davies_liquidity considerations of counterparty credit risk

8/13/2019 Davies_Liquidity Considerations of Counterparty Credit Risk

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Liquidity Considerations of

Counterparty Credit RiskIECA Spring Conference,

Hilton Head, SC

March 20, 2010

Morgan DaviesDirector of Corporate Creditand 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 NewWorld)


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Financial Liquidity within a Capital AdequacyFramework (CAF)

Economic Capital Financial Liquidity

(Short term)(Long term)

Capital

Adequacy


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Financial Liquidity within a Capital AdequacyFramework (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 liquiditystress

- Adverse price movements in commodities (i.e. reliance on the spotelectricity 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 liquidityto be allocated in support of the organization


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Framework for Measuring LiquidityAdequacy

1. From CCRO Whitepaper Emerging Practices for Assessing Capital Adequac y

1


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Liquidity Considerations of CounterpartyCredit Risk



Dodd Frank and Liquidity Considerations (aka: Brave New World)


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Measuring Financial Liquidity

Mitigation Tools

- Master Contracts- Novations

- Financial Engineering


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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) andoutput (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 todetermine 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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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 thehistorical credit management Importantly, at the contract level

- Developing workflows to manage expirations and reductions in static collateralpostings (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 forprospective transactions to minimize collateral

Actively look for opportunities to net and set-off transactions across contractsand commodities both on a bilateral and multilateral basis


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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 andphysical 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) 1Variation 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 4contracts per day Henry Hub NaturalGas (NG), Cal 2012 1

Party A is long 4 NG contracts per day Cal2012 with CME

Party B is short 8 NG contracts per day 2Cal 2012 with CME

Party A and Party B agree to novate their 4contracts per day deal to the CME

Result

Both Party A and B reduce their marginposted to the CME

Party A is able to utilize the $2MM from thein-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 protectliquidity. 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 availabilityof $200 million contingent on natural gas futures contract prices exceeding certainthresholds

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 tomanage liquidity in high price environments (oil/gas, generators, etc.)

- RWR counterparties become a secured party and gain comfort from the fact that themarket value of the assets in the collateral package will increase with an increase in theprice 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 companyfrom getting into a liquidity squeeze under a high price scenario where thecompany 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 thecommodity producing asset

- As less than 100% of the portfolio will be hedged, this creates additional collateralfor 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)

Asse

t Valu

e

MTMExp

osure

S p a r k S p r e a d

Valu

e

Inc reas ing

cus h ion due to

hedg ing

l im i ta t ions


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Liquidity Considerations of CounterpartyCredit Risk



Dodd Frank and Liquidity Considerations (aka: Brave New World)


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DoddFrank Wall Street Reform and ConsumerProtection Act

Title VII Wall Street Transparency and Accountability Act of2010

-Are you a Major Swap Participant or Swap Dealer

- If so you may be subject to capital and margin requirementsamong other things =>What is the impact on your entitiescurrent liquidity requirements and contingent liquidityrequirements?

- 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?


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davies_liquidity considerations of counterparty credit risk

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