wisdom of crowds

First, there’s shock. Then, there’s sadness. Once the city with the highest per capita income in the U.S., Detroit’s slow tumble and decay over the past 50 years has left local government owning and managing too much city space and collecting too little in taxes to keep it running, given so many outstanding obligations. Promises to its public sector unions, pensioners, and bondholders could amount to as much as $20 billion, with no realistic ability to meet those claims as currently organized. Thus, a heavy hearted Detroit filed for Chapter 9 bankruptcy on July 18th, the largest municipal filing in U.S. history.

You don’t have to live near or work in this city to be affected by Detroit’s finances. Already, other cities intending to issue new general obligation bonds expect their rates to rise. Philadelphia, for example, has suggested Detroit’s bankruptcy filing is likely to add a quarter point to its borrowing rate, costing roughly $500k per year over the next twenty years. Moments like these don’t just shake the markets; they shake the “full faith and credit” foundation of all municipal obligations, and by extension, remind us that credit risk is very real and lurking in every contractual cash flow, including in your derivative transactions. So, while it’s upsetting to many to see the once great city fall on tough times, it is also a powerful reminder that the strong and vibrant counterparty to your transactions can be altered through time and circumstance as well, exposing you to greater credit risk than expected.

It’s important to note that derivative end users have rarely incurred losses due to counterparty defaults – it simply does not happen that often. The Lehman bankruptcy is a notable exception, and one that is still being dealt with in the courts nearly five years after their filing (per the WSJ, as many as 1,000 disputing counterparties still remain). But prudent risk management would call for a periodic assessment of your situation, to continue to make such losses a rare event. Therefore, while Detroit is garnering headlines and is front of mind, let’s review how credit exposure affects your derivative transactions, and understand how to measure, monitor, and mitigate these risks.

Measure. Credit risk is the risk to earnings or capital of an obligor’s failure to meet the terms of its contract with you or otherwise fail to perform on its contractual cash flows. Fundamentally, your concern is that your counterparty won’t be there when you need them the most – which is in a higher rate environment, if you have purchased caps or entered into swaps. Measuring your exposure means understanding both the current exposure and the potential future exposure. Current exposure is simply the current value of the derivative – if it is currently an asset to you, you are exposed to your counterparty by the amount of the current market value. The potential future exposure (PFE) is an assessment of how large an asset it can be and thus how large a liability to your counterparty, given some preset assumptions. Purchased caps are always assets to you, but they would be even larger assets given an increase in rates (with same or higher volatilities). Pay fixed swaps typically start out as close to flat, but an increase in rates can flip the instrument to an asset and thus leave you exposed to your counterparty. That means the PFE would contemplate some future date when the derivative is expected to be an asset to you, regardless of the current valuation (even if currently negative). You want to capture both the current exposure and PFE, in order to effectively deal with counterparty risk.

Monitor. What exactly should you monitor, and for how long? Simply put – you want to monitor the current market value of your derivatives, the PFE, and your counterparty’s creditworthiness – for life of the trade. Most deals are 3yrs or more, but it is not uncommon to see 10yrs or longer transactions. Where will rates be over 10yrs? What will be the value of your derivatives then? What will be the status of your counterparty? These are long periods of time; so long, in fact, that you can’t possibly know if your counterparty will be there to perform. Check values regularly (at least quarterly if not more often), and run or look to Chatham to run new PFE calculations to understand what you are up against. While you are monitoring your derivatives, you also want to pay attention to the counterparty’s creditworthiness. Changes in your counterparty’s credit ratings or borrowing rates should prompt reassessment of the risks. The financial strength you observe today in your counterparty could deteriorate or be gone tomorrow.

Mitigate. So what next? You see a potential problem on the horizon with regard to counterparty credit risk. What should you do? For starters, set policy limits on how much exposure you allow to any one counterparty. If you base this on credit ratings, be sure that monitoring these levels means lowering limits where necessary. Once a limit is reached, the practical implication is that you do not do another transaction with that entity, unless you are able to go the opposite direction – which could mitigate some of the existing credit risk. Consider your ISDA agreement, and whether you have or can put in place a credit support annex (CSA) to collateralize your positions. If this is not feasible, then consider whether it’s time to transfer away from your counterparty to someone more creditworthy. Again, look to your agreement to see how a transfer would work – at a minimum, it generally requires consent of all parties involved. Finally, if none of the above will work for you, consider unwinding your position and putting it back on with a more creditworthy counterparty. Keep in mind you will likely incur fees to do so, which could outweigh any real benefits if not carefully examined. The point is that you have choices to mitigate credit risk, when your counterparty no longer seems capable of living up to its agreement with you. Take action when called for to reduce or eliminate this risk.

Detroit’s bankruptcy is a sad chapter in the proud history of the Motor City, but no doubt they will not let this event define them. So too, you can’t let your exposure to a less-than-creditworthy counterparty define your hedging program or prevent you from properly assessing and managing business risks. If you have questions about your derivative portfolio or your counterparties, please reach out to us!