The "Enron loophole" exempts most over-the-counter energy trades and trading on electronic energy commodity markets from government regulation.[1] The "loophole" is so-called as it was drafted by Enron Corporation lobbyists working with U.S. Senator Phil Gramm to create a deregulated market for their experimental "Enron On-line" initiative.[2]

The "loophole" was enacted in sections (h)(3) and (g) of the Commodity Exchange Act, 7 U.S.C. as a result of the Commodity Futures Modernization Act of 2000, signed by U.S. president Bill Clinton on December 21, 2000.[1] It allowed for the creation, for U.S. exchanges, of a new kind of derivative security, the single-stock future, which had been prohibited since 1982 under the Shad-Johnson Accord, a jurisdictional pact between John S.R. Shad, then chairman of the U.S. Securities and Exchange Commission, and Phil Johnson, then chairman of the Commodity Futures Trading Commission.

On June 22, 2008, U.S. Senator Barack Obama proposed the repeal of the "Enron loophole" as a means to curb speculation on skyrocketing oil prices.[3]

11) The entire CDS market was transformed into a huge casino. It is totally unregulated, and even the new steps by the New York State Insurance Commissioner, Eric Dinnallo, only covers the least egregious part of the market, where people actually have an insurable interest (i.e. hold the underlying bond). Regulation of this market was specifically prohibited under the Commodity Futures Modernization Act of 2001. That provision was slipped into the bill in the dead of night by our old friend Senator Phil Gramm of Texas -- now Vice Chairman of UBS (NYSE: UBS - News).

People use this market to bet on the credit worthiness of companies, and often hedge funds will hold both long and short positions on the same underlying credit. For example (NOTE: figures are made up here, not a reflection of the actual creditworthiness of GE), the hedge fund might make a bet that it is worthwhile to get $200,000 up front and be on the hook for $10 million if GE defaults sometime in the next five years. Then after a few months, GE raises a bunch of capital which significantly strengthens its balance sheet and lowers the risk of default, so it can make a bet with someone else who would now be willing to take just $100,000 to bet that GE will not go belly up within then next five years. The hedge fund could have a perfectly matched book, so in theory they were totally indifferent if GE survives or not.

However, suppose that one of the bettors goes bankrupt themselves and can't pay up. That hedge fund might then have a hard time paying its counter party. This is where the fear of 'cascading cross defaults' comes in.

All this is to say that the CDS market has seen more growth than practically any market in the history of mankind. It is currently at over $62 TRILLION, up from under $1 Trillion a decade ago. It would not take a very big percentage of that market to fail to leave a very big mark on the world financial system. When the dust settles from all the current mess, bringing this market under control has to be high on the agenda.

--------------------- end -----------------------

The following link and copy are from the NY Times of 11/25/08. There is a lot more information on Credit Default Swaps at the link.

From: http://topics.nytimes.com/top/reference/timestopics/subjects/c/credit_default_swaps/index.html?inline=nyt-classifier

Credit default swaps, which were invented by Wall Street in the late 1990's, are financial instruments that are intended to cover losses to banks and bondholders when a particular bond or security goes into default -- that is, when the stream of revenue behind the loan becomes insufficient to meet the payments that were promised.

In essence, it is a form of insurance. Its purpose is to make it easier for banks to issue complex debt securities by reducing the risk to purchasers, just like the way the insurance a movie producer takes out on a wayward star makes it easier to raise money for the star's next picture.

Here is a more detailed, but still simplified explanation of how they work, given by Michael Lewitt, a Florida money manager, in a New York Times Op-Ed piece on Sept. 16, 2008:

"Credit default swaps are a type of credit insurance contract in which one party pays another party to protect it from the risk of default on a particular debt instrument. If that debt instrument (a bond, a bank loan, a mortgage) defaults, the insurer compensates the insured for his loss.

"The insurer (which could be a bank, an investment bank or a hedge fund) is required to post collateral to support its payment obligation, but in the insane credit environment that preceded the credit crisis, this collateral deposit was generally too small.

"As a result, the credit default market is best described as an insurance market where many of the individual trades are undercapitalized."

The market for the credit default swaps has been enormous. Since 2000, it has ballooned from $900 billion to more than $45.5 trillion — roughly twice the size of the entire United States stock market. Also in sharp contrast to traditional insurance, the swaps are totally unregulated. (Note from Martin R. Carbone: The swaps were evidently not regulated because there was a tacit agreement by (a) Congress, (b) The Treasury Department, (c) The SEC, (d) The Federal Reserve (e) Two President(s), (f) Timothy Geithner, (g) Lawrence Summers, and (h) Alan Greenspan that the swaps were being traded by large sophisticated companies who (it was assumed) knew what they were doing and did not have to be protected from each other. Since the public and small companies were not involved -- there did not have to be regulation. It seems that all of the (a) to (h) entities referenced above overlooked the fact that a catastrophic failure of a very large company in a very small town would have enormous repercussions on the citizens of that small town and small businesses in that town. Similarly, It might have been expected that the failure of companies trading securities worth twice the size of the U.S. stock market might have caused some trouble for small companies and the general public. It is mind boggling that this possibility was overlooked.)

When the mortgage-backed securities that many swaps were supporting began to lose value in 2007, investors began to fear that the swaps, originally meant as a hedge against risk, could suddenly become huge liabilities.

The swaps' complexity and the lack of information in an unregulated market added to the market's anxiety. Bond insurers like MBNA and Ambac that had written large amounts of the swaps saw their shares plunge in late 2007.

Credit default swaps also played an integral role in the federal government's decision to bail out the American International Group, one of the world's largest insurers, in September 2008. The Federal Reserve concluded that if A.I.G. failed and defaulted on its swaps, throwing the liability for the insured securities onto the swaps' counterparties, the result could be a daisy chain of failures across the international financial system.

The next cell tells about Timohy Geithner and Lawrence Summers -- who seem to have been at the center of credit default swaps debacle.

November 25, 2008 / NY Times / Editorial
Mr. Obama’s Economic Advisers

In introducing his economic team on Monday, President-elect Barack Obama said that he had chosen leaders who would offer sound judgment and fresh thinking. Was that an order?

In various high-level government positions, Timothy Geithner, Mr. Obama’s choice for Treasury secretary, and Lawrence Summers, his choice for director of the National Economic Council, each have demonstrated a capacity for good judgment and good ideas.

Both served in the Clinton Treasury Department — Mr. Summers as secretary and deputy secretary and Mr. Geithner as a top aide — where they won high marks for helping manage the fallout of that era’s crises, (Note by Martin Carbone -- Did they have any part in causing those crises by lax management?) including the Mexican peso devaluation, the Asian financial meltdown, the Russian bond default and the collapse of the hedge fund Long Term Capital Management.

Both men, however, have played central roles in policies that helped provoke today’s financial crisis. Mr. Geithner, currently the president of the Federal Reserve Bank in New York, also has helped shape the Bush administration’s erratic and often inscrutable responses to the current financial meltdown, up to and including this past weekend’s multibillion-dollar bailout of Citigroup.

Given that history, the question that most needs answering is not whether Mr. Geithner and Mr. Summers are men of talent — obviously they are — but whether they have learned from their mistakes, and if so, what.

We are not asking for moral mea culpas. But unless they recognize their past mistakes, there is little hope that they can provide the sound judgment and leadership that the country needs to dig out of this desperate mess.

As treasury secretary in 2000, Mr. Summers championed the law that deregulated derivatives, the financial instruments — a k a toxic assets — that have spread the financial losses from reckless lending around the globe. He refused to heed the critics who warned of dangers to come.

That law, still on the books, reinforced the false belief that markets would self-regulate. And it gave the Bush administration cover to ignore the ever-spiraling risks posed by derivatives and inadequate supervision.

Mr. Summers now will advise a president who has promised to impose rational and essential regulations on chaotic financial markets. What has he learned?

At the New York Fed, Mr. Geithner has been one of the ringmasters of this year’s serial bailouts. His involvement includes the as-yet-unexplained flip-flop in September when a read-my-lips, no-new-bailouts policy allowed Lehman Brothers to go under — only to be followed less than two days later by the even costlier bailout of the American International Group and last weekend by the bailout of Citigroup.

It is still unclear what Mr. Geithner and other policy makers knew or did not know — or what they thought they knew but didn’t — in arriving at those decisions, including who exactly is on the receiving end of the billions of dollars of taxpayer money now flooding the system.

Confidence in the system will not be restored as long as top officials fail or refuse to fully explain their actions.

Mr. Summers does not face Senate confirmation; Mr. Geithner does. The senators should press him for the answers that have been lacking. That is the only way to understand his philosophy and approach going forward.

Congress must play a more active role in crafting, analyzing and continuously monitoring all bailout efforts — current and those to come. Unlike President Bush, who ceded far too much power to his treasury secretary, Mr. Obama must challenge and question his advisers’ recommendations and decisions. He has chosen tough advisers. He must be even tougher than they are.