Cushing & Co., healthcare corporate governance

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Derivative: What is it?
Have you ever asked someone to explain to you what a financial instrument called a derivative is? Try it and see the variety of answers you get. The Bank of International Settlements estimates the derivative market to be in excess of $500 trillion. Yes, that is trillion. Staggering numbers for an unregulated market. Putting it in perspective, the
U.S. federal budget is $3 trillion

I will use an example of a derivative as a means of describing what a derivative is.
A major area of derivative growth has been credit derivatives. One form of credit derivative, a CDO or collateralized debt obligation, has significance in the present credit crisis. So, we will use it as a simple example.
A bank has an inventory of loans, mortgages, consumer credit card debt etc. that it maintains as assets and products of its business operations. The bank may have a need to increase its liquidity or a need to transfer risk associated with these assets off its balance sheet and transfer the risk to others. To accomplish this, the bank will create a derivative, in this case a CDO. The bank puts together a collection or portfolio of debt instruments, such as corporate bonds, mortgages, corporate loans, credit card debt etc., and produces a basket of loans called a CDO. It then markets the CDO, the basket of loans, to investors. Investors seem to have had an insatiable appetite for derivatives over the last 6 years. To attract investors, the bank will structure the CDO as a hybrid of notes and equity so that investors can easily buy pieces of the CDO at different levels. They can purchase senior notes on portions of the CDO which have low interest rates but have the highest payment priority. They can purchase intermediate or mezzanine portions with a higher interest rate and a lower payment priority than the senior notes. Or, they can purchase equity positions that will accrue all returns that do not go to the other priority holders first.
Depending on the type of debt instrument used, the CDO can also be called a CLO, collateralized loan obligation, or a CBO, a collateralized bond obligation.
A very big potential problem with CDOs is that institutions that package and sell them know that they can transfer the associated risk of these loans to CDO investors. This may, with a high probability, induce the financial institution to make riskier loans than it would normally have made, since it knows it can transfer the risk to investors. Just think about all the sub-prime loans that have been made in the last 5 years and which have been collected into baskets and repackaged as derivatives and sold to investors. Many of these loans were made without documentation. I do not think that the institutions making the original loans would have neglected the underwriting and documentation required for these loans if they knew that they would not be able to easily transfer the risk to others. And that others would willingly or unknowingly accept the risk.
The investors will normally not do the necessary due diligence to determine the true risk associated with the CDO. They, usually, will not spend the effort and time to look, at a minimum, at the degree of potential default correlated with the mix of debt instruments in the CDO, check the quality of each debt instrument, and examine the seniority structure of the CDO.
A formal definition of a derivative is: a derivative is a financial instrument whose value is derived from other assets, in this case the basket of loans, and whose value changes in response to changes in the variables, i.e. interest rates, default rates etc., that can affect the underlying asset or assets, the basket of loans. Our example satisfies the formal definition of a derivative.
I hope that this takes the mystique out of what a derivative, in simple form, is. Derivatives can be much more complex and based on a wide range of assets such as commodities, equities, bonds, interest rates, currency rates, a market index, weather conditions, or as a form of insurance. But the basic form of derivative still holds.
In future podcasts, which can be found on the links page of this site or my blog, I will discuss credit derivatives, credit default swaps, how they are valued, what counterparty risk is, the market for derivatives, asset swaps, and the legal issues associated with derivatives. As an investor or member of a board, I think it is critical that all become more aware of the derivative market in order to manage risk better.
Credit Default Swap: What is it?
A credit default swap is a major form of credit derivative. It is a financial instrument that allows the transfer of credit risk from one market participant to another. Think of it as an insurance policy. It is not to be confused with a classical commodity swap.
The market for credit default swaps, as it seems with all derivatives, is huge. It is estimated to be in excess of $45 trillion dollars U.S.
Lets use an example to describe a credit default swap. Again, we will use a bank in our example. A bank which has made a loan to a corporate customer, but who is becoming concerned with the credit risk associated with the loan made to this corporate customer, and who wants to reduce or hedge its risk.
The bank will look for an investor or investment firm that is willing to accept a share of the risk for a price.
When the bank and investor or firm connect, they will negotiate and enter into a contract called a credit default swap, or CDS. The contract, CDS, will require the bank to made periodic payments, insurance premium payments, to the investor or firm. The investor or firm will promise to make a lump sum payment to the bank in the event of a default on the loan by the banks corporate customer.
Sounds like an insurance policy doesnt it? The bank has effectively transferred a portion of its risk to the investor or firm and the investor or firm have accepted the risk exposure for a periodic stream of premium payments from the bank.
The bank, in this transaction, is called the buyer of protection. The investor or firm is called the seller of protection, and the corporation with the loan is called the referenced entity.
I see a big problem with credit default swaps. If the CDS is a form of insurance requiring it be sold by an individual with a license to sell insurance, the CDS contract may not be enforceable, if it was sold illegally, as a form of insurance, by an entity without an appropriate state license to sell insurance.
The International Swaps and Derivatives Association, Inc. has standard documents that are generally used for the execution of credit default swaps and other derivatives. Its U.S. documents incorporate the law of the State of New York as binding. The State of New York says an Insurance Contract means any agreement, or other transaction whereby one party, the insurer, is obligated to confer benefit of pecuniary value upon another party, the insured or beneficiary, dependent upon the happening of a fortuitous event in which the insured or beneficiary has, or is expected to have at the time of the happening, a material interest which will be adversely affected by the happening of such event.
The structure of a CDS satisfies the definition of an insurance contract in the State of New York.
The State of New York goes on to say: No person, firm, association, corporation or joint-stock company shall do an insurance business in this state unless authorized by a license in force Clearly, a license is needed to sell insurance and credit default swaps.
I can envision a seller of protection, upon the circumstances of a default, attempting to circumvent the payment of its lump sum obligation by using the argument that the CDS was entered into in violation of law requiring the seller of protection to have been licensed. The extension is that transaction was illegally entered into and the contract, therefore not enforceable.
The other aspect is the fraud executed by the unlicensed sale of insurance. Even if there was not a default, the seller of protection would be at risk.
So, as an investor or director, I would be interested in having the exposures listed above evaluated as a means of risk management.
Bank Uses of Credit Derivatives
Credit derivatives are used to avoid risk or take risk. It just depends on what side of the fence you are sitting. Banks are the main users of credit derivatives, as buyers of protection to reduce risk.
As part of risk management banks will continually monitor their overall credit risk, as a means of identifying concentrations of risk that require attention. Consider that a bank, in reviewing the risk in its pool of corporate loans, decides that its exposure to a particular corporate customer has become too large and uncomfortable. Now, the banks exposure would not have gotten to this point if the corporation was not a good and favored customer of the bank.
The bank could make a decision to not renew existing loans and limit future lending. But, the bank needs to retain its good and favored customers. Once they go somewhere else, they never return.
The bank could also sell some of the corporations loans in the secondary market. The corporation would have to agree to this and, I am sure, would not be happy about this. The bank may be reducing its portfolio risk a bit, but it has incurred a significant risk of losing a good corporate customer. No one likes a vote of no confidence.
So, what can the bank do? How can it reduce its risk and maintain its relationship with its corporate customer. It could look to a derivative as a solution. A credit default swap would do the trick. The bank goes out and buys default protection and reduces its risk exposure to the corporate customer. The loan remains on the banks books and the corporate customer does not have to be notified of the transaction. The relationship is maintained.
Banks use derivatives in managing reserves. If a bank loans a corporate customer $100 million US, it is required to set aside capital equivalent to 8% of the loan amount as a reserve. If the bank considers the corporate customer to be a very good credit risk, the bank will want to reduce this reserve requirement and do something else with some of the required reserve of $ 8 million.
In order to get around its reserve requirement, it will, naturally, use a derivative, a credit default swap. The bank will purchase protection from another bank. The selling bank, because it is a bank, is considered a low credit risk and has lower reserve requirements than a corporation. The buyer of protection would inherit the selling banks, 1.6% reserve requirement on the portion of the $100 million loan covered by the CDS. This would free up significant reserves for use elsewhere.
Banks can be either buyers or sellers of protection. They can sit on either of the fence and be very creative in their use of derivatives. We have only touched the surface.
If banks can reduce their reserve requirements from 8 % to 1.6 % by simply selling each other credit default swaps, it makes it easy to minimize reserve requirements and, potentially, to increase risk exposure when things turn bad. And, things always turn bad sooner or later. That is when appropriate reserves are good to have.
As an investor or director, particularly a director, I would like to know what, why and how derivatives are being used and what impact they have on risk and customer exposure. As A corporate director, I would like to know if any of our loans are a subject of a CDS. You wont know if you dont ask.
Counter Party Risk
Counter party risk is simply the risk of the other party, or parties, to a derivative contract defaulting and not meeting their payment obligations.
Counter party risk can be reduced by assuring that the selling party is credit worthy. But, this may be more difficult to do today then in the past. Rating agencies may not be reliable and financial institutions, as sellers of protection, seem to be more poorly managed than in the past. We will use a simple credit default swap as the basis for our discussion.
A buyer of protection has to be aware of the risk of the seller of protection defaulting or becoming insolvent. If the seller of protection becomes insolvent, the buyer of protection will have to purchase new or replacement insurance. These credit default swaps will probably be substantially more expensive.
The buyer must also be aware of the risk of the reference entity, the corporation, and the seller of protection becoming insolvent at the same time. This could happen, particularly if there is a linkage between them.
The buyer must also determine the possible future value of the reference entitys debt if there is a default. The lower this recovery value is the higher will be the cost of buying protection.
The buyer must also anticipate that the seller of protection may assign its obligations to others, which may make it difficult for the buyer of protection to achieve a timely payment if there is a default. It may be difficult to determine who has been assigned the credit default obligation if the original seller does not cooperate.
To minimize counter party risk, one should deal only with financial institutions with highest credit worthiness. Again, this may be more difficult to determine today because of questionable ratings and poor institutional management
Again, the buyer must make every effort to determine if the seller of protection and the reference entity have any linkage and possibility, even remote, of insolvency to both.
The buyer of protection can also require the seller of protection to post collateral against a possible default on its obligations under the credit default swap. This may not produce a complete recovery but will soften the landing.
I never assume anything today. I think as an investor or director, we have to ask about all areas of risk, and not proceed until all questions are answered in a common sense and easily understood manner. The more complex an answer is the more nervous I get. Counter party risk requires a common sense approach. Dont do business with someone who may not pay.
Derivatives: How are they valued?
Derivative pricing starts with the Black-Scholes-Merton model, a mathematical model developed in 1973 and 1974 as a tool to calculate an options price. The Black-Scholes-Merton model calculates an option price based on input, such as:
1. the price of the underlying asset,

5. an expected rate of return without risk, i.e. treasury rate.
As the input above is common to derivatives, the Black-Scholes-Merton model has been used as a basis for models used in derivative valuation. Over time, the Black-Scholes-Merton model has been enhanced and extended as a means of countering the limitations of the initial model
As with any model, the value of many of the input variable are finite values which are simply best guesses. Any result is simply an approximation based upon the input values. Any model can be controlled to produce a desired result if the input is skewed to produce a favored result. If youre the seller of a derivative you could increase the derivatives value by skewing the input. If youre the buyer, you should have your own valuation models and be prepared to play the what if game by changing the input values and doing model iterations in order to determine a valuation you feel is accurate.
Based upon recent history, the valuations of these models tend to produce results which are overvalued.
Ratings based models have also been introduced. But, with the uncertainty of the ratings awarded by rating agencies, these models are also suspect.
The message is simple. Derivative valuations, simply approximations of value, are primarily a function of mathematical estimates produced by mathematical models. These approximations have a wide range within which they can fluctuate. As an investor or director, I would like to know:
1. How are we doing derivative valuation?

7. Who is responsible for the valuations?
In my experience, those who create models have technical skills and knowledge, but limited business acumen which I find is so necessary for developing accurate and reliable valuation and forecasting tools. I think we will, in the next few years, find out just how necessary this business acumen is.

We, as a nation, are still trying to find out who is to blame for the credit crisis and the loss of faith in the U.S. financial markets. Previously, I have pointed the finger directly at the U.S. government as the cause of the crisis. Our politicians, on both sides of the aisle, are trying to deflect their culpability by pointing fingers at short sellers, outdated legislation, and regulators.
They are right to point their fingers at regulators. They all actively conspired to cause the financial crisis by acts of omission and commission. They neglected their responsibilities of oversight, in every manner, that would have prevented the crisis. They allowed the financial community to function as an unregulated behemoth.
Short sellers were simply taking advantage of the market conditions created by the crisis and have actually been instrumental in bringing it to a head. Without them it might have been ignored for a longer period and become even a greater crisis than it is today.
Outdated legislation is not a good argument from our politicians. They have responsibility for the creation of legislation that is needed for the effective running of our country. Their argument certainly shows that they have not been minding the store. They have neglected needed legislation in order to accommodate lobbyists and their special interests such as Wall Street, Commercial Banking, Insurance Companies such as AIG, Fannie Mae, Freddie Mac and many others.
The real blame lies with President Bush and his administration. They created and maintained the environment which fostered the crisis.
A leader hires in his own image. President Bush selected people with his values or more appropriately his lack of values. The crisis would not have occurred if the people selected as regulators had a moral compass that directed them to do what was right. The crisis could have been avoided by simply doing the right thing and forcing others to do the right thing.
The right thing for regulators would have been to monitor and control the creation of derivative financial instruments to assure that each new instrument was a viable financial product. If this had been done then many of these products would not have been sold to investors. The institutions creating and selling these instruments would have been on notice that the regulators were watching and they would have thought twice before doing the wrong thing selling a knowingly defective product to a customer.
It is unfortunate that Wall Street does not have the moral fiber to independently do the right thing. The mantra of Wall Street seems to be greed over morality, ethics and common sense. I do not understand how they thought they would be immune from the consequences of their behavior. Sooner or later, it always catches up to you.
Some years ago Warren Buffett described derivatives as Weapons of Mass Destruction. President Bush would have done our country a service if he had invaded Wall Street because of its financial WMDs. Instead, he invaded Iraq which did not have WMDs. The invasion of Iraq and the financial crisis has, so far, amounted to approximately a two trillion dollar price tag to U.S. citizens. A recently announced rescue plan will add an additional trillion dollars to U.S. taxpayers obligations. Thats three trillion dollars of taxpayers money being used to pay off the losses of unscrupulous and inept members of the U.S. financial community and an unjustified invasion of Iraq. It is simply another way for this administration to protect its friends and to allow them to again raid the Treasury of the American people.
President Bushs stewardship of our nation has allowed this to occur. It cannot be an accident. No one can be that inept.
An unfortunate result of President Bushs stewardship will be the abandonment of the U.S. Dollar as a reserve currency by the worlds Central Banks if the Bush administrations rescue plan, whatever it may turn out to be, does not work.

As an individual who initially developed his business acumen, skills and ethics in the 60's and '70's I have to comment on what I have observed in the last 12 or so years. In the 90's I watched the formation of illusory IT companies which were allowed to go public without any or minimal due diligence on the part of regulators, financial institutions or the public. This frenzy, fueled by investor and institutional greed, naturally ended up in a catastrophic situation when the falsity and illusory nature of the situation was realized. The Federal Reserve then brought interest rates to new low levels in an attempt to correct the fallout.
These low interest rates were then used by financial institutions and speculators as a vehicle to induce the public to part with or "invest" their money into another asset, real estate. To speed the process up new financing vehicles were created and due diligence on the part of intermediaries and financial institutions was completely abandoned. Again, this behavior was completely ignored by the regulators charged with oversight.
A significant portion of the suspect mortgages were packaged as financial instruments and sold, with deceptively inflated value, to institutional investors. The investors did not actively seek to determine an accurate valuation before they bought nor did the regulators become involved in oversight.
The present administration's economic plan primarily revolved around its constant message to citizens to go out and spend. The nation's people listened and dutifully responded. They bought real estate and anything else that was not nailed down as debt was easy to incur.
Again, the falsity and illusory nature of the mortgage market and other credit markets have been realized and the pendulum has swung the other way. Financial institutions, in an attempt to salvage their own skin, have been forced to limit, if not abandon, the issuance of credit. The consumer, who has become reliant upon excessive debt, now faces the reality of having to meet its obligations. A significant number cannot and seek assistance from the government.
The government has responded with a stimulus package that will be delivered late and in insufficient quantity to have any effect. The Federal Reserve, asleep at the switch as this calamity developed, now is betting an historic amount of its capacity to stem the deterioration of the credit market. The amount of funds they are creating will not be enough as the unregulated markets have become enormous in comparison.
I have found that a correction of any financial indiscretion will be as deep as the the indiscretion was high and will take as long as or longer then the duration of the indiscretion to correct. I hear daily that the financial markets only have a memory of "days" and will, once the present situation is addressed, return to "normal." I am not sure what "normal" is, but I am sure things will never be the same. A great many people and institutions, worldwide, have been effected by this meltdown. The Chinese, from personal experience, do not have short memories. Nor does the remainder of Asia. The Europeans and Arabs do not have short memories. They will not soon forget the damage these "creative" and deceptive financial instruments have produced nor forget were they came from.
The world has watched the U.S. government mismanage the world's largest economy. The world, a much different place then 12 years ago, has realized its own ability to move on without the support of the U.S. The rest of the world has decided to allow the U.S. to enter into and endure its self induced recession, as it cannot continue to support a government that continually mismanages its economy and which has created and relies upon a culture that is based solely on debt as its economic engine.