Published: January 02, 2008
The subprime crisis is not just the epicentrer of an earthquake that occurred in the U.S., it is a crisis from which the aftershock, like a tsunami, quickly reached the shores of the European markets, and particularly the monetary fund markets, which had been considered to be risk free and stable. More than just the single-handed cause of this crisis, we can think of subprimes as only the tip of a gigantic iceberg. The impact may be tremendous on a global level, including financial difficulties for certain credit institutions (such as Northern Rock, IKB and Sachsen), as well as doubt cast on an entire weakened sector, a lack of confidence in the interbank loan market, a rise in the cost of credit, and increased credit spreads even with a risk of credit crunch. Paradoxically, all of these consequences have occurred despite an extremely liquid environment, with companies that have never been so financially healthy.
One big question still remains about these products. Who owns what? It is this lack of clarity that is causing problems. Did we really know what we were investing in? We can’t be too sure.
Shortage and higher cost of credit
Treasurers have had to work twice as hard in these somewhat troubled times. Yet the golden rule of cash management should be applied at all times, particularly when the storm is raging. You must always have a financial ‘safety net’ to ensure the survival of operations. The best prepared treasurers had committed facilities and backup lines to ensure liquidity and compensate for the failings of the commercial paper (CP) market. They did not suffer too greatly from the increase in credit margins and the credit shortage. The treasurers who had to borrow during this period without previously signing an underwriting agreement saw their financing costs rise and the issue of their credit sometimes delayed. We can assume that the cost of this underwriting service will worsen in the coming months. Some bankers, particularly the Americans, have suffered from delays in setting up syndicated loans.
Fortunately, many treasurers have reaped the benefits of the financial health of their respective companies over the past few years. Many of them are sheltered because they have little or no debt.
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Less expensive assets and a return to the ‘equity’ currency
The good news is that stocks are once again becoming an exchange currency worth considering. Likewise, asset valuation multiples have decreased. This will make assets more affordable to purchase. In addition, the refinancing difficulties encountered by venture capitalists and other private equity funds will ease the inflation in M&A prices that we have seen over the past few years. No one will complain.
Favouring quality over yield
Treasurers have decided to fly to quality and the purest possible monetary funds. Triple A-rated American funds are popular for the stability of their yield, even in this crisis, and for the rating quality offered. This flight to quality will be good for the most stable issuers, particularly the corporate ones.
Less dynamic management
European management has become less active and less aggressive. Investments in funds considered to be ‘dynamic’ have declined sharply, in favour of purely monetary funds, as the term is defined in IFRS 7. Yield is now a lesser consideration than risk, where often, in recent years, the opposite was true. What we were seeing was a race to the highest yield (for example EONIA +15-20 bp ‘all in’). As a result, people resorted to products invested in CDO structures backed by subprime risk, in particular.
Direct management
Some treasurers now prefer direct investment of all or part of their assets in order to avoid this risk and lack of clarity and to have better control over the investments they make. The simple bank account deposit has regained its appeal. Once the commercial paper market turns around, some will invest in it directly. Consequently, now more than ever, diversification is on the agenda for liquidity portfolio management.
Many treasurers have reaped the benefits of the financial health of their respective companies over the past few years.
Opportunity to revise the internal rules of procedure
This summer was also an opportunity to review every aspect of the various internal rules of procedure and policies on operations and investments. CFOs will begin to exert better control over liquidity surplus management.
Seeking information and dialogue with managers
Treasurers are seeking more information from their banking counterparts. What are the underlying securities in which they are invested? What risks are they incurring? Now more than ever, benchmarks are essential. How are they performing compared to other funds? And finally, what are other treasurers doing? (simply for validation of their choices)
Sensitivity tests such as V@R could also be used for MMFs. In the future, managers will have greater information obligations with respect to their clients, the current MiFID context notwithstanding.
Fewer buyback transactions
Buyback transactions could decline, as has already been observed in the U.S. since this crisis began. This marked decrease is indicative of a real fear on the part of companies of a prolonged shortage of access to credit and an economic slowdown, which has resulted in fewer buyback transactions (September was the slowest month in over four years in the U.S.). This decrease reflects the cautious approach adopted by American companies in dealing with possible pressure on access to credit. Some companies took advantage of these low interest rates to finance buybacks with debt. This will have an impact on earnings per share (buybacks accounted for one fifth of the growth in the S&P 500). Corporates want to ensure that they will have sufficient liquidity reserves so that they are prepared for a turnaround in the economic trend that many are predicting. McDonald’s may run the risk of having its rating changed, since it has confirmed its intention to increase dividends and buy back stocks. [[[PAGE]]]
Associations such as the IMMFA have a major role to play, particularly to encourage this transparency. Treasurers’ associations have an obligation to inform their members. Yet this issue has been the topic of many heated debates for many of them since the crisis began. The perverse effect is the suspicion created, causing us all to mistrust one another and the products offered. Banks, associations, managers, rating agencies and regulators must work together to restore this waning confidence.
Rating agencies have been criticized for their slowness and unresponsiveness. They are sometimes known to act suddenly, but late, according to investors and governments such as the European Union. In fact, the stock market has penalized the agencies or their shareholders (Moody’s -40%, McGraw-Hill, which owns S&P -35%, and Fimalac -40%). We may even see some agencies sued by investors who got burned. They will go right to the source for their money. Let’s not forget that in 1994, Orange County was reimbursed 140,000 USD for its ratings fees. The State of Connecticut unsuccessfully attempted a similar lawsuit in 2001 as a result of the Enron ordeal.
Now more than ever, benchmarks are essential.
The rating agencies will revise their procedures for rating complex financial instruments and providing investors with information.
Moody’s has also announced its intention to reform its procedures for complex instruments as a result. They will also address liquidity and market value risks, which indicate an instrument’s risk of default, in response to criticism and requests from regulators and governments.
Bank mergers will find a catalyst for the next phase of consolidation in the sector. Treasurers may find that they have fewer partners than before, but these partners will also be more stable. The cream of the banking sector will certainly rise to the top. As with any crisis, ‘every cloud has its silver lining’, as the saying goes. We can hope to see an improvement in practices and in the market. With the closure of Q3 accounts, not a day goes by without announcements of significant losses (such as UBS, WestLB, CS, Citigroup, and others).
The positive aspect of this crisis is that certain practices of certain monetary funds have come to light (we mustn’t generalize). Yet, they were considered to offer low risk on principal invested and yield approaching that of a rate index (such as the EONIA overnight index). This crisis has had an impact on many managers. For example, in France, the total amount invested in this type of fund lost nearly EUR 20 billion. This is a massive loss. When we take a closer look, we can see that they may not be as monetary as we thought. There is more than just bond risk and short-term floating rates. There are also asset-backed securities (ABS). Many other institutional investors, pension funds and other hedge funds were, themselves, heavily invested in these monetary funds.
Treasurers may find that they have fewer partners than before, but these partners will also be more stable.
Treasurers have sometimes had blind trust in these funds, which they wrongly thought were almost risk free, and when it came to more ‘dynamic’ funds, they believed that there were no major risks. The siren song of high yield seduced them into a state of complacent euphoria. The month of August gave them a rude awakening.
This crisis is more than just a tornado that simply comes and goes. Market participants, and treasurers most of all, understand that it will undoubtedly last a few months. If there is one thing we can be sure of, it is that it will take some time to heal.
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