Monthly Archives: January 2011

Hedging with vertical integration — oil company edition

The NYTimes today carries a Reuters Breakingviews column arguing for a break up of the vertically integrated oil majors. The author trots out a number of questionable arguments in favor of a break up. He then voices a counterargument that is directly relevant to the themes of this blog:

“Executives argue that lumping refiners and explorers together offers a natural hedge. In theory, when falling crude prices hurt production, the refining business gets relief from lower input costs.”

Some might claim this is just a straw man, but I hear this thinking often enough that I think it is worth pushing back against it.

Two points.

First, in its simplest form, this argument just has to be wrong. At a first approximation, combining production with refining in no way hedges production. The oil producer is a natural long. The refiner is neither long nor short. The refiner both buys crude oil and sells refined oil products. It captures the margin between the two. Adding up the exposure of a producer with the exposure of a refiner yields a company that still has the exposure of a producer. There is no natural hedge there.

What I mean by ‘at a first approximation’ is that we assume that the price of crude and the prices of refined products all move together, one-for-one. Of course, this assumption doesn’t hold. When crude prices move, margins on refining often move, too. But the relationship is complicated, and in no way can it be described as a natural hedge. At best, it is like any two distinct operations within a broadly defined industry which have exhibited some negative correlations in the past so that profits from the two divisions seem to hedge one another. Whether the correlation is really there and reliable in the future is a very difficult question to resolve.

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OTC #7 The Collateral Boogeyman – realism, Portuguese edition

Gillian Tett at the FT reports that

…the Portuguese debt management agency formally announced in an e-mail that it would start posting collateral (such as cash or government bonds) on derivatives trades that it cuts with banks. It is intended to have a “positive effect” on its financing costs, and reduce “credit exposures”, it said. To onlookers, this might all sound dull and technical.
But in reality it carries considerable symbolic and practical significance. This week’s is just one sign of a much bigger paradigm shift about how investors and risk managers are now re-evaluating their assumptions about “safe” public sector debt.

Yes, it signifies a paradigm shift in how Portugal’s creditors view its debt. But it also signifies another paradigm shift as society gradually comes to grip with accurately assessing the costs of credit implicit in derivative transactions and compares this with the explicit cost of collateral.

As we have written in an earlier post, when a derivative contract is written without requiring collateral, the dealer bank is implicitly extending credit for potential losses incurred by the counterparty. It has to charge for that. In the case at hand, the bank itself finds it expensive to have that credit on its books or to offload it by hedging in the credit default swap market.

It is one thing to hedge the risk of a firm in an industry that has many players. At least the common factors that impact that industry are readily available for trading through alternative CDS contracts. It is another thing to hedge a risk that is a lot more specific, which involves finding someone who is willing to bear that risk in an inherently thin market. Moreover, markets tend to dry up when things get rough with the number of active players shrinking to a mere handful. Evidently, search and contractual costs are high in an imperfectly competitive market such as the CDS market for Portuguese risk when the country is close to the abyss. At this critical juncture it is crucial that the high CDS spreads do not feed a vicious cycle of higher rates that prompt even higher CDS spreads. What this means is that it may be better for the Portuguese government to post collateral on the derivatives transactions, and avoid buying its credit on costly terms from the dealer bank.

The question is, however, how much collateral has the Portuguese government still in store?

Which Factors are Reshaping Corporate Cash Choices?

We’ve posted before about the increasing cash balances at many companies – here and here. The WSJ today has an article about Apple’s large cash hoard and the debate over whether the company should return some of it to shareholders or keep it for future investment. In one of our earlier posts, we emphasized the impact of the Great Recession on the expected returns from new investment. Of course, with the interest rate earned on cash balances at rock bottom, can the return on investment really be even lower? This question highlights the fact that the cash balance decision is about more than just a simple comparison of the immediate return on investment against the return on cash. Cash balances earn an implicit return as a precaution against future events – the so-called convenience yield. The Great Recession has not only recalibrated the forecasted return on investments, but has also recalibrated the convenience yield on cash, increasing the value of larger balances. Here are two ways.

First, the collapse of Lehman and all the troubles in the financial sector made access to external funding more difficult and uncertain. In the last two years, many banks have felt overextended in lines of credit previously granted to corporations, and with weak balance sheets banks have been unable to raise capital to expand their loan portfolios. So companies worry more that external capital is less available, which raises the value of accumulating their own reserves against future cash needs.

Second, anyone following the troubles of the Japanese economy in the last two decades knows that a weak financial system combined with deflation can be deadly to companies that rely on debt. With sales slumping and prices falling, levered companies find trouble servicing their debts given positive real interest rates. Cash reserves are useful not just to repay debt if deflation kicks in, but also as an alternative source of funds when debt needs to be rolled over by a reluctant financial system.

The options facing shareholders, too, have been reshaped by the Financial Crisis and the Great Recession, and this may be another explanation why some are untroubled by companies that are holding onto the cash. Until very recently things were so bleak and uncertain that investors didn’t have a better idea for their savings, and just replicated what corporations were doing. As recently as August 2010, there was talk that the US economy might fall into a double dip recession with the risk of deflation in the horizon, prompting an energetic response by the Fed (the QE2 program); in the Eurozone, a mounting government debt crisis kept many spirits alarmed. Under these conditions, investors put their money in short term assets and repaid their debts. Indeed, this is what the data on the flow of funds reveals.

None of these factors reshaping the corporate cash decisions is easily measured. We lack very useful normative models that can be recommended as reliable tools for guiding corporate decisions on cash; at least not any that are readily benchmarked against measurable factors. All we can really do is watch what individual corporations do and how their shareholders respond. It will be fun to watch the debates at Apple as the company reports its earnings today and begins to discuss its decisions about the future.

Hedging and the Terms of Debt

A new academic research paper by Campello, Lin, Ma and Zou takes a stab at documenting the impact of corporate hedging on the terms at which the company can borrow money in the syndicated loan market. (older version available here for free) For the last two decades, syndicated loans have been the largest source of funding for corporations, larger than the bond issuances. The study looks at hedging and loans at 1200 firms over the years 1996-2002. The authors advertise the paper as a look at one important channel through which hedging may add value to companies.

The findings are…
1. Increased hedging lowers the loan spread.
Companies with average usage of hedging derivatives are charged loan spreads that are 28% lower than non-hedgers. The impact is stronger for companies with higher probability of bankruptcy (lower Z-scores) and for companies with higher growth opportunities (higher market-to-book ratio).
2. Increased hedging lowers the probability that a loan will include a covenant restriction on investments.
An average hedger has 20% less probability of facing investment restrictions than a non-hedger. In addition, a one-standard deviation drop in Z-score increases the likelihood that the lender will impose a capital expenditure restriction on a non-hedger by 15.5%, compared to a statistically insignificant 5.2% for a hedger.
3. Increased hedging increases investment spending by 13% over the mean level.

Three comments.

First, while the paper’s results are surely important, the discussion of the impact on firm value is very confused. For example, an effort is made to decompose the portion of the loan spread that reflects an adjustment in the nominal rate in order to compensate for the expected loss of default, and the portion that equals the true economic rate of return. The authors label this latter variable the “true cost of debt”. But it is not a deadweight cost, so whether hedging reduces this true cost or not does not answer the question of whether hedging raises the value of the firm. Assuming a Modigliani-Miller world, hedging lowers the systematic risk of the firm and therefore its expected return on capital. The return on debt will fall, accordingly. But this leaves firm value unchanged. We can abandon the Modigliani-Miller assumption and recognize that hedging may somehow reduce deadweight costs and therefore does increase firm value. But still, this reduction in deadweight cost isn’t measured by the authors’ “true cost of debt” variable.
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GE’s CFO, on Forecasting, Financial Planning and Earnings Guidance

The Fall 2010 Journal of Applied Corporate Finance printed an edited version of a presentation by GE’s CFO, Keith Sherin, on “Financial Planning and Investor Communications at GE (With a Look at Why We Ended Earnings Guidance). The original talk happened at the University of Notre Dame’s Center for Accounting Research and Education (CARE) conference on “Financial Statement Analysis and Valuation: Forecasting Firm and Industry Fundamentals” held at Coral Gables, Florida on April 9, 2010. The video is available here. Sherin gives a clear exposition of the financial planning process at GE and its role in management, how they compare ex post performance to projections, etc.

Futures Prices: The Weapon of Choice in Acreage Battles

The Financial Times reports that farmers are looking to futures prices as they decide which crops to plant:

Keith Phillips, a Missouri farmer, plans ahead. In November he determined how to plant his family’s 7,000 acres this year: mostly corn and soyabeans, with the rest alfalfa and wheat.
But a question mark remains against several hundred acres as he awaits signals from Chicago’s futures markets that could swing them from beans to corn. …

Many farmers have invested in fertiliser and seed and begun selling crops forward on futures markets, making planting plans inflexible.

This is, of course, exactly how it’s supposed to be. It’s always fun to see how mundane economic decisions can be spiced up with a good slogan: the FT headline calls this the “battle for acreage.”

In an article last month, the FT says that Cargill traders call this the “fight for dirt.” In this battle, futures prices determine the winner: “The planting projections will change as forward prices oscillate.”

Should corporates manufacture inflation hedges?

Reuters’ Breakingviews has a column suggesting that a number of corporates are issuing floating rate debt in order to service the demand of investors for an inflation hedge. Recent issuers mentioned are Berkshire Hathaway, General Electric and MetLife. The column is entirely conjectural on whether this is the actual motivation of these companies. And the column makes much of a tiny sample  and short window. But…

There is very good evidence that companies are more likely to choose a floating rate issue over fixed when the yield curve is steep as it is today and has been for a while. The recent literature began with a paper by Michael Faulkender (now at UMaryland) in the Journal of Finance. There has been a long stream following that. Faulkender studied issuance by companies in the chemical industry and found:
(i) their exposure to interest rates did not predict their choice of floating vs. fixed interest rate debt — i.e., hedging needs did not drive the choice, and
(ii) the price of interest rate risk did not predict their choice –i.e., they were not selling the highest value security.
Instead, the companies appeared to be choosing floating vs. fixed in order to:
(a) manage earnings, or
(b) ride the yield curve, a familiar and dubious speculative strategy.

The Reuters conjecture that corporates are giving bond investors the inflation hedge they deserve is at odds with Faulkender’s results. It matches explanation (ii) above, which the data did not support. In my mind, Faulkender’s results are very weak on (ii) because it is very hard to measure this sort of thing. So perhaps these issuers are providing the market something it demands. Right now, however, there is little substantive evidence in favor of the Reuters conjecture and good evidence that company financial officers have all the wrong incentives and are insufficiently monitored and disciplined for gambling on interest rates.

The Dark Side of Financial Innovation

There is a paper by Brian Henderson and Neil Pearson soon to be published in the Journal of Financial Economics (pre-publication working paper is available for free here) that documents significant overpricing of a complicated structured equity product marketed by investment banks to retail customers. The authors evaluate a set of SPARQS created by Morgan Stanley between 2001 and 2005. SPARQS stands for Stock Participation Accreting Redemption Quarterly-pay Securities. These are a classic derivative security in that they repackage the payoff from an underlying equity security.

The authors find that on average customers pay 8% above the fair market value for securities. On the assumption that Morgan Stanley is producing a uniquely valuable payoff structure that customers find it difficult to produce for themselves, it could make sense that the bank might charge a premium. In fact, it would have to in order to cover its own costs of manufacturing the payoff. However, the size of the premium in this case is very large. So large, in fact, that the authors document that customers should expect to earn less than the risk-free rate of interest. Moreover, the payoff structure seems to be similar to what can be obtained from more pedestrian securities already easily obtained in the marketplace. So the product offers no unique hedging value that could offset the high price paid. The authors point out that “…most SPARQS investors would likely have been better off investing in non-interest bearing accounts.”

Henderson and Pearson present the results as a challenge to the claim that financial innovation always makes the world better.

Financial institutions’ ability to create securities providing state-contingent payoffs tailored to the needs or desires of specific investors or groups of investors seems especially conducive to achieving these potential benefits. But there is a darkside to the ability to create instruments with tailored payoffs. If some investors misunderstand financial markets or suffer from cognitive biases that cause them to assign incorrect probability weights to events, financial institutions can exploit the investors’ mistakes by creating financial instruments that payoff in the states that investors overweight and payoff less highly in the states that investors underweight, leading the investors to value the new instruments more highly than they would if they understood financial markets and correctly evaluated information about probabilities of future events.

It will be interesting to see if someone challenges the valuations or the argument made with them.

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