Enron Harvard Business Case Study
Essay by Zomby • December 1, 2011 • Case Study • 1,942 Words (8 Pages) • 5,128 Views
Kyle Musser
Case #2: Enron Credit Sensitive Notes
11/19/11
What is a credit derivative?
The first point when looking at this case is to understand what a credit derivative is specifically what the credit sensitive notes. A securitized derivative is one whose value is derived from the credit risk of an underlying bond, loan or any other financial asset. Creating, structuring and the issuance of such financial instruments known as derivatives involve managing the credit risk of an entity other than the counterparties or the transaction itself. This entity is known as the reference entity and may be corporate, sovereign or any other form of legal entity which has incurred debt. Credit derivatives are bilateral contracts between a buyer and seller under which the seller sells protection against the credit risk of reference entity. Credit derivatives bypass barriers between different classes, maturities, rating categories, debt structure senior levels and so on thus creating great opportunity for investors to exploit the constantly changing of credit risk in an underlying investment.
There are various types of credit derivative instruments that can be utilized by investors. Traditional contracts such as forward interest rate derivatives and options contracts are some of the early derivative products that were utilized by investors. These original products have transformed into more complex vehicles of which include hybrid and contingent products for example that can even be utilized together to create multi-layer protection for investment portfolios. These products allow for investors and investment management teams to find ways to exploit and manage risk in the fixed income investment arena and include metrics such as balance sheet management, shareholder growth and overall business performance underlying the financial assets. Derivatives are not only in the fixed income space but provide risk management opportunities for investors looking to take advantage of variety of asset classes including interest rates, currency, commodities and equities taking into account macro-economic risks, interest rate changes, inflation, credit expectations, etc.
Why is the management of the firm's "own" credit risk important to its derivatives operations?
There are three different types of credit risk that a firm or investors have to be concerned about. These credit risks include 1) default risk, 2) credit spread risk, and 3) downgrade risk. Default risk has to deal with the satisfying of the terms of the agreement in respect to timely payment of interest and principal of the derivatives. Credit spread risk is associated with the changing of interest rates relative to a benchmark (usually Treasury) and the market value of the bonds and price performance that is associated with the spread changing. The third and final risk that investors must manage and take into consideration when investing in derivatives is called the downgrade risk of which results in the credit spread widening and price of the bond declining after the ratings agencies such as S&P or Moody's change. Should a company be hit with a downgrade and the obligation becomes due sooner than expected because of terms of the deal then this is called obligation acceleration. This is very important especially in the ways through which a company manages expectations for financial planning within their strategic plan and should bond issues be called to be repaid prior to that of which was previously assumed this can have a tremendous effect on the cash flows of a company thus creating further pain for the organization.
Most companies are not driven to bankruptcy by credit sensitive notes such as the ones issued by Enron and other companies. The interest costs that are associated with the notes are usually quite small in relative terms to the overall structure of the firms financing that a company pursues. However, there may be other covenants or terms within the deal that could cause problems such as the ways through which the firm is deploying their capita or the firm's willingness to expose itself to additional costs including incurring more liabilities. These covenants when enacted could cause the repayment of debt to trigger sooner than expected and there could be redemptions that the financial management team did not expect causing illiquidity of the firm and their ability to cover their obligations. There are also terms and covenants deal with the company's asset side of the balance sheet and can trigger certain changes to deals based upon the level of certain assets that a company books on their financials. Depending upon the leverage and the different derivative issuance that the company has deployed credit events such as downgrades, bankruptcy, or cross acceleration can be very damaging to a company.
What are the different approaches to managing one's own credit risk?
Credit risk arises from changes in the financial stability of a company and more specifically the solvency of the firm or individuals. When a party defaults the lender or party is exposed to financial loss because of the obligor's failure to perform under the stated contracts. There are numerous approaches to which a company or party can manage their risk including: quantitative and qualitative. The key element is to understand the behavior and predict the likelihood of particular issuers defaulting on their obligations. Higher potential loss is indicative of the credit risk of the firm. In cases where the amount that can be lost is different then we need to factor in not just the probability of default but also the expected loss if there were to be a default. Determining which counterparty may default is both an art and a science of credit risk management. Some utilize statistical modeling, judgment, deterministic or relationship models and involve many outside factors that must be taken into consideration when deploying these products.
How are credit derivatives being used as an alternative to other approaches of managing credit risk? Are they more efficient?
Until credit derivative products were introduced there was really no sure way to manage the various aspects of a portfolio especially in the fixed income arena. For example a corporate bond portfolio manager has to take into consideration many
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