The Collateralized Lending Regime: An Under-reported Shift in Capital Structure #1-9

As noted above in addition to their effects on systemic risk, the safe harbor exemptions are unfair because they give preferential treatment in bankruptcy to derivative counterparties.  This problem is exacerbated by the fact that financial reporting has not yet adapted to a world with derivatives.  Safe harbor creates a class of asset that is exempt from bankruptcy – and thus senior to all other creditors.  However, because reporting is quarterly and does not include details about the potential for near-term collateral calls, unsecured lenders have no way of knowing what fraction of assets reported will be seized by counterparties at the moment of bankruptcy.  Without this knowledge, bond and shareholders have no way to evaluate the assets on which they have a claim.  Furthermore, one can no longer expect a firm’s financial statements to be comparable from one year to the next, because derivatives that simulate bonds and other assets have effects that are not reflected in financial statements.

Let’s think about an example of how derivatives can affect the meaning of financial statements.  A firm can sell preferred stock to an investor and at the same time enter into a total return swap with the investor.  The terms of the total return swap require the investor to pay the total return (i.e. any cash flows) on the preferred stock; in return the firm pays the investor the money market rate plus some spread and compensates the investor for any losses on the preferred stock (in case of bankruptcy).  The net effect of these two transactions ­is that the preferred shares are just a smokescreen to put on the balance sheet.  In fact the firm has used a self-referencing derivative to issue secured adjustable rate debt.[1]

In this example, the firm’s financial reports show an increase in equity.  The market value of the total return swap will be reported initially as zero (because the income from the investor perfectly offsets the cashflow to the investor) and later as a financial asset or liability depending in part on the movement of the money market rate.  The firm reports an increase in equity, when the economic reality is that the firm has increased its debt load.  Note also that secured debt generally pays a lower interest rate than preferred stock, so the firm reduces its cost of funding by using derivatives in this manner.

The problem of course with this example is that the true state of the firm’s balance sheet is invisible to existing shareholders and bondholders.  When they review the firm’s financial statements, they will see an increase in equity and the increase in secured financing will remain hidden.  Of course, the more a firm funds itself with secured debt, the lower the recovery that both shareholders and (unsecured) bondholders can expect to receive in the case of bankruptcy.

Derivatives, as they are currently reported on financial statements, can be used to obscure the true nature of a firm’s liabilities.  While self-referencing derivative transactions may under certain circumstances be fraudulent in the United States, a legal note dated March 2009 concludes that they can be used – with caution.[2] Furthermore, because over the counter derivative markets are unregulated and not subject to reporting requirements, there is no way of knowing to what degree this is a problem.  In other words, there is no way of evaluating the inaccuracy – or accuracy – of financial statements.

Even in the absence of self-referencing derivatives, heavy reliance on derivative contracts can obscure the recovery that is available to shareholders and bondholders.  While the accounting rules for netting derivative and collateral exposures are strict,[3] reporting only takes place on a quarterly basis and there is no requirement to estimate or report collateral calls to which the firm may be subject in the near future.  Because large financial firms have significant exposures to derivatives, it is likely that, as a firm’s financial condition deteriorates, the same contracts that are generating losses will also generate collateral calls.  Furthermore many derivative contracts use credit rating downgrades as a trigger for collateral calls; this, too, means that a firm in deteriorating financial condition is likely to experience a sudden change in collateralized lending.  Currently shareholders and bondholders do not have the information needed to estimate the level of collateralized lending at the time of bankruptcy.

The current crisis illustrates the problem of changes in the level of collateral posted.  The ISDA Margin Survey reports that collateral posted tripled from 2007 to 2009.  The average amount of collateral posted per respondent was $4 billion in 2007 and $18 billion in 2009.  Furthermore because most of the collateral posted is delivered by the largest firms, firms that reported executing more than 1000 collateral agreements posted on average $16 billion in 2007 and $53 billion in 2009.  In short, the amount of collateral posted against derivative contracts can change dramatically from one reporting period to the next.  For this reason investors should be given information about potential future collateral calls whenever a firm trades in derivatives.

This information shortage regarding future collateral calls may mean that losses to shareholders and bondholders in the current crisis will end up being much more severe than expected.  If the losses experienced through the current downturn do indeed turn out to be excessive, firms may find it difficult in the future to finance themselves using bonds and other forms of unsecured lending.  In short, preferential treatment in the bankruptcy code for derivatives may completely change the capital structure of firms.

[1] I thank “A Credit Trader” for this example.

[2] Linklaters LLP, New York, March 12 2009, “Synthetic debt repurchase transactions and other transactions utilizing self-referencing exposure”

[3] FASB Interpretation No. 39


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