Monthly Archives: January 2012

Phantom Costs to the Swap Dealer Designation and OTC Reform

The CFTC is working to finalize the rule defining swap dealers and major swap participants. Under the Dodd-Frank financial reform, the rules governing operation of the OTC derivative market operate in large part through codes of conduct imposed on these entities. As reported most recently by Silla Brush at Bloomberg, a number of companies are hoping that the rules will be redrafted so that they escape designation and the responsibilities that go along with it. To bolster their lobbying effort, these companies commissioned a report by the economics consulting company NERA to estimate the costs of applying the law to them. The Bloomberg story quotes me as saying that “the study exaggerates the costs of the rule.” Here’s a little more meat behind what I meant.

NERA calculates the cost of posting margin as follows. According to the 26 companies that sponsored its report, the average company would have had to post $235 million in margin. NERA estimates the margin account would have earned interest at a rate of 3.49%, pre-tax. According to NERA, the Weighted Average Cost of Capital (WACC) for the energy companies who sponsored its report at 13.08%, pre-tax. That is, in order to raise the capital needed to fund an extra $1 in the margin account costs the average company 13.08%, but that account only earns 3.49%. The difference is 9.59%. The idea is that a company is losing the difference, or 9.59%, on every $1 is has to post in margin. Multiplying 9.59% by $235 million per firm yields an annual cash flow shortfall of $23 million per firm, NERA’s estimated Annual Carrying Cost of Margin.

One big error in the calculation is the use of the 13.08% WACC figure as an estimate of what it would cost to fund the margin account. This is comparable to the error of discounting a specific project’s cash flow using the company’s WACC, ignoring the fact that the risk of the project may be very different from the average risk of the firm. Every introductory corporate finance textbook warns the reader against this mistake. The average WACC reflects the average riskiness of all of the different assets of the firm. It makes no sense to compare the average WACC against the expected return of a specific asset or project and claim that that is a rate of return shortfall. A manager who did that, would consistently see a shortfall in relatively safe projects and a premium in relatively risky projects, regardless of the actual NPV of each project. The NPV is determined by comparing the project’s expected return against the project’s own cost of capital, not against the firm’s average cost of capital. Only in the specific case that the project’s risk equals the firm’s average project risk, is the WACC coincidentally the right cost of capital. That is clearly not the case for the margin account. It is invested in relatively safe assets. In contrast, the NERA companies’ average WACC reflects investments in power plants, oil wells, and derivative trading operations, all of which can be expected to be much riskier. That is why NERA’s calculation is an exaggeration. It isn’t just off by a rounding error. The key number it uses has absolutely nothing to do with what NERA purports to measure.

Yelling over Credit Lines

After arduous negotiations and risking approaching a dangerous zone, last week, Yell, the publisher of the yellow pages, reached an agreement to buy back £159.5m in debt.

The company has seen continued decline in print revenue from competition of internet search engines. Struggling under a £2.6bn debt burden, it became clear last year that the loan covenants (Net debt-to-Ebitda no higher than 5.7X) had to be renegotiated.

Yell’s management devised a turnaround plan that aimed to see earnings and cash-flow return to growth in three years, and also presented the lenders a proposal that would create breathing space to the company. The key components of the plan were a debt buy back, taking advantage of deeply discounted market prices, and a reduction of the £173 in undrawn bank credit facilities down to £30m. The company also would pay £15-£20m to the banks in return for the extra headroom on the loan covenants.

The lenders supported the turnaround plan, but clashed on the debt restructuring plan. On one side, Yell’s main banks, which hold about half of the company’s debts, wanted the reduction in the undrawn credit facilities. On the other side, hundreds of institutional investors objected that the reduction favored the banks at their expense.

To the group of institutional investors, a revolving credit line is a commitment made by a lender to be used by the borrower at its discretion, as long as the covenants are respected. It does not matter whether the facility is undrawn or not; what matters is that it is an option owned by the borrower that has been written by the lender. The terms of the undrawn credit facilities had been negotiated when Yell and the markets were doing much better. The institutional investors pointed out that these credit facilities therefore had value that should be shared by all lenders. Reducing the undrawn credit facility, they pointed out, was equivalent to repaying the banks the credit facilities at face value, when the value of the institutional investors’ debts sold at a deep discount.

So, as the price of their agreement to relieve the banks from their credit exposure to Yell, the institutional investors demanded that other lenders be paid compensation proportional to the portion of the credit facilities that would be voluntarily cancelled.

By sticking together, and since they (conveniently) held more than two-thirds of the votes necessary to have the debt plan approved, the group of dispersed institutional investors reached a compromise with the other lenders, clearing the way for Yell to buy back part of their debt at prices close to a 70 percent discount to face value, and push out a possible covenant breach by two years.

Whether that is enough for a company that has refinanced the terms of its loans twice in two years and is living one day at the time, only time will tell. For now, Yell should display its corporate logo upside down, proudly exhibiting the V, for victory.

Climate apples and oranges

Monday’s post discussed a proposal by Vikram Pandit, the CEO of Citigroup, calling for a comparison of the results produced by risk models across different banks when evaluating a standardized “hypothetical” portfolio of assets. Exercises like this are standard fare in many research fields where modeling encompasses a broad array of complicated issues, and there can be wide disparity in both structural and parameter choices.

Let’s look at the economics of controlling greenhouse gas emissions. A number of major research institutions have developed economic models to assess the costs of mitigation, including one of the MIT centers where I work. The results from these models play a useful role in public discussion about what should be done.

But these models are inherently very complicated. Greenhouse gases are produced in many different sectors of the economy, in particular in the energy sector which is, in turn, an input to many other sectors, so an economy wide model is required. The greenhouse gas problem operates at long time scales, so technological evolution over many decades is key. Finally, greenhouse gases are a global public goods problem, so a global economic model is required. Building a model to meet these demands is a heroic effort, demanding many judgment calls on major issues.

Understanding the different assumptions and structural choices and how they impact the results is useful, and can shape how the results are read. During the Bush administration, the U.S. government, which underwrites much of the research in this area, ran a comparison exercise on these economic models similar to what Vikram Pandit is proposing for bank risk models. They took 3 of the leading models, and had them generate a suite of diagnostic results when analyzing a common set of policies. They then published an analysis of the different results and the underlying modeling choices that generated the differences. This was done as a part of the Climate Change Science Program and the full results can be found here.

To illustrate the variation across models, here’s just one of the diagnostics, the forecasted change in the price of natural gas. The three models produced strikingly different results. One model produces a forecast that increases more than 800% by the end of the century under modest emissions constraints, while another forecasts increases less than 200%.

Seeing such widely variant results is an eye opener. Novices in any research area often take modeling results for granted. Seasoned researchers are more attuned to the weaknesses and uncertainties and range of different opinions across the scientific community. Comparison exercises, like the one done by the U.S. Climate Change Science Program, or like the one Citibank’s Vikram Pandit is proposing, shine light on differences that the public needs to be better attuned to.

Of course, knowing that there are differences isn’t the end of the process, and doesn’t solve all of the problems. But it’s a useful contribution.

Banking apples and oranges

Vikram Pandit, the CEO of Citigroup, used an opinion piece in last week’s Financial Times to make an interesting proposal on risk disclosures: banks and other financial institutions should be required to report how their internal modeling assesses the risk in a “benchmark” portfolio. Regulators would define the contents of this hypothetical portfolio, and banks would report “a hypothetical loan/loss reserve level, value at risk, stress-test results and risk-weighted assets.”

It’s a useful proposal that could give investors and other market participants additional useful information. But it also has its limitations, and does not resolve some inherent problems with risk-based capital requirements, and does not eliminate the need to control bank size and risk by other means.

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