How do derivatives affect capital structures?

Question

Yesterday, I was at a lecture where the speaker said that the impact of derivatives was often to make senior debt, in effect, subordinated debt (in terms of priority, recovery rates, etc.)?

How do derivatives accomplish this result? Are they usually listed on the balance sheet? (I have thought that most of the time, they were off balance sheet contingent liabilities)? Does one need to "recast" the balance sheet to display their position/impact, even if they are technically off balance sheet? Or is it the case that they weaken the income statement, basically the interest and debt service coverage ratios to the degree that formerly "safe" senior debt is no long so safe?

Answer 1

Accounting for derivatives varies by jurisdiction and by user type, so let's not get bogged down in that. Let's focus on the economics: derivatives are usually legally pari passu with senior debt (have the same seniority in bankruptcy). However, they may in effect get paid earlier- for example, derivatives are usually subject to a CSA (credit support annex) which causes any mark to market losses to be paid on a daily basis. Hence if an entity is heading towards bankruptcy, the derivatives liabilities may get paid before the senior debtholders. In addition, there is new proposed legislation for US banks that would force banks to issue debt that is subject to a "bail-in" provision (this means that debtholders in the event of an insolvency), making this debt specifically junior to derivative liabilities.

Answer 2

I suspect that your lecturer might be right; but for all the wrong reasons ;-)

If a company uses derivatives to hedge its balance sheet, these assets/liabilities are effectively working capital. Its position with the CME/CBOE is no more (legally) senior or junior than its liabilities to John the plasterer, for doing up the Houston office last month. The exchange/central-counterparty is just another short-term payable or receivable. As such, it is subordinate debt, if it goes wrong. But since the company has to mark-to-market and margin daily, this subordinate (legal) position can economically trump (legally-superior) obligations.

The senior debt is thus not subordinated in any way; but the company can use subordinated tools to make the seniority of senior debt effectively irrelevant. Thus it become subordinated, to your lecturer's point.

From an accounting perspective, only the current value at the reporting date is reported in the accounts. The footnotes to the accounts MIGHT reveal more; but the scale of a potential gain or loss is not recognised as either, so no accounting recognition thereof of market risk.

Financial derivatives are thus effectively off-balance-sheet, except in-so-far-as they realise and generate cashflow! How are the accountants supposed to value an option, when the bankers and hedgees disagree about this? :-)

Answer 3

Senior debt has the highest priority in bankruptcy and therefore the lowest risk. Thus, this type of debt typically carries or offers lower interest rates. Meanwhile, subordinated debt carries higher interest rates given its lower priority during payback. A borrower's credit credit evidences their ability to repay debt. A stronger borrower would have a better credit rating ('AAA' rating) where a weaker borrower would have a weaker credit rating ('B' rating).

The credit spread on the borrowers issued debt considers two factors - 1. Loss given default (i.e. senior/subordinated) and 2. probability of default (borrower credit rating). The interest rate a borrower pays on the issued debt compensates the purchaser for includes a credit spread. The higher a borrower's risk of default and the expected loss if there was a default, the higher the interest rate required for someone to purchase the borrower's debt. It wouldn't make sense for a borrower to provide a collateral default swap on their issued debt because the premium (cost) the borrower would have to pay on the swap to another institution for guaranteeing repayment on their debt would probably be slightly more than the savings they would get from a lower interest rate on the issued debt.

An indenture is a is a formal debt agreement that establishes the terms of a bond issue (senior/subordinated). An ISDA is the agreement that establishes the terms of a derivative such as an interest rate swap. If the ISDA Agreement requires the borrower to post collateral in the event of default on the interest rate swap payment then the company maybe forced to issue the bond as subordinated as they may have no more collateral to post for the bond. There could also be cross-collateralization betweeen the two (indenture/ISDA) if the derivative and bond are executed between the same parties (borrower/purchaser).

Derivatives are off-balance sheet. GAAP requires a company to disclose the fair value of all its financial instruments (both assets and liabilities), whether recognized or not on the balance sheet. So public companies report derivative values and their impact on income in the footnotes of their financial statements (10-Q, 10-K). An analyst therefore analyzing two different companies (one with reported derivatives and one without reported derivatives) should consider the reported fair value of derivatives in the footnotes. The analyst could add that fair value to the balance sheet as a asset/liability depending if the derivatives have a positive/negative fair value. Then the analyst could determine their financial ratios which would be based on a better apples to apples comparison of the two companies.

Derivatives could strengthen or weaken the income statement. For example, a borrower could enter into an interest rate swap to hedge the interest rate risk of their issued debt. If the borrower wanted to hedge against falling interest rates the borrower would elect to receive fixed interest payments over an agreed upon period of time and pay floating interest payments on the swap (derivative). The floating interest payment would be based on an index (i.e. 1 month LIBOR + 1.5%). In this scenario, the income statement then would strengthen if the 1 month LIBOR rate went down during the period or weaken if the 1 month LIBOR rate went up during the period.