Enron Corp - Credit Sensitive Securities (harvard Business Case Solution)

Enron Corp.

Credit Sensitive Notes

HBS Case 29709

MICHIGAN STATE UNIVERSITY

ELI BROAD SCHOOL OF BUSINESS

Zhiping Mao, Rong Huang,  Linqiao Gong, Tianlai Li

Question 1: What is a credit derivative?

        Generally speaking, a credit derivative is an “insurance policy” against losses due to the possibility of borrower’s default so the users can use it to manage their exposure to credit risk. The value of this special financial instrument is determined by the default risk of an underlying asset. Credit derivatives allow a lender or borrower to transfer the default risk of a loan to a third party. As a result, credit derivatives are mostly desired when one party is not confident about whether the other party will be able to pay back its money on time.

        The general procedure for two parties to enter a credit derivative agreement is to sign a negotiable bilateral contract that requires one party, for a fee, to cover any loss incurred in the event of the borrower’s default. However, if the borrower does not default, the insuring counterparty is not required to pay anything to the initial lender, and it gets to keep the fee as a gain. For example, if our group wants to borrow $50,000 from the Michigan Credit Union to start a new business, and the MCU believes that we carry significant default risk. The MCU can either simply reject our request or enter into a credit derivative agreement with the Chase Bank by paying the CB a fee. The terms of the agreement will state that if our group cannot pay back the loan, the Chase Bank will be required to compensate MCU for us, but if our group does not default on that loan, the Chase Bank will be able to keep the fee without paying anything.

Question 2: Why is the management of the firm’s “own” credit risk important to its derivatives operations?

There are three types of credit risk for a firm: default risks, additional spread risks, and downgrade risks. Default risk is the risk that the company fails to meet its payment obligation; Additional spread risk is the changes of interest rate compared with the treasury bond yield. The downgrade risk is related to the changing of the credit rating. If the credit spread becomes larger, the price of the bond will decrease. Successfully managing all the aforementioned risks is very important to companies because those risks are directly related to their derivatives operations.

Management of firms should take care of their own credit risk because on the one hand, credit risk could potentially affect the price of their future credit derivatives. On the other hand, the credit derivatives reflect the credit risk level of the firm. As a result, the credit derivatives are one of the securities that indicates the credit risk of the firm. If a firm fails to control its credit risk, the public would know the tough situation and the firm might get into monetary crisis. If the price of credit derivatives went up, the cost of debt would be higher, and the company would have a tough time to get new loans.

To sum up, we believe that evaluating the price, the rates, and the contract between two parties in a credit derivative agreement could potentially be a way for the public to rate the risk level of the firm. In addition to that, investors could also have a better understanding of how confident are the management of those firms about their company’s future financial stability.

Question 3: What are the different approaches to managing one’s own credit risk?

        The credit risk of a company depends on whether the firm can pay back its debt, or solvency of the firm. There are numerous approaches for companies to manage the credit risks includes quantitative and qualitative methods.

For quantitative methods, we believe that firms need to first take a careful look of their historical financial statements, and then evaluate their ability to pay back debt based on their historical debt borrowing level and their historical income level by calculating the debt to income ratio (monthly recurring debts of a company divided by the gross monthly income). Companies with a debt-to-income ratio below 35% are considered as having acceptable credit risks. As a result, if a company gets a ratio that is higher than 35%, it should be alarmed and starts to pay close attention when considering borrowing new loans.

Another quantitative method a company can use to manage its own credit risk is to get its FICO score from the Fair Isaac Corporation. A FICO score is a type of credit score that considers numerous factors in five areas to determine credit worthiness: payment history, current level of indebtedness, types of credit used, length of credit history and new credit accounts. Lenders such as banks usually use borrowers' FICO scores along with other details on borrowers' credit reports to assess credit risk and determine whether to extend credit. As a result, companies can manage their own credit risk by creating specific strategies based on their FICO scores such as: (1) managing credit accounts, (2) evaluating the types of credit used to whether those types fit the company’s financial situation, (3) paying closer attention to manage its credit history and the length of the history.

For the qualitative method, we think in order for the managements of a company to manage their own credit risk, they need to focus on the big picture by evaluating and adjusting the entire operation chain. Since credit risk refers to the risk that a borrower may not repay a loan, one of the most practical ways to minimize the credit risk of a company is to ensure the company will have stable if not increasing future cash flows. A company can achieve that goal by (1) increase its operation efficiency to maximize profits using limited resources, (2) hire talents to better manage the company’s financials, (3) find ways to expand its market shares and improve their overall credit ratings.

Question 4: How are credit derivatives being used as an alternative to other approaches of managing credit risk? Are they more efficient?

Investors and fund managers had limited ability in regard to managing the credit risk of bonds because bond holders could not affect the investment decisions made by the board. As a result, a conflict of interests occurred--bondholders wanted to get their money back on time but the management wanted to invest in risky project to generate higher future profit (agency problem) which might lead to default.