Housing Treasury – Financing Risk

B3: Managing derivatives in a complex environment and European Market Infrastructure Regulation (EMIR)Speakers: Henrietta Podd

Head of Advice and Origination Canaccord Genuity

Peter Moore Assistant Director of Corporate FinanceCircle Housing Group

Chair: Joseph CarrPolicy Leader

National Housing Federation

PRIVATE & CONFIDENTIAL

The good, the bad and the uglyInterest rate derivatives23 October 2013

Interest Rate Derivatives

Derivatives are incredibly useful tools in the Treasurer’s box of tricks

increase financial flexibility allowing a borrower to limit risk absolutely, to limit downside or take a managed view on ratesto separate from funding decisions from views on ratesto exploit arbitrages

allow for the management of specific risks The absolute exposure to moves in interest rates in terms of a mix of fixed

and floating debtAdjusting the sensitivity of a portfolio to moves in interest rates in terms of

duration

can be procured through a competitive process

with more counterparties than in the loan market

Derivatives have served Housing Associations well

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Interest Rate DerivativesThe Good…. But increasingly expensive

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Standalone derivatives, so long as they are not over complex, are also transparent

 Can be independently valued and pricedMay have a fixed costHave a secondary market valueSubject to standard termination termsCan be assigned to other counterparties

However, In the case of swaps, are likely to be subject to collateral calls Are, of course, subject to hedge accountingAre subject to radical regulatory changeAnd have become very expensive to transact

 

Interest Rate DerivativesThe “not as good as we thought they were”

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Fixed or index linked borrowers still have contingent exposure to derivatives

These may be less flexible and less transparent than standalone contracts – consequently more difficult to manage

The banks have a legacy swap problem just as they have a legacy loan problemAssymetric collateral agreementsUnderestimated mark to market exposureMis-priced credit exposureUnderprovisioning due to upfronting excessive profitsNew regulation and risk models demanding increased capital allocation

They will offer you a deal…

Most of the derivatives that HAs entered into were pre-2008 and were embedded as part of the loan agreement

Interest Rate Derivatives

The bank may offer to:

Terminate the swap this will lead to the crystallisation of the Banks mark to market cost which will be recharged

to the borrower as a lump sum

Restructure the loan with the swapthis may spread the mark to market cost over a number of years - at a cost in terms of

margin (as the bank is now lending more) and almost certainly a reduction in tenor

Dis-embed the swapeither to terminate the swap and leave the loan in place orif permitted under treasury policy, become subject to an ISDA

Good friends

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However, most HAs do not have sufficient surpluses to absorb the cancellation costs

Simple interest rate swaps and capsMore virtues than vices

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Simple interest rate swaps are extremely useful for Treasurers in reducing risk

Business plans can be effectively de-risked by using short term derivatives to lock in rates

For those able to use standalone swaps, derivatives can be overlaid to manage some of the embedded fixes which are no longer fit for purpose

In particular, over hedging where borrower has forward starting swaps which are no longer necessary

ameliorating mark to market with fixed to floating swaps.

However, there are still challengesCollateral AccountingReporting

More complex interest rate swaps

Complex derivatives often have a purpose beyond reducing interest rate riskThe most obvious are using complex derivatives to reduce interest cost – usually by selling an optionOthers are trying to manage cashflows by cutting cash debt service costs – using accreting swaps,

increasing gearing

These swaps can move in unexpected waysThis means they are extremely difficult to value and often only the bank that wrote them

can unwind them

However, it may be in the interests of both the Bank and the borrower to exit the position: A transaction was arranged earlier this year to transfer an inflation swap with a punitive break clause

to a pension fund• The swap was restructured helping the utility• The bank removed it from its balance sheet and• pension fund received a 150bps premium over the credit risk of the utility for taking he swap.• The pension fund was advised by investment adviser Redington

Vicious or just ugly?

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CollateralCollateral

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Risk mitigation through CollateralOne way CSAsThresholdsCash, cash equivalent and property

New counterpartiesExchangesInstitutional investors

Bilateral vs OTC derivativesOpportunities offered by exchange traded

derivativesChanges to credit risk and collateralTransparent and competitive

LHS shows the MTM liability owed by HAs to banks on IR derivatives , split between unsecured threshold, property and cash collateral, except prior to Sept 2011 when only collateral shown. RHS shows 15 years swap as proxy for the average term of sector’s IR derivatives

HCA: Derivatives and collateral calls - cash and property Mar 2013

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Circle Housing GroupEMIR and derivative reporting– What we have done so farOctober 2013

EMIR – where did it all start

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G 20 leaders made a commitment in Pittsburgh in September 2009 that:

All standardised OTC derivative contracts should be traded on exchanges or

electronic trading platforms, where appropriate, and cleared through central

counterparties by end-2012 at the latest. OTC derivative contracts should be

reported to trade repositories. Non-centrally cleared contracts should be subject

to higher capital requirements. We ask the Financial Stability Board and its

relevant members to assess regularly implementation and whether it is sufficient

to improve transparency in the derivatives markets, mitigate systemic risk, and

protect against market abuse.

EMIR introduces:

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• Reporting obligation for OTC derivatives

• Clearing obligation for eligible OTC derivatives

• Measures to reduce counterparty credit risk and operational risk for bilaterally

cleared OTC derivatives

• Common rules for central counterparties (CCPs) and for trade repositories

• Rules on the establishment of interoperability between CCPs

EMIR applies to:• To all types and sizes of EU entities that enter into any form of derivatives contract

• Even indirectly to non-EU firms trading with EU firms.

So, what does this mean?

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All derivatives trades, both exchange-traded and OTC, must be reported to a Trade Repository

• All trades, including all intra-group, but excluding embedded derivatives

• Backdated from 16 August 2012

OTC derivatives: minimum set of information to be provided

• Unique Trade Identifiers (UTI) – Unique global trade ID

• Legal Entity Identifiers (LEI) – Identification of counterparties

• Universal/Unique Product Identifiers (UPI) – a globally agreed product identifier

• Valuation – MtM valuation required on cleared OTC contracts

• Collateral – information on exposures including collateral valuation and currency

• In total 85 data fields could be required

So, what did this mean for Circle?

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Our Structure and the issue this created

Circle Housing Group

Funding SPV

Circle Anglia Limited (parent)

Registered Providers

x9Banks

So, what did this mean for Circle?

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15 Sept 2013EMIR Portfolio Reconciliation

and Dispute Resolution

7 November 2013ESMA Publish List of TRs

12 February 2014All Asset Class Reporting

Start Date

October 2013Sign up to UnaVista TR

August 2013TR selection process

30 August 2013Pre-LEI (IEI) codes issued &

Co-signed TriOptima’s TriResolve QuickPort

9 September 2013Completed EMIR Portfolio

Reconciliation

15 March 2014EMIR Reconciliation of

uncollateralised, collateralised and intercompany derivatives

July 2013Started EMIR

project

What we have done since implementation

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EMIR Portfolios Reconciliation and Dispute Resolution Reviewed ISDA protocol

Identified Counterparty classification; Non-Financial Counterparty (NFC-)

Portfolios Reconciliation; Portfolio data receiving entity

Dispute identification and resolution procedure

- Signed up to TriOptima’s TriResolve QuickPort; Circle Anglia Treasury Limited - Set up an email for future communication

EMIR Reporting A Trade Repository (TR) selection process; UnaVista vs. REGIS-TR

Issued pre-Legal Entity Identifier (pre-LEI) codes

Set up the Mark-to-Market (MtM) valuation via Bloomberg

Reconciled all the trades we had since 16 August 2012

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Thanks for listening!

Any questions?