CREDIT RISK MEASUREMENT – A PORTFOLIO VIEW

By Jim Rich and Curtis Tange

It would be an understatement to say that credit managers of energy companies have been
busy over the last several months. The PG&E and Enron bankruptcies of last year were
obvious wake-up calls that credit risk was a real threat to the health of their own
companies. Shortly after the bankruptcies came the expected increased industry-wide
scrutiny by the Ratings Agencies followed closely by a round of credit rating
downgrades. It remains a matter for heated discussion whether the downgrades caused a
liquidity crisis in the remaining merchant traders or vice versa. Whatever the case, what
is clear, however, is that several additional “name brand” energy companies will only
escape bankruptcy over the next several months through a bit of luck and some well-
timed aggressive asset dispositions.

How times have changed from the “good old days” of credit risk management. No longer
can credit managers hide behind the false comfort that they only approve transactions
with companies that pay their bills. This past year has highlighted the fact that
sometimes companies do not pay their bills. What is needed in an appropriately
functioning credit risk quantification framework is a portfolio perspective and a long time
horizon. The portfolio perspective accounts for the realization of an average low level of
losses most of the time punctuated with an occasional large loss and an even more
infrequent period of several correlated losses. The long time horizon is necessary to
capture the risk associated with that period of correlated losses. This is highlighted by
the graphic that depicts annual portfolio losses below (Figure 1).

Figure 1: Portfolio Perspective of Annual Credit Losses

Driven by a large number of

simultaneous defaults
Loss Rate ($)

Driven by either high default

rates or large exposures

Average Loss

Time

The key here is a long time horizon – something like a year. Credit managers can not
afford to set limits and manage credit risk based only on accounts receivables balances
plus current mark-to-market exposures. A view of Potential Future Exposure (PFE) is
critical (see our recent article from the May 15, 2002 issue of PUF entitled “Potential
Exposure: The Long View On Credit Risk” for a more complete discussion of PFE).
PFE is an important driver of credit risk for two reasons that are both highlighted by the
table below depicting the fallout from the Enron bankruptcy (Figure 2). First, when
Enron initially filed for bankruptcy it left these “Top-10” Energy companies holding the
bag for over $750 million1 of exposures. Exposure this large obviously came from
somewhere other than accounts receivables. Secondly, as the last column highlights, it
has taken time for full effect of the “credit event” to run its course. It is now obvious
almost a year later that the market believes several other Enron “look-alikes” will not
survive the crisis. One may argue that the troubled companies today had separate and
distinct problems of their own but the liquidity crisis that has settled over the industry
since the Enron filing has certainly not helped their cases.

Figure 2: “Top 10” Energy Counterparties Exposed to Enron – Revisited2

Updated Stock Price
Top-10 Energy Exposure to Stock Price Change
Change
Counterparties Enron ($MM) 9/28/01 – 12/3/01
12/2/01 – 7/26/02
NewPower Holdings,
$110 -69% -100%
Inc.3
Duke Energy $110 -5% -37%
The Williams
$100 -3% -96%
Companies, Inc.
Reliant Energy, Inc $80 -4% -65%
Dynegy, Inc. $75 -22% -97%
Aquila/Utilicorp United $72 -9% -80%
Mirant Corporation $60 7% -87%
American Electric Power $50 -4% -29%
El Paso Corporation $50 2% -76%
ONEOK, Inc. $40 5% 0%
Average Price Change $747 -10% -67%

Some believe that a sweeping round of industry re-regulation will cure the credit risk
problem. Do not count on it. Look no further than the banking industry as a case in
point. No amount of regulation in this industry has proved successful at eliminating bank
failures from credit defaults. Instead, prudent credit managers of Energy companies
should be asking themselves what tools can they deploy to manage credit risk. Again, the
Banking industry is a case in point. It is here that the Economic Capital (EC) credit
portfolio framework was first developed to measure and manage credit risk. Sure Energy
companies are different from banks but the credit risk is the same and the EC framework
can be adapted to account for the differences. In the remainder of this article we lay out
the EC framework for credit risk quantification. Following that we discuss how the
framework can be successfully employed by an Energy company to effectively manage
firm-wide credit risk.

1
“Companies’ Enron exposure estimated at $6.3 BLN”, Reuters News Service, December 7, 2001.
2
As the Enron bankruptcy has not been completely resolved, all figures are preliminary.
3
NewPower Holdings, Inc. was formed through a subsidiary and partnerships of Enron Corporation and is
44% owned by Enron. It has subsequently filed for bankruptcy.
Economic Capital Framework for Credit Risk Quantification

There are two metrics required to quantify Credit Risk. The first metric is called
Expected Loss (EL). EL in statistical terms is the average amount of credit losses per
period that a credit manager should expect to lose. Strictly speaking, since this is an
expectation it is not risk and should be built into the cost of a transaction. The second
metric gets to the heart of credit risk and is referred to as Economic Capital (EC). Where
EL measures the anticipated average loss from a portfolio over the relevant time horizon,
EC captures the variance or the uncertainty of the losses around the average. With its
focus on uncertainty, EC quantifies the portfolio credit risk. These concepts are depicted
in the loss distribution presented here (Figure 3).

Figure 3: The Metrics of Credit Risk

Probability

Expected
Loss

Credit Risk Measured as

Economic Capital

Credit Losses

“Worst-Case” Loss

Expected Loss

Expected Loss is measured by multiplying together three factors: Probability of Default

(PD), Expected Exposure (EE) and Loss Given Default (LGD). The logic behind
multiplying these factors together is straightforward and depicted in the figure below
(Figure 4).
 Figure 4: Measuring Expected Loss

Expected Loss = EL

1. What is the probability of a

Probability of Default = PD
counterparty defaulting?

X
2. If the counterparty defaults,
what is our exposure?
Expected Exposure = EE

X
3. How much of the exposure
amount do we expect Loss Given Default = LGD
to lose?

The probability of default is determined by a counterparty’s or customer’s credit quality.

In the case of large long-term deals with energy marketers, this can be based upon credit
quality measures such as agency debt ratings. The way to measure expected exposure
depends upon the nature of the exposure. For retail customers, this could be measured by
current accounts receivable, whereas for merchant energy counterparties, the appropriate
measure is accounts receivables plus current mark-to-market exposure of contracts plus
the Expected Potential Future Exposure of contracts. Loss given default is determined by
what remedies you may have to mitigate credit losses (e.g., LOC, parent guarantee). The
resulting EL calculated for each individual counterparty in a portfolio is additive across
all counterparties to identify the portfolio level EL.

Economic Capital

Economic Capital is a bit trickier. To be specific, EC is a measure of the amount of

resources a firm must maintain to cover a “worst case” credit loss, and still remain
solvent. It should be clear that the amount of EC is driven by how an organization
decides to define a “worst case” loss. The drivers of EC for a “worst case” loss are the
same three drivers of EL:

• Counterparty/customer Credit Quality – the more likely a customer or

counterparty is to default, the higher the “worst case” loss is
• Expected Exposure – the more exposure that you have to credit losses obviously
leads to higher amounts of “worst case” loss
• Loss Given Default – the less you can recover from your defaulted exposures, the
higher your loss given default and “worst case” loss will be
Plus two additional drivers:

• Portfolio Concentration and Correlation – having exposures to limited numbers

of counterparties or concentrations in certain types of counterparties is like having
all your eggs in one basket. This results in potentially large amounts of losses
when things start going bad, resulting in larger “worst case” losses
• Target Debt Rating – the more credit worthy you want your institution to be
means that you have to be willing to cover and increasingly worsening “worst
case” scenario. In other words a “A” rated institution has to be able to weather a
worse “worst case” loss than a “B” rated institution.

A properly developed EC framework incorporates these drivers in such a way to quantify

the credit risk of an entire portfolio and (more usefully) attribute the credit risk back to
the individual counterparties or business activities within the portfolio. A framework that
is capable of doing this facilitates several useful credit risk management applications.
These applications are highlighted in the next section.

Useful Applications

A framework for quantifying credit risk is useful in and of itself but is enhanced greatly
by the applications it supports. The EC framework with its single metric for quantifying
credit risk stands out as particularly useful stemming from its ease of application in
various risk management situations. These include:

• Capital Adequacy – One of the first useful questions that a quantitative credit risk
measurement framework addresses is whether or not the firm has sufficient
resources (i.e. equity) to be able to cover credit losses resulting from its
operations. Comparing the actual amount of capital (i.e., shareholders equity) to
the calculated amount of EC provides an analysis of capital adequacy

• Credit Approval and Limit Monitoring – A credit measurement framework that is

capable of attributing EC back to an individual counterparty or business
opportunity facilitates limit management. Unlike a limit management system that
is based on exposures, an EC framework focuses on the risk from a given
counterparty

• Business Opportunity Analysis – For asset deals that generate credit risk (e.g.
acquiring a generation asset with a long-term PPA to a customer which may
default), building in a quantification of credit risk from the transaction may decide
the financial attractiveness of the deal

• Prudence Reserve Management – A quantitative method for measuring credit risk

can assist in setting the appropriate amount of prudence reserves to cover credit
losses. The reserves are often set at some level above EL but well below EC
depending on corporate policy
 • Portfolio Management – A versatile credit portfolio model assists in the
management of counterparty exposures by highlighting diversification
opportunities and preventing excessive concentrations of exposures to a single
counterparty or industry.

Conclusion

In addition to the many useful applications of an Economic Capital framework for

quantifying credit risk, one of its strongest attributes is its ability to resonate with two key
stakeholder groups; shareholders and debtholders. The figure below provides a
representation of the conflicting interests of both groups and highlights how Economic
Capital “bridges the gap” as the common metric to serve the differing interests of the two
groups (Figure 5).

Figure 5: Economic Capital Bridges the Gap Between Shareholders and Debtholders

Capital productivity Capital adequacy

“Shareholder view” “Debtholder view”

Economic Profit Financial Strength

Corporate
Managers
Risk vs. Reward Risk vs. Capital

Business
Economic Capital
Opportunity Economic Capital
Capital Structure
Evaluation

In the case of shareholders, whose interest is that of maximizing return on invested

capital, Economic Capital provides the framework to evaluate business opportunities on a
common footing. Likewise in the case of debtholders, who are more interested in making
sure the company pays its bills; Economic Capital provides a measure of the appropriate
capitalization of the organization. Economic Capital provides the single measure that
allows the competing views to strike an appropriate balance between profits and
prudence.

While Economic Capital will not solve all the problems currently gripping the Energy
industry, it certainly provides credit managers with a powerful tool for measuring credit
risk and facilitates several credit risk management applications. In addition, it gives
corporate managers a communication device that resonates well with the competing
interests of shareholders and debtholders.

Jim Rich and Curtis Tange are Vice Presidents in the consulting group of ERisk, Inc.
©2003 ERisk. All rights reserved.