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.

Dynamic Hedging or Futile Speculation?

chesapeake

Chesapeake still thinks it can time the market.

On Tuesday management held its Conference Call to update to investors and stock analysts. Steve Dixon, the acting CEO, said “We’ve also taken advantage of the recent surge in natural gas prices to lock in additional price protection in 2013, and we have begun to hedge natural gas production in 2014 at prices well above $4, a level the market has not seen for some time.”

The company has had problems in the past from its foolish attempts to time natural gas prices. Last time prices were falling and the company took off its hedges. This time prices are rising and its putting on hedges. But the mindset is the same.

Behind this dynamic hedging strategy is a common misunderstanding about mean reversion in natural gas prices. The same misunderstanding applies to other commodities as well.

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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.

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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?

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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.

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3 points on the futurization of swaps

Today, the CFTC is hosting a Roundtable on the “Futurization of Swaps.” More than 30 people from various parts of the industry are speaking. I’m on the first panel. Here are 3 points I’ll be making:

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Tax Reform & Derivatives

Representative Dave Camp, Republican Chairman of the House Ways and Means Committee, has released a discussion draft on new rules for the taxation of derivatives. The press release is here. Detail material is found here.

In the draft, derivatives used for hedging are excluded. The criteria proposed here for determining whether a derivative is used for hedging in tax accounting are similar to the criteria already applied in financial accounting. However, a large fraction of derivatives held by non-financial companies are not accounted for using hedge accounting. So, it seems to me that this proposal would probably affect the tax treatment of those holdings.

It will be interesting to see how this discussion unfolds.

Crude oil basis risk is receding… for now.

Companies that hedge oil prices have been forced to reevaluate their strategies over the last couple of years. Many companies have used the NYMEX WTI contract, one of the oldest energy futures contracts and still one of the most liquid. The WTI contract is for oil delivered into Cushing, Oklahoma, but since crude oil is a global commodity and transportation links have historically been good, fluctuations in the WTI price have been a reasonable benchmark for global supply and demand.

However, in the last few years, the differential between WTI and Brent, the other leading global benchmark, have exploded and been very volatile. Suddenly, geography made a great deal of difference. Technology has opened up new production in North America, first from the Canadian oil sands and more recently from US tight oil fields. A bottleneck in the capacity of pipelines for shipping production out of Oklahoma down to the US Gulf Coast meant that the central US experienced a glut of supply, disconnecting the regional price from the global one.

Historical Spreads 2

This has meant that fluctuations in NYMEX’s WTI futures price reflected local variations in demand and supply that did not necessarily track variations in global supply and demand and global crude price. Hedgers not located in the central US faced increasing basis risk in using the WTI contract. Some switched to using the ICE Brent contract instead. Others adjusted their hedge ratios. These events have been a key feature of the recent marketing duels between NYMEX and ICE over which contract is best.

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