Did Capital One Run Into A Commodity Prepay Wall?

Submitted by Jacques Simon,

In our last post we touted a too-big too fail return in the commodity-sector (a name nobody dare to pronounced. Today prices are down but market volatility is up (VaR is up, prices are down). Capital one, a FDIC-insured bank is allowed to skip a $1B margin call related to energy exposure of an undisclosed nature.

Zero Hedge suggested that the CFTC (Fed by extension) was quietly bailing out Capital One.

`As part of that business, Capital One enters into commodity swaps with its commercial oil and gas clients to help them mitigate the risk of energy price swings and the related borrowing risks. Typically, those trades do not bring Capital One’s swaps exposure anywhere close to the CFTC’s registration threshold, according to the CFTC’s Friday notice“.

But the 50% plunge in crude oil prices caused by the coronavirus and a flood of supply by top producers has seen its exposure on those swaps balloon, putting it on course to hit the threshold by the end of this month, the CFTC said.

As Reuters details, the threshold kicks in if a bank has $1 billion in daily average aggregate commodity swap exposure that is not secured by collateral, such as cash margin. Which, it appears, was the case with CapitalOne.

“Why was Capital one spec-ing long crude anyway” asked a trader?

He noted that they cannot really call it a “hedge“ as they are directly hurt by falling prices…

– Capital One is not registered as a swap dealer, nor is a major swap participant with the CFTC. -How in the course of normal lending can they be long the equivalent of 50,000 Nymex contracts.

“The cumulative exposure facing Capital One would be many billions, and could potentially render the bank insolvent“.

The Virginia-based lender with less than a 1.5% exposure to the U.S energy and 3-sig worst case scenario prints a $1B loss or (is it more a $2B). These inputs can be left for further scrutiny.

• Moreover raising the risk ceiling instead of triggering a margin call shows that FED-BIS enacted rules (VaR, minimum capital requirements) are malleable.

• In other words, the people in charge of stability are avoiding the institution realizing its loss and they are now MTM (at a loss) somewhere on the balance-sheet.

• Meanwhile, NYMEX Traders are frisked; initial margins are now at 50%…

• Minimum 1/4 of the liquidity has evaporated. Volatility is bigger, this is not too good for hedgers but some of it might just be self-inflicted we muse.

The Capital One pseudo-bailout remains the greatest mystery since the loss of the merchant card processing with Costco wholesale. Jokes aside, nobody really knows what is exactly their exposure to energy, only that they raised a white flag, “we surrender.”

What’s in the left tail, and why the the CFTC won’t let the CME liquidating the long positions (self-liquidate this risk)?

We muse that behind Capital One’s $1B m-t-m (soon to become loss) exposure there is a structured deal that was not recognized fully as a commodity exposure by the bank regulators. It was only uncovered in the recent times, when the energy prices drastically dropped. Risks can often be the biggest movers in these energy sell-offs. Jacques, S and Simondet, A. (2016)“Traders or Commodity Finance Banks”, explains the role of the commodity prepays, simplify their mechanics and link them to market risk.  We focused on the role of the traders, using the prepays to lend money.

Traders using prepays to offshore producers, lack a credit rating have utilized the commodity pre-financing to open their document letter of credits collateralized by the oil. A lot of these deals have squandered: with inadequate cash sufficient to preserve the prepaid transaction’s cash flows, the physical flows were brought to a halt.

By contrast in the U.S, the commodity prefinancing facilities are asset-based. The pre-pay would be linking the financial institutions with a credit rating to utilities purchasing natural gas with a gas supply agreements tied to a swap line.

In these gas supply agreements, the physicality is very minimum except for one thing; the take-or-pay(s) feature in the contracts. Take or pay is a type of provision in a purchase contract that guarantees the seller a minimum portion of the agreed on payment if the buyer does not follow through with actually buying the full commodity.

Pipelines cannot be easily stop so the deltas between the contract prices (and tied to the loans) require a cash settlement. Utilities are rate-based, and cannot pass their loss to their customers (fuel cost adjustments).

Likely that’s how Capital One would be long (namely on the Henry Hub) through the exposure of a debt laden utility ( both forced to hedge long NYMEX in any times), but rejecting gas (forced by capacity planning).

It suggests this interpretation on what those Commodity pre-pays are: margin calls funding on a long.

Capital One doesn’t have to be necessarily trading to lose; simply its gross nominal swap exposure can increase by the mere fact that it agreed to fund margin calls (it is part of the commodity pre-pays, the name of bank, as a guarantor, enables the utility to fund it’s gas purchases).

The CFTC knows that these funding agreements cannot be easily unwound so it prefers to wait for markets to return to a normal state below the bank $1B limit.