Category Archives: debt/liabilities

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


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.

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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.

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.

Exelon’s On- and Off-Balance Sheet Collateral Costs

In covering the Intercontinental Exchange’s decision to move its energy swap trades onto its futures exchange, the Wall Street Journal’s Jacob Bunge and Katy Burne cited data on the power company Exelon in order to highlight how this move might impact end-user costs:

One company worried about costs, Exelon Corp., said in a regulatory filing on May 10 that “even if the new regulations do not apply directly to us, [its power plant subsidiary Exelon Generation] estimates that a substantial shift from over-the-counter sales to exchange cleared sales may require up to $1 billion of additional collateral.”

But the $1 billion figure is only half the story. The other half of the story is the contingent capital that Exelon saves. But since that contingent capital is off-balance sheet, it is commonly overlooked, leading both corporate executives and reporters to significantly exaggerate the cost of using cleared futures exchanges.[1]  In comparing the financing costs of non-margined OTC trades against the financing costs of exchange-traded derivatives, it’s important to look at both the on- and off-balance sheet capital demands.

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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.

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.

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.

Repo Tricks

Brokers dealers and investment banks get a substantial amount of their funding from the repo market. In a typical repo, party #1 (the borrower) gets funds from selling securities to party #2 (the lender); when the repo matures the transaction is reversed: party #1 repurchases the securities by paying party #2 the initial funds plus interest (the repo rate).

To protect the lender, the funds initially received by the borrower are less than the market value of the securities used as collateral. The difference, reflecting the credit risk of the repo borrower and the volatility in the prices of the securities, is commonly referred to as the haircut. To make matters straight, a repo contains bilateral credit risk for both the lender or the borrower might default.

U.S. accounting standards determine that repos be treated as secured financing (FAS 140, §218) in the case of arrangements to repurchase or lend securities typically with as much as 98 per cent collateralization (for entities agreeing to repurchase) or as little as 102 per cent overcollateralization (for securities lenders). In secured financing the loan is reported by the borrower as a liability, while the funds received go to the asset side of the borrower’s balance sheet. More important, in secured loans, the securities remain in the books of the borrower. The idea is that the borrower maintains control of the collateral because it has received sufficient funds to repurchase the securities even if the lender defaults.

The problem is that setting an interval [98-102] opens the opportunity for dubious accounting. Suppose that a borrower agreed to a $1M repo with a haircut higher than 2 per cent for liquid fixed income securities, say 4 percent. Then, it would be judged as not having received sufficient funds to repurchase the securities. The repo transaction would then be reported as a sale of securities plus a forward contract to repurchase for $1M securities valued at $1.04M. The sale of securities would be recorded as a credit entry for $1M in cash, but no associated loan. The repo does not increase the liabilities. Furthermore, the cash can be used to pay off additional loans.

This is how an increase of $1M in liabilities can show up in the books as a reduction of $1M in liabilities. According to the Valukas report (2010) this is how Lehman systematically deceived the markets.[1]

[1] See “Hidden debt: From Enron’s Commodity Prepays to Lehmon’s Repos 105s”, Donald. J. Smith, The Financial Analysts Journal, October 2011.

Shoot the messenger?

Something about yesterday’s earnings announcement by JPMorgan has folks rattled:

Third-quarter results included the following significant items:$1.9 billion pretax ($0.29 per share after-tax) benefit from debit valuation adjustment (“DVA”) gains in the Investment Bank, resulting from widening of the Firm’s credit spreads…

The market is pricing JPMorgan’s outstanding debt with higher spreads, i.e., at a lower value, so JPMorgan books a GAIN equal to the creditors’ market value losses.

Commentators on JPMorgan’s announcement are troubled by the paradoxical result that a higher probability of default–or some other cause of higher spreads–produces an earnings gain. Readers can find commentary on this here, here and here, among many other places.

If assets and liabilities are going to be accounted for using any version of market value, then there is no way to get around the fact that a drop in the market value of a liability must be a gain to the company. The problem arises not from the market valuation of JPMorgan’s debt, but from a failure to see how this one item fits into the larger picture of the company’s earnings and valuation. If the market’s assessment of the company’s future is driving down the value of the company’s debt, that’s not good news for the company as a whole. If the company’s future is less secure, then the multiple that’s applied to its regular earnings should be much less. Properly assessed, this bad news will always swamp the bump in value from the market valuation of liabilities. In the case of JPMorgan, that means the “value” of its other long-term earnings has declined by a lot more than the $1.9 billion pretax bump from the debt valuation adjustment. It’s that decline that analysts ought to be discussing.

By the way, it’s not just bank accounting statements that occasionally exhibit this paradoxical result. It strikes non-financial companies, too. Here’s some text from Constellation Energy’s FY 2007 10K, as that company began to adopt SFAS No. 157, Fair Value Measurement:

SFAS No. 157 requires us to record all liabilities measured at fair value including the effect of our own credit risk. As a result, we will apply a credit spread adjustment in order to reflect our own credit risk in determining fair value for these liabilities which will reduce the recorded amount of these liabilities as of the date of adoption. As a result of this change, we expect to record a pre-tax gain in earnings of a range of approximately $10-$15 million in the first quarter of 2008.

But for most non-financials, the scale of the valuation adjustments in liabilities on the books at market value are usually much smaller than they are for financials.

Corporate financial policy deciphered (2)

In the upcoming years, European telecoms need to issue an average of €30 billion in bonds. But financial market instability suggests that even highly credit-worthy companies may have trouble gaining access to funds.

Liquidity risk management once again became a pillar of corporate financial policy following the Lehman collapse in 2008. It involves a continuous exercise of cash control and refinancing plans that goes far beyond the traditional purpose of bridging temporary imbalances between receipts and disbursements.

For the past two and half years we have been living with the ominous threat of a financial market freeze. These concerns were highlighted by the events of the past week, described in a June 24, 2011, Financial Times article by Michael Mackenzie and Nicole Bullock:

Investors are withdrawing cash from money market funds heavily exposed to short-term debt issued by European banks out of fear that a Greek default could spark contagion across the region’s financial sector.

At the same time there is increasing reluctance among US banks to lend to their European counterparts in the past two weeks…

Investors have not forgotten how some money market funds, viewed as cash-like holdings, had short-dated Lehman Brothers debt and lost money after the bank declared bankruptcy in September 2008.

Once banks stop lending to each other out of concern with counterparty risk, money markets shut down and short-term credit to corporations ceases.  When this happens, companies have to support themselves without backup, a situation which can be exacerbated if key customers and critical partners do not meet their obligations.

Companies therefore need their own liquidity sources to be robust enough to carry them through periods of disruption.  They need to ensure capital availability and a tight grip over operating cash flows in different scenarios, selecting for each scenario the appropriate actions that reduce the probability and/or impact of bad events, for a given degree of residual risk tolerance.

Most importantly, companies must correctly simulate their debt refinancing needs, adjust debt maturities to the risks of a market freeze, diversify alternative funding sources, and ensure that the available credit facilities are committed, unrestricted and long term.

Liquidity risk management is necessary for companies to implement their strategic goals and avoid costly business interruptions.  It is often said in finance that “cash is king”. It certainly is so when cash is the difference between success and failure, life and death.  When equity financing is not viable and good assets sell below their full value, companies should remember: long live the king.


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