Today is the day. Even the apolitical among us know that if the two parties don’t agree today to something, anything – then the government will shut down at midnight. At least parts of it will. What comes next depends on whether you fall into the “essential” or “non-essential” category of government work. Services such as defense, homeland security, mail delivery, and even Congress will stay open for business, while national parks, and passport processing, among others, will grind to a halt as the funding tap runs dry. Without a spending resolution passed by Congress and signed into law, nearly 25% of the 3.3 million government workforce will be furloughed. As it turns out, when it comes to government spending, disagreement and indecision are all that is needed to shut it down.
Whether you are for it or against it, the government shutdown would be a consequence of inaction (i.e., no action). Most things don’t work that way in our personal and business lives. Inaction usually means things keep going, driven by prior instruction, and sustained by inertia. Even when something should be shut down, like that gym membership you never use, or that old magazine subscription that keeps coming but is never read, it usually takes pro-action on your part to put a stop to such things. That is how your derivative transactions work as well. The following scenarios require overcoming this inertia, and decisively putting an end to transactions that no longer serve their purpose.
Shut it down when you no longer have risk. You hedged your interest rate risk when you took out floating rate debt to buy a building. Rates have risen since then, and the associated swap is an asset to you. Instead of unwinding, you want to keep the swap on when you prepay the loan, thinking rates will continue to run up. First off, if you take no action and keep the swap, it would be hedging…nothing. When you sell the building and prepay the loan, the underlying risk goes away. The swap is officially speculative in nature at that point in time. This means it can still easily move against you, despite your view. Just as important, though, many banks will have some form of additional termination event in their contracts, whereby a partial or full prepayment of the loan requires a partial or full termination of the swap. To do nothing risks the likely scenario that your counterparty is the one who will take action, forcing a termination, and exercising all available rights and remedies under your agreement. Better to proactively negotiate an unwind than lose control of the situation due to inaction.
Shut it down when it’s no longer doing what you thought. You hedged the future sales price of an asset, whose overall changes in value were expected to be substantially offset by changes in value of an associated interest rate swap. As this asset was a highly rated corporate bond, you were a little surprised to hear the news of credit ratings downgrades hitting this corporate entity. Your bond asset was hit hard, and now trades with junk status, and at a significantly lower price. A quick look at your interest rate hedge reveals a new, very poor correlation to the bond. What started out as a bond, whose changes in value were substantially tied to changes in underlying interest rates, has now been dramatically devalued by changes in the underlying credit. In short, this hedge is no longer working, and in fact could get even worse, because interest rate changes have little impact on the price of the bond now, but clearly continue to impact the swap. You entered the hedge for a specific economic reason, and should consider proactively exiting this agreement when that reason is no longer justified.
Shut it down when it fails hedge accounting. You have converted your fixed rate asset to a floating rate in a designated fair value hedging relationship. Regression analysis at inception showed a highly effective hedge, and P&L volatility from ineffectiveness was tolerable. Then, over time, quarterly regression analysis got worse and worse, and finally this quarter your hedge failed the regression analysis test. The result of this in isolation is that the hedge would need to be de-designated, but could continue as a mark-to-market instrument from here on out. What started out as tolerable ineffectiveness between the hedge and underlying hedged item, though, is now a situation in which the entire changes in value of the hedge will go through earnings, with no offset. Doing “nothing” means keeping the hedge on, with potentially significant earnings volatility to follow. Instead, consider proactively terminating the hedge agreement, if changes in the accounting treatment result in an undesirable situation.
If no deal is made today, the government will commence its shutdown activities sometime after midnight tonight. However, if you do nothing when your underlying risks, correlations, or accounting changes, your derivatives will go on with their contractual cash flows as planned, or leave you in a situation which you no longer control. It’s best to consider a proactive unwind in these scenarios, or at least reassess the facts to understand the impact of inaction. As always, Chatham would be happy to help you think through your options. Let us know if we can help! Give us a call 610.925.3120 or email us!