- The Enron belly flop stunned almost everyone, but a
select
circle of Wall Street pros had an early warning system you can't
access.
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- Tyco, the Gap, Ford Motor Credit and Dow Chemical: Are
these the next corporate implosions waiting to happen? Maybe not, but
a little-known early warning system indicates they are entering dangerous
territory.
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- The warning system is an obscure electronic-trading
market where banks and other big players buy and sell credit-protection
contracts as an insurance policy against loans that might go bad. Lately
the price of such contracts is surging, for these companies and
others.
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- It's arcane stuff most investors could ignore, but for
this:This credit-protection market sounded alarms about Enron months
before
the scandal-scarred energy giant collapsed. Enron's stock didn't begin
its most breathtaking plunge until mid-October, when the company's
offshore
partnerships were uncovered. But two months before that the trouble signs
showed up in credit trading.
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- On Aug. 15, the day after Enron chief Jeffrey Skilling
abruptly resigned, Enron stock barely budged, closing just above the $40
mark. But on the same day, the price of an Enron credit contract jumped
18%. Contracts bought that day were priced at 185 basis points ($185,000
annually for protection against default on a $10 million loan). And by
Oct. 25, as the troubles sparked headlines, Enron stock had dropped more
than 50%, while the credit contract had soared in price to $900,000 per
$10 million annually.
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- Even at the much higher price, it was a great deal.
Just as Citigroup used the credit-protection approach to insure $1.4
billion
in loans to Enron, other banks and security firms shrewdly sidestepped
a big hit by purchasing credit-protection contracts on Enron.
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- "It's like taking out extra fire insurance just
as your house starts smoking," says Sunil Hirani, cofounder of
Creditex,
an intermediary in this relatively new game. "What's the biggest risk
in the financial system? Credit risk. Everyone has it. And it's the
least-managed
risk in the system."
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- Too bad credit-derivatives prices aren't published in
the paper like stock prices. You could have seen trouble brewing at Gap
well in advance of credit-rating downgrades (see chart, below).
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- http://www.forbes.com
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