For Merrill Lynch Bank, the search for a more reliable risk model dates back to 2001, when the bank was seeing its deposits swell as the result of a program that allowed retail clients to sweep cash from their brokerage accounts into bank deposits. The influx set off a drive to design better lending strategies, and CP backstop credit portfolios were among them. What soon fell under review was the amount of liquidity–an automatic 50% of the value of the undrawn credit line for each CP backstop customer across the board–the bank had historically been setting aside against each backstop credit line. "We took an extremely conservative and blunt approach with the 50% assumed draw level," says Allen Braithwaite, first vice president and assistant treasurer at Merrill Lynch. "We wanted to take a more scientific approach. We had a thirst to get better risk-adjusted returns." What was needed was a reliable probability distribution of liquidity exposure for credit portfolios at various risk tolerance levels. To make the situation that much more challenging, there was no reliable research on CP backstop liquidity risks and no off-the-shelf analytical software. So the bank was forced to develop its own solution.

The answer came in the form of a Monte Carlo model that simulates credit line usage for each company over a five-year period. Using each borrower's timing and the amount of credit use as a function of its credit rating and prior month's use, the model estimates the monthly liquidity requirements of the total existing portfolio of lines of credit. "We built a portfolio approach into the model," says Adeesh Setya, director and treasurer at Merrill Lynch Bank & Trust and Merrill Lynch Bank USA, who oversaw much of the design and implementation of the new model. "It allowed us to capture the diversified effect across the various companies in the CP backstop portfolio." The model establishes probability levels around usages of credit lines based on simulations from a wide number of scenarios. The bank uses that information to quantify its liquidity exposure for a particular risk tolerance level.

Outside inputs provided key metrics as well. With the help of data provided from Merrill's corporate credit group, the model incorporates Moody's Investors Service's credit transition data to establish correlations within and across industry sectors. The mathematical modeling used Arena simulation software as its platform. Merrill's management science group provided technical skills to construct a model that would incorporate correlated random variables to quantify portfolio risk and an easy-to-use interface for running the model and generating reports. A team from credit risk management also helped to develop historical data for revolving line of credit usage, data on industry correlations and business rules governing tranche renewal. An easy-to-use interface was also created to run the model and produce reports.

The results have already won praise: In April, Merrill Lynch was awarded the Daniel H. Wagner Prize by the Institute for Operations Research and the Management Sciences for its CP backstop liquidity risk model.

SILVER AWARD WINNER

Yahoo! Inc.

Last January, Yahoo! Inc. CFO Sue Decker approached Treasurer Gideon Yu with the following request: Come up with a new capital allocation strategy they could present to Yahoo!'s board in March. At issue was what to do with the Internet powerhouse's growing stockpile of cash, which at the time was nearing $4 billion and was expected to increase to $6 billion by yearend. In the earlier days of the company's growth, hoarding cash was seen as vital, given the volatility of business conditions following the collapse of stock prices starting in 2000. But by 2005, Yahoo!'s operations were far more stable, and despite a steady stream of acquisitions, cash and cash equivalents on the balance sheet continued to rise. In addition, since the returns on cash were below its cost of capital, the company's return on equity (ROE) was taking a hit.

Luckily, Yu and his team had already started thinking about the cash "problem" in the months before, and with a two-month deadline looming they sprang into action. What they had to decide was the optimal level of cash to keep on hand for future acquisitions and "insurance" against another market decline, situations that included many unknowables. Early on, the group decided to take a risk-based, strategic approach to its assignment and that the plan would likely include a payout to shareholders. "We said let's look at this as a portfolio of small businesses, including inherent volatilities for each independent business and how they, the business risks, interact with each other," says Yu. "We wanted to make sure the board thought of cash and allocation of capital in terms of risk."

The team developed a framework with the help of outside consultants, including various investment banks and Nobel Prize winner Bob Merton and his financial think tank, Integrated Finance Ltd. It then ran a Monte Carlo simulation on the model to see how much cash would be needed, according to some 10,000 different market and business condition scenarios. The model determined that under a 99% confidence interval, Yahoo!'s downside cash balance scenario is between $1 billion and $2.7 billion, even after factoring for a $3 billion share repurchase.

When Yu and Decker presented the board of directors with their optimal plan of establishing a $2 billion share repurchase plan, the reaction was better than they could have hoped. "Our board, which includes some financial heavyweights, said 'We think your analysis is spot on, let's increase it,'" says Yu. The repurchase plan was raised to $3 billion. "It has enhanced the image of Yahoo! in the external investment community, that there is more intelligent management of our cash and investment portfolios," Yu adds. "For finance guys like us, this is as exciting as it gets."

BRONZE AWARD WINNER

Goodyear Tire & Rubber Co.

By early 2002, it was clear that Goodyear Tire & Rubber Co. had skidded into a rough patch, hit by a combination of economic weakness, excess capacity and two years' worth of disappointing financial results. The Akron, Ohio-based manufacturer's credit rating was lowered to non-investment grade with a negative outlook, and in 2003 it was forced to refinance its bank debt with stringent financial covenants and a two-year maturity. At the same time, a new management team began seeing operational opportunities that could form the basis of a business rebound, but without access to fresh lines of liquidity those plans were in doubt.

It was within such a challenging environment that Goodyear's finance team was charged with establishing a multi-phase capital structure improvement plan to improve access to liquidity, extend maturities and lower interest margins. "The first phase of the capital structure plan was the stabilization phase," says Darren Wells, senior vice president of business development and treasurer at Goodyear. "We had to get the company an adequate level of liquidity and a couple of years of added financing." Before the plan could be set in motion, the company was rocked by multiple accounting restatements, internal accounting investigations that caused a delay in the filing of financial statements and an SEC probe. All this required the treasury team to do a major rethink of its plans. "It required some creativity," says Wells. "Our preference was to go to more standard financial markets … but we had to change our plans to achieve our objective."

Without the benefit of current financial filings, the team pushed forward by securing a $650 million additional tranche to a senior secured asset-backed facility, part of which was used to partially pay down a U.S. term facility. It also conducted a private placement offering of $650 million of senior secured notes, a portion of which was at a fixed rate of 11%. These securities proved especially hard to place since the company's poor credit rating and dim outlook prevented it from pricing them in the more standard corporate bond market. Fortunately, the company's results for 2004 started showing momentum and three other transactions were completed at more favorable terms, including a pan-European accounts receivable securitization. A final set of transactions took place in April 2005. These included refinancings that allowed Goodyear to extend all its global bank facilities another five to six years, which gives the company more breathing room for its operational turnaround at sharply lower spreads and more flexible terms. Wells credits his team's persistence for achieving the goal and the company's solid relationships with lenders and investors. Most important, he says, was good communication. "We communicated frequently, effectively and openly with key business partners, banks and credit rating agencies."