Thursday, May 6, 2010

Why exempting some end-user derivative transactions from central clearing is a bad idea

According to Wallace T. Turbeville, "the ‘end user’ exception that would exempt certain businesses from mandatory clearing of transactions is not the right path for financial reform." In this post on New Deal 2.0 her explains why:

Banks that trade with end users often agree to forgo collateral within set limits. Banks have finite amounts of potential credit exposure to companies and can deploy this capacity by making conventional loans. Alternatively, it can deploy this capacity by carrying risk in derivatives trades with that company. It is well known that using the capacity in connection with trades is far more profitable for banks than lending.

On the surface, it appears illogical for an end user to agree to transact a derivative that is not collateralized. A company could always use its credit capacity with its bank to borrow money to fund the collateral requirements. The effect on available credit capacity should be the same. If banks make more money by packaging the credit extension with the derivative, the all-in cost to the company must, by definition, be higher than separating the credit from the derivative by borrowing to fund collateral.

Similar logic applies to end users’ non-bank counterparts. These parties also extend credit if collateral is foregone, but an end user can only borrow so much and still maintain its credit standing. Unless the counterpart is mispricing the transaction, it will charge for the extension of credit. In theory, the end user should be indifferent about whether it borrows money to post collateral or transacts with the agreement that collateral will be foregone.

These are simple examples. In reality, there are very complex and costly arrangements which enable companies to transact without posted collateral.

Based on all of this, why do end users resist requirements to collateralize so strenuously? Remember that the cost is not the amount of collateral; the collateral is returned if there is no default. The cost is the difference between the cost of borrowing the funds used as collateral and the investment return on the collateral while it is posted.

One reason for resistance is convenience and avoiding operating expense. However, many end users trade on cleared exchanges as well as in bi-lateral markets, so the processes for collateralization are familiar. This suggests that additional factors enter into their motives.

It may be more productive to focus on factors other than costs. Companies that use derivatives to hedge their business risks receive advantageous treatment under accounting rules. Current hedge accounting rules provide that price movements that change values as described above are not recorded as profit or loss. The theory is that the value of the derivative and the value of the hedged item are inversely related.

While this rule makes sense, it does not make sense to ignore the embedded debt (in the form of foregone collateral) in a derivative. Simply stated

• the financial statements of a company that borrows money from a bank to post collateral on a derivative should look the same as

• the financial statements of a company that has an agreement with a counter party to forgo posting collateral.

While I have not reviewed the accounting treatment of every end user and every arrangement, it is certain that in a number of situations, foregone collateral credit arrangements are not treated as balance sheet debt. It may be that these transactions are misunderstood. It would be unfortunate if the end user exemption became a mechanism for continuing this practice.

This is far from trivial. Most agreements to forgo collateral require immediate funding of collateral if adverse credit events occur. It becomes a demand loan-a loan that can be called for repayment at any time. This can cause a liquidity crisis at the very time that the company is most vulnerable, resulting in a death spiral. Such events have occurred several times in the past. After the Enron meltdown, the ratings agencies responded by trying to measure the risk of a liquidity crisis resulting from this phenomenon, but it is difficult to craft general rules to measure the risk. The problem continues and periodically threatens the marketplace.

These arrangements are pervasive in the market. A line graph representing bi-lateral credit exposures in certain markets would look like a plate of spaghetti with a multitude of credit arrangements. What a challenge for the credit officers and legal teams for each of these companies to make sense of it all!

Finally, financial institutions almost never post collateral to end users. The end users simply do not have the market power to demand it. But that’s alright. After all, is there any risk that a financial institution like Lehman would ever go into default?

Avoiding an accounting exemption is very appealing. But perhaps the better way to address this is to encourage efficient, third party systems, short of full on clearing, to track these exposures and to facilitate efficient collateral funding in bi-lateral transactions. The simple exemption for end users in financial regulation does not encourage the development of such a system. It ignores a troubling practice which need not burden the marketplace.

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