Did you hear the story about the successful company with no liquidity?  No, you did not.

Recent failures of finance and commodity trading companies have again brought into sharp focus the incredible importance of liquidity.  Profitability is good, too, but many firms suffer losses and keep on chugging - for a while at least.  Inability to meet immediate funding demands, though, has swift and dramatic consequences.  You can be out of business NOW.

Although it is possible that many trading companies with significant problems may be able to eventually work things out, the simultaneous refusal of a large number of counterparties to trade with them on open credit can easily make collapse a fait accompli.

That is why the immediate response by many troubled firms to relieve market concerns is to raise large sums - or at least increase access to committed funds - and then crow about it as loudly as possible.  Their hope is to reduce or prevent a "run on the bank" like the one described by Jeff Skilling to explain the speed of Enron's fall.  Bear Stearns' approach was to immediately offer guarantees by prospective acquirer JPMorgan Chase to their trade counterparties; Enron's was to quickly get a $1.5 billon loan from Dynegy.  Obviously, that response doesn't always work.

Even firms not as firmly in the crosshairs understand the need to reassure the market at the first hint of even flimsy rumors.  Lehman loudly made it public knowledge that they not only had $30+ billion in cash and $60+ billion in available credit, but they were issuing billions in additional capital as well.  Just to calm any remaining doubters.

This is because many trading companies operate in the over the counter (OTC) market at reduced cost by maintaining large open credit lines with their trading partners.  They simply get to buy on credit in a manner not allowed on exchanges, which mark exposures to market every day - essentially "collateralizing" them anyway in a "pay-as-you-go" manner but reducing the magnitude of an unforeseen "liquidity shock" from the instant loss of open credit lines.  Maintaining the confidence of one's OTC counterparties is obviously critical.

Illiquidity often stems from collateral demands from trade counterparties for mark-to-market (MTM) exposures for fixed price deals.  This is to cover the difference between current market prices and the contracted amount the parties originally agreed to for deals which occur in future periods.  When market prices move away from those fixed contract prices, one party is exposed to the future performance of the other.  In fact, if a fixed price deal is struck while the market is open, one party will likely have some amount of MTM exposure within minutes.

Trading contracts often contain provisions permitting frequent - often daily - margining between counterparties if exposures exceed approved limits.  They may also permit the reduction or elimination of those approved limits upon a "material adverse change" in the condition of the parties or even in the case of events causing "reasonable" grounds for insecurity of a party.  This means that not only does a company have to worry about a.) suffering actual capital losses on completed transactions as well as b.) whether their current MTM position of ongoing deals will exceed approved open credit limits, but they also need to fret about c.) whether their existing limits will disappear on the whim of their counterparties who may be spooked by market rumors and bring current and future business to a halt until "adequate assurance" is provided.

It is ironic that the actions intended to mitigate concerns over a company's future performance can cause its immediate failure.  "We are not sure that you will survive, so we are gonna kill you now."

It is even more ironic that the fixed price positions put on by a company could spell its doom even though they may be part of a profitable hedge or may become profitable over time if permitted to run their course.  This is not baseball, though, where "it ain't over ‘til it's over".  When facing a liquidity crunch, it is not uncommon for companies to be forced to close out or sell off even positive positions at a discount in exchange for quick cash or to stop the bleeding.  In fact, a large part of hedge fund Amaranth's approximately $6 billion hit in 2006 (2/3 of the fund's value) was due to its being forced to immediately sell illiquid positions at fire sale prices and lock in losses.  The urgent need to trade was accelerated by collateral calls and the damage was done in only a few days.

It can't be stated too loudly or too often - liquidity is the mother's milk of a trading operation and must be managed with that in mind.  You can make a bad deal here or there and live to tell about it, but if you run out of cash or other collateral, you may be out of business even if the value of your trading book is positive.  It is critical that those running such efforts understand the consequences of the contractual terms they agree to and the market venues they choose.

Don't be too surprised by the recent revelations that allegedly fraudulent activities of a trader at Société Générale went unnoticed for some time.  The chain of events put in motion by trading activities not only provide ample opportunity for a knowledgeable individual to exploit a weakness, but the sheer complexity of the discrete deal attributes in many markets introduce numerous chances for honest mistakes as well.

The market, credit, liquidity, operational, and other risks must all be considered in the appropriate context of the specific situation.  In fact, after many years as a credit manager working trade floors in the energy industry, I have personally seen numerous examples of control weaknesses and heard of countless others.  I have never heard of an entity which had no areas for improvement - particularly if they traded extensively in physical markets, with its numerous additional obligations associated with delivery of a commodity.

"Do we trade over the counter (OTC) or on an exchange"; "Standard enabling agreements, or via proprietary contracts?"; "Margining or no margining"?; "With the A-rated public entity or the three-man hedge fund?"; "Fixed or floating prices?"; "In the physical or the financial markets?"; and etcetera. 

The nature of the resulting risks changes with the answer to all of those and many other questions.  Before long, the resulting decision tree for one transaction alone has an impressive number of branches.  Now imagine tracking an entire forest of unique trees.  Broken branches are fairly common (to belabor the analogy).

Sometimes weaknesses are glaringly simple, such as finding users who post their passwords on a sticky note next to their computer.  Other times, and as was apparently the case at Soc Gen, it requires intimate knowledge of the control process.  Still others result from lack of training or simple oversights, such as failing to properly negotiate a letter of credit or incorrectly assuming that you have netting rights for offsetting exposures.

Unfortunately, such weaknesses are pervasive.  Even worse, not everyone recognizes that fact - although such naïveté is becoming less common.  As reported by the Wall Street Journal, Ken Moelis, former head of investment banking at UBS said "Until recently, every investment bank believed it had built an outstanding risk-management system".

Indeed, when reviewing the trading risk management efforts of numerous financial institutions, S&P Credit Analyst Prodyot Samanta said they found "no concentration of best practices at any single institution".  It is good that ratings agencies are aware of the problem.  When credit ratings begin to suffer due to weak controls - causing financing costs to rise, you can expect companies to pay significantly more attention to the issue.

Additionally, the growing interest in enterprise risk management (ERM) also signals that companies are finally beginning to appreciate the fact that market risks aren't the only risks worth addressing.

Those entities which aren't already doing so would be well advised to start taking this effort seriously.

Risk Managers, rejoice, you are getting smarter and better looking with each passing day!  Folks who help manage risk are enjoying unprecedented respect these days, much like “overnight sensations” in the music industry whose worth is finally discovered after spending most of their careers in dingy bars.  (That analogy turned out even better than I thought it would.)  I predict that 2008 will be the breakout year for those who provide enterprise risk management goods and services as entities race to implement greater controls and deal with decreased access to liquidity.

This epiphany has come about because the last 10 years or so have been a stunningly risky period for corporate stakeholders with one massive problem after another.  The most recent, the meltdown in the mortgage industry and its subsequent effects, may have been the coup de grâce for any remaining risk-tolerant holdouts.  The growing clamor for more effective risk controls has now turned into a deafening roar.

During the past decade alone, we have had an internet boom and subsequent bust; an energy bust and subsequent boom – with an “energy crisis” thrown in the middle for good measure; numerous geopolitical conflicts; prosecutions of corporations and their executives, both justified and overzealous; natural and unnatural disasters; deregulations and re-regulations; a credit market meltdown; and assorted other calamities.  That, my friends, is risk.  No wonder people are finally looking for help.

How would YOU like to be a corporate executive these days?  Using the energy industry as an example, where would you turn for help with risk mitigation?  The commodities market?  Please.  That is often the source of the problem.  Improperly structured market positions which fail to consider associated credit and liquidity risks can doom a company quicker than remaining unhedged.  A small producer who is otherwise profitably selling its products under fixed prices in a rising market could easily see margin calls deplete its liquidity, leaving none for operating needs.  And as we all know, net income doesn’t pay the bills – cash flow pays the bills.

How about the credit market?  As we have seen, it has contracted significantly due to the surprising collapse in the mortgage industry.  While it is still possible to get funding, the terms and conditions now reflect recent events.  Exacerbating the resulting liquidity shortage, more energy entities are transacting under contracts with risk-mitigating – but logistically challenging - margin provisions and face more collateral demands as described above.

Insurance products may or may not be cost effective, either.  Although coverage continues to evolve to address the risks of structured and other transactions, insurance companies have had their share of challenges lately, too.   For example, in addition to the billions in exposure for human-caused events like 9/11 and corporate malfeasance, insured losses for natural disasters such as earthquakes, hurricanes, and floods cost the industry a record $44 billion in 2004, nearly triple the previous year, and THAT record more than doubled to $94 billion in 2005, according to reinsurer Munich Re.  To top it all off, Lindsey Lohan started driving – sort of.

International energy matters continue to produce significant uncertainty as well.  In the last year alone, energy entities have been “strongly encouraged” to renegotiate their contracts or have had assets nationalized outright in Bolivia, Venezuela, and Russia, to name a few.  Additionally, there continues to be concern over the security of the gas supply from Russia to Europe, which is also moving quickly to deregulate its gas and power markets.  Think it is difficult to implement deregulation in the U.S.?  Imagine trying to do it while considering the demands of numerous sovereign entities with different languages and national interests.  How and when it will ultimately work is still to be decided.

For some, the prospect of increased regulation by government entities represents a considerable risk as well.  For example, as executives of numerous oil majors in the U.S. found out, even if you earn a return in line with other industries, you may still be hauled before Congress and threatened with criminal sanctions and a tax on “windfall profits”.  Additionally, hedge funds are being increasingly criticized by authorities for, among other things, failing to manage counterparty credit risks and for introducing systemic risk to energy markets.  Look for them to begin to respond by enacting greater controls fairly soon.

All of these issues, as well as many others, have contributed to the growing recognition of the need for entities to navigate the corporate minefields and effectively manage enterprise risk.  That will require investment in people, processes, and systems.  In fact, even if there is a significant effort already in place, it must be demonstrably effective and bring confidence and comfort to auditors and others.

 Whether the pressure is coming from regulatory entities who want to prevent abuse, investors and shareholders who want to know the risks they are assuming, employees who want to ensure that their companies are well run, or executives who are concerned with compliance demands, the value of a solid risk management effort has never been more appreciated.

So we salute you, Mr. and Ms. Risk Manager.  2008 is your year!

The interest in Enterprise Risk Management (ERM) began to grow in recent years and continues to pick up speed.  As reported by Marine Cole in a recent edition of Financial Week, Standard and Poor’s may soon include ERM assessments in its rating evaluations of non-financial companies, a practice already in place at Moody’s.  In my opinion, this would be a welcome enhancement to their review of the trading risk management practices of energy companies with active trading efforts, which they described in a Commentary Report in April 2006.  That move was itself an expanded use of S&P’s “PIM Approach”, which has been applied to financial institutions since 2004 and refers to assessments of the risk management policies, infrastructure, and methodologies (PIM) of subject entities.  According to S&P Credit Analyst Terry Pratt, the PIM Approach, along with assessments of liquidity and capital adequacy, is used by S&P to evaluate an energy company’s trading risk position.

The reason I support a more holistic view of the risk management practices of energy firms is because, in over 20 years in the business, I have never seen – or even heard of – an entity which had completely nailed its risk management challenges.  Not even the financial entities, which are typically considered to be sophisticated at risk mitigation.  In fact, S&P Credit Analyst Prodyot Samata noted in 2005 that applying the PIM Approach to its review of the trading risk management efforts of numerous financial institutions found, surprisingly, “no concentration of best practices at any single institution”.

In my experience, even those entities which have taken significant steps to mitigate market risk do not typically address counterparty credit risk to the same degree.  It is simply not well understood that even balanced positions – those which bring such comfort to trade floors and risk control groups - often introduces credit risk on one side of the position and liquidity risk on the other.  Long after the traders have completed the transactions, these exposures must be managed every single day – sometimes for the years it may take them to roll off. 

In addition to the sheer volume of the growing pool of transactions which must be managed, consider for a moment the stunning breadth and complexity of the resulting credit task, with its dizzying array of possible entities, products, contracts, venues, tenors, pricing arrangements, and other variables which must be considered.

The participants in the “bizarre bazaar” which is the international energy market are amazingly diverse.  They have varying degrees of financial wherewithal ranging from the economic power of an entire nation to a trading operation with nothing more than a Cadillac and a car phone.  Their actions can be regulated as tightly as a parolee’s or as loosely as Paris Hilton’s.  Their motivations for transacting can range from blind greed to geopolitical interests to risk mitigation.  They trade products on their own account or via wholly-owned subsidiaries, partially-owned joint ventures, or agents, with other entities which have done the same.  They trade in venues including exchanges - such as the NYMEX, electronic trading platforms - such as the ICE, or “over the counter” (OTC) – such as the phone call, restaurant, or golf course.

The products themselves include hundreds of thousands of natural hydrocarbon compounds as well as the energy they can produce and ancillary services associated with their delivery.

  They are traded in physical or theoretical form based on the commodities themselves or their related derivative instruments.  The transactions can be for fixed or floating prices ranging in tenors from minutes to decades and volumes valued from a few dollars to tens of billions.  The contracts which govern the entire business relationship as well as the individual transactions themselves can be standardized, proprietary, or undocumented (i.e. verbal).

It is easy to see that it takes significant resources including personnel with the requisite knowledge and experience, well-developed processes, and robust systems to effectively manage the exposures which can arise under relationships with such a complex web of possible transactions.  Now compare that fact to the amount of resources which are typically allocated to the effort.  Between the time deals are entered into the multimillion-dollar trading system and the time they are processed by the multimillion-dollar accounting system, the Credit Department often handles things under the direction of an exhausted Credit Manager armed with a few young analysts and some spreadsheets.  

When credit risk is not properly managed, entities can be bankrupted within days – even despite a lack of market or other risks which may have been successfully mitigated.  Any effort which acts to consider energy trading risks holistically is definitely another step in the right direction.