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Indeed, that so many firms were able to manage their Enron credit exposures despite Enron’s misleading financial statements suggests that the Enron debacle is a success story in credit r

Credit Risk

Mitigation after Enron

2 1 1

11

CR EDI T R ISK M ANAGEMENT LESSONS FROM ENRON

C HRISTOPHER L C ULP

As of June 1999, Enron had disclosed $34 billion in assets on its

balance sheet, but another $51 billion in assets—many of which were troubled or impaired—lay hidden in Enron’s unconsolidated special purpose entities (SPEs) As explained in Chapters 2, 8, and 10, these abuses of structured finance were not limited to concealing invest-ment losses Enron engaged in similar malfeasance to project an artifi-cial image of finanartifi-cial resilience by camouf laging its total indebtedness

At the end of 1998, Enron had $7.37 billion in long-term balance sheet debt, but borrowing by unconsolidated Enron SPEs accounted for another

$7.6 billion in leverage.1

Politicians and media commentators have been quick to argue that Enron represents a significant malfunction in the process by which firms self -police and monitor one other As a result of this perceived “market failure” of credit risk management, greater regulations on accounting, disclosure, and financial transparency have been recommended, as well

as heightened direct supervision of certain market participants by their regulators

Credit risk management is the process by which firms attempt to mon-itor and control the potential for unexpected losses arising from an obligor’s unwillingness or inability to honor all of its commitments Despite

an apparent unawareness in many cases of Enron’s fraudulent activities, few firms dealing with Enron regarded the company as a “good” credit risk Thanks to the proliferation in the past decade of financial products and techniques enabling firms to reduce or transfer away certain credit

exposures, many firms doing business with Enron had taken consider-able steps to reduce their Enron exposures well before news of Enron’s troubles became public This widespread use of credit risk transfer prod-ucts also helped spread Enron credit risk fairly evenly around the global capital markets, thus preventing a significant buildup of Enron credit concentration in any single industry that might have made Enron’s fail-ure significantly more disruptive to global financial markets than it ac-tually was Indeed, that so many firms were able to manage their Enron

credit exposures despite Enron’s misleading financial statements suggests that the Enron debacle is a success story in credit risk management, not

a failure

This chapter begins with a brief review of the nature of credit risk The techniques used by market participants to manage their credit risks are reviewed The introduction of credit risk mitigation products is brief, but Kramer and Harris provide significantly more discussion of these so-lutions in Chapter 12 The next section then examines where Enron’s fail-ure appears to have precipitated credit losses, as well as examining where,

thanks to successful credit risk management, losses did not occur The

final section provides some concluding policy observations

TH E NATU R E OF CR EDI T R ISK

Credit risk exists only for assets When a company owes money, services, or

assets to another firm, the insolvency of the counter party does not affect

the original obligation But when a company is owed, the inability or

un-willingness of an obligor to honor its commitments can translate into losses.2Credit risk has two components: the likelihood of default by the obligor and the amount that will be lost if a default does occur The

lat-ter is often called the loss given default (LGD) or credit exposure of an

asset or obligor

An important determinant of a f irm’s credit exposure is what that firm can recover from a counter party in the event of a default For sim-plicity, assume the default occurs because of insolvency Insolvency laws in different countries then govern the recovery process, and claimants ini-tiate that process by filing claims with the insolvency trustee

Secured obligations are those for which collateral has been specifi-cally pledged to cover any default-related losses—for example, a real es-tate loan that allows the lender to repossess an underlying piece of property if the borrower fails to make a promised payment Assets that have been pledged as collateral must be applied to the obligations they se-cure and cannot be used to honor other outstanding obligations of the defaulting firm

The amount a firm can recover on an unsecured claim depends on

the value of the defaulting f irm’s remaining assets and the priority of claimants on those assets Bank debt, for example, is often senior to other obligations The proceeds from the liquidation of the defaulting firm’s assets thus must be used to pay off banks and other senior creditors en-tirely before any lower priority claims can be honored Junior unsecured creditors often recover only a pro rata portion of the remaining assets of the insolvent firm after all senior claimants have been made whole The credit exposure on traditional assets (e.g., coupon bonds) is typ-ically known over the whole life of the transaction, at least to a first ap-proximation Contracts such as oil and gas forwards and swaps, however,

can be either assets or liabilities depending on movements in oil and gas

prices since the transaction was initiated

When a counter party to a derivatives contract becomes insolvent or defaults on a required obligation, the contract is generally either “accel-erated and terminated” or “assigned.” In the former case, all remaining payments and/or deliveries on the contract are accelerated to the present and marked to their current market values A single net termination oblig-ation is calculated and either is due from the nondefaulting party or be-comes a general unsecured claim of that party on the remaining assets of the insolvent firm

If a derivatives counter party wishes instead to preserve its contract rather than accelerating and terminating it (e.g., to guarantee the subse-quent physical delivery of an asset), the original counter parties and a sol-vent third party can all agree to an assignment of the old contract The contract is first marked to its current replacement cost (i.e., the cost of ne-gotiating a contract with the same terms at current market prices) and be-comes either a payable or receivable of the insolvent firm Unlike before,

however, the contract is not accelerated or terminated; all remaining

de-livery and payment obligations of the insolvent firm are assigned to the new third party Because the contract has been marked to its replacement cost,

no payment is required to effectuate such a transfer, and the contract then runs on as before between the nondefaulting party and the new third party

CR EDI T R ISK M A NAGEM EN T TEC HNIQU E S

As Palmer explains in Chapter 13, some f irms have a “credit culture” and others do not One aspect of a credit culture is the existence of a business unit within the firm whose objective is to monitor and perhaps manage credit risks assumed in the normal course of the firm’s business Historically, banks and insurance companies have had such divisions, whereas credit risk management is a newer arrival in the world of

investment banking—and a very new arrival in industries such as power

marketing, as the example in Neves’ Chapter 4 of the U.S electricity market credit crisis of 1998 illustrates

Not surprisingly, the process by which f irms actively manage their credit risk differs widely across types of firms Nevertheless, this process invariably includes three common components discussed in the following sections

De fault Risk Monit or ing

Predicting the failure of another f irm is essentially impossible Even with perfect financial disclosure, firms are subject to uncertain and ran-dom financial market movements whose impacts can never be perfectly anticipated Nevertheless, monitoring the financial strength of obligors

is an essential component of the credit risk management process at least

to develop some idea of how likely it is that a firm can honor all of its obligations

Direct Monitoring Financial institutions—banks and insurance companies, in particular—typically rely on internal systems to estimate or rank the default risks of their counter parties Internal rating systems en-compass a wide range of methods, some of which rely almost exclusively

on the subjective judgment of credit off icers and others of which rely more on default risk models that infer default probabilities from a firm’s published financial criteria, external ratings, industry characteristics, eq-uity and asset volatility, and the like.3

Firms with signif icant credit-sensitive exposures to a given f irm, moreover, often take internal monitoring beyond a review of public in-formation Due diligence, credit analysis, and ongoing credit surveillance

of the obligor are all hallmarks of a well-developed credit risk monitoring process These activities often include on-site inspections, interviews with key personnel at the obligor, a review of internal financial and risk man-agement documents, and the like

External Monitoring For many firms, an independent credit analy-sis division is a luxury that the size and nature of their credit exposures cannot justify Gas pipeline customers of Enron, for example, probably did not have internal credit departments Such firms tend to rely instead on ex-ternal monitoring to track their credit risks Exex-ternal monitoring occurs when one firm relies on the credit analysis of a professional credit moni-toring service for its information about the default risk of its obligors

The most prominent external credit monitors are the rating agencies, although firms sometimes also look to external auditors (e.g., resignation decisions) and regulatory agencies (e.g., enforcement actions) for addi-tional credit information External monitors frequently use methods com-parable to the internal credit risk analysis divisions of banks and insurance companies Default modeling, due diligence, on-site investiga-tions, and ongoing surveillance are all undertaken at some level by ex-ternal monitors

Delegated Monitoring Delegated monitoring is based on the belief that

banks have (or at least had when the theory was developed) a comparative advantage in assessing the credit risk of their customers A senior bank lender’s decision to roll over an unsecured revolving line of credit thus

“sends a signal” of ongoing borrower creditworthiness and abrogates the need for relatively less -informed creditors such as bondholders to under-take an independent credit assessment of the borrower (Diamond, 1984; Fama, 1985; James, 1987; see also Diamond, 1991; Rajan, 1992)

Delegated monitoring, then, is the reliance on signals from senior un-secured creditors about the credit quality of their obligors as a substitute for engaging in independent credit risk analysis This type of delegated monitoring is frequently combined with at least some reliance on exter-nal monitoring, as well

Delegated monitoring is not only beneficial for those firms wishing to avoid the costs of performing their own credit risk monitoring, but also can be very sensible for the firms being monitored that want to avoid

mul-tiple repetitive credit checks by outsiders The incentive to be a delegated

monitor, however, is limited Because delegated monitors cannot explicitly charge the firms that rely on their credit analysis, delegated monitoring

of this type is essentially “free riding.”4

Exposure Limits

Although the default probability of a potential obligor can and should

be monitored, only the obligor can take actions to change its default

prospects The credit exposure of a transaction, by contrast, can be

con-trolled by either party to the transaction.

One popular means by which a firm tries to keep its credit exposure below a maximum tolerable loss threshold is by maintaining a system

of credit limits For firms whose credit exposures are relatively static and homogeneous, limits are usually based on categories or types of counter parties rather than on specif ic obligors or “names” (i.e., individual

companies) A power marketing firm, for example, may specify that all swap counter parties must be rated AA or above by Standard and Poor’s (S&P) Firms whose exposures are dynamic and involve multiple f inancial product types tend to rely instead on numerical obligor-specif ic limits that can be compared to actual estimates of credit exposure Measures of credit exposure on which such limits are based range from crude ap-proximations such as the size or notional principal of a transaction to more sophisticated forward-looking risk measures such as conditional ex-pected loss or credit value-at-risk (Culp, 2001)

Exposure Reduct ion Techniques

Exposure reduction techniques allow firms to reduce their exposure or LGD to a given obligor or on a particular asset Exposure reduction can enable f irms to increase the volume of business they do with relatively riskier counter parties for a given exposure limit or risk tolerance Ex-posure reduction methods also allow firms to bring risk exEx-posures back

in line with risk limits and tolerances in the event that a change in mar-ket prices or an unexpected decline in obligor credit quality increases the LGD of an existing asset Exposure management methods come in at least five forms

Exposure Management through Contracting Terms Exposure man-agement is often as simple as the judicious inclusion of certain provisions

to the legal documentation underlying one or more transactions Bond covenants, for example, have been used for many years to protect public creditors from expropriation and other unnecessary credit exposures (Smith and Warner, 1979)

The practice of documenting multiple transactions across product

types with the same counter party under a single master netting agreement

can also be an effective exposure management device by guaranteeing

close-out netting in the event of insolvency Close-out netting requires that

all obligations between the firm and a defaulting obligor be marked to market and then netted down to a single net payment in the event of a de-fault If Firm A owes Enron $1 million on a swap and is due $2.5 million

on a forward, for example, close-out netting requires Enron to net the two obligations into a single net payment of $1.5 million due from Enron

to Firm A

Close-out netting prevents “cherry picking,” or an attempt by a de-faulting firm to collect its receivables without honoring its payables to the same firm—for example, Enron demands its $1 million on the swap without paying its $2.5 million on the forward Most master netting

agreements (e.g., the ISDA Master Agreements) have been subjected to intensive legal scrutiny to minimize the risk that close-out cross -product netting provisions will be deemed unenforceable in the event of insol-vency in a given legal jurisdiction (Culp and Kavanagh, 1994)

The credit exposure of a transaction can also be reduced through contractual requirements for periodic cash resettlement By marking as-sets to their current replacement costs at regular intervals, a

nondefault-ing firm can never lose more than the change in the replacement cost of

the contract since the last mark-to-market date

Early termination and acceleration triggers are further examples of exposure management through contracting terms Price triggers in de-rivatives, for example, allow the transaction to be terminated if the un-derlying asset price rises and/or falls by a specif ied amount This guarantees that either party can get out of the transaction if it reaches a maximum tolerable credit exposure Call and put provisions in bonds can serve a similar purpose

Early termination and acceleration triggers can also be linked directly

to indicators of credit quality Some contracts terminate automatically, for example, in the event of a credit rating downgrade by one of the parties Similarly, cross -default provisions in derivatives commonly allow for early termination by a firm if its counter party misses a single required payment

on any of its obligations with the firm In some cases, cross -default

provi-sions even allow a f irm to terminate a derivatives contract early if its

counter party defaults on any obligation to any firm.

Credit Enhancements Credit enhancements are assets or perfor-mance bonds that are attached to a credit-sensitive obligation to reduce the LGD Secured loans are credit enhanced with the underlying collat-eral, so the credit risk of a secured loan is driven more by the credit risk

of the collateral than the original borrower Similarly, collateral require-ments on derivatives typically mandate that one or both firms post a fixed amount of acceptable collateral at the inception of the transaction, in ef-fect forcing firms to prepay some portion of their potential credit losses Acceptable collateral usually includes Treasury securities, bank letters of credit (LOCs), and third-party performance guarantees from credit sup-port providers as discussed in the next section

In some cases, credit enhancements are combined with contractual

exposure management tools, such as triggers that create contingent credit

enhancements Callable collateral, for example, is a supplemental amount

of collateral that can be demanded on top of the initial collateral required

in the event of a counter party rating downgrade

Insurance In the 1980s, insurance and capital markets began to con-verge rapidly in the alternative risk transfer (ART) market (Culp, 2002) Products that were once considered solely the domain of commercial

in-surance applications suddenly became popular for financial applications.

One such product of the ART revolution was credit or asset insurance Credit or asset insurance reimburses its purchaser for actual losses incurred following an event of default by an obligor on one or more des-ignated reference assets As is standard in indemnity contracts that di-rectly compensate a f irm for actual economic damage sustained, the insurance purchaser must have an “insurable interest” (i.e., must in fact sustain damage to justify the reimbursement) To ensure that insurance purchasers remain vigilant in their own exposure management practices after the insurance is in place, credit insurance usually includes a de-ductible and policy limit

Credit insurance is marketed in several different forms The most

gen-eral and unconditional is a financial guaranty, or an unconditional promise

by an insurer to reimburse the protection purchaser if a loss is sustained following the occurrence of a specific “triggering event.” Guarantees usu-ally def ine the triggering event very narrowly—for example, the bank-ruptcy filing in a court by a specific obligor—but otherwise contain very few exclusions and are payable essentially on demand except in the case

of fraud on the part of the insurance purchaser

Credit insurance can also be provided through surety bonds Shown in

Figure 11.1, a typical surety bond involves the provision by an insurance company (the surety) of a performance bond to an obligee on behalf of

a principal In the event of nonperformance on some specific obligation

by the principal, the obligee can make a claim on the surety

FIGURE 11.1 A Typical Surety Bond

Principal

Obligee

Surety Obligation Performance Guaranty

Payment

or Loan