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PART FOUR Credit Risk Mitigation after Enron 211 11 CREDIT RISK MANAGEMENT LESSONS FROM ENRON C HRISTOPHER L. C ULP A s 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 investment losses. Enron engaged in similar malfeasance to project an artifi- cial image of financial resilience by camouflaging 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 monitor and control the potential for unexpected losses arising from an obligor’s unwillingness or inability to honor all of its commitments. De spite 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 212 CREDIT RISK MITIGATION AFTER ENRON 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 products 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 failure 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 failure 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. THE NATURE OF CREDIT RISK 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 unwillingness of an obligor to honor its commitments can translate into losses. 2 Credit 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 firm’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 secure and cannot be used to honor other outstanding obligations of the defaulting firm. CREDIT RISK MANAGEMENT LESSONS FROM ENRON 213 The amount a firm can recover on an unsecured claim depends on the value of the defaulting firm’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 typically 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 “accelerated 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 obligation is calculated and either is due from the nondefaulting party or becomes 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 becomes either a payable or receivable of the insolvent firm. Unlike before, however, the contract is not accelerated or terminated; all remaining delivery 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. CREDIT RISK MANAGEMENT TECHNIQUES As Palmer explains in Chapter 13, some firms 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 214 CREDIT RISK MITIGATION AFTER ENRON 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 firms actively manage their credit risk differs widely across types of firms. Nevertheless, this process invariably includes three common components discussed in the following sections. Default Risk Monitoring Predicting the failure of another firm 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 officers 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, equity and asset volatility, and the like. 3 Firms with significant credit-sensitive exposures to a given firm, moreover, often take internal monitoring beyond a review of public information. 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 management documents, and the like. External Monitoring For many firms, an independent credit analysis 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 external monitoring to track their credit risks. External monitoring occurs when one firm relies on the credit analysis of a professional credit monitoring service for its information about the default risk of its obligors. CREDIT RISK MANAGEMENT LESSONS FROM ENRON 215 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 external 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 unsecured 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 external 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 multiple 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 specific obligors or “names” (i.e., individual 216 CREDIT RISK MITIGATION AFTER ENRON 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 financial product types tend to rely instead on numerical obligor-specific 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 Reduction 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 firms 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 exposures back in line with risk limits and tolerances in the event that a change in market 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 management 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 default. 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 defaulting 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 CREDIT RISK MANAGEMENT LESSONS FROM ENRON 217 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 insolvency 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 assets to their current replacement costs at regular intervals, a nondefaulting 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 derivatives, for example, allow the transaction to be terminated if the underlying asset price rises and/or falls by a specified 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 provisions even allow a firm to terminate a derivatives contract early if its counter party defaults on any obligation to any firm. Credit Enhancements Credit enhancements are assets or performance bonds that are attached to a credit-sensitive obligation to reduce the LGD. Secured loans are credit enhanced with the underlying collateral, so the credit risk of a secured loan is driven more by the credit risk of the collateral than the original borrower. Similarly, collateral requirements 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. 218 CREDIT RISK MITIGATION AFTER ENRON 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 insurance 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 directly compensate a firm 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 general 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 usually define the triggering event very narrowly—for example, the bankruptcy 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 [...]... at least some Enron credit exposure.7 Dodd (20 02) estimates that Enron had about $773 billion in notional principal outstanding on derivatives contracts at year-end 20 00: $1 52 billion in natural gas contracts, $26 7 billion in oil contracts, $338 billion in electricity contracts, $9 billion in interest rate derivatives, $7 billion in equity derivatives, and $55 0 million based on foreign exchange S&P’s... reference names or assets Virtually unused until 19 92, credit derivatives have exploded in popularity in recent years Nearly $1.6 trillion in notional principal was reported outstanding in credit derivatives in mid -20 02. 5 Credit derivatives include single-name and pooled contracts Singlename credit derivatives are contracts in which the protection seller makes 22 0 CREDIT RISK MITIGATION AFTER ENRON a payment... derivatives CREDIT RISK MANAGEMENT LESSONS FROM ENRON 22 5 contracts negotiated with major swap dealers, Enron was viewed as a significant credit risk Even Enron’s lifetime high credit rating of BBB+ was still well below standard for derivatives Consequently, few dealers agreed to conduct derivatives business with Enron without appropriate exposure management By 20 01, many of Enron’s derivatives dealers had... delivery obligations to the SPE served as collateral for the SPE to secure the loan from Citibank At the time of Enron’s failure, $2. 5 billion in cash-settled delivery commitments from Enron to Citibank (via the intermediary SPEs) remained outstanding on those prepaids (Roach, 20 02) The credit risk on a prepaid is significantly greater than on a traditional forward In the event of a default by Enron on a... top lenders The other $8 .5 billion in Enron’s debt was unsecured and in the form of Enron bonds The two largest concentrations of Enron bond holdings appear to be in the asset management ($3.8 billion) and life insurance ( $2. 6 billion) industries Importantly, about a third of Enron’s bonds ($3 billion) were held in CDOs as small parts of much larger credit pools (Azarchs, 20 01) To combat apparently... previously hidden losses were disclosed, an acceleration trigger was hit on a $690 million loan to one of Enron’s remaining undisclosed SPEs Originally due in 20 03, the entire balance on that loan was suddenly accelerated to a due date of November 27 , 20 01 Enron disclosed this in a restatement of its third-quarter earnings filed with the SEC on November 19, along with its disclosure at the same time of... Notional Amount × Spread Credit Protection Buyer (Asset Owner) Reference Asset(s) Contingent on Reference Asset Default Notional Amount FIGURE 11 .2 A Physically Settled CDS Credit Protection Seller (Swap Dealer) CREDIT RISK MANAGEMENT LESSONS FROM ENRON 22 1 buyers thus often prefer structures such as first-to-default basket swaps, in which the protection buyer identifies a basket of reference assets... Essentially, CDOs enable firms to swap a single-name credit exposure for a portfolio of credit risks A firm holding Enron bonds, for example, might sell those bonds to a CDO that holds bonds issued by all of 22 2 FIGURE 11.3 Administrative and Custody Services Fees Portfolio Management Fees A Typical CDO Trustee Collateral Manager/Servicer Swap Dealer Actual Interest Payment Transfer of Debt Instruments Periodic... Of the $8 billion notional in Enron-based credit derivatives rated by Mengle in Chapter 7, Khakee and Ryan (20 01) estimate that around $2. 7 billion notional principal was transferred to credit derivatives dealers in single-name or smallbasket credit derivatives transactions In addition, about 50 pooled credit derivatives transactions included an Enron asset in the reference portfolio Those transactions... offering of “bankruptcy swaps” through EnronCredit.com (Fox, 20 02, pp 187–188) Synthet ic Enron Bond Holde rs Enron’s failure also precipitated losses to holders of credit-linked notes issued by Enron counter parties seeking to manage their own Enron credit risk These losses are best illustrated by the most prominent example From December 1993 through 20 01, Citibank made $4.8 billion in payments to Enron . exposure. 7 Dodd (20 02) estimates that Enron had about $773 billion in notional principal outstanding on derivatives contracts at year-end 20 00: $1 52 billion in natural gas contracts, $26 7 billion. unused until 19 92, credit derivatives have exploded in popularity in recent years. Nearly $1.6 trillion in notional principal was reported outstanding in credit derivatives in mid -20 02. 5 Credit derivatives. derivatives, and $55 0 million based on foreign exchange. S&P’s estimate of the replacement cost of Enron’s derivatives liabilities was about $19 billion on September 30, 20 01 (Azarchs, 20 01). Replacement

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