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To Manage Credit Risk, Banks Opt for Bermuda Options

(Complete Article from the September '09 Newsletter)

If you had the occasion to (or will soon have to) negotiate ISDA agreements with your bank counterparties, you may face unwelcome surprises. As banks continue to recover from the financial industry meltdown, they are taking various steps to cap their interest rate risk (for more about this, see last quarter's newsletter article) as well as their credit risk exposure. So far, the evidence is anecdotal and thus it's not clear how many banks or customers are involved. However, it's useful for everyone to be aware of some of these new requirements and their potential impact on hedge accounting under FAS 133, reported earnings, and disclosures

One new way banks have been trying to mitigate their credit risk is by attempting to insert new language into ISDA agreements; referred to as an elective early termination clause, the language gives either party the option to cancel or "call" the derivative at some specified interval, e.g., at 3 or 6 or 12 months, and at similar intervals thereafter. This sort of bilateral option is often called a Bermuda option. (Another way banks have tried to manage their credit risk is by adding minimum liquidity clauses into the ISDA, e.g., $2 million in cash and cash equivalents.)

Calling a Spade a Spade

Be it a Bermuda option or a liquidity "floor," both approaches are pretty much the equivalent of a margin call on the exchanges or a collateral requirement, resulting in similarly unpredictable cash consequences. There's irony here. On the one hand, banks have been lobbying hard to exempt corporate end users from the exchange or clearing house requirements in the Administration's proposed derivative legislation. Under the proposal, much of the OTC market will be driven into exchanges or clearing houses, to mitigate non performance risk and enhance price transparency. On the other hand, banks are clearly attempting to reshape the way they do business with corporate clients to reduce their credit exposure, but in this case, no promise of heightened price transparency.

The way most Bermuda options are structured present some immediate issues for companies - from hedge program to disclosures.

While there was some initial confusion of whether, e.g., a 12-mos forward with a 6-mos Bermuda option would qualify as a hedge of a 12 month exposure at inception, there seem to be no are no issue at inception. However, when either party calls the derivative at the stated interval, the derivative will settle at market and any gains or losses will be booked into OCI where they will stay until the maturity debt of the underlying transaction. At the same time, the company would presumably enter into a new derivative, at market, to hedge the reminder of its exposure.

Bermuda options must also be seen through the lens of FAS 161, which requires companies to disclose any event that would trigger a call on cash. The early termination clause certainly fits the mold. So, if companies accept their banks' ISDA language, they will have to update their disclosures under 161 to reflect the potential for early termination, detailing both the terms and the dollar amounts at risk to a "collateral call".

Be Proactive

When banks attempt to alter the ISDA language, companies can and do fight back. "We just had our legal discussion with the bank," reported one treasury executive. An important component of the discussion was the fact that the company would prefer not to transact its longer-term cash flow hedges with this specific institution. Some companies have already pushed back "I know of at least one other corporate that successfully convinced its bank to drop the language," said the treasury professional.

She advised treasury to do its homework and ensure any ISDA-related edits are reviewed and discussed before the documents begin to be tossed back and forth between respective legal departments. The idea is to give the bankers a chance at understanding how the new language would affect their customer's business as well as their own.

The Bottom Line

But perhaps the most important lesson to be learnt is that banks' heightened credit concerns are clearly changing the market dynamics and way counterparties do business, well before the implementation of new derivative regulations. In both the case of the legislation and the retooled ISDAs, derivative trading will require a form of collateral or margin. But while the legislation promises to shine a bright light leading to price transparency, the ISDAs come with no such guarantee.