Monthly Archives: November 2011

Prop trading under the guise of hedging: The forgotten lesson of Metallgesellschaft and the Volcker Rule

In the world of finance, the name Metallgesellschaft (MG) is known primarily as one of the early “derivative disaster” cases. MG was a metal, mining and engineering company, and the 14th largest corporation in Germany. At the start of 1994, the company stood on the brink of bankruptcy because of more than $1 billion in losses racked up by a small trading office in New York with a big bet in oil futures. MG’s debacle sparked a vigorous debate—our contribution is here, and a collection of many contributions is available here.

MG was short on a set of long term contracts for the delivery of refined oil products to small businesses for periods of up to 10 years. Many of the contracts were negotiated with a fixed price, while others had more complicated terms. On the other side, MG was long a set of crude oil futures or OTC swap contracts for delivery in one to six months. Taken together, this looked like a long dated short position in the physical hedged by a short dated stack of futures. The critique focused on two questions. First, was the short dated stack a successful value hedge, or had traders at MG failed to accurately “tail the hedge”? Second, did the attempt to hedge such a long horizon physical obligation using derivatives subject the firm to one-sided margin calls, producing a liquidity crisis that the firm could not withstand? From these two questions flow a host of related questions about alternative designs of a better hedge, about the accuracy with which the accounting reflected the underlying financial reality, and governance.

From the narrow perspective of financial engineering, these are all useful questions to consider. However, these questions all start from the premise that the task is to hedge the company’s given exposure on the physical contracts. That is what the situation looked like at first glance, from outside. But courtesy of the acrimony between the team that crafted the failed futures trading strategy and the corporation that dismissed them, a number of internal documents with details on the strategy became public.

Those documents reveal that this premise was incorrect. The traders at MG operated under a very different premise: the long futures position was the real source of profit. If it had been up to them, they would have concentrated on building it up. However, corporate risk management rules limited the quantity of long futures contracts to the volume of physical deliveries. The traders, therefore, had an incentive to market the physical delivery contracts. The more they expanded their long positions in the futures contracts, the more they could loosen the limits imposed by the internal risk limitations, and expand speculative trades. The long futures position only looked like a hedge. In fact, it was a speculation. Traders used hedging to engage in risk taking.This was a classic prop trade disguised as a hedge of a customer facing transaction. When the prop trade blew up, it nearly brought down the entire firm. This aspect of the case is often forgotten.

Eighteen years later, this lesson from the MG case has renewed relevance in light of the $2 billion trading loss by trader Kweku Abdoli at the Delta One desk of the Swiss bank UBS. That spectacular loss gave a fresh reminder of the dangers posed by prop trading at banks, and of the need for prohibitions like the Volcker Rule. So long as taxpayers are the backstop for banks, the traders, the management and shareholders do not suffer the full penalty of the risks from trading. Opposition to the Volcker Rule by bankers is strong, and takes many forms. They argue that any customer facing business, like a Delta One desk, is protected from the prohibition by the mere fact that it is customer facing. This is nonsense. Thankfully, the current draft regulations for the Volcker Rule look to all of the fingerprints of prop trading, and do not provide any such simplistic exceptions. Both the MG case and the UBS case show that prop trading can operate under various guises. It’s prop trading that is the problem, regardless of how it is cloaked.

Song of the Martingale

John Kay at the Financial Times has a nice column reminding us of the delusions of following a martingale betting strategy. It’s a persistent delusion that shows up in many different contexts.

Shareholder value creation at Dynegy

Earlier this month, Dynegy filed for bankruptcy. Well, not the entire company, just one part of it.

The bankruptcy seems to have been written on the wall after failed attempts to sell the entire company.  The old management, external auditors and rating agency Moody’s all declared that Dynegy, saddled with debt and facing declining cash flows, would be unable to survive on a standalone basis.

Some equity holders didn’t see it that way. So they took control of the company and orchestrated a scheme devised to create shareholder value. No, not the way you learn in your MBA. They split the company into two and transferred the profitable assets to Dynegy Inc, which has little debt and room to borrow more to keep operating. Most of the debt and a few less good assets were left with Dynegy Holdings. It is Dynegy Holdings which filed for bankruptcy. Dynegy Inc and its subsidiaries remain out of bankruptcy. Here’s the coverage in the WSJ. Interestingly, the documents filed with the bankruptcy court showed that Dynegy Holdings has assets worth $13.8bn, and debts of $6.2bn. Only fudging NPV calculations are the assets of Dynegy Holdings worth that much.

In control of the show, equity holders are doing everything one can imagine in the realm of bond holder-equity holder conflicts. They reshuffled and ring-fenced the assets, thus eliminating the ability of bond holders to seize them; they committed some of the assets to make them even more bankruptcy remote; they are issuing new debt with a higher priority to existing debt.

What were bond holders thinking when they bought these covenant free bonds? That the loans were relatively risk free just because Dynegy at the time was a stronger credit? That these transactions were impossible, or would be judged fraudulent (still a possibility)? That credit default swaps would protect them? It blows one’s mind that lenders didn’t think they needed covenants.

The events at Dynegy also show the risks of unsecured debt: that when things go wrong, some street smart equity holders take every opportunity to reverse the bankruptcy priority rules. That creditors, especially when they are dispersed, can be slaughtered by investors seeking fortune not by creating wealth, but by devising brilliant holdout plans that redistribute wealth to them at the expense of everybody else. No matter what the bankruptcy documents say about the proposed reorganization, the game at Dynegy is not a serious attempt to walk back the stock price to a higher value by sweating and restructuring the assets. It is pure arm-twisting and lunch-eating of the unsecured bond holders, the lease-holders and the employees.

The events surrounding Dynegy’s bankruptcy could have important repercussions in the corporate bond markets, be these in terms of restrictions on investment-grade issues, repayment triggers, risk premiums and even credit availability. Yes, the cost of capital should go up. And yes, it yields lawyers’ fees galore.

Manufacturers as Banks

EADS, the European aerospace group and owner of the Airbus family of jetliners is busy redesigning its boundaries to become a banker of last resort.

The company recently bought PFW Aerospace, one of its suppliers of specialty pipes and ducts, which became victim of the European credit crunch. With banks sharply deleveraging, even to suppliers of EADS, and with strong sales and orders that will sustain growth for years to come, the company has had to step in on several occasions and provide financial support to its sub-contractors.

EADS’ takeover of suppliers and its role as a financial intermediary are an act of necessity, not of choice. EADS cannot risk delay by suppliers that, for lack of bank credit, don’t meet its timing and quality requirements. Finding replacements and renegotiating contracts would involve huge costs and take years.

For many European corporations, coordinating production through the market has just become too risky. EADS never envisaged it would become a banker to its suppliers nor that it would have to bring some suppliers in-house in order to protect the integrity of its supply chain. Clearly, this is not in EADS’ nature. EADS’ example shows an often forgotten cost of the financial crisis: that firms are the (second best) alternative to the market mechanism. When the credit arteries get clogged it is more efficient to produce in a non-market environment.

Europe’s banking crisis is forcing many firms to redefine their boundaries. It is also sending many others to the graveyard.

The cost and value of variability in electricity generation

The Bloomberg terminal offers an LCOE function provided by its New Energy Finance unit. The function calculates the levelized cost of electricity for a number of generation technologies. The LCOE is the discounted lifetime cost of a generating one unit of electricity from a particular plant type taking into account all capital and operating costs. Shown here are the results for solar thermal, offshore win, solar PV, biomass and municipal waste incineration, geothermal, wind onshore, coal fired, natural gas combined cycle, and landfill gas:

But just because you can crunch the formula doesn’t mean the results are meaningful. Average cost is interesting, but it ignores two things that are critical to properly evaluating different generation technologies. Continue reading


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