Microsoft got its credit risk management stress test when Circuit City approached insolvency just as the 2008 holiday season arrived. "We had to have our hardware and software on retailers' shelves for the holidays," says treasurer George Zinn. "The business expected it. But we could see Circuit City's credit quality vanishing. So we chose to sell our hardware on consignment. It was there on the shelves for shoppers right up until Circuit City closed its doors. Then we sent in our trucks to pick up our hardware. It was the ultimate compliment to our collections team that we didn't even make the creditors' committee."
The deep global recession is making the job of managing credit risk more difficult and more critical. Treasury and credit pros, suddenly in the spotlight, are buying more intelligence, running the credit and collections machinery in high gear and gingerly exploring what's left of the credit derivatives market. After years of relative obscurity, credit performance is now discussed at almost every board meeting, says Phil Gootee, president of Global Credit Services, a credit risk management firm in New York City.
"The line of visibility from the board through the CFO, treasurer and credit manager to the credit analyst is now clear," he notes.
Microsoft was ready for situations like Circuit City because the growing risk had inspired its treasury to adopt a 360-degree view of credit risk, Zinn says. All exposures--investments, trade credit, bank balances and hedging counterparties--are pulled into one inclusive report, and that visibility provided some surprises. "One exposure we honed in on after seeing a report was the automobile sector," he reports. "What surprised us was how much of the exposure came not from selling software to big auto but from online advertising receivables."
Microsoft takes exposure visibility literally. The top 25 exposures are shown as colored balls on a chart whose x and y axes represent the size of the accounts receivable and the percentage delinquent, respectively. The bigger the ball, the bigger the all-in exposure, Zinn explains. And as an account's credit quality deteriorates, the ink literally changes to red, moving across a green-to-red spectrum.
Other companies also are sharpening their tools. "We now include not only an assessment of the counterparty's historical financials," says James Haddad, vice president of finance at $1 billion Cadence Design Systems in San Jose, Calif., "but we've added, where possible, analyst reports on the company and even on its business sector. We also include a third-party default risk monitor as a guide when evaluating the need for a specific reserve, and we watch credit default swap rates."
Acting on what you know means closer coordination than ever between finance and sales. "We frequently include sales in discussions with customers where the payment is delayed beyond 60 days," Haddad says. "I and the credit/collections team management that reports to me get involved with specific problem accounts and don't hesitate to escalate involvement within the sales organization leadership when we need to." Compensation plays a role. At Cadence, "a portion of the credit analysts' comp is tied to collection metrics," Haddad reports.
In this market, any disconnect between sales and finance could be fatal, warns Jerry Flum, CEO of CreditRiskMonitor in Valley Cottage, N.Y. "Getting sales and credit in the same room is critical. The CFO, the head of sales and the credit manager should all be looking together at the same fact patterns."
One of the clearest signs of the times is the voracious appetite for credit intelligence. When Westwood, Mass.-based CreditPointe started in 2006, it was investment analysts, not treasurers, who signed up first. CreditPointe's pitch to credit managers was "give us the accounts that keep you awake nights," recalls John LaRocca, senior vice president for marketing and business development. But starting in April 2008, treasurers and credit managers began to buy reports on even their strongest customers and sometimes on companies that weren't customers. The reason: "They have to give reports to senior management that show comparative risk," LaRocca says. And they want to put credit research into familiar reporting formats so that it's easy for senior management to understand what is happening, he adds.
Effective reporting needs to show results at both the individual customer level and the portfolio level so senior management can see developments "from 40,000 feet," says Global Credit Services' Gootee.
What kinds of intelligence do treasury staffs want? "We're getting more requests for analysis of footnotes in financial statements," LaRocca says. "They want to know if their customers are complying with their loan agreements or renegotiating any covenants. And they want to see trends--projections of whether their customers will be able to comply with loan covenants six months from now."
"Better predictive risk monitoring should give legal departments time to prepare for possible bankruptcies," says Patrick Finegan, principal for enterprise risk management at Towers Perrin in Stamford, Conn. Prepare to do what? If your company provides equipment to a line of business that is profitable, for example, legal can start to work far in advance of a bankruptcy filing to see that the line of business survives the reorganization or liquidation, perhaps through an arranged sale to another company that would keep it operating, he explains.
Of course, treasury staffs would like to transfer credit risk to someone else. Some now wish they had bought credit insurance, the traditional risk transfer tool, a couple of years ago. Applications for credit insurance are up 60% at Coface North America, reports Michael Ferrante, president and CEO of this major underwriter based in East Windsor, N.J. But the premiums Coface takes in are up only 10% to 12%, even with double-digit price increases, Ferrante says, because underwriting is much tighter. "We're underwriting more conservatively. We almost always turn down certain accounts in the portfolios we insure. In today's market, it's hard to tell where the next problem will surface." Coverage is no longer available on auto companies or auto suppliers, and credit insurers are now taking a close look at the suppliers to the suppliers of automakers, he reports.
For Paris-based Euler Hermes, another big credit insurance underwriter, 2008 brought a 41% increase in applications for insurance over 2007. But business grew only 24% as underwriting tightened. "In our 115-year history, 2008 was the greatest year for new business development," says executive vice president Joe Ketzner. The company's U.S. operations are located in Owings Mills, Md.
So demand is up, supply is down and prices are high. Zinn expresses a skepticism shared by many corporate treasurers: "The market is very efficient and credit insurers are expert and attentive. By the time you'd look for insurance, it's smarter to absorb the loss than pay the premium."
Derivatives like credit default swaps or put options on receivables offer newer, less familiar ways to transfer risk, but they're also scarce and expensive these days. Theoretically, the credit derivatives market is a good way to mitigate risk, "but execution has not been good," says Flum, a former hedge fund manager. That market has been hugely dependent on over-the-counter products that are "very individualized and hard to trade," he explains. "And in this recession, there is concern that one side of the contract might not perform and leave the other side naked long or naked short."
While credit derivatives are supposed to serve as a hedge against extreme volatility, they have been shown to have "huge unintended consequences," Flum says. "These are very complicated contracts and not well understood. For those who used them, it was exciting but sometimes lethal."
For a while, credit insurers faced competition from investment bankers offering credit default swaps and receivables put options. "These were growing before the collapse of the financial institutions," says Coface's Ferrante. "They were one-shot deals, done by large corporations to cover large exposures like a $50 million line to a key customer. It was a one-off market, whereas credit insurers were insuring whole portfolios."
Corporate treasurers have employed credit default swaps to hedge credit risk, but the market was primarily used by bank lenders and institutional investors to liquefy bank assets by insuring loans to corporations, explains Sasha Rozenberg, product manager for credit derivatives at SuperDerivatives, which has offices in London and New York. The swaps essentially expanded the secondary market and allowed banks to lend more, making more credit available to corporate borrowers at lower rates during good times. "Banks have limits on the risk they can take. When they transfer some of the risk, they can lend more," Rozenberg says, adding that the credit crunch has now shut down most of that activity. "The market is restructuring itself and will be back in full force soon," he predicts.
Put options--buying an option to put a single receivable to a counterparty if stipulated events occur--provided a way for a corporate treasury to spend serious dollars to offset serious risk and allow a large sale to a troubled buyer to go forward, says Euler Hermes' Ketzner. Default swaps were used mainly for investment-grade debtors, while put options were used primarily with distressed debtors, he adds. Ketzner notes that put options only work when the debtor is a public company with an active market for its bonds, while most trade debtors are private.
The idea of hedging away credit exposure is intriguing but largely irrelevant for the time being. "With the AIG crisis, the credit insurance and receivables put option markets pretty much dried up," says Robert Carbonell, executive vice president and chief credit officer at Bernard Sands, a boutique rating agency in South Plainfield, N.J. "Providers only cover the very low-risk accounts." Factors, which buy receivables without recourse and take the loss if the debtor doesn't pay, are adding a surcharge of up to 1%, based on the perceived risk of the receivable, he adds. "Many manufacturers and wholesalers are keeping more credit risk because of the hard insurance market," Carbonell concludes.
Even old stand-bys like bank trade letters of credit (LC) offer less reliable protection now that trade creditors have to worry about whether the bank can perform, Gootee notes. More treasury staffs are getting large, healthy banks to guarantee LCs from smaller or struggling banks. They are also watching their LC concentration by bank, he adds. One of his clients had acquired LCs as collateral from two banks. The concentration exposure by bank was completely outside the company's risk tolerance level.
The procurement strategy of the past several years, which drove more business to fewer preferred suppliers, is undergoing a stress test because fewer relationships mean greater efficiency but also greater dependency. Companies that buy critical inventory from a single supplier are negotiating back-up deals with other suppliers just in case--and paying for that insurance. "There's little redundancy left," Finegan says. "Losing even one or two key suppliers can cripple the buyer's ability to produce its product." Single suppliers of critical materials can be sure that threatening to hold orders until payment is received will get a quick response, he adds.
With limited help from third parties, treasuries are dusting off some basic tools that haven't seen much use lately. One way to protect yourself is to sell on consignment, as Microsoft did, so that you own the merchandise sitting on the shelves, rather than the merchant or distributor, Gootee says. Another way is to operate a field warehouse within a customer's warehouse--sometimes literally marked off with yellow tape. While it's legally your warehouse and your merchandise, you can help your customers reduce their working capital and shorten the procure-to-pay cycle. But if the customer declares bankruptcy while the merchandise still sits on your side of the yellow line, you can take it back. Operating a field warehouse is cumbersome and expensive, though, Gootee adds.
Sometimes there are steps that can be taken internally to reduce an exposure--something Microsoft is doing. "For strategic reasons, we put $5 billion into AT&T and then took them out of the index we use for our investment portfolio," Zinn explains. "We didn't want to double down on AT&T by keeping them in our investment portfolio."
One creative strategy, Carbonell reports, is putting smaller payments on a personal or business credit card. "I know of one small retailer that routinely keeps his small suppliers comfortable by charging those purchases on an American Express card. The vendors are very happy to collect quickly, and the company may earn rewards or rebates from using the card this way." There may be times when it pays to ask for payment by credit card.
On a macroeconomic level, the dramatic rise in credit risk is partly a result of the very success of credit risk mitigation tools and strategies, Flum argues. "We've done a lot to promote stability and off-load risk, but the more risk companies transfer, the more they leverage up. When you hedge credit risk with derivatives, you feel confident in taking on more debt."
The illusion of safety achieved by theoretically reducing risk has encouraged companies to take steps that increase the consequences of negative developments. "Because the foundation seems stable, you build a skyscraper," Flum says. "It's rewarding but catastrophic when it falls." Whether and how the skyscraper will be rebuilt will be a big issue for treasuries of the future.