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Rehabilitating CDS (Credit Default Swaps)

http://www.economist.com/opinion/displaystory.cfm?story_id=12562363

Derivatives

Giving credit where it is due

Nov 6th 2008
From The Economist print edition

The credit-default swap needs reform, not abolition

FINANCIAL innovations tend to go through four phases. At first, they are hailed as proof of the brilliance of the bankers who devised them. Then they succumb to rampant speculation, as investors try to exploit them. And that leads to revulsion, as a crisis causes widespread losses. The question is: should the fourth phase be rejection or rehabilitation?

The latest innovation to pass through the cycle is the credit-default swap or CDS. Despite its forbidding name, the CDS is a simple idea: it allows an investor to buy insurance against a company defaulting on its debt payments. When it was invented, the CDS was a useful concept because more people felt comfortable owning corporate debt if they could eliminate the risk of the issuer failing. The extra appetite for debt helped lower the cost of capital.

But now investors are showing a greater disdain for risky debt - and fears about a looming credit crunch have shaken investor confidence worldwide. The Dow Jones industrial average plunged 311 points Thursday - its second-worst day of the year - and sent global stock markets reeling. The Dow opened lower Friday as well but later stabilized and was little changed in mid-morning.

Besides triggering a global stock selloff, the jitters are casting a shadow on the buyout boom and could slow down everything from private equity buyouts to corporate restructuring plans.

Housing slump gets longer, and longer …

The housing market, meanwhile, is still struggling to find a bottom. The subprime meltdown started the worries in credit markets - and the extent of the problems in the subprime mortgage market remains uncertain.

“The ultimate outcome of the decline in mortgage credit quality is not wholly predictable,” Moody’s Economy.com said in a July 26 report. While there are efforts being made to forestall the surge in foreclosures, “the downside risks outweigh the positives,” the report said.

Credit markets have been roiled as investors have begun shying away from risk, demanding better terms on corporate bonds and loans, meaning the old days of cheap, easy money for corporations may be past.

“This is part of a process of removing liquidity and increasing the expected returns required of people to tolerate risk,” Charles Diebel, an analyst at Nomura International, said about the turbulence in the market.

Tighter credit is troubling to investors for two reasons. It’s likely to slow the buyout boom that’s helped prop up stock prices. And it could raise the cost of borrowing for companies, hurting corporate earnings. To date, there have been roughly 20 buyout-related debt deals that have been postponed as credit markets have tightened.

The battle to be ‘King of the Street’

Earlier this week, Chrysler delayed a debt sale related to its takeover by Cerberus Capital Management. The sale of $12 billion in loans underwritten by JP Morgan (Charts, Fortune 500), Bear Stearns (Charts, Fortune 500), Goldman Sachs (Charts, Fortune 500), Citigroup (Charts, Fortune 500) and Morgan Stanley (Charts, Fortune 500) was put on hold, according to Reuters Loan Pricing Corp. - although Cerberus said its purchase of Chrysler would still be completed in August.

The wave of credit worries is also upsetting corporate plans in
Europe. British pharmacy giant Alliance Boots, which is being taken over by Kohlberg Kravis Roberts and an Alliance executive, ran into trouble financing its buyout earlier this week.

Britain’s Cadbury Schweppes said Friday it’s delaying the sale of its beverage unit because of troubles in the debt markets. The company said it pushed back the timetable of the sale “to allow bidders to complete their proposals against a more stable debt financing market.”

Now there are concerns the darkening mood in the debt market could hit other big deals in the pipeline. A number of high-profile buyouts still need to be financed, including the $28 purchase of wireless phone company Alltel (Charts, Fortune 500) and the $44 billion takeover of Texas utility TXU Corp (Charts, Fortune 500).

“Clearly, deals will get done. But capacity again has become an issue. Syndicating a $5 billion loan once again seems daunting, arrangers say, to speak nothing of a $10-15 billion credit,” Standard & Poor’s Leveraged Commentary & Data said in a note Thursday.

If financing for buyout firms dries up, overall deal activity would be hit hard. Private equity firms have announced about $782 billion in deals this year, or about a quarter of worldwide deal activity, according to Thomson Financial.

The weak conditions also come when buyout firms may start crowding the exit doors, which would make it more difficult for other deals coming along.

Given the length of the current merger wave, which started in 2003, the M&A market is already ripe for a drop off, according to Scott Moeller, a visiting professor of finance at Cass Business School.

“At some point, this market will go down, and because of the way liquidity has driven this merger wave, when we have the fall - it’s going to be steeper, and the drop is likely going to be faster than in the past,” he said.

Private equity firms typically hold their investments for three to five years. The question now is will they be forced to start unloading the firms scooped up in the recent buying spree sooner than they had wanted.

It remains to be seen what will trigger the selling wave among private equity firms, but when liquidity starts to dry up, “everyone is going to rush to the exits,” Moeller said.

So what’s the spread on the impending CDO disaster?

Jun 29 10:37
by Paul Murphy
Comment

A cool $125bn to $250bn, according to Bloomberg, which stated rather boldly on Friday that a failure on the part of rating agencies S&P, Moody’s and Fitch to downgrade securities backed by suspect home loans was masking burgeoning losses. More…

A cool $125bn to $250bn, according to Bloomberg, which stated rather boldly on Friday that a failure on the part of rating agencies S&P, Moody’s and Fitch to downgrade securities backed by suspect home loans was masking burgeoning losses.

Almost 65 per cent of the bonds in indexes that track subprime mortgage debt don’t meet the ratings criteria in place when they were sold, according to Bloomberg’s data.

“You’ll see massive losses from banks, insurance companies and pension managers,’’ Joshua Rosner, a managing director at New York investment research firm Graham Fisher, told the news service. “The longer they wait, the worse it’s going to be.”

Mr Rosner co-authored a study last month that said the main credit rating agencies understate the risks of subprime mortgage bonds. He estimates that losses related to collateralised debt obligations will hit $125bn. Meanwhile, Institutional Risk Analytics, a California-based company that writes computer programs for the four biggest accounting firms, says 25 per cent of the face value of CDOs is in jeopardy, or $250 billion.

Speaking up for the rating agencies, Brian Clarkson, Moody’s global head of the structured products in New York, told Bloomberg: “We’re taking action as we see it …We’re not doing knee-jerk responses.”

In: Capital markets

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S&P, Moody’s Hide Rising Risk on $200 Billion of Mortgage Bonds
By Mark Pittman

 

“For Sale” and “Open House” signs

June 29 (Bloomberg) — Standard & Poor’s, Moody’s Investors Service and Fitch Ratings are masking burgeoning losses in the market for subprime mortgage bonds by failing to cut the credit ratings on about $200 billion of securities backed by home loans.

The highest default rates on home loans in a decade have reduced prices of some bonds backed by mortgages to people with poor or limited credit by more than 50 cents on the dollar and forced New York-based Bear Stearns Cos. to offer $3.2 billion to bail out a money-losing hedge fund. Almost 65 percent of the bonds in indexes that track subprime mortgage debt don’t meet the ratings criteria in place when they were sold, according to data compiled by Bloomberg.

That may just be the beginning. Downgrades by S&P, Moody’s and Fitch would force hundreds of investors to sell holdings, roiling the $800 billion market for securities backed by subprime mortgages and $1 trillion of collateralized debt obligations, the fastest growing part of the financial markets.

“You’ll see massive losses from banks, insurance companies and pension managers,” said Joshua Rosner, a managing director at investment research firm Graham Fisher & Co. in New York and co-author of a study last month that said S&P, Moody’s and Fitch understate the risks of subprime mortgage bonds. “The longer they wait, the worse it’s going to be.”

Loss Estimates

Rosner estimates that collateralized debt obligations, which have packaged thousands of bonds and derivatives into new securities, will lose $125 billion. Institutional Risk Analytics, a Hawthorne, California-based company that writes computer programs for the four biggest accounting firms, says 25 percent of the face value of CDOs is in jeopardy, or $250 billion.

Losses may rival the savings and loan crisis of the 1980s and 1990s. The Resolution Trust Corp., formed by the U.S. government to resolve the thrift crisis, sold $452 billion of assets at a cost to taxpayers of about $140 billion.

The current debacle threatens the growth of asset-backed bonds, securities that use consumer, commercial and other loans and receivables as collateral. That market, which includes mortgage securities, has doubled to about $10 trillion since 2000, according to the Securities Industry Financial Markets Association, a New York-based trade group.

Executives at New York-based S&P, Moody’s and Fitch say they are waiting until foreclosure sales show that the collateral backing the bonds has declined enough to create losses before lowering ratings on some of the $6.65 trillion in outstanding mortgage-backed debt.

`Knee-Jerk Responses’

Homeowners may be delinquent on mortgage payments for at least three months before foreclosure proceedings begin, and the process can be delayed if a borrower files for bankruptcy or fights eviction. Even when lenders repossess a home, the value of the mortgage isn’t written down until the house is sold. Bondholders only see a loss if the price of a house is lower than the loan used as collateral for debt securities.

“We’re taking action as we see it,” said Brian Clarkson, Moody’s global head of the structured products in New York. “We’re not doing knee-jerk responses.”

Ratings companies are postponing the inevitable and are dumping securities as defaults by subprime borrowers increase, investors say.

Lehman Brothers Holdings Inc., the biggest underwriter of mortgage bonds, sold $2.43 billion of Structured Asset Investment Loan Trust bonds a year ago. An $18 million portion of the bonds rated BBB- fell to 43 cents on the dollar from 98 cents in January, according to prices compiled by New York-based Merrill Lynch & Co.

Increased Delinquencies

More than 15 percent of the mortgages in the securities are at least 60 days delinquent and another 8 percent are in foreclosure, according to the bond trustee. Moody’s and S&P say they are considering downgrading the debt.

A total of 11 percent of the loan collateral for all subprime mortgage bonds had payments at least 90 days late, were in foreclosure or had the underlying property seized, according to a June 1 report by Friedman, Billings, Ramsey Group Inc., a securities firm in Arlington, Virginia. In May 2005, that amount was 5.4 percent.

The increase in delinquencies means CDO investors, who sometimes use borrowed money to magnify their bets, may be holding securities that are riskier than their ratings indicate, said Bill Gross, chief investment officer at Pacific Investment Management Co., based in Newport Beach, California.

“The Petri dish turns from a benign experiment in financial engineering to a destructive virus,” Gross, who oversees the world’s biggest bond fund, said this week in a commentary on the firm’s Web site. The companies gave the mortgage bonds investment-grade ratings, duped by the “six-inch hooker heels” of collateral that can’t be trusted, he said.

No Disclosure

CDOs aren’t required to disclose the contents of their holdings to the U.S. Securities and Exchange Commission and most can change them after the bonds are sold.

Losses reflect the decline of the U.S. housing market, where the national median home sale price is poised for its first annual drop since the Great Depression, according to the National Association of Realtors.

Investors are responding by retreating from all sorts of riskier assets, threatening to reduce credit. Companies canceled at least $3 billion of bond sales worldwide in the past two weeks. U.S. Treasury notes snapped a six-week losing streak last week, pushing yields down from the highest in five years, as investors sought the haven of government bonds.

The subprime meltdown is sending shock waves through the capital markets in part because mortgage bonds are the world’s biggest debt market, according to the Securities Industry Financial Markets Association.

Thousands of Investors

Thousands of investors own mortgage bonds, ranging from fund managers such as Pimco, a unit of Munich-based Allianz SE, to the California Public Employees’ Retirement System, the biggest U.S. public pension fund, and foreign banks like Fortis SA in Brussels.

CDOs are created by taking bonds, loans and other securities, pooling them together and chopping them into new securities with ratings ranging from the safest AAA to ones so risky they have no rankings. Investors snapped up $500 million of the securities globally last year because they typically yield more than bonds with the same credit ratings. Sales of CDOs have risen five-fold since 2001, according to JPMorgan Chase & Co.

One reason for the higher yields on some CDOs is that subprime-related debt made up about 45 percent of the collateral backing the $375 billion of CDOs sold in the U.S. in 2006, data compiled by Moody’s and New York-based Morgan Stanley show.

Drexel Creation

Credit Suisse Group, based in Zurich, created a $1 billion CDO called Class V Funding III Ltd. in February by combining the A rated portions of 91 other CDOs that invest in debt backed by consumer obligations.

The biggest portion, or $859.2 million of bonds, is rated AAA and pays interest as low as 5.70 percent. The smallest piece, or $2.5 million, is ranked BBB and has a coupon of 10.61 percent, according to a May 22 report produced by the trustee for the CDO.

At the time of the report, AAA rated corporate bonds had an average yield of 5.45 percent, while BBB debt yielded 6.03 percent, according to Merrill Lynch index data.

Demand for CDOs, first used in 1987 by bankers at now- defunct Drexel Burnham Lambert Inc., is drying up as mortgage bond losses spread. Planned sales of CDOs that rely on high- rated asset-backed debt dropped to $3 billion this month from $20 billion in May, according to analysts at JPMorgan, the third-largest U.S. bank.

First Year Rankings

“A lot of these should be downgraded sooner rather than later,” said Jeff Given at John Hancock Advisors LLC in Boston, who oversees $3.5 billion of mortgage bonds. The ratings companies may be embarrassed to downgrade the bonds, he said. “It’s easier to say two years from now that you were wrong on a rating than it is to say you were wrong five months after you rated it.”

Fitch is “deliberate” in its actions, John Bonfiglio, the firm’s head of U.S. structured finance ratings, said in an interview in his New York office. Fitch is a unit of Paris-based Fimalac AS. “I would not say we were slow.”

The ratings companies point out they have downgraded bonds less than a year after they were sold, the first time that has ever happened. S&P has lowered a total of 15 subprime bonds sold in 2005, or 0.31 percent of the total, and 32 sold in 2006, or 0.68 percent.

“People are surprised there haven’t been more downgrades,” Claire Robinson, a managing director at Moody’s, said during an investor conference sponsored by the firm in New York on June 5. “What they don’t understand about the rating process is that we don’t change our ratings on speculation about what’s going to happen.”

Bear Stearns Jolt

Accurate rankings for mortgage bonds and CDOs become even more important because the securities rarely trade, so investors can’t immediately value their holdings when market conditions change. Instead, they often rely on sales of similar securities or computer models that use ratings and past performance of the underlying collateral to come up with a value.

CDO investors were jolted this month by the losses in the Bear Stearns hedge funds.

The funds, called High-Grade Structured Credit Strategies Fund and High-Grade Structured Credit Strategies Enhanced Leverage Fund, had borrowed $10 billion from securities firms and banks to make bets on CDOs, mortgage bonds and other securities. As the values of the holdings declined, creditors seized some of the collateral pledged for the loans and sold them through auctions.

Fire Sale

A concern was that a forced sale would slash prices on CDOs, providing new, lower benchmarks that investors would have to use to value their holdings, resulting in billions of dollars of losses.

“We remain nervous about the end of the week, when many leveraged investors in the CDO markets will have to mark down their positions,” debt strategists at Barclays Capital in New York said in a June 28 report. “The worry is that this will be large enough to trigger margin calls which, in turn, will cause other liquidations and so on.”

Merrill Lynch threatened to take and sell $850 million of bonds held as collateral for loans it had made to the funds. Lehman, JPMorgan and Cantor Fitzgerald LP, all based in New York, also pulled out.

Bear Stearns avoided an even worse fallout by offering to provide one of the funds with loans. The original $3.2 billion provision was reduced to $1.6 billion after the firm sold securities and lenders took some of the collateral.

UBS, Queen’s Walk

Other hedge funds are closing down or reporting losses because of subprime losses. Zurich-based UBS AG shuttered a hedge fund unit that saddled the biggest money manager for wealthy investors with 150 million Swiss francs ($122 million) of first-quarter losses.

Queen’s Walk Investment Ltd., a London-based fund, reported a loss of 67.7 million euros ($91.2 million) last week for the year ended March 31. Cambridge Place Investment Management LLP, another London money manager, said yesterday that it will close Caliber Global Investment Ltd., a fund that had $908 million of assets in March.

A sweeping downgrade of bonds would lead to sales of assets by investors, banks and pension funds who operate under rules that would cause them to adjust their portfolios to reflect the new ratings. S&P, Moody’s and Fitch have restricted their ratings changes on BBB- rated mortgage bonds to 1.3 percent of those outstanding, according to Credit Suisse analyst Rod Dubitsky in New York. About 80 percent of the remainder will eventually have their ratings reduced, he said.

Abandoned Criteria

“We’re talking about massive, massive downgrades here,” Dubitsky, the No. 2 asset-backed real estate debt analyst in last year’s Institutional Investor magazine poll of researchers, said in a telephone interview.

S&P abandoned seven-year-old criteria for determining a bond’s protection against default in February.

Under the old guidelines, S&P said a bond’s “credit support” must be twice the rolling 90-day average of the sum of value of mortgages delinquent by three months or in foreclosure plus real estate that has been seized by the lender.

Credit support for a bond is determined by looking at the number of lower-rated securities that would have to go bust before it suffered losses, the dollar amount of mortgages available to pay back the interest and the annualized interest the mortgages generate in excess of what needs to be paid to bondholders.

The measure was one of four tests used by S&P, said Chris Atkins, a spokesman for the company, a unit of New York-based McGraw-Hill Cos. A failure to meet the credit support standard wouldn’t have automatically resulted in a downgrade, he said.

$200 Billion

Of the 300 bonds in ABX indexes, the benchmarks for the subprime mortgage debt market, 190 fail to meet the credit support standard, according to data released in May by trustees responsible for funneling interest payments to debt investors.

Most of those, representing about $200 billion, are rated below AAA. Some contain so many defaulted loans that the credit support is outweighed by potential losses. Fifty of the 60 A rated bonds fail the criteria, as do 22 of the 60 AA rated bonds and three of the 60 AAA bonds.

All but five of 120 securities in BBB or BBB- rated portions of the mortgage-backed securities would have failed S&P’s criteria, according to data compiled by Bloomberg.

None have been downgraded, though S&P and Moody’s have parts of three pools of securities linked to the index under review for a downgrade. Fitch has downgraded parts of three mortgage pools tied to the ABX and put four on watch for downgrade.

`Warrant Our Attention’

“Don’t misunderstand me: I’m not saying these others are performing great,” Robert Pollsen, a director in S&P’s residential mortgage surveillance in New York, said in an interview last month. “And they certainly might warrant our attention several months from now, which obviously we’re going to do.”

Some investors say the ratings companies are waiting too long before downgrading the mortgage bonds and the CDOs that contain them. They noted that S&P and Moody’s maintained their investment-grade ranking on Enron Corp. until days before the Houston-based energy trader filed for bankruptcy.

“That’s like saying these trees are just fine as there’s a forest fire on the other side of the hill,” said James Melcher, president of money-management firm Balestra Capital Ltd. in New York, who runs a $105 million hedge fund.

To contact the reporter on this story: Mark Pittman in New York at mpittman@bloomberg.net .

Last Updated: June 29, 2007 00:00 EDT

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http://www.phptr.com/articles/article.asp?p=704314&seqNum=6&rl=1

Hedge Funds Ate My Money: Facts and Fantasies in Alternative Investments

 

• By Satyajit Das.
• Article is provided courtesy of Financial Times Prentice Hall.
• Date: Mar 9, 2007.

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Article Information

 

 

Contents

1. In Fashion?
2. Keeping Up with the Joneses
3. The Rise and Rise of Hedge Funds
4. Style Gurus
5. Fees for All
6. Risk? What Risk?
7. “Embedded”
8. More Money Than You Know What Do With?
9. Woodstock for Hedge Funds
10. The Fall of Hedge Funds?
11. Whos in Charge?
12. Hedge Funds Ate My Lunch?
13. References

 

Article Description

Hedge funds have been around for 50 years, but they’re not well understood. Satyajit Das removes some of the murk from this corner of the financial universe, clarifying what you need to know about the history and the reality of hedge funds (and hedge fund managers).

 

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Risk? What Risk?

Hedge fund returns are hot. Based on the fee structure, you paid for a Ferrari—not some anemic, environmentally correct hybrid!

Some hedge funds have shown high returns. There are wide divergences between the best- and worst-performing funds. Long-run returns are clouded by the “survivorship bias”—that is, many hedge funds have perished along the way. High returns require that you select the better-performing funds.

You need to consider the sustainability of returns. Macro funds were beneficiaries of the confluence of specific factors: the integration of emerging economies into global markets, the end of communism in Eastern Europe, the growth of world trade, and deregulation of financial markets such as currencies and interest rates. These epochal events were once-in-a-lifetime occurrences that created trading opportunities. For example, Soros’ triumph in breaking the pound was predicated on the collapse of a highly flawed system of currencies. In 1997-98, hedge funds made substantial returns when similarly pegged currencies fell apart. This can be seen in the varied fortunes of macro funds in recent years. Some have prospered, but many funds, included the fabled Quantum and Tiger Funds, have restructured or disappeared.

Relative-value hedge funds were beneficiaries of similar events. LTCM’s early success was linked to opportunities related to the creation of a single European currency and tax arbitrage opportunities. Relative-value funds benefited in the 1990s from the introduction of new and innovative products that few understood and fewer had the skills and systems to value. The shrinkage of opportunities has forced relative-value funds to migrate into new areas—credit being the major one.

Hedge funds may offer investors 15–20% p.a. returns with minimal risk—but such funds are far riskier than the risk statistics reveal. The systems used don’t actually capture the real risks. Investors use Sharpe or information ratios to measure performance. Assume that Treasury bills yield 5% p.a. Further assume that hedge fund A has an annualized return of 20% with a volatility of 10%, and hedge fund B has a return of 15% with a volatility of 5%. The Sharpe ratios, are, respectively:

• Hedge fund A = [20% – 5%] / 10% = 1.5
• Hedge fund B = [15% – 5%] / 5% = 2.0

Hedge fund B, despite its lower absolute performance, provides the investor with greater returns relative to risk than hedge fund A.

Sharpe ratios are flawed. They are ex post (based on actual risk) rather than ex ante (expected risk). Actual risk return achieved should be compared to the risk that was known to be taken at the time the position was taken. This generally shows higher risk and lower risk-adjusted returns.

There are alternative risk models. The Sortino ratio, a variation of the Sharpe ratio, focuses only on adverse price changes, using deviation below a specified level. A personal favorite is “drawdowns”—a euphemism for actual losses incurred and the cash that must be found to cover a peak-to-trough change in the fund’s position.

The real risks of hedge funds are correlation risk, liquidity risk, and complexity or model risk. Unsurprisingly, traditional systems are poor at capturing these risks. Traders, whether in hedge funds or otherwise, are extremely skilled in arbitrage—internal arbitrage. Traders arb the internal risk metrics to inflate risk-adjusted returns on which their bonuses are based. Nature abhors a vacuum.

• Correlation risk. Hedge funds should show low risk—remember, they’re simultaneously long and short securities. If the prices move identically, then the gains and losses will cancel out, leaving zero return where the portfolio of long and short positions are perfectly balanced. For the fund to make money, the price relationship between the long and short securities must change—correlation has to shift. Correlation may move unfavorably—the asset where you’re long falls in value and the asset where you’re short rises in value, triggering losses. Many hedge fund strategies are effectively correlation positions, where the risks are not properly captured.
• Liquidity risk. Liquidity risk is the inability to sell out of or continue to finance positions. Hedge fund trading assumes liquidity risk. The position may be large. The assets held are illiquid. The liquidity risk is compounded by leverage. Hedge funds generally trade on margin—putting up a small fraction of the value of the asset as collateral. If prices fall, the hedge fund is required to post more collateral. If losses on the leveraged position exceed the hedge fund’s ability to meet margin calls, the position is liquidated, realizing losses. This severely limits the holding power of hedge funds. Risk models assume “perfect” liquidity.
• Complexity or model risk. Hedge funds now use complex securities and derivatives in their trading. They use computers and sophisticated quantitative models to value and hedge positions. The models are highly subjective. They’re sensitive to minor changes in parameters and inputs. There may be no transparent market in inputs, making them difficult to value. Mark Twain provides the definitive view on “model risk”: “It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.”A number of hedge funds have suffered terminal losses in mortgage-backed securities. Model failure was a factor in many of these losses. Currently, some funds trade CDO²—that is, a CDO of a CDO, a complex instrument. Different funds use different models. Recently, I had to get market prices for some CDO² securities. There was no market to speak of, and wide variation in prices. Masters of the Universe don’t measure model risk when quantifying risk.

Many hedge fund trades seek to buy or sell “mispriced” securities. The position is hedged by an offsetting trade using similar securities. The idea is that the values will converge. The market prices may correct, allowing the trader to unwind his trades at a profit. If the market prices don’t correct, the trader must hold the position through to maturity to realize the profit. The holding period can be long, very long—on the order of 30 years. Hedge funds have short risk horizons—no longer than 6–12 months. Changes in mark-to-market values, the resulting margin calls, and the investor’s right to redeem capital periodically make it difficult to manage this risk. Leverage, liquidity risk, and complexity are lethal companions.

LTCM liked to arbitrage small value differences between similar securities. The returns were small, so LTCM typically leveraged the trades to increase returns. After the Asian crisis, credit spreads (the margin above government bonds for additional risk) blew out well above what was needed to cover the actual risk of people not paying up. LTCM wanted to lock this in and leverage the position.

LTCM entered into interest-rate swaps where they received fixed rates, getting government bond rates plus a margin (credit spread). Then they went short government bonds on the other side, paying the government rate. LTCM effectively locked in the credit spread. They leveraged the position massively. The game depended on the spread getting smaller (convergence) or holding the position to maturity (10 years). Unfortunately, the spread kept getting wider. Interest rate swaps rose, and government rates fell. LTCM now had losses on both legs of the trade. They had to find cash to cover their losses, and they ran out of money. The LTCM principals witnessed firsthand the truth of John Maynard Keynes’ observation: “There is nothing so disastrous as a rational investment policy in an irrational world.”

In 2006, emerging markets took a hit. Market-neutral hedge funds losses mirrored the fall in the market. A short memory and a rising market generally passes for investment genius. One hedge fund manager explained: “Everything in the market was a compelling buy. We could find nothing to short.”

Over 50% of the hedge funds that fund-of-funds managers invest in have been in existence for less than 2 years. The majority of hedge funds are small—less than 10 staff. The operational risk and key personnel dependency is high.

In 2006, Amaranth, a multi-strategy hedge fund with around $9 billion under management, lost $6 billion in natural gas trading. [4] In 2005, Brian Hunter, a 32-year-old Canadian, made a bet that natural gas futures would rise. Surging gas prices following Hurricane Katrina made large trading gains for the fund, and Hunter was named head of Amaranth’s energy trading operations.

He placed a similar bet in 2006, but natural gas prices fell sharply, triggering losses. Amaranth’s positions were staggeringly large, representing around 10% of the global market in natural gas futures. Amaranth ultimately discontinued operations. A spokesman for the hedge fund made the following observation regarding the losses: “We did not expect that the market would move so aggressively against our positions!”

“Embedded”

In his book Hedge Funds: The Courtesans of Capitalism, [5] Peter Temple compares hedge funds to courtesans—high-class prostitutes whose clients are drawn from the wealthy or upper classes. If hedge funds are the prostitutes (the girls), then the banks are clearly the pimps and bordello keepers.

Creating hedge funds to house trading activities “off balance sheet” solves many problems for banks. The introduction of capital controls on trading in 1994 made it punishable for banks to hold trading positions on balance sheet. Hedge funds also alleviate the problem of attracting and remunerating “gun” traders. Bank shareholders, regulators, the public at large, and bank CEOs react negatively to large payments to traders, especially when it exceeds their own salaries. The hedge funds are also able to leverage more than the banks themselves.

Banks help set them up hedge funds, invest in them, and trade with them. A whole new service, “prime brokerage,” combines settling and clearing hedge fund trades, execution services, and financing hedge funds. Investment banks have set up “incubators” to help budding traders create hedge funds. The services include training in etiquette and investor relations to communicate properly with investors.

Banks also design products around hedge funds, such as capital-guaranteed hedge fund investments for risk-averse investors—you can’t lose your principal, although you may end up earning nothing on your investment for 10 years. This type of investment helps explain why, in the words of Groucho Marx, many investors in hedge funds “work [themselves] up from nothing to a state of extreme poverty.”

Dealers love hedge funds. Dealers earn from hedge funds at around 30–40% plus of their total earnings. The bulk of earning is from lending money to hedge funds. No bank, at least I think, would lend to hedge funds. Lending is made possible through repurchase agreements (repos) and derivative trades.

In a repo, the bank lends money against the value securities held or sold short by the hedge fund. The value of the security (collateral) secures repayment. Derivatives don’t require initial investment, just a promise to perform in the future. The promise is secured by the hedge fund’s lodging cash or securities. The collateral is increased or reduced as market prices change to ensure adequate coverage. This is no-risk lending—regulators don’t require banks to hold capital against these transactions.

If a position moves adversely, the bank will require the hedge fund to lodge more collateral—a margin call. What happens if they can’t come up with it? In order to reduce risk, banks use a “haircut”—over-collateralization to ensure that it has a buffer if the hedge fund cannot meet a margin call. Banks are under competitive pressure to reduce the haircut. LTCM didn’t require any haircut at all; it was “special.” Writing in the Wall Street Journal, Holman Jenkins observed, “Would hedge funds even exist without a fatty dollop of moral hazard somewhere along the great protein chain of lending?” [6]

The setting of the haircut is flawed. To cover their risk, banks must estimate the worst-case daily change in value of the positions. This is art, not science. Hedge fund strategies have “event” risk when the value of the position could change a lot.

The relationship between dealers and hedge funds is littered with moral hazards. Senior executives at many banks were personal investors in LTCM. Some were involved in negotiating the bailout. It’s all part of the “special” relationship.” [7]

Banks love dealing with successful hedge funds so they can copy from the “best and brightest.” Banks have internal hedge funds that work closely with special sales desks that service hedge funds. Some had been created specifically to serve LTCM. They worked out LTCM’s trading strategies and then did the trades for their own account. When risk limits were full, they marketed the same strategies to other banks and hedge funds.

When the storm hit in mid-1998, all the traders found that they had put on the same trades. LTCM were perhaps the only ones who were not aware of this. Louis Bacon, the principal of Moore Capital, once remarked, “There are those who know that they are in the game; there are those who don’t know they are in the game; and there are those who don’t know they are in the game and have become the game.” [8] In the end, LTCM was the game.

Under stress conditions, prices are affected by illiquidity. Sometimes, prices are unavailable. The valuation of positions are often very conservative, triggering larger mark-to-market losses, necessitating more collateral. Mark Twain observed, “A banker is a fellow who lends you his umbrella when the sun is shining, but wants it back the minute it begins to rain.” To this day, LTCM swears that the banks manipulated the prices to force them out of business.

Even if the hedge fund goes under, banks can make money by buying the positions at an “undisclosed” (read: “distressed”) price. They make money from unwinding the position. Banks provide a true cradle-to-grave service for hedge funds.

8. More Money Than You Know What Do With?

More Money Than You Know What Do With?

Hedge fund managers are the new elite. Brian Hunter, responsible for energy trading at Amaranth before it imploded, earned $75–$100 million in 2005. This, by the by, only ranked him a middling 29th-highest paid in his profession, according to Trader Monthly. [9] One hedge fund manager earned $1 billion in 2005! [10] Apparently money isn’t important; it’s just a scorecard of success.

Having more money than you can possibly spend creates new challenges for the Masters of the Universe. Billionaire hedge fund managers bid up the price of luxury apartments and modern art. Michael Steinhardt owns a large estate containing exotic wildlife. He was seeking to collect every duck and swan variety in the world.

Hedge funds managers are often generous donors to charities—tax deductible, of course. There is the paradox of charity—how enrichment by a variety of means paves the way for conspicuous generosity. George Soros supports free markets and democratic initiatives in Eastern Europe. Detractors question whether it has anything do with the fact that hedge funds are beneficiaries of the opening up of these economies. Some “donations” are also “involuntary,” to settle antitrust and securities charges.

Hedge fund managers are generally secretive. Paradoxically, some hedge fund managers brazenly seek acceptance as “thought leaders.” George Soros has written many books—The Alchemy of Finance: Reading the Mind of the Market, Staying Ahead of the Curve, The Crisis of Global Capitalism: Open Society Endangered. He thinks of himself as a “financial and philosophical speculator,” says Peter Temple. [11]

The centerpiece of Soros’ musings is “reflexivity.” Markets don’t tend toward equilibrium; markets feed on their own misconceptions to produce exaggerated price changes until they reach an “inflexion point” when it changes. Soros suggests following the trend and selling as it reaches the peak. This advice takes about 400 pages. In the December 1998 issue of The Economist, the following review of The Crisis of Global Capitalism appeared. [12]

Because of who he is there will always be buyers for his books, publishers for his books, and cash-strapped academics to say flattering things about his books. None of this alters the fact that his books are no good…. A remarkable thing happens to money when it passes through Mr. Soros; it emerges multiplied, but otherwise unchanged. With other inputs the results are more disappointing—to be blunt, more in line with biology. Mr. Soros gorged on chopped philosophy, mashed economics, and fact and figures swimming in grease. It was too much. Before he knew what was happening out rushed this book.

Woodstock for Hedge Funds

The hedge fund industry’s search for acceptance has reached new realms. In 2006, the industry staged “Hedgestock.” [13] The title paid homage to Woodstock—the historic three days of peace, love, promiscuity, music, drugs, and shockingly bad dancing. Hedgestock was to be two days (nobody could afford three days in this time-challenged age) of networking and finance. Adam Smith understood networking: “People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in conspiracy against the public, or in some contrivance to raise prices.” [14]

The hippies had celebrated their counterculture movement at Woodstock. Hedge fund managers are keen to advertise that they were the vanguards of the “alternative” movement—”alternative investments,” that is! It was the dawning of the age of hedge funds, not the age of Aquarius.

The Fall of Hedge Funds?

Hedge funds have underperformed more traditional asset classes such as equities in recent years. Investors always chase yesterday’s returns. Adjusted properly for risk and the absence of liquidity, hedge funds return at best no more than—and frequently less than—traditional assets.

A recent study found that hedge fund performance doesn’t appear to deliver alpha consistently. [15] There are exceptions, but they’re few and far between. Many of the really good hedge funds are closed to investors. Even where you can invest, the flow of funds into better-performing funds rapidly erodes returns. Too much money is chasing too few opportunities. Clever people can make money if there are only a few clever people and lots of opportunities. This is scalability—what works on a small scale cannot work on a larger scale. In 2004, Hilary Till argued that the maximum size of the hedge fund industry was 6% of institutional (and high net worth) assets. [16] There are other constraints. Some hedge fund strategies need liquid markets and a complete set of instruments. There are few such markets.

Ultimately, if you make money from inefficiency, someone—other investors—must supply the inefficiency. We cannot all exploit inefficiencies, as nobody would be supplying the market inefficiency in the first place. To be “alternative,” there has to be a majority; the alternative cannot be the majority.

Hedge funds with certain areas of expertise began to trade in other markets as opportunities became limited, creating “style drift.” LTCM had drifted from their métier—relative-value trading in fixed income—into volatility trading, credit-spread trading, and merger arbitrage. Lack of disclosure meant that you didn’t know how far the ship was off course until it was on the rocks. Cases of fraud and other common crimes had also begun to surface.

Smart investors know that there’s no money to be made from investing in hedge funds. In investing, the majority is always wrong. The focus is now “incubators”—venture capital for hedge funds. They identify traders, seed startups, and allow them to establish a track record. Once established, the hedge fund seeks third-party funding, allowing the original investors to exit. They retain the real money—a free carry or shareholding in the general partner or fund manager. Incubators are only open to the really rich and connected.

The hedge fund universe is overheated. At the suggestion of a “bubble,” one hedge manager bristled that hedge funds weren’t an “asset class,” and therefore there was no “bubble” to burst—only asset classes experienced bubbles. Another hedge fund apologist argued that all funds managers in the future would be hedge funds. The semantics aren’t reassuring.

Hedge funds are also under attack from clones. Hedge fund performance doesn’t depend significantly on skill, nor is it as distinctive as the Masters of the Universe claim. In fact, hedge fund returns can be replicated using readily available instruments such as equity index futures and corporate bonds. [17] Banks are starting to clone hedge funds using precisely these instruments. [18] The advantage for investors is lower fees, with the risk of blowups like Amaranth or LTCM. The clones are not the real thing—they’re cheap reproductions. Some analysts argue that the replication models are flawed, though they have their own version that works.

Who’s in Charge?

As John Kenneth Galbraith observed, “In central banking as in diplomacy, style, conservative tailoring, and an easy association with the affluent count greatly and results far much less.” Regulators see hedge funds as providing essential liquidity and distributing risk more efficiently, reducing risks of a major financial shock. There is also a ideological element. In the aftermath of the Asian crisis, economist Robert Wade wrote, “[Greenspan] and other U.S. officials see it as imperative to make sure that the troubles in Asia are blamed on the Asians and that free capital markets are seen as key to world economic recovery and advance; the idea that international capital markets are themselves the source of speculative disequilibria and retrogression must not be allowed to take root.” [20] Bailouts of troubled banks in developed countries are naturally not contrary to free market principles.

In theory, hedge funds remove risk from regulated banks. But banks are deeply embedded in the hedge fund industry. The only significant control is on lending to or entering into derivative trades with hedge funds using collateralization to manage risk. Writing in the Motley Fool Internet Bulletin Board, Lou Corrigan noted, “Alan Greenspan was mistaken in believing that the largely unregulated hedge fund industry can be effectively controlled by regulating creditors. […]Creditors can be just as prone to greed as the latest wizard of Wall Street, but they are often the last to understand the risks that would ordinarily help fear counterbalance greed.” [21]

Benign neglect is giving way to concern. Timothy Geithner, president of the Federal Reserve Bank of New York, has warned that the changes in markets may make financial crises less common but more severe. Australia’s Reserve Bank governor Glenn Stevens has speculated that, in crises, hedge funds are users rather than providers of liquidity. The UK’s Financial Services Authority has identified conflicts of interest as well as operational risks in the relationship between banks and hedge funds.

Hedge Funds Ate My Lunch?

There is a temptation to dismiss the Masters of the Universe, their culture of risk, the hedge funds, and the extreme money games as peripheral to “real life.” After all, fast and foolish money will always find a way to play extreme sports. Isn’t it just a case of a few rich investors playing around with their courtesans and getting more excitement than they bargained for?

Not really. Hedge funds affect all of us—directly and indirectly. Your money—your savings, your retirement funds, the money you invest in banks—increasingly finds it way into the hands of hedge funds. Corporate or government pensions and defined-benefit schemes are a thing of the past. The investment performance of hedge funds—preservation of capital and returns—will shape your senior years and the ability of your company pension funds to meet their liabilities.

Hedge funds also affect us indirectly. In 1997, attacks on the overvalued currencies of Asian countries helped bring about deep recessions, resulting in the collapse of companies, massive unemployment, and social unrest. Malaysia’s prime minister Mahathir blamed hedge funds. “It was greed; a kind of greed that cares nothing for the destruction caused for the collapse of perfectly healthy and prosperous economies, greed that thrives on the misery of others.” [22]

Mahathir did not refer to the poor government, crony capitalism, and corruption that created the conditions for the problems. But the activities of hedge funds undoubtedly exacerbated the severity of these problems. Hedge funds may have colluded in manipulating markets to maximize their returns. In the event of a major shock, hedge funds will sharply increase volatility and the severity of any adjustment.

Any major problems in the hedge fund industry will ultimately affect the stability of the banks and the financial system itself. Hedge funds trade with banks. Banks provide the leverage that hedge funds use. Hedge funds don’t really disperse risks. They increase and concentrate them.

In recent years, there have been warnings: the turmoil in the credit market in 2005 when General Motors and Ford were downgraded; the emerging market correction in mid 2006; the collapse of Amaranth in 2006. Commentators have seized these situations to illustrate the robustness of the system. Banks and financial systems emerged seemingly unaffected.

But banks and hedge funds sustained significant losses in each episode, which were absorbed by profits or gains in other activities. Low cost of money allowed the problems to be handled without a meltdown. The markets also recovered, helped by traders’ increasing positions, assuming the correction was a “buying” opportunity at “better price levels.” Banks sometimes merely bought the portfolio from the distressed hedge fund to avoid potential losses from a forced liquidation of the position. The bank was getting the positions at attractive price levels and hoped they could trade their way out of it.

The greatest concern is concentration of risk. Shortage of trading opportunities means that traders—both in hedge funds and banks—focus on “events”—the emergence of the BRIC economies; commodity prices; corporate actions (mergers, leveraged buyouts, and bankruptcy). There are innovations—volatility swaps (bets on the level of volatility), correlation swaps (bets on correlation), and gamma/dispersion swaps (bets on both volatility and correlation). Hedge funds use them to further leverage up their bets on the “big” stories. The tremendous volatility created by relatively minor events points to the explosive buildup of risk concentration.

Matthew Lynn, writing in UK’s Sunday Business, warned, “[T]he risk to the stability of the world’s financial system posed by the existence of these massive vehicles has not gone away. We have chosen, in the main, not to think about it—in the same way that wives sometimes choose not to think about whether their husbands are really working late at the office. The implications of thinking about it are just too scary.” [23]

Courtesans have played pivotal roles in the rise and fall of empires. Hedge funds may yet play such a role. If a major event occurs, the effect on the Masters of the Universe and the extreme money games may seriously damage financial systems and economies, and taxpayers will bear the losses. Australian economist Ian Macfarlane commented, “Hedge funds have become the privileged children of the international financial scene, being entitled to the benefits of free markets without any of the responsibilities.” [24] Yet the popular investment consensus is that hedge funds, alternative investments, should be a part—indeed, a growing part—of your investment strategy.

Huge structural imbalances in the world, an excess of investment capital chasing returns, and the gradual withdrawal by central banks of the liquidity that has fed recent growth are capable of triggering the problem. How far off is that event? Economists only exist to make climatologists look good. I’ll tell you after the event.

In any major global city today, you can find homeless people sleeping rough. They are the dark underbelly of capitalism. If you look into their eyes, you see resignation, hopelessness, despair, and occasionally defiance. Why are they there? Substance abuse, mental illness, just sheer bad luck. But I fear a future when many us will be on the streets. Etched into the tattered piece of cardboard will be our story: “Please help. Hedge funds ate my money!”

References

[1] Martin Baker, A Fool and His Money: How to Understand the Money Markets and Those Who Work in Them (Orion Publishing, 1995).

[2] Tom Wolfe, The Bonfire of the Vanities (Bantam, 1987).

[3] Alan Kohler, “Hedging Your Bets for a Life Less Ordinary,” Weekend Edition Sydney Morning Herald, 5–6 August 2006.

[4] See “Flare-up,” The Economist, 21 September 2006.

[5] Peter Temple, Hedge Funds: The Courtesans of Capitalism (John Wiley & Sons, 2001).

[6] Holman W. Jenkins, “How a Cat Becomes a Dog,” Wall Street Journal, 5 April 2000.

[7] Merrill Lynch, Bear Stearns, and Paine Webber senior executives are understood to have invested in LTCM. See Roger Lowenstein, When Genius Failed: The Rise and Fall of Long-Term Capital Management (Random House, 2001).

[8] Quoted in [5].

[9] See [4].

[10] The manager is reputed to be Jim Simons of Renaissance Technologies; see [3].

[11] See [5].

[12] Quoted in [5].

[13] See Stephen Schurr, “Hedge Funds Jump on Hippie Bandwagon,” Financial Times, 3–4 June 2006; Penny Wark, “Selling Themselves Short,” The Times, 9 June 2006; The Economist, “Tune On, Tune In, Meet Clients,” 10 June 2006.

[14] Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations (Methuen and Co., Ltd., 1776).

[15] William Fung, et al., “Hedge Funds: Performance, Risk, and Capital Formation,” 19 July 2006.

[16] Hilary Till, “On the Role of Hedge Funds in Institutional Portfolios,” Journal of Alternative Investments, Spring 2004.

[17] See Jasmina Hasanhodzic and Andrew W. Lo, “Can Hedge-Fund Returns Be Replicated? The Linear Case,” 16 August 2006.

[18] See H. Kat and H. Palaro, “Who Needs Hedge Funds? A Copula-Based Approach to Hedge Fund Return Replication,” “Replication and Evaluation of Fund of Hedge Fund Returns,” “Superstars or Average Joes? A Replication-Based Performance Evaluation of 1917 Individual Hedge Funds,” “Tell Me What You Want, What You Really, Really Want! An Exercise In Tailor-Made Synthetic Fund Creation Alternative,” all working papers of the Investment Research Centre, Cass Business School, City University, London.

[20] Robert Wade, “The Asian Economic Crisis and the Global Economy,” quoted in [5].

[21] Quoted in [5].

[22] Quoted in [5].

[23] Matthew Lynn, “Financiers Play with Fire Again,” Sunday Business, 9 April 2000.

[24] Quoted in [5].

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Commodity Hedge Funds - Dealing with Liquidity, Market, Credit and …

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Credit Risk, Liquidity Risk, and Optimal Capital Structure under Incomplete Accounting Information

WOLFGANG BÜHLER
University of Mannheim - Department of Business Administration and Finance
TIM O.H. THABE
University of Mannheim October 2006EFA 2006 Zurich Meetings Paper
Mannheim Finance Working Paper No. 2006-13

Abstract:
In a structural model for credit risk we endogenize inability to pay as a second independent reason for default besides overindebtedness. Inability to pay is triggered by rational behavior of incompletely informed outsiders. The firm needs to raise additional cash via secondary equity offerings in order to service it’s coupon payments. Underpricing of secondary equity offerings is explained as necessary for these offerings to be successful. In addition to Duffie/Lando (2001) we find that the liquidity risk has a strong impact on the current firm value and the optimal leverage. Credit spreads of debt in the primary market depend on the degree of liquidity risk. They can be lower or higher than in case without liquidity risk.Our results have a number of additional, interesting consequences. Contrary to Duffie/Lando (2001) incomplete information of outside investors has an impact on the default probability of the firm and therefore on the optimal capital structure which is determined in the primary market. The debt-equity ratio is typically lower than in the Duffie/Lando (2001) model that operates under complete information in the primary market and can result in lower credit spreads.
Keywords: Bond Default, Credit Spread Modelling, Incomplete Accounting Information, Optimal Capital Structure, Seasoned Issue Underpricing

JEL Classifications: D82, D92, G12, G13

Working Paper Series

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Suggested Citation

Bühler, Wolfgang and Thabe, Tim O.H., “Credit Risk, Liquidity Risk, and Optimal Capital Structure under Incomplete Accounting Information” (October 2006). EFA 2006 Zurich Meetings Paper Available at SSRN: http://ssrn.com/abstract=906988

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=906988

	How Will FASB’s Accounting Changes Affect Shareholders’ Equity and Credit Ratings? On September 29, 2006, the Financial Accounting Standards Board (FASB) released its Statement of Financial Accounting Standards No. 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans (SFAS 158).SFAS 158 requires firms to put the net financial status of their postretirement plans on their balance sheet, and eliminates all smoothing of actuarial gains and losses in the funding position that flows into the other comprehensive income section in shareholders’ equity. Under the new rules, a pension’s current financial health will be reflected in its sponsor’s book value. In the past, companies could show an underfunded pension plan as an asset on the balance sheet. SFAS 158 also requires sponsors to measure plan funding and expenses as of fiscal year-end rather than allowing an optional earlier measurement date. Earlier this year, Watson Wyatt projected the effects of disclosing the funded status of postretirement benefit obligations on corporate balance sheets for the FORTUNE 1000 (see Watson Wyatt Insider, February 2006). That earlier analysis assumed the changes were in place for fiscal year 2004. To get a more current snapshot, this analysis looks at the pension finances of the FORTUNE 1000 for fiscal 2005. The Fiscal 2005 Analysis As in the previous study, we measured difference between a plan’s funding position — calculated as the projected benefit obligation (PBO) (or APBO for non-pension plans) the market value of assets — and the net recognized on the balance sheet. To estimate the after-tax effect, we assumed a 35 percent tax-rate effect on the difference between PBO underfunding and the net amount recognized on the balance sheet (Table 1). Table 1 | Estimated Impact of SFAS 158 on Shareholders’ Equity for the FORTUNE 1000 ($ billions) Total shareholders’ equity for 2005 $3,648 According to these projections, recognizing the funded status of their postretirement plans will significantly reduce shareholders’ equity in FORTUNE 1000 companies. The aggregate decrease in shareholders’ equity is 8.7 percent — $318 billion. The 2005 snapshot actually depicts a smaller total decrease in shareholders’ equity than the 2004 snapshot, which projected a 9.54 percent decrease. The median decrease in shareholders’ equity is 4.69 percent. But while the overall effect of SFAS 158 is significant, the results vary widely by industry. Table 2 shows the effect of SFAS 158 at an industry level. Echoing previous studies, the durable manufacturing sector will take the biggest hit to shareholders’ equity, primarily due to its retiree health obligations. In stark contrast, the new accounting rules should have a minimal effect on shareholders’ equity in the finance industry. Those companies typically sponsor well-funded plans, and, for the most part, their balance sheets already accurately reflect their plans’ funded status. Will Lower Shareholders’ Equity Affect Share Price? The implementation of the FASB’s accounting changes has prompted concern about how lower shareholders’ equity will affect a company’s share price. Only time will tell for sure, but many analysts expect the effects to be minimal. The funded status of pension and retiree health plans was already available in the footnotes to companies’ financial statements, so equity analysts and investors have long had access to the information and methodologies for analyzing its effects. One could say that the FASB has essentially aligned its accounting measurements with current market practices. Table 2 | Total Changes in Shareholders’ Equity by Industry ($ millions)   Shareholders’ equity before SFAS 158 Shareholders’ equity after SFAS 158 Percentage change in shareholders’ equity Loss due to FAS 87 (pensions) Loss due to FAS 106 (retiree health) (A)PBO underfunding/ shareholders’ equity *PBO underfunding as a percentage of shareholders’ equity was actually positive for the service industry due to overfunding in large pensions sponsored by a few companies. What About the Effect on Credit Ratings? Another concern is whether lower shareholders’ equity will affect companies’ credit ratings. Similar to the effect on share prices, however, credit analysts have been fully aware of pension deficits from the pension footnotes. An earlier Watson Wyatt analysis found “a notable positive relationship between higher pension deficits and lower credit ratings” (see Watson Wyatt Insider, October 2005). Table 3 depicts the change in shareholders’ equity due to SFAS 158 for the FORTUNE 1000 based on Standard & Poor’s debt ratings. Credit ratings of BBB and higher are considered investment-grade, while ratings below BBB are non-investment-grade or “junk” status. Table 3 | Estimated Impact of SFAS 158 on Reported Shareholders ’ Equity of FORTUNE 1000 Firms ($ billions) Based on Investment Grades Bond rating classes Median decrease Aggregate decrease SFAS 158 will have much less effect on shareholders’ equity in firms rated AA and higher than in firms with lower investment grades. Table 3 suggests that credit analysts may already recognize and react to pension deficits — whether they appear in the footnotes or on the balance sheet. Elimination of Early Measurement Dates Before SFAS 158, companies could measure plan funding up to three months before their fiscal year-end. SFAS 158 closes the three-month window, and starting December 31, 2008, plan sponsors must measure their assets and liabilities as of the end of their fiscal year. The FASB wants to ensure that companies record events in the same year they occur. Thirty percent of FORTUNE 1000 defined benefit plan sponsors currently use a measurement date other than their fiscal year-end and will have to change their practices to comply with SFAS 158. This may create some data collection and timing challenges. Looking Ahead The balance sheet changes took effect December 15, 2006, for public companies, and will be tougher on some companies and industries than on others. Some firms will have to change their measurement practices to meet the new requirements. After roughly a year of rising interest rates and decent market returns, plan funding ratios for 2006 are expected to improve significantly, which should reduce the hit to shareholders’ equity for many firms. However, many companies’ 2006 balance sheets will now reflect higher pension deficits and lower shareholders’ equity, and the immediate recognition of gains and losses will create significant balance sheet volatility. However, the financial impact on the corporate cost of capital from changes in share prices and credit ratings may not be significant. The Pension Protection Act of 2006 (PPA) should gradually improve the financial health of postretirement benefit plans, which might smooth out some of this balance sheet volatility in the future. Watson Wyatt believes that companies may react to the PPA and the new accounting rules by adopting investment approaches that better hedge their long-term pension liabilities. The shift is part of a global trend to more closely match pension investments with plan liabilities, rather than focus only on the amount of plan assets. December 2006 http://www.watsonwyatt.com/us/pubs/insider/showarticle.asp?ArticleID=16895