In their ghoulish way, Wall Streeters are preparing for the next down cycle in the economy, which they think of as an ??06 issue.? Those among them who did well investing in distressed energy assets the last time around, or selling consulting, credit-rating, or advisory services, are looking at the electricity business again, trying to decide how the outlook has changed and where they should place their bets. In some ways, highly leveraged power companies are in better shape than last time?in that the dangerous part of the maturity schedules has, for many, been pushed out to 2008 and beyond. Also, the demonization of power traders is no longer appealing; the books and documentaries you?re seeing this year were commissioned a couple of years ago. In the next recession, it?ll be people from some other industry who?ll be dragged through the streets to the guillotine. That means the regulatory risk isn?t as great for the industry as it was between 2001 and 2003. However, the Street?s best-case scenario has another couple of major bankruptcies in the power world. This won?t cause the same disruption to power trading as the demise of Enron did, though, because energy trading has, to a significant degree, been taken over by the financial companies. Those banks and securities dealers?backed up by the Fed?have a less gun-slinging approach to managing risk than the operating companies did. Independent system operators, including?or, rather, especially?CAISO have a very strict and systematic approach to reducing counterparty risk, which means there aren?t going to be credit-crisis-induced blackouts such as those of 2001. There are, however, some financial supports for the power industry that were in place during the last crisis that won?t be there this time. One, obviously, was the portfolio of wonderfully overpriced Department of Water Resources contracts, now nearly run off. The other?not so visible to either policy makers or even industry people?was the then-rapidly growing market for credit derivatives. ?If it hadn?t been for the CDS [credit default swap] market, a bunch of these companies couldn?t have refinanced,? I was told recently by a senior executive of a ratings firm. This requires a little explanation. Credit default swaps, which many policy people have never heard of, represent a trillion-dollar-plus market. They are a way to buy and sell insurance against a corporation or country defaulting on its debts, with ?default? now carefully defined after some earlier confusion. If you ?sell protection? against a default, you are taking the same risk as if you had bought a company?s bonds. If you buy protection, you are betting on a default, or hedging your portfolio against the possibility of default. For instance, a gas supplier to Mirant (now in bankruptcy) could have bought protection with a credit default swap against its net exposure. When Mirant went into Chapter 11, the gas supplier could have collected. Default swaps became popular because they can be traded more easily and faster than actual bonds. It?s easier to go short with a company?s credit in the CDS market, because you don?t have to go to the trouble of finding someone to lend you bonds, the first step in a short sale. In the last recession, a lot of capital was continuing to pour into the CDS market, which spilled over into providing more liquidity for the corporate bond market. That liquidity, or ease in finding buyers and sellers, and discovering a consensus on the price of bonds, made it much easier for banks and investment dealers to execute energy company restructurings on fairly easy terms. That was then. In March of this year, the unraveling of the auto companies? credit led to huge losses among the hedge funds that had speculated in high-risk bonds. The situation was made much worse by the complex ways in which the CDS and related markets had sliced and diced the risks in the auto debt. Come the end of this month, the hedge funds and investment company trading groups will be reporting huge losses on their credit portfolios. The pain will get worse when their disappointed investors withdraw capital in the following quarter and at year-end. This means that there will be less cheap money, and less of a CDS-market-provided cushion, for any energy restructurings that take place next year or in subsequent years. The other problem for gas-fired independent power producers is that operators of coal-fired plants are able to deeply undercut their pricing in the merchant market. I recently discussed this with Mark Morris, the chief executive officer of Ohio?s American Electric Power. He figured that in his service area, at least two years? of demand growth could be accommodated by further decreases in forced outages. After that, he told me, he intends to go out and buy some gas-fired capacity; I got the impression he didn?t think he?d have to pay up for the plants. Gas-fired IPPs in California, along with the state?s policy community, may think that the Schwarzenegger administration?s anti-global-warming program, as well as popular opposition to coal plants, will keep coal-fired power out of California. Well, take a look at the Supreme Court?s decision voiding state laws that prohibit the direct sale of wine by vineyards to consumers. Lawyers for coal-fired generators?and yes, they employ good ones?believe that this will prevent California from discriminating against the purchase of coal-fired power from out-of-state plants. That means that the new Western mine-mouth coal plants will pose a significant competitive threat to the California gas-fired generators. It?s a few years off, but any continuation of the gas reserve decline will bring that day closer. So while the electricity industry will have a better debt profile come the next recession and credit crunch, the end to its time of troubles is probably at least one economic cycle away. <i>?John Dizard is also a columnist for the <\/i>Financial Times.