Plus ça change, plus c’est la même chose: Margining and Value at Risk – is there a better way

The concepts, ‘margining’ and ‘value at risk’ led the global financial system into a very dangerous place recently, but there is no sign that they are being challenged. Is anyone searching for or developing a better way to deal with ‘future risk’ in price volatile commodity and associated derivative markets?

When margining is in place and prices move against a company’s position its counterparties feel safe because they receive cash daily to cover their revised net exposure. That is the amount that would be due to them should the company have gone bankrupt at the close of business the previous day.

Additionally, a value at risk calculation – based on probability (gambling) theory – informs the management of the counterparties daily how much exposure they may incur during any necessary close-out period following a default, say five or 10 days, with a mathematically calculated degree of certainty. Thus empowering the management of counterparties to call for additional ‘initial margin’ or ‘adequate assurance of performance’, if it is felt that such ‘close out period related exposure’ is excessive. Let us remember at this point that value at risk calculations have proved to be nonsensical and useless in many cases, despite the claim that they provide a 95% or 99% degree of mathematical certainty.

Value at risk (VaR) calculations are based on the assumption that markets will behave in the future – as to price volatility and trend – in the same way as they did in the past. Such an assumption is patently spurious, hence the failure of VaR calculations to be of any use in a crisis situation. Nevertheless those who manage and regulate our financial markets cling to the belief that VaR calculations are capable of predicting such ‘worst case’ crisis or extreme situations.

In times of extreme price volatility or price spikes, margining drains the liquidity of companies that are on the wrong side of the price movement, particularly if they are either ‘market makers’ with open (un-hedged) positions, or physical commodity consumers that have to wait for the cash arising from the transaction hedged, thus are unable to find the cash to ‘post’ margin immediately.

If a company is thought to be having difficulty finding cash to pay (post) margin immediately it is often downgraded by the infamous S&P, Moody’s or Fitch, and immediately faces increased margin calls on existing positions hence its end in bankruptcy becomes more certain and more immediate.

At the point of bankruptcy, those counterparties that have secured their positions cheer, then pat themselves on the back and gloat as the zero sum game they play sees another august competitor brought to its knees by lack of liquidity alone.

The schadenfreude moment is short-lived however as counterparties scramble to replace the hedges lost as a result of the bankruptcy.

When Lehman Brothers was destroyed many counterparties lost millions through the need to replace hedges in the midst of the panic that followed, as good old ‘demand and supply’ drove prices to spike beyond anything forecast by any VaR calculations.

Do we have to suffer this cycle repeatedly?

The markets continue to use margining (against daily mark-to-market calculations) so it seems inevitable that the Lehman Brothers fall-out scenario will be repeated time and again, perhaps not so spectacularly nevertheless some fine companies and many jobs will be destroyed in the process. Following the Enron debacle, we saw a similar episode almost destroy Dynegy but the margining and VaR concepts were not questioned at that time.

The margining and VaR concepts and related practices need to be reviewed urgently since they appear to be unsound and unsuitable foundations upon which an untold number of interlocking financial transactions are built. The potential consequences of the failure of these concepts to protect markets have been presented in the stark reality of the ‘credit crunch’.

The danger to global financial markets persists and will persist as long as such crude and impractical tools are considered adequate. Therefore now is the time to re-examine the way in which future risk (performance and delivery) is assessed and how related exposure to counterparty bankruptcy risk is secured.

More information is available in the presentation and articles found at: http://www.barrettwells.com/CVaREnergyRiskFeb2008web.pdf,
http://www.barrettwells.co.uk/performance.html, and
http://www.barrettwells.co.uk/crmsforum.html.

Please post your ideas and comments on this subject, or write an article for a professional journal.

Ron Wells

China: A Review of Developments in Credit Management

Ron Wells recently gave a presentation titled China: A Review of Developments in Credit Management. To view this presentation go to http://www.ccrinteractive.com/ and register. Registration is free and only takes a couple of minutes.

After you register you will find yourself on the opening page of the website, with a video of a politician making one of the conference opening speeches starting to play. Below that video window you will see several buttons. Click on the INTERNATIONAL button and a menu of videos will appear, one of which is this presentation, click on that item and the presentation will begin. It runs for 25 minutes....

Editor

Once again the major Credit Rating Agencies (S&P, Moody’s and Fitch) have failed; once again they are being reprieved…

The following extracts from recent BBC.com reports point out only the most recent in a string of failures clocked up by the major credit rating agencies. Yet once again all we hear from these agencies is that once again they are reforming.

The message is …..do not rely solely on the credit ratings published by these agencies when making credit risk decisions. Treat such ratings merely as ‘input’ to be considered as part of your overall analysis, or you will risk more than credit, you’ll risk your company and your job…..

QUOTE:

Problems found at ratings firms

A report into the much-criticised activities of credit rating agencies has found conflicts of interest at the firms it studied.

The US financial regulator, the SEC, found that the firms, which rate investments, had broken its rules.

It began looking into their work after they gave positive ratings to sub-prime related investment products whose value later slumped.

The agencies are now implementing better procedures, the SEC said.

See: http://news.bbc.co.uk/2/hi/business/7496599.stm

(Editor: We heard the same after Enron and Parmalat, let’s hope this time ‘better procedures’ will mean more useful credit ratings)

Tougher rules for rating agencies

Credit rating agencies could be banned or prosecuted under a draft European Union law aimed at making them more accountable for the advice they give.

Firms that rate debt investments, such as Fitch, Moody's and Standard & Poor's, have been criticised for their role in the sub-prime mortgage crisis.

The new law would replace a voluntary code of conduct.

…..it was generally accepted that the agencies had "failed to reflect early enough in their ratings the worsening of market conditions thereby sharing a large responsibility for the current market turmoil".

http://news.bbc.co.uk/go/pr/fr/-/1/hi/business/7535911.stm

(Editor: So what’s new? This has happened time and time again…..)

Letters of Credit … should state applicable law and jurisdiction

Letters of Credit (LCs) are still widely used in international trade, although they cover a diminishing proportion of that trade. Most sellers who receive and buyers who initiate LCs and their bankers know that their LCs must be opened subject to the Uniform Customs and Practices for Documentary Credits 2007 revision, as published by the International Chamber of Commerce, in publication number 600; generally called UCP 600.

However relatively few bankers and very few exporters and importers realise the importance of ensuring that the LCs they open, receive or initiate should stipulate the law and legal jurisdiction which applies in each case.

This becomes vitally important if a dispute arises regarding an LC. If applicable law and jurisdiction are not stated, the parties to the dispute may do some ‘jurisdiction shopping’ and/or place the matter in the hands of a court inexperienced in matters of international trade, which has to work with law that does not adequately support an equitable ruling.

UCP 600 is a body of rules incorporated into the LC contract. It is not law hence it does not have the force of law in any jurisdiction. It is a contract between the parties to the LC so the rules will be interpreted by a court simply as rules agreed by the parties, against the background of the applicable law.

I recommend the inclusion of a clause in all LCs stipulating either English law and English Courts, or Singapore law and Singapore Courts, or Hong Kong law and Hong Kong Courts, or New York law and New York Courts; simply because it is these courts that by virtue of the fact that they are based in trading hubs, have extensive experience and sound legislation and/or precedent decisions on which to base broad-minded judgements.

It may not always be possible to persuade an opening bank to include a law and jurisdiction clause but I have found through experience that most banks will agree. I have found that if you persist in requesting this clause it is possible to achieve a high percentage of success.

Feel free to take professional legal advice on this matter, but I recommend that if you do so you consult a lawyer with experience in international trade. I will be happy to recommend some appropriate legal firms if you are not familiar with the field.

Ron Wells

Bretton Woods - No. Globalisation - Yes

Greetings …

I had the pleasure of attending the FCIB Conference in Budapest a couple of weeks ago. The key-note speech by the Chief Economist of Fortis Bank was amusing, interesting and informative. This was a veritable highlight. Some comments that stuck include; the USA resembles the Roman Empire before it fell, with a near zero savings rate and a $9 trillion debt burden. You can hear the silent cry of US residents – so we have no money, never-mind let’s go to the mall and spend some more of someone else’s money! The prediction is that – if we are all very lucky – the lenders to the US citizenry will not ask for repayment until about 2012/13. So we only have to deal with the sub-prime fall out for now.

The other point well made, amid many a chuckle, was that (i) globalisation, and (ii) technology have changed the rules for the world economy, so the Bretton Woods US consumer dominated model and the associated control mechanisms no longer apply.

Participation in the world economy has grown ten fold since 1990 (800 million American-European-Japanese participants to 6000 million citizens) and technology has made the world ten times faster. Business has been turned on its head by technology and open access, from a heavy asset based fixed address model to an intelligence-connectivity model. Nation states have lost control since intelligence and connectivity has no fixed address.

The positive spin-off for all world citizens has been enormous. Sustained and stable economic growth, low inflation and low real interest rates; despite the world financial crises companies in the real economy are still in good shape.

Were you at the FCIB conference I Budapest? If so, what were your impressions? If not, do you agree with the sentiments that I have poorly represented above?

Regards Ron

PS: Find out more about the FCIB on www.fcibglobal.com

Invitation to join GCMG – No formalities required …

You are warmly invited to become a member of GCMG – in fact you are already a member. We do not need to know your name, or where you live, you need no qualification other than an interest in B2B credit management, which you obviously already possess. There is no fee to pay!

There are three types of member of GCMG, you are free to choose which one you wish to be and free to change category whenever you like.

The first type of member is a Spectator, who visits the blog from time to time and reads the content. Spectators sometimes pass on a link to friends and colleagues, or send a copy of an interesting item posted.

The second is a Questioner, who visits regularly and from time to time submits a question related to international B2B credit management.

The third is a Contributor, who offers answers and advice to Questioners via blog comments. Contributors are also encouraged to suggest books and articles that members may find interesting and to post reviews. Suggestions regarding new techniques and technologies are likewise welcome. Send an email to info@barrettwells.com and your contribution will be posted under your name or nom-de-plume, as you wish.

All members are valuable, all are welcome.

Ron Wells

Note: B2B = business to business

Introduction

Comments published on behalf of the GCMG will appear here regularly.

The formation of the GCMG was inspired by the exploits of Credit Agent 007.24 Samuel James Bond Barrett in Central Africa in the mid-nineties. That amazing story illustrated the way forward for 21st century credit management.

Read the full story at http://www.barrettwells.co.uk/gcmg.html.

I’m also looking forward to reading your comments in due course.

Ron Wells