By the time they grew to $1.5 billion, Michael Roseman, MF Global’s Chief Risk Officer, was concerned about the firm’s positions in bonds of Italy, Spain, Portugal, Ireland and Belgium. He was worried the trade might endanger the entire firm if the financial problems in Europe got too tough. Roseman believed MF Global didn’t have enough liquidity to withstand a credit rating downgrade.
Roseman joined MF Global in 2008 to improve risk-management culture after a rogue trading incident cost the firm $140 million. As the Euro sovereign positions grew to $6 billion, they blew through trading limits that he had helped put in place before John Corzine, MF Global’s new CEO, became his boss.
It was Roseman’s job to get the directors to approve any increases in those trading limits. He made at least three separate requests to increase sovereign debt exposure. Each time, directors asked him about the risks of the trade. And each time, in spite of the fact it challenged the CEO’s pet strategy, he did what he was supposed to do: he outlined the risks as he saw them.
But Corzine insisted on maintaining the trade, even threatening to resign if the board did not back him. So Roseman was replaced, and a new risk officer, Michael Stockman, took over in March 2011. But he was not allowed to weigh in on the broader implications of the sovereign debt trades, including the risk of ratings downgrades, loss of investor confidence, and funding problems.
Which, of course, is exactly what happened. By October, MF Global had succumbed to a liquidity squeeze and filed for bankruptcy. This sad story prompts lots of questions, but for us the most interesting one is, “Could a better risk culture have protected the firm and its clients from Corzine’s bullying and blunders?”
Lack of an effective risk culture has been cited as a factor in the collapse of Bear Stearns and Lehman Brothers and troubles at many other firms. But what is risk culture? And what are the signs an outside analyst can use to tell whether a firm’s risk culture is strong or weak?
We have our own ideas, which we’ll share with you later. But first we’d like to hear from you. How do you define risk culture? How do you evaluate it? We look forward to getting your comments, and, in the meantime, happy New Year.
The New York Times DealBook blog just put out a fine piece on the collapse of MF Global: A Romance with Risk That Brought on a Panic by Azam Ahmed, Ben Protess, and Susanne Craig (December 11, 2012). It’s the most comprehensive summary of the events that led to the firm’s bankruptcy that we’ve seen so far. Until the investigations are done and the books are written, it’s a good source for thinking about the credit risk lessons to be learned in MF Global’s sad story.
MF Global seems to have made a lot of risk management mistakes. It took on a big dose of market risk with its $6.3 billion exposure to the European debt crisis – over the objections of its senior risk manager. With only $1.4 billion in capital, the company could barely afford to take any losses.
There may have been operational risk issues at the firm as well. About $1.2 billion of client money has gone missing, and after weeks of searching the company’s records it’s still not clear where most of it is. At best, this is a serious systems failure; at worst, it could be a lot more sinister.
But the fatal risk at MF global was a form of credit risk called counterparty risk. That’s the risk that a firm involved in a trade fails to pay what it owes. Counterparty risk is where market risk and credit risk intersect: as a company’s trading losses grow, its ability to pay decreases.
Moody’s downgraded MF global from Baa2 to Baa3 in October, citing exposure to European sovereign debt, a regulatory capital shortfall, and poor risk management. The market had been concerned about MF global for months, but the downgrade made it official. MF global was a poor counterparty.
That triggered collateral calls, with trading partners and clearing houses demanding that the firm either close out its positions or post more collateral – usually in the form of cash. The firm that cleared MF Global’s sovereign debt trades demanded $300 million in cash collateral alone. MF Global’s risk challenges suddenly became a fatal liquidity problem.
That should not have been surprising. The same thing happened to Lehman Brothers and even to Goldman Sachs. The combination of collateral demands and a runoff in repurchase financing drove Goldman’s liquidity pool from $120 billion to $57 billion in just four days after Lehman went under.
MF Global’s counterparty credit squeeze suggests the likely explanation for the missing client money: desperate to meet collateral calls, the company used client funds to try to plug the holes in its liquidity dike. That changes the nature of MF Global’s operational risk problem. It’s worse than a mistake; it’s a crime.
We’ve been running a poll on the Comments on Credit blog for the past few months asking 2 questions:
It is no surprise that bankers like the debt service coverage and fixed charge coverage ratios best – they are good measures of a company’s ability to pay its financial obligations as they come due (without relying on external financing). We think they are the best ratios to measure a company’s liquidity (much better than the current and quick ratios, but that is a topic for another post).
If debt service coverage and fixed charge are the best measures of coverage (and liquidity), the real question is why we don’t use them more often in covenants? The most used coverage covenant (in our survey and in our experience) is EBITDA coverage.
Accuracy vs. Simplicity
Whenever we look at ratios, for analytical purposes or for covenants, there are always the conflicting goals of accuracy and simplicity. We could write a ratio that looks at a company’s internally generated cash flow (say, free cash flow) relative to all of its future, normalized financial and operating cash outflows, but by the time we write the definition into a credit agreement it would be too long and cumbersome. As it is, we’ve see fixed charge coverage definitions that exceed one full page of (very small) text. And even then, there may be disagreements between borrower and lender about how it should be calculated.
So, in order to make the numbers easy to calculate and avoid disputes in the future, we sometimes go with simpler covenants, even if they are not the best measures of a company’s risk. Thus, EBITDA coverage is used more often than debt service coverage.
There have been movies about finance before: Wall Street and Wall Street: Money Never Sleeps, for instance. There are films about the financial crisis as well: HBO’s Too Big to Fail. But the best movie about finance has to be Margin Call, just out in theaters and available on iTunes and at Amazon.
It’s a fictional account of a Wall Street firm’s effort to save itself from a massive trading loss in mortgage backed securities. The writing is crisp, compelling, and completely authentic. The characters aren’t Occupy Wall Street caricatures of evil bankers; they have real dimension. They’re callous and loyal, principled and greedy, ruthless and erudite all at once.
Best of all, Margin Call is the only movie we know that features risk and the people who manage it. And the risk managers are played by Stanley Tucci and Demi Moore! We loved it, but don’t take our word alone. According to Rotten Tomatoes, critics and audiences loved it too. So we recommend you go long on Margin Call and invest a few hours of your valuable time watching Kevin Spacey, Paul Bettany, and Jeremy Irons struggle with understanding and dealing with risk.
Michael Woodford lost his job on October 14. He had been CEO of Olympus, the Japanese maker of medical systems and cameras, only since last July; and as recently as September, the company’s Chairman had said he was “extremely pleased” with Mr. Woodford’s performance. But then the board fired him for “causing problems for decision making.”
He definitely was causing problems. He kept asking embarrassing questions about the Olympus’ 2008 acquisition of Gyrus, another medical equipment company. Olympus paid $2.2 billion for Gyrus, including $687 million in advisory fees to AXAM, an obscure Cayman Island firm that vanished from the trade register a few months after the deal. See this interview of Mr. Woodward in the Financial Times for more information.
The Olympus case reveals big weaknesses in Japanese corporate governance: unaccountable senior executives, weak disclosure standards, and dangerously passive shareholders. At the heart of these is an issue behind many failed companies and damaged lenders — poor governance.
Board Strength
Many things contribute to good governance, but the key factor is a strong board of directors. We think there are three dimensions to board strength.
Independence. The majority of directors on any board need to be independent of management. There are different standards of independence in use around the world, if not in Japan. Among the most rigorous is one from the Council of Institutional Investors, which defines independence this way: “An independent director is a person whose directorship constitutes his or her only connection to the corporation.”
Expertise. Directors of an effective board have relevant industry and management experience. They are well equipped to evaluate the company’s strategy, operating results, and finances, as well as the complexity, opportunities, and challenges management must deal with.
Effort. Being a director is hard work. Good directors spend a great deal of time and energy preparing for meetings, working on committees, and contributing to the decisions the board must make.
Board Strength at Olympus
How does the board at Olympus measure up to these standards?
Independence. Of fifteen directors on the board at Olympus, only three were outsiders. All the rest were executives of the company. It’s not clear that any of the outsiders were truly independent. In Japan, outside directors often come from subsidiaries or the company’s lead bank.
Expertise. Japanese disclosure about directors can be quite limited. But none of Olympus’ directors appear to have any top-level management experience or be seasoned deal makers.
Effort. Judging by Mr. Woodford’s account of the special board meeting at which he was fired, Olympus’ directors aren’t a very engaged or energetic bunch. Mr. Woodford was not allowed to speak, and there was no discussion. The board simply voted to approve every resolution Tsuyoshi Kikukawa, the Chairman, put before them.
It’s Not Over
The Olympus story is still unfolding. For more information on Mr. Woodford’s sudden departure, try this report in Reuters and this article in Fortune. Troubling new information about other deals with shadowy investment firms is emerging; see this article in the New York Times. And, as Japan Today reports, Mr. Kikukawa has resigned as chairman and president but remains on the board.
Whatever else develops, it’s clear that when it comes to Mr. Woodford’s dismissal, the rapid cycle of promote, praise, and pitch overboard doesn’t speak well for Olympus’ board. The company’s fumbling, contradictory explanations of the Gyrus acquisition only make management and the board look stupid or deceitful. So far, Olympus seems to be a poor example of how to govern a company. Who knows? As the story unfolds, it may prove to be an even worse one.
There are a number of worthwhile accounts of the firms that failed or nearly failed in the great financial market collapse of 2007-2009. Too Big to Failby Andrew Ross Sorkin and All the Devils Are Here by Bethany Maclean and Joseph Nocera are two strong general accounts. House of Cards by William D. Cohan tells the Bear Stearns story very well, and Fatal Risk by Roddy Doyle does the same for AIG.
But the stories they tell are mainly about the personalities of the men who led those companies and the blunders they made in strategy and funding. None of them focus closely on risk management. So to correct that, we thought we’d start building a timeline of major risk management mistakes made in the run-up to the crisis.
It’s not comprehensive. It’s just a series of anecdotes drawn from books, press coverage, government reports, and other sources. Please help us build it up by contributing more stories. We’ll add them to the timeline as you do.
Sometime in 2005
Stan O’Neal, CEO at Merrill Lynch, puts Ahmass Fakahany, his Chief Administrative Officer, in charge of risk. Over the next two years, Fakahany dismantles Merrill’s risk organization, firing senior managers and moving the remaining risk managers off the trading floor. Merrill’s exposure to the mortgage market grows to $55 billion, and the company is forced to merge into Bank of America in 2008.
June 2006
Citigroup demotes Richard Bowen, a senior risk manager for raising the alarm over the decline in underwriting standards in its mortgage business. His report reaches Vice-Chairman Robert Rubin, but Rubin fails to act on it. The next year, Citigroup takes over $20 billion in mortgage loan losses.
September 2006
The Market Risk Committee at UBS warns of the high concentration of risk in the firm’s CDO warehouse program, which at its peak reached $50 billion. Management ignores the warning, and UBS takes $40 billion losses on its CDO portfolio in 2007 and 2008.
August 2007
Joseph Cassano, head of AIG Financial Products, refuses to give Joseph St. Denis, an internal auditor, information on potential collateral calls on Financial Product’s $420 billion portfolio of credit default swaps on mortgage backed securities. St. Denis leaves the firm, but Cassano stays. Just over a year later, when collateral calls peak at $80 billion, AIG is rescued from bankruptcy by a government bailout.
September 2007
Lehman Brothers removes Madelyn Antoncic, its well-regarded Chief Risk Officer, from the Executive Committee, clearing the way for the company’s disastrous Archstone-Smith acquisition in October. That drives Lehman’s commercial real estate exposures to $40 billion just as the market peaks. To avoid write-downs, Lehman tries to spin off its real estate portfolio. But that only highlights the company’s weakness, and Lehman fails in September 2008.
February 2008
Oliver Wyman issues an internal report criticizing Bear Stearns’ risk management for being a low priority. CEO Alan Schwartz says the report doesn’t indicate any substantial deficiencies. Within two weeks Bear Stearns’ funding evaporates, and the firm is forced to merge into JP Morgan.
When the Deepwater Horizon blew up in April of 2010 and the Macondo well started spilling thousands of barrels of oil a day into the Gulf of Mexico, BP’s management had to deal with massive human, environmental, operational, and financial challenges. The controversy over how well BP handled the disaster will take years to resolve. But BP’s response to the financial aspects of the crisis is beginning to come into focus.
This post is about how BP met the financial challenges that flowed from the Macondo well spill. Although the company may not be a model for safety management or environmental stewardship, BP is a surprisingly good model for liquidity management under stress.
Operating Results Suffer
The financial impact on BP was sudden and severe. Although BP’s revenue was scarcely affected, there was a massive operating loss in the second quarter of 2010; and the company barely broke even in the third quarter.
Spill Costs Soar Then Plummet
Costs for the spill were $32.1 billion in the second quarter, but then fell to $7.7 billion in the third and to only $1.0 billion in the fourth. The expense in the second quarter was a special charge to create a reserve for oil spill costs. Adjusted for spill costs, BP’s operating margins fell only slightly — from 12.9% in the first quarter to 11.8% in the fourth.
Spill Expenses Exceed Spill Spending
The cash outlays for the spill followed a different pattern from the expenses. BP accrued $40.9 billion in spill expenses in 2010 but made only $17.7 billion in cash payments related to the spill.
Rising Liquidity Position
Still, coming up with $17.7 billion in a hurry was a problem for BP, as it would be for any company caught in a costly, fast-growing crisis. Yet BP was able to improve its liquidity in the face of those extraordinary demands on its cash by adding $7.6 billion in new revolving credit commitments and $20.0 billion to its cash reserves.
Sources and Uses of Cash
With so much money pouring into the Gulf oil spill, how was BP able to add so much to its cash reserves? The company cut uses – mainly shareholder payouts (dividends and share repurchases), which fell from $2.5 billion in the first quarter to under $100 million in each of the last three. It also boosted sources – mainly $16.4 billion in asset sales and $10.8 billion in borrowings in the last two quarters. That drove cash flow to $10.2 billion for the year, in spite of outlays for the spill.
How to Handle a Liquidity Crisis
What made BP’s response so effective? Is what BP did a good model for evaluating companies facing liquidity problems? We think so. Companies struggling with liquidity problems need to:
React quickly
BP recognized the severity of the problem right away. In financial terms, that meant taking a big charge in the same period as the Deepwater Horizon disaster.
Reduce discretionary spending
BP stopped share repurchases and cut most of the dividend in the second quarter. It had less flexibility with capital spending, which remained at pre-spill levels or more throughout the year.
Increase cash from operations
In the second quarter, BP was able to generate only slightly less cash flow from operations than in the first, thanks to a $13.5 billion inflow from working capital. Big gains in working capital efficiency are difficult to sustain, and BP’s cash flows from operations went negative in the following two quarters.
Exploit other internal sources
What BP couldn’t get from operations it generated from asset sales. The company sold gas and oil fields, pipelines, and retail operations to strategic buyers.
Tap external sources
BP turned to the financial markets for funding. It raised $4.6 billion in bank loans backed by crude oil sales from fields in Angola and Azerbaijan. It raised another $6.2 billion from bond issues in Europe and the United States.
It’s not over for BP: costs and cash outlays are likely to rise. But the worst of the crisis is behind them. Today, Tokyo Electric Power Company is struggling with an even greater problem. The challenges they are facing are likely to dwarf BP’s. It will be interesting to see how well they cope with them, and, financially at least, whether they are as effective as BP.
We welcome your comments and questions. Here’s a question from one of our readers:
“I frequently come across credits that have a substantial amount of non-cash interestexpense related to hybrid financial instruments.Specifically, the one I have in mind has subordinated mezzanine financing with warrants attached. Embedded in the company’s interest expense is “change in fair value of warrant liability” and “amortization of discount and issuance costs on notes payable”.
In a few of your recent articles (Comments on Credit and RMA) there is some mention of this kind of debt in relation to subordination agreements etc., but I cannot find a good explanation of how to calculate debt service coverage ratios on firms that have these kinds of instruments.
We frequently syndicate our transactions with other traditional commercial banks and in their analysis I’m finding that they don’t exclude non-cash interest expense like this out of their debt service calculations. Some of the banks are more sophisticated than others, but I get the feeling that a lot of them don’t frequently deal with companies like this.
Can you provide any clarity on how one should debt service in a company like this? I can see cases for both excluding and including the expense, but would really like to get your perspective and see if there is something I’m missing.”
Here’s our response:
The two non-cash items that we see most often included in interest expense on a company’s income statement are:
1) Amortization of discount and issuance costs (sometimes called deferred or capitalized financing fees) – very common, but typically very small
2) Accrued and capitalized interest on zero coupon debt or “payment in kind” (or “PIK”) debt – not very common, but sometimes used by higher risk companies
Mezzanine debt is typically used by high-risk, middle market and smaller companies. The total return expected by mezzanine investors is in the mid to high teens. Since borrowers typically can’t afford to pay that much cash interest, mezzanine debt includes other non-cash compensation, including original issue discount (”OID”), PIK interest, and equity warrants. The cost of these items (cash or not) must be included in interest expense in each year. They typically are not broken out on the income statement, but should be detailed in the footnotes.
Now to your question. Non-investment grade and middle-market borrowers typically have a coverage covenant in their bank debt. It may be:
EBITDA coverage: EBITDA / Interest
Debt Service Coverage: EBITDA / (Interest + Scheduled Principal Payments)
Most often, the interest part of this formula is interest expense, right off of the income statement (i.e. including any non-cash interest amounts). However, as with any type of ratio analysis, covenant formulas should be adjusted to fit the unique characteristics of each borrower. For example, retailers with lots of rent expense typically use EBITDAR Coverage (i.e. EBITDAR / Interest + Rent) instead of EBITDA Coverage.
If a company has a lot of non-cash interest, we recommend (and often see) the coverage ratios adjusted to include only cash interest expense (i.e. excluding amortization of issuance costs, capitalized interest, etc.). Here’s why: we see coverage as a measure of liquidity – will the company have enough cash to pay its short-term financial obligations? As such, the closer you can get to cash measures, the better.
Of course, EBITDA isn’t really a cash measure, but that’s a topic for another day …
It may be disappointing, but it can’t be surprising that Borders Group went bankrupt this week. It was clear some time ago the company was heading deep into distress. What made it so clear? The six classic early warning signs of financial distress. We covered the first three in our last blog post. Here’s a brief video about the last three.
We blogged about Borders Group back on January 4. Even though the company has a new financing commitment, it continues to have problems paying suppliers. It looks like Borders is still circling the drain.
Borders’ survival is questionable, but for us the more interesting question is, “How could we have have seen the trouble at Borders coming?” What were the warning signs of Borders’ distress? In this video post we talk about three of the six early warning signs of financial distress and see how they apply to Borders. We’ll talk about the other three in our next post.
Jean Marie Messier became Chairman of Compagnie General des Eaux in 1996 at the age of 38. He was a graduate of elite French universities. At age 29, he held a senior post in the French Ministry of Economy and Finance. At age 32, he joined Lazard Frères, where he became the French investment bank’s youngest general partner.
He renamed the company Vivendi in 1999. And under Messier, Vivendi’s deal flow was staggering: the company sold 39 businesses and bought control of or stakes in 65 others. The capstone deal was a merger with Seagram-Universal and Canal Plus in 2000.
The share price climbed to a record high, and Messier became a darling of the financial press. Time magazine named Messier the 12th most influential businessperson in the world, and the French Government awarded him the Legion of Honor. Articles in Business Week and Fortune compared him to Jack Welch, the legendary CEO of General Electric.
The French press called him Jean “Magic” Messier. But Messier preferred J6M, which stood for Jean Marie Messier, moi-meme maitre du monde (“Jean Marie Messier, myself, master of the world”).
Massive impairment charges hurt the company’s credit ratings in 2001, which led to problems rolling over short-term debt, which put pressure on liquidity, which hurt the share price. Messier fought back in 2002 with a massive increase in share buybacks, a special dividend, and a request for a big increase in his compensation. Directors began resigning in packs, and Messier lost his job that July.
He paid over $2 million in civil fines for misleading investors in France and the United States. Now he’s been convicted on criminal charges for the same offense. In these difficult times, it may be gratifying to see a member of the global business elite in trouble. But what’s the lesson in the Messier mess for risk analysts? How could a manager so brilliant, so accomplished, so successful get himself and his company into so much trouble?
We think the answer is at the intersection of management and character. Messier displayed many of the traits of spectacularly unsuccessful people Sidney Finkelstein describes in his excellent book Why Smart Executives Fail.
1. They see themselves and their companies as dominant. Messier overestimated his ability to control events, especially when Vivendi got into trouble in 2001 and 2002. Instead of shoring up the company’s finances, he threw money at the share price and kept insisting Vivendi had more liquidity than it really had, as if his assurances alone were enough to save the company.
2. They identify completely with the company. But the relationship is inverted: the company’s good doesn’t come first, the manager’s does. Messier believed what was good for him must be good for the company. That’s how he could ask for a raise when Vivendi was in the middle of a liquidity crisis.
3. They think they have all the answers. Messier’s self-confidence and vanity were legendary. No one could persuade him to see the mistakes in business and financial strategy that led to Vivendi’s liquidity problems.
4. They eliminate anyone who isn’t 100% behind them. Messier fired the only other widely admired manager at Vivendi, Pierre Lescure, the highly popular CEO of Canal Plus. He stuffed the board with friends and supporters.
5. They are the company’s spokesperson. Messier loved the limelight and cultivated it. He became obsessed with the appearance of success, insisting that there were no real problems at Vivendi, even when losses were growing and financing shriveling away.
6. They underestimate obstacles. Messier refused to admit the extent of Vivendi’s funding problems. His CFO tried to warn him, saying, “I’ve got the unpleasant feeling of being in a car whose driver is speeding up into the bends and that I’m in the death seat.” But Messier ignored him.
7. They rely on what worked for them in the past. When things began to go wrong for Vivendi, Messier just did more of what he’d always done. He increased the pace of acquisitions and divestitures, raised share buybacks and dividends, and made more public appearances.
Messier, for all his ability, was a catastrophe masquerading as a hero. Fortunately, he did not destroy Vivendi, the way Bernie Ebbers did at WorldCom or Jeff Skilling did at Enron. But he came close. Analysts and investors who want to avoid the next management disaster should pay attention to character, and these seven traits are a great help for that.
The Wall Street Journal reported yesterday that Borders Group Inc. was halting payments to some suppliers, and that one publisher had stopped shipping books to Borders. The end is near. As we discussed in an earlier post, if trade creditors lose faith in a company, bankruptcy is almost unavoidable. The term we use is “confidence sensitive cash flows,” which includes, in addition to trade credit, short term borrowings like commercial paper (think Lehman Brothers) and counterparty credit (think Bear Stearns). Once one supplier stops shipping, they all will stop.
Today, the Wall Street Journal reported that two senior executives had resigned (the General Counsel and the Chief Information Officer). This is another classic early warning sign. Let the countdown begin …
Here’s our list of the top 10 topics on the minds of credit professionals in 2010:
10) Risk Management – We’ve written many times this year about risk management, both good and bad. Whether it was BP and operational risk, suppliers dealing with customer concentration risk (or “Wal-Mart Risk”), or Lehman just not managing risk. This topic was on our radar in 2010 (and needs to stay there into 2011 and beyond).
9) Games CFOs Play – Aggressive financial reporting (and outright fraud) can happen at any time, but management’s motivation to do it is heightened during an economic downturn when there is pressure to “hit the numbers” (and not breach covenants, etc.).
8 ) Managing High Risk Clients – Sure the recession is over, but many companies are still struggling with high leverage, high competition, low sales growth, and high costs. Lenders and bondholders will be working with many “high risk” clients well into 2011.
7) Intercreditor Priority – When times are good (think the 2003-07 credit bubble), no one pays much attention to collateral and subordination (or covenants, or any other part of credit documentation for that matter). The restructurings and bankruptcies of the great recession reminded us how important these issues are. We fear that the market is already starting to forget these lessons (think covenant lite and second lien!).
6) Cash Flow Analysis – Cash is king. Real cash, not EBITDA. Enough said.
5) Liquidity – Many CFOs (and lenders) have learned the hard way that liquidity can be the most important element of financial strategy. Our favorite analytical tool for looking at liquidity is the liquidity position.
4) Financial Strategy- Leverage matters too. A company’s debt strategy should depend on its business needs and business risk, not just the condition of the capital markets. The levering up we saw in the boom is evidence that some companies forgot this rule – many have been working to delever since 2008.
3) The Credit Cycle - The debt markets have returned (although not to the levels of 2006-07, yet). The return hasn’t been smooth, however. Issuers and investors have been looking closely at the relationships between the loan and bond markets, perhaps venturing where they haven’t been before.
1) New Opportunities – With the economy (slowly) improving (think increasing loan demand), and bank capital on the mend (think increasing loan supply), we think the increasing bond and loan volumes we saw in the second half of 2010 will continue into 2011. Here’s hoping that 2011 brings you many new opportunities.
What “hot topics” do you see looking forward – leave a comment…
With the success of the GM IPO, we may be tempted to forget the terrible decade the U.S. auto industry has just completed. Car sales steadily declined from 2000 through 2007, then collapsed in 2008 and 2009 to a level not seen since 1951. Truck sales, which saw dramatic growth in the 1990s and finally eclipsed car sales in 1999, saw some growth in the early 2000s, but also dramatically retreated in the 2007-09 recession.
The “big 3” U.S. auto makers also suffered market share declines in this period, from a combined 65% of the U.S. market in 2000, to 53% in 2006, to 44% in 2009. It should be no surprise that GM and Chrysler filed for bankruptcy in 2009. The real question is: Why didn’t Ford go bankrupt?
Why Didn’t Ford Go Bankrupt?
By 2006, it was clear to the big 3 auto makers that there was a problem. Ford’s sales and net income had been flat for many years. Ford, like the other auto makers, began a major restructuring to reduce capacity, cut costs, and accelerate product development. The key to Ford’s success, however, was in aligning its business and financial strategies.
How did the Ford finance team respond to declining sales and the company’s new operational restructuring? By borrowing over $12 billion, increasing the company’s auto sector debt (excluding the financial services business) by 66% from $17.9 billion to $30.0 billion. Ford borrowed this money at the peak of the credit bubble, right before the recession hit and vehicle sales dropped by over 1/3. Why isn’t Ford bankrupt?
Why the New Debt?
Ford’s financial strategy was to maintain adequate liquidity to complete the operational restructuring, consistent with the auto industry’s high degree of cyclicality. So why borrow over $12 billion? The bulk of the new debt, almost $9 billion, went to increase the company’s cash hoard, with the remainder funding losses, capital expenditures, and other operating needs. During 2006, the company’s auto sector cash and marketable securities increased from $25 billion to almost $34 billion. Add to that over $12 billion available under the company’s revolving credit facilities (which were also renewed in 2006), and the company’s total liquidity going into the recession was over $46 billion.
Debt Maturities Matter Too
In addition to building cash and revolver availability, Ford had a conservative strategy on debt maturities. At December 31, 2006, 95% of Ford’s auto sector debt was long term (i.e. maturing beyond 1 year). In fact, over 88% matured beyond 5 years. While long-term debt typically costs the issuer more than short-term debt, Ford accepted this additional cost in order to reduce the risk that it would have to come to the financial markets to rollover debt during a downturn.
Lessons Learned
Ford, GM and Chrysler all faced significant operational challenges in the mid-2000s. All began major operational restructurings to cut capacity and costs and simplify their manufacturing and distribution networks; we are seeing signs of the operational turnaround at all three companies.
Ford was able to avoid bankruptcy in 2009 because of its operational restructuring, but also because of a successful financial strategy. It opportunistically borrowed money under favorable terms, built a large cash position, and kept very long maturities on the bulk of its debt. This financial strategy gave the operating side of the business the breathing room to complete its restructuring and survive the recession.
By the time they grew to $1.5 billion, Michael Roseman, MF Global’s Chief Risk Officer, was concerned about the firm’s positions in bonds of Italy, Spain, Portugal, Ireland and Belgium. He was worried the trade might endanger the entire firm if the financial problems in Europe got too tough. Roseman believed MF Global didn’t have enough liquidity to withstand a credit rating downgrade.
Digg This!
The New York Times DealBook blog just put out a fine piece on the collapse of MF Global: A Romance with Risk That Brought on a Panic by Azam Ahmed, Ben Protess, and Susanne Craig (December 11, 2012). It’s the most comprehensive summary of the events that led to the firm’s bankruptcy that we’ve seen so far. Until the investigations are done and the books are written, it’s a good source for thinking about the credit risk lessons to be learned in MF Global’s sad story.
Michael Woodford lost his job on October 14. He had been CEO of Olympus, the Japanese maker of medical systems and cameras, only since last July; and as recently as September, the company’s Chairman had said he was “extremely pleased” with Mr. Woodford’s performance. But then the board fired him for “causing problems for decision making.”
Specifically, the one I have in mind has subordinated mezzanine financing with warrants attached. Embedded in the company’s interest expense is “change in fair value of warrant liability” and “amortization of discount and issuance costs on notes payable”.
Jean Marie Messier became Chairman of Compagnie General des Eaux in 1996 at the age of 38. He was a graduate of elite French universities. At age 29, he held a senior post in the French Ministry of Economy and Finance. At age 32, he joined Lazard Frères, where he became the French investment bank’s youngest general partner.
The Wall Street Journal 
