Morning Mumble / PM Bolt-On: Exclusively Volkswagen (VW) - Derivatives (one-way collateral agreements), cuts in production & bitter Lemons

Good Morning/Good Afternoon,

We shall limit today to VW. 

In a recent analyst note (Morgan Stanley 1 Oct 2015) on Volkswagen entitled ‘Balance sheet just about strong enough on our assumptions’ gained our attention.

We could raise issues on what the right numbers are for the costs that Volkswagen faces but there is perhaps an issue that analysts are missing. Our attention was drawn to an article by Nick Dunbar (Autogeddon registration may be required) (H/T Paul Murphy@FT for the link to the site) and a crucial couple of sentences (our emphasis):

‘When my contact told me that Volkswagen had forced its derivative dealers to accept one-way collateral agreements (so VW received collateral but didn’t have to post any in return), I saw this as prudential risk management. I didn’t imagine that banks might ever have a reason to worry about the credit risk of Volkswagen. I certainly didn’t think about VW as a source of risk to my health and that of millions of others. ‘

Let’s remind ourselves that companies can suffer a liquidity issue even whilst they are solvent. It is essentially possible to have a ‘billion dollars of assets on your balance sheet and still not have cash at hand to pay your staff.’

So how much derivatives exposure does Volkswagen have on its balance sheet? Turning to the 2014 Annual report we note that:

On page 266 of the 2014 Consolidated Financial Statements (link to page)  (Excel here):

NOTIONAL AMOUNT OF DERIVATIVES
		REMAINING TERM						TOTAL NOTIONAL AMOUNT		TOTAL NOTIONAL AMOUNT
€ million		under one year		within one to five years		over five years		Dec. 31, 2014		Dec. 31, 2013
Notional amount of hedging instruments used in cash flow hedges:
Interest rate swaps		1,228		3,926		–		5,154		6,127
Currency forwards		40,822		43,421		–		84,243		65,366
Currency options		7,222		9,024		–		16,246		10,365
Currency swaps		4,461		474		4		4,938		4,883
Cross-currency swaps		315		1,300		–		1,615		1,293
Commodity futures contracts		360		498		–		858		749
Notional amount of other derivatives:
Interest rate swaps		18,991		42,981		14,216		76,188		65,568
Interest rate option contracts		–		–		–		–		61
Currency forwards		5,437		1,336		1		6,774		7,077
Other currency options		45		91		–		137		42
Currency swaps		8,475		259		–		8,734		5,226
Cross-currency swaps		4,034		4,890		11		8,935		10,022
Commodity futures contracts		895		1,099		–		1,994		1,384

The sum of the numbers for 2014 was a mere €215,816 million (Dec 2014). Previous year was €178, 163 million (Dec 2013)

And immediately after the table the company states:

‘In addition to the derivatives used for hedging foreign currency, interest rate and price risk, the Group held options and other derivatives on equity instruments at the reporting date with a notional amount of €1.5 billion (previous year: €1.5 billion) whose remaining maturity is under one year.’

Elsewhere in the same report (p96) the group states ‘In all refinancing arrangements, interest rate and currency risk is generally excluded by entering into derivatives contracts at the same time.’ [Earlier on the same page it states that Volkswagen Group did refinancing of €50 billion in 2014.]

Page 262 contains the following table (Excel Download ) – note that this suggests a total derivative exposure of €113,094 million (but should we include the financial liabilities line?)…. 

MATURITY ANALYSIS OF UNDISCOUNTED CASH FLOWS FROM FINANCIAL INSTRUMENTS
		REMAINING CONTRACTUAL MATURITIES								REMAINING CONTRACTUAL MATURITIES
€ million		under one year		within one to five years		over five years		2014		under one year		within one to five years		over five years		2013
* Prior-year figures adjusted.
Put options and compensation rights granted to noncontrolling interest shareholders*		3,185		–		–		3,185		3,117		–		–		3,117
Financial liabilities		67,634		63,296		12,011		142,941		62,263		61,233		9,565		133,062
Trade payables		19,526		4		–		19,530		18,009		14		–		18,024
Other financial liabilities		4,652		1,470		94		6,216		3,455		1,047		91		4,593
Derivatives		61,623		51,265		207		113,094		54,325		46,626		1,158		102,109
		156,619		116,034		12,312		284,965		141,170		108,920		10,814		260,904

Its prudent to remind readers of the ECB turning down Volkswagen paper (e.g. ECB suspends purchase of loans backed by VW assets)

So our questions for Volkswagen 'dieselgate' watchers are:

1. What is the gross derivative exposure of VW Group (including the VW bank)? And what is the netted exposure by counterparty? (Remember that it is net exposure with each counterparty that will require collateral; not the overall net number).
2. How much cash and other financial assets on the VW balance sheet are actually ‘one-way collateral’ provided by third parties to VW for derivative arrangements?
3. If VW has to start posting collateral how much would that be? And what would be the impact on VW liquidity? Do they have the cash?
4. If the ECB will not accept VW paper as collateral, or if VW paper’s rating is downgraded by the credit agencies. What will VW provide as collateral; or alternatively what ‘haircuts’ will counterparties take on VW paper?
5. Which banks are the counterparties?

And after considering all the above does the following statement need to be reviewed: ‘Balance sheet just about strong enough’

With an element of prudence - VW have cut a shift at an engine plant line (albeit allegedly a special shift) and halted new employment within their finance division (Reuters). With the amendment to orders and sales being pushed back, its not unwise. 

With the class action suits quick to file its sensible to consider some of the complaints, such as those from HBSS Law. In the complaint for the class action (PDF). and remember it's a one sided version, so caveats apply.  It makes for an interesting read: 

Page 9, Item 24 Beginning in April 2015, Volkswagen issued VW Action Code 2306, which was a recall for CleanDiesel equipped vehicles. Volkswagen claimed that the recall was a “repair” and that it “improved” the engine management system. But many owners recorded a marked decrease in fuel efficiency and performance after the recall was completed. 

Notwithstanding the above, its prudent to consider VW vitamin intake. It would appear that VW may soon be squinting with the bitter taste of lemons (Consumer law consideration). In the fluid world of litigation and regulation, VW's outlook is looking decidedly pith like. Assuming the fuel efficiency and performance cannot be rectified what are the likely options for the consumer/VW? 

1. Refund?
2. Replacement vehicle?
3. On-going payments for the differential in cost of fuel and a one-off performance related payment?
4. Consumer rejection?
5. Wholesale scrapping? Assuming the Clean Air Act cannot be met?
6. Resale values - admittedly other vehicles have not been impacted by higher risks including air-bags and deaths. 

Atb Fraser

Further reading: The Bank of England gets economical with its derivatives - one-way collertalised agreements