What’s behind the hedge?

If there’s one topic that is almost guaranteed to quieten a board meeting, it’s when the CFO starts proposing that the company takes out a hedge. This is a very complex area of financial management and almost no-one understands them, and even fewer want to admit it¹. Typically, the proposal is couched in obscure technical language, usually inspired by clever bankers, who outdo themselves to devise ever more complex devices and jargon.

However, non-executive directors should not be afraid to ask questions about proposals for hedging and should not assume that anyone else on the board understands it more than they do². In fact, there are a set of eight basic questions that every non-exec should ask about a hedging proposal.

Companies put hedges into place to transfer a financial risk from themselves to someone else. This is like an insurance policy, which transfers the risk of something happening from the policy holder to the insurance company. Hedges are usually put in by using a derivative³, which is simply a financial contract whose value depends upon the outcome of something else. The whole purpose is to reduce, or hedge, the risk for the person buying the hedge.

That’s the theory, but let’s look at some fictional examples⁴ (inspired by real events).

A bit too much to drink

Manufacturer W was a large food and drink company that wanted to gear up its balance sheet. Its bank was delighted to lend this money, but insisted that the company hedged the interest rate risk. After all, the company wouldn’t want to risk its interest rate payments increasing dramatically if market rates went up. Fortunately, the bank was able to write a derivative to do precisely this and would be delighted to sell it to the company. The derivative was finalised and signed just a few days before the loan agreement was ready. But in between these events, the market worsened significantly. As a result, the loan agreement was never actually signed. However, with the market downturn, market interest rates suddenly fell heavily. When the company tried to cancel the hedge, it found that the derivative was already heavily in loss. Assured by advisers that the market situation was temporary, and interest rates would recover, management held onto the derivative as the loss grew. Eventually it sold 75% of the hedge at a cost of hundreds of millions of pounds. The Board couldn’t face up to taking a bigger hit. It persuaded itself that since it would always need debt, and as interest rates⁵ couldn’t go any lower, the 25% holding was justified. Neither was true and eventually, it conceded to the inevitable and sold the remaining for a further loss of nearly £100m. Both the CFO and CEO resigned.

Nothing left on their plate

Mr & Mrs X ran a popular and profitable restaurant in South Wales. They took out a variable rate £200,000 25-year mortgage from their bank, who sent some sharp suited bankers to frighten them that interest rates could go up, making the mortgage unaffordable. They had the ideal product – a 25-year interest-rate swap (ie a derivative that swapped a fixed rate for a variable one, effectively fixing the interest rate), so that they need never worry about interest rates going up again. In fact, interest rates fell, so that as their mortgage payments reduced, this was offset by payments to the bank for the hedge. Five years later, they decided to sell up and move on. There was no problem in redeeming the mortgage, but the bank explained that that there was a big price to exit the hedge. Interest rates had gone down by 2% and so there were 20 years of 2% interest payments due, some £80,000. This wiped out the couple’s equity on the restaurant and left them with nothing.

Property foundations sink

Company Y was a small listed property company. Pressurised by an activist shareholder, the company geared up and took a £200m 30-year variable-rate loan from its bank, which insisted also on the company taking out an interest-rate swap to fix that rate. Cash proved tight and so a couple of years later the company negotiated improved terms, for which the bank insisted that it get a break clause in the loan agreement at 5 years, giving the bank the right to unilaterally demand it be repaid at that point. The bank assured the company that this was just a technical measure to do with its capital ratios. Shortly after this, the bank announced that it would be withdrawing from commercial lending in a couple of years’ time. As Y’s cash flow had improved in those intervening years, the loan had been gradually repaid, leaving £100m outstanding. The bank then informed Y that it would call in the loan at the first break clause, and by the way, the hedge would need to be cancelled at the same time. The mark-to-market loss on that derivative was now £40m. So the company had to refinance the £100m loan while at the same time paying out £40m for the hedge. This £140m cash requirement was greater than Y’s total market capitalisation. Both the CFO and CEO lost their jobs and Y, a good and successful property company, came within a few short hours of going bust.

Too little flying costs a lot

Company Z was a large airline. Like most airlines, it hedged the price of fuel, usually 90% of its annual requirements. This year the global pandemic suddenly devastated the market. Most flights were cancelled and the oil price slumped. Z was looking at a situation in which it would fly much less than half its planned number of sectors, and its fuel requirements were slashed. It was however still committed to pay for the difference between the low market price of fuel and the higher hedge price for fuel, even on the fuel that it wouldn’t actually be buying. The full loss was expected to be over £1bn.

What do we learn from these stories?

Hedges do not remove risk, but transfer it. A perfect hedge transfers a risk from the purchaser to the bank. However, I’ve never seen a ‘perfect hedge’ in practice. Focus tends to be directed at the ‘rate’ – whether the derivative is based on 0.5% or 0.7% interest rates, 3-month LIBOR, or $80 a barrel of oil, for example. However, there are other even more important elements that don’t get reviewed enough. Non-execs should be particularly aware that;

1. Hedges may actually increase risk. At times they are liable to escalate risk and can quite easily become so big that they become an existential threat. It can be like trying to put a fire out with a petrol bomb.
2. The tenor (ie length of) the derivative is important. If you sign up to a 30-year swap, then you can generally cancel it or sell it to another party earlier than 30 years, but you almost certainly will need to pay for any market loss (ie the loss over the whole outstanding period of the derivative) at that point. That could be 30 years of loss, that will add up to a lot of money, as the restaurant X and property company Y found out. Beware particularly that if you take out a long-term swap and the thing that you are trying to hedge (eg a loan) doesn’t last that long, then you are exposing yourself to interest rate risk that may well be much bigger than the risk that you thought you were hedging! An ‘ultimately mismatched’ swap will increase risk, not reduce it.
3. The ‘size’ of the derivative is crucial. The size of the swap can be mismatched too. When property company Y reduced the size of its loan, the ‘excess hedge’ became an unmatched liability. It didn’t bother to, or couldn’t, face the loss that it would have to have crystallised in reducing the size of the swap. The airline couldn’t conceive that it wouldn’t need all that fuel. Unless the size remains exactly in line with the underlying liability throughout the tenor of the swap, it will produce a new risk.
4. A hedge may well introduce a new cash risk. As Y found out, there may be a break clause in a derivative, that is likely to require settling any market loss in cash now. The originator of the swap may well require that a company regularly settles any mark-to-market loss (ie make margin payments). If the swap is showing a loss (ie ‘out of the money’) you may have to pay up the full loss immediately, whilst not receiving for many years the benefit of the lower interest rate, exchange rate or oil price. The small print of the swap documentation may require regular margin payments or may trigger them if the purchaser fails some covenant tests (ie their credit becomes less worthy).
5. A hedge may introduce new P&L risk. This seems counterintuitive. Why hedge something if it doesn’t allow you to fix the risk at least in the P&L account? The accounting rules (IFRS 9) that allow a company to account for a hedge to match P&L impacts of the hedge to the underlying risk are complex and tightly written. If the hedge does not qualify as an ‘effective’ hedge⁶, the derivative could be marked to market in each set of accounts, giving a lumpy profit or loss that does not match the underlying liability.
6. There is no such thing as relationship banking in derivatives. Companies W, X and Y all trusted their relationship banks and thought that there was a mutual interest in helping a customer. In fact, derivative trading is a tough numbers game, with large profits and bonuses at stake. The bank that sells the derivative is quite likely to sell it on to another financial institution very quickly after it has sold it to a customer. In this way its profit and bonus are locked in on day one, and the bank may have no further role or responsibility⁷.
7. You don’t have to hedge every risk. Boards need to decide how much risk they are willing to bear (their “risk appetite”) and then model how much risk would there be if you didn’t hedge. For example, say your annual profit is £100m, and you wouldn’t want an increase in interest rates to hit you by more than 5%, ie £5m. You could therefore accept a ‘value at risk’ of £5m. If your floating rate debt is £150m, that means that you would accept a risk that interest rates would go up by 3.3% (ie 5/150). If you think it is very unlikely that rates would go up so much, then you do not need to hedge at all.
8. Swaps are potentially very dangerous. Theymay well not be the most appropriate hedge. In the preceding example, if you think that there is a chance rates could go up by 3.3%, you could buy a derivative (a ‘cap’) that pays out only if interest rates increase by more than this. Options, by their nature, are less dangerous as you don’t have to take them up. There are many different types of derivatives, but remember that the more complex and the more difficult to understand, the more risk this creates.
9. Only agree to a hedge that is tightly and precisely related to a specific existing risk. Hedges are not transferrable. A key reason why companies W and Y were willing to have an over-hedged position was that they persuaded themselves that they would always have some variable rate debt that they could ascribe the hedge to. It meant that they had to turn down attractive fixed rate debt, because they needed variable rate to justify the hedge. Y found that it just didn’t need, and couldn’t afford, as much debt over time. You just can’t hedge something that doesn’t exist. It’s like taking out an expensive car insurance policy just in case you ever buy a car.

Eight questions a non-exec should ask about a hedging proposal

1. Does the size and tenor of a proposed derivative exactly match that of a specific risk that already exists?
2. Do both the risk and the hedging derivative have the same break clauses?
3. Is the hedge treated as effective under IFRS9, and if not, why not?
4. Has the company had independent advice from a 3^rd party expert, and if so, what did it say?
5. What other forms of derivatives could the company take out, especially as an alternative to a swap?
6. What is the value at risk, ie what possible liability are they hedging? Is the value at risk bigger than we are comfortable with (if not, why hedge at all)?
7. Is the derivative effective as a cash flow as well as profit hedge? Are there circumstances where the company would need to make cash margin payments or terminate the derivative at a cost that exceeds any contemporaneous profit benefit?
8. If the risk goes away for any reason, what are the implications of getting out of the hedge?

Summary

Hedging is a very complex area, and I have barely touched the surface in this article. However, it is the complexity that usually hides the risks that many hedges introduce. At heart however, hedging is a simple activity – to reduce financial risk. If the CFO cannot answer these questions in a manner that is understandable to a non-executive, do not approve the proposal.

After all, it’s never a good idea to leap over a hedge if you don’t know what’s behind it.

Notes

1. A major reason for the 2007/8 Great Financial Crash was that even the bank management didn’t understand their own derivatives, and certainly not the full risks that they were incurring.
2. I am not a banker nor an expert in derivatives. This is just some practical cautionary words based on my own experience seeing companies trying to hedge risks.
3. I focus on swaps here, as they are some of the most dangerous derivatives, but there are many different, complex and exotic derivatives available. You should distinguish however between derivatives that force an outcome (such as a swap) and those that allow, but don’t force, you to do something (such as an option). The latter are usually less dangerous by nature.
4. All of these articles focus on when the hedges go wrong. Of course, sometimes a company can get lucky and a poorly designed hedge becomes profitable. That however is not the objective of a hedge.
5. People tend to focus on the short-term LIBOR, but a long-term derivative is priced to the forward LIBOR. When short term rates are very low, as now, you would usually find that longer term rates are higher as markets expect interest rates will rise one day. So if the CFO tells you that 3 month LIBOR is 0.5% and surely can’t go any lower, ask to see the yield curve (ie future interest rates) and suggest that it could flatten.
6. The fact that a hedge doesn’t qualify under IFRS9 as an effective hedge does not mean that it isn’t a useful hedge. It is however a warning sign.
7. By no means are all toxic derivatives the result of misselling. However there have been many accusations of banks misselling derivatives, although few successful legal actions by companies. The courts have generally been unsympathetic in these situations as judges deem companies to be innately financially sophisticated and so should have been understood what they were buying.