Monthly Archives: February 2012

Can Hedging Save Greece?

As a part of its restructuring of debt, the Greek government has decided to issue GDP-linked securities:

Each participating holder will also receive detachable GDP-linked Securities of the Republic with a notional amount equal to the face amount of the New Bonds of the Republic issued to that participating holder. The GDP-linked Securities will provide for annual payments beginning in 2015 of an amount of up to 1% of their notional amount in the event the Republic’s nominal GDP exceeds a defined threshold and the Republic has positive GDP growth in real terms in excess of specified targets.

The payout on these securities goes up and down with the country’s ability to pay. Yale professor Robert Shiller has been advocating this type of financing for a while, including in the most recent issue of the Harvard Business Review. A small number of countries have tried this before. The recent case of Argentina is notable since its GDP-linked bonds have paid off handsomely.

What about the U.S.? Could GDP-linked bonds be helpful in managing this country’s debt burden? That’s the case the advocates are making. Although the idea isn’t yet mainstream, it has at least made an appearance deep in the slide deck delivered by the Treasury’s Office of Debt Management to the Treasury Borrowing Advisory Committee last year.

Not everyone is enthusiastic about the idea.

The True Cost of Government Guarantees — Take 2

As part of the fallout from last August’s bankruptcy of the Federally-backed solar firm Solyndra, the Obama Administration appointed Herbert Allison, a Republican banker and former Treasury official to review the Department of Energy’s loan guarantee program. His report was completed at the end of January and released earlier this week. It contains many useful observations and recommendations and is criticized as well for what it doesn’t contain.

I want to use this post to focus on one specific issue: the correct measure of the cost of a government loan guarantee. In an earlier post about a recent CBO report on the nuclear loan guarantees I described how the current, legislatively mandated method for calculating the budgetary cost significantly understates the cost because it ignores the full cost of the risk imposed on taxpayers. Future payouts on the guarantees are discounted at US Treasury rates, but the true cost of those future payouts should include a market risk premium. I used the CBO report to estimate that the underestimate of the cost of the guarantees for the new nuclear plant at Vogtle amount to $640 million. The Allison Report tells us something about the underestimate on other parts of the portfolio.

The key comparison is between the last column of figures in Table 4, where the cost is estimated using the legislatively mandated FCRA method that ignores the price of risk, and the last two columns of figures in Table 6, where the cost is estimated using the FMV or fair market value method that uses the market price of risk. In total, the FCRA subsidy cost is $2.682 billion whereas the FMV subsidy cost is between $4.970 and $6.839 billion. Taking the FMV cost as the benchmark, the FCRA cost ignores between 46 and 61% of the full cost to taxpayers because it ignores the price of risk.

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Hedging by Racing Cash Out

Speaking at GlaxoSmithKline’s annual results presentation last week, CEO Andrew Witty disclosed some of the strategies the company is employing to manage the risk posed by the Eurozone debt crisis:

We sweep all of our cash raised during the day out of the local banks and send it to banks here in the U.K. which we think are robust and secure. … We don’t leave any cash in most European countries. … And we’ve done that with a huge focus on getting paid. Like all things, if you focus on it, then eventually you do get paid.

GSK is not alone. According to the WSJ, Switzerland’s Novartis changed the incentives for its sales force in countries with significant debt issues, to collect the cash, not just generate the sales and put receivables on the company’s balance sheet. And Vodafone moves cash out of Greece every evening to guard against an exit from the euro, according to its CFO Andy Halford.

In some earlier posts, we have described some of the risk mitigating strategies by companies doing business in the Eurozone–here, here and here. The case made public by the CEO of GSK shows that companies also take precautionary actions by moving money across borders and between banks, as well as by taking steps to claw back money owed them by clients in financially distressed economies. Racing cash out of troubled zones is often done by multinationals operating in third-world countries. What is new is the use of that in first-world Europe.

One might ask whether this is a good way to actively manage risks, since it appears that by cutting funds to these countries companies like GSK are making the crisis worse and increasing their own risks of doing business.

Asked why GSK has taken these steps, Witty replied:

There was a period when things looked more worrying. The action that the [European Central Bank] took over the last six months has clearly had a very positive effect on bank liquidity and confidence. But there was a period last year when every day you were getting a phone call about Bank A, B or C which was perceived to be about to go or there were risks or there was anxiety about different banks in different countries. And we did a very comprehensive review about which banks we thought were the strongest and which weren’t. We moved our cash accordingly.

Witty’s remarks highlight the problem of bank (or country) runs. Whether GSK stays or leaves, it matters little, for if others leave the system collapses. The only way to avoid failure is if everybody stayed, but this is impossible to coordinate when each suspects that the others might leave. Such belief is by itself sufficient to bring down the system. Thus, the role for Leviathan, in Witty’s words impersonated by the ECB, and its actions to provide liquidity and confidence.

One final remark: When asked what the hedging strategy is with the money brought back daily to the U.K., Witty replied:

Remember that we pay our dividend in sterling so actually bringing the cash back to the U.K. is not a bad thing anyway because we always have use for sterling-denominated resources, so it’s really not an issue for us.

Surely that can’t be the whole story, for Witty understands that there are many ways to hedge exchange rate risk. The real problems are the concern over counterparty risk (banking freeze) and having money locked in a country that might fall off the cliff and impose capital controls.  Witty still remembers an emerging markets crisis where the “general manager took bags of money to people’s [GSK staff's] houses”.

Credit Suisse note is not a solution to bonus culture

Credit Suisse (CS) has announced it will pay a portion of its bankers’ bonuses with a structured note instead of cash. The note pays a fixed coupon of around 6% per year, and is backed by a package of derivative contracts currently in the balance sheet of CS. Since the value of the portfolio is risky, the payout is not guaranteed.

In a memo to staff, CS CEO Brady Dougan touts the structured note as a way to address the criticism made against the financial industry’s bonus structures. But is that true?

The central criticism is that the relationship between risk and return is out of whack. The principal behind past bonus structures has been “heads I win, tails you lose”. Performance has been rewarded without regard to risk. Losses have been put to shareholders or to taxpayers. A related criticism is that the process for setting bonuses is opaque and managed by insiders, at the expense of shareholders and taxpayers. This makes it unlikely that insiders ever fail to succeed against the benchmarks that are set, and ensures that the system is skewed against shareholders and taxpayers.

Does the new CS structured note address these criticisms?

No it doesn’t.

It was designed with an entirely different purpose in mind, which is strengthening the bank’s capital position in light of new banking rules. The derivatives portfolio backing the structured note comes from CS’s balance sheet, and CS hopes the move will decrease the measured risk of its balance sheet and improve its capital ratio under the new Basel III agreement. CEO Dougan is straightforward about this strategic objective. But he also wants to advertise the move as addressing shareholder and public concerns on bonus rules.

The structured note fails to address either of the two key criticisms.

Most importantly, it is terribly opaque. Many details haven’t yet been released, but in his memo to staff, CEO Dougan acknowledged that “Instruments such as PAF2 are inherently hard to value. It’s obviously not something that is traded in regular markets so has to be modeled.” Only an investment banker still locked in a pre-2008 mindset would structure a note like this as a step forward to transparency and accountability?

It is also hard to see how the structured note provides a sensible risk-reward relationship for the bank’s senior staff. No one starting from a blank piece of paper would design a compensation scheme based this way on the portfolio of derivatives now on the bank’s balance sheet. Indeed, CS has designed the arrangement with an escape hatch should the capital regulations surrounding its real strategic objective change:

PAF2 represents an effective and real sharing of risk but, nonetheless, we still need to reserve the right to amend this structure in the event of changing requirements. The most likely change would be to amend PAF2 to an instrument that instead of referring to our specific portfolio would reference a public index of credits. In our view this would be just as good for our employee investors. We also need to include a call at market value in case these requirements change so materially that the instrument is no longer effective.

If the note were also a real solution to the bonus problem, it would survive changes in the regulatory capital rules that are its real objective.

If CS’s management were serious about addressing the compensation problem, they would design a durable scheme, not a one-off gimmick. The scheme would include a clear downside for managers and a clear tie to the long-term fortunes of the bank. Simon Nixon at the Wall Street Journal’s Heard on the Street column mentions UBS’s plan to pay bonuses as contingent convertibles as one example in this direction. Another alternative would be the explicit clawback provisions being pushed by New York City Comptroller John Liu. The key is that managers should not be able to walk away from the future fortunes of the bank, and the scheme should encourage cross monitoring of risks among managers within the bank. And these incentives should be clear to all, inside and out. The CS proposal is not a step forward on this front.

The Value in Futures

Today’s Wall Street Journal has a piece by Ian Berry about the possible restructuring of the CME’s rice futures contract. The design of the contract determines how effectively “farmers, elevator operators and beer brewers” can use the contract to do their hedging. The article is about problems that have shown in up in recent times and proposals to fix them. These problems impact how farmers and others manage their operations and investments:

“We are losing rice acres to other crops, and the lack of ability to comfortably hedge is a major reason,” said John Owen, a Louisiana producer who has chaired a committee with the U.S.A. Rice Federation, a trade group, to examine the issue.

Farmers said growing rice becomes too risky if they can’t lock in prices at the start of the season. Most of their expenses come up front, so they need some assurances on what they will get for their crop.

“We need to get our rice farmers back to farming rice,” said John David Frith, a farmer in East Carroll Parish, La., where a vast majority of growers have stopped planting the grain.

Designing the terms of a futures contract is a tough problem. Getting it right is how a market like the CME helps make the economy more productive.


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