A report on financial risk based on a survey answered by 175 bankers, regulators and corporate users was published last month by the Centre for the Study of Financial Innovation. They were asked to list the top-10 risks to the financial system. The results are paradoxical: high up were both credit risk (at number one) and, at four, the financial instruments banks have designed to cope with it. Racing up the league of perceived big risks was complex financial instruments, which went from tenth place last year to the fourth-biggest risk this year. Bankers are worried by companies’ use of structured finance techniques such as swaps and synthetic CDOs to hide debt and manipulate revenues. One respondent to the survey says: “Financial derivatives are largely unregulated, untransparent and misunderstood.” Another, Chris Sutton of IT company Logica, says derivatives are mainly used as a way of “circumventing regulations”.
Their anxiety is shared by regulators. New measures are being considered in the US that could seriously affect both the credit derivative and securitization markets – just about the only financial markets that are booming at the moment, thanks to synthetic CDOs – by bringing special purpose vehicles back on balance sheet. In the UK, the Financial Service Authority’s Howard Davies said in a speech earlier this year: “One investment banker recently described synthetic CDOs to me as ‘the most toxic element of the financial markets today’. When an investment banker talks of toxicity, a regulator is bound to take a heightened interest.”
The tough talk from regulators has been prompted by a sudden epidemic of financial puritanism in the US and Europe. One banker complains of the difficulty of convincing companies of the need to use legitimate derivatives in this atmosphere of suspicion. His bank has just underwritten a convertible bond for an issuer with an interest rate derivative attached. The bank suggested the company use a swaption to extend the interest rate derivative if the shares underperform and bonds do not convert into shares by the dates it expects. But the board refuses to sign off on it. It all looked too complex. So the company is potentially left with interest rate exposure its finance director doesn’t want.
The number-one risk to banks, though, according to CSFI’s survey, is credit risk – in other words banks and companies are worried that they are exposed to too many potential bankruptcies through bonds and loans. Paradoxically, the solution to this would be to hedge the credit risk with credit derivatives.
So credit derivatives are either the problem or the solution, the evil underminer of the financial markets or the only thing sustaining them, depending on how you look at it.
Enron was a leading user of credit derivatives, and of other types of derivatives such as telecom capacity swaps and commodity derivatives. It went from merely hedging itself through these instruments to speculating in them, to becoming a market maker in them, before finally tripping over its own complex network of subsidiaries and collapsing. That collapse is bound to make people suspicious of derivatives, which have always struck members of the public as simply a way of irresponsibly betting, of making something from nothing. Derivatives has been a dirty word since the scandals of Gibson Greetings and Procter&Gamble in the early 1990s.
But there’s reason to believe that the effect of Enron on the world economy, as well as the effect of the default of Argentina, could have been far worse had credit derivatives and synthetic CDOs not spread the risk exposure to these two credit events.
Lex Maldutis, director of structured credit products at CSFB, says: “If you look at the US banking crisis of a decade ago, it was driven mainly by overexposure to high-yield bond portfolios and real-estate loans. Substantial defaults in those portfolios led to some banks’ capital being wiped out, precipitating the crisis. By the time the banks realized the danger it was too late.”
He continues: “It illustrates how in the past, before there were ways of hedging credit risk, there wasn’t much you could do if there was a problem – you just hoped to ride it out. If credit derivatives didn’t exist now, I’m pretty sure the combination of recent credit events would have led to some sort of banking crisis. The fact that this has not happened is at least partly due to the availability of credit derivatives.”
And it’s not just banks that stand to benefit from the use of credit derivatives. A research note sent out last month by the Goldman Sachs credit derivatives team says companies could learn a lot from banks’ use of credit derivatives. It gave the example of two unnamed energy companies that had exposure to Enron. One, a small independent energy company, had an exposure of around $10 million. When Enron went bankrupt, the company reported its exposure and its share price fell 40%. It is now struggling to obtain new financing. Another company, described as a large provider of electricity, had to terminate several commodity futures contracts with Enron and was made to mark the futures contracts to market. The note says: “As Enron declined into bankruptcy, the market capitalization of the power company fell from about $300 million on October 1 2001 to $100 million on December 3 2001.” Goldman Sachs points out that the companies are based on real examples. As the note says: “Failure to hedge credit exposures has resulted in significant earnings volatility and a substantial decline in shareholder value.” These risks could have been mitigated by buying a single-name credit default swap on Enron.
Others have been rallying to the credit derivatives cause. William Harrison, the chairman of JPMorgan Chase, told 800 of the bank’s clients at a special meeting in January that JPMorgan Chase was protected from being more seriously hit by Argentina and Enron because it had hedged its risk through credit derivatives. “Credit derivatives,” he said, “are one of the must-haves for a global full-scale investment bank.”
Companies have been taking the hint – the number of credit derivative transactions has gone up steeply since Enron, particularly in the energy sector. The head of credit derivatives at one investment bank says companies that have never bought credit risk protection have been asking about it since Enron. Particularly in the energy sector, Enron has made companies realize that they are far too exposed to credit risk. So the bankruptcy of Enron has actually been a spur to the credit derivatives market rather than a hindrance.
Bankers fear a heavy hand
It’s not surprising that banks have seized the chance to talk their book. JPMorgan Chase is easily the biggest bank in the $1,500 billion credit derivatives market, with a 40% market share. Many other banks are also deriving revenues from selling CDOs, as well as using them to shift loans and bonds off their balance sheets to free up capital in preparation for Basle II. There is a real fear that this market, along with the equally lucrative securitization market, will be squashed by heavy-handed regulators driven by the public’s fit of structured-finance bashing. One banker says: “Everyone in the market is concerned because if regulatory changes are based on purely political rather than economic reasons, the end result is going to be a mistake.”
So are regulators and the press being “absurdly bearish” – in the words of Bear Stearns’ head of European CDOs – about the dangers of exotic risk management strategy? It is true that credit derivatives have diversified risk away from banks but they have not spread it that far or that thinly.
The main buyers of the 55 synthetic CDO deals launched in Europe last year, according to a Lehman report, were a few large insurers and reinsurers, hungry for exposure to corporate risk.
No-one can accuse insurers of not understanding risk but there is a chance that at least one of these insurers might have bitten off more than it can chew in the scramble for the attractive spreads on CDOs relative to probable default rate. CDOs in Europe tend to have exposure to a lot of the same names.
Most bankers think that even if a large insurer went bust it wouldn’t have a major negative effect on the credit derivatives market. After all, Enron was both a major credit in the credit default market and a major counterparty in swap contracts. And the market has survived that test.
But even if the credit derivatives market is looking remarkably healthy, Enron has made it clear that certain types of derivatives, particularly swaps, are a useful way of dodging accounting laws to make revenues seem larger. Swaps seem to have played their role in inflating the financial bubble of the late 1990s.
Swaps have a fine tradition as a mode of book-cooking. Italy was in the spotlight recently from a report by the International Securities Market Association which claimed a country (later identified as Italy) had used a confidential swap with a negative interest rate to get cash up front. This, the report claims, was so that it was able to meet the deficit requirements of the Maastricht treaty. That is, Enronitis on a sovereign scale.
And telecom companies such as Global Crossing are now being accused of having used capacity swaps – swaps of broadband capacity between different telecom companies – without any real business purpose but purely to boost apparent revenues for the benefit of their shareholders. This type of transaction has earned the name “hollow swaps” because it is making revenues out of nothing.
Booking revenues 50 years early
Soykan Soyucali of the telecoms advisory and trading department at Dresdner Kleinwort Wasserstein says: “Some of the smaller, newer telecom companies were using swaps as a way to inflate revenues, so they could compete with the bigger companies. It’s a way of appearing to do better than you’re doing. Some of these swap contracts were for 50-year leases, and they’d book the revenues up front, so their balance sheets look healthier. It creates a bubble.”
Yet capacity swaps have a genuine commercial purpose. They enable companies from one jurisdiction to expand into other geographical regions where they don’t have broadband networks. And it enables them to make money off their excess capacity in their own networks by leasing it to foreign companies.
However, like other kinds of derivative they can easily be abused by unscrupulous CFOs. The good news is that Enron and the spate of telecom scandals have shown you can’t get away with it for ever. Soyucali says: “There’s been a bunch of rumours about who’s been doing what. The market knows who’s been abusing swaps.” So market discipline will have the biggest effect on how companies use risk management.
Shareholders will also need to say what they expect from a company’s treasury. Derivatives can be used for three reasons – to hedge risk, to speculate, or to cook the books. The first is completely necessary. The third is completely unacceptable. The second is up to the company and its shareholders. It can decide, like Enron, to turn itself from a normal revenue-based company into an asset-light gambler on the derivatives markets. Many corporate treasuries see themselves not just as hedgers of risk but as profit centres in their own right, taking positions in derivatives and even making markets in them. But there’s an obvious danger of corporate treasuries thinking they are banks while lacking the decades of experience in capital markets that banks have. Investors in those companies should be able to judge the risks attendant to the earnings.
The two types of business – normal revenue-based and speculative – need to be distinct for accounting purposes. You can’t speculate about normal business revenue, as Enron did with its broadband business. And shareholders have to give companies the all-clear to speculate in financial markets. One head of derivatives says: “You have to make sure treasuries’ mandate is to hedge and not to speculate. If they do speculate, make it clear it is outside their mandate.”
