Author Archives: Antonio Mello

Risk manager of the Year: Bob “Kid Rock” Ritchie

When Rap-metal-rocker “Kid Rock” launched his album Devil Without a Cause fifteen years ago, he became an instant success, after years of toiling in obscurity.

Now, the man is shooting to superstardom in finance, by tackling the high costs of attending rock concerts. If he succeeds (and I hope he does) he will turn the music industry on its head!

Singers are paid an agreed fee per concert (say $200,000), with the rest going to the organizers of the event. Organizers are the residual claimants and bear all the risks. Sometimes they win, other times they lose. To protect themselves, organizers charge high ticket prices and control a large concentration of the concert venues.

Egg head Kid Rock figured this might not be an optimal arrangement. So he is willing to give up the big upfront fee and instead share in the net income and the risks with the concert organizers. What’s really daring about this proposal of a self-confident singer turned entrepreneur, is that Kid Rock wants to lower ticket prices to just $20 (instead of $80+). Wow!

Some think that Kid Rock is motivated by an ego that thrives in exhilaration with a house packed with fans, who otherwise would not be able to afford a memorable night out. Others say that low concert ticket prices are used as a mechanism to boost sales of his records afterwards. Others venture that seeing the man perform makes you a lasting fan. Perhaps, but I don’t believe this is the whole story, simply because Kid Rock’s idea had to pass mustard with the concert organizers.

What Kid Rock seems to understand is that there are a lot of other things that people buy when they attend a concert, from drinks, food, parking, to all the paraphernalia that is stimulated by the overwhelming emotions experienced in such events. All of these can bring big bucks that are directly related to what’s going on stage! In fact, listening to Kid Rock’ Bawitdaba makes people so excited, with all the lights shining, the bodies in constant motion and the collective singing, that one feels the instant desire to gulp down another beer, even if it costs three times more than at a local liquor store. The lyrics anesthesiate any remaining sense of frugality.

The Wall Street Journal calls the deal with Live Nation Entertainment “unorthodox”. Really? This is optimal risk sharing and the right alignment of interests between the parties involved. In the process, monopoly rents might get cut a bit. And when all this happens at once, there are truly big welfare gains.

“They can’t read your brain, but they can read your lips”, Kid Rock, but “they get scared when they hear that you were coming with hits”. Big Hit, indeed!

Deleveraging and the creation of the Eurozone Keiretsu

Many Eurozone banks are going through huge deleveraging: they are selling their portfolios of loans to hedge funds, reducing and cutting revolvers to corporations, and shortening the overall maturity of their exposures. Faced with higher capital requirements as they experience melting equity values, and unable to raise funds from the US money market, European banks are left with no options but downsizing and help from the European Central Bank.

The banks’ deleveraging is paralyzing the European economy. Even healthy borrowers can’t be certain they’ll have the loans and lines of credit necessary for their regular operations. Many are going capital light: cancelling investments, shrinking working capital and selling non-core assets. Banks’ deleveraging has fostered a downward spiral amplified by institutional and retail investors dumping the stocks and bonds of banks and bank dependent borrowers. This is particularly nasty for the Eurozone, given the role banks have traditionally played in funding European firms.

New forms of intermediation are being developed. The most vigorous are via internal capital markets. Holding companies are tightening their grip over funds available at their subsidiaries—even when these are exchange listed companies—and are playing a much more prominent role in the allocation of funds.

A few large corporations are going beyond that and creating their own banks to make up for the vacuum created by the banks disappearing from the funding scene. Having a bank allows these corporations direct access to funds from the ECB, and enables them to store their excess liquidity in-house, instead of in deposits at outside banks that may be vulnerable to runs. The European aerospace firm EADS is considering doing just that. EADS’ bank could be the financial center of a large network of entities with business relations with the corporation, each with access to funds and able to deposit funds with EADS bank. If one counts EADS’ suppliers and major customers, as well as the suppliers of EADS’ suppliers and all their employees combined, that could be a very large bank indeed.

Out of necessity, the European Keiretsu is born!

Temporary Hedges eventually force Deleveraging

Companies are often required to hedge when taking a loan, and especially companies with volatile revenues and little flexibility to quickly adjust their costs to stabilize earnings. Creditors care about being paid back, so they worry that the firm does not fall into a state of low earnings. Hedging reduces the likelihood of that happening, and consequently increases the borrowing capacity of a company.

The problems of Energy Future Holdings (EFH), recently reported in the press, highlight an interesting issue of maturity mismatch between hedging and (excessive) leverage.

What are the problems?

EFH was created in 2007 when a group of private equity investors paid $45 bn to acquire TXU, a Texas power company. The takeover, at the height of the buyout period before the financial crisis, was financed with a debt-to-equity ratio of 4.625X. The deal required EFH to hedge its medium term revenues.

A number of things have happened since then: The development of drilling techniques that tap large deposits of natural gas trapped in shale rock formations in the US and Canada. To make things worse, the deal was signed during a period of high gas prices, prompting many power companies to switch to alternative sources of energy.  The additional supply and reduced demand led to a sharp fall in the price of natural gas, currently hovering around $2.30 per BTU. Even if this price makes gas powered turbines attractive, it takes time to convert existing facilities and build new ones.

EFH uses gas price as a proxy for the Texas electricity price. It shorts natural gas derivatives to make money when the price of the commodity falls. The profits from trading gas derivatives offset the decline in revenues from selling electricity at prices indexed to the spot price of natural gas.

The problem is that the hedges covering the anticipated generated output have been declining over the years and will expire in 2014. By then the company will be highly exposed to natural gas prices, and unless these prices recover significantly, the company will not be able to repay the maturing debt.

Currently, 5-year CDSs on EFH debt have an implied rate of 9.5 per cent. Without much hope, creditors have been writing off a significant portion of their loans. This is, in effect, deleveraging. They have also agreed to extend the debt maturities in a gamble that gas prices will rise significantly. This is not consistent with the slight increase in the natural gas futures curve over the next two years.

The example of EFH shows how hedging, or for that matter financial derivatives, can be used to hide more fundamental problems with many leverage deals: That temporary gains in hedges cannot support excessive long-term debt.

Without these temporary hedging profits, investors in EFH are being forced to deleverage. They can do it voluntarily as they seem to be doing, or they can do it through bankruptcy.

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”.

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.

Manufacturers as Banks

EADS, the European aerospace group and owner of the Airbus family of jetliners is busy redesigning its boundaries to become a banker of last resort.

The company recently bought PFW Aerospace, one of its suppliers of specialty pipes and ducts, which became victim of the European credit crunch. With banks sharply deleveraging, even to suppliers of EADS, and with strong sales and orders that will sustain growth for years to come, the company has had to step in on several occasions and provide financial support to its sub-contractors.

EADS’ takeover of suppliers and its role as a financial intermediary are an act of necessity, not of choice. EADS cannot risk delay by suppliers that, for lack of bank credit, don’t meet its timing and quality requirements. Finding replacements and renegotiating contracts would involve huge costs and take years.

For many European corporations, coordinating production through the market has just become too risky. EADS never envisaged it would become a banker to its suppliers nor that it would have to bring some suppliers in-house in order to protect the integrity of its supply chain. Clearly, this is not in EADS’ nature. EADS’ example shows an often forgotten cost of the financial crisis: that firms are the (second best) alternative to the market mechanism. When the credit arteries get clogged it is more efficient to produce in a non-market environment.

Europe’s banking crisis is forcing many firms to redefine their boundaries. It is also sending many others to the graveyard.

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.


It is becoming clear that the UBS scandal that rocked financial markets last week is not just about a single trader suddenly gone awry. UBS’s controls – both in risk management and auditing – failed miserably. Top bankers in the investment banking arm of UBS didn’t have a clue about what was going on in the trading desks and in the back office. When a kid can so easily blow a $2.3 billion hole in the balance sheet, and cause so much damage to the reputation of a top tier bank, there’s something awfully wrong.

But the failures of the system go beyond UBS alone. Kweku Adoboli made trades that apparently didn’t require prompt confirmation with its counterparties. Why? Because in Europe, where UBS’s Delta-One trading desk is based, the vast majority of trading in exchange-traded funds (ETF) occurs over the counter (OTC), in bilateral trades. The rapid growth in ETF trading (a profit center) has outpaced spending in back-office and reporting activities (a cost). According to the Wall Street Journal, a report published in 2009 states that over three quarters of European ETF trading didn’t require any reporting.  The Bank of England, among other supervisory authorities, has called attention to the growing complexity and interconnectedness of ETFs. Unregulated OTC trading also makes them obscure. The inherent lack of transparency of OTC markets provides a fertile ground for misrepresentation and outright fraud. It is also likely that opacity makes it much harder to measure the risks taken by ambitious traders.

The European Commission is now carefully saying that it will look into the possible regulatory implications of the case. The Commission, scared to death by the banks’ threat to leave if new regulations are imposed, has ignored the lessons of the 2008 Jerome Kerviel affair, responsible for Societé General’s $7.2 billion mishap with ETFs and related OTC derivatives transactions. It would serve the European Union well if it learned from the US, where ETF trades are reported and cleared through public and open exchanges. No opacity, less room for cheating.

The Risk Management of Economic Angst

I’ve just returned from Europe where I spent part of the summer talking to companies in different European nations. Everywhere I went, the signals are flashing yellow. In Europe, the recovery seems to be coming to a standstill.

A poisonous mix of sluggish output, sovereign debt crisis, fragile banks and lack of political will has created a perverse cycle of lower growth, less than expected tax revenues (despite VAT and income tax hikes), obstinate fiscal deficits, growing public debt, more turmoil in financial markets, stressed banks that refuse to ease lending, further austerity and spending cuts, which further undercut business and consumer confidence, as well as disposable income, which lead to yet lower economic growth and so on. It is as if much of the Eurozone and the UK are dangerously balanced on the edge of another recession…without even having been able to recover to the levels of output seen before it all started in 2008.

Recent data tells a sad story. Industrial production in the 17-nation euro area fell 0.7 percent in June compared to May. GDP has slowed to a meager 0.2 per cent in the second quarter from 0.8 per cent in the previous three months. Even mighty Germany is decelerating fast, with last quarter GDP slowing to a shocking 0.1 percent, and the latest IFO Business Climate Index shows that German businesses have turned much less optimistic.

No question that the coming year will be challenging for European businesses. Many companies have been closely monitoring how the situation is evolving, and are diligently working on contingency plans that deal with possible sinister Eco-Fin scenarios.

The following figure shows the risk matrix used by a European manufacturing company (call it MadeInEU) back at the beginning of 2010 (a few months after the beginning of the Greek debt tragedy). The risk matrix plots the different drivers of risk that matter to MadeInEU. The horizontal axis measures the likelihood of a particular driver of risk happening; the vertical axis measures how a driver influences operations, EBITDA and Cash flows. A heuristic combination of probability and impact helps managers rank the drivers of risk by their relative importance.

The same risk matrix redrawn at the end of June showed a different picture. The most important changes that caught management attention were the significant upgrades in three drivers: (1) Macroeconomy; (2) Access to Capital; (3) Financial Risks (mainly related to the outlook for the Euro).

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