Credit Risk Management Post Dodd-Frank and MF Global April 11, 2012

1. Credit Risk Management Post Dodd-Frank and MF GlobalApril11, 2012 Vince Kaminski Presentation to the CFA Society of Houston

2. Credit Risk

3. Credit Risk • The risk of losing market value due to changes in your own or counterparty credit quality and / or counter party failure to perform • Three conventional wisdoms • Credit risk management is limited to analysis and mitigation of counterparty credit risk • Credit risk arises exclusively from a counterparty bankruptcy • Financial innovations reduced overall market and credit risk

4. Credit Risk (2) Walter Bagehot: If you have to prove you are worthy of credit, your credit is already gone.

5. Credit Risk (3) Again, it may be said that we need not be alarmed at the magnitude of our credit system or at its refinement, for that we have learned by experience the way of controlling it, and always manage it with discretion. But we do not always manage it with discretion. There is the astounding instance of Overend, Gurney, and Co. to the contrary. Ten years ago that house stood next to the Bank of England in the City of London; it was better known abroad than any similar firm known, perhaps, better than any purely English firm. The partners had great estates, which had mostly been made in the business. They still derived an immense income from it. Yet in six years they lost all their own wealth, sold the business to the company, and then lost a large part of the company's capital. And these losses were made in a manner so reckless and so foolish, that one would think a child who had lent money in the City of London would have lent it better. After this example, we must not confide too surely in long-established credit, or in firmly-rooted traditions of business. We must examine the system on which these great masses of money are manipulated, and assure ourselves that it is safe and right. Walter Bagehot, “The Lombard Street,” London 1873

6. Credit Risk (4) • Most energy companies have specialized units responsible for management of credit risk at the corporate level • Credit risk management is particularly important to energy trading operations • Management of credit risk requires cooperation of professionals with multiple skills, using different conceptual frameworks and languages • Lawyers • Risk analysts • Quantitative modelers

8. Credit Group’s Responsibility • Development of systems and procedures for assessment and management of credit risk • Development of the counterparty data base • Negotiation of credit agreements with trade counterparties • Establishment and enforcement of credit lines and credit limits • Assessment of credit risk related to • Specific transactions • Different counterparties across all the transactions • Overall credit risk of the entire portfolio • Mitigation of credit risk

9. Credit Risk Measurement

10. Credit Risk Measurement • Credit risk can be measured at the level of a single transaction or the entire portfolio • Credit risk of an individual transaction may be measured as current + potential risk • Current credit risk of a single transaction is the cost of replacing the transaction in the market place in case of the counterparty default • Portfolio credit risk requires assessment of credit risk across a portfolio of • Different transactions with the same counterparty • In case of transactions with the same counterparty netting may apply (assets and liabilities netted) • A portfolio of original transactions with many counterparties, possibly supplemented with risk mitigation instruments

11. Credit Exposure Credit Exposure Current Potential Accounts Receivable Current Unbilled Exposure Current MTM Potential MTM Provisional Unbilled Exposure Source: Jones School, Rice University

12. Potential MTM Exposure 1 Year Swap “Maximum” Potential Forward Exposure Exposure 95 % Confidence Interval 50 % Confidence Interval Threshold Current MTM 1 Year 3 Months

13. Bilateral Credit Risk Management

14. Credit Risk Mitigation • Credit Agreements • Credit Limits and Credit Thresholds • Collateralization of Credit Risk • Netting • Credit Risk Hedging • Credit Derivatives • Credit Insurance

15. Master Agreements • Master credit agreements cover netting, set-off, cross-default and collateral arrangements • The templates are provided by a number of standardized documents: • International Swap Derivatives Association Inc. ― Master Agreement (ISDA) • Edison Electric Institute ― Master Purchase & Sale Agreement (EEI) • Western Systems Power Pool ― Western Systems Power Pool Agreement (WSPP) • North American Energy Standards Board ― Base Contract for Sale and Purchase of Natural Gas ― (NAESB) • Gas Industry Standards Board ― Base Contract for Short-Term Sale and Purchase of Natural Gas (GISB)

16. Master Netting Agreements • Benefits. Master netting agreements: • Reduce credit risk • Free up cash and corporate guarantees • Facilitate integration of risk management systems and allow for development of Enterprise-Wide Risk Management System • Reduce legal overhead requirements • Master credit agreements should address the issues of netting • Across different product lines • Across physical and financial transactions • Across different jurisdictions • Many provisions of the credit agreements have not been tested in bankruptcy

17. Credit Thresholds and Credit Limits • Bilateral credit risk is managed primarily through the establishment of the credit limits and credit thresholds • Credit limits define the maximum credit exposure with respect to a given counterparty • Additional transactions require approval of the credit department • Credit thresholds define maximum credit exposure that does not require posting collateral • Once credit exposure exceeds the credit limit, the excess credit exposure will be collateralized • Credit thresholds can be adjusted based on the credit ratings changes or the so-called MAC clauses in credit agreements

18. Setting Collateral Requirements • Collateral provides a level of assurance regarding counter-party performance – “bankruptcy safe” • Once credit threshold is set, collateral is normally required for transactions that exceed this threshold • Example, counter-party has been extended $20MM of credit based upon its BBB+ investment grade rating and certain financial characteristics • Transaction with counter-party is now marked-to-market at $25MM • Counter-party must provide $5MM of collateral • Counter-parties below investment grade • Collateral is usually 100% (or more) of the marked-to-market amount of the transaction • Frequent use of over collateralization (O/C) for these counter-parties (>100%) • Counter-parties prefer O/C over contract termination

19. Threshold Example

20. Setting Collateral Requirements • Material adverse change in financial conditions (MAC) language allows either party to increase its collateral requirements or terminate contract • If financial conditions imply performance impairment: • Counter-party must post-adequate assurance • Thresholds may be reduced (possibly to zero) • Reduction of credit thresholds may start a death spiral • Credit downgrade below investment grade has similar consequences • The potential for death spiral

21. Problems with Using Collateral Requirements • Differences in transaction valuation between counter-parties • Illiquid markets • Often a negotiated value is used by the counter-parties • Valuation differences are often split 50-50 – potential collateral shortfall may result • Disturbing trend – credit personnel negotiating contracts lacking experience in financial valuation techniques • Time lag of transaction valuation vs. receipt of collateral (2 - 5 days) • Linking a subsidiary with the parent company (establishing parent-child relationship) is a challenging task • Many financial firms offer hedging instruments combined with automatic credit lines (secured with physical assets) that can be used to post collateral

22. Problems with Using Collateral Requirements (2) • Major risk: re-hypothecation • This is a critical risk that has no been recognized by the industry • Comingling of collateral with the firm’s own fund and using it for general corporate purposes • Re-hypothecation is the mechanism behind the growth of shadow banking • Differences between the US and UK laws governing re-hypothecation

23. Central Clearing Counterparties

24. Central Clearing Counterparties • Clearinghouse mechanics • A bilateral transaction is broken up through a process called novation into two transactions • A clearinghouse is inserted between two original counterparties • The concept of a clearinghouse was developed in France • Caisse de Liquidation des Affaires en Marchandise (1882) • Predecessors • Dojima: rice futures market in Osaka, Japan, in the 18th century • Coffee Exchange in New York City

25. Bilateral Clearing

26. Central Clearing • CCP

27. Central Clearing Counterparties (2) • Two CCP designs used in practice • Vertical, integrated structure: a clearinghouse owned by/associated with an exchange • An example: The CME • A horizontal structure: a CCP accepting for clearing transactions executed on multiple exchanges • An example: London Clearinghouse • A trend towards establishment of vertical structures

28. Mechanics of Clearing • Novation • Both counterparties post an initial margin (performance bond) • The positions are marked-to-market (usually twice a day) • If the equity in the account of a counterparty falls below the so-called maintenance margin, variation margin has to be posted • The failure to post variation margin triggers liquidation of positions

29. Central Clearing Counterparties (3) • CCPs have a number of safeguards to protect against a default by a clearing member, other members and their clients • Such measures include (in addition to marking-to-market and margining) • Defining financial strength thresholds for clearing members • Audits of clearing members • Strict governance rules for the CCP and clearing members • The right to liquidate and/or transfer positions of clearing members and their customers • Default fund and additional insurance

30. FCM • FCM (Futures Commission Merchant) • Executes orders to buy or sell futures or options on futures • Collects from customers funds or other assets to support these orders • Funds collected from the customers remain their property and cannot be comingled with the FCM’s own assets • There are currently 65 FCMs in the US • Top 30 FCMs held over $163 billion of customer funds as of March 2011 • An FCM typically collects more funds than the minimum required by a clearing organization

31. FCM (2) • The CEA and CFTC regulations require that the customer collateral received by FCMs be segregated • An FCM is allowed to invest funds held in the customers accounts • CFTC Rule 1.25 determines what are allowed investments • The value of customer account must remain intact all the times • FCM are subject to the CFTC regulations which are enforced by DSROs (Designated Self Regulatory Organizations) • Regulation 1.10 • Regulation 1.16

32. FCM (3) • Regulation 1.10 • The CFTC Regulation 1.10 requires FCMs to file monthly unaudited financial reports with the Commission and the DSRO • Segregation and net capital schedules details • “Further material information as may be necessary to make the required statements and schedules not misleading.” • Reports are filed under oath (CEO or CFO)

33. FCM (4) • Regulation 1.16 • The CFTC requires FCMs to file annual certified financial reports with the Commission and the DSRO • Audits requirements include: • Information about disagreements with statements made in reports prepared by prior auditors • Inadequacy tests for internal controls that may inhibit an FCM from effectively protecting customers’ assets or result in violation of the CFTC’s segregation requirements

34. Lessons Learned

35. Recent Developments: DF • Dodd-Frank requires mandatory clearing of standardized derivatives • Exemption for the end-users of derivatives • A likely outcome: proliferation of clearing houses • “As long as the clearinghouse is well capitalized and manages its risks well, there is no material counterparty risk with the clearinghouse. This fact explains the widely-held belief that requiring clearing for over-the-counter derivatives will significantly reduce systemic risk. It is important, however, to understand that we have much experience with exchange clearinghouses and little experience with over-the-counter clearinghouses. Over-the-counter clearinghouses have not been tested in a financial crisis.”“Testimony of René M. Stulz to The House Committee on Financial Services”

36. Recent Developments: DF (2) • Potential for concentration of credit risk in a small number of clearinghouses • Clearinghouses may become a source of systemic risk • Solution: • Access to central bank liquidity • Restrictions on clearinghouse membership • Minimum capitalization levels for clearing members • Higher assessments and fees to build up a default fund • Additional insurance

37. Lessons Learned – MF Global • Bankruptcy of MF Global and the curious case of missing funds in segregated accounts • Balkanization of the regulatory infrastructure • The CFTC regulates FCMs but lacks resource to implement effective oversight infrastructure • The day-to-day oversight responsibilities are delegated to the DSROs • The trend towards demutualization of exchanges creates profit pressures • The CFTC rules covering FCMs will be rewritten • The CFTC is likely to receive additional funding to enhance oversight of FCMs

38. Lessons Learned – MF Global (2) • Consequences and potential remedies: • An adverse impact on the efficiency of the US economy • Risk management principles should be revisited • Are risk managers truly independent? • Changes in management of relationships with brokers • More proactive management and monitoring of the financial conditions of a broker • More effective cash management • Using several FCMs to reduce potential exposure to any single broker