TREASURY UPDATE

At first glance, this statement seems counterintuitive as by
now we should be well acquainted with the value-adding premise of risk
management: to thwart the demons of cash flow volatility.  Further, it’s likely that we’re all keenly
aware of the potential for added volatility to net income, albeit non-cash
volatility, due to the intricacies of FAS133 and its evil reach, namely that of
hedge ineffectiveness.  So, outside of poorly executed hedge
strategies, i.e. whereby the economics of the hedge instrument do not
adequately offset or, by some chance, add to the volatility of the underlying
risk exposure, where else do we check for potential added
volatility?  Check your CSA (credit
support agreement) appended to your counterparty’s ISDA and the risk of margin
requirements.

Given today’s heightened awareness of counterparty credit
risk, one cannot overlook the risk of margin calls, or the cash reserves
potentially required to post against the net-unrealized loss on the hedge
portfolio.  A margin call can be a severe
risk to liquidity reserves.  Moreover,
given the volatility of certain underlying exposures hedged, namely oil prices
as of late, this risk can be substantial and difficult to predict.  Essentially, depending on the size and term
of one’s hedge portfolio, the risk to cash can be as severe as reserving
against a substantial portion of the expected future losses of the hedge
portfolio (almost like pre-paying for future expected losses if prices do not
change).  This added risk can potentially
overwhelm the benefit of the initial hedge objective, which is to mitigate cash
flow volatility, making it even more difficult to execute an effective hedge
strategy.

Consider the case of US airlines, most of whose credit
ratings have dropped below investment-grade status since early 2000.  In the airlines’ situation, their
over-the-counter (OTC) trading counterparty likely requires them to post cash,
or a suitable substitute, as collateral in a restricted account with the
counterparty, or a third-party trust, if the fair value of the hedge drops
below pre-determined thresholds, i.e. in an unrealized loss position.  Further, this margin requirement may increase
as the airlines’ credit deteriorates.

Case in point (WSJ – Airlines Grab Cash Amid Crunch.
12/30/08):  amid declining oil prices
“several airlines have had to post collateral to trading partners against their
fuel hedges.  United [UAL] had to pony up
$900 million, and American [AMR] expects to post $550 million in hedge
collateral by year end.  Delta [DAL] said
it posted $1.1 billion in collateral for fuel hedges earlier this month.”  $1billion in posted collateral!  Basically, they are paying, or posting as
reserve, a portion of potential fuel hedge losses up front.  As of September 30, 2008, Delta reported, ”for
each $5 per barrel reduction in the price of crude oil, we would be required to
post additional margin of approximately $100 million.”  Further, as Delta indicated, ”the majority of
this margin relates to contracts that settle through the end of the first
quarter of 2009” (DAL 10-Q 10/16/08 p.34). 
Although Delta maintains that “margin requirements are short-term and
manageable given $5.6B in liquidity” (DAL 8-K. 12/2/08), the risk is severe
nevertheless.  As such, Delta’s, as well
as other airlines’, ability to adequately hedge themselves is likely severely constrained.

Margin risk can have the effect of limiting firms’ ability
to hedge for any term other than the short-term, forcing them to chase the
market up or down over time.  Of course,
hedging only buys time.  It adds
predictability for the time hedged.  You
can’t beat the market, and that’s not the premise of hedging.  A ‘typical’ strategy may be to hedge more in
the short-term and roll into longer term hedges over time.  But the ability to execute on that strategy
is severely limited when faced with the risk of cash calls, and rightfully so;
it adds an additional element of cash flow unpredictability.

The difficulty in hedging their fuel expense amid the quick
and severe rise in oil prices, increased volatility, and potential margin risk likely
played a key role in airlines being under-hedged during the run-up in oil
prices through much of this decade.  The
severe
deterioration in credit standing and liquidity among airlines in the early part
of 2000 decade led to the inability to obtain long-term hedging contracts in
the OTC market as counterparties were reluctant to take on added credit
exposure to airlines.  These obstacles
left airlines with limited hedging alternatives.  Even the use of call options, or caps, was
curtailed given the expense amid rising volatility and the up-front cash costs
to enter such contracts. 

To be fair, margin requirements typically go both ways
(bi-lateral agreements) with the counterparty required to post and/or return
collateral as the market value of the portfolio returns above the thresholds.  This solves nothing but to mitigate your risk
to your counterparty’s credit, or ability to pay.

A consequence here is that the unpredictability of potential
cash reserve requirements impedes the ability to use fixed-price contracts such
as forwards or swaps, leading to more option-based hedging, which can be both
expensive (note, the decision to use options vs. fixed-price contracts is based
on the costs/benefits of each among other potential issues at the time) and
cash intensive as well.  Further, it may
lead firms to follow a shorter-term hedging strategy. Who knows what oil prices
are going to do – that’s why we hedge in the first place, but what if that only
adds to the problem?  So, does this potential, added risk,
diminish, or worse eliminate, the value in hedging?  I’m not sure there is a definitive ‘no’ or
‘yes’ response to that question, but we will cover that topic in part 2
(forthcoming).  Finally, to see what a risk manager can do in light of
margin risk, return for part 3 (also forthcoming).