As Darkness Descends on Enron, Light is Shed on Collateral Management
The Enron tumble is the latest in a string of high-profile collapses that have brought credit risk to the forefront of the financial-services industry. After the fall, collateral management is rising from the ashes as an important tool to mitigate credit risk and protect against counter-party default.
The 1990s proved to be a decade of high-profile credit-risk catastrophes and losses -- from the Savings and Loans crisis in the early 90s to the Orange County bankruptcy, the Asian economic crisis, the Russian Rouble devaluation and, finally, the Long Term Capital Management bailout that rounded out the years of turmoil.
Billions of dollars were lost as every two to three years the financial community faced major reminders of the vital role credit-risk management can play when dealing with counter parties.
And once again, the financial industry has been reminded that credit-risk management is serious business. Although it is still too early to calculate the full extent of losses, the fall of Enron and its ultimate bankruptcy has shone a spotlight on credit-risk management, and how collateral management in particular could have offered some protection to firms with credit exposures to the seemingly solid energy company.
While the tally for the exact dollar amount of exposures to Enron continues to grow, it is crystal clear that most of Wall Street, as well as other utilities and power companies transacting with the energy giant, has realized losses.
As of December, a long list of financial services and energy-trading companies reported losses totaling $5.9 billion, including loan, bond and contract exposures. Some of those losses, such as those estimated by JPMorgan Chase and Citigroup, have easily reached into the millions-of-dollars range for the individual firms. And with the trend toward collateralization on the rise and major events such as the Enron collapse to remind collateral managers of the importance of credit-risk mitigation, the technology behind it is also getting increasing attention.
The Derivatives Downside
In documents prepared by the law firm of Orrick, Herrington & Sutcliffe LLP, Enron reportedly had about 100,000 trades that counter parties were attempting to unwind just before the bankruptcy case began. The documents state, "Enron entered into complex, innovative transactions trading everything from oil derivatives to interest-rate swaps to broadband capacity and also writing credit default protections on other companies."
While some of these transactions were most likely backed by collateral, some may not have been, in which case the losses would be difficult, if not impossible, to recover.
Additionally, the holders of Enron's credit derivatives could face major losses depending on which way the mark-to-market value goes once the contracts are terminated -- in favor or against the Enron counter party.
Enron traded with various counter parties, from commercial and investment banks to utilities and other power companies. These credit derivatives are used as insurance-like tools for investors to hedge or gain the risk of another issuer defaulting on a loan or a bond. In these credit-derivatives transactions, Enron has a total of about $3 billion in exposure that was traded. But it remains to be seen how much of this amount would be lost if the derivatives contracts are valued against the defaulted-Enron counter party. In general, collateral can be defined as an asset or a third-party commitment accepted by the collateral taker to secure an obligation of the collateral provider. This transaction is generally intended to protect against the default of the counter party. The assets that are usually accepted as collateral in derivatives transactions include government securities, traditionally U.S. Treasuries, and cash.
But while the trend to collateralize has been increasing, some firms that might have only a few select counter parties, or those that might only trade with highly rated counter parties have been slower to jump on the bandwagon.
Nonetheless, collateral management is becoming widespread as trading in the over-the-counter derivatives market grows and credit-risk management has become a hot topic thanks to the major catastrophes of the 90s. In addition, regulator's are pushing to ensure financial firms are monitoring their risk appropriately.
So while financial institutions continue to calculate and disclose their exposures and potential losses, mitigating credit risk has come to the forefront yet again.
When dealing in the derivatives market in particular, collateral management is a key risk-reduction strategy. Derivatives transactions are especially vulnerable to credit-risk losses, as the payment on these trades is often a distant time period away, and with changing market conditions and credit ratings, the likelihood of default by a counter party only increases, or at least the uncertainty of such default. And as the collateral market continues to grow and the collateral agreements and transactions follow suit, the need for more sophisticated collateral-management technology is critical.
A Growing Market for Collateral
The International Swaps and Derivatives Association's 2001 Margin Survey estimates that the total amount of collateral in circulation in the derivatives markets exceeds $250 billion. This number represents a 25 percent increase over the previous year, with U.S.-government securities and cash as the most common assets put up as collateral.
In addition, the ISDA survey found that the total number of collateral agreements in place in the derivatives market for 2001 exceeded 16,000, which is a 45 percent jump from the previous year.
"The 45 percent increase in the number of agreements demonstrates not only the expansion of larger practitioners' programs, but that small players are also increasingly involved," says Louise Marshall, policy director at the ISDA. "It is a fairly staggering increase in terms of the actual number of agreements in place."
She adds that the use of collateral in the derivatives market will continue to grow in the future. "We're encouraged by the number of new entrants coming into the market and the more mature participants are obviously ramping up their use of collateralization," says Marshall.
Why has the use of collateral been increasing? Marshall points out that the main driver for collateralization is, of course, credit-risk reduction. But regulatory-capital savings and increased competitiveness in the markets are also behind the collateralization trend.
"Collateralizing positions mitigates existing credit exposures and frees up credit lines, enabling practitioners to increase the amount of OTC derivatives transactions they can undertake," says Marshall. In other words, the credit department will allow the firm to participate in more transactions with other counter parties as the exposure is brought down through collateralization.
Mark Johnson, first vice president and head of global derivatives at Bank One, agrees that collateralization is catching on thanks in large part to the high-profile events of the last few years, including the recent Enron failure. He adds that moving forward, the Enron impact will "reinforce the trend that collateral or margin is important in the financial markets." He also points to the Sept. 11 events as driving collateralization, "I think a lot of counter parties, and us included, felt more comfortable having collateralized relationships when the markets got a little choppy."
The Technology Behind Collateral
Not surprisingly, as the amount of collateral in circulation and the number of agreements in place continue to grow, the demand for technology to support these transactions has also been increasing. "There's a momentum starting to develop in collateral systems," says Deborah Williams research director at Meridien Research. While collateral-management solutions are likely to remain a part of the larger risk-management technology infrastructure, they are moving away from the back office and toward the more important front- and middle-office areas where the greatest benefits from collateralization can be achieved.
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