Avoiding the Icebergs: Mitigating Financial Disaster
by Martin Bellin, Founder and CEO, BELLIN GmbH
It was the middle of the night and as RMS Titanic floated through the North Atlantic, ladies and gentlemen, elegantly dressed, sat in the lounge drinking champagne without a care in the world. The iceberg didn’t come as a complete surprise; the captain knew they were in dangerous waters, the crew was watching for ice, but everyone thought that the ship could take it. Yet when the iceberg hit, the ship was torn apart, and the glitz and jewels of that night, April 14 1912, sank to the bottom of the sea.
It can be tempting to see our corporate enterprises as the White Star Line of Boston Packets saw RMS Titanic: masterfully structured, intricately protected (be it by financial instruments or inch-thick steel), big enough to survive even the largest problems that might come its way. Yet when struck by the iceberg of frozen liquidity, a corporation too can sink, and the 2008 recession brought the chill of that iceberg to the decks of many a company. But while Captain Smith relied on reports from the lookout, with little information about structure of the ship, we can use centralised treasury information, technology and processes to fully understand our liquidity today and tomorrow – and avoid disaster.
You shouldn’t need to be warned that we are currently in dangerous waters, and indeed we have been for the last 30 years or so. Globally, we’ve been through one crisis after another: the Latin American debt crisis of the 80s which resulted in such a liquidity crunch that entire nations (Brazil and Mexico) ended up defaulting; the ‘87 ‘Black Monday’ stock market crash which dropped the Dow Jones by 22.61%; the Japanese asset price bubble from 1986-1991, which saw stock prices plummeting to half of what they were at its peak; the US savings and loan crisis; then the dot com collapse. Not to mention numerous national/regional crises.
Due to the evolving global market economy, increased trade relationships, and the advance of global capital, the impact of these crises has increased in severity, making it more challenging to navigate and find a safer financial route for corporations.
Then 2008 hit. If the last 30 years were troubled waters, 2008 was the sudden drop in temperature on the night of the impact. There were a multitude of financial effects: FX fluctuations, commodity rate fluctuations, etc. all which can have significant impact on the bottom line, but they will hardly sink the ship. What hit hard during the financial crisis was the limiting of bank loans, which before were relatively easy to access and fairly inexpensive. In most cases bank loans could be provided but now with a much higher cost of funding, especially due to increasing risk adjusted premiums. Today’s treasury departments need to incorporate the future potential risk premium in interest yield curves – and eventually shortages in liquidity – when they perform scenario analysis.
What’s your iceberg?
Like an iceberg in the ocean at night, these problems can be hard to foresee. For some they come in the form of changing markets, restricted borrowing, or even sometimes something as innocent looking as a contract provision.
The latest financial crisis also showed the impact that loan documentation clauses such as ‘material adverse change’, ‘cross default’ and ‘negative pledge’ could have, quickly becoming problems for both parties. Sure, they were meant to protect against placing any one lender in advantageous situation over another, but they also caused very quick and uncontrollable situations for companies in a market that didn’t behave ’normally’ – restricting control of a company’s liquidity.
So how do we know when we have a ’material adverse change’, especially for an undrawn Revolving Credit Facility? When one debt cross-defaults, suddenly the house of cards falls. A negative pledge prohibits any collaterised borrowing – unless exempt assets have been clearly defined. Other covenants may protect lenders, but we should ask ourselves if these covenants aren’t a devil in disguise for both parties, especially given the potential for future financial crises.
As a treasurer, you should ask yourself:
- Have you included these scenarios in the risk management planning? And if yes, how is that included in the future liquidity forecasting?
- As a consequence of the latest financial crisis bankers have constructed many new and complex credit structures, but have you tested them against a potential future financial crisis similar to or even more severe than the last?
- Do you have a centralised, real time-reliable system for all agreed covenants that can be easily viewed and assessed per facility, per type and per counterparty?
These questions are especially important if you have a global organisation with full or partly decentralised borrowing mandates.