allegedly boasted "never fails, it works 100% of the time." Reifler disputes the recollection. The complaint was settled privately.

In 1994, Dittmer moved Refco from Chicago to Wall Street, reflecting his global ambitions. But the firm's rough-and-tumble regulatory history accompanied it and grew apace. In 1999, the CFTC fined Refco $6 million for massive record-keeping violations and lax internal controls and ordered it to pay $1 million more to fund an industry study to curtail customer abuses.

Under pressure, Dittmer resigned. Bennett, the smooth-talking, Cambridge University-educated financial professional whom Dittmer recently had promoted to CEO, added the title of chairman.

With Bennett at the helm, Refco pushed harder into fast-growing unregulated markets that served hedge fund and institutional customers, and further away from its traditional base of buying and selling agricultural commodities for individuals.

Bennett negotiated the acquisition of 16 smaller competitors and grew Refco revenue by nearly 24% a year through 2004. The firm's reach grew to encompass 200,000 customers in 14 countries.
...

Now check out this March 1988 article in the NY Times discussing the role that the futures market, and Refco, http://select.nytimes.com/gst/abstract.html?res=FB0711FD355D0C748EDDAA0894D0484D81">played in the stock market crash of 1987 and the evolution and growing importance of futures in the financial markets in the past couple decades:

SUDDENLY, IT'S CHICAGO

By MARTIN MAYER; MARTIN MAYER IS THE AUTHOR OF ''THE BANKERS.'' THIS ARTICLE DRAWS UPON HIS RESEARCH FOR ''MARKETS,'' WHICH WILL BE PUBLISHED IN JUNE. (NYT); Business World Magazine
Late City Final Edition, Section 6, Page 23

IF DANTE HAD SEEN THE TREASURY BOND PIT AT the Chicago Board of Trade, he would have added another circle to his vision of hell. Imagine a ring of steps around an octagonal floor, about 35 feet in diameter on the top step, occupying the northwest corner of a wood-paneled trading room the width of a city block. Some 600 men and women stand jammed together in this pit, shouting and gesticulating, sometimes swaying in unison like tulips in the wind, from 8 o'clock in the morning when trading begins until 2 o'clock in the afternoon. Nobody goes to lunch, and few will risk losing their places by visiting the bathroom. Such abstinence is possible because almost everyone is under 35. (''Don't be confused by those gray heads you see,'' said the Virgil showing a visitor around. ''They're 28 years old, too.'') The Treasury bond pit works by open outcry, which means that each bid and offer is good only for the instant of utterance and must be incessantly repeated. The noise is devastating.

These men and women, with their primitive gestures and raucous calls, are buying and selling contracts to purchase, at a particular price on a particular future date, $100,000-face-value United States Treasury bonds with an 8 percent yield. On Black Monday, the New York Stock Exchange traded about $21 billion in stocks, and this one pit in Chicago traded more than $50 billion in Treasury bond futures contracts.

The prices ''discovered'' here are arguably the most important in the world. Interest rates on Treasury bonds are the strongest single influence on the exchange value of the dollar and on the movement of prices in the stock markets.

Other pits at the Board of Trade discover the prices of contracts for future deliveries of wheat and corn and soybeans, prices that predict what the farmer will get for his crops when they ripen and what the food processor will pay for his raw material. And half a mile away, in the new twin-skyscraper headquarters of the Chicago Mercantile Exchange, other traders and brokers, on black plastic steps and a floor with raised buttons to prevent sliding, bid for futures contracts in cattle and in pork bellies, 90-day Treasury bills, three-month dollar-denominated bank deposits in Europe (Eurodollars) and the Standard & Poor's 500 index. Trading in the S.&P. 500 index, which measures the movement of prices for something more than three-quarters of the value of the securities traded on the New York Stock Exchange, was $2.3 trillion last year; the volume on the exchange itself was $1.9 trillion. (Across the street from the Board of Trade at the Chicago Board Options Exchange, 1987 trading in the separate S.&P. 100 index was $2.4 trillion.) All this pricing of paper is very new. The New York Stock Exchange has been around for 196 years, and the Board of Trade has been trading foodstuffs since the 1840's, but the Treasury bond contract first appeared 10 years ago, and trading in the S.&P. 500 index began only in 1982. Today, three-quarters of the action in Chicago involves financial products rather than agricultural commodities.
...

Here's an interesting article about the http://www.futuresindustry.org/fimagazi-1929.asp?a=607">history of the futures market.

...
These instruments have already wrought a revolution in finance, with more to come. They are the means by which the over-advertised globalization of the markets is to be accomplished. The Board of Trade has a night session to accommodate Japanese customers, and the Merc - as the Mercantile Exchange is universally known - has reached an agreement with Reuters that will permit round-the-clock trading of all its contracts through the Reuters screens that serve the worldwide community of foreign exchange dealers.

Last month, a division of the Securities and Exchange Commission, reporting on ''The October 1987 Market Break,'' suggested that ''The character of the market has changed to the point where the 'price discovery' feature of the market is leading, rather than following, price trends in the underlying markets.'' Farmers have complained for generations that the gamblers in the futures pits determine the prices they receive when they sell their crops and livestock. Now the tail of financial futures wags the majestic dog of the New York Stock Exchange."

But the reason for this leadership from Chicago, the S.E.C. report stressed, was not a burst of public gambling; it was ''the increasing use of the futures market by institutional investors.'' The ardent defenders of the Chicago stock index contracts against those who would blame the futures market for the October crash have been these institutions - the big banks, the pension funds and the insurance companies - and the university professors and the establishment press.

Elephants are running in the squirrel cages and computers are their mahouts. ''The era of the individual trader is gone,'' says Tone N. Grant, president of Refco Group Ltd. ''We are in the era of the machine.'' Refco itself, by far the largest brokerage in the futures business worldwide, exactly illustrates the change from the derring-do of the speculator to the statistical strategies of the corporate C.F.O.
...

This is part of what makes Refco so potentially important: It was an industry leader in a segment of the financial sector that has revolutionized finance and enabled the globalization of financial markets.

...
THE NAME REFCO COMES FROM THE INITIALS OF A MEAT--and-grain futures trader named Ray E. Friedman, now retired, who sold the business to his stepson, Thomas H. Dittmer, in 1974. A former Army guard in President Johnson's White House, Dittmer had become, under Friedman's guidance, one of the legendary traders on both the Mercantile Exchange and the Board of Trade. A scourge of the cattle pits, Dittmer was censured and fined by the Merc and the Commodity Futures Trading Commission for acquiring positions larger than the rules allowed in an apparent effort to push several markets around.

Now, after making a fortune variously estimated at $200 million to $400 million, supporting a life style of private jets, a baronial estate in Lake Forest, Ill., and a spectacular collection of contemporary American art that ornaments the Refco offices, Tom Dittmer has become, at 45, the all-but-invisible chairman and C.E.O. of a major financial services company.

Refco is open 24 hours a day in Chicago and New York and staffed with brokers who speak Japanese and the major European languages during the hours when the overseas customers are at work. There are branches in Lon-don, Paris, Zurich, Hamburg, Milan, Singapore and Sydney. The firm represents buyers or sellers for more than a fifth of the world's options and futures trading.[/b

[nam78_two]

1. Bookmarked -thanks again FTR

for a detailed and scholarly dairy :toast: -your stuff, like Dr.Debug's, is content heavy but informative!

[ftr23532]

4. Thanks!

:-)

[nam78_two]

2. Delete-dupe

dupe

[ftr23532]

3. oh crap, the original post got cut off

I just noticed the final quarter of this original post got cut off (I might have hit the character...looks like calling it an "egregiously long post" was an understatement)....here's the rest for anyone interested. There's some interesting info about how the role credit derivatives played in Enron's affairs and how little regulations actually were imposed in the derivatives market following the Enron dabacle. It's a potentially vital topic given some of http://money.cnn.com/2005/09/22/markets/credit_derivatives/index.htm">these http://www.ft.com/cms/s/ab1305a4-f4b2-11da-86f6-0000779e2340.html">recent http://www.ft.com/cms/s/333247dc-7dbc-11db-9fa2-0000779e2340.html">articles.


So, continuing where the previous post was cut off with the http://select.nytimes.com/gst/abstract.html?res=FB0711FD355D0C748EDDAA0894D0484D81">1988 NY Times article talking about Refco's role in the 1987 stock market crash:

...
THE NAME REFCO COMES FROM THE INITIALS OF A MEAT--and-grain futures trader named Ray E. Friedman, now retired, who sold the business to his stepson, Thomas H. Dittmer, in 1974. A former Army guard in President Johnson's White House, Dittmer had become, under Friedman's guidance, one of the legendary traders on both the Mercantile Exchange and the Board of Trade. A scourge of the cattle pits, Dittmer was censured and fined by the Merc and the Commodity Futures Trading Commission for acquiring positions larger than the rules allowed in an apparent effort to push several markets around.

Now, after making a fortune variously estimated at $200 million to $400 million, supporting a life style of private jets, a baronial estate in Lake Forest, Ill., and a spectacular collection of contemporary American art that ornaments the Refco offices, Tom Dittmer has become, at 45, the all-but-invisible chairman and C.E.O. of a major financial services company.

Refco is open 24 hours a day in Chicago and New York and staffed with brokers who speak Japanese and the major European languages during the hours when the overseas customers are at work. There are branches in Lon-don, Paris, Zurich, Hamburg, Milan, Singapore and Sydney. The firm represents buyers or sellers for more than a fifth of the world's options and futures trading. That trading is done on instructions from a roster of only 6,000 customers, including virtually every big bank, insurance company and pension fund in the world, and none of it is done for Refco as principal or for Dittmer himself.

Dittmer says in mock bewilderment that the change in his business was made in 1983 without his knowledge by a pair of men he had recruited to Refco only two years before: his president, Grant, a 42-year-old smoothly confident former Yale quarterback, Marine, lawyer and banker, and his chief financial officer, Phillip R. Bennett, a former Cambridge University rugby back who came over from the Chase Manhattan Bank, where at the age of 32 he had been supervising lending to the commodities markets. ''All I know,'' says Dittmer - casual, long-headed, a little jowly, seated beside a pool of soft incandescent light in an office that is like a dark cave off Refco's Chicago trading room - ''is that I went to the bathroom one day, and when I came back Tone and Phil had turned the whole business around.''

Refco is privately held - Dittmer has 51 percent of it, Grant and Bennett split the rest - and publishes no financial statements. Revenues from brokerage activities apparently ran in 1987 something like $200 million, and another $100 million was apparently derived from management fees, services associated with transforming futures contracts to the actual commodities, arranging financing for customers and clearing fees. There are 500 employees worldwide.

Capital in the business is about $200 million, but most of it has to be retained in the firm's own operations, in case foreign customers require assistance to clear their trades in time zones very different from their own. Profits in 1987 were $42 million, and the October crash cost nothing. Refco has no trading positions, and its clients delivered during that day and overnight, no sweat, $365 million of additional margin demanded by the exchanges on Black Monday. ''The experience of the last couple of weeks,'' Bennett said dryly in November, ''shows the benefit of our strategy.''

Refco has grown with the futures markets and by acquisition, having bought the third- and fifth-largest commodity brokerage houses, Conticommodity Services in 1984 and the commodity end of Donaldson, Lufkin & Jenrette in 1985. Grant's accomplishment is to have kept the bulk of the institutional business these acquisitons brought while sloughing off more than two-thirds of the people who had handled it before Refco took over. ''One very able person,'' Grant says rather coldly, ''can do the work of several others.''

...

Donaldson, Lufkin & Jenrette's co-founder, William Donaldson, http://money.cnn.com/2002/12/10/news/donaldson_sec/index.htm"> was nominated head of the SEC in December 2002.

...
OCT. 19 WAS A RELATIVELY quiet day in most of the Chicago pits. Even contracts tied to interest rates did not burst into violent activity until the next day, when the Japanese led a ''flight to quality'' away from stocks and into bond contracts. There was an eerie feeling on the floors. The little guys in the cattle pits, making their few bucks by purchasing contracts for steers on their way into the feedlots and selling contracts for fat cattle, stared across the room in horror at the panic in the S.&P. pit. The nation's great institutions - pension funds, insurance companies, endowments - were dumping stock index futures, triggering the worst crash in the history of securities trading in the United States.

All this was pursuant to a theory that said institutions could safely allocate a greater share of their portfolios to stocks than they had ever done before because stock index futures contracts permitted them to hedge their risks. The funds could ride the bull market up, assured that when prices started down, they could lock in their profits by selling contracts in Chicago. This ''portfolio insurance'' assumed that the futures markets provided infinite liquidity, a bottomless pit (if I may) of speculators prepared to buy contracts when the theory told the institutional investors to sell.

Two months after the crash, the Presidential Task Force on Market Mechanisms - led by Nicholas F. Brady, chairman of Dillon, Read & Company - pointed to a hopeless flaw in this theory as a market strategy. Because the theory had been widely circulated, everyone knew after the market decline on Friday, Oct. 16, that the ''insured'' funds had to be selling on Monday. Nobody in the futures pits would be willing to buy contracts that the funds would keep selling, driving the prices ever downward. ''Dumbest idea ever accepted by an substantial part of mankind,'' said Howard M. Stein, C.E.O. of Dreyfus & Company, who was a member of the task force. ''How could anybody believe everybody could sell at the same time?''

There was another prospective purchaser of contracts in a crash: the ''index arbitrager,'' who would find it profitable to purchase contracts in Chicago whenever the price of the contract fell below what a seller would receive by selling these 500 stocks in New York. Purchasing the ''derivative'' contracts and selling the underlying stocks, arbitragers could lock in a small, sure profit for themselves. That provided a plausible answer to the question of who would want to buy the contracts the ''insured'' funds had to sell, but it left open the question of who would then buy the stocks from the arbitragers.

Index arbitrage was merely a transmission belt by which the declining prices of the futures contracts would be transmitted to the floor of the stock exchange. As the prices on the stock exchange fell under the selling pressure from arbitragers, the portfolio insurance theory would tell the institutional funds to sell more contracts, starting the process all over again. There were speculators who reached for what they thought was a bottom both in the pits and on the exchange floor. On the morning of Oct. 19, one foreign buyer committed $218 million to the pits, briefly moving the S.&P. index futures price higher than the total price of the underlying stocks. At midday, two large investment banks, First Boston Corporation and Drexel Burnham Lambert, bought heavily at a level more than 300 Dow Jones points above the level at which the market eventually settled that evening.

Most potential buyers just disappeared. A few dozen traders in the index futures pits took their fingers out of the dikes quite early and went home to get away from the market. In New York the great broker/dealer firms that normally put together block trades for the institutions simply dumped the sell orders onto the floor and then complained that nobody at the stock exchange was prepared to buy.

In Chicago, the index arbitragers vanished from the pit. Eager to get out, and unwilling to sell at the very low prices bid in the Chicago pits, the pension funds abandoned their failed insurance theories and shifted their selling orders onto the stock market floor itself. The General Motors fund led the pack, pumping no less than $1.3 billion in stock into the declining market. Debacle became crisis and crisis became panic.
...

According to this http://www.bloomberg.com/apps/news?pid=20601039&refer=columnist_gilbert&sid=a_PxZwWboMT8">recent Bloomberg article, it's now looking like Bond derivatives are wagging the tail of the corporate debt market with "feedback cycle" potential. Yay!

And it sounds like http://www.boston.com/business/technology/articles/2006/11/24/bernanke_pushes_computer_modeling/">Fed Chairman Bernanke is pushing a new computer modeling scheme for economic forecasting. Double Yay!

...
HOW THE FUTURES MARKETS WORK

COMMODITY FUTURES ARE contracts to purchase or deliver something on or near a particular date at a price fixed by the contract. They exist essentially to permit producers and consumers to expand the time frame in which they can sell and buy. The farmer can sell his pigs or beans at a known price long before he has to come to market with pork bellies or ripe beans while the food processor can lock in his raw-material costs for bacon or teriyaki sauce.

Financial futures serve a similar purpose. A banker who commits himself to give a home-buyer a mortgage in 60 days at today's interest rate runs a risk that rates will rise. When selling a futures contract for Treasury bonds, the banker in effect locks in today's cost of the funds he will need to write the mortgage; his profit on his Treasury bond contract makes up for any loss he may suffer if the rates increase. An S.&P. contract permits a pension fund that gets money from the employer in June to buy a varied portfolio of stocks in June at April prices by making a small down payment.

Through these markets, farmers and bankers shift their risks to speculators who assume them, usually, for very short periods of time. That's most of the noise you hear in the pits - speculators constantly taking on risks and quickly laying them off. Of course the real world is not that simple. Farmers and bankers gamble as well as hedge, and the most aggressive speculators are forever hedging.

Financial futures are different from agricultural futures in only one important respect. Agricultural futures contemplate production and consumption, while financial futures deal only with the transfer of ownership of pieces of paper. The pits where real commodities are traded impose limits on the number of contracts any participant can hold to make sure there aren't more contracts outstanding at the end of the period than there are bales of cotton in the warehouse or barrels of oil in the storage tanks. In financial futures, however, hedgers, with prior approval, can keep creating contracts as long as other traders are willing to take the opposite side; on Oct. 20, one institution sold well over $1 billion worth of S.&P. 500 contracts. Financial futures thus offer a field much larger than agricultural futures on which institutional players - money-center banks, corporations, pension funds, insurance companies - can play on a grand scale.

These behemoths can do business with the little locals in the pits because the Chicago markets long ago organized themselves to eliminate all customer concerns about the credit-worthiness of those on the other side of a trade. At the moment when a trade is executed, a clearing corporation associated with the exchange itself becomes the counterparty for every buyer and every seller. The buyer agrees to accept delivery of the pork bellies or Treasury bonds, not from the seller but from the clearing corporation; the seller agrees to deliver the commodity, not to the buyer but to a delivery point specified by and controlled by the exchange.

Thus while contracts are easily created, they are also easily extinguished. The purchaser of a contract to buy can take the other side on his next trade, and the exchange simply offsets his two transactions in the clearing process, wiping out both contracts; he is credited with a profit if his contract to deliver is at a higher price than his contract to buy, or debited with a loss if he sells for less than the price of his purchase. A week with $10 billion in trading may produce only $1 billion in surviving contracts, the so-called open interest.

In the stock market, the buyer acquires title to an asset, and has to pay for it. The Federal Reserve permits him to borrow no more than half of what he must pay; he has to put up 50 percent ''margin.'' In a futures market, however, the buyer of a contract assumes an obligation rather than acquiring an asset. As an ordinary matter, that obligation will be fulfilled by the execution of a countervailing trade. If the trade shows a loss, the loser pays the difference in price between the two contracts. The sole concern of the clearing corporation to whom the futures trader owes his obligations is assurance that when this contract expires or is extinguished, the trader will be able to pay what he owes. The clearing corporations require a deposit against possible liabilities on every contract.

Each night, the amount of money in the trader's deposit account is increased or reduced according to how his contracts moved that day. If his losses were such that his deposit has fallen below a required minimum, he will have to bring it up to snuff by 7 o'clock the following morning.

To calculate how large a deposit is required, the commodity exchanges use extraordinarily sophisticated computer models to predict how fast and how far prices will move in each of the pits. If in fact, prices move even faster and further, the clearing corporations can demand that traders increase their deposits while the markets are still open.

In general, depending on the contract and the trader, deposits run from 3 percent to 15 percent of the market price of the contract. Alas, the same word, ''margin,'' is used to describe the deposit that both sides of a futures trade must make at the commodities exchange and the fraction of the purchase price that the buyer alone must put up at the stock exchange. As the Romans put it, more or less: Those whom the gods would destroy, they first confuse.

So that's some background on Refco scandal...probably far more than any of us wanted to know. And we’re not done yet.


fun with derivatives
Now let’s take a quick look at the derivatives market and the Enron scandal, because Refco, and Enron are part of the same general phenomena of an unregulated unleashing of these new tools on the global financial scene over the last couple of decades.

First, let’s review Wendy Gramm, former head of the CFTC during the Bush Sr administration, and the role she played http://www.thenation.com/doc/20060213/scheer0201"> in enabling the Enron scandal:

Truthdig by Robert Scheer
Enron's Enablers



Finally, after four years of legal maneuvering, the trial of Enron top dogs Ken Lay and Jeffrey Skilling opens a new window on the outrageous practices of our modern-day robber barons. But it is depressing that the politicians who benefited from Lay's largesse, and who changed the law enabling Enron's chicanery, are going unpunished and even uncriticized.

Indeed, the larger crime, in any proper moral dimension of that word, was committed in the rewriting of the law on corporate regulation to permit Enron's very existence as a humongous stock market swindler. There simply would be no Enron story were it not for the deregulation of the energy market ushered in by Republican politicians, as Lay himself acknowledged freely in a 2000 interview when asked to explain the "common thread" in Enron's business model.

"I think the common elements first are that, basically, we are entering markets or in markets that are deregulating or have recently deregulated, and so they have become competitive, moving from monopoly franchise-type businesses to competitive, market-oriented businesses," said Lay.

Enron's domination of those deregulated markets was made possible, to a large degree, through the work of the powerful Washington couple, Phil Gramm, then-Republican senator from Texas, and his wife, Wendy, then-chair of the Commodities Futures Trading Commission (CFTC). Perhaps predictably, neither Gramm has been charged with any crimes in connection with the Enron scandal, and both are barely mentioned in the two leading books on the scandal by New York Times business writers. But their antics, well documented by the leading public-interest watchdog group Public Citizen, are the key to understanding the Enron debacle.

Back in 1993, when Enron was an upstart energy trader and Wendy Gramm occupied the position of chair of the CFTC, she granted the company, the biggest contributor to her husband's political campaigns, a very valuable ruling exempting its trading in futures contracts from federal government regulation.

She resigned her position six days later, not surprising given that she was a political appointee and Bill Clinton had just defeated her boss, the first President Bush. Five weeks after her resignation, she was appointed to Enron's board of directors, where she served on the delinquent audit committee until the collapse of the company.

There was perfect quid pro quo symmetry to Wendy Gramm's lucrative career: Bush appoints her to a government position where she secures Enron's profit margin; Lay, a close friend and political contributor to Bush, then takes care of her nicely once she leaves her government post.

Although she holds a doctorate in economics and often is cited as an expert on the deregulation policies she so ardently champions, Gramm insists that while serving on the audit committee she was ignorant of the corporation's accounting machinations. Despite her myopia, or because of it, she was rewarded with more than $1 million in compensation.

...

And here's some more on the http://archive.salon.com/tech/feature/2002/02/05/funny_money/print.html">Enron's enabled shenanigans in the derivatives market:

Risky business
How did Enron break into the elite Wall Street world of bankruptcy insurance?

- - - - - - - - - - - -
By Damien Cave

Feb. 5, 2002 | Congressional investigations, class-action lawsuits, campaign contributions and 401K reform. Paper shredding, books cooking and wives crying for "Today Show" cameras.

Enron's collapse has generated so many huge stories that it's been easy to miss one of the most ironic and self-revealing of all its myriad ventures. Enron, now famous for the largest corporate bankruptcy in American history, was also a big player in the relatively new market for buying and selling bankruptcy protection.

Enron's whiz kids dabbled in a wide variety of high-finance maneuvers. But its presence in the market for what are technically called "credit derivatives" was eye-opening -- or should have been, to anyone paying attention. The credit derivative game is dominated primarily by huge banks -- just seven institutions handle 96 percent of the multibillion-dollar business.

With good reason. Credit derivatives are designed to minimize risk. They are, in their simplest form, insurance policies on other assets. By buying a credit derivative, a bank, for instance, will pay another entity to assume the risk of a loan that it fears will not be paid back. If its hunch proves correct, the seller of protection will have to cover the loan. Since credit derivatives carry the potential for sudden, huge payouts, buyers rarely want to purchase credit derivatives from a risky provider. So sellers tend to be big and rich enough to handle large defaults without going bankrupt.

So what was a supposed energy trader from Texas doing in a market that epitomized Wall Street? According to derivatives experts, the Houston company bluffed and cajoled its way to the table, pretending to be bigger and more stable than it really was. At the same time, it used its formidable lobbying power in Washington to ensure that federal oversight over precisely this type of market was to all practical purposes nonexistent, and then proceeded to screw it up on a vast scale.

Operating without a net -- or a watchdog -- Enron trotted into one of the world's most complex financial arenas and made a colossal, billion dollar mess, inserting risk into a market designed specifically to avoid it. According to Standard & Poor's, the credit rating agency, Enron's collapse has thrown at least $3 billion worth of credit derivatives contracts into limbo. So far, Enron's bankruptcy hasn't set off a wider financial panic, but according to some experts, the credit derivatives fiasco nevertheless reveals larger systemic problems. The company's push into credit derivatives not only proves that it's possible to dupe some of the best financial minds in the world, but it also exposes potentially dangerous loopholes in the U.S.'s financial regulatory system. The SEC regulates the investment banks that typically dominate credit derivative trading. But Enron wasn't a bank -- so it escaped supervision.

Because derivatives markets are easy to enter and disclosure rules are weak, some experts believe that it's only a matter of time before another rogue derivatives player surfaces, fails and sends even greater shock waves through the system.

"There are other potential time bombs ticking," says Michael Greenberger, a law professor at the University of Maryland and the former director of trading and markets at the Commodity Futures Trading Commission (CFTC). "We don't know how many other companies like Enron are out there."
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Refco was apparently one of those other companies like Enron, although it http://www.post-gazette.com/pg/05292/591299.stm">wasn't a big player in the credit derivatives market, which is fortunate considering it has http://www.bloomberg.com/apps/news?pid=20601039&refer=columnist_gilbert&sid=a_PxZwWboMT8">grown to a $20 Trillion market this year, it was http://www.cfo.com/article.cfm/4477500/c_4477613?f=home_todayinfinance">growing at a 128% annualized rate in the first half of 2005, and Warren Buffet has termed them http://www.fenews.com/fen33/one_time_articles/mar_hedge_conference.html">"Financial weapons of mass destruction".

...
The term "derivatives" is used to describe a class of financial contracts that are derived from another asset and priced according to that asset's value. Also known as a form of "risk management," over the past 20 years derivatives trading has become increasingly popular on Wall Street as a way to "hedge" risk; to protect yourself from an investment bet that goes sour or from swings in interest rates or currency prices. Over the course of those 20 years, the debate on whether to regulate such trading has been one of the more abstruse battlegrounds between Washington and Wall Street -- and Enron has been a major player in that fight.

One of the first derivatives to gain popularity in the newly deregulated financial markets of the 1980s was the "interest-rate swap," which takes its value from underlying loans. Interest-rate swaps allow a bank that has, for example, a majority of variable rate loans to protect against the risk of falling interest rates -- which would decrease borrowers' payments and thus bank profits -- by "swapping" the loans for fixed rate debts held by another bank. The actual loans never change hands; the contract allows the banks to trade only the interest-rate risks, with the price of the deal being determined by the size of the loans and the probability of interest-rate fluctuations. If it looks like the Federal Reserve will raise rates, the fixed-rate bank will pay a higher premium. But if the Fed signals a cut, the bank with a high level of variable rate loans will pay a larger fee.

New kinds of derivatives are constantly being dreamed up by everyone from Nobel Prize laureates to MBAs fresh from the finest business schools. It is hardly an exaggeration to call derivatives the cutting edge of capitalism, the fanciest way humans have yet devised to gamble for big bucks. Credit derivatives, specifically, are one of the more recent products of this high-finance drive to innovate. For a company like Enron, which considered itself able and willing to trade anything, bankruptcy protection was just another commodity.

Dreamed up about 10 years ago in order to protect banks from risky borrowers, credit derivatives extended the concept of risk trading to all forms of credit risk, not just interest rates. They grew from a simple mix of reality and logic: "When you have a portfolio of loans, some are strong and some are weak," says Kathryn Dick, director of treasury and market risk for the Office of the Comptroller of the Currency, a division of the Federal Reserve. "Trying to keep a good balance, that's what started the thinking that became credit derivatives."

Large investment banks, led by J.P. Morgan, began to tout the idea in the early '90s. The first "products" focused specifically on bank loans. "Credit default swaps," for example, gave a bank in the Midwest that had mostly manufacturing loans -- which are especially sensitive to business cycles -- the ability to insure its debt by paying a New York bank to take on the risk of default. If the borrower couldn't pay, the New York bank ponied up the cash.

Each player in this equation has an incentive to make a deal. The mediator, or trader, bringing both sides together picks up a percentage of the price paid; the firm buying protection gains the ability to extend more credit without holding onto the risk, while the firm selling protection brings in extra cash by agreeing to cover for loans that it thinks it won't have to cover.

Banks also enjoy other advantages from the use of credit derivatives. If a bank sells a loan to another bank -- an older way to get rid of risk -- it then must inform the borrower that the loan has been picked up by another party. But because credit derivatives are not actual assets but rather meta-level contracts, lenders can keep the loans on their books without telling borrowers what's going on behind the scenes.

"One of the reasons that banks like credit derivatives is because of the way that the financial world has evolved," says Dick. "Banks now have very large corporate clients. They don't want to keep all of that exposure, but they want to maintain a relationship with the client. Credit derivatives let them do that."

Even with these incentives, many banks at first hesitated to buy or sell protection on their own loans, bonds or other securities. The pricing models were untested. The laws surrounding the new product remained murky. The Commodities Futures Trading Commission had exempted credit derivatives and other swaps from federal oversight in 1993, but because each contract was tailor-made to the deal at hand (instead of traded on a formal or over-the-counter exchange), the language of the contracts tended to vary too much for the bankers' tastes. It wasn't clear what would hold up in court in the case of a "credit event" like a bankruptcy.
...

It appears that the credit derivatives market is still lacking in oversight. In October of 2006, http://www.iht.com/articles/2006/10/10/bloomberg/bxinsider.php">Bain Capital was amongst the players using credit derivative in manner implying insider trading, prompting calls for more oversight.

"The problem with the market then was that the contracts were all different," says Mickey Mandelbaum, a spokesman for Morgan Stanley, which began researching credit derivatives in 1994. "There was a big joke that the busiest person on the derivatives desk was the lawyer."

Big investment banks eventually managed to standardize the contracts. J.P. Morgan and Credit Suisse launched credit derivatives products lines in 1997. Others followed, and in 1999 the International Swaps and Derivatives Association (ISDA), the industry's trade group, issued formal rules. The market began to quickly swell. In 1997, $55 billion in debt was covered by credit derivatives contracts; by the fourth quarter of 1999, that figure topped $287 billion.

The massive run-up spawned a recapitulation of age-old debates. Proponents of financial innovation argue that products like credit derivatives are nothing less than tools of progress -- market-oriented weapons that protect against instability and risk. But critics contend that new, untested markets always give con men and unscrupulous wheeler-dealers more room to hide.

Altogether, by the end of 1997, derivatives contracts represented more than $25 trillion in real assets. The question of whether the government should regulate the market or let it grow, untethered by red tape, began to heat up, fueled by some high-profile derivatives failures.

"Congress started saying that we need to regulate this stuff," recalls Greenberger, who was then the director of trading and markets at the CFTC. "Dingell wanted to introduce legislation creating a derivatives exchange."

Enter Enron. The energy trader was fast leaving behind its commodity trading and delivery roots, and moving ever more aggressively into the world of pure finance. Enron, unsurprisingly, opposed the formalization of derivatives regulation. In April 1993, aggressive Enron lobbying had encouraged the CFTC to grant a broad exemption to the trading of energy derivatives, in which electricity dealers and wholesalers sign contracts that let both sides hedge against future price swings. But energy derivatives were just one front on which Enron's executives were advancing.

"They had an exciting agenda," said one East Coast finance professor who did some consulting for the company. Some of the brightest minds in finance and risk management wanted to work with Enron because, he said, "they were trying to move forward."

Wall Street also opposed derivatives legislation, but for slightly different reasons. The big banks argued that new laws would be too costly. Derivatives were not like the futures contracts used to lock in prices on grain and other commodities, they argued, so the CFTC should leave them alone. The SEC seemed willing to go along.

There was one dissenting voice. Brooksley Born, a Clinton appointee who became the head of the CFTC in 1996, refused to accept the industry's stance. "In late 1997 and early 1998, she said the emperor has no clothes," says Greenberger. "She said that derivatives are futures contracts and that the CFTC had jurisdiction."

On May 7, in a 62-page report, the CFTC announced that changes in the derivatives market "require the commission to review its regulations." Born called for public comment and hearings.

But Enron refused to buckle. Protests from Wall Street's major players drew more attention than Enron's opposition, but a July 4, 1998, Washington Post article revealed that Enron was forging ahead at that very moment in an attempt to create an entirely new market for "weather derivatives" -- in which contracts on energy supplies would be dependent on bets as to whether the weather was hot or cold. Such contracts would be exactly the kind of new product that CFTC regulators would likely examine.

A handful of legislators, including Sen. Phil Gramm, R-Texas, kept the forces of regulation at bay. For Gramm, derivatives deregulation was a family affair: His wife, Wendy Gramm, chairwoman of the CFTC from February 1988 to January 1993, had earlier shepherded through the exemption that (in April 1993) let Enron trade energy derivatives without federal oversight. (A few months after passage of the exemption, she quit the CFTC and took a seat on Enron's board of directors.) Enron also found a set of allies in the U.S. Treasury Department, the Federal Reserve and the SEC. All three agencies, though headed by Born's fellow Clinton appointees, scorned the new CFTC proposal. They even issued a rare joint statement declaring that "we have grave concerns about this action and its possible consequences. We seriously question the scope of the CFTC's jurisdiction in this area."

Congress, caught in the middle of a regulatory turf war that involved some of the country's most generous campaign donors, also declined to show interest in regulation. It maintained this stance even as, in September 1998, the huge hedge fund Long Term Capital Management warned the Fed that, in part because of its derivatives strategy, it was about to go under -- and threatened to drag several major banks down with it.

But despite the link between LTCM and derivatives, calls for regulation fell on deaf ears. After organizing a bailout of LTCM, Fed chairman Alan Greenspan -- along with SEC chairman Arthur Levitt; William J. Rainer, Born's replacement at the CFTC; and Lawrence Summers, secretary of the treasury -- penned a 42-page report that favored less, rather than more regulation.

To get a sense of just how leveraged a company to get with the use of derivatives, http://mondediplo.com/1998/11/05warde2">check out these stats for LTCM before its implosion: $4.8 billion in capital, a $200 billion portfolio, and derivatives with a notional value of $1.25 trillion.

Alan Greenspan, it should be noted, has continued to be an outspoken opponent of derivatives oversight for years. In 2002, http://money.cnn.com/2002/09/25/news/economy/greenspan.ap/index.htm">Greenspan warned that "Regulation is not only unnecessary...it is potentially damaging". In 2005, following a series of http://sfgate.com/cgi-bin/article.cgi?f=/news/archive/2005/05/05/financial/f064101D68.DTL&type=business">accounting scandals involving mortgage giants Fannie Mae and Freddie Mac that included http://money.cnn.com/magazines/fortune/fortune_archive/2004/10/18/8188047/index.htm">improper accounting of derivatives, Greenspan once again warned against increased regulations (although he sort of http://www.washingtonpost.com/wp-dyn/content/article/2005/06/09/AR2005060902077_pf.html">back tracked on that the following month). Overall, it appears that the proponents of unfettered, unwatched growth in this crucial segment of the global financial markets have managed to maintain their dominance in the post-Enron environment.

…
Congress followed suit, passing the Commodity Futures Modernization Act in December 2000.

"The CFMA made it clear that this kind of trading would be exempted," Greenberger says. "Only a handful of congressmen and senators probably realized that they were enacting this deregulatory provision."

Brooksley Born "had it just right," and should be considered a hero, adds Martin Mayer, a finance expert and author of more than a dozen books on the U.S. banking system. "The whole political establishment, from Rubin and Greenspan and Levitt and Phil Gramm, turned on her."

And Enron forged on, stepping up its involvement in derivatives markets dramatically. The company's spokespeople failed to return calls for comment; Born also refused to comment because her law firm now represents several Enron creditors. But observers argue that the CFMA essentially let Enron move forward with its plan to aggressively court derivatives buyers and sellers.

By the end of 2000, a year after the launch of Enron's Web-based trading site EnronOnline, the company's derivatives business had more than quintupled in a single year. Assets increased from $2.2 billion to $12 billion; derivative-related liabilities increased from $1.8 billion to $10.5 billion.
…

In November of 2004, the http://www.ieca-us.com/about.html">Industrial Energy Consumers of America (IECA) demanded a reversion back to the pre-2000 CFMA policies,http://www.energyrisk.com/public/showPage.html?page=199322">asserting "The markets worked very well until 2000, but volatility went through the roof when the CFMA came into force in 2000".

…
It's not clear how much of this growth came from credit derivatives, although S&P's finding of $3.3 billion in exposure at Enron suggests that it played a major role. But regardless, Frank Partnoy, a law professor at the University of San Diego who cited Enron's derivative growth figures in testimony before Congress on Jan. 24, argues that Enron should never have been able to become such a powerful derivatives player. The financial and government institutions that protect the financial markets shouldn't have let the company gain so much as a foothold, he says.
"The collapse of Enron makes plain that the key gatekeeper institutions that support our system of market capitalism have failed," he told the Senate Committee on Governmental Affairs. "The institutions sharing the blame include auditors, law firms, banks, securities analysts, independent directors and credit rating agencies."
Specifically, Partnoy argues that the derivatives market is too easy to penetrate because all that's required is "credit worthiness and decent reputation." If one of the nation's three credit-rating agencies -- Moody's, Standard & Poor's or Fitch IBCA -- give a company an investment grade rating, it can essentially act like J.P. Morgan Chase or Citigroup, two of the world's biggest banks. But Enron was able to offer credit without being required to keep a set amount of capital in place, as banks are. And whereas traders dealing with securities or futures contracts must pass difficult licensing exams, companies that trade only in derivatives often can do as they please.
Enron managed to become a major player in the derivatives market not just by taking advantage of these loopholes. The company also built up its reputation through a mix of deceit, hobnobbing and bravado. Its high credit rating was maintained by hiding billions of dollars of debt in off-balance sheet partnerships. Its gravy train included prominent economists, politicians and journalists. By dint of ceaseless self-promotion, executives like Ken Lay and Jeffrey Skilling made Enron's name synonymous with successful financial innovation.
…

Yep, in a market where “credit-worthiness” that, itself, can be created through shoddy accounting and can translate into hyper-leveraged financial clout, successful fraudsters can reign supreme. Like so much in our world, the financial sector is increasingly a system of trust…wildly misplaced and abused trust.

…
Investment bankers now speak with derision of Enron's arrogant attempt to invade the turf of the big boys. And many in the investment community are quick to separate themselves from Enron's taint. The fault for Enron's collapse lies with Enron, they argue -- not the lack of regulation. The company gamed the system and paid the price. New rules, they stress, would only punish the innocent companies with higher costs and more red tape. The lesson of Enron's collapse is not that government needs to save the markets from themselves, but rather that bad companies fail, says Nik Khakee, director of Standard & Poor's structured finance derivatives group.
"Some people would argue that it's good for there to be more players in the derivatives market, but you need to make sure that they're all operating under an accepted set of rules," he says. Enron, he implied, made up its own rules.
Proponents of credit derivatives, in particular, dismiss the idea that Enron's fall has any larger systemic importance. Enron's derivatives will simply be redistributed, they argue. In fact, Enron's involvement with credit derivatives should be seen as "a bright spot," according to William Harrison, CEO of J.P. Morgan Chase, who defended them on Jan. 16, according to a Financial Times report. Without credit derivatives, Harrison and others have argued, Enron's $33 billion debt default would have been more highly concentrated, forcing banks that had a direct relationship with Enron to lose massive amounts of money, or close.
…

Let’s hope JP Morgan doesn’t see a lot of systemic risks with derivatives…http://www.forbes.com/reuters/newswire/2004/03/31/rtr1318534.html">as of 2004 they had a derivatives portfolio with a notional value of $36 trillion.

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In other words, credit derivatives make the system more stable, so as to prevent disruption when events as catastrophic as Enron's failure happen. But not everyone shares this view. Enron may not create a chain reaction of economic disruption by itself, but if dozens of companies engage in the same kind of practices, free from any kind of government oversight, a series of failures could threaten to undermine even the most stable banks and financial firms, Partnoy, Greenberger and others argue.
Clarifying disclosure rules may not even be enough to protect against another Enron, according to Greenberger. "You need to have some sort of regulatory structure," he says, noting that banks have federal examiners in-house. "You can debate what kind of structure to put in place, but you need stronger enforcement because financial statements are not going to protect the public from imprudent, unsound or fraudulent practices."
Ultimately, as Partnoy pointed out in his testimony, "Congress must decide whether, after 10 years of steady deregulation, the post-Enron derivatives markets should remain exempt from the regulation that covers all other investment contracts."
As Partnoy noted in his Senate testimony, the gatekeepers failed, and their continued failure may set the stage for even greater economic distress. Enron's derivatives adventures, ultimately, leave us with one major, and as yet unanswered, question. Who will guard the gatekeepers?

Who will guard the gatekeepers? That’s a good question and one of many raised by this Refco mess.