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CREDIT RISK MANAGEMENT LESSONS FROM ENRON 227 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 termination 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, 10 Citibank 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 investments by the SPE in securities rated at least AA Citibank entered into a credit swap with the credit SPE that reflected 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 interest income on the credit SPE’s investments. In return, the credit SPE received payments from Citibank in an amount sufficient to cover the interest payments due to investors in the debt notes. The gross interest payments from Citibank to the credit SPE for payment to note investors had two components: a pure interest component financed 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 228 CREDIT RISK MITIGATION AFTER ENRON 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 discussed 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 customers and not just Enron, and JPMC required all of those customers 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’ financial statements, whereas surety bonds are not. CREDIT RISK MANAGEMENT LESSONS FROM ENRON 229 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.” 11 These 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—five days after Enron filed 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 camouflage 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 230 CREDIT RISK MITIGATION AFTER ENRON fi nancial 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 multiline 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 billion charge in the fourth quarter of 2002 largely to deal with Enron litigation matters. That charge-off reflected 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. CONCLUSION 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 market failure in the credit risk monitoring of Enron are overstated. Given Enron’s duplicity in its financial statements, those firms with the pre- science to have relied on credit risk mitigation and risk transfer to manage their Enron exposure should not be criticized but should be praised for their astuteness. Although many of the conventional criticisms of credit risk management 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 Knowledge of Fraud Royal Bank of Canada (RBC) made a $517 million loan to an Enron af- filiate in November 2000 and hedged its credit risk by entering into a CREDIT RISK MANAGEMENT LESSONS FROM ENRON 231 credit swap with the Dutch Cooperatieve Central Raiffeisen-Boerenleen- bank BA (better known as Rabobank). In June 2002, Rabobank 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 financially 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 Monitoring is No Substitute for Direct Monitoring 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 monitoring to ascertain Enron’s creditworthiness probably found themselves in trouble. As noted previously, firms that rely on delegated monitoring are essentially “free riders” on more senior creditors. An implication is that delegated 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 232 CREDIT RISK MITIGATION AFTER ENRON 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 financial institution hedges its credit risk to a particular obligor is no easy task. Harder still is for a junior creditor to determine how much credit is retained by the credit protection provider. Credit insurance providers, for example, routinely reinsure their primary policy lines instead of retaining 100 percent of their exposures. 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 flag to purchasers of credit-backed securitized 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 backing those structures is at least as important as the credit risks of the structures 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. External Monitoring Is No Substitute for Direct Monitoring 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 flags 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 obligations, the rating agencies are no more capable of predicting financial 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 CREDIT RISK MANAGEMENT LESSONS FROM ENRON 233 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 monitors 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. Regulation Is Not the Answer Some have commented that the proliferation of credit risk management tools has destabilized the financial 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 attention 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 reduced 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 management 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 financial system to absorb the 234 CREDIT RISK MITIGATION AFTER ENRON 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). NOTES 1. See Fox (2002) for a good discussion of the investment losses that led Enron to slowly bleed to death financially. 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 confined to unwillingness or inability to make payments or deliveries because of financial 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 firms they are monitoring, but at least some part of the benefit to delegated monitoring cannot be priced because of nonexclud- ability. In other words, a delegated monitor cannot prevent firms 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 financial 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 financially 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. CREDIT RISK MANAGEMENT LESSONS FROM ENRON 235 11. See JPMorgan Chase Bank v. Liberty Mutual et al., USDC SDNY 01 Civ. 11523 ( JSR) Amended. 12. This is not exactly the same as the figure shown in Chapter 9 because the issues 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). 236 12 CREDIT DERIVATIVES POST-ENRON A NDREA S. K RAMER AND A LTON B. H ARRIS C redit derivatives—bilateral contracts and debt securities, the value of which is linked to the credit status of a company, a debt obligation, or a pool of debt obligations—have been available since 1992. 1 The importance and frequency of use of these products, however, were transformed by the events of 2001. During that year, corporations defaulted on 211 bond issues valued at more than $115 billion, a record number and dollar value. More than 250 public companies filed for bankruptcy 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 history—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,” 2 the use of credit derivatives grew in 2002 at a rate that “exceeded all expectations.” 3 For the first 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. 4 And the ex- plosive growth in this market appears to have only begun. By 2004, the British Bankers Association (BBA) predicts that the global credit derivatives 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. [...]... greater leverage (20 percent), to reduce a portfolio’s capital intensity (20 percent), to hedge counter party credit risk (18 percent), to speculate ( 16 percent), and for other reasons ( 16 percent) (D’Amario, 20 02) The various types of credit derivative used to achieve these objectives can be generally divided into those that are not funded before a credit CREDIT DERIVATIVES POST-ENRON 23 9 event—for example,... became insolvent, investors in the Enron CLNs were left holding the bag, and the Enron lenders walked away without loss .22 Six separate issuances of CLNs are the subject of the Hudson Soft litigation ,23 but the basic structure of various transactions appears to have been much the same .24 An SPE issued one primary class of CLNs to investors and a second, much smaller, class of notes subordinate to the... information CREDIT DERIVATIVES POST-ENRON 24 1 would be required about volatilities and implied forward credit spreads ( J.P Morgan, 1998) Funded Credit De r ivat ives Credit-Linked Notes CLNs are debt securities, the value of which are linked to the creditworthiness of third-party reference entities or reference obligations A CLN “represent[s] a synthetic corporate bond or loan, because a credit derivative... by an SPE, the SPE is typically “collateralized with high-quality assets to assure payment of contractual amounts due.” 16 CLNs are generally simple and f lexible structures The default contingency in a CLN can be based on a variety of underlying obligations, including a specific corporate loan or bond, a portfolio of loans or bonds, sovereign debt instruments, or an emerging markets index It may also... CDOs) backed by the cash f lows from the transferred portfolio; and a payment to the transferor of the proceeds of the CDO sale While there are various types of CDOs (for example, arbitrage or balance 24 2 CREDIT RISK MITIGATION AFTER ENRON sheet CDOs employing either cash f low or market value management), for purposes of this discussion, we view all such transactions simply as one more way to repackage... the obligations in the reference CREDIT DERIVATIVES POST-ENRON 24 3 portfolio, proceeds from the collateral are used to compensate the sponsor Any collateral remaining at the maturity of the transaction is repaid to the note holders The SCDO market is dominated by three distinct products: (1) regulatory-driven balance sheet transactions, (2) tranched basket default swaps, and (3) managed arbitrage CDOs... offerings of debt securities linked to Enron’s creditworthiness (Enron CLNs) .20 In these transactions, introduced brief ly in Chapter 11 by Culp, Citigroup and Credit Suisse First Boston Corp (collectively, Enron lenders) transferred much of their Enron credit exposure arising from loans and structured finance transactions21 to third-party investors through variously structured CLNs issued by SPEs... laying off the type and amount of risk they do not wish to carry among a wide range of market participants American banks, for example: 23 8 CREDIT RISK MITIGATION AFTER ENRON have effectively used credit derivatives to shift a signif icant part of the risk from their corporate loan portfolios to insurance firms here and abroad, to foreign banks, to pension funds, to hedge and vulture funds, and to other... payment equal to the notional amount of the contract (physical settlement), or the protection seller pays the buyer the notional amount minus the then-value of the reference obligation (cash settlement). 12 CDSs can be entered into with respect to a single reference entity or obligation or with respect to a specified portfolio of reference entities or obligations CDSs that reference a portfolio of some... higher rated debt Whatever the precise structure of a CMO’s tranches, however, this credit derivative product allows one party (protection buyer) that is holding, for example, a portfolio of high-yield corporate bonds to eliminate its credit exposure to this portfolio by transferring that risk, in restructured form, to investors Synthetic Collateralized Debt Obligations While conceptually straightforward, . judgment and rescheduled a trial date in early 20 03. On January 2, 20 03, JPMC announced that it was taking a $1.3 billion charge in the fourth quarter of 20 02 largely to deal with Enron litigation. problems (Azarchs, 20 01). NOTES 1. See Fox (20 02) for a good discussion of the investment losses that led Enron to slowly bleed to death financially. The numbers in this paragraph are also based on Fox (20 02) . 2. . Memorandum of Law in Opposition to Plaintiff Motion for Sum- mary Judgment (February 11, 20 02) . 23 6 12 CREDIT DERIVATIVES POST-ENRON A NDREA S. K RAMER AND A LTON B. H ARRIS C redit derivatives—bilateral