CORPORATE AFTERSHOCK 2 PHẦN 6 potx

To address the significant credit risk of a default by Enron on its ter-mination payments, Citibank used a credit-linked note, the history and mechanics of which are described in more de

advanced payment to Enron, however, the termination payment did not

represent the usual replacement cost of the net purchase and delivery obligations, but rather the gross replacement cost of all remaining asset

deliveries

To address the significant credit risk of a default by Enron on its ter-mination payments, Citibank used a credit-linked note, the history and mechanics of which are described in more detail in Culp (2002) Shown

in its most basic form in Figure 11.4,10Citibank set up an unconsolidated credit SPE that issued notes and equity certificates to a broad range of investors Proceeds from these securities funded the acquisition of in-vestments by the SPE in securities rated at least AA- Citibank entered into

a credit swap with the credit SPE that ref lected the terms of the loans the bank made to the prepaid SPE to finance the Enron prepays

As long as Enron did not experience an adverse credit event, the credit SPE made regular payments to Citibank on the swap equal to the actual in-terest income on the credit SPE’s investments In return, the credit SPE received payments from Citibank in an amount sufficient to cover the in-terest payments due to investors in the debt notes The gross inin-terest pay-ments from Citibank to the credit SPE for payment to note investors had two components: a pure interest component f inanced by the interest

FIGURE 11.4 An Unconsolidated Credit SPE

Credit SPE

Prepaid SPE

Interest and Principal

Cash at Inception Cash at Inception

Cash Payments Indexed to Gas/Oil Prices Prepaids

Yield and Principal

Interest

and

Principal

Interest and Principal

Proceeds

of Initial

Issue

Proceeds

of Initial

Issue

Citibank Credit Swap

Note Interest and Certificate Yield Interest on Trust Investments

Investments

Held in Trust

Enron

Debt

Notes

Equity Certificates

Citibank received on its loans to the prepaid SPE and a credit insurance premium paid to credit SPE note holders to compensate them for bearing Enron credit risk

In the event of an Enron default, the credit SPE would swap its low-risk investments with Citibank for senior unsecured Enron debt The debt notes issued by the credit SPE thus functioned as synthetic Enron debt As long as Enron remained a viable business, holders of notes issued by the credit SPE would earn a healthy premium over regular interest rates But

in the event of an Enron default, holders of notes issued by the credit SPE ended up holding senior unsecured claims on Enron

Setting aside the significant political controversy over prepaids dis-cussed in Chapters 9 and 10, these structures worked well enough for Citibank Holders of the synthetic Enron bonds, rather than Citibank, ultimately had to absorb the $2.5 billion credit loss (before recoveries) from Enron’s bankruptcy Kramer and Harris, however, explore some legal questions that have arisen around structures similar to these in Chapter 12

Credit Insurance

JPMorgan Chase ( JPMC) was a lead creditor, derivatives counter party, project finance lender, securities underwriter, and a merger advisor to Enron By 2001, Chase Manhattan Bank and later JPMC had arranged about $3.7 billion in commodity prepaids with Enron The main vehicle through which JPMC conducted its Enron prepaids was Mahonia Ltd., a Channel Islands SPE whose history and mechanics were presented in Chapter 9 When Enron filed for bankruptcy protection, JPMC was owed

$1.6 billion in loans made to Mahonia that had been used to finance now-defaulted oil and gas prepaids (Roach, 2002)

JPMC chose a different credit exposure management solution than Citibank for its prepaids Initially, Mahonia was dealing with multiple cus-tomers and not just Enron, and JPMC required all of those cuscus-tomers to obtain bank LOCs that could be drawn in the event of default to make any required termination payment to Mahonia

Beginning in 1998, Enron asked JPMC to let Mahonia accept APSBs (see previous discussion) in lieu of LOCs as collateral for the Mahonia loans that funded the Enron prepaids In retrospect, that Enron preferred surety bonds to LOCs is hardly surprising An LOC generally reduces the borrowing capacity of the principal, the surety bond does not LOCs are also generally carried as contingent liabilities on borrowers’ f inancial statements, whereas surety bonds are not

Despite their obvious appeal to Enron, JPMC was initially hesitant to accept surety bonds in place of LOCs To assuage its concerns, the bank requested that all the sureties backing the Enron APSBs provide several forms of assurance that the APSBs “would be the functional equivalent of letters of credit, and, like letters of credit, would constitute absolute and unconditional pay-on-demand financial guarantees.”11These assurances were apparently provided, and with JPMC’s consent, APSBs began to re-place LOCs as collateral pledged to Mahonia Providers of the APSBs were all multiline insurance companies, most of which were domiciled in New York, and included Liberty Mutual, Travelers Casualty & Surety, and

St Paul Fire and Marine The essentials of the transaction structure are shown in Figure 11.5.12

On December 7, 2001—f ive days after Enron f iled for bankruptcy protection—JPMC filed written notice with Enron’s sureties of the nearly

$1 billion due to Mahonia and JPMC under the APSBs The sureties de-clined payment, arguing that the APSBs “were designed to camouf lage loans by [ JPMorgan] Chase to Enron, and that [ JPMorgan] Chase de-frauded the surety bond providers into guaranteeing what were purely

FIGURE 11.5 The Transaction Structure

JP Morgan

Chase

Enron

Insurance Companies Mahonia

Prepaid Forwards and Swaps

Secured Lending

Gas/Oil for Future Delivery(-ies)

Principal/Interest Secured by Enron Prepaids

Advance Payment Supply Bonds (Surety)

Cash at

Inception

Cash at

Inception

f inancial obligations which they otherwise would not, and statutorily [under New York law] could not, have bonded.”13 In other words, the sureties claimed that because the prepaids were “bank debt in disguise,”

the APSBs represented financial guarantees that cannot be offered by

mul-tiline insurers under New York insurance law

After the sureties failed to pay JPMorgan voluntarily, the bank filed

a motion to compel the sureties to pay The lower court denied motions for summary judgment and rescheduled a trial date in early 2003

On January 2, 2003, JPMC announced that it was taking a $1.3 bil-lion charge in the fourth quarter of 2002 largely to deal with Enron lit-igation matters That charge-off ref lected a settlement with insurers, reached on the same day the trial was to begin As suggested by the 7.5 percent increase in JPMC’s stock price the day word leaked out about the settlement, the settlement was a bigger victory for JPMC than ex-pected Under the settlement, the 11 insurers agreed to pay about 60 percent of their obligations to JPMC under the APSBs, or $655 million out of the $1 billion total owed

CONC LUSION

By far, the greatest monitoring failure of Enron was a failure by virtually everyone—lenders, regulators, rating agencies, and counter parties—to recognize the depth of Enron’s deceptions Unfortunately, a firm that is

absolutely intent on perpetrating a fraud often can, and neither new

reg-ulations nor changes in credit risk monitoring practices is likely to change that

In virtually every other context, however, claims of a widespread mar-ket failure in the credit risk monitoring of Enron are overstated Given Enron’s duplicity in its f inancial statements, those f irms with the pre-science to have relied on credit risk mitigation and risk transfer to man-age their Enron exposure should not be criticized but should be praised for their astuteness

Although many of the conventional criticisms of credit risk manage-ment in the case of Enron are misplaced, the episode has served as a re-minder of several important lessons and areas of ongoing concern

Sound Credit Risk Management Does Not Imply

K nowledge of Fraud

Royal Bank of Canada (RBC) made a $517 million loan to an Enron

af-f iliate in November 2000 and hedged its credit risk by entering into a

credit swap with the Dutch Cooperatieve Central

Raiffeisen-Boerenleen-bank BA (better known as RaboRaiffeisen-Boerenleen-bank) In June 2002, RaboRaiffeisen-Boerenleen-bank announced

a suit against RBC for $517 million on the grounds that RBC “knew Enron was a corrupt organization liable to implode at any time.” Vehemently denying the allegations as “ridiculous,” RBC indicated its intent “to de-fend this attack totally and with vigor” (Heinzl, 2002)

The Rabobank claim against RBC illustrates a fairly widespread mis-conception—namely, firms dealing with Enron that had suspicions about

Enron as a financial or credit risk could not have been ignorant of Enron’s

broader efforts to mislead and defraud the market How could firms have known that Enron was f inancially questionable without knowing about Enron’s undisclosed investment losses and borrowings?

Counter party suspicions about Enron’s credit risk, however, are hardly tantamount either to knowledge of or complicity with Enron’s fraudulent activities Swaps are arms -length transactions in which dealers frequently lack information about how the counter party is using the contract or how the transaction affects the counter party’s total risk If a counter party mis-represents the purpose of a transaction to a dealer, it is possible for the dealer to remain uninformed about any abuses in which their transactions are playing a part while still having concerns about the company’s ability

to pay its bills

As Bassett and Storrie emphasized in Chapter 2, even Enron’s

pub-lished financials did not project the image of a strong firm Enron had the

reputation in the market for being aggressive and for taking risks, and Enron’s top management fueled that image Market participants had

plenty of reasons to be concerned about Enron as a credit risk without being

a coconspirator with the company

Delegated Monit or ing is No Subs t it ute for

Di rect Monit or ing

Enron provides a good case study of the dangers of delegated monitoring, or

reliance on the credit decisions of other institutions as a substitute for in-dependent credit risk analysis Institutions that relied on delegated mon-itoring to ascertain Enron’s creditworthiness probably found themselves

in trouble

As noted previously, firms that rely on delegated monitoring are es-sentially “free riders” on more senior creditors An implication is that

del-egated monitors lack any real incentive to inform free riders of any change

in their credit risk assessments or risk management practices Consider, for example, a bank with an unsecured loan to Enron Delegated monitors

will view that bank’s renewal decision as a signal about Enron’s ongoing

credit quality But suppose the bank hedges its default risk and continues

to roll over the loan to earn the servicing fees In this case, creditors that look only at the rollover decision will draw the wrong conclusion Determining when and how much a f inancial institution hedges its credit risk to a particular obligor is no easy task Harder still is for a

ju-nior creditor to determine how much credit is retained by the credit

protec-tion provider Credit insurance providers, for example, routinely reinsure

their primary policy lines instead of retaining 100 percent of their expo-sures Similarly, credit protection sellers in the credit derivatives market regularly hedge through securities borrowing If estimates of who bore

the brunt of Enron’s failures are even now unknown, the likelihood that a

junior creditor could have figured that out in December 2001 is negligi-ble indeed

The problems of delegated monitoring that Enron highlights simul-taneously raise a cautionary f lag to purchasers of credit-backed securi-tized products such as CDO tranches As the overall performance in the CDO market over the past few years has confirmed, purchasers of such

products often confine their own credit analysis to the actual issuer of the

securities—that is, the CDO manager or SPE But as the Enron failure

starkly illustrates, the credit risk of the underlying population of assets

back-ing those structures is at least as important as the credit risks of the struc-tures themselves In the future, investors in securitized products backed

by credit-sensitive assets would be well served to step up their direct credit monitoring a notch or two

Exte r nal Monit or ing Is No Subs t it ute for Di rect Monit or ing

Numerous commentators have been quick to criticize external monitors for having missed the Enron fiasco Rating agencies, in particular, raised few of the traditional red f lags that would normally be associated with a financial catastrophe of the magnitude of Enron Worth remembering, however, is that although rating agencies are in the business of selling credit analysis and an assessment of an entity’s ability to service its

obli-gations, the rating agencies are no more capable of predicting f inancial

failures than any other market participants

To the extent that the rating agencies were late to classify Enron as tee-tering on the brink, they are even then not entirely at fault To some extent,

a false sense of trust and overconfidence in external delegated monitors have been encouraged over the years by regulatory and political biases that have overinstitutionalized the role of these organizations, as well as erected barriers to entry for their would-be competitors And that problem is about

to get worse Under the planned revision of the Basel Capital Accord, bank capital requirements would be increasingly tied to the external ratings of their obligors This will serve to entrench further the role of the rating agencies in the global financial system and discourage competition from

“unrecognized” rating services

With no real capital at risk (lawsuits aside), external delegated mon-itors are punished for being wrong only through a loss of reputation But without free entry into the ratings provision arena, reputation risk is not

a particularly compelling source of market discipline Although blaming external monitors for missing the boat on Enron is tempting, more con-structive is to blame the system that has drastically attenuated the incen-tives of external monitors to remain as vigilant as possible

Regulat ion Is Not the Answe r

Some have commented that the proliferation of credit risk management tools has destabilized the f inancial system by reducing front-line senior creditors’ attention to direct credit risk monitoring The theory is that the less risk a senior creditor has, the less monitoring a senior creditor will

do The popular solution proposed is to regulate more strictly and more broadly the use of credit derivatives and other credit risk management products by banks and other prominent financial intermediaries

To blame the innovations in credit risk management for reduced at-tention to credit risk is backward logic for several reasons First, many

users of credit risk management tools still retain some exposure to their

obligors and use those tools only to keep their exposures in line with credit risk limits and risk tolerances Citibank, for example, succeeded in managing up to $2.5 billion in Enron exposure using credit-linked notes

But those were not the only exposures that Citibank had Citibank did

lose from Enron’s failure Credit risk management innovations simply

re-duced the amount of the loss, not the incentive of the bank to monitor and manage its exposure

Second, to argue that the availability of better credit risk manage-ment tools abrogates credit monitoring ignores the fact that most firms

would not know when to use exposure management tools without even

more careful and ongoing attention to counter party credit risk Credit

en-hancements and credit risk transfer is not free, after all Knowing when

to use credit risk management devices, which tool to choose, and how

much exposure to manage increases the attention of firms to their credit

exposures, not the other way around

Finally, credit risk transfer mechanisms should be lauded for strengthening the ability of the global f inancial system to absorb the

Enron failure Without these tools, the credit exposures to Enron would have remained very heavily concentrated in the financial and energy sec-tors Instead, thanks to CDOs, credit derivatives, and insurance, Enron’s default risk was, in fact, spread broadly and evenly throughout the whole financial system, including asset managers and insurance companies that had no direct dealings with Enron at all S&P emphasized this as a major reason that the Enron failure did not precipitate “systemic” problems (Azarchs, 2001)

NOTE S

1 See Fox (2002) for a good discussion of the investment losses that led Enron

to slowly bleed to death f inancially The numbers in this paragraph are also based on Fox (2002).

2 For simplicity, this chapter ignores failed transactions, or obligations that are

not honored for purely operational reasons Attention here is conf ined to unwillingness or inability to make payments or deliveries because of f inan-cial problems.

3 Surveys of techniques for modeling default risk can be found in Crouhy, Galai, and Mark (2000); Culp (2001); and Saunders (2002).

4 Delegated monitoring is what is known as a positive externality Delegated

monitors can charge the f irms they are monitoring, but at least some part of

the benef it to delegated monitoring cannot be priced because of nonexclud-ability In other words, a delegated monitor cannot prevent f irms from

mak-ing decisions based on revealed credit decisions about bank borrowers.

5 International Swaps and Derivatives Association Mid-Year Survey of Deriv-atives Activity, 2002.

6 Probably the only reason the November 19 disclosure did not decimate Enron immediately was that the Dynegy merger was still on the table at this time.

7 EnronOnline was essentially a matching engine for f inancial transactions

in which one party seeking to go long a contract was matched with a seller

of a comparable contract Until a match could be identified, however, Enron acted as counter party to the unmatched leg of the transaction Matching in liquid markets sometimes occurred within minutes, but, in other markets, Enron remained a counter party for days or weeks See Herron’s Chapter 6

in this volume for a more detailed discussion.

8 CDS hedging and pricing is discussed in Fage and Liu (2002).

9 As described in Chapter 9, cash-settled means that no oil or gas was intended

to be or was actually delivered The cash payments made by Enron were nev-ertheless tied to oil and gas prices and thus f inancially equivalent to oil or gas deliveries.

10 Figure 11.4 is intended only to illustrate the basic form of a synthetic Enron bond, not any of Citibank’s actual structures.

11 See JPMorgan Chase Bank v Liberty Mutual et al., USDC SDN Y 01 Civ 11523

( JSR) Amended.

12 This is not exactly the same as the f igure shown in Chapter 9 because the is-sues being discussed are different In particular, how Mahonia and/or JPMorgan Chase hedged its exposure to changing gas or oil prices is omit-ted here to keep the discussion focused.

13 See Defendants’ Memorandum of Law in Opposition to Plaintiff Motion for Sum-mary Judgment (February 11, 2002).

2 3 6

12

CR EDI T DER I VAT I V ES

POST-ENRON

A NDREA S K RAMER AND A LTON B H ARRIS

Credit derivatives—bilateral contracts and debt securities, the value

of which is linked to the credit status of a company, a debt obliga-tion, or a pool of debt obligations—have been available since

1992.1The importance and frequency of use of these products, however, were transformed by the events of 2001 During that year, corporations de-faulted on 211 bond issues valued at more than $115 billion, a record number and dollar value More than 250 public companies filed for bank-ruptcy protection, a 46 percent increase over the previous year’s 176, which itself had been a record (Li, 2002) And, the year ended with Enron’s astonishing bankruptcy, the largest in American corporate his-tory—until it was eclipsed just eight months later by WorldCom’s even more extraordinary and unanticipated collapse

As a consequence of what Alan Greenspan has referred to as this

“sharp run-up in corporate bond defaults, business failures, and investor losses,”2the use of credit derivatives grew in 2002 at a rate that “exceeded all expectations.”3 For the f irst half of the year, the notional principal amount of reported outstanding credit derivatives was $1.6 trillion, 50 percent greater than the reported amount for all of 2001.4And the ex-plosive growth in this market appears to have only begun By 2004, the British Bankers Association (BBA) predicts that the global credit deriva-tives market will reach $4.8 trillion, a 500 percent increase over what it was in 2000.5

Copyright November 2002 by Andrea S Kramer and Alton B Harris, all rights reserved.