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During the late nineties stock market boom, borrowing reachedastounding rates. Today, both financial institutions and industrialcompanies are carrying huge debt liabilities created throughborrowing, repos, derivatives, and lending to other leveragedsectors of the economy. Liquid assets, many companies' classicsafety net, are far outweighed by liabilities, leaving themoverexposed.
This book offers expert advice on proper liability management forfinancial officers, analysts, traders, investment advisors, loanofficers, accountants, and auditors whose daily activities concernthe management of liabilities and the control of exposure. Filledwith examples and case studies of problems in some of the biggestcompanies, Liabilities, Liquidity, and Cash Management providesexpert advice on proper modern liability management.
Volatile global markets, changing regulatory environments, and theproliferation of new financial products have made the management ofliabilities and assets in the balance sheet a critical task. Moderntools like simulation, experimentation, and real-time financialreporting make the job easier, but current assets and liabilitiesmanagement strategy is changing under the weight of growing debt.This book will bring readers up to date on new theory andpractices.
Entities with a large amount of debt must pay a great deal ofattention to the quality of liabilities management, includinglevels of leverage, liquidity thresholds, and cash management.Credit risks, market risks, and reputational risks can beeffectively controlled with a proper internal control system. Butas a growing number of examples demonstrate, a large number ofinstitutions either have inadequate liabilities management systemsor management itself fails to recognize the warning signs.
This book sets out a process of liabilities management for today'sleveraged economy. Divided into four parts, the book considers thegeneral principles of liabilities management, liquidity management,cash management, and credit risk. Case studies of the telecomindustry and major companies like Bank One, Daewoo, and Xerox helpreaders understand the importance of good liabilities managementand the consequences of inadequate liabilities management.
PART ONE: CHALLENGES OF LIABILITIES MANAGEMENT.
1 Market Bubble of Telecoms Stocks.
2 Downfall of Lucent Technologies, Xerox, and Dot-Coms.
3 Liabilities and Derivatives Risk.
4 Reputational and Operational Risk.
PART TWO: MANAGING LIABILITIES.
5 Assets, Liabilities, and the Balance Sheet.
6 Virtual Balance Sheets and Real-Time Control.
7 Liquidity Management and the Risk of Default.
8 Market Liquidity and the Control of Risk.
PART THREE: CASH MANAGEMENT.
9 Cash, Cash Flow, and the Cash Budget.
10 Cash on Hand, Other Assets, and Outstanding Liabilities.
11 Money Markets, Yield Curves, and Money Rates.
12 Mismatched Risk Profiles and Control by the Office of ThriftSupervision.
PART FOUR: CREDIT RISK, MARKET RISK, LEVERAGE, AND THEREGULATORS.
13 Credit Risk, Daewoo, and Technology Companies.
14 Marking to Market and Marking to Model the Loans Book.
15 Changes in Credit Risk and Market Risk Policies.
16 Summary: Management Blunders, Runaway Liabilities, and TechnicalMiscalculations Leading to Panics.
The need for a sophisticated approach to assets and liabilities management (ALM) has been evident for many years. Volatile global markets, changing regulatory environments, and the proliferation of new financial products, with many unknowns, have made the management of liabilities and of assets in the balance sheet a critical task. Modern tools such as simulation, experimentation, and real-time financial reporting help in fulfilling this responsibility, but, at the same time, the whole assets and liabilities management strategy is changing under the weight of a fast-growing amount of debt.
Leverage is often managed with easy money that typically is not invested in a prudent manner. AT&T, for example, bought high and sold low. Its chief executive officer (CEO) bought TeleCommunications Inc. (TCI) and MediaOne when valuations for cable TV assets were near their peak. He paid about $105 billion for these assets in the name of "synergy." The same assets were worth $80 billion when AT&T's spinoffs were contemplated in late January 2001-another hit-and-run management decision.
What has really changed during the last decade in assets and liabilities management is that the pillar on which it rests has moved from the left to the right side of the balance sheet, fromassets to liabilities. Since the invention of the balance sheet in 1494 by Luca Paciolo, a mathematician and Franciscan monk of the order of Minor Observants,
The ledger was based on assets.
Liabilities were there to balance the assets side.
Today, by contrast, the critical element of the balance sheet is liabilities.
Assets are there to balance, it is hoped, the liabilities side.
But, as was seen in the AT&T example, such assets may be melting away.
This turns traditional thinking about assets and liabilities management on its head. The old rules are no longer valid. Quite often the price of leveraged assets is justified only by the "greater fool theory"-the expectation that other investors would bid their value even higher, and they will come up with the cash. Debts that are due-liabilities-primarily fall into the following classes:
Obligations to commercial banks and other entities in the form of loans, credit lines, or similar instruments
Commercial paper, such as short-term "IOUs," of variable-rate, floating-rate, or variable-amount securities
Unpaid invoices by suppliers, salaries, wages, and taxes
Certificates of deposit, time deposits, bankers' acceptances, and other short-term debt
Exposure assumed against counterparties through derivative financial instruments
Repurchase agreements involving securities issues by commercial and industrial organizations
Fixed income securities issued by the firm
Equity that belongs to the investors
As the weight of the economy has changed sides, from the assets to the liabilities side of the balance sheet, companies inflated their liabilities and their market capitalization, which zoomed in the second half of the 1990s and the first three months of 2000. Since these securities are publicly traded, one company's inflated liabilities became another company's assets.
Over-the-counter derivatives deals and publicly traded inflated equities violated the basic notions behind the balance sheet concept. They also changed the nature of what a balance sheet represents. The economy became overleveraged from intensive borrowing from the capital markets and from banks, borrowing that was behind the big boom of 1995 to 2000. But unlike assets, which are the company's own, liabilities have to be paid when they become due.
Despite the equities blues of late March and of September to December 2000-and beyond that in 2001-overleveraging sees to it that credit risk far exceeds market risk. Hence everyone, from big and small companies to consumers, must be very careful about liabilities management. Solutions cannot be found in textbooks because they go beyond conventional thinking.
LEVERAGING MAKES THE GLOBAL FINANCIAL MARKET FRAGILE
In his book On Money and Markets, Henry Kaufman laments: "The potential excesses and fragility of global financial markets" and brings into perspective "the consequent need for more effective international approaches towards regulation and supervision." He also points out "the lack of fiduciary responsibility displayed by many financial institutions in recent decades."
The change in weight from the left side to the right side of the balance sheet is not the only significant event of the last three decades, but it is the largest and most far reaching. It was predated by the inflationary spiral of the 1970s and the recycling of petrodollars by money center banks, which inflated the liabilities side; the killing of the inflationary spiral and the junk bonds and stock market boom followed by a short-lived correction in 1987; and fiscal policy excesses practically all over the world in the 1990s, which led to the rapid growth of liabilities in that same decade.
Eventually all these events converged into unprecedented liabilities leveraging, which was known as the virtual economy. Practically everyone was happy about the rise of the virtual economy and its overtaking of the real economy-which is the assets side of the balance sheet. But as long as the euphoria lasted, hardly anyone thought of the consequences:
Growing in the virtual economy is synonymous to carrying huge positions, therefore huge liabilities.
Very few analysts have been clear-eyed enough to add total borrowings to total contingent liabilities in derivatives, repos, and other obligations, to measure exposure.
Yet, this exposure is real. Even if its origins are found in the virtual economy, someone will have to pay the debt. The leveraged positions just mentioned are adding up rather than netting out, thereby creating a mountain of risk individually for each entity and for the economy as a whole.
What is different about 2000 and 2001, conditioned to a considerable extent on liability management and therefore the focus of this book, is that it has been a period of excess correction. The central banks of the Group of Ten (G-10) increased liquidity for the transition to the twenty-first century, and this increased liquidity was used to finance a tremendous investment boom in technology.
The surge of technology stocks that started in the mid-1990s and greatly accelerated in February and March 2000 provided a euphoria in the financial markets. This euphoria translated into a surge in demand for consumer goods and capital equipment. The result was an exaggeration, followed by a correction in late March/early April and by another much more severe correction in September to December 2000-with the eye of the storm in mid-October 2000, roughly two years after the collapse of Long Term Capital Management (LTCM).
The telecommunications industry (telecoms, telcos) in 1999 and 2000 and LTCM in 1998 had much in common: They both tried and failed to defy the law of gravity. Overcapacity, price wars, and low cash flows by telecom vendors exacerbated their liabilities. Capitalizing on the fact that advancing technology cuts the cost of a given level of telecommunications channel capacity by half every nine months, telcos and other channel providers have used the new facilities they installed to wage deadly price wars with one another. These wars hit their cash flow and profit figures at the same time, as shown in Exhibit 1.1.
British Telecom, Vodaphone, Deutsche Telekom, France Telecom, Telecom Italia, Telefonica, and Dutch KPN have among them an unprecedented amount of short-term debt. The debt of British Telecom alone is £30 billion ($44 billion). In one year, from March 2000 to 2001, France Telecom increased its debt by 400 percent to Euro 61 billion ($55 billion). AT&T and the other U.S. operators match these exposures. For the whole telecoms sector worldwide, $200 billion comes due in 2001.
The failure in interpreting the business aftermath of the Law of Photonics led to negatives at the conceptual and financial levels. The market has showed that plans by telecom operators were erroneous. While the telecoms did not have the cash to boost spending, they did so through high leveraging. Disregarding the growth of their liabilities and their shrinking cash flow because of intensified competition, the telecoms increased their purchases of equipment by nearly 30 percent in 2000.
The telecom companies' cash shortfall amounted to $50 billion, most of which had to be raised from the capital market, the banks, and equipment companies themselves.
By March 2001 total carrier debt has been estimated at about 93 percent of sales, compared with 29 percent of sales in 1997.
Theoretically, the telecoms capitalized on what they saw as capacity-enhancing advances in fiber optics, which allowed them to slash prices by 50 percent or more every year, in a quest to gain market share and build traffic. Price drops can be so dramatic because technology permits carriers to get into disruptive pricing. But what technology might make possible does not necessarily make good business sense. The telecoms could have learned from the failure of others who overloaded their liabilities and paid a high price:
The Bank of New England in 1989 and Long Term Capital Management in 1998 were the first manifestations of a liability management crisis hitting the big financial entities one by one.
The events of the fourth quarter of 2000 were different in that the crisis in liability management hammered many technology companies at once, with the whole capital market being the epicenter.
Making the liabilities side of the balance sheet the heavyweight is akin to specializing in the creation of debt. On its own, this is a strategy like any other-but it has to be managed in a rigorous manner. Major failures can come from lack of attention in liabilities management, augmented by the fact that both the methodology of how to manage liabilities and the tools needed to do so are still evolving.
According to Henry Kaufman, in the 1980s the corporate leveraging explosion was accompanied by a severe drop in corporate credit quality. For eight years, downgrading in credit quality outpaced upgrading. The damage from credit downgrading is not so visible in boom years, but it becomes a source of concern in a downturn, as is the case in the first couple of years of the twenty-first century.
Today, both financial institutions and industrial companies have huge debts. The liabilities are made up of exposures through borrowing, repos, and derivatives as well as lending to other leveraged sectors of the economy such as corporate clients, households, businesses, and governments. Liquid assets, the classic security net, are tiny when compared to these exposures.
Take the household sector as an example of indebtedness. Exhibit 1.2 shows only a fraction of its exposure, which has been skyrocketing. From 1990 up to and including 2000, stock market margin debt has been unprecedented. In January 2001 private borrowing totaled a record 130 percent of gross domestic product (GDP).
Part of this bubble is due to the so-called wealth effect. From 1985 to 2000, Wall Street (NYSE and NASDAQ) reached a capitalization of about $20 trillion. This is 200 percent the gross national product (GNP) of the United States. (An estimated $8.8 billion was lost in the stock market blues from late March 2000 to the end of May 2001.) Private households, companies, and states accumulated a debt of $30 trillion. That is 300 percent the GNP of the United States.
Besides showing overleverage, these statistics are also a source of major risk for the coming years, until the real economy takes care of this indebtedness. Faced with such exposure and the cost of carrying it, many consumers may decide it is time to pay off debt and digest those acquisitions. Since business investment, especially of high-technology items, has fueled half the growth in recent years, the expansion may lose one of its major motors.
Another development that has increased the downside risk for the U.S. economy is the run-up in energy prices, which has drained purchasing power from households and businesses. The Organization of Petroleum Exporting Countries (OPEC), which in 2000 hiked oil prices at an inopportune moment, was an accessory to other disturbing events, such as the problem of electricity prices and power blackouts hitting vital parts of the U.S. economy.
Liability management takes planning and a complete understanding of all the problems that may arise, including spillover effects and cross-border aftermath. Even a custom-tailored solution for the U.S. economy has to consider the slowing growth overseas. Where economists once assumed that pickups abroad would offset sluggishness at home, in a highly leveraged global economy each slowdown reinforces the other.
CREDIT CRUNCH CRIPPLES AMBITIONS OF TELEPHONE OPERATORS
Alert economists see the pyramid schemes of the 1920s as the predecessor to the wave of leveraged buyouts of the 1980s and 1990s. In the 1920s, the theme was real estate; in 2000-2001 the late 1990s, it was the high-risk debt financing of telephone companies and other entities. The gearing of telecoms is also being compared to the overleveraging of public utility holdings in the years preceding the Great Depression.
An example of early twentieth century overleveraging among construction companies and real estate developers are the junior liens by S.W. Straus & Co. of New York. In a way that parallels the loans to telephone operators in 1999 and 2000, 80 years ago the mortgage real estate bond business was considered to be too large, too important, and too well established to be affected by failures. Real estate mortgages have been one of the important factors in rebuilding the United States. But at the same time leveraging was overdone, and with junior liens the whole enterprise became a kind of Ponzi scheme.
The real estate mortgage bonds S.W. Straus and its kin sold were often construction bonds. In many cases, the collateral behind them was merely a hole in the ground. There was nothing to assure the project would succeed. Typically, if it did not succeed, the bond issuer forgot to inform bondholders but continued to pay the principal and interest from the money brought in by newcomers. As James Grant says: "Each new wave of investors in effect paid the preceding wave." Eventually the bubble burst.
In the 1990s, 70 years down the line, the telecoms and the dot-coms of the United States and Europe repeated this tradition. Old firms and newcomers in the telecommunications industry relied more and more on external financing to fund their capital budgets. The dot-coms did not have much in the way of capital budgets to worry about, but they did get overleveraged to make ends meet for their operating budgets.
Excerpted from Liabilities, Liquidity, and Cash Management by Dimitris N. Chorafas Excerpted by permission.
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