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The Doomsday Scenario

Debt + secret triggers = another Enron.

Fortnightly Magazine - April 1 2002

reveal Mirant's cash flows, and therefore its ability to cover its obligations.

Moody's Investors Service and Standard & Poor's said in early February that they had asked several hundred investment grade companies to disclose their borrowings and trading agreements in a bid to avoid being blindsided by risks such as those that were caused by Enron, according to press reports. Enron stunned investors in November when it disclosed it had to pay off a $690 million note because of a recent downgrade. As a result, the credit agencies have demanded better disclosing of triggers.

Clifford Griep, S&P's chief credit officer, said the usage of such triggers have become so common that there is a need to incorporate triggers in the rating process. But as S&P and Moody's sort through hundreds of MAC clauses to incorporate in rating, what is to stop another credit agency downgrade from inadvertently causing another bankruptcy?

Doomsday: From Run on Bank to the Domino Effect? Widget Energy, a fictional merchant energy trading company, finds itself being compared by investors to Enron because of its use of mark-to-market accounting. This has led to investors calling Widget a "black box" like Enron because they feel that the company's earnings are not transparent to investors. This results in a visible decline in the company's stock value. At the same time, credit ratings agencies are concerned over Widget's large levels of debt that the company has accumulated due to its merchant power plant development program.

The drop in the stock and the downgrade of debt to "junk status" triggers a series of MAC clauses in the company's bank credit facilities and backup commercial lines. The company has to pay off a $700 million note. But because the stock has dropped, Widget has triggered another guarantee for another $200 million. Also, energy trading counterparts, due to the credit rating downgrade, are asking Widget to unwind all trades. Not having any other choice due to lack of access to capital, Widget declares bankruptcy.

But Widget is not the only merchant operator to see its stock drop and its credit rating decline. The credit ratings agencies, due to multiple downgrades in the sector, have inadvertently caused MAC clauses to be triggered in several other energy companies, leading to a credit crunch in the industry, or liquidity crisis. The liquidity crisis leads to multiple bankruptcies.

Could this scenario happen? At the Edison Electric Institute's International Financial Conference in London, chief financial officers I talked with were showing quite a bit of concern over their MAC clauses and how their companies were being perceived as a result of their use of mark-to-market accounting. One company, Dominion, outwardly boasted of what a small share its mark-to-market contracts were in number to other hedged contracts. In addition, other CFOs confessed they were actively swapping out their MAC clauses for other credit facilities that might be considered less onerous, focusing on reducing the number of triggers contained in contracts.

So, the industry is reacting to investors and credit agency concerns by paying-off debt, by selling off assets, and improving its