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:

  1. Ensure you are plugged into the discussions so you can remain situationally-aware.
  2. Remain diversified (% of holdings, total amount of any one holding, source of ratings or proxy for ratings).
  3. Ensure the technological tools are in place to monitor your holdings, counterparty risk levels, changes in quality of issuers, etc.
  4. 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.

 
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Misconceptions About Hedging – Part 6

On February 1, 2010, In Derivatives, Hedging, Risk Management, By Craig Jeffery

PART 6

Misconceptions About Hedging (continued) – This post is a continuation of a previous series of posts on the various misconceptions about hedging. Over the next several BLOG posts I will raise a particular misconception about hedging and provide an alternative viewpoint. If you have an agreeable or a counter viewpoint, then feel free to respond either on the post or email me directly at DStowe@StrategicTreasurer.com .

Misconception about hedging #6: Hedging Requires Crunching
Numbers. Though some number-crunching may be involved (one needs to quantify their exposures and analyze various risk scenarios), it is often overlooked that effective risk management requires more communication than calculation. From understanding a firm’s exposure, to determining its risk appetite and risk capacity (the ability to absorb such risks), to gaining buy-in from senior management and establishing clear objectives, it’s more important to spend the time communicating on both a pre- and post-hedging basis up, down and across an organization. You need buy-in from executive management and related staff to execute your strategy and prevent Monday-morning quarterbacking. Lack of communication, therefore, leads to misunderstanding of risk management activities, which can lead to the worst
pitfall of all: Inaction. DWS

 
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Misconceptions About Hedging – Part 5

On January 25, 2010, In Derivatives, Hedging, Risk Management, By Craig Jeffery

PART 5

Misconceptions About Hedging (continued) – This post is a continuation of a previous series of posts on the various misconceptions about hedging. Over the next several BLOG posts I will raise a particular misconception about hedging and provide an alternative viewpoint. If you have an agreeable or a counter viewpoint, then feel free to respond either on the post or email me directly at DStowe@StrategicTreasurer.com.

Misconception about hedging #5: Derivatives = Speculation.

This may be the most common misunderstanding in hedging. Warren Buffet’s now famous quote that “derivatives are weapons of mass destruction” (Berkshire Hathaway Annual Report 2002) has been over generalized by the media. Derivatives are merely tools, as are other financial instruments, that when used properly can offer an effective offset to an exposure to other risks, i.e. foreign exchange, interest rate, or commodity prices, for example. While there is no question that derivatives offer a vehicle to speculate on a highly leveraged basis, that is not their primary use in  hedging, which is to reduce risk. Not managing one’s risks, and, therefore, the choice to float with market prices, is speculation whether it is by choice or naivety. This is not to say, that all risks need to be hedged and/or that derivatives are the only vehicle for managing such risks – the choice to hedge and with what comes down to ones risk appetite / risk capacity and other available alternative instruments / strategies. Contrary to the popular media, derivatives did not kill Wall Street during the financial crisis of 2008, unbridled speculation, combined with significant leverage, was a primary, but not only, weapon. DWS

 
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Misconceptions About Hedging – Part 4

On January 18, 2010, In Derivatives, Hedging, Risk Management, By Craig Jeffery

PART 4

Misconceptions About Hedging (continued) – This post is a continuation of a previous series of posts on the various misconceptions about hedging. Over the next several BLOG posts I will raise a particular misconception about hedging and provide an alternative viewpoint. If you have an agreeable or a counter viewpoint, then feel free to respond either on the post or email me directly at DStowe@StrategicTreasurer.com .

Misconception about hedging #4: It’s Important for My Hedges to Make Money.

This premise misses the point in hedging (see Strategic Treasurer’s Treasury Update Volume 4, Fall 2008/Spring 2009). While no prudent financial manager consciously makes a decision to lose money, the objective in hedging is more about providing predictability to cash flows or the ability for management to plan, which are two key factors, among others, which contribute to hedging’s impact on a firm’s value. It is not about making money or beating the market, per se, that matters, although many hedges are put in place opportunistically, i.e. to lock-in or secure an attractive level in a commodity or rate – this, of course, is based on one’s perception of the future, which is situational of course. In the end, it’s the net exposure, or the combined value of the exposure, whether interest rate, foreign exchange or commodity price level, combined with the hedge position (level) that matters. The point is, you shouldn’t cheer for your hedges to make money, per se. The primary performance metric to consider is whether you, as risk manager, met your hedge objective, and NOT whether your hedge made money. Too often, the fear of losing money on a hedge is an unfortunate reason for not hedging, which really falls into the realm of speculation. If that is a primary concern, or a risk in itself, i.e. you lock in a level that would put your firm at a competitive disadvantage, then there are other alternatives, including hedging less (this still has to satisfy your firm’s risk constraints) or utilizing options, which give you the right, but not the obligation to lock-in future prices. DWS

 
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Misconceptions About Hedging – Part 3

On January 11, 2010, In Derivatives, Hedging, Risk Management, By Craig Jeffery

PART 3

Misconceptions About Hedging (continued) – This post is a continuation of a previous series of posts on the various misconceptions about hedging. Over the next several BLOG posts I will raise a particular misconception about hedging and provide an alternative viewpoint. If you have an agreeable or a counter viewpoint, then feel free to respond either on the post or email me directly at DStowe@StrategicTreasurer.com .

Misconception about hedging #3:Risk Management Equals Hedging.

Not necessarily. Hedging, or offsetting one’s exposure with an opposing financial position for example, is just one choice in the risk management process. There are three primary choices in addressing risk: Accept it (it’s within your risk appetite), avoid it (you can’t endure it or you choose not to), or manage it, which focuses on either / both changes in operational management or hedging. If you choose not to accept or can’t avoid the risk, then managing it begins at the operational level. Specifically, where can firms reduce their exposure, i.e. make changes in their production inputs, product markets, pricing and/or consumption levels to mitigate exposure? Once undertaken, it’s the residual risk, or the risk remaining, that should be the focus for hedging, only if this risk is still not within the company’s risk tolerance level. Further, hedging should be undertaken to the extent that it brings this residual risk within a firm’s risk appetite. DWS

 
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Misconceptions About Hedging – Part 2

On January 4, 2010, In Derivatives, Risk Management, By Craig Jeffery

PART 2

Misconceptions About Hedging (continued)– This post is a continuation of a previous series of posts on the various misconceptions about hedging. Over the next several BLOG posts I will raise a particular misconception about hedging and provide an alternative viewpoint. If you have an agreeable or a counter viewpoint, then feel free to respond either on the post or email me directly at DStowe@StrategicTreasurer.com .

Misconception about hedging #2: Risk is Absolute.

On the contrary, the perception of how risky an exposure is depends on who you ask, since risk is relative and depends on a company’s (their stakeholders (stockholders, creditors, employees, retirees, etc.) appetite for it. Every organization, even those in similar competitive markets, may approach risk management differently. One firm’s risk appetite, or more specifically, its capacity to absorb risks, can depend on several factors, including: Its business (why it’s in a particular market or product); financial or operating leverage (how much debt or other fixed cash obligations it must endure); liquidity reserves or access to liquidity (its ability to absorb cash flow volatility); or ownership (whether a company is public or private). It’s not always practical to do just what another firm is doing since one approach may not be relevant to another company’s situation. DWS

 
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Misconceptions About Hedging – Part 1

On December 30, 2009, In Derivatives, Risk Management, By Craig Jeffery

PART 1

Misconceptions About Hedging – One would think that after many years’ worth of ‘experience’ with hedging that we would have the subject down pat; that we would no longer have any misconceptions about it. We landed on the moon in ’69, yet we still have various misunderstandings when it comes to hedging. Confusion about Global Warming
I can understand, it’s new (ok, we’ve been talking about it for a long time, but to recent converts – it appears new, or even suspect). But hedging? Some very smart people have been writing about it and/or doing it for a very long time. There are at least two truisms in life that I believe: “…nothing can be said to be certain except death and taxes” (B. Franklin), and effective risk management, which may involve hedging, enhances a firm’s value. Nevertheless, the subject remains misunderstood. Or, as with any subject, there are different opinions on it. Over the next several BLOG posts I will raise a particular misconception about hedging and provide an alternative viewpoint. If you have an agreeable or a counter viewpoint, then feel free to respond either on the post or email me directly at DStowe@StrategicTreasurer.com .

Misconception about hedging #1: Hedging Eliminates Cash-flow Volatility.

This is more of an irony than a misconception, and would depend on a company’s particular situation with its  counterparties (see Strategic Treasurer’s Treasury Update Volume 5 – Spring/Summer 2009). When the posting of cash as margin for the unrealized loss of the hedge portfolio is required, the volatility / unpredictability of cash flow due to margin calls can actually worsen, as opposed to mitigate, hedging’s primary objective, which is generally the predictability of cash flow. Currently this may be situation-specific — dependent on a company’s credit standing and bilateral negotiations with each counterparty, it may, however, become a significant issue for more firms if proposed regulations for the over-the-counter derivatives market end up requiring a central clearing mechanism for all trades. DWS

 
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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

 
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Reval (HedgeRx) announces acquisition of competitor FXPress (FIRST)

On September 1, 2009, In Automation, Derivatives, Partner Merger Acquisition, Risk Management, Technology Tuesday, By Craig Jeffery

Reval (HedgeRx) announces acquisition of competitor FXPress (FIRST), bringing together two innovative leaders in the software-as-a-service
(SaaS) space for risk management and hedge accounting technology.

At first glance, it appears as one competitor taking over another.  The benefits of competition (price, service, innovation) notwithstanding, the melding of these two market leaders could prove to be a boon for current and future clients.  While the roadmap of how the combined unit will leverage the best of each technology remains to be seen, it will hopefully unfold in a thoughtful manner over time. The near term benefits to users should be a fill-in of gaps in each system from the strengths of the other through future releases.  To allay any concerns, there does not appear to be any plan in the works to sunset either system.  Nevertheless, it wouldn’t appear to be efficient to keep both products moving along separate paths in the long term.   All in all, this should be a plus for clients of both systems, and a potential concern for other providers in this space.

Both systems are noted for their strengths in similar areas, namely derivative valuation and hedge accounting.  But each system grew from different sides of the trade.  Reval, with CEO Okochi’s background on the sell-side, sprung from the bank trading desk perspective with a focus on quantitative valuation and data sources. While FXPress, with CEO Richardson’s tenure in the corporate treasury domain, grew from a practitioner’s perspective, predominantly focused, at least in the initial years, on FX hedging. Each brought their strengths to the market of corporate hedge practitioners over time in an ever advancing need for valuation, hedge accounting, and straight-through-processing (STP).  Now, the combined entity will leverage its roughly 350 clients with the intent of claiming the title of the ‘undisputed leader in the space.’

For the client, current and future, it’s an opportunity to leverage the strength of each, mitigating the give and take in making the decision to go with one over the other in the past.  Reval’s strengths lie in their breadth of hedging  instruments and exposures, valuation models, internal data sources across a plethora of markets, and, most notably, their expertise in hedge-accounting (FAS133/IAS39) and fair value analysis (FAS157).  On the other hand, given the
complexity of the subject matter, the system can appear intimidating to the uninitiated at first glance.  FXPress on
the other hand, most noted for their experience and expertise in FX hedging, is often renowned for their workflow – ‘following the life of a trade,’ and often focused more on the front-end user – the trader, in an apparently more familiar, or softer, look and feel.  Further, FXPress is renowned for their   ability to customize reports to clients’ needs in a nimbler fashion.   While there are many similarities and other strengths of each, these seemed to be some of the most notable at first glance. Again, the biggest winner here should be the customer.

To Mr. Okochi (Reval’s CEO) and Mr. Richardson (former CEO of FXPress and now senior executive with Reval), when you’re contemplating what your future wish list for your ‘new’ system should look like one day, we have a few suggestions of things we would like to see added to benefit the corporate hedging practitioner even further.  The current sophistication and strength of the systems notwithstanding, coupled with the daunting task of trying to reinvent the wheel, we’d like the system to further automate / streamline the decisions and management of the
life of the hedging process.  In light of that, we’ve outlined our own Christmas Wish List, some of which the systems may already possess but we didn’t want you to think we didn’t appreciate what we already have.

The Life of a Hedge Wish List:


  • Tools for understanding our risks
    • Exposures, or visibility to them, coupled with reports to aid our senior management in providing feedback in setting our hedge objectives.
  • Pre-trade analysis tools
    • Help us select among alternative tools (swaps, forwards, options, and the like) and strategies (hedge exposure levels and time horizons, for example).
    • These tools may include a simpler break-even analysis, historical volatility analysis, quick and simple stress testing, orthe more advanced, model-based, simulations such as cash-flow at risk.
    • Pre-trade reports would also benefit us in convincing management of our chosen strategy as well.
  • Historical analysis
    • Some view on how our hedges have worked in the past, or potentially would have. No guarantee of the future we know.
  • Data
    • Embedded in the system. Our auditors hate when we select the data and import it.
  • Trade execution
    • Nice to automate the bid and execution through a single portal.
  • Trade confirmation
    • We hate paper, or at least we lose it.
  • Trade settlement
    • At initiation and at expiration. Straight-through-processing to/from our G/L, ERP, and/or Treasury Workstation (TWS) would be nice.
  • Hedge accounting
    • Pro-forma G/L and hedge accounting (FAS133/IAS39) assistance and recommended solutions. We like to keep the Controller off of our backs as perceived accounting risk can sometimes trump the economic risk that we’re trying to hedge.
  • Valuation
    • For the trader: it’s important to keep a close eye on our dealer’s quotes.
    • For the accountants; they like to reassure our auditors (FAS157 is a bear!)
  • Counterparty exposures
    • Can’t be too careful these days. Any chance for us to integrate some of our other exposures, credit, etc. with these counterparties for aone-stop view of our risks?
  • Performance analysis
    • We need to know whether we’re meeting our objectives and where the gaps lie.
  • Reports
    • Customizable / templates – we spend most of our time pulling data from all of our great systems to give our managers the reports they want, not what you think they want.
  • Graphs
    • Keep in mind that we, and especially our bosses, are very busy, and sometimes simple minded – a picture is worth a thousand words here; trust us.
  • Dashboards
    • We’ve been asking for them, and they are very helpful in these high-stress / high-volatility times; it pays for the resilient treasury to be aware and prepared!
  • Workflow
    • Show us the gaps and necessary handoffs, confirmations, etc. still to be processed.
  • Look and feel
    • With respect to your biggest competitor in the market (spreadsheets), we’d like it to look similar and integrate easily with what we already know very well, although we don’t expect those spreadsheets to get much use as, hopefully, we’ve contained all that we need in the system.

While many of these attributes are already included in one or both systems, some gaps across both still remain, but, as we’re keenly aware – ‘the engines are there’. Did we forget anything? Probably, but Christmas is still a ways away, and we’re sure we’ll see you again. We’ve been nice corporate hedgers this year – despite the challenges.

All in all, this acquisition should be a win for clients in this space. Will this benefit the market with increased capabilities or result in less competitive development and pricing? Should their
competition be worried? In a time when acquisitions have quieted down in the treasury space, this may signal some additional move as others seek to counter this activity. Will this make WSS , Sungard and IT2 behave differently?

 
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Counterparty Risk- Bank Closures

On February 9, 2009, In Risk Management, By Craig Jeffery

On Friday, the FDIC closed three more banks. This brings the
total for 2009 to nine closed.  In 2008, 25 banks were closed
including some rather large institutions.  There were also quite a few
enormous banks who participated in the ‘optional’ capital injection program
some of whom might have otherwise made it onto the closure list. If you add the
financial institutions that were sold or merged in rapid fashion, the total
institution number climbs slightly. However, as you look at the asset size of
the institutions in these categories sweaty palms are a normal response to the
magnitude of the disruption.

So, who is safe to deal with? We continue to have a number
of conversations about counterparty risk and concentration with a single
counterparty. A few key points seem worth repeating for those who are pushed
towards consolidation.


  • Diversity of Credit.  Concentrating all of your activity with
    a single creditor puts a firm at greater risk if the bank decides at some
    point that they either don’t like the firm or have too much concentration
    in that particular industry. It also creates a situation that if one
    creditor becomes gravely impaired then you as a customer could be impacted
    at an extraordinary level.
  •  Diversity
    of Services.     Most services will likely be continued if a bank was seized or
    merged forcefully. However, this still could represent a situation where
    you have to move 100% of your operational business in a hurry. This
    represents multiple risks to your organization. While you may currently
    have services with several relationship banks, moving away from several
    others may have some unintended consequences. If the party you have your
    operating business with develops a problem, you may have to re-initialize
    a relationship that you moved away from. Or, you may have to start a new
    relationship at exactly the wrong time.
  •  Divergence
    from other Treasurer’s Practices.      Diversity and managing counterparties
    is a very important activity that has received heightened interest in the
    past six to nine months. Treasurers and CFOs are NOT concentrating business
    to a single provider save some fee income and they are not concentrating
    credit, instruments and services UNLESS they have to in order to secure
    adequate capital.  If not absolutely required, concentrating all your
    services and credit to a single provider represents a divergent practice.
  •  Ratings
    and Rating Proxy.      While rating agency’s data should not be ignored, they can’t
    be the only source of information on your counterparties. They seem
    frustratingly slow to downgrade at exactly the time you need it. Many
    organizations monitor their key counterparties via several avenues
    (including rating agencies) and will also look at the credit default swap
    pricing as an indicative number.
  •  Visibility
    and Monitoring.     Ensuring that your organization has clear visibility to all
    instruments, cash, bank accounts and counterparties isn’t simply something
    that is nice to have. It is possible and necessary. Thankfully there are
    some great service and technology providers that makes this so much easier
    than just a few years ago.

The key point is rather simple. Diversification has always
been important. Every Treasurer must work to make sure they can survive at
least one bad situation whether with a credit provider or other counterparty,
instrument class or instrument type.  It is easy to say that there won’t
be a problem with any one bank or other counterparty (or even instrument).
Saying it doesn’t make it so. It is a lot easier to take the extra grief of the
incremental ‘cost’ of having a more resiliency and visibility built into your
structure than to always explain how unprecedented conditions brought down or
impaired your firm in job interviews.

 -c

 
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