JP Morgan Chase thought it had its Enron risks insured. Now it is fighting a legal battle to reclaim the money. The case raises wider questions about the effectiveness of credit insurance and the much-heralded convergence between banking and insurance. 

In one corner, JP Morgan Chase, the most blue-blooded and respected of America's banks. In the other, the cream of its insurance companies. At stake in this contest of the heavyweights, a $1.1bn bill, which the loser collects. The referee: the United States District Court, Southern District of New York. The date: February 27.

The issue between the two financial heavyweights is, at one level, the interpretation of a legal contract. But, at another, it involves a difference in style, structure and regulation of different industries. Wall Street observers are talking about no less than "a clash of financial civilisations", of the kind that markets will increasingly witness as banking and insurance converge to form a global capital market.

Particularly galling to JP Morgan is that among the insurers fighting the case - which include many great names of American insurance such as St Paul Fire and Marine, and Hartford Fire - are Travelers Casualty and Surety and Travelers Indemnity. The latter two, part of JP Morgan's deadliest rival Citigroup, are on the nail for $266m.

To add to its discomfort, JP Morgan has since discovered that Citigroup had introduced a well-timed hedging operation against its own $1.2bn Enron exposure. This involved the issuing of credit-linked notes, between August 2000 and May 2001, just when Enron's share price was beginning to slide. Investors' money was put into highly rated securities and was returnable if Enron's position remained stable over five years. A fixed coupon was paid on the notes. The scheme acted as an insurance policy for Citi because, if Enron went bankrupt, the bank kept the capital and the investors received nothing more than unsecured Enron debt.

Loser takes all

While Citi looks well-covered on its Enron exposure, JP Morgan appears exposed. But is this because JP Morgan understood and managed the risks less well than its rival, or was it entitled to expect that the insurance companies would stand by it? The wider question is: if insurance companies always rush to court to dispute a payout, should banks really be using this type of credit insurance in their risk management armoury?

The insurance policy in question was not a sophisticated structure based on credit derivatives of the type that is worrying regulators. They fear that insurance companies investing their capital in bonds backed by credit derivatives do not themselves understand the risks involved. The JP Morgan/Enron case is different.

This involved the bank, through its offshore entities Mahonia and Mahonia Natural Gas, paying a premium to the insurers, and the insurers offering cover against an Enron default. This is a standard-style insurance contract whereby the insured party pays a premium in return for risk cover relating to some kind of negative event.

Tooth and clause

The surety bonds, as they are called, came with a clause, which looked plain enough in June 1998 as Enron was a high-flying company, stating that: "The surety bonds guarantee obligations of Enron Natural Gas Marketing Corp and Enron North America Corp under certain natural gas and oil forward sales contracts with Mahonia."

Now that clause is proving critical. The contracts are of particular concern to JP Morgan, as the bank relies on the satisfactory completion of the energy contracts to obtain reimbursement in full of a $2bn loan it had made to Enron, the US energy trading company. The repayment stream was only half completed when Enron filed for Chapter 11 on December 7, 2001. The bank's exposure related to the insurance cover when the energy trading ceased due to Enron's collapse has been estimated by the bank at $965m. Outstanding letters of credit account for the difference between that sum and the $1.1bn that JP Morgan is demanding from the insurers. JP Morgan sees this clause in the surety bond as its best hope of retrieving something out of the Enron ashes. The insurance companies, which refused to comment on the case, are arguing that the contracts are defective in some way and were disguised loans. This suggests that they consider they were insuring something much more specific than broad credit risk.

Ray Soifer, an independent New York financial consultant, says: "The insurance companies considered the contracts to be defective. They said they were disguised loans and not derivatives contracts they originally agreed to. In the eyes of the insurers and their lawyers, the contract of insurance was not valid. Obviously, JP Morgan has a different view."

"Under no circumstances"

JP Morgan executives refused to discuss the case with The Banker on the record. But one JP Morgan executive, who asked not to be named, said: "The insurance companies are refusing to pay even though in the original contracts, the wording is iron clad. It says "under no circumstances" are the insurance companies allowed not to pay, not to back up the surety bonds. The insurance companies knew what they were doing. They have very smart people that work there and either you take credit risk or you do not." JP Morgan's line has found favour with other Wall Street banks. Wayee Chu, a banking analyst at Merrill Lynch in New York, is in no doubt. "We take the part of Morgan. It is guaranteed. Nothing seems to counter why they would not sue its insurers. It expects payment back from the insurers, the surety bond guarantees that, so how can that not be secure for Morgan?"

But sources close to the insurance industry argue that the contract may not be quite as clear cut. There are grey areas over which the lawyers can argue. One says: "The insurance companies are claiming that their sureties were not given against Enron going bankrupt; it was given against the fact that Enron may not deliver gas or electricity or whatever power it provides." Others in the industry say this legalistic form of argument is typical in disputed insurance cases. A risk manager at Citibank, who, despite the banking rivalries, has sympathy for JP Morgan, says: "The bond holders are trying to wriggle out of it. I would think that Morgan had right on its side. The reason you are paid a large coupon is that you assume the credit risk, and that is the trade-off. That is pretty clear for a court to uphold." The first court hearing is on February 27.

Playing the game

A source inside JP Morgan in London dismisses out of hand the insurance case. "It is the nature of the insurance industry to contest every claim, wherever it feels it is possible to do so. It literally does a cost-benefit analysis about what is the cost to pay up now or the cost to litigate or settle out of court. So, sadly, it is not at all unusual for the industry." John Manion, a principal at actuary Towers Perrin in London, says: "Where there is a legal question over what the insurance policy covers, the insurer asks: 'Is this a claim we are required to pay under the terms of the policy?' If there is a reasonable chance that it is not, then they will argue it out in court."

Disputes of this kind between banks and insurers are set to become much more frequent, observers say, as globalisation of capital grows apace. Banks' eagerness for access to insurers' pools of capital and insurance companies' need to enhance returns pull the two sides together, but differences in business culture could threaten to pull them apart without speedy regulatory intervention. Barry Hancock, a managing director at Standard & Poor's Financial Services, says: "We are seeing the final convergence between the insurance markets and the credit market."

The convergence is not without its complications for regulators either, say some observers. They note the warning issued recently by Sir Howard Davies, chairman of the UK's Financial Services Authority, about insurers' growing exposure to capital market instruments such as collateralised loan obligations (CLOs) and collateralised debt obligations (CDOs).

Sam Theodore, managing director and global banking co-ordinator at ratings agency Moody's, says: "Insurance companies have large investment portfolios, which they try to diversify as much as they can. So the world of insurance and the world of banking are inter-related, which is why insurers and bank regulators are increasingly concerned with the areas of co-mingling that do not seem to be regulated well by both parties." The issue is particularly acute in the US, where banking and insurance are separately regulated.

Different attitudes towards risk and pricing underpin the clash of cultures, says Mr Manion of Towers Perrin: "When insurers look at something, they try to work from the true cost of the risk. Insurance markets come down to principles of insurance. When capital markets look at it, they say 'what price will someone give me for it?' They can be very different answers."

Arbitrage between the capital and insurance markets has long been an established practice, but as JP Morgan's predicament indicates, the risks and costs need to be understood. JP Morgan is understood to have used the surety bond in the insurance markets to protect its exposure to Enron because it cost, according to one market observer, as little as 10% of the cost of a credit default swap. If so, this economy measure failed to take account of the quality of cover it was buying. An actuary at a leading London firm says: "Unless you go to the insurer and say 'here's the terms of the contract with Enron, we want you to mirror the contract we have with Enron so there will not be any chance of us losing money', there is always a chance of a mismatch.

"The insurance policy might say that if Enron defaults, you can make a claim. But legally, Enron might not have defaulted, something else might have happened legally. If that is another event, even though the impact is exactly the same, the actual event you are insuring for is not identical to the risk you are running."

Differing approaches

Insurance sources point to different approaches to interpretation of contracts that create obstacles for capital markets players involved in insurance activities. Treatment of risk is considered differently by the two sides. While insurers specify the risks they cover and those they decline based on documentary evidence established in law, capital markets transfer risks through appropriate pricing.

When there is a problem over a repayment, capital markets are more likely to strike deals over price to ensure some return of their investment more quickly, while insurers need to establish a principle that a claim is due, and will leave a claim outstanding while they complete this process.

Negotiating in such a minefield presents major problems for bankers who are expected to keep regulators, markets and shareholders informed quickly when problems and possible losses are expected. When JP Morgan's exposure to Enron was first put under the spotlight, on November 28, 2001, the bank said it was owed $900m. This was composed of $500m of "unsecured exposure to Enron entities, including loans, letters of credit and derivatives" and $400m secured by the Transwestern and Northern Natural pipelines.

By December 19, when the bank had examined its insurance policies, and taken on board the possibility that the insurance companies were going to resist paying out, exposure to non-performing surety bonds was put at $965m.

On top of that, but including the original $900m, the bank revealed exposure to Enron of $1635m. This was made up of a $250m for a "debtor-in possession" financing, a $165m letter of credit backing an Enron-related swap contract on which a 'European bank' was refusing to pay out, unsecured loans worth $620m and secured loans worth $600m. Total Enron exposure amounted to no less than $2.6bn.

Legal risk

The dramatic increase has led to widespread speculation about what went wrong. According to Professor Henry Hu, of the University of Texas at Austin, an expert in banking and finance law: "It seems that JP Morgan was surprised by the attitude of the providers of surety bonds. It appears to have been a legal risk that it had not taken into account. We are seeing here one of the more structural biases present in a lot of derivatives and exotic financial products. To the extent that there is this uncertainty, the potential for systemic risk is present. To the extent that some of these banks think they have transferred risk over to somebody else and it turns out not to be the case, there is the risk of potential disruptions."

Luigi La Ferla, a former managing director for international trade finance at Deutsche Bank, and now head of LTP Trade, is also critical of how bank managers in general approach credit insurance. He says: "A business manager in a bank wants to persuade his risk manager that the bank's exposure is guaranteed. An insurance policy is one way of doing this. But a good risk manager demands to see the policy and also gets a second opinion."

Conditional guarantee

"Insurance is never an unconditional guarantee and, if any bank thinks it is buying an unconditional guarantee, it is greatly mistaken. The moment it is not an unconditional guarantee, you cannot shift the risk out of the balance sheet. At most, the banks are getting a credit enhancement. Insurance is a protection against losses incurred when a contract is not fulfilled."

JP Morgan's case against the insurers has implications for the surety bond market more generally. Bankers say that if the bank loses in the New York court, the instrument will be badly, perhaps fatally damaged. The beneficiary is likely to be the credit derivatives market, which JP Morgan eschewed in this case. Some would even argue that the damage will go much further, leading to a rupture in relations between capital market operators and insurers. Convergence between insurance and capital markets will be damaged and the wider market suffer as a result. But S&P's Mr Hancock adds a calming voice: "Some institutions will lose, but it is unlikely to cause a general collapse in the system or cause any major crisis. Banking is in a much healthier position than it was 15 years ago."

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