Seven years ago this month, bankers across Wall Street breathed a sigh of relief. Two rate cuts in two weeks by the Federal Reserve had finally stanched the bleeding at Long-Term Capital Management — but not before the Fed cajoled some 14 banks into buying pieces of the collapsing hedge fund to stave off a larger financial collapse.
"Investors have a pretty good idea about balance-sheet risks; they are completely befuddled with regard to derivative risks," concluded Roger Lowenstein in When Genius Failed, a chronicle of LTCM's fall. "As the use of derivatives grows," he warned, "this deficiency [in disclosure] will return to haunt us."
Could that time be now? Just last month, in a move eerily reminiscent of LTCM, representatives of 14 banks arrived at the offices of the Federal Reserve of New York in response to a Fed invitation to discuss hedge fund practices. And a slew of reports by regulators and market participants over the past six months have fretted over the operational risks that have swelled with the explosive growth of derivatives (particularly credit derivatives), credit-oriented hedge funds, and structured finance in the years since LTCM (see "What, Me Worry?" at the end of this article). Yet, most of this attention focuses on the mounting interdependence of banks and hedge funds. Corporations — the so-called reference entities, whose financial survival is the subject of most of these derivative bets and counterbets — are largely ignored.
A Great Advance?
Does that mean companies shouldn't worry? At a minimum, they certainly feel the changes these financial innovations have wrought in their banking relationships. "Banks' risk aversion has increased," notes one respondent to CFO's banking survey (see "Last Banks Standing"). So has their "need for fee business," says another. Led by JPMorgan Chase & Co., banks have become adept in recent years at reducing the amount of lending against their own balance sheets, even as they seek to increase fees. Between 2001 and 2003, the percentage of bank assets made up of corporate loans fell from 20 percent to 17 percent.
Banks serve both goals — lowering their balance-sheet risk and increasing fee revenue — by packaging debt into various forms of structured securities and selling them to investors (including hedge funds, which often buy the riskiest slices). Banks also buy derivatives themselves to lay off risk (often, again, to hedge funds) from their loan portfolios. And, increasingly, banks market the same risk-management techniques to corporate customers in the form of credit-default swaps, not to mention a wide variety of other swaps and derivative contracts.
Many in the banking industry — including its regulators — consider the resulting dispersion of risk to be a great advance in managing threats to the world financial system. Indeed, speaking at the Federal Reserve's Jackson Hole conference in August, Fed governor Donald L. Kohn described support for risk dispersal as a key pillar of the "Greenspan doctrine."
But it's not clear that shifting risk once concentrated at banks out to a larger market has reduced overall risk to the financial system. In fact, it may create new threats while also contributing to a corporate credit bubble. A July report by Fitch Ratings warns that a forced deleveraging of one or more large credit-oriented hedge funds would "be felt across multiple segments of the credit markets, rather than being contained to one or a few sectors." For non-investment-grade firms, Fitch predicts, the resulting drop in liquidity could mean ratings volatility, lower issuance of junk bonds, and less access to various forms of structured financing.
"There has been a real structural shift in the credit markets, and it has happened fairly rapidly," observes Fitch's Roger Merritt, who wrote the report. Merritt is referring to the rise of highly leveraged hedge funds that trade in credit and credit derivatives. A survey by Greenwich Associates says hedge funds now control as much as 30 percent of the trading volume in high-yield bonds and 26 percent of leveraged loans. In the structured-finance markets, notes Merritt's report, "hedge funds now play a critical role in financing the least-liquid, highest-yielding subordinated tranches of transactions, giving them a degree of influence that far outstrips the notional size of their investments." Further, Merritt says hedge funds are able to influence pricing throughout the credit market through their use of credit derivatives.
The collapse of Bayou Securities in August has revived talk of hedge fund regulation since this time last year, when former Securities and Exchange Commission chairman William Donaldson pushed through a rule requiring that hedge funds register with the agency. His successor, Christopher Cox, has reiterated that the rule will take effect in February, as scheduled.
Even Wall Street has expressed some concerns. Just this summer, Gerald Corrigan, a former Federal Reserve official who conducted a bank-sponsored postmortem on LTCM, reprised his role. The 273-page report of the Counterparty Risk Management Policy Group II painted a rosy picture of improvements in the financial world's handle on market and credit risk, but warned that operational risks resulting from the rapid rise in the use of credit derivatives and other financial innovations since LTCM's fall could, under the wrong circumstances, spiral out of control.
The CRMPG II report was not issued in a vacuum. In addition to — or perhaps in response to — Donaldson's push for registration, regulators and even market participants have been openly discussing derivatives and complex financial structures since last spring. Perhaps most strikingly, Fed chairman Alan Greenspan, who has often praised banks' use of derivatives to manage risk, seemed to hedge his previous comments in a May speech. He, too, focused on operational risks, noting that derivatives provide little risk mitigation if counterparties (read: hedge funds) fail to meet their contractual obligations when defaults occur.
May was also the month that Standard & Poor's and Fitch downgraded Ford and General Motors to junk status. Although they strained hedge funds and the credit-derivative market, the downgrades seem to have had little serious impact.
In June, however, the Bank for International Settlements (BIS) warned that structured finance — particularly structured credit derivatives — has grown so complex that market participants are forced to rely heavily on ratings. Yet, it noted, the very slicing and dicing of these products into different risk categories skews rating methodologies and makes ratings less reliable. Later that same month, the BIS also warned that the GM and Ford downgrades — widely cited as proof that the markets could withstand a major credit event — had been long expected and "might not be a true reflection of how these markets would function under stress" (see "What Is Operational Risk?" at the end of this article).
A Faster Credit Crunch?
Operational risk aside, Fitch's Merritt is careful to note that banks' risk-management practices have improved dramatically since the days of LTCM — in large part via the use of credit derivatives. And he credits hedge funds with adding liquidity to the market. Still, he says, "while banks have been using credit-default swaps to diversify their risk, there's a possibility that risk is being reconcentrated in hedge funds." Finance executives surveyed by CFO appear to understand this paradox. While 34 percent believe that innovations ranging from securitization to various types of derivatives efficiently transfer risk to the market, another 21 percent say they create hidden concentrations of risk.
Those concentrations raise a troubling specter for corporate borrowers. Hedge funds borrow heavily on margin from Wall Street, notes Merritt. "In times of stress," he says, "we've seen that financing can be withdrawn very quickly." Historically, corporations are used to cycles in which banks loosen and tighten credit, usually in response to changing default rates. Far from smoothing that pattern, hedge funds might actually accelerate it. "If there were a liquidity squeeze for some of the larger hedge funds," posits Merritt, "we could see credit availability withdrawn — and credit prices rise — faster than we've seen in the past."
Still, if such a crunch happened tomorrow, its impact would most likely be limited to companies heavily dependent on financing. Most companies, cash-rich and refinanced at rock-bottom interest rates, would go largely unscathed. But over the next three years, such an event could have an increasingly serious impact, as recently refinanced debt comes due and balance-sheet liquidity drops. "A lot of it has to do with the timing," notes Merritt. Moreover, with large global banks estimated to get as much as 25 percent of their revenue from business related to hedge funds, even companies that command unsecured loans from their bankers could find the price of credit spiking.
Among the dizzying array of derivatives, credit-default swaps are perhaps the most significant in terms of their potential impact on corporations. A booming market, the total notional amount of outstanding credit-default swaps is $6.4 trillion. The only specific mention of corporate risk in the Corrigan report warns that the credit-default market may undermine "one of the great strengths of the financial system...its capacity to organize and execute restructurings for troubled but viable companies."
That's because credit-default swaps create a potential moral hazard. Investors that purchase protection against a company's default, observes Merritt, "might not have the same incentive to pursue a successful workout that a traditional bank lender would." This, too, was acknowledged by CFO survey respondents, 27 percent of whom said that in general, derivatives and other financial innovations make restructuring more difficult.
Credit derivatives, of course, are not the only financial innovation that exposes corporations to banks' penchant for risk transfer. Indeed, healthy companies are more likely to experience that when taking part in a structured financing, particularly securitization. Instead of lending a company its own money, the bank acts as a middleman, raising money for the company by selling bonds backed by company assets that represent future cash flow (such as receivables). For companies, securitization has the added benefit of being off balance sheet for accounting purposes (despite a slew of new disclosure rules).
In and of itself, securitization is a widely accepted practice. Securitization of trade receivables alone has grown from $2.4 billion in 1985 to $305 billion in 2004, and securitization overall is a $1.8 trillion market. But it and other forms of structured finance rely on techniques that were badly abused by Enron. "Transparency and the degree to which accounting and disclosure standards achieve their goals can be greatly diminished by the use of structuring, even when that structuring appears to comply with the standards," wrote the SEC in a June study of off-balance-sheet liabilities required by Sarbanes-Oxley. That comment concerned lease accounting, but the SEC staff warned that it saw similar corruption of accounting standards for securitization and derivatives. "Interpretation No. 46(R), which addresses the consolidation of variable interest entities (including SPEs), could well suffer a similar fate. In some cases, securitizations and derivatives have been used in accounting-motivated transactions."
Banks, of course, are painfully aware of this: many paid billions in fines and settlements over transactions they helped structure for Enron. "Recent events demonstrated that structured-finance transactions, in part because of their complexity, were subject to abuse," notes M. David Krohn, a partner at law firm Alston & Bird LLP. (Krohn served as the lead structured-finance lawyer for Enron's bankruptcy examiner, although a court-imposed gag order prevents him from commenting on the case.)
And where there's structured financing, says Krohn, there are banks. "They market it, they structure it, they serve as counterparties for related derivatives contracts," he says. This, in turn, creates another type of risk: reputational and legal risk, which has recently become a hot potato between banks and their clients.
In May 2004, banking regulators and the SEC issued proposed guidelines intended to help banks avoid reputational and legal risk stemming from "a wide array of structured-finance products, including financial derivatives for market and credit risk, asset-backed securities with customized cash-flow features, and specialized financial conduits that manage pools of purchased assets."
While the responses from individual banks, particularly those involved with Enron, were understandably muted, their industry groups objected strenuously that far from reducing banks' reputational and legal risk, the guidelines actually shifted more risk to banks by requiring that they police their corporate customers.
No Stinking Badges?
"A surprising number of financial institutions expressed to us serious concerns about the proposed statement," the American Bankers Association (ABA) wrote to regulators, adding that the primary cause of all of its concerns was the "insistent subtext" that banks should "insert themselves into their customers' business dealings and corporate governance."
The guidelines did propose that banks "ensure that financial-institution staff appropriately reviews and documents the customer's proposed accounting treatment of complex structured-finance transactions, financial disclosures relating to the transactions, and business objectives for entering into the transactions." They also suggested that banks develop policies for "analyzing and documenting the customer's objectives and customer-related accounting, regulatory, or tax issues." Under certain circumstances, banks would also be required to seek review from "higher levels of [the] customer's management" or even "communicate directly with the customer's independent auditors."
The guidelines also required extensive document retention, including minutes of "critical" meetings with clients, all client correspondence, and — particularly galling to critics — documents about transactions proposed but ultimately disapproved. "The proposed standards appear more aptly designed to affect the deputization of financial institutions as prosecutorial archivists," complained a joint letter from three industry groups.
Regulators also urged banks to decline any transaction that might result in a customer issuing a materially misleading financial statement, or, failing that, "condition [the bank's] participation upon the customer making express and accurate disclosures" through legally binding representations and warranties. While few companies should object to agreeing to simply disclose a transaction, says Krohn, "if banks are looking for a covenant that you'll account for it in a certain way, that creates some risk until your accountants have signed off."
Ironically, the idea that banks demand assurance of proper accounting treatment from their customers was first proposed by Citigroup and, subsequently, JPMorgan Chase, in August 2002, in response to Enron. In a 2003 interview with CFO, then-CFO Todd Thomson reiterated this requirement, although he avoided repeated questions about whether such assurances would be required in writing. (Citigroup's own response to the guidelines focused fairly narrowly on certain definitions and, while endorsing a letter from the Bond Market Association, did not endorse the stronger objections of the ABA.)
So strong was the industry response that the agencies withdrew the proposed guidelines. A revision, expected in August, has yet to appear. "I'd guess we'll see some pretty significant changes," says Krohn. "I can't imagine they'll just fix some typos."
Despite the heated objections to the guidelines, says Krohn, banks are extraordinarily careful these days, particularly when corporate customers propose a transaction. "There is absolutely no interest in walking close to any line on any of these transactions," he says, adding that he has begun to see representations and warranties about accounting disclosure "creeping in" to structured-finance contracts.
Yet, all this demonstrates just how fine the line is between legitimate and fraudulent transactions. "Structured-finance transactions will continue to be an important part of the capital markets," says Krohn. "Banks are not responsible for customers' financial statements. But if they know their financial product is being used to manipulate or create misleading financial statements, then the elements of aiding and abetting have been met."
Skin in the Game
The debate over the structured-finance guidelines begs the question of who actually proposed many of the infamous transactions that got Enron et al. into so much trouble. Most likely, both sides were well aware of their intended purpose.
The irony is that despite their penchant for shifting financial risk, and despite their heightened aversion to financial-statement manipulation, banks still seek an insider role when it comes to managing the capital structure of their corporate customers. "Some banks have been keen to move toward principal finance, because the value is potentially high to the client while also being high to the bank," says Nick Studer, head of the North American corporate and institutional banking practice at Mercer Oliver Wyman in New York. "You can potentially structure some nice trades that earn highly profitable [spreads] from the issuer client. And when you've bought these slightly funky assets, you can restructure and sell them on to investors."
Just as CFOs attempt to shed risk and reduce inventory turns by having their suppliers hold the inventory, "my bank is a business partner in my balance-sheet-management process," adds Chuck Bralver, executive director and head of the strategic finance practice at Mercer Oliver Wyman.
Strictly speaking, this new partnership is nothing of the sort. A bank that provides an unsecured loan is more of a partner — in the traditional sense of sharing liabilities — than one that simply structures a securitization without taking risk onto its own balance sheet. Indeed, notes Studer, even as companies become more adept at gauging how much business they give their banks (see "Inside Your Banker's Head"), securitization "has the added advantage [for the banks] of having pretty opaque profitability."
Ultimately, then, companies must realize that as much as banks want to be their strategic-finance advisers, they also want far less skin in the game. Indeed, says Studer, "we shouldn't be pie-eyed here — it's never going to be a close partnership. There's always a bit of tension, and it's a client-supplier relationship."
Tim Reason is a senior editor at CFO.
Credit default swaps may make creditors less sympathetic to companies facing insolvency, but that's not the only risk they pose to Corporate America. Companies, of course, also purchase credit-default swaps (though they account for just 3 percent of the market). The recent Counterparty Risk Management Policy Group II report warns banks and other sellers to make sure investors — which, in this case, include corporations — understand the derivatives they buy. That's a key issue, since corporations typically buy single-name credit-default swaps only when one of their major suppliers or customers is already clearly in trouble.
"The biggest thing we have to do is educate our corporate counterparties on the trigger events," says Joseph A. Chinnici III, managing director at Cleveland-based KeyBanc Capital Markets. While bankruptcy is an obvious trigger event, others — such as a non-Chapter 11 restructuring or the failure of a company to pay certain bills — must be carefully defined. Once a corporation determines that a credit-default swap is the best form of protection, says Chinnici, "90 percent of our time is spent talking to the customer about triggers, making sure they understand the idiosyncrasies of the contract." —T.R.
What Is Operational Risk?
Several observers, notably the Bank for International Settlements, have warned that the market's relatively painless absorption of General Motors's and Ford's downgrades might not be a true stress test. For one thing, GM and Ford didn't default. In other words, while the value of existing credit-derivative contracts referencing the automakers probably fluctuated wildly, their downgrade didn't necessarily trigger payouts, as a default would. And while "operational risk" may sound relatively mundane, it refers in part to the fact that the majority of credit-derivative contracts are still paper transactions. A June survey by the International Swaps and Derivatives Association — citing "important advances" — noted that 40 percent of contracts are now confirmed by automated systems, up from 24 percent the year before. That's still less than half.
Indeed, despite the financial industry's success in rewriting the bankruptcy code to allow immediate termination of almost all types of derivative contracts in the event of a default (see "The Banker's Protection Act"), the ISDA survey showed that it still takes hedge funds and banks an average of 11.6 days to even properly record the new owner of a resold credit-derivative contract. If corporate defaults rise in the coming year, as many suspect they might, operational risk could become very serious indeed. —T.R.
What, Me Worry?
A slew of recent reports frets about growing systemic risk. While few of the reports focus directly on corporations, all have profound implications for banks that serve them.
May 14, 2004
"Interagency Statement on Sound Practices Concerning Complex Structured Finance Activities"
Issued by the Office of the Comptroller of the Currency, Office of Thrift Supervision, the Federal Reserve, the FDIC, and the SEC
Proposes ways for banks to monitor structured-finance transactions set up for corporate clients to avoid legal and reputational risks (to the banks). The banking industry responds with strong objections. A revision is still expected.
May 5, 2005
"Risk Transfer and Financial Stability"
Issued by Federal Reserve chairman Alan Greenspan
Seeming to hedge, though not reverse, his previous praise for derivatives, Greenspan says that regulators can't track credit risk transferred outside the banking system (typically to hedge funds), that risk-mitigation benefits of derivatives could be undermined by contractual failures, and that some market participants are not exercising sufficient care.
May 12, 2005
"Remarks before the Foundation Financial Officers Group"
Issued by SEC chairman William Donaldson
In remarks on "staving off future crises," Donaldson defends requiring hedge-fund registration, citing the size of the market and the difficulty of detecting fraud.
June 1, 2005
"Operations Benchmarking and FpML Use Survey"
Issued by the International Swaps and Derivatives Association
Citing "advances," the ISDA reports the average backlog for credit-derivative confirmations is 11.6 days. Only 40 percent of such contracts generate automated confirmations.
June 10, 2005
Quarterly review: "Structured Finance: Complexity, Risk, and the Use of Ratings"
Issued by the Bank for International Settlements
Notes that the complexity of structured-finance products makes credit ratings less reliable, "even as their complexity creates incentives to rely more heavily on ratings."
June 15, 2005
"Report and Recommendations Pursuant to Section 401(c) of the Sarbanes-Oxley Act of 2002 on Arrangements with Off-Balance Sheet Implications, SPEs, and Transparency of Filings by Issuers"
Issued by the SEC
Although inspired by Enron-style complex structured transactions, the SEC's off-balance-sheet report also focuses on more-mundane off-balance-sheet issues, such as leasing and pension-fund accounting. Its discussion of leasing, however, takes a swipe at the market's response to Fin 46(R), warning that the use of securitizations and derivatives in accounting-motivated transactions may already be undermining FASB's effort.
June 27, 2005
Issued by the Bank for International Settlements
Warns that risks involved in structured-credit products may not be fully understood by all market participants. Reiterates that credit ratings may be misleading, adding that standard portfolio risk models may also be inadequate. Also warns that credit conditions fostering growth of CDS and CDO markets may not continue, and that it remains to be seen how these "markets would handle a string of credit blow-ups or a sharp turn in the credit cycle."
July 18, 2005
"Hedge Funds: An Emerging Force in the Global Credit Markets"
Issued by Fitch Ratings
Warns that the impact of hedge funds on credit markets is poorly understood and that a forced deleveraging could be felt across multiple credit-market segments, reducing access to high-yield debt and structured-finance securities.
July 27, 2005
"Toward Greater Financial Stability: A Private Sector Perspective"
Issued by the Counterparty Risk Management Policy Group II
Issued by the same group that autopsied Long-Term Capital Management in 1999, this report suggests that operational risks pose the greatest current threat to the financial system. It also warns banks and others to make sure investors — including corporations — understand the derivatives they buy.
"Don't Bank on Strong Governance: Observations on Corporate Governance in U.S. Banks"
Issued by Moody's
Notes that corporate governance is an increasingly important consideration in bank ratings. Among other conclusions, notes that Basel II's requirement to identify and mitigate risk — including operational risk — is "becoming harder as the pace of innovation in financial instruments quickens."
"Systemic Risk and Hedge Funds"
Issued by Nicholas Chan et al., MIT
Concludes that "systemic risk is currently on the rise" for hedge funds and that their "symbiotic relationship with the banking sector" means that hedge-fund risk exposures "may have a material impact on the banking sector."