Derivatives and off-balance-sheet risks

RMA Journal, The, March, 2002 by Darryl Sparrow

The risks often hidden in derivatives and off-balance-sheet transactions are of increasing concern to bankers everywhere. A team of credit analysts at an international bank has developed a framework for considering off-balance-sheet risks in the context of financial analysis.

Recent catastrophes, notably in the energy sector, have highlighted the role of off-balance-sheet exposures in the development of financial difficulties in large corporate borrowers. Enron is a case in point, due to that company's widespread derivative trading activities, and the presence of options in receivables securitization transactions that acted to accelerate the company's demise once the rot set in.

Although accounting disclosures have been improved over recent years, financial analysis techniques are still developing in terms of how to treat off-balance-sheet entries in assessing creditworthiness. In any case, it is often a challenging task to identify these liabilities, and a detailed reading of the Notes to the Accounts is usually necessary.

This article outlines the major groups of contingent and off-balance-sheet exposures, and methods my team uses to assess the level of risk undertaken.

Guarantees

Many companies provide their financial guarantee in respect to the performance of affiliates, thereby providing stronger collateral to lenders to the affiliates. For example, the affiliate may he a joint venture vehicle established with minimal capital and support from its sponsors by way of guarantees on the JV's borrowings. Depending on the financial and negotiating power of the sponsors, the guarantees may be limited to respective proportions of the JV's debt, or they may be "joint and several," meaning that each venture partner is potentially liable for the whole debt.

Another type of guarantee obligation is the rental bond, a common requirement of landlords who lease office or warehouse premises to companies. Typically, a bond is required for several months' rental as a surety--the bond provided by an insurance company or bank, backed by a counter-indemnity from the company.

There are a number of other types of bonds (issued by banks or insurers) that may appear in the Notes to the Accounts.

* Performance bonds, in connection with completion of contractual obligations. For example, a warranty bond on an article of equipment or a bond that supports environmental remediation of a land redevelopment.

* Bid bonds, opened at the time of tendering for a large contract. The bid bond concept is designed to provide an initial hurdle to eliminate spurious bids from small companies for large projects.

* Import Letters of Credit, opened by banks on behalf of importers, also will find their way into notes about guarantees. Effectively, the importer guarantees its bank that it will pay for goods being purchased in exchange for the hank opening a letter of credit in the (overseas) supplier's favor.

The argument can be proposed that all guarantees are not likely to he called at once, enabling us to consider only a proportion of guarantees. This may be the case if there is a large portfolio of such liabilities, for example, a construction company. However a call under a bond or guarantee is often a sign of deeper managerial or operational problems, and the possibility of a snowballing effect through cross-default and loss of confidence should not be discounted.

The crucial test is whether the company has sufficient cash-at-bank or undrawn credit to meet its guarantee commitments A further question is whether these guarantees relate to core business. Is the company guaranteeing ventures that are peripheral to the main game but hidden off the balance sheet to keep shareholders, auditors, or regulators happy?

Operating Leases

A variety of business infrastructure needs are met through operating leases. Office rental, vehicle fleets, key equipment--all arc frequently subject to medium-term contracted arrangements that may be accelerated in the event of financial difficulty.

Specific issues with operating leases:

Use of operating lease as surrogate finance. This is particularly pertinent for such businesses as trucking lines or railways, which often enter into long and large operating lease commitments on equipment. From a balance sheet management perspective, operating leases limit the impact on gearing and leverage of fleet expansions. From a credit angle, however, operating leases are quasi-debt, and it is appropriate to recalculate gearing to include operating lease debt as a component of long-term finance, where significant lease commitments are identified. How leveraged is your borrower, really?

* Rental commitments in the profit-and-loss account. Lease rentals can be a major P&L item but are excluded from interest cover calculations--a neat opportunity to stretch the financial constraints without breaching loan covenants. Where operating leases are large, it is helpful to revisit interest cover by adding back operating lease rentals to both numerator and denominator.