Financial Crisis Comments | TREASURY UPDATE

Treasury: Situational Awareness – Lehman and San Mateo County

On February 24, 2010, In Current Affairs, Financial Crisis Comments, Liquidity, Political-Financial, Risk Management, By Craig Jeffery

February 24, 2010’s WallStreet Journal ran an article entitled Lehman’s Ghost Haunts California. This article is well worth a good and critical read. Emphasis on the critical. It covers, essentially, one side of the story about San Mateo County and their loss of $155mm (reported by them) from the collapse of Lehman Brothers. We’ll be more frank in this blog entry even if it makes people feel uncomfortable.

The article states that “San Mateo’s board of supervisors ordered an independent review of the way the county investment fund was run, but found no wrongdoing.” And, a little later “San Mateo’s treasurer had invested in highly rated securities and put no more than 10% of the fund in any single issuer.” Okay, no laws were broken. Nobody violated the written investment policy as written. However, this fails to tell all of the key points about what was going on at the time. I would like to see the reporter dig up some useful information to tell us – such as:

Why, according to San Mateo County’s own research (as shown in a chart in the same WSJ article) did they hold $155mm when the next seven largest county/municipal holders of Lehman paper held less than that in total?
Since everyone was talking about Lehman issues before its collapse – and most were reducing their holdings – what was San Mateo doing to stay situationally-aware? By everyone – we include treasurers of municipalities and counties.
If they were increasing these holdings, why? For the yield?

“If there are warning signs all over the place about ice on the road - and snow is falling, anyone who doesn’t slow down to adjust for conditions is responsible for flying off the road. Claiming they didn’t break the posted speed limit isn’t going to be a good argument – especially if they were accelerating into the corner when they hit the ice.”

The article highlights a push to try to secure bailout funds for municipalities that held Lehman paper and makes comparisons to the bank bailout. While we can all argue about appropriateness of the ‘voluntary’ capital infusions to banks, there are some important differences that are not noted:

Bank bailouts didn’t seem to be voluntary
The US Government – and taxpayers – appear to be getting their principle back with substantial interest
Bailout for the banks equates to temporary loan with interest
Bailout, if given, to those who held Lehman Bros paper equates to a gift with nothing coming back

Lessons Re-Learned:

Ensure you are plugged into the discussions so you can remain situationally-aware.
Remain diversified (% of holdings, total amount of any one holding, source of ratings or proxy for ratings).
Ensure the technological tools are in place to monitor your holdings, counterparty risk levels, changes in quality of issuers, etc.
Take responsibility.

If anyone thinks that reducing treasury staff levels or eliminating funding for treasury systems and tools is a good idea, they may need some shock therapy or recent (and old) history lessons. However, no system can completely prevent operator error.

Derivatives and Beaver Country Day School

On September 17, 2009, In Current Affairs, Derivatives, Financial Crisis Comments, Risk Management, By Craig Jeffery

The Wall Street Journal of Thursday, September 17, 2009 has, on page C1, and article entitled The Specter of Lehman Shadows Trade Partners. This article, for the most part, addresses some of the counterparty risks and issues that organizations who had derivative contracts with Lehman.

The problem that compelled me to write had to do with the picture, text and illustration about Beaver Country Day School. Here we have the finance director standing in an outside hallway with some kids milling around with the caption below titled BURNED BY LEHMAN. Since institutions were indeed burned by Lehman, I read on with interest awaiting the sordid details. Then I saw the illustration and text.

Illustration Heading: Rate Swap | Lehman Trading Partners’ derivative dilemma
- A dilemma…must be good
A school issues debt with a floating interest rate.
- Fair enough. If they wanted to pay fixed, they may have had a hard time issuing a fixed rate note at an affordable rate.
It enters into an interest-rate swap with Lehman to lock in a fixed rate.. The school commits to pay fixed interest rate to Lehman, which agrees to pay a floating rate to the school.
- Sounds like the school was able to borrowing by paying a floating interest rate, but didn’t want the ‘downside’ risk of rising interest rates. They wanted some stability.
When floating rates were higher than the fixed rate Lehman paid the difference to the school.
- The chart shows a comforting green shading showing they received money from Lehman – which means that the school on a net basis paid the fixed rate they agreed to. Then the area/time chart passes the x-axis and is now colored red (meaning bad).
Since central banks cut interest rates in 2008, the school has been paying the difference to Lehman.
- Factual again. And, this means too, that the school has been paying the same fixed rate they agreed to. They are paying a lower amount to the lender and another amount to Lehman. In total these should approximate the fixed rate that they wanted when they locked things in. Well, isn’t that what they intended? The final text box reads:
Terminating the swap requires the school to pay a hefty fee, so it chooses to keep paying Lehman while it waits for the position to be unwound.
- It makes sense that they would have to pay a fee to get out of a contract wouldn’t it? Lehman bore the risk of upward movement in interest rates by fixing a rate with the school. Why should someone just be able to exit a contract?

If the illustration text indicated some other problem (something that would be a dilemma) that would be one thing. (perhaps if it say “the school is paying Lehman and getting the fixed rate they agreed to when the rate is below their benchmark variable one. However, if the rate increases, Lehman (or the trustees) will not be able to pay them (or there is a concern about that)”. Then the case for the dilemma could exist. Nothing seems to be said to indicate that.

In looking at the headlines and the illustration we are left with the impression that a school was simply burned by Lehman. It seems, upon reading the article, that the issue for the school is that the termination fees are too high if they wanted to exit the position or move to another counterparty. Perhaps a discussion about managing counterparty risk or ensuring reasonable terms are in swap counterparty agreements would be more useful. If we wrote the article we would have included the following points:

Beaver Country Day School paid for predictability and got it.
They would be in a similar situation (of having a cost to unwind) if they had originally issued fixed rate debt.

I think some people believe they should only pay for insurance if they are going to have a claim right then.

-c

Money Market Mutual Funds – 2a-7 Rule Changes and ARS?

On August 25, 2009, In ARS Auction Rate Securities, Financial Crisis Comments, Liquidity, By Craig Jeffery

The majority of corporate practitioners use Money Market Mutual Funds as their benchmark. And, MMMF have long (over 50 years since rule 2a-7) been prevented from investing in securities such as Auction Rate Securities due to the fact that they use an auction mechanism and can't be put back. Will the newly proposed 2a-7 rules really help with liquidity management and liquidity markets?

Requiring a larger percentage of liquidity to be readily available (percentage to cash: 10% within a day, 30% within a week).
- Will these percentages really be enough if a 'run' starts?
- What will funds start to do (after things settle down) with the other 70% of the funds when they are in tough competition for YIELD performance? Will this cause strange behaviors (buying out on the curve as far as possible? Making a funds holdings disproportionate?
- Why aren't there simply disclosure rules that perhaps require: show the % of the fund that is liquid within 1, 7, 15, 30, 60, 90 and 90+ days?
  - We are not convinced the proposal is a NET improvement as constructed.
  - Allowing the NAV to float off a buck seems helpful as it adds visibility to a funds true liquidity risk. (The SEC asking for comments on this with regard to adding it to the proposal).
Elimination of Tier 2 Investments (moving from 5% to 0%).
- Who is comfortable relying on rating agencies alone now anyway? Many of the impaired assets were Tier 1 when they froze up.
- What funds are currently holding Tier 2 investments?
  - This cleans up the language of the rule – which is pleasant. But, it doesn't appear to make a practical difference. You should be able to see what a money fund holds – whether they have a few percentage
Decreasing the Weighted Average Maturity to 60 Days (from the historical 90 days) and creating the Spread WAM.
Diversification. The Capital Advisors Group put forth a proposal to place a concentration limit in Financial Issuers. Their point is that there is a high correlation risk between these issuers.

Disclosure may be a far better safeguard than a large number of rule changes meant to make everyone comfortable. At the end of the day it is not about regulations that will make money funds stronger, it is about visibility for the investor.

-c

When Hedging Exacerbates a Firm’s Cash Flow Volatility / Predictability (part 1).

On January 14, 2009, In Current Affairs, Derivatives, Financial Crisis Comments, By Craig Jeffery

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).

Trends in Treasury 2009

On December 22, 2008, In Financial Crisis Comments, By Craig Jeffery

Trends In Treasury 2009 – Primarily due to the financial events of 2007 – ‘08, the
fall-out of which may continue to unfold well into 2009, the Treasurer no
longer works in obscurity. Not that
the position was insignificant or lacked Board / C-level visibility prior to
now, but once routine and low profile issues such as credit facility
renewals, banking partner choices, hedge counterparty selection, and the cash
investment policy, among other basic Treasury operating procedures, have
risen to the top of both Sr. Officers’ and the Board’s agenda. Moreover, the demands placed upon an
already stretched Treasury department continue to increase with added
due diligence and communication requirements, among other
responsibilities. Further, securing
access to adequate liquidity, once part of routine operating procedure for
most Treasuries, has risen to the top of the list of critical risks. The often overlooked / rubber-stamped
requirement to ‘know thy counterparty’ has taken on added significance,
as the risk / consequence to acceptance of common assumptions, namely reliance
upon rating agency criteria, for example, have shown to be potentially
fatal – both for the firm’s financial position as well as for the
Treasurer’s career prospects.

As we move into 2009, some typical
/ reoccurring trends remain at the forefront, i.e. technology / automation
and risk management, while some not-so-new issues seek to regain
prominence, including: investment management, cash forecasting, credit
exposure, and bank / creditor relationship management. Further, the Treasurer’s plate is expected to
be full with a few new trends / prominent issues as well, including, for
example:

the forced march towards de-leveraging,
fair value evaluation,
diversification of surplus cash investments,
maximization vs. optimization of
liquidity, and, most importantly,
resilience in avoiding financial distress.

Treasury Technology: It is better to have it and not need it than to need it….

On September 29, 2008, In Automation, Current Affairs, Financial Crisis Comments, Technology Tuesday, By Craig Jeffery

It is better to have it and not need it….than to need it and not have it.

With the dislocation in the markets, there is a great demand on Treasurers these days. Information is crucial. Great visibility is extremely important. Good and careful planning is paying dividends. And, those who have invested in technology and built out their capabilities can answer questions quickly. And, they can even provide information on a proactive basis to prevent excessive 'running around'. Questions abound:

Liquidity – where is our money today? At which banks? What are my investments in? Are they liquid? What is happening to my committed and uncommitted lines?
Counterparties and Relationships - How much financial exposure do I have with (fill in the space with the name of a once rock-solid bank)? Where are our hedges? Will they be able to fulfill their commitment? What operating business do we have at (same thing) and do I have to worry about operating challenges?
And so on – the list goes on.

The board is asking all of these questions. These days Treasurers are definitenly earning their keep. Those who implemented good systems and ensure that all of the data is being gathered, all necessary reports are built, and policies are being followed are faring much better than those who…have yet to do so.

Treasury systems (risk management, treasury workstations, compliance services) have all been having a very decent year so far. Expect the current market disruption (which feels more severe and happening faster than two decades ago) to drive sales of good treasury systems up much faster. Expect too, that Treasurers will make sure they build their system(s) out to realize the benefits. Saving a few dollars will seem like a poor strategic move while memories of financial market mayhem remain fresh.

Building out your system is a key component to your financial risk management framework. It helps on a daily and monthly operational basis too of course. But, it really pays dividends when the financial system starts going sideways…like it seems to every decade or two.

-c

Exiting Gracefully…or Not

On September 26, 2008, In Financial Crisis Comments, By Craig Jeffery

Uncommitted credit lines have always seemed useful to corporations as well as banks.
Banks like them because it provides additional balance sheet flexibility if situations change either at the bank or at the company. Banks typically make money on uncommitted lines that are used. Not so with unused lines.
Corporates like them as part of their overall capital structure since they only pay for what they use. Sure, it isn't too wise to put all of your liquidity in a line that can go away quickly.

Uncommitted lines can be pulled by the bank, hence the adjective uncommitted. Of course.

Exiting an uncommitted line can be done in numerous ways. However, each way can be classified as either gracefully or ungracefully.

Watching the turmoil of late it is interesting to see the graceful and not so graceful moves of various banks. We share some examples:

Graceful. Providing early warning and notice that approximately 100 days in the future that this particular uncommitted line would be gone. This was communicated clearly and sincerely. It allowed this corporate to find a replacement line without a short term panic attack.
Not so much. The less than one week notice that the uncommitted line was going away may be allowed, but it sure makes things difficult. Is everyone really sure the bank couldn't have given more notice about this?

Business is business, we all understand. However, kudos and thanks go to those banks that are highly professional and value relationships enough that they ensure their approach to difficult conversations and decisions has a certain measure of grace.

Relationships are important whether the conversation is easy and fun or challenging and unenjoyable.

-c

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