Credit Derivatives

Credit Derivatives

Credit derivatives are instruments that allow lenders to pass on to others the risk that borrowers will default in return for a fee. In other words, credit derivatives are securitized in that the risk is transferred to an entity other than the lender. Examples of credit derivatives include credit default swaps, credit sensitive notes, and collateralized debt obligations. The value of these instruments is derived from the credit performance of the underlying party. Credit derivatives can be highly valuable for a company looking to spread and minimize risk.

These derivatives arose to hedge and diversify credit risk and as a means for taking on credit exposure. In 1989, Enron created its Credit Sensitive Note (CSN) as a way to make money in a difficult time. According to the case, these notes were designed to lower the price risk for bonds by paying a different coupon as the firm's credit level changed. The coupon payments are linked to the S&P and Moody's credit rating of Enron itself. These unique types of debt paid interest rates that varied based on Enron's credit rating. When the rating was downgraded the coupon payments increased at a greater rate than when Enron's rating was upgraded. In other words, the coupon payments decreased at a slower rate when ratings improved than the larger rate when ratings worsened.

The outcome of this is a bond price influenced by probabilities of a change in credit ratings as well as credit risk, recovery rates, company performance, and the outlook for rates. What is unique about Enron's case sensitive note is that the bond price would not decline in a ratings downgrade scenario and would instead compensate for the default risk. This is a special circumstance seeing that most bonds default risk is correlated with their credit rating. Since Enron's case sensitive notes derive their value from Enron's performance, this makes the notes credit derivatives.

The Management of Credit Risk and Relation to Derivatives Operations

Credit risk originates from the inability of an organization to fulfill the financial commitment that was previously made. Through managing a firm's "own" credit risk, a company has the opportunity to significantly impact the risk they take on.

Enron has grown substantially through much capital spending and acquisitions over the decades. Since the company has grown to be one of the world's foremost energy providers there has been much change to stabilize and expand business segments. One segment in focus is Enron Capital and Trade Resources.

This trading division is the largest purchaser and marketer of natural gas in North America. The company manages the world's largest portfolio of natural gas fixed-price and risk management contracts and deals with a wide volume of transactions resulting from its physical energy trading operations. Here, the natural gas contracts and other risk management contracts act as over-the-counter derivatives, or OTC. With such a huge portfolio, Enron endures much risk in its OTC derivatives due to the exposed risk of counterparties not fulfilling their commitments to pay or unable to continue operations.

As a result of this, investors and clients are exposed to default risk as well as continuing to perform obligations despite drastic events, such as a possible Enron bankruptcy. To deal with such risk and minimize it in a way for counterparties to feel secured when investing with Enron, Enron must manage credit risk appropriately. This will make counterparties more comfortable while being exposed to Enron's credit risk. With that the company will be able to provide a stable inflow of cash flows and capital and continue operations at a high level.

Approaches to Managing Credit Risk and its Importance to Derivative Operations

Covenant protection was taken highly in consideration as a result of the late 1980s where company's bond prices were hit with investment grade debt because of the LBO boom and increased M&A. Companies most vulnerable were industrials, transportation companies, and natural gas pipeline companies. The lack of such protection and the disastrous effects to corporate capital led to estimated losses of $951 million in 1988 and totaling $690 million in 1989.

As a result, "poison puts" were used as a form of protection against exposure to a high level of credit. These puts on a bond allows investors to sell bonds back to the issuer at par if a given event occurred, such as a change in control among other factors. Other forms of protection were demanded by investors to protect against credit risk and to mitigate loss. With such covenants needed brought a greater possibility of risk and a lower credit rating because of rules and regulations set forth to control companies issuing bonds. Though these puts and forms of protection made a company's debt safer they do not guarantee the ability of a company to repay.

Still, covenants were needed for the new issues of bond security and so, a form of credit derivatives were used to more efficiently manage credit risk. One such form, as mentioned earlier, is a credit default swap. Credit defaults swaps are the most commonly used credit derivatives for financial institutions and they guarantee a full repayment in exchange for period payments. A special characteristic that puts credit defaults swaps a step higher than puts and covenants is that these swaps can be traded and are liquid. Swaps are not solely reliant on a company or firm's ability to repay either, where if one party defaults, the seller of the swaps would guarantee the par value of the bond.

Continuing on, credit default swaps are not only beneficial to the parties but also reduce complex factors that may arise out of trading such a liquid credit instrument. A couple factors are the legal structure and process of credit defaults swaps is far less complicated as they follow a set of guidelines and regulations under the International Swaps and Derivatives Association. Also having such a liquid corporate instrument allows for low transaction costs and greater market access to attract investors. Using these swaps and credit derivatives as a whole secures and minimizes risk and is an effective and efficient way to manage credit risk. Not only to provide a good return but doing so in a less complicated way.

Benefits of Issuing Credit Sensitive Notes

There a few benefits to the issuer when managing credit risk using credit sensitive notes. The issuer is able to minimize risk and attract investors in by taking on more risk by purchasing these notes