Category Archives: credit risk

Moody’s correction

Moody’s issued a correction today.[1] It had previously tagged as ‘credit negative’ for energy companies, the decision by ICE to move many of its cleared energy OTC swap contracts over to its futures exchange platform. Now Moody’s recognizes that as ‘credit neutral.’ Platt’s coverage is here. Continue reading

Moody’s Slips on ICE

As reported by Platts, Moody’s recently issued an analysis of the decision by ICE, the Intercontinental Exchange, that starting January 2013 its cleared OTC energy swap products would switchover and be traded as futures products. Moody’s called that “credit negative for power producers.”[1]

There are many things wrong with the Moody’s analysis. Continue reading

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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Turn a Blind Eye to Credit Risk?

When a bank makes a loan to a business it assumes some risk that the loan will go bad. Regulators, when they do their job, demand that the bank estimate that risk and hold capital against it. That’s safe and sound banking.

What if a bank embeds the same loan inside a derivative it sells to the business? Should the regulators treat that credit risk the same and demand that the bank estimate that risk and hold capital against it? Six U.S. Senators say “no.” They want bank regulators to turn a blind eye to credit risk so long as that risk is packaged inside an OTC swap. So much for safe and sound banking.

Yesterday Senator Mike Johanns (R-Neb.), Mike Crapo (R-Idaho), Herb Kohl (D-Wis.), Jon Tester (D-Mont.), Pat Toomey (R-Pa.) and Kay Hagan (D-N.C.) filed a bill (S. 3480) designed to block bank regulators from recognizing the credit risk embedded in OTC derivatives sold to end-users. Naturally the Senators’ press releases wax lyrical about how their bill protects these end-users by lowering their costs of managing risk. This is a dangerous illusion.

All American businesses suffer when the U.S. financial system is made unsafe and unsound. Following on the Dodd-Frank Act, banking regulators last year proposed a sensible rule finally requiring banks to properly recognize the credit risk embedded in the derivatives they sell. That’s safe and sound banking, and if this country can find its way back to a safe and sound banking system all of America’s businesses will benefit.

The proposed bill seeks to reverse course, directing bank regulators to turn a blind eye once again to obvious risks. It’s a seductive proposition. With a stroke of a pen, the Senators believe they can save a few businesses the costs associated with this credit risk. But no act of law can actually erase the credit risk and the associated cost. The proposed bill only encourages more unsound trading and the accumulation of unaccounted for risk. For a short while, certain businesses will benefit by not having to pay full fare for the risks they add to the banking system. It’s always good while the party lasts. But, in the end, we all lose.

CVA Lessons: Is it better to charge or to subsidize credit risk?

One often hears that competition promotes the efficient and weeds out the inefficient. Yes, but only insofar as there is a level playing field. Give special privileges to certain players, and the best might end up dominated by the inefficient.

Analysts who overlook the power of privileges may mistake dominance for efficiency, getting backwards the true state of affairs.  They also miss that the distortion reduces the welfare of society and redistributes wealth and power in favor of the inefficient.

That’s true in any industry and especially relevant in the case of the dominance of OTC derivatives markets over exchange trading during the last three decades.

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NERA Doubles Down

In a previous blog post, I criticized a study by the economics consulting firm NERA purporting to measure the costs companies would face as the Dodd-Frank reform of the OTC derivative markets is implemented. NERA is working on behalf of a group of energy companies lobbying to avoid some of the law’s mandates. Last week, NERA filed a “Briefing Note” with the CFTC specifically addressing my criticism and explaining the reasoning that leads them to stand by their original numbers.

What is at issue? Dodd-Frank forces companies to margin swap trades that previously could be executed without margins. Does this impose extra costs on those companies? If so, how large are these costs?

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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.

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.

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.

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