The stench of Enron's accounting games may still be in the air, this time wafting through the credit-linked notes market - a warning to investors not only in the those complicated financial instruments but also in more plain-vanilla loans and bonds.

The ratings agencies were lambasted after the fall of Enron for not picking up on the energy firm's accounting trickery sooner, and recently questions have been raised about their surveillance of developing markets. That criticism may have played a part in prompting Fitch Ratings to issue a report recently that describes so-called self-referenced credit-linked notes, and to raise related concerns.

Roger Merritt, a managing director and co-author or the report, said evidence of the transactions was, for the moment, still scant.

"Anecdotally, we believe it to be a more recent phenomenon, more prevalent over the last few years. But it's completely unclear how significant it is to the overall market," Merritt said.

Indeed, Fitch notes in its report that it intends to survey market participants in an effort to gauge the prevalence of self-referenced CLNs and other structured securities with imbedded credit derivatives, and it "expects to make appropriate adjustments to liquidity and capital measures as needed."

The self-referenced CLNs are problematic because a borrower issues a credit-linked note - a security with a credit default swap embedded in it - and essentially sells protection on its own name. Typically, a third party sells that protection, so that if the borrower runs into problems and defaults on its debt, a party unrelated to the borrower holds the obligation to reimburse the protection buyer, much like an insurance claim. In the case of self-referenced CLNs, the borrower has collateralized a special purpose vehicle, typically with its own capital, to act as the protection seller.

"What makes these instruments unique is the company buying ... the credit risk is buying the credit risk on itself," Merritt said, noting, "So if a company is buying a note paying a stated return, and something happens to the company's credit profile, then the payout [the company must pay] on that note is linked to the credit performance of that company."

That means the company essentially becomes its own creditor. That could leave the credit protection buyer in the lurch, since it is buying credit protection on a credit, say a loan, issued by the very company that is obligated to repay it under the terms of the credit-linked note, if that company experiences an adverse credit event. In fact, a self-referenced CLN could accelerate the company's credit deterioration, Merritt said.

An investment manager of money market funds at a major mutual fund company said he has dabbled s in credit-linked notes, but generally stays away from more complicated instruments. Indeed, he described investing in self-referenced CLNs as "stupid - you would never buy protection from the guy you bought the underlying note from." He added, however, that the relationship may be obscured by an SPV issuing the credit-linked note, since while the SPV was set up by the borrower, without proper due diligence its origins may remain hidden. He added that more aggressive investors, like high-yield funds and collateralized debt obligations, might not be able to afford the time for such due diligence.

Copyright 2004 Thomson Media Inc. All Rights Reserved.

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