Russian financing is one of the many areas in which banks have been left nursing losses. So how were the banks lending and how have they withstood the recent equity market rout? Writer Natasha de Terán.
Those with a sense of history will note, perhaps with a sense of irony, that a decade on both Russia and margin calls are, once again, at the epicentre of a market crisis.
Back in mid-1998, the giant hedge fund Long-Term Capital Management (LTCM) experienced a sudden fall in the value of its positions. Such a fall would not have mattered so much to the world at large, had LTCM not been so highly geared. It was supporting assets of about $125bn on a capital base of just $4bn. As prices fell, LTCM was forced to liquidate its assets in order to raise money for margin calls. The effect was devastating: asset prices plummeted and huge, widespread losses were felt throughout the financial markets.
Western losses
The almost simultaneous experience in Russia was more painful. The precipitous decline in the value of Russian GKO treasury securities in mid 1998 – and Russia’s subsequent default – left Western institutions nursing large-scale losses. Many Western firms had financed Russian debt through the repo market, taking margin against the positions. When the value of the securities suddenly fell by 80%, no institution’s haircut on the securities proved sufficient cushion.
In the event, Russia defaulted, but an effort was made to avoid the precipitous unwinding of LTCM’s portfolio that would have followed the firm’s default. A private sector agreement, led by the Federal Reserve Bank of New York, recapitalised LTCM and allowed its positions to be unwound in an orderly manner over time.
The near-collapse of LTCM could have proved much worse. The hedge fund conducted repo and reverse repo transactions with 75 counterparties. In most cases, the mark-to-market exposure was collateralised and some counterparties were even holding collateral to offset potential future exposure.
But LTCM had also obtained some exceptionally generous terms from its lenders. It was one of the top five money-making clients for many of the big brokerage firms at the time, and its bankers often waived their usual requirements for initial margin and collateral. The fund was able to get 100% financing for some of its purchases – the equivalent of taking out a mortgage without a downpayment.
Had secured lending counterparties been obliged to close out their transactions, they would have been forced to sell their collateral into a rapidly depreciating market. The cost of closing out their positions might have proved greater than the realised value of the securities or cash held as collateral, and its lenders would still have been exposed to losses.
Combined, the two episodes taught lenders a stern lesson about the paramount importance of good quality collateral and collateral liquidity, as well as about adequate haircuts, documentation and margining. Those banks that had been financing domestic bonds in Russia lost heavily – the collateral cover they had proved inadequate to cover the money they had lent.
In the aftermath, Western institutions moved quickly to improve their leveraged lending practices, most notably by tightening their repo lending practices.
Lesson learnt?
Did the lessons hold for a decade? As has become all too clear, Western firms returned to collateralised lending with a vengeance, not least in Russia, where corporates, large private investors and oligarchs are understood to have borrowed tens (if not hundreds) of billions of dollars against one form of collateral or another.
As recently as July this year, for instance, the Russian oil giant Rosneft refinanced itself with a $2.35bn repo agreement. The repo agreement, which was unusual in that the details were made public, was secured by a portion of Rosneft shares. Barclays led a syndicate of banks, including BNP Paribas, Credit Suisse Securities, JPMorgan Securities, Morgan Stanley, Nexgen Capital Limited, Société Générale and Royal Bank of Scotland, who all lent cash at 5.75% for one year against the shares.
Patrick Mole, managing director responsible for strategic equity transaction for Russia and eastern Europe at Société Générale, says the Russian equity financing market has been the fastest and biggest growing in the region – largely because Russia is the most developed in the region in terms of market capitalisation and because of the rise in Russian valuations. “This made Russian individuals, investors and corporates become very rich in paper. Many of them subsequently adopted aggressive diversification and monetisation policies,” he says.
Mr Mole says that the appetite for using the equity finance route owes itself to the fact that since mid-2007 bonds, new share issuance and equity linked–transactions proved unattractive to Russian borrowers, either because the cost of financing was perceived to be too high, or the discounts too large. “The equity finance route has provided an alternative means of raising finance.”
The Russian stock market has taken one of the most severe hammerings globally and, unsurprisingly given the suspected extent of the equity-based borrowing that was prevalent, margin calls have come in thick and fast. The Russian authorities have moved in repeatedly to close the two local stock markets, which have at times appeared to be locked in the deadly downward spiral typical of the forced deleveraging triggered by margin calls.
Scramble for liquidity
In a report published in mid-September, Gintaras Shlizhyus, a Russian expert from Raiffeisen Zentralbank Österreich, attributed the worst of the falls to margin calls. He wrote: “Collapsing stock prices began triggering margin calls on stock repo, which put the Russian market and banks into a tailspin. Local banks scrambled for liquidity to deliver margin calls, rushed to the loan market and tried to get rid of their dwindling stock holdings.”
So far, several Western banks have closed out their positions, liquidating borrowers’ collateral in the cash markets when borrowers have been unable or unwilling to make the necessary margin increases. Experts say that only a fraction of the details have become public, but a few high-profile cases have hit the headlines, including that of the billionaire Oleg Deripaska.
Basic Element, a Russian machinery company owned by Mr Deripaska was forced, in early October, to hand over a 25% stake in the Canadian automobile components maker Magna to creditors. Basic Element had apparently paid $1.54bn for the Magna stake, but by the time the margin call came in, its value had plummeted to about $912m.
A week later, on October 9, Mr Deripaska gave up a 10% stake in Hochtief, the German construction group, although whether that was the result of another margin call is unclear. Bankers involved in the market are, however, still sanguine about the business. They are confident that their means of structuring and hedging these deals, the diversity of their portfolios and their margin balances will see them through.
Unclear pledges law
Mr Mole, for instance, says that most of Société Générale’s transactions have been structured as repos, rather than pledges. “The Russian law on pledges is not entirely clear: in the case of a default, you have to organise a bid, ensure that the price you can realise for the assets is fair and demonstrate that in court before you are able to liquidate. As a result, we prefer to use a repo structure since in a repo a ‘true sale’ is effected and we become the owner of the shares.”
SocGen’s transactions were either structured as bilateral repos with the cash borrower, or through repos with special purpose vehicles (SPVs) that were refinanced by notes secured by the shares.
“We then hedged that risk by selling the notes out to other banks in the syndicate. The notes out tradable and reflect exactly what is written in the repo documentation so that, in the case of a trigger event, the SPV would sell the shares and redeem the notes.”
In the case of bilateral transactions, Mr Mole says that banks would typically either onlend the assets, or will have hedged out the risk with other banks through equity default swaps. “These instruments have proved an attractive unfunded alternative to repo. In this case, the lead bank would carry the financing risk, but their EDS counterparts would be exposed to the gap risk on the stock.”
He also says that banks will typically have a limit per single stock of, say, $500m per single stock and a loan-to-value ratio (LTV) ranging from 30% to 50% – for example, taking in $1bn shares as collateral and lending out $500m in the 50% LTV scenario.
The head of a Russian group at a major European firm said that again in his case the deals were typically structured at low LTV ratios and contained embedded margin triggers.
Furthermore, most margins were payable in cash, not shares. He stressed that he would only finance equities that were also listed on overseas exchanges in the form of American depositary receipts (ADRs) or global depositary receipts (GDRs).
Nonetheless, both he and Mr Mole believe there were more aggressive players active in the Russian lending business, some of whom may now be paying the price.
Aggressive bids
The banker, declining to be named, adds: “We believe that some counterparts were bidding very, very aggressively for this sort of business and the margins which they were working on suggested that they saw this as part of their relationship banking role, rather than as a business line requiring appropriate, independent returns.
“There probably are a few banks with pretty big, concentrated positions in Russian stocks through heavily levered equity financing trades.
“Some of them were playing at the dicier end of the spectrum. Some were lending cash against stock into which the borrowers were reinvesting, some were doing pre-initial public offering financing and some were happy to finance Russian equities that are not listed overseas. In all cases, they will have found themselves unable to liquidate and they will be in trouble.”
It is too early to draw conclusions from the events thus far. However, it is clear that those cash lenders who have used all the tools at their disposal to protect themselves will have fared better that those that didn’t. Nonetheless, the very tools that the savvier lenders deployed have come back to haunt highly leveraged borrowers, who may think twice in the future about using equity finance as a monetisation or leverage strategy in the future.
Same problems
However, another banker noted that the problem differed little from that experienced in the credit sector, where many leveraged investors have been forced to sell down their assets to meet prime brokers margin calls. The root of the problem in both cases was the same – a lack of diversification and arguably too much leverage.
He says: “In both cases, the markets have been on strong upward trajectories for a long time, and neither Russian investors nor credit funds wanted to diversify. The highly correlated nature of the relationship between the assets they were pledging as collateral and re-investing in came back to bite them both.
“It is a learning curve and they will learn from this – as will lenders. But I don’t think this rout has discredited equity financing as a vehicle. Once normality resumes, lenders will become more sophisticated in using it – and borrowers will be more cautious about how they use it.”
