debt securitization

Enron seems to have been an illustration. JP Morgan Chase, Citigroup, and several other banks lent had billions of dollars to Enron, but they appeared to have provided very little oversight, either while Enron was thought to be healthy or after its fortunes began to deteriorate. There no doubt were many reasons that the banks were
missing in action, but surely one of them was credit derivatives. The banks that financed Enron had used massive amounts of credit derivatives to limit their exposure
in the event Enron defaulted? by one estimate, they used more than 800 swaps to lay off $8 billion of Enron risk. The banks would have preferred that Enron survive, even after buying all this protection. After all, a healthy Enron meant the ability to keep making loans to Enron and to continue pocketing the fees. But the prospect of Enron?s decline meant much less to Enron?s banks than if their loans were fully exposed.

The phenomenon is familiar in business life. Bank managers may sleep better at
night if they hedge their nine digit exposure to a company like Enron, just as the
managers of well-diversified conglomerates slept well in the 1960s. But the protection dulls their incentive to actively monitor. And since banks are often particularly well-positioned to monitor? due, among other things, to their sophistication and the access they have to the details of a debtor?s finances? the use of credit default swaps can neutralize a very good monitor. There may be offsetting benefits when a bank hedges its risk, of course, as we saw in the previous part. But lenders? access to credit default swaps complicates the assumption that a significant bank presence invariably translates to active oversight of the borrower.

In theory, the counterparties to a credit default swap could take up the slack,
assuming the banks? monitoring role along with their credit risk exposure. Hedge funds that sell credit derivative protection may emerge, in time, as active monitors of the companies that are the subject of credit derivative contracts.29 But the pension funds and insurance companies that take on much of the risk are unlikely to provide meaningful monitoring. Unlike banks, they have no relationship with the borrower and are less skilled and experienced in evaluating risk. Overall this suggests that credit default swaps may reduce monitoring oversight, and can lead to moral hazard on the part of borrowers who are subject to less financial discipline from their lenders.

Partnoy & Skeel. The Promise and Perils of Credit Derivatives http://lsr.nellco.org/upenn/wps/papers/125