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The Doomsday Scenario

Debt + secret triggers = another Enron.

Fortnightly Magazine - April 1 2002

It's a nightmare scenario that used to keep only bankers awake at night. It's now a plausible scenario that should be keeping energy executives awake at night, as well.

Much the same way that bankers used to worry about a "run on the bank," where there is an overwhelming demand for liquidity that causes a solvent bank to fail, so should energy companies be worried that their use of material adverse change (MAC) clauses might trigger an overwhelming demand for liquidity that causes a once solvent energy company to fail. Of course, the banks now have the Fed to protect the financial system from a liquidity crisis. No such luck for the energy industry.

Some may say that the concept is preposterous, and that other energy companies have a greater asset base and bear no resemblance to Enron because of non-existent off-balance sheet partnerships.

But many energy companies have MAC clauses in credit facilities and backup commercial paper lines that could increase the company's burden in the event of a downgrade, such as by forcing it to pay off debt immediately or pay a higher interest rate. Other MAC clauses could be triggered by a company's falling share price. In fact, it was financial triggers that led Enron to losses when its stock price fell below a certain threshold.

The worry is that some energy companies, which are experiencing investor backlash for being in energy trading like Enron, are using mark-to-market accounting like Enron, or having high debt levels like Enron, are seeing their credit ratings downgraded and their stocks pummeled, unmercifully. The real question is will another energy company's fate be like Enron's? The answer depends on an energy company's MAC triggers embedded in contracts and credit lines, which are a mystery, except to trading counterparts, banks and, obviously, to the companies themselves.

Credit Ratings Agencies: Playing With Fire? It's not my business to tell credit rating agencies how to run their business. I know they have the bondholder's best interests at heart. But it appeared a bit dangerous to me, almost reckless, to be downgrading energy companies during December, January and February without fully knowing the consequence of those downgrades on companies.

Ever since the Enron bankruptcy, credit rating agencies have been quick to downgrade companies like Calpine, Mirant and Williams. How did they know that a downgrade wouldn't lead to bankruptcy? MAC clauses inherently change the risk proposition that a company may default on its obligations. Furthermore, rating agencies create a self-fulfilling prophecy when a downgrade to "junk" status tips the company into bankruptcy, which may mean that bondholders may not get their money back.

Susan Abbott of Moody's Investors Service told me that she has no problem with the energy trading and marketing business model, and feels that the industry has a future. But some changes have to be made, she adds.

For example, in the case of Mirant, she believes that the company has taken on too much debt and that the company's use of mark-to-market accounting does not adequately

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