COLLATERAL – NOT JUST CASH
AND LC’s ANY MORE
J. Scott Davis
Dynegy Inc.
jonathan.scott.davis@dynegy.com
Mike Deluca
One Source Risk Management and Funding, Inc.
mike@onesourcerm.com
281.240.3100
Craig R. Enochs
Jackson Walker L.L.P.
cenochs@jw.com
713.752.4315
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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.
2
As more speculative- grade corporate debt and commercial real
estate loans come due…
In Billions of
Dollars
© New York Times
3
… the U. S. government also will be borrowing record sums.
In Trillions of
Dollars
New borrowing that will have short- term maturities is not included.
© New York Times
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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 Swaps
3. 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 Liens
4. 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 Liens
5. Advantages to Counterparty
 Right in tangible asset rather than contractual interest
 Aligned interests with lender
 “Right-way risk”
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II. First Liens
6. 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 Liens
8. 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 Liens
9. 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.
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