Liquidity Considerations of

Counterparty Credit Risk

IECA Spring Conference,
Hilton Head, SC
March 20, 2010
Morgan Davies
Director of Corporate Credit
and Contracts
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Liquidity Considerations of Counterparty Credit Risk
Financial Liquidity within a Capital Adequacy Framework
Liquidity Management
Dodd Frank and Liquidity Considerations (aka: Brave New
World)
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Financial Liquidity within a Capital Adequacy
Framework (CAF)
Economic Capital Financial Liquidity
(Short term) (Long term)
Capital
Adequacy
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Financial Liquidity within a Capital Adequacy
Framework (CAF)
CAF should measure the adequacy under stressed or unforeseen conditions
Risks to economic capital and financial liquidity are the same
- Except financial liquidity includes:
- Contract rules
- Other cash flow factors
Important to be able to evaluate to meet liquidity demands
- For example S&P reviews liquidity of trading operations of energy
companies specifically through its Liquidity Adequacy Survey
The environment energy companies operate in, can subject them to liquidity
stress
- Adverse price movements in commodities (i.e. reliance on the spot
electricity market, lack of a hedged portfolio)
- A credit downgrade (i.e. below investment grade, MAC event, causing a
requirement to post liquid collateral)
The BOD should approve the amount of economic capital and financial liquidity
to be allocated in support of the organization
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Framework for Measuring Liquidity
Adequacy
1. From CCRO Whitepaper Emerging Practices for Assessing Capital Adequacy
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Liquidity Considerations of Counterparty
Credit Risk
Financial Liquidity within a Capital Adequacy Framework
Liquidity Management
Dodd Frank and Liquidity Considerations (aka: Brave New World)
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Liquidity Management
Measuring Financial Liquidity
Mitigation Tools
- Master Contracts
- Novations
- Financial Engineering
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Measuring Financial Liquidity
A balance between managing market risk and short-term liquidity is essential
- i.e. Company executes 3 year fixed price PPA and simultaneously hedges the fixed
price gas exposure via exchange
- If gas prices decline substantially and/or volatility increases, a liquidity crisis could
result due to initial and variation margin requirements by the exchange
- yet economically the company is the same
Modeling Cash Flows is an important step in managing financial liquidity:
- At the Corporate and Business Unit Levels (including What-if and Scenario/Stress
Analysis)
- Model the same contract T&Cs for calculating credit exposure (i.e. netting rules,
triggers)
- Use these same contract rules against the simulated base case input (i.e. gas) and
output (i.e. power) prices over the time horizon
- Use the distribution of net cash flows over the confidence interval (i.e. 99%, n day)
Results from modeling cash flow, including scenario analysis, should be used to
determine potential liquidity requirements and liquidity protection
- Use of contingent capital facilities
- Setting hedge levels
- Incenting transaction flow to less capital/liquidity structures
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Measuring Financial Liquidity
Monitoring capital utilized by the different business segments (trading,
origination, development, etc.)
- Includes having robust systems
- Credit systems today are being built to perform liquidity analysis as well as the
historical credit management Importantly, at the contract level
- Developing workflows to manage expirations and reductions in static collateral
postings (i.e. LOCs)
- What if and stress scenario analysis
- Ratings downgrade
- Change in prices of a commodity
- Potential deal impact on cash flow (and credit risk)
Active review of exchange positions for opportunities to reduce initial margin
Providing the traders with tools to monitor collateral with counterparties for
prospective transactions to minimize collateral
Actively look for opportunities to net and set-off transactions across contracts
and commodities both on a bilateral and multilateral basis
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Liquidity Management
Measuring Financial Liquidity
Mitigation Tools
- Master Netting Agreements & ISDAs
- Novations
- Financial Engineering
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Master Netting Agreements & ISDAs
Ability to net exposures across different exposures (i.e. physical gas and
physical power and financials)
($000) No MNA With MNA
Party A Party B Party A Party B
Phys Power -EEI 3,000 (3,000) 3,000 (3,000)
Phys Gas -NAESB (2,000) 2,000 (2,000) 2,000
Financials -ISDA (2,000) 2,000 (2,000) 2,000
Credit Exposure 3,000 4,000 0 1,000
Collateral Required 4,000 3,000 1,000 0
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Novation Example
Pre Novation Party A Party B
Bilateral Exposure $2MM ($2MM)
Bilateral Collateral Posted $0 ($2MM LOC) 1
Variation Margin CME $0 $0
Initial Margin CME ($4MM) ($8MM) 2
Capital Supporting Position ($4MM) ($10MM)
Post Novation Party A Party B
Bilateral Exposure $0 3 $0
Bilateral Collateral Posted $0 $0
Variation Margin CME $2MM ($2MM)
Initial Margin - CME $0 ($4MM)
Capital Supporting Position $2MM ($6MM)
Capital Reduction $6MM $4MM
Party B posting $2MM to Party A
Supports sale by Party A to Party B of 4
contracts per day Henry Hub Natural
Gas (NG), Cal 2012 1
Party A is long 4 NG contracts per day Cal
2012 with CME
Party B is short 8 NG contracts per day 2
Cal 2012 with CME
Party A and Party B agree to novate their 4
contracts per day deal to the CME
Result
Both Party A and B reduce their margin
posted to the CME
Party A is able to utilize the $2MM from the
in-the-money position (returned to A) 3
Credit risk reduced for both parties
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Financial Engineering
Products can be financially engineered to manage liquidity including:
Oil and gas producers often hedge to lock in price levels which can also protect
liquidity. Examples include:
- Fixed for float swaps, participation swaps, collars, caps
REPs securitizing accounts receivables (i.e. lock boxes)
Contingent Capital Facilities
- Knock-in Options: Known as a barrier option, where the entity is buying an option
for the right to strike prior to expiration if the predetermined condition is met
- From Calpines Q1 2009 10-Q [the knock-in facility] provides an initial $50 million of
available capacity for the issuance of letters of credit up to a total maximum availability
of $200 million contingent on natural gas futures contract prices exceeding certain
thresholds
1st Lien Structures (Right-Way Risk)
- A transaction in which there is a positive correlation between the value of assets
and the price of the commodity producing asset (used by energy companies to
manage liquidity in high price environments (oil/gas, generators, etc.)
- RWR counterparties become a secured party and gain comfort from the fact that the
market value of the assets in the collateral package will increase with an increase in the
price of the commodity producing asset
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RWR Concept
Ratings agencies consider right-way risk structures in the ratings process
- S&P has stated the structures absorb less credit capacity and prevent a company
from getting into a liquidity squeeze under a high price scenario where the
company would otherwise be healthy
- S&P Report Right-Way Risk Can Help U.S. Energy Companies' Hedging Capabilities, September 11, 2006
Counterparty MTM exposure is positively correlated to changes in prices of the
commodity producing asset
- As less than 100% of the portfolio will be hedged, this creates additional collateral
for the secured lender/counterparty as the value of the enterprise increases
- In the case of a generator, increases in the spark spread increases value in the
commodity producing asset (the power plant)
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Increas ing
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Liquidity Considerations of Counterparty
Credit Risk
Financial Liquidity within a Capital Adequacy Framework
Liquidity Management
Dodd Frank and Liquidity Considerations (aka: Brave New World)
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DoddFrank Wall Street Reform and Consumer
Protection Act
Title VII Wall Street Transparency and Accountability Act of
2010
- Are you a Major Swap Participant or Swap Dealer
- If so you may be subject to capital and margin requirements
among other things =>What is the impact on your entities
current liquidity requirements and contingent liquidity
requirements?
- Other Issues to assess the [potential] impact of:
- Elimination of letters of credit
- Proposes a five (5) day holding period for calculating initial
margin
- Requires the posting of initial margin
- Daily cash settlement
- Cash on deposit to be held in a segregated account
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Questions?