Derivatives markets were born in the 1840s, when grain farmers discovered that Chicago’s storage centers were too full to accommodate booming harvest-season supplies, yet lay empty in the spring. To guard against resulting price swings, farmers and speculators entered into contracts that locked in prices for future delivery.
Risk management has come a long way since then. Today corporations use an array of derivatives to guard against volatility in commodity prices, interest rates, currency values and even weather. But they’re having a more difficult time dealing with an increasingly potent threat: the possibility of major customers’ or suppliers’ going bankrupt.
A handful of companies, including IBM Corp. and German engineering concern Siemens, use credit default swaps to manage this risk. First developed by banks in the late 1990s to hedge their loan portfolios but now more widely used by hedge funds and other investors, default swaps are essentially insurance against corporate defaults. In a common application, an investor that owns a company’s bonds can buy a default swap from a bank, which agrees to make the investor whole for its losses if the company defaults and receives a premium in return.
But default swaps are an imperfect hedge for companies that are worried about woes with suppliers and customers; they protect against defaults on debt, not failures to deliver or pay for goods and services.
“The standard credit derivative product was not really structured with the thought, ‘I sold goods to Company A, they may not be able to pay me, and I need to hedge that exposure,’” explains Thomas Benison, credit product manager for North America at J.P. Morgan Chase & Co.
Because they are not a direct hedge against accounts-receivable defaults, credit derivatives used for that purpose must be marked to market on corporate balance sheets under U.S. accounting rules. Declines in the market value of such derivatives can thus eat into earnings. That’s perhaps the biggest reason corporations are still marginal players in the $17 trillion market.
“Credit derivatives have not been adopted at close to the levels at which corporations have used interest-rate or foreign-exchange derivatives,” says Raj Bhattacharyya, head of debt derivatives and structured credit origination at Deutsche Bank, who estimates that three quarters of listed companies hedge interest-rate movements, compared with just a few dozen that use credit derivatives.
“Unfortunately, current accounting standards are hindering corporate use of derivatives for hedging purposes,” adds Ralf Lierow, a senior portfolio manager for Siemens’ financial services division, which uses credit derivatives to manage its vendor-financing risk. “However, I don’t believe risk management strategies should be dictated by accounting rules.”
Recent troubles in the energy, airline and automotive sectors have only underscored the threat of related-company defaults. With credit derivatives largely on the shelf, Wall Street firms have begun marketing an alternative: accounts-receivable puts that are triggered by debt defaults. The amount of the payout is not linked to a company’s bonds or loans but is determined by the value of the receivables owed by the company in default. Receivable puts don’t have to be marked to market. But they are more customized, and therefore more expensive, than default swaps. During the past two years a small but growing group of companies — mostly in the retail, automotive and airline industries — have bought these instruments, bankers say.
Companies seeking protection from supplier problems, then, need to carefully consider the pros and cons of both default swaps and receivable puts. The high premiums on the puts helped convince Siemens’ Lierow, for instance, that swaps were a more effective hedging strategy. Bhattacharyya says clients that have used receivable puts (he declines to name any) have frequently gone on to use credit derivatives. But he’s also hopeful that the Financial Accounting Standards Board will make default swaps eligible for hedge-accounting treatment. (FASB won’t comment.)
Companies worried about customer defaults must decide whether the chance of problems is significant enough to justify either the high cost of accounts-receivable puts or the potential hit to earnings from owning default swaps. Or, they could risk doing nothing.
