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Saturday, December 27, 2008

Plus ça change, plus c’est la même chose: Margining and Value at Risk – is there a better way

The concepts, ‘margining’ and ‘value at risk’ led the global financial system into a very dangerous place recently, but there is no sign that they are being challenged. Is anyone searching for or developing a better way to deal with ‘future risk’ in price volatile commodity and associated derivative markets?

When margining is in place and prices move against a company’s position its counterparties feel safe because they receive cash daily to cover their revised net exposure. That is the amount that would be due to them should the company have gone bankrupt at the close of business the previous day.

Additionally, a value at risk calculation – based on probability (gambling) theory – informs the management of the counterparties daily how much exposure they may incur during any necessary close-out period following a default, say five or 10 days, with a mathematically calculated degree of certainty. Thus empowering the management of counterparties to call for additional ‘initial margin’ or ‘adequate assurance of performance’, if it is felt that such ‘close out period related exposure’ is excessive. Let us remember at this point that value at risk calculations have proved to be nonsensical and useless in many cases, despite the claim that they provide a 95% or 99% degree of mathematical certainty.

Value at risk (VaR) calculations are based on the assumption that markets will behave in the future – as to price volatility and trend – in the same way as they did in the past. Such an assumption is patently spurious, hence the failure of VaR calculations to be of any use in a crisis situation. Nevertheless those who manage and regulate our financial markets cling to the belief that VaR calculations are capable of predicting such ‘worst case’ crisis or extreme situations.

In times of extreme price volatility or price spikes, margining drains the liquidity of companies that are on the wrong side of the price movement, particularly if they are either ‘market makers’ with open (un-hedged) positions, or physical commodity consumers that have to wait for the cash arising from the transaction hedged, thus are unable to find the cash to ‘post’ margin immediately.

If a company is thought to be having difficulty finding cash to pay (post) margin immediately it is often downgraded by the infamous S&P, Moody’s or Fitch, and immediately faces increased margin calls on existing positions hence its end in bankruptcy becomes more certain and more immediate.

At the point of bankruptcy, those counterparties that have secured their positions cheer, then pat themselves on the back and gloat as the zero sum game they play sees another august competitor brought to its knees by lack of liquidity alone.

The schadenfreude moment is short-lived however as counterparties scramble to replace the hedges lost as a result of the bankruptcy.

When Lehman Brothers was destroyed many counterparties lost millions through the need to replace hedges in the midst of the panic that followed, as good old ‘demand and supply’ drove prices to spike beyond anything forecast by any VaR calculations.

Do we have to suffer this cycle repeatedly?

The markets continue to use margining (against daily mark-to-market calculations) so it seems inevitable that the Lehman Brothers fall-out scenario will be repeated time and again, perhaps not so spectacularly nevertheless some fine companies and many jobs will be destroyed in the process. Following the Enron debacle, we saw a similar episode almost destroy Dynegy but the margining and VaR concepts were not questioned at that time.

The margining and VaR concepts and related practices need to be reviewed urgently since they appear to be unsound and unsuitable foundations upon which an untold number of interlocking financial transactions are built. The potential consequences of the failure of these concepts to protect markets have been presented in the stark reality of the ‘credit crunch’.

The danger to global financial markets persists and will persist as long as such crude and impractical tools are considered adequate. Therefore now is the time to re-examine the way in which future risk (performance and delivery) is assessed and how related exposure to counterparty bankruptcy risk is secured.

More information is available in the presentation and articles found at: http://www.barrettwells.com/CVaREnergyRiskFeb2008web.pdf,
http://www.barrettwells.co.uk/performance.html, and
http://www.barrettwells.co.uk/crmsforum.html.

Please post your ideas and comments on this subject, or write an article for a professional journal.

Ron Wells