During the last few years, many financial institutions have applied the tools of financial engineering to the problems of credit management. New and powerful techniques have been developed to estimate the credit exposures of individual financial transactions and of entire portfolios, to incorporate credit risk into the pricing of different instruments, and to manage credit risk efficiently by separating it from other risks and selectively transferring it to other institutions.1

Historically, the management of credit risk has been limited to exercising judgement in selecting credit counterparties, to monitoring developments once the decision has been made to enter into a transaction, and to working with a counterparty to resolve unfolding problems. The main tool used in this process was diversification - a policy designed to avoid excessive concentration of credit exposures and implemented through credit line limits. The new techniques of financial analysis and new financial instruments have changed credit management in sophisticated financial institutions. In this chapter, we evaluate these new tools from the point of view of a non-financial company, and offer a viewpoint on credit derivatives that other non-financial firms may find useful.

The chapter is based on the experience acquired by the authors in the process of managing various aspects of credit risk in Enron Capital & Trade Resources (ECT) - a unit of Enron Corp. ECT has four principal businesses:

• cash trading of the full spectrum of energy commodities: natural gas, gas liquids, crude oil, refined products, coal, and electricity;
• origination of energy-related risk management products, both for other units of Enron and external customers;
• provision of equity and debt capital to other companies, primarily in the energy business; and
• acquisition and operation of long-term physical merchant assets related to energy production and transportation.

Two features of our business have a profound impact on the credit process. First, our transactions combine, often in one deal, financial and physical aspects. Many ECT contracts for delivery and purchase of physical energy commodities have options embedded in them. These options are aggregated in predefined portfolios (or "books" in our internal jargon) and are managed in a systematic and disciplined way. Credit risk management, like price risk management, must be performed at the level of groups of these portfolios so as to capture the exposure to counterparties across all markets and transaction types. Second, ECT often acts as a lender or as an equity investor, either directly, or by embedding the loan component in a physical or financial commodity transaction.

These aspects of our activities require a strong and multidimensional credit culture. One special feature of our approach is a heavy reliance on quantitative methods, as discussed below.

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"Actively Managing Corporate Credit Risk - New Methodologies and Instruments for Non-Financial Firms" was reproduced with the permission of Risk Books from Credit Derivatives: Applications for Risk Management, Investment for Non-Financial Firms, published in October 1998.

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