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COLLATERAL – NOT JUST CASH AND LC’s ANY MORE
J. Scott DavisDynegy Inc.
Mike DelucaOne Source Risk Management and Funding, Inc.
Craig R. Enochs
Jackson Walker [email protected]
713.752.4315
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What Movie is This?What Movie is This?
A young lady is transported to a surreal location and kills the first woman she comes in contact with. She then meets up with three perfect strangers and kills again.
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In Billions of Dollars
As more speculative- grade corporate debt and commercial real estate loans come due…
© New York Times
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… the U. S. government also will be borrowing record sums.
New borrowing that will have short- term maturities is not included.
© New York Times
In Trillions of Dollars
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• Credit Risk mitigation tools:– Credit Default Swaps– First Liens– Credit Insurance– Liquidity Transactions
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• Why Credit Risk Mitigation Products?
– Protection against abnormal or catastrophic bad debt losses
– Converts a variable cost – Reserves to a fixed cost – Premium + Client Risk Retention
– Allows for increased sales without increased exposure
– Allows for open terms or extended terms– Enables a lender to increase advance rate with
enhanced collateral– Helps manage risk during price fluctuations
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• Why Protect/Hedge Accounts Receivable?– Accounts receivable typically represent more than
40% of a company’s assets.– The accounts receivable asset is the most vulnerable
to unexpected loss and business cycles.– Few companies can compete without extending
credit.
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Most companies protect against every other unpredictable event that has a high potential for loss….property, liability, business interruption….. But have no protection against excessive credit write-offs.
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• What Risk Mitigation Products Are Not– A credit management substitute
– Routine bad-debt protection
– Trade dispute protection
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I. Credit Default Swaps
1. Settlement
If a “Credit Event” occurs, Seller pays the difference between:
The face value of the Reference Obligation; and
The current market value of the Reference Obligation.
Commonly documented through the ISDA
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I. Credit Default Swaps
2. Purpose Increase or decrease credit exposure without
transferring assets or obligations
Seller immediately increases its credit exposure without having to outlay any cash
Buyer immediately decreases its credit exposure without having to dispose of any outstanding obligations
Popular with banks and hedge funds because of ability to manage exposure
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I. Credit Default Swaps3. Regulation:
Exempt from CFTC regulation because: Not executed on a Trading Facility (Over-the-Counter)
Entered into between Eligible Contract Participants
Exempt from certain SEC regulations because: Constitutes a “Security-Based Swap Agreement”, which is
expressly excluded from the definition of “Security” in the Securities Act and Exchange Act.
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I. Credit Default Swaps
4. CDS Transactions v. Insurance Contracts Material interest in underlying obligation
Insurance contract requires “insurable interest”
Buyer of CDS protection does not need to show any interest in the Reference Obligation
Proof of loss Insurance contract requires insured to show “proof of loss”
before amounts are paid under the policy
Seller pays Buyer CDS amounts whether or not Buyer has actually incurred any loss related to the Reference Obligation.
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I. Credit Default Swaps Rates
Insurance contracts: Rates adjusted by insurer on annual basis
CDS Transactions: Fee remains constant throughout the term of the deal.
Termination Insurance contract: Insured can generally terminate at will
CDS Transaction: Set term is defined in the Confirmation, so Buyer cannot unilaterally terminate. If Buyer fails to pay CDS fee, then Seller may declare Event of Default under the agreement
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I. Credit Default Swaps
5. Advantages:
Seller’s creditworthiness is substituted for the creditworthiness of the party whose obligations are secured by the CDS Transaction
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I. Credit Default Swaps
6. Risks: Seller may become less creditworthy over the term of
a CDS Transaction
Seller may fail to pay CDS obligations upon the occurrence of a Credit Event
Buyer may be exposed if it is not holding some form of collateral or security from Seller
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II. First Liens
1. Overview Debtor has provided a first lien and security interest
in a tangible asset to lenders under an existing credit facility
Debtor enters into trading agreements with hedge counterparties relating to the asset, and offers first lien as collateral
Hedge counterparty holds first priority lien and security interest pari passu with lenders
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II. First Liens
2. Advantages to Lenders: Reduces risk
Ex: If hedge counterparty sells natural gas to run debtor’s power plant, reduces the risk that the plant will be unable to produce electricity
Increases value of the asset Ex: If debtor sells a power plant’s electricity to hedge
counterparty, this increases the value of the plant by mitigating the risk that debtor will not be able to find an economic purchaser for the plant’s output
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II. First Liens
3. 3 Types of First Lien Credit Structures
(1) Replacement Structure
(2) Threshold Structure
(3) Tail Risk Structure
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II. First Liens
(1) Replacement Structure First lien wholly replaces any other collateral obligations
of debtor under the trading agreement
Debtor not required to provide any cash, letter of credit or guaranty Cheaper to implement than other forms of credit support
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II. First Liens
(2) Threshold Structure Hedge counterparty assigns a value to the first lien
Such value establishes a fixed collateral threshold for debtor under the trading agreement
Debtor only provides alternative forms of collateral if hedge counterparty’s exposure exceeds the threshold
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II. First Liens
(3) Tail Risk Structure Debtor initially posts collateral to hedge counterparty up
to a fixed amount
The First Lien covers debtor’s “tail risk” over and above the credit limit Debtor’s collateral obligations are fixed despite any
subsequent market fluctuations altering hedge counterparty’s exposure.
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II. First Liens4. Advantages to Debtor
No additional collateral needed
No liquidity needed
More equity may be available under Credit Agreement than in other credit structures
Lower administrative burden
More efficient use of the capital locked up in the assets of the first lien estate
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II. First Liens5. Advantages to Counterparty
Right in tangible asset rather than contractual interest
Aligned interests with lender
“Right-way risk”
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II. First Liens6. Disadvantages to Debtor
Hedge counterparty may demand additional collateral or price concessions
Low asset valuation for credit purposes
First liens are fairly illiquid and contingent upon terms of a Credit Agreement or actions by lenders
Requires positive multiple of equity to debt on assets in facility
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II. First Liens First lien places hard assets at risk that are not
otherwise affected in other credit structures
Even if counterparty accepts first lien, counterparty may impose ultra conservative risk limits and parameters in the transactions secured by the first lien
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II. First Liens8. Disadvantages to Counterparty
Highly illiquid collateral
Extended delay between default and payment
Lack of control in collateral Acting as part of a group of creditors rather than individually
Risk if counterparty’s interests diverge from other lenders and hedge counterparties
Not fungible
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II. First Liens9. Additional Considerations with First Liens
Voting Rights Generally contained in the Credit Agreement
Matters on which hedge counterparty can vote (and weight of vote) often differ from lenders
Compared to lenders in the credit facility, hedge counterparty may have little or no voting power
Hedge counterparties must work with lenders because interests are linked
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III. Credit Insurance
• Do I need credit insurance?– Insurers like a spread of risk but will consider
segment or individual account coverage.• Whole Turnover / Portfolio Coverage• Portfolio Hedging / Catastrophic Excess of Loss• Segment of Accounts Coverage• Individual Account Coverage
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III. Credit Insurance
• The Basic Insurance Coverage– Commercial Risk – Domestic/Export
• Buyer Insolvency• Protracted Default• Non Acceptance• Contract Frustration
– Political Risk – Export• Inability to obtain hard currency• Changes in Import/Export regulations• Contract frustration due to Act of War• Foreign government non-payment
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III. Credit Insurance
• Types of Underwriters– Limits Underwriters
• The carrier can help manage your business on a transactional basis. (set up to underwrite large numbers of names)
– Portfolio Underwriters – The carrier will underwrite the top limits and then provide
large discretionary cover.
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III. Credit Insurance
• Types of Insurance Coverage– Cancelable Limits
• Carrier assists in monitoring accounts and provides warning and guidance in the event there is increased likelihood of default
– Non-Cancelable Limits • Carrier will not cancel limits, but the action of the
limit could cancel itself.
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IV. Contingent Liquidity 1. Characteristics
– Designed to be utilized in a high commodity price environment. Mitigates tail risk liquidity exposure.
– First tranche of collateral posted by purchasing company within the normal distribution of expected collateral requirements .
– Committed source of funding indexed to underlying commodity prices.
– Incremental funding supplementing primary sources of liquidity.
– Can be structured in many forms, such as Bank Credit Facility, Derivatives, Etc… .
– In other words a “Call Option” on liquidity.
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IV. Contingent Liquidity
2. Benefits – Mitigates tail risk of potential collateral calls from
extreme price movements.
– Protects existing positions from being unwound due to a lack of liquidity.
– Provides upside potential to commercial operations to execute favorable hedges during commodity price spikes.
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IV. Contingent Liquidity
3. Risks– Can be costly. Depending upon the amount required
and timing of the purchase. – Can be more administratively burdensome to credit
group then primary sources of funding. Especially the bank facility structure.
– Possibility exists of not utilizing contingent facility at all and not receiving value for upfront premium costs.
– Events of Default for issuing Bank or Counterparty.
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IV. Contingent Liquidity
4. Considerations – Purchase of a contingent liquidity product is most
cost effective when bought in preparation for a possible tail event rather than during or right before one transpires. This is applicable to the financial, commodity and credit markets.
– Structure of the contingent facility should be designed to mitigate current or future transactions with correlated movement of exposure, such as a toll or large power or gas position.
– Size of the facility should be tied to the Potential Future Exposure of the targeted position at which point exposures exhaust or strain the primary sources of liquidity.
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IV. Contingent Liquidity
4. Considerations (continued)
– Contingent liquidity should then be indexed to an underlying commodity curve (usually gas) and become available once the indexed curve exceeds a minimum price level.
– As prices increase above the minimum level the available funds within the contingent facility grow indexed to the underlying curve. Usually the facility is capped at a maximum size.
– In many structures the facility availability will amortize over the term of the agreement as the PFE related liquidity position diminishes.
