Credit Derivatives

Taking a look at why they could be risky for some companies.

By Adam Ismail

In January, United Natural Foods Inc. (UNFI) disclosed that it was taking a $5.3 million charge to get out of a credit derivative contract it had en­tered. Credit derivatives have been the subject of quite a lot of controversy in recent years. Not so long ago, a Connecticut-based hedge fund called Long Term Capital Management lost so much money that it almost caused a collapse of the entire U.S. financial system. Even Warren Buffett has chimed in saying the dangers are unknown and that none of his companies will use them again.

What on earth could be so scary about these things? Well, the most basic kind of credit derivative is an in­terest rate swap. When one company has to pay a variable interest rate on its debt, but does not want to, it can swap its interest rate payments with a company that has a similar amount of fixed rate payments. It sounds simple e­nough and not that dangerous. However, imagine interest rates go up; suddenly the company that has to pay the floating rate is required to pay more. In general you would only want to enter this contract if your receivables are tied to variable interest rates. In the nutrition industry that is not very common, but nutrition companies can swap with companies like banks and credit companies, which do change their rates.

These don’t sound so dangerous, they actually sound like they make sense. The real danger, however, is that many treasurers of public companies enter into them to make some gains on their company’s cash and end up losing fortunes. These contracts can be traded by financial intermediaries and treasurers will buy the rights to the cash flows. It is essentially a bet on where interest rates will go and when they are wrong they can lose all of their company’s money.

These instruments do have a no­torious track record in the nutrition industry. Most companies are not big enough to use them effectively because they require having a substantial amount of debt to hedge or capital to invest. However, there are a handful of companies, like UNFI, that are large enough and do have enough debt and capital.

Another case is Yakult, the Japanese probiotic drink maker. As the company grew and its needs for capital increased, the company began buying more and more derivatives to report quick gains to the stock market and to also eliminate its exposure to currency risks. However, in 1998, nearly all of the Asian economies began to crumble at once and Yakult was left holding worthless credit derivative contracts that they could not sell. The company ended up losing over ¥100 billion, at that time equivalent to $769 million. The company nearly closed down for good.

So what was UNFI doing? Imagine what would happen if it caused UNFI to go bankrupt—this industry would be severely hurt. Fortunately, we don’t have to worry about that in this case. The charge it took was not a rogue element within the company trading volatile credit derivatives. Some of the company’s debt was fixed to the London Interbank Borrowing Rate (LIBOR), and it was concerned that if interest rates went up it would have to pay more. It was a natural concern because in the distribution business a retailer is not going to pay you interest based on what LIBOR is doing. So if LIBOR did go up, the company would be receiving the same amount as before, but end up having to pay out more. Thus, in the same year Yakult almost collapsed, it entered into a swap that would allow it to pay a fixed 5.00% interest rate on $60 million of its debt instead of the variable interest. It en­tered into a second swap for the same reason in 2001, which a­l­lowed it to pay a fixed 4.81% interest on $30 million of its debt.

However, these contracts were considered ineffective swaps either because the maturity of the swap did not match the maturity of the debt, leaving it with significant exposure, or because it did not match the amount of risk the company was taking. Regardless, as interest rates fell the swaps were less and less valuable. It would have been better off paying the rate that varied with LIBOR because it kept falling and UNFI would have ended up paying much less than the 5.00% or 4.81% it was now obligated to pay. The problem with ineffective swaps is that when their value falls, accounting rules dictate that you record the loss. In fact, in UNFI’s first quarter, it ended up taking a $1.7 million charge due to the loss in value of the derivative. For reference, that was more than three times the charge it took for losing Wild Oats’ primary distributor business that quarter. Clearly the swaps did not make sense for them and they were concerned about taking further charges, so they decided to try and exit the contracts. However, the contract is an obligation to pay, so if you want to leave the contract you are going to have to pay. They ended up finding another party willing to take over the payments, but UNFI ended up paying $5.3 million to get out of it, plus the interest accrued since the last payment.

Now the company is back where it started, paying its interest based on what LIBOR does. The company still has one more contract that it entered into, but it considered an effective swap and the company does not have to worry about changes in value. It has also noted that going forward it will be against company policy to enter into ineffective swaps, so even it recognizes the dangers.NW