Category Archives: credit risk

End-User Horror Stories #1 – FMC

horror victim

ISDA, the trade association for OTC derivatives, released a paper today purporting to document the dangers of derivatives reform. As usual, the alleged victims are ‘end-users’, the non-financial firms using derivatives to hedge risk. The paper is organized around 4 case studies of firms and their OTC derivative hedges, and makes specific claims about their specific hedges. This is a refreshing change from the usual vague generalities, so it is worthwhile examining those claims in some detail. Moreover, ISDA hired two accomplished finance professors to author and lend their credentials to the paper, so there is a promise that the arguments will have more substance than the usual lobbying pitches.

Unfortunately, the promise of something new is unfulfilled. The paper repackages old, debunked claims. Its arguments are shallow and unpersuasive.

Take as an example the case of the chemical company, FMC, and its hedge of natural gas prices. Although the abstract says that the authors will examine hedge effectiveness, the accounting treatment and the impact on earnings per share, in fact, the paper does none of those things. Instead, it makes two other points which I will examine in turn.

First, the ISDA paper claims that the reform increases FMC’s administrative burden of hedging. How? By forcing FMC out of the OTC derivative market and into exchange traded futures. It takes a cumbersome assemblage of 13 futures to reproduce what can be done with 1 OTC swap. The paper implies that managing this cumbersome assemblage is costly, although it never really accepts the burden of quantifying the extra cost.

This argument does not stand up to scrutiny. The whole premise is wrong. The reform does not prohibit FMC from using OTC swaps instead of futures. So why is the comparison of 13 futures to 1 OTC swap relevant? The paper never explains the premise. It’s just implicit in the comparison of the burden of managing an OTC swap against managing a package of futures. Moreover, suppose we imagine that the OTC market was outlawed. Even then, there is nothing in FMC’s customized swap that cannot be reproduced in the futures market. Clearly the risk profile can be perfectly reproduced, as the package of 13 futures demonstrates. So the only problem we are left with is the administrative burden. FMC cannot handle the 13 contracts itself in house. That’s why it’s dealer constructed a packaged swap. But our imaginary prohibition of the OTC market doesn’t outlaw all forms of financial services. FMC’s banker is free to offer the service of managing a package of 13 futures which replicates FMC’s desired risk profile. In fact, that’s exactly what FMC was getting from its OTC derivative dealer. And you can be sure that FMC paid for that service, although the paper’s authors conveniently overlooked the price charged. There is absolutely nothing in the derivatives reform that stops FMC from outsourcing the management of its natural gas exposure using futures contracts. And there is absolutely nothing in the ISDA paper to suggest that it is more costly for the finance industry to provide that service using futures contracts.

Second, the ISDA paper claims that the reform increases the amount of margin FMC must post, and the paper calculates the margin on FMC’s natural gas hedge. The paper implies that this extra margin is an extra cost. This assumes a false equality between margin paid and cost incurred. An OTC derivative saves FMC the burden of paying margin only by having the dealer extend FMC credit. You can be sure that FMC is charged for that service. Unfortunately, the ISDA paper completely overlooks the price paid for credit risk. My paper on “Margins, Liquidity and the Cost of Hedging,” with my colleague Antonio Mello, shows that when you take into account credit risk, FMC’s costs are exactly the same whether they use the non-margined OTC swap or a fully margined futures package.

The Value of Clearing Derivatives

financial dominos

What are the costs and benefits of the reform of derivative markets now taking place? A report released last week by the Bank for International Settlements (BIS) pegged the central estimate of the benefits at 0.16% of annual GDP.[1] With US GDP at something more than $15 trillion, that’s $24 billion annually. For the OECD as a whole, the figure is nearly triple that.

Approximately 50% of the benefits are due to the push to central clearing. Continue reading

Regret in the here and now, joy in a parallel universe

Morgans

Steven Davidoff, the New York Times’ Deal Professor, thinks that management and shareholders at the Morgans Hotel Group got suckered back in October 2009 when they sold their souls a PIPE for cash. Davidoff implies that the investor, Ronald Burkle’s Yucaipa Companies, is doing fine, while management and the other shareholders are squirming to escape as various control triggers are closing in on them.

Continue reading

Can Hedging Save Cyprus?

Lenos Trigeorgis has a piece in the Financial Times’ Economists’ Forum advocating the use of GDP-linked bonds for Cyprus.

Suppose that its steady-state GDP growth is 4 per cent and that fixed interest on EU rescue loans is 3% per cent Instead of the fixed rate loan, Cyprus could issue bonds paying interest at its GDP growth minus 1% (the difference between the average growth rate and the EU bailout rate). If GDP growth next year is 0 per cent, lenders would pay the Cypriot government 1%, providing Cyprus with some relief in hard times. But if after, say, 10 years GDP growth is 7 per cent, lenders would instead receive 6 per cent. In essence, during recession EU lenders will provide insurance and interest subsidy to troubled Eurozone members, helping them pull themselves up, in exchange for higher growth returns during good times. Increased interest bills in good times might also discourage governments from sliding back into bad habits.

As we’ve written in a couple of earlier posts, this is easier said than done. But it’s certainly thinking along the right lines.

Margins, Liquidity and the Cost of Hedging

JACF

Our paper on end-users and the cost of margins is now out in Morgan Stanley’s Journal of Applied Corporate Finance.

Two Tales of Debt Financing

Debt financing is always a gamble. And often a seductive bet.

The Financial Times’ Andrew Jack reports on the pharmaceutical company Valeant which has been on a buying spree financed by debt. For an ambitious businessman with a view, debt is the tool that makes scale feasible. And, as long as everything works out as planned, the returns are great.

But what if they don’t work out as planned? Who’s bearing that risk?

The Deal Professor, Steven Davidoff over at the New York Times takes a look at debt financing concocted the other way ‘round. Instead of used as a tool to enable acquisitions, it is offloaded as a part of a spinoff.

In these cases, it’s often much clearer who is bearing the risk.

How large is the taxpayer subsidy to Too-Big-To-Fail banks?

The issue came up yesterday when Fed Chairman Ben Bernanke testified before the Senate Banking Committee. Senator Elizabeth Warren cited a Bloomberg report that put the number at $83 billion to the 10 largest U.S. banks. The Bloomberg figure is extrapolated from the finding of an IMF study that the backstop provided to banks lowers their cost of borrowing by approximately 0.8 percentage points.

Matt Levine at Dealbreaker makes the provocative claim that “The Too Big to Fail Subsidy is Negative Sixteen Billion Dollars”. This comes in the second round of Levine’s tit-for-tat with Bloomberg. His original critique started off with a reasonable and incisive drill down into the numbers.[1] Now, after an effective rejoinder by Bloomberg, he abandons the two main points from his original critique and substitutes new ones.

Continue reading

Alternatives to Captives & Contagion

Last week we wrote about the financial contagion from Peugeot’s auto manufacturing business to its captive finance unit, Banque PSA Finance (PFA). The important question this raises for management is whether there are other ways to get the synergies associated with a captive finance unit without at the same time being susceptible to the contagion.

One set of alternatives keeps the unit as a captive, but tries to find financial structures that are not subject to the contagion. This includes separating funding sources and eliminating cross recourse. PFA is now considering offering deposits and making its liabilities separate from the Peugeot.

It is also possible to capture the synergies by some other means such as a strategic alliance with an otherwise independent bank. That’s what Fiat/Chrysler is doing with Banco Santander. The new venture, Chrysler Capital, will provide funds to consumers purchasing and leasing Chrysler’s cars and trucks, as well as loans to dealerships construction, real estate and working capital.

In the new venture with Santander, the automaker Chrysler will not even be listed as a shareholder. Chrysler decided against it because of its low credit rating (B1 by Moody’s and B+ by S&P), arguing that it would have damaged Chrysler Capital’s borrowing costs and ability to raise funds. Chrysler Group vice president of dealer network development and fleet operations, Peter Grady, is quoted in the Bloomberg story saying that “We were looking for a bank with some significant heft” that could “provide the financial backstop that would be needed in a downturn if another capital market disruption occurred.”

 

Hiding Risk by Netting Exposures

whistling past the graveyard

Which representation of a bank’s derivative portfolio provides a fairer picture of the risk it presents, the net or gross balances? US banks, operating under US Generally Accepted Accounting Principles (GAAP), report the balance after netting out offsetting exposures with the same counterparty together with collateral. European banks, operating under International Financial Reporting Standards (IFRS), report the balance gross.[1] Consequently, a naïve comparison of banks using total assets as reported under the two different standards gives an erroneous impression that US banks are much smaller relative to their European counterparts. Were the assets reported on a comparable basis, US banks would climb in the rankings. But which comparable basis is the right one? Should the US bank assets be adjusted upward with the netted derivative assets added back, or should the European bank assets be adjusted downward by netting out more of their derivative assets. A number of US banking regulators and experts have recently started calling for putting the gross exposure onto the balance sheet. Not surprisingly, the big US banks and derivative trade associations like the International Swaps and Derivatives Association (ISDA) argue that the net exposure is the right one.

What is at the root of the disagreement?

Continue reading

Captives and Contagion

peugeot

The French automaker Peugeot is in trouble. Automobile sales in Europe saw a dramatic 8.6% slump in 2012. For Peugeot it was even worse: a 15% drop. Since the company relies overwhelmingly on sales in Europe, the company was burning through cash at a rate of €200 million per month, according to the Financial Times. Earlier today the company reported a loss of €5.01 billion in 2012. Already last March, Moody’s had downgraded the company’s credit rating to junk. To stabilize its finances, management last year initiated a program of asset sales, an issue of new equity, and the closure of one of its manufacturing plants near Paris.

Like many other manufacturers, Peugeot owns a captive finance arm, Banque PSA Finance (BPF). The bank has a special access to Peugeot-Citroen dealer networks and supports automobile sales by offering loans, leases and insurance to customers.

The bank gets its funds in the wholesale market, as shown in the figure below, taken from the bank’s 2012 annual report.

BPF

BPF’s captive relationship with Peugeot-Citroen exposes it to the risks of the car company. The sales volumes achieved on Peugeot and Citroën cars directly affect the bank’s own business opportunities. The ownership relationship, too, creates exposure. Accordingly, the credit rating agency Moody’s determined that its rating of the bank is constrained by its rating of the parent.

In 2012, the automaker’s financial problems infected the bank. As the parent was downgraded, Moody’s also reviewed the rating of the bank, and it was downgraded. In July, the parent was downgraded to junk, and Moody’s announced that the bank’s credit rating was in review for possible downgrade to junk status.

Continue reading

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